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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 Working Capital TerminologyTerminology
Working capital a firm’s investment in short-term assets
cash marketable securities inventory accounts receivable
Working Capital Working Capital TerminologyTerminology
Net working capital Current assets minus current liabilities the amount of current assets financed by
long-term liabilities
Working Capital Working Capital TerminologyTerminology
Working capital policy target levels for each current asset account how current assets will be financed
Working Capital Working Capital TerminologyTerminology
Working capital only includes current liabilities that are specifically used to finance current assets
Working Capital Working Capital TerminologyTerminology
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
Working Capital Working Capital TerminologyTerminology
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
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
360
sold goods ofcost Annual
Inventory
dayper sold
goods ofCost
Inventory
Inventory
⎟⎠
⎞⎜⎝
⎛=
⎟⎟⎠
⎞⎜⎜⎝
⎛=
The Cash Conversion CycleThe Cash Conversion Cycle
2. The receivables collection period average length of time required to convert
the firm’s receivables into cash also called days sales outstanding (DSO)
The Cash Conversion CycleThe Cash Conversion Cycle
The Cash Conversion CycleThe Cash Conversion Cycle
period collection
360
salescredit Annual
sReceivable
salescredit daily Average
sReceivable
sReceivable
⎟⎠
⎞⎜⎝
⎛==
The Cash Conversion CycleThe Cash Conversion Cycle
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
360
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
+ _
The Cash Conversion CycleThe Cash Conversion Cycle
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
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
Current AssetsCurrent Assets
Temporary current asset current assets that fluctuate with seasonal
or economic variations in a firm’s business
Current AssetsCurrent Assets
Temporary current asset
Temporary current assets
Current AssetsCurrent 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
Alternative Current Asset Alternative Current Asset Financing PoliciesFinancing Policies
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
Alternative Current Asset Alternative Current Asset Financing PoliciesFinancing Policies
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
Advantages and Disadvantages of Advantages and Disadvantages of Short-Term FinancingShort-Term Financing
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
Advantages and Disadvantages of Advantages and Disadvantages of Short-Term FinancingShort-Term Financing
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
Sources of Short-Term Sources of Short-Term FinancingFinancing
Short-term bank loans maturity typically 90 days promissory note specifies terms and
conditions amount, interest rate, repayment schedule,
collateral, and any other agreements
Sources of Short-Term Sources of Short-Term FinancingFinancing
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
Sources of Short-Term Sources of Short-Term FinancingFinancing
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
Sources of Short-Term Sources of Short-Term FinancingFinancing
Commercial paper unsecured short-term promissory notes
issued by large, financially sound firms to raise funds
Sources of Short-Term Sources of Short-Term FinancingFinancing
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
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
Cash Management Cash Management TechniquesTechniques
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
Cash Management Cash Management TechniquesTechniques
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
Cash Management Cash Management TechniquesTechniques
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
Cash Management Cash Management TechniquesTechniques
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
Cash Management Cash Management TechniquesTechniques
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
Cash Management Cash Management TechniquesTechniques
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
Cash Management Cash Management TechniquesTechniques
Disbursement control centralized disbursement system
more control, but can delay payments
Cash Management Cash Management TechniquesTechniques
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
Cash Management Cash Management TechniquesTechniques
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
Cash Management Cash Management TechniquesTechniques
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 ManagementCredit Management
Credit standards standards that indicate the minimum
financial strength a customer must have to be granted credit
Credit ManagementCredit Management
Terms of credit the payment conditions offered to credit
customers length of credit period and any cash
discounts offered
Credit ManagementCredit Management
Credit period the length of time for which credit is
granted after that time, the credit account is
considered delinquent
Credit ManagementCredit Management
Cash discount a reduction in the invoice price of goods
offered by the seller to encourage early payment
Credit ManagementCredit Management
Collection policy the procedures followed by a firm to collect
its accounts receivables
Credit ManagementCredit Management
Receivables monitoring the process of evaluating the credit policy
to determine if a shift in the customers’ payment patterns occurs
Credit ManagementCredit Management
Receivables monitoring 1. Days sales outstanding (DSO)
the average length of time required to collect accounts receivable
also called the average collection period
Credit ManagementCredit Management
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)
Credit ManagementCredit Management
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
Inventory ManagementInventory Management
Finished goods inventories that have completed the
production process and are ready for sale
Optimal inventory level sustain operations at the lowest possible
cost
Inventory ManagementInventory Management
Stockout when a firm runs out of inventory and
customers arrive to purchase the product
Inventory ManagementInventory Management
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
costs
( ) ⎟⎠
⎞⎜⎝
⎛×+⎟⎠
⎞⎜⎝
⎛××=
⎟⎟⎠
⎞⎜⎜⎝
⎛×⎟⎟⎠
⎞⎜⎜⎝
⎛+⎟⎟
⎠
⎞⎜⎜⎝
⎛×⎟⎟⎠
⎞⎜⎜⎝
⎛=
Q
T O
2
Q PPC
orders
ofNumber
order
perCost
inventory in
units Average
unitper
cost Carrying
Inventory ManagementInventory Management
Economic order quantity (EOQ) the optimal quantity that should be
ordered it is the quantity that will minimize the
total inventory costs
Inventory ManagementInventory Management
EOQ model formula for determining the order quantity
that will minimize total inventory costs
PPC
TO2 EOQ
×××
=
Inventory ManagementInventory Management
EOQ model extensions reorder point
the level of inventory at which an order should be placed
Inventory ManagementInventory Management
Inventory ManagementInventory Management
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
Inventory ManagementInventory Management
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 ManagementInventory Management
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 ManagementInventory Management
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 ManagementInventory Management
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 ManagementInventory Management
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
Multinational Working Multinational Working Capital ManagementCapital Management
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
Multinational Working Multinational Working Capital ManagementCapital Management
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