Working Capital Management Chapter 15. uWorking capital management F the management of short-term...

Working Capital Working Capital ManagementManagement

Chapter 15

Working capital management the management of short-term assets

(investments) and liabilities (financing sources)

Working Capital Working Capital TerminologyTerminology

Working capital a firm’s investment in short-term assets

cash marketable securities inventory accounts receivable

Net working capital Current assets minus current liabilities the amount of current assets financed by

long-term liabilities

Working capital policy target levels for each current asset account how current assets will be financed

Working capital only includes current liabilities that are specifically used to finance current assets

Working capital does not include current liabilities that may be due in the current period if they are due from long-term capital decisions, even though these must be considered when assessing the firm’s ability to meet its current obligations

Not working capital: current maturities of long-term debt financing associated with a construction

program that will be funded with the proceeds of a long-term security issue after the project is completed

use of short-term debt to finance fixed assets

Seasonal variations Business cycles Expansion requires more

working capital

The Requirement for The Requirement for External Working Capital External Working Capital

FinancingFinancing

The length of time from the payment for the purchase of raw materials to manufacture a product until the collection of accounts receivable associated with the sale of the product

The Cash Conversion CycleThe Cash Conversion Cycle

1. The inventory conversion period length of time required to convert

materials into finished goods and then to sell those goods

the amount of time the product remains in inventory in various stages of completion

1. The inventory conversion period

periodconversion

sold goods ofcost Annual

Inventory

dayper sold

goods ofCost

Inventory

⎟⎠

⎞⎜⎝

⎟⎟⎠

⎞⎜⎜⎝

2. The receivables collection period average length of time required to convert

the firm’s receivables into cash also called days sales outstanding (DSO)

period collection

salescredit Annual

sReceivable

salescredit daily Average

sReceivable

⎟⎠

⎞⎜⎝

3. The payables deferral period average length of time between the

purchase of raw materials and labor and the payment of cash for them

perioddeferral

sold goods ofCost

payable Accounts

dayper purchasesCredit

payable Accounts

Payables

⎟⎠

⎞⎜⎝

4. The cash conversion cycle net the three periods average length of time a dollar is tied up in

current assets

Cash conversion

cycle=

Inventory conversion

period

Receivables collection

period

Payables deferral period

Working Capital Investment Working Capital Investment and Financing Policiesand Financing Policies

Two basic questions: 1. What is the appropriate level for current

assets, both in total and by specific accounts?

2. How should current assets be financed?

Relaxed current asset investment policy relatively large amounts of cash and

marketable securities and inventories are carried and sales are stimulated by a liberal credit policy that results in a high level of receivables

Alternative Current Asset Alternative Current Asset Investment PoliciesInvestment Policies

Restricted current asset investment policy holdings of cash and marketable securities

and inventories are minimized

Alternative Current Asset Alternative Current Asset Investment PoliciesInvestment Policies

Moderate current asset investment policy a policy that is between the relaxed and

restricted policies

Current AssetsCurrent Assets

Permanent current asset current asset balances that do not change

due to seasonal or economic conditions these balances exist even at the trough of a

firm’s business cycle

Permanent current asset

Permanent current assets

Temporary current asset current assets that fluctuate with seasonal

or economic variations in a firm’s business

Temporary current asset

Temporary current assets

Alternative Current Asset Alternative Current Asset Financing PoliciesFinancing Policies

Maturity matching, or “self-liquidating” approach a financing policy that matches asset and

liability maturities this would be considered a moderate

current asset financing policy

Aggressive approach a policy where all of the fixed assets of a

firm are financed with long-term capital, but some of the firm’s permanent current assets are financed with short-term nonspontaneous sources of funds

Conservative approach a policy where all of the fixed assets, all of

the permanent current assets, and some of the temporary current assets of a firm are financed with long-term capital

Advantages and Disadvantages of Advantages and Disadvantages of Short-Term FinancingShort-Term Financing

Speed a short-term loan can be obtained much

faster than long-term credit

Flexibility for cyclical needs, avoid long-term debt

cost of issuing long-term debt is higher penalties for payoff prior to maturity restrictive covenants

Cost of long-term versus short-term debt yield curve is generally upward sloping short term interest rates are generally

lower than long-term rates

Risk of long-term versus short-term debt short-term debt subjects the firm to more

risk than long-term debt short-term interest expenses fluctuate firm may not be able to repay short-term

debt, thus might be forced into bankruptcy

Short-Term CreditShort-Term Credit

Any liability originally scheduled for repayment within one year

Sources of Short-Term Sources of Short-Term FinancingFinancing

Accruals continually recurring short-term liabilities liabilities such as wages and taxes that

increase spontaneously with operations

Accounts payable (trade credit) credit created when one firm buys on credit

from another firm

Short-term bank loans maturity typically 90 days promissory note specifies terms and

conditions amount, interest rate, repayment schedule,

collateral, and any other agreements

Short-term bank loans (cont.) compensating balances of 10 to 20 percent

may be required to be maintained in a checking account

line of credit may be arranged specified maximum amount of funds

available

Short-term bank loans (cont.) revolving credit agreement

line of credit where funds are committed, or guaranteed

commitment fee fee charged on the unused balance of a

revolving credit agreement

Commercial paper unsecured short-term promissory notes

issued by large, financially sound firms to raise funds

Secured loans loan backed by collateral for short-term loans, the collateral is often

either inventory or receivables factoring is the sale of receivables the lender may seek recourse (payment)

from the borrowing firm for uncollectible receivables used to secure a loan

Interest rateDollar cost of borrowingAmount of usable funds=

rate annual0.1

periodper

rateInterest 1 EAR

Effectivem

−⎥⎦

⎤⎢⎣

⎡⎟⎟⎠

⎞⎜⎜⎝

⎛+==

rate percentageim

periodper

rateInterest APR

AnnualSIMPLE=×⎟⎟

⎞⎜⎜⎝

Computing the Cost of Computing the Cost of Short-Term CreditShort-Term Credit

Discount interest loan a loan in which the interest, which is

calculated on the amount borrowed (principal), is paid at the beginning of the loan period

interest is paid in advance

Managing Cash and Managing Cash and Marketable SecuritiesMarketable Securities

Cash management goal of minimizing the amount of cash the

firm must hold for use in conducting its normal business activities, but sufficient to: pay suppliers maintain its credit rating meet unexpected cash needs

Firms Hold Cash For:Firms Hold Cash For:

1. Transaction balancecash balance necessary for day-to-day

operationsthe balance associated with routine payments

and collections

2. Compensating balancedeposit to meet bank loan requirements

Firms Hold Cash For:Firms Hold Cash For:3. Precautionary balance

cash balance held in reserve for unforeseen fluctuations in cash flows

access to line of credit can reduce the need for precautionary balances

4. Speculative balance cash balance that is held to enable the firm to

take advantage of any bargain purchases that might arise

easy access to borrowed funds can reduce the need for speculative balances

Cash Management Cash Management TechniquesTechniques

Cash forecasts predict the timing of cash flows

Synchronized cash flows cash inflows coincide with cash outflows,

permitting a firm to hold low transaction balances

Float the difference between the balance shown

in a checkbook and the balance on the bank’s records

Disbursement float the value of checks that have been written

and disbursed but that have not fully cleared through the banking system and thus have not been deducted from the account on which they were written

Collection float the amount of checks that have been

received and deposited but that have not yet been credited to the account in which they were deposited, because they have not cleared through the banking system

Net float the difference between disbursement float

and collection float the difference between the balance shown

in the checkbook and the balance shown on the bank’s books

Acceleration of receipts lockbox arrangement

reduce float by having payments sent to post office boxes located near customers– faster mail delivery

– faster check clearing within the same Federal Reserve district

Acceleration of receipts preauthorized debit system

allows a customer’s bank to periodically transfer funds from that customer’s account to a selling firm’s bank account for the payment of bills

Acceleration of receipts concentration banking

a technique used to move funds from many bank accounts to a more central cash pool in order to more effectively manage cash

Disbursement control centralized disbursement system

more control, but can delay payments

Disbursement control centralized disbursement system

more control, but can delay payments

zero-balance account (ZBA) special account used for disbursements

that has a balance of zero when there is no disbursement activity

Disbursement control controlled disbursement accounts (CDA)

– checking accounts in which funds are not deposited until checks are presented for payment, usually on a daily basis

Marketable securities securities that can be sold on short notice

without loss of principal or original investment substitute for cash balances temporary investment

– finance seasonal or cyclical operations

– amass funds to meet financial requirements in the near future

Credit ManagementCredit Management

Credit policy a set of decisions that include a firm’s

credit standards, credit terms, methods used to collect credit accounts, and credit monitoring procedures

Credit standards standards that indicate the minimum

financial strength a customer must have to be granted credit

Terms of credit the payment conditions offered to credit

customers length of credit period and any cash

discounts offered

Credit period the length of time for which credit is

granted after that time, the credit account is

considered delinquent

Cash discount a reduction in the invoice price of goods

offered by the seller to encourage early payment

Collection policy the procedures followed by a firm to collect

its accounts receivables

Receivables monitoring the process of evaluating the credit policy

to determine if a shift in the customers’ payment patterns occurs

Receivables monitoring 1. Days sales outstanding (DSO)

the average length of time required to collect accounts receivable

also called the average collection period

Receivables monitoring 2. Aging schedule

report showing how long accounts receivable have been outstanding

the report divides receivables into specified periods, which provides information about the proportion of receivables that is current and the proportion that is past due for given lengths of time

Aging ScheduleAging Schedule

Net AmountOutstanding Average Days

0-30 72,000$ 40% 1831-60 90,000 50% 5561-90 10,800 6% 77

Over 90 7,200 4% 97180,000$ 100%

DSO = 0.40 (18 days) + 0.50 (55 days) + 0.06 (77 days) + 0.04 (97 days)

= 43.2 days

Fraction ofTotal Receivables

Age of Account(in days)

Analyzing proposed changes in credit policy Use NPV analysis the same as for capital

budgeting analysis (Chapter 13) Timing of the cash inflows and cash

outflows is important to the analysis

Inventory ManagementInventory Management

Raw materials inventories purchased from suppliers that

will ultimately be transformed into finished goods

Work in-process inventory in various stages of completion

Finished goods inventories that have completed the

production process and are ready for sale

Optimal inventory level sustain operations at the lowest possible

Stockout when a firm runs out of inventory and

customers arrive to purchase the product

Inventory costs carrying costs

storage, insurance, use of funds, depreciation, etc…

ordering costs costs of placing an order the cost of each order is generally fixed

regardless of the average size of inventory

Total inventory costs (TIC)

Totalcarrying

costs +

Totalordering

( ) ⎟⎠

⎞⎜⎝

⎛×+⎟⎠

⎞⎜⎝

⎛××=

⎟⎟⎠

⎞⎜⎜⎝

⎛×⎟⎟⎠

⎞⎜⎜⎝

⎛+⎟⎟

⎞⎜⎜⎝

⎛×⎟⎟⎠

⎞⎜⎜⎝

orders

ofNumber

perCost

inventory in

units Average

unitper

cost Carrying

Economic order quantity (EOQ) the optimal quantity that should be

ordered it is the quantity that will minimize the

total inventory costs

EOQ model formula for determining the order quantity

that will minimize total inventory costs

TO2 EOQ

×××

EOQ model extensions reorder point

the level of inventory at which an order should be placed

EOQ model extensions reorder point

the level of inventory at which an order should be placed

safety stocks additional inventory carried to guard

against changes in sales rates or production/shipping delays

EOQ model extensions quantity discount

a discount from the purchase price offered for inventory ordered in large quantities

seasonal adjustments EOQ computed separately for each season

to account for sales variations

Inventory control systems red-line method

an inventory control procedure in which a red line is drawn around the inside of an inventory-stocked bin to indicate the reorder point level

Inventory control systems computerized inventory control system

a system of inventory control in which a computer is used to determine reorder points and to adjust inventory balances

Inventory control systems just-in-time system

a system of inventory control in which a manufacturer coordinates production with suppliers so that raw materials or components arrive just as they are needed in the production process

Inventory control systems out-sourcing

the practice of purchasing components rather than making them in-house

Multinational Working Multinational Working Capital ManagementCapital Management

Cash management speed up collections and slow down

disbursements shift cash as rapidly as possible to those

areas where it is needed put temporary cash balances to work

earning positive returns

Credit management credit policy is more important

risk of default political and legal collection constraints exchange rate changes between sale and

time receivable is collected

Inventory management concentrate inventory or distribute ?

costs versus distribution schedules

exchange rates affect inventory threat of expropriation tax effects

End of Chapter 15End of Chapter 15

Working Capital Management

Working Capital Management Chapter 15. uWorking capital management F the management of short-term...

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