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The Management of Working Capital
Chapter 15
© 2003 South-Western/Thomson Learning
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Basics
Working Capital Basics The assets/liabilities that are required to operate a
business on a day-to-day basis• Cash• Accounts Receivable• Inventory• Accounts Payable• Accruals
These assets/liabilities are short-term in nature and turn over regularly
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Working Capital, Funding Requirements, and the Current Accounts
Gross Working Capital (GWC) represents the investment in assets
Working Capital Requires Funds Maintaining a working capital balance
requires a permanent commitment of funds• Example: Your firm will always have a minimum
level of Inventory, Accounts Receivable, and Cash—this requires funding
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Working Capital, Funding Requirements,
and the Current Accounts
Spontaneous Financing Your firm will also always have a minimum
level of Accounts Payable—in effect, money you have borrowed
• Accounts Payable (and Accruals) are generated spontaneously
• Offset the funding required to support assets• Net working capital is Gross Working Capital – Current
Liabilities (or spontaneous financing)• Reflects the net amount of funds needed to support
routine operations
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Objective of Working Capital Management
To run the firm efficiently with as little money as possible tied up in Working Capital Involves trade-offs between easier operation
and the cost of carrying short-term assets• Benefit of low working capital
• Able to funnel money into accounts that generate a higher payoff
• Cost of low working capital• Risky
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Objective of Working Capital Management
InventoryHigh Levels Low Levels
Benefit: Happy customers Few production delays (always have needed parts
on hand)
Cost: Expensive High storage costs Risk of obsolescence
Cost: Shortages Dissatisfied customers
Benefit: Low storage costs Less risk of obsolescence
CashHigh Levels Low Levels
Benefit: Reduces risk
Cost: Increases financing costs
Benefit: Reduces financing costs
Cost: Increases risk
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Objective of Working Capital Management
Accounts ReceivableHigh Levels (favorable credit terms) Low Levels (unfavorable terms)
Benefit: Happy customers High sales
Cost: Expensive High collection costs Increases financing costs
Cost: Dissatisfied customers Lower Sales
Benefit: Less expensive
Payables and AccrualsHigh Levels Low Levels
Benefit: Reduces need for external finance--using a
spontaneous financing source
Cost: Unhappy suppliers
Benefit: Happy suppliers/employees
Cost: Not using a spontaneous
financing source
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Operations—Cash Conversion Cycle
A firm begins with cash which then “becomes” inventory and labor Which then becomes a product which is sold Eventually this will turn into cash again
The firm’s operating cycle is the time from the acquisition of inventory until cash is collected from product sales
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Figure 15.2: Time Line Representation of the Cash Conversion Cycle
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Permanent and Temporary Working Capital
Temporary working capital supports seasonal peaks in business
Working capital is permanent to the extent that it supports a constant of minimum level of sales
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Figure 15.3: Working Capital Needs of Different Firms
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Financing Net Working Capital
Since working capital is of a short-term nature, it should be financed with short-term sources This is known as the maturity-matching
principle Permanent working capital can be
financed either long or short term Temporary working capital needs should be
supported with short-term funds
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Short-Term vs. Long-Term Financing Long-term financing
Safe but expensive• Safe because you can raise lots of capital • Expensive because long-term rates are generally higher
than short-term rates
Short-term financing Cheap but risky
• Cheap because short-term rates are generally lower than long-term rates
• Risky because you are continually entering marketplace to borrow—borrower will face changing conditions
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Alternative Policies
The mix of short- or long-term working capital financing is a matter of policy Use of longer term funds reflects
conservatism
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Figure 15.4—Working Capital Financing Policies
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Working Capital Policy
Firm must set policy on following issues: How much working capital is used The extent to which working capital is
supported by short- vs. long-term financing The nature/source of any short-term
financing used How each component of working capital is
managed
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Sources of Short-term Financing
Spontaneous financing Accounts payable and accruals
Unsecured bank loans Commercial paper Secured loans
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Spontaneous Financing
Accruals Money you owe employees, for example, for work
performed but for which they have not yet been paid • Tend to be very short-term
Accounts payable (AKA trade credit) Money you owe suppliers for goods you bought on
credit• Credit Terms: Terms of trade specify when you are to
repay the debt• Example of terms of trade: 2/10, net/30
• You must pay the entire amount by 30 days• If you pay within 10 days, you will receive a 2% discount
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Spontaneous Financing
The prompt payment discount Passing up prompt payment discounts is
generally a very expensive source of financing
If the terms of trade are 2/10, net 30, and you elect to not pay by the 10th day, you are essentially paying 2% interest for 20 days’ use of money. There are 18.25 20-day periods in one year (365 days 20). We can convert the 2% foregone discount into an annual rate by multiplying 2% by 18.25 to obtain 36.5%. Thus, most prompt payment discounts are very attractive.
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Spontaneous Financing
Abuses of Trade Credit Terms Trade credit, while originally a service to a firm’s
customers, has become so commonplace it is now expected
• Companies offer it because they have to Stretching payables is a common abuse of trade
credit• Paying payables beyond the due date (AKA: leaning on
the table)• Slow paying companies receive poor credit ratings in credit
reports issued by credit agencies
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Unsecured Bank Loan
Represent the primary source of short-term loans for most companies
Promissory note (AKA Notes Payable) Note signed promising to repay the amount
borrowed plus interest• Bank usually credits the amount to borrower’s
checking account
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Unsecured Bank Loans
Line of credit Informal, non-binding agreement between bank and
firm that specifies the maximum amount firm can borrow over a specific time frame (usually a year)
• Borrower pays interest only on the amount borrowed
Revolving credit agreement Similar to a line of credit except bank guarantees the
availability of funds up to a maximum amount (effectively a binding agreement)
• Borrower pays a commitment fee on the unborrowed funds (whether they are used or not)
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Unsecured Bank Loans
A: Arcturus will have to pay both interest on the money borrowed and a commitment fee on the unused balance of the revolving agreement.
Monthly interest rate: (Prime + 2.5%) 12 = 1% Monthly commitment fee: 0.25% 12 = 0.0208% $4 million was outstanding for the entire month of June and $2 million was
outstanding for 15 days of June, so the total dollar interest charges are:Exa
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15$4,000,000 0.01 + $2,000,000 $50,000
30 The commitment fee must be paid on an average of $5,000,000 that was unused
during June, or:• $5,000,000 .000208 = $1,040• Total interest payment = $51,040
Q: The Arcturus Company has a $10 million revolving credit agreement with its bank at prime plus 2.5% based on a calendar year. Prior to the month of June, it had taken down $4 million that was outstanding for the entire month. On June 15, it took down another $2 million (assume the funds were available on June 16). Prime is 9.5% and the bank’s commitment fee is 0.25% annually. What bank charges will Arcturus incur for the month of June?
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Unsecured Bank Loans
Compensating balances A minimum amount by which the borrower’s
bank account cannot drop below (therefore it is unavailable for use)
• Increases the effective interest rate on a loan Typically between 10% and 20% of amounts
loaned
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Unsecured Bank Loans
Q: A firm borrows $100,000 subject to a 20% compensating balance. The firm will only receive $80,000 in usable funds and the remaining $20,000 must remain in the firm’s account. If the stated rate on the loan is 12%, what is the effective rate?
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A: The firm must pay the 12% on the entire $100,000 borrowed. Thus, the firm will pay $12,000 in interest for a year on $80,000 of usable funds. This translates to an effective annual rate of 15%, or $12,000 $80,000.
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Unsecured Bank Loans
Clean-Up Requirements Theoretically a firm can constantly roll-over
its short-term debt• Borrow on a new note to pay off an old note
• Risky for both the firm and the bank
Banks require that borrowers clean up short-term loans once a year
• Remain out of short-term debt for a certain time period
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Commercial Paper
Notes issued by large, financially-strong firms and sold to investors Basically a short-term corporate bond
• Unsecured (usually)• Buyers are usually other institutions (insurance companies,
mutual funds, banks, pension funds)• Maturity is less than 270 days• Considered a very safe investment, therefore pays a
relatively low interest rate• Rather than paying a coupon rate, interest is discounted• Commercial paper market is rigid and formal—no flexibility
in repayment terms
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Short-Term Credit Secured by Current Assets
Debt is secured by the current asset being financed
More popular in some industries than in others Common in seasonal businesses
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Short-Term Credit Secured by Current Assets Receivables Financing:
Accounts receivable represent money that is to be collected in the near future
Banks recognize that this money will be collected soon are are willing to lend money based on this soon-to-be-collected money
• Pledging AR: firm promises to use the money paid from the collected AR to pay off bank loan (but AR still belong to firm which still collects the accounts)
• If firm doesn’t repay, lender has recourse to borrower
• Factoring AR: firm sells AR to lender (at a severe discount) and the lending firm (factor) takes control of the accounts
• AR are now paid directly to lender
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Short-Term Credit Secured by Current Assets
Pledging Accounts Receivable Firm promises to use the money paid from the collected
accounts to pay off bank loan Accounts Receivable still belong to firm which still collects the
accounts• If firm doesn’t repay, lender has recourse to borrower
Lender can provide• General line of credit tied to all receivables
• Lender likely to advance at most 75% of the balance of accounts
• Specific line of credit tied to individual accounts receivable• Evaluates based on creditworthiness of account
• Lender likely to advance as much as 90% of the balance of accepted accounts
Expensive form of financing
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Short-Term Credit Secured by Current Assets—Example
Q: The Kilraine Quilt Company has an average receivables balance of $100,000 which turns over once every 45 days. It generally pledges all of its receivables to the Kirkpatrick County Cooperative Finance Company, which advances 75% of the total at 4% over prime plus a 1.5% administrative fee. If prime is 11%, what total interest rate is Kilraine effectively paying for its receivables financing?
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A: Since the finance company advances 75% of the receivables balance, the average loan amount is $75,000. Interest at 4% over prime is 15%. The firm pledges all of its receivables, thus $800,000 in new receivables are pledged each year ($100,000 x 360/45). The administrative fee of 1.5% is charged on this amount and is $12,000, or 1.5% x $800,000. This amounts to 16% of the average loan balance ($12,000 $75,000), thus the annual interest rate is 16% + 15%, or 31%.
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Short-Term Credit Secured by Current Assets Factoring Accounts Receivable
Firm sells Accounts Receivable to lender (at a severe discount) and the lending firm (factor) takes control of the accounts
• Accounts Receivable are now paid directly to lender Factor usually reviews accounts and only accepts
accounts it deems creditworthy Factors offer a wide range of services
• Perform credit checks on potential customers• Advance cash on accounts it accepts or remit cash after
collection• Collect cash from customers• Assume the bad-debt risk when customers don’t pay
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Short-Term Credit Secured by Current Assets Inventory Financing
Use a firm’s inventory as collateral for a short-term loan Popular but subject to a number of problems
• Lenders aren’t usually equipped to sell inventory• Specialized inventories and perishable goods are difficult to market
Types of methods used• Blanket liens—lender has a lien (claim) against all inventories of the
borrower but borrower remains in physical control of inventory• Chattel mortgage agreement—collateralized inventory is identified by
serial number and can’t be sold without lender’s permission (but borrower remains in physical control of inventory)
• Warehousing—collateralized inventory is removed from borrower’s premises and placed in a warehouse (borrower’s access controlled by third party)
• When inventory is sold a paper trail is generated and copy sent to lender (signaling lender to expect money from borrower soon)
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Cash Management
Why have cash on hand? Transactions demand: need money to pay bills
(employees, suppliers, utility/phone, etc.) Precautionary demand: to handle emergencies
(unforeseen expenses) Speculative demand: to take advantage of
unexpected opportunities (purchase of raw materials that are on sale)
Compensating balances
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Objective of Cash Management
Cash doesn’t earn a return Want to maintain liquidity without losing
too much in return Can place a portion of cash balance into
marketable securities (AKA: near cash or cash equivalents)
• Liquid investments that can be held instead of cash and earn a modest return
• Examples include Treasury bills, commercial paper
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Check Disbursement and Collection Procedures When you pay a bill, the process generally works like
this: You write a check and place it in the mail to payee (2-3 days of
mail float) Payee receives check and performs internal processing (1 day
of processing float) Payee deposits check in its own bank (1 day of processing
float) Payee’s bank sends check into Federal Reserve’s interbank
clearing system which processes the check (2 days of transit float)
As a payer, you want to extend this time period As a payee, you want to reduce this time period
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Figure 15.5: The Check-Clearing Process
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Accelerating Cash Receipts
Lock-box systems A post office box(es) located near customers in order to
shorten mail and processing float• Payee rents post office box(es) in strategic locations and hires a
bank to check the box and deposit payments received into account
• After deposits are made, copies are send to payee’s office and internal processing completed
Concentration Banking A single concentration bank manages balances in multiple
remote accounts, sweeping excess cash into a central location for investment in marketable securities
• Funds can be moved electronically or via a depository transfer check
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Figure 15.6: A Lock Box System in the Check-Clearing Process
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Lock-Box Example
Q: Kelso Systems Inc. operates primarily on the East Coast, but has a cluster of customers in California that remit about 5,000 checks a year. The average check is for $1,000. West Coast checks currently take an average of eight days from the time they are mailed by customers to clean into Kelso’s East Coast account. A California bank has offered Kelso a lock box system for $2,000 a year plus $0.20 per check. The system can be expected to reduce the clearing time to six days. Is the bank’s proposal a good deal for Kelso if it borrows at 12%?
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A: On average Kelso has $109,589 tied up in cash, or [(8 365) x $1,000 x 5,000] but the proposed lockbox system will reduce this to $82,192, or [(6 365) x $1,000 x 5,000]; thus, freeing up $27,397 of cash. Kelso will be able to borrow $27,397 less, thus saving $3,288 in interest [$27,397 x 0.12]. The system is expected to cost $3,000, or [$2,000 + ($0.20 x 5,000)]. Hence, the bank’s proposal is only marginally worth doing.
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Accelerating Cash Receipts
Wire Transfers Transferring money electronically
Preauthorized Checks A customer gives the payee signed check-
like documents in advance When payee ships product it deposits the
preauthorized check in its bank account• Eliminates mail float entirely• Requires certain amount of trust on part of payer
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Managing Cash Outflow
Control issues Decentralization of cash payments can lead to a large number
of cash balances around the country Zero balance accounts (ZBAs)
Empty disbursement accounts at a firm’s concentration bank for its various divisions
Divisions write checks on ZBAs that are funded automatically as checks are presented for payment
Solve the problem of decentralized cash accounts Remote disbursing
Using a bank in a remote location for your disbursement checking account
• Increases transit float
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Managing Accounts Receivable
Generally firms like as little money as possible tied up in receivables Reduces costs (firm has to borrow to support the
receivable level) Minimizes bad debt exposure
But, having good relationships with customers is important Increases Sales
Firm needs to strike a balance on these issues
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Managing Accounts Receivable
Objective: Maximize profitability (not Sales) Questions that need to be answered:
Credit Policy—what type of customer will you lend to? How financially viable must that customer be?
Terms of sale (Trade)—What terms will the firm offer to credit customers?
Collections Policy—How will the firm collect from those customers who don’t pay?
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Credit Policy
Must examine the creditworthiness of potential credit customers Credit report Customer’s financial statements Bank references Customer’s reputation among other vendors
Having a tight credit policy means you’ll probably have lower Sales Having a loose credit policy means you’ll probably have high bad
debts Conflicts often arise between the sales and credit departments
Sales department’s job is to generate sales and if salespeople are paid on commission it can get personal
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Terms of Sale
Credit sales are made according to specified terms of sales Example: 2/10, net 30 means the customer receives
a 2% discount if payment is made within 10 days, otherwise the entire amount is due by 30 days
Prompt payment discount is usually an effective tool for managing receivables
• Customers pay quickly to save money
Generally follow industry standard
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Collections Policy
Collections department’s function is to follow up on overdue receivables (called dunning) Mail a polite letter Follow up with additional dunning letters Phone calls Collection agency Lawsuit
A firm’s collection policy is the manner and aggressiveness with which a firm pursues payment from delinquent customers Being overly aggressive can damage customer relations
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Inventory Management
Mismanagement of inventory has the potential to ruin a company
Inventory is not the direct responsibility of the finance department Usually managed by a functional area such as
manufacturing or operations However, finance department has an oversight
responsibility for inventory management• Monitor level of lost of obsolete inventory• Supervise periodic physical inventories
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Benefits and Costs of Carrying Adequate Inventory
Benefits Reduces stockouts and backorders Makes operations run more smoothly, improves customer
relations and increases sales Costs
Interest on funds used to acquire inventory Storage and security Insurance Taxes Shrinkage Spoilage Breakage Obsolescence
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Inventory Control and Management
Inventory management refers to the overall way a firm controls inventory and its cost Define an acceptable level of operating
efficiency with regard to inventory Try to achieve that level with the minimum
inventory cost
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Economic Order Quantity (EOQ) Model EOQ model recognizes trade-offs
between carrying costs and ordering costs Carrying costs increase with the amount of
inventory held Ordering costs increase with the number of
orders placed EOQ minimizes the sum of ordering and
carrying costs
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Economic Order Quantity (EOQ) Model
The EOQ model is:1
22 Fixed Cost per Order Annual DemandEOQ =
Annual Carrying Cost per Unit
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Economic Order Quantity (EOQ) Model—Example
A: Since the unit carrying cost is 20% of the part’s price, the annual carrying cost per unit in dollars is $1, or 20% x $5. Substituting the known information into the EOQ equation, we have:
1
22 $45 1,000EOQ = = 300 units
$1
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The annual number of reorders is 1,000 300, or 3.33. Carrying costs are $150 a year, or (300 2) x $5 x 20%; and ordering costs are $45 x 3.333, or $150. The total inventory cost of the part is $300.
Q: The Galbraith Corp. buys a part that costs $5. The carrying cost of inventory is approximately 20% of the part’s dollar value per year. It costs $45 to place, process and receive an order. The firm uses 1,000 of the $5 parts per year. What ordering quantity minimizes inventory costs and how many orders will be placed each year if that order quantity is used? What inventory costs are incurred for the part with this ordering quantity?
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Safety Stocks, Reorder Points and Lead Times Safety stock provides a buffer against
unexpectedly rapid use or delayed delivery An additional supply of inventory that is carried at all
times to be used when normal working stocks run out Rarely advisable to carry so much safety stock that
stockouts never happen• Carrying costs would be excessive
Ordering lead time is the advance notice needed so that an order placed will arrive at the needed time Usually estimated by the item’s supplier
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Figure 15.9: Pattern of Inventory on Hand
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Tracking Inventories—The ABC System Some inventory items warrant a great deal of
attention Are very expensive Are critical to the firm’s processes or to those of
customers Some inventory items do not warrant a great deal
of attention Commonplace, easy to obtain
An ABC system segregates items by value and places tighter control on higher cost (value) pieces
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Just In Time (JIT) Inventory Systems Suppliers deliver goods to manufacturers just in
time (JIT) Theoretically eliminates the need for factory
inventory A late delivery can stop a factory’s entire
production line JIT works best with large manufacturers who
are powerful with respect to the supplier Supplier is willing to do almost anything to keep the
manufacturer’s business
