FIN 419 Week 3 Working Capital Management Example

Freeing $1.6 Million Without Borrowing It: Receivables From the Hospital, Linen in Circulation, an Early-Payment Discount and the Cash Conversion Cycle at Bluewater Linen

[Student Name]

University of Phoenix

FIN/419: Finance for Decision Making

Week 3 Assignment

[Instructor Name]

[Date]

Bluewater Linen Services and all figures are composites written for a model paper; working capital methods and research findings come from the sources listed.

Once Bluewater Linen Services signs the hospital contract analyzed in Weeks 1 and 2, its annual revenue will rise to about $24.2 million and its cost of services to about $16.9 million. The finance manager projected the balance sheet a year into the contract and found that receivables and linen in circulation would absorb far more cash than the $700,000 assumed in the capital budget. Growth that is profitable on paper can still drain a company's bank account if customers pay slowly and inventory piles up. This paper measures the working capital cycle and shows how to shorten it.

Measuring the Cycle

Days sales outstanding measure how long customers take to pay. With the hospital's 60-day payment practice, projected receivables of $3.85 million on revenue of $24.2 million give 58 days. Days of inventory measure how long goods sit before use. For a laundry, the largest inventory is linen in circulation, the sheets, gowns and towels owned by Bluewater and rented to customers. Projected linen and supplies of $3.5 million on cost of services of $16.9 million give about 76 days. Days payable outstanding measure how long Bluewater takes to pay suppliers: payables of $1.39 million give 30 days. The cash conversion cycle is 76 plus 58 minus 30, or about 104 days (Brigham & Ehrhardt, 2022).

Speeding Collections

The hospital system pays invoices in 60 days, but its contract allows 45 days after receipt of a correct invoice. Most delays come from invoices rejected for missing purchase order numbers or departments. Bluewater will move to electronic invoicing through the hospital's supplier portal, with each delivery ticket scanned and matched, and assign one billing specialist to the account to resolve disputes within a week. If collections reach 45 days, receivables fall to about $2.98 million, freeing about $870,000.

Reducing Linen in Circulation

Laundries typically hold several sets of each item for every set in use: one on the bed, one in the laundry, one on the shelf and extra to replace losses. Without tracking, Bluewater buys extra linen to cover items that disappear, and its par levels drift upward. Radio-frequency tags sewn into each item would let the company count linen at each customer site and in the plant, identify where losses occur and bill customers for items lost beyond an agreed rate. Laundries that use such tags report lower replacement purchases. Bluewater's target is to cut inventory days from 76 to 60, reducing linen and supplies to about $2.78 million and freeing about $720,000, after a tagging cost of about $180,000.

The Supplier's Discount

Bluewater's chemical vendor bills on 2/10 net 30 terms: a 2 percent discount for payment within 10 days, otherwise full payment in 30. Passing up the discount means paying 2 percent to keep $98 for 20 more days. Spread over a year, that 2/98 premium for 20 days of credit works out to about 37 percent. Bluewater's line of credit costs 8 percent. Taking the discount, even when it requires drawing on the line, saves about $20,000 a year on $1.3 million of chemical purchases, net of the interest on the line. Paying early shortens days payable slightly, which the paper accepts because the discount is worth far more than the float.

Payables Without Stretching

For other suppliers, Bluewater pays on the due date rather than early, using scheduled electronic payments. Stretching beyond due dates would extend the cycle but risk late fees, worse prices and damaged relationships, a false economy.

The New Cycle

With collections at 45 days, inventory at 60 days and payables at about 29 days after the discount, the cash conversion cycle falls from about 104 days to about 76 days. Together the receivable and inventory changes free about $1.59 million of cash, more than twice the working capital assumed in the capital budget.

What the Freed Cash Is Worth

At Bluewater's 9 percent cost of capital, $1.59 million no longer tied up in working capital saves about $143,000 a year, or allows the company to borrow that much less for the tunnel washer. Kieschnick et al. (2013) found that, for the average company in their sample, an additional dollar invested in net operating working capital was worth less to shareholders than an additional dollar held in cash, evidence that excess working capital destroys value.

Working Capital and Profitability

Deloof (2003) studied more than 1,000 large Belgian companies and reported a link between shorter receivable and inventory periods and higher gross operating income, suggesting that managers can raise profitability by shortening the cycle within reasonable limits. The causation can run both ways, since less profitable firms may pay suppliers more slowly, but the evidence supports managing each component actively.

A Line of Credit for What Remains

Even with improvements, Bluewater faces seasonal swings: hotel volume peaks in summer, and the hospital contract's startup will add costs before its first payments. The finance manager forecast a peak short-term need of about $900,000 in the first quarter of the contract. A $1.25 million revolving line at 8 percent, secured by receivables, covers that need with a margin. Long-term assets such as the tunnel washer will be financed with long-term debt, not the line, following the matching principle.

Policy Choice

Bluewater's approach is moderate: it holds enough linen to serve customers without shortages, extends normal terms and funds permanent working capital with long-term money while using the line for seasonal peaks. An aggressive policy with lower linen levels could save more cash but risks shortages that would breach the hospital contract's service standards.

Targets

The finance manager will report monthly on days sales outstanding, with a target of 45 for the hospital and 30 for other customers, inventory days with a target of 60, linen loss rates by customer and the cash conversion cycle, with a target under 80 days.

Conclusion

The hospital contract would stretch Bluewater's cash conversion cycle to about 104 days. Electronic invoicing, linen tracking and taking the supplier's discount shorten it to about 76 days and free about $1.59 million, worth about $143,000 a year. A modest line of credit covers seasonal needs, and monthly targets keep the gains in place.

References

Brigham, E. F., & Ehrhardt, M. C. (2022). Financial management: Theory and practice (17th ed.). Cengage.

Deloof, M. (2003). Does working capital management affect profitability of Belgian firms? Journal of Business Finance & Accounting, 30(3-4), 573-588. https://doi.org/10.1111/1468-5957.00008

Kieschnick, R., Laplante, M., & Moussawi, R. (2013). Working capital management and shareholders' wealth. Review of Finance, 17(5), 1827-1852. https://doi.org/10.1093/rof/rfs043