Working Capital Management

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Working Capital Management

• Chapter 15

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Working Capital Terminology

• Working capital management
• the management of short-term assets (investments)
  and liabilities (financing sources)

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Working Capital Terminology

• Working capital
• a firms investment in short-term assets
• cash
• marketable securities
• inventory
• accounts receivable

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Working Capital Terminology

• Net working capital
• Current assets minus current liabilities
• the amount of current assets financed by
  long-term liabilities

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Working Capital Terminology

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

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Working Capital Terminology

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

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Working Capital Terminology

• 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 firms ability to meet its current
  obligations

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Working Capital Terminology

• 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

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The Requirement for External Working Capital
Financing

• Seasonal variations
• Business cycles
• Expansion requires more working capital

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The Cash Conversion Cycle

• 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

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The 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

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The Cash Conversion Cycle

• 1. The inventory conversion period

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The Cash Conversion Cycle

• 2. The receivables collection period
• average length of time required to convert the
  firms receivables into cash
• also called days sales outstanding (DSO)

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The Cash Conversion Cycle
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The 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

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The Cash Conversion Cycle

• 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
_


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Working Capital Investment and 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?

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Alternative Current Asset Investment Policies

• 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

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Alternative Current Asset Investment Policies

• Restricted current asset investment policy
• holdings of cash and marketable securities and
  inventories are minimized

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Alternative Current Asset Investment Policies

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

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Current 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
  firms business cycle

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Current Assets

• Permanent current asset

Permanent current assets
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Current Assets

• Temporary current asset
• current assets that fluctuate with seasonal or
  economic variations in a firms business

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Current Assets

• Temporary current asset

Temporary current assets
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Alternative Current Asset Financing 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

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Alternative Current Asset Financing Policies

• Aggressive approach
• a policy where all of the fixed assets of a firm
  are financed with long-term capital, but some of
  the firms permanent current assets are financed
  with short-term nonspontaneous sources of funds

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Alternative Current Asset Financing 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

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Advantages and Disadvantages of Short-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

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Advantages and Disadvantages of Short-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

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Advantages and Disadvantages of Short-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

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Short-Term Credit

• Any liability originally scheduled for repayment
  within one year

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Sources of Short-Term Financing

• 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

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Sources of Short-Term Financing

• Short-term bank loans
• maturity typically 90 days
• promissory note specifies terms and conditions
• amount, interest rate, repayment schedule,
  collateral, and any other agreements

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Sources of Short-Term Financing

• 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

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Sources of Short-Term Financing

• 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

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Sources of Short-Term Financing

• Commercial paper
• unsecured short-term promissory notes issued by
  large, financially sound firms to raise funds

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Sources of Short-Term Financing

• 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

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Computing the Cost of Short-Term Credit

• Interest rate

Dollar cost of borrowing Amount of usable funds

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Computing the Cost of Short-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

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Managing Cash and Marketable 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

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Firms Hold Cash For

• 1. Transaction balance
• cash balance necessary for day-to-day operations
• the balance associated with routine payments and
  collections
• 2. Compensating balance
• deposit to meet bank loan requirements

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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

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Cash Management Techniques

• 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

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Cash Management Techniques

• Float
• the difference between the balance shown in a
  checkbook and the balance on the banks 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

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Cash Management Techniques

• 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

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Cash Management Techniques

• 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 banks
  books

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Cash Management Techniques

• 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

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Cash Management Techniques

• Acceleration of receipts
• preauthorized debit system
• allows a customers bank to periodically transfer
  funds from that customers account to a selling
  firms bank account for the payment of bills

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Cash Management Techniques

• 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

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Cash Management Techniques

• Disbursement control
• centralized disbursement system
• more control, but can delay payments

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Cash Management Techniques

• 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

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Cash Management Techniques

• 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

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Cash Management Techniques

• 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

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Credit Management

• Credit policy
• a set of decisions that include a firms credit
  standards, credit terms, methods used to collect
  credit accounts, and credit monitoring procedures

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Credit Management

• Credit standards
• standards that indicate the minimum financial
  strength a customer must have to be granted credit

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Credit Management

• Terms of credit
• the payment conditions offered to credit
  customers
• length of credit period and any cash discounts
  offered

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Credit Management

• Credit period
• the length of time for which credit is granted
• after that time, the credit account is considered
  delinquent

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Credit Management

• Cash discount
• a reduction in the invoice price of goods offered
  by the seller to encourage early payment

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Credit Management

• Collection policy
• the procedures followed by a firm to collect its
  accounts receivables

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Credit Management

• Receivables monitoring
• the process of evaluating the credit policy to
  determine if a shift in the customers payment
  patterns occurs

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Credit Management

• Receivables monitoring
• 1. Days sales outstanding (DSO)
• the average length of time required to collect
  accounts receivable
• also called the average collection period

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Credit 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

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Aging Schedule
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Credit 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

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Inventory Management

• Raw materials
• inventories purchased from suppliers that will
  ultimately be transformed into finished goods
• Work in-process
• inventory in various stages of completion

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Inventory 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

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Inventory Management

• Stockout
• when a firm runs out of inventory and customers
  arrive to purchase the product

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Inventory 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

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Inventory Management

• Total inventory costs (TIC)

Total carrying costs
Total ordering costs


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Inventory Management

• Economic order quantity (EOQ)
• the optimal quantity that should be ordered
• it is the quantity that will minimize the total
  inventory costs

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Inventory Management

• EOQ model
• formula for determining the order quantity that
  will minimize total inventory costs

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Inventory Management

• EOQ model extensions
• reorder point
• the level of inventory at which an order should
  be placed

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Inventory 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

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Inventory 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

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Inventory 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

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Inventory 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

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Inventory 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

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Inventory Management

• Inventory control systems
• out-sourcing
• the practice of purchasing components rather than
  making them in-house

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Multinational Working Capital 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

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Multinational Working Capital 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

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Multinational Working Capital Management

• Inventory management
• concentrate inventory or distribute ?
• costs versus distribution schedules
• exchange rates affect inventory
• threat of expropriation
• tax effects

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End of Chapter 15

• Working Capital Management