Working Capital Management

Working Capital Definitions and Policies Cash Management Inventory Management Credit Management Short-Term Financing
Trade Credit Bank Debt and Commercial Paper Secured Loans
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Basic Definitions

Gross working capital: Total current assets. Net working capital: Current assets - Current liabilities. Net operating working capital (NOWC): Operating CA Operating CL = (Cash + Inv. + A/R) (Accruals + A/P)
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Working capital management: Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable. Working capital policy:
The level of each current asset. How current assets are financed

Please meet Danny the Banker.

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Selected Ratios for SKI

Current Quick Debt/Assets Turnover of cash DSO (365-day basis) Inv. turnover F. A. turnover T. A. turnover Profit margin ROE Payables deferral

SKI 1.75x 0.83x 58.76% 16.67x 45.63 4.82x 11.35x 2.08x 2.07% 10.45% 30.00

Industry 2.25x 1.20x 50.00% 22.22x 32.00 7.00x 12.00x 3.00x 3.50% 21.00% 33.00

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How does SKIs working capital policy compare with the industry?

Working capital policy is reflected in a firms current ratio, quick ratio, turnover of cash and securities, inventory turnover, and DSO. These ratios indicate SKI has large amounts of working capital relative to its level of sales. Thus, SKI is following a relaxed policy.
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Alternative Current Asset Investment Policies

Current Assets ($) Relaxed Moderate Restricted

Sales ($)
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Is SKI inefficient or just conservative?

A relaxed policy may be appropriate if it reduces risk more than profitability. However, SKI is much less profitable than the average firm in the industry. This suggests that the company probably has excessive working capital.
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Cash Conversion Cycle

The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales:
Cash Inventory Receivables Payables conversion = conversion + collection - deferral . cycle period period period

What does the cash conversion cycle tell us about working capital management?

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Cash Conversion Cycle (Cont.)

Payables CCC = Days per year + Days sales deferral Inv. turnover outstanding period CCC = 365 + 45.6 30 4.82 CCC = 75.7 + 45.6 30 CCC = 91.3 days.

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Shortening the Cash Conversion Cycle

Reduce the Inventory Conversion Period by processing and selling goods more quickly Reduce the Receivables Collection Period by speeding up collections Lengthening the Payables Deferral Period by slowing down the firms own payments

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Cash Management: Cash doesnt earn interest, so why hold it?

Transactions: Must have some cash to pay current bills. Precaution: Safety stock. But lessened by credit line and marketable securities. Speculation: To take advantage of bargains, to take discounts, and so on. Reduced by credit line, marketable securities. Compensating balances: For loans and/or services provided. But, Fee-Based Systems are rapidly replacing compensating balances.
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What is the goal of cash management?

To reduce cash held to the minimum necessary to conduct business, yet maintain sufficient cash balances to: Make timely payments, Take trade discounts, Maintain firms credit rating, and Meet unexpected cash needs. However, since cash is a non-earning asset, the goal is to have not one dollar more than necessary. The Internet and telecommunications technology have dramatically affected cash management.
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What are precautionary and speculative balances?

Precautionary balances: Cash reserves for unforeseen inflow/outflow fluctuations. Speculative balances: Cash held for possible bargain purchases. Both are better met with borrowing capacity and/or liquid securities.
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Two Internet Addresses for Cash Management Techniques

Bank of America
http://www.bankofamerica.com/index.cfm?pa

ge=corp

Wachovia
http://www.wachovia.com/corp_inst

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Ways to Minimize Cash Holdings

Use lockboxes. Insist on wire transfers from customers. Synchronize inflows and outflows. Use a remote disbursement account.

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Increase forecast accuracy to reduce the need for a cash safety stock. Hold marketable securities instead of a cash safety stock. Negotiate a line of credit (also reduces need for a safety stock).

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How can a firm synchronize its cash flows and what good would this do?

Synchronize cash flows by arranging to bill customers and pay bills on regular billing cycles throughout the month. Synchronized cash flows reduce the need for cash balances and required bank loans, thus lower interest expense and boost profits.
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Define disbursement float, collections float, and net float.

Float: The difference between the balance shown in a firms checkbook and the balance on the banks books.
Red Book Balances

Disbursement float: Amount of funds tied up in checks the firm has written but which the bank has not yet deducted from its checking account balance. (More...) 18
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Collections float: The time it takes a firm to deposit checks it has received and for the bank to process them and credit the firms account with good funds.
Ledger Balances vs. Available Balances

Net float = positive disbursement float (Good) negative collections float (Bad)

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What is float and how can it be affected by cash management?

Float is the difference between the balance shown on the firms books and the balance on its banks records. If it takes SKI 1 day to deposit checks it receives and it takes its bank another day to clear those checks, SKI has 2 days of collections float.
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If it takes 6 days for the checks that SKI writes to clear and be deducted from SKIs account, SKI has 6 days of disbursement float. SKIs net float is the difference between the disbursement float and the collections float: Net float = 6 days - 2 days = 4 days. If SKI wrote and received $1 million of checks per day, it would be able to operate with $4 million less working capital than if it had zero net float.

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Components of Float
Mail-Time

Float Processing Float Clearing or Availability Float

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Techniques to Accelerate Inflows

Lock Box System - Post Office Box

Retail - Large Number of Consumers Wholesale - Typically Businesses

Automatic Debit - Automated Clearing House (ACH) Debits (Preauthorized)

e.g. Utilities debit users on a monthly basis

Payment by Wires Field System Concentration Banking

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Funds transfer tools between banks are used to accelerate inflows

Electronic (ACH) depository transfer. Uses data files to transfer funds. One Day Clearing. Wires. The concentration bank instructs the field bank to initiate a wire transfer.

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Techniques to Manage Disbursements

Payables Centralization Internet Disbursement Controlled Disbursement Accounts

Formerly Remote Disbursement

Zero-Balance Accounts
Money is moved from the Master Account to

the Subsidiary Account to zero it out. Breakdown by type of account and division

Payable Through Drafts

An order to pay, but not payable on demand
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Additional Disbursement Techniques

Automated Clearing House (ACH) Credits

e. g. Direct Deposit of Payroll GM automatically wires funds on 13th day to

regular suppliers; no float but GM gets discounts (2/10, n/30). With lower interest rates, emphasis has shifted to increased information benefits, ethical behavior, and decreased administrative costs.
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Account Analysis

Bank Provides Monthly: Summary of the Charges for Services Used Analysis of the Balances Maintained Credits Earned on the Balances

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Why would a firm hold lowyielding marketable securities?

Substitute for cash balances

Reduces risk and transactions costs Available for bargain purchases

Temporary investment resulting from:

Seasonal or cyclical operations. Need to meet some unknown financial

requirement. Firm has just sold long-term assets.

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What factors should a firm consider when building its marketable securities portfolio?

Default risk (safety first) Interest rate (price) risk Purchasing power (inflation) risk Liquidity and marketability risk Returns on securities (yield) Taxability When it might need funds Alternatively negotiate a line of credit
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Securities suitable to hold as liquid reserves:

U.S. Treasury bills Commercial paper Negotiable CDs Money market mutual funds Eurodollar market time deposits

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Securities not suitable to hold as liquid reserves:

Speculative derivatives U.S. Treasury notes, bonds Corporate bonds State and local government bonds Preferred stocks Common stocks
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Cash Budget: The Primary Cash Management Tool

Purpose: Uses forecasts of cash inflows, outflows, and ending cash balances to predict loan needs and funds available for temporary investment. Timing: Daily, weekly, or monthly, depending upon budgets purpose. Monthly for annual planning, daily for actual cash management.
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Data Required for Cash Budget

1. Sales forecast. 2. Information on collections delay. 3. Forecast of purchases and payment terms. 4. Forecast of cash expenses: wages, taxes, utilities, and so on. 5. Initial cash on hand. 6. Target cash balance. Finance 402 7. Interest rate on outstanding loans

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SKIs Cash Budget for January and February

Net Cash Inflows January February Collections $67,651.95 $62,755.40 Purchases 44,603.75 36,472.65 Wages 6,690.56 5,470.90 Rent 2,500.00 2,500.00 Total payments $53,794.31 $44,443.55 Net CF $13,857.64 $18,311.85
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Cash Budget (Continued)

January February

Cash at start if no borrowing $ 3,000.00 $16,857.64 Net CF (slide 34) 13,857.64 18,311.85 Cumulative cash $16,857.64 $35,169.49 Less: target cash 1,500.00 1,500.00 Surplus $15,357.64 $33,669.49
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Should depreciation be explicitly included in the cash budget?

No. Depreciation is a noncash charge. Only cash payments and receipts appear in the cash budget. However, depreciation does affect taxes, which do appear in the cash budget.

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What are some other potential cash inflows besides collections?

Proceeds from fixed asset sales. Proceeds from stock and bond sales. Interest earned. Court settlements.

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How can interest earned or paid on short-term securities or loans be incorporated in the cash budget?

Interest earned: Add line in the collections section. Interest paid: Add line in the payments section. Found as interest rate x surplus/loan line of cash budget for preceding month. Note: Interest on any other debt would need to be incorporated as well. Use Spreadsheet systems such as EXCEL. 38 Finance 402

How could bad debts be worked into the cash budget?

Collections would be reduced by the amount of bad debt losses. For example, if the firm had 3% bad debt losses, collections would total only 97% of sales. Lower collections would lead to lower surpluses and higher borrowing requirements.
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SKIs forecasted cash budget indicates that the companys cash holdings will exceed the targeted cash balance every month, except for October and November.

Cash budget indicates the company probably might be holding too much cash. SKI could improve its EVA by either investing its excess cash in more productive assets or by paying it out to the firms shareholders.
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What reasons might SKI have for maintaining a relatively high amount of cash?

If sales turn out to be considerably less than expected, SKI could face a cash shortfall. A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative. The cash may be there, in part, to fund a planned fixed asset acquisition.
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Inventory Management: Categories of Inventory Costs

Carrying Costs: Cost of Capital tied up, storage and handling costs, insurance, property taxes, depreciation, and obsolescence.
Ordering Costs: Cost of placing orders, shipping, and handling costs. Supply Chain Management. Costs of Running Short: Loss of sales (from stockouts), loss of customer goodwill, and the disruption of production schedules.
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Effect of Inventory Size on Costs

Reducing the average amount of inventory held generally: Reduces carrying costs.

Increases ordering costs.

Increases probability of a stockout. Air freight was stopped for a week or so after September 11, 2001 Effects of hurricanes Finance 402
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Is SKI holding too much inventory?

SKIs inventory turnover (4.82) is considerably lower than the industry average (7.00). The firm is carrying a lot of inventory per dollar of sales. By holding excessive inventory, the firm is increasing its operating costs which reduces its NOPAT. Moreover, the excess inventory must be financed, so EVA is further lowered.

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If SKI reduces its inventory, without adversely affecting sales, what effect will this have on its cash position?

Short run: Cash will increase as inventory purchases decline. Long run: Company is likely to then take steps to reduce its cash holdings.

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Inventory Control Systems

Computerized Inventory Control Systems Supply Chain Management Just-In-Time (JIT) Systems Out-Sourcing Relationship between production scheduling and inventory levels This topic will be discussed further in Chapter 22.
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Accounts Receivable Management: Do SKIs customers pay more or less promptly than those of its competitors?
SKIs days sales outstanding (DSO) of 45.6 days is well above the industry average (32 days). SKIs customers apparently are paying less promptly. SKI should consider tightening its credit policy to reduce its DSO. 47

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Does SKI face any risk if it tightens its credit policy?

YES! A tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

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If SKI succeeds in reducing DSO without adversely affecting sales, what effect would this have on its cash position?
Short

run: if customers pay sooner, this increases cash holdings. Long run: over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase EVA.
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Credit Management

What terms of credit should the firm use? To whom should the firm grant credit?

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Amount of Credit Outstanding

The

amount of Credit Outstanding at any given time is dependent on two factors:

The volume of credit sales The average length of time between sales

and collections

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Monitoring Accounts Receivable

Days Sales Outstanding (DSO) or Average Collection Period (ACP) Aging Schedules

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Monitoring A/R and Seasonal Fluctuations

A seasonal increase in sales will increase the numerator more than the denominator, and will raise the DSO
Thus the DSO will look worse, but nothing has

happened

A seasonal increase in sales will increase the amount of A/R that are less than 30 days outstanding
The Aging Schedule will look better, but nothing has

happened

This topic will also be covered in Chapter 21.

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What five variables make up a firms credit policy?

Cash

discounts Credit period Credit standards Collection policy Size of credit line

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Elements of Credit Policy

Cash

Discounts: Lowers price. Attracts new customers and reduces DSO. Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales.
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Credit Standards: Tighter standards reduce bad debt losses, but may reduce sales. Fewer bad debts reduces DSO. Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships. Credit Line: The firm determines the size of the line of credit extended to a particular customer.
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Credit Terms

Discounts
For example, 2/10...

Credit Period
For example, n/30; or n/30 EOM Seasonal Dating, for example n/30, July 1st

Promotes Sales Reduces Inventory Smoothes Production Transfers Risk of Obsolescence Might offer Anticipation Discount Covered more fully in Chapter 21

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The six Cs of Credit Extension and Standards

Character Capital Collateral Capacity Conditions Country

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Credit Standards

Might use Dun & Bradstreet ratings:

1 = excellent 2 = good 3 = fair 4 = limited

Credit Scoring Systems

Multiple Discriminant Analysis (MDA)

Judgmental Scoring Systems

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Sources of Credit Information

The Sellers Prior Experience Credit Associations

Credit Interchange

Credit Rating Agencies

Dun & Bradstreet Equifax Experian Trans Union Fair Isaac

Analysis of Customers Financial Statements Customer Visit

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Credit Investigation
Proceed Sequentially in examining credit worthiness and making the credit decision.
Begin with the least costly and time consuming method. Then ask, is it worth it to continue further? Use of computers in Relational Data Bases and Data Warehouses.
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Collection Policy

Procedures the firm uses to collect past-due accounts

Charges for late payments

Letters
Phone calls Legal action

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If a firm has no bad debts, does that mean that the credit manager is doing a good job?

No! The credit policy may be too restrictive, and the firm may be losing sales, profits and stockholder wealth.
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Size of Credit Line

A key option is that the seller may grant a limited amount of credit, called a credit line or credit limit. Possible reasons for this limit:
Limits are not as enforced as rejection Increases in production costs Funds Constraints

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Working Capital Financing Policies

Moderate: matches the maturity of the assets with the maturity of the financing.
Self-liquidating approach

Aggressive: uses short-term (temporary) capital to finance some permanent assets. Conservative: uses long-term (permanent) capital to finance some temporary assets.

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The choice of working capital financing policy is a classic risk/return tradeoff. The aggressive policy promises the highest return but carries the greatest risk. The conservative policy has the least risk but also the lowest expected return. The moderate (maturity matching) policy falls between the two extremes.

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Moderate Financing Policy

$

Temp. NOWC

S-T Debt (Temporary) L-T Fin: Stock, Bonds, Spon. C.L. (Permanent) Years

Perm NOWC

Fixed Assets

What are permanent current assets?

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Relatively Aggressive Financing Policy

$ Temp. NOWC S-T (temporary) Debt Perm NOWC L-T Fin: Stock, Bonds, Spon. C.L.

Fixed Assets Years

More aggressive the lower the dashed line.

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Conservative Financing Policy

$
Marketable Securities S-T Financing Requirements

Perm NOWC

Fixed Assets

L-T Fin: Stock, Bonds, Spon. C.L.

Years
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What Is Short-term Credit? What Are the Major Sources?

Short-term credit: Debt requiring repayment within one year. Major sources:
Accruals

Accounts payable (trade credit)

Commercial paper Bank loans

Unsecured Loans Secured Loans - Accounts Receivable Secured Loans - Inventory

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Choosing a Source of Short Term Financing

Cost
Annual Percentage Rate Effective Annual Rate (Compounded Rate)

Impact on credit rating Reliability Restrictions

Degree to which assets are encumbered

Flexibility Availability
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What are the advantages of short-term debt vs. long-term debt?

Lower

cost-- yield curve usually slopes upward. Can get funds relatively quickly with lower flotation costs. Repayment penalties can be expensive for long-term debt Long-term debt typically contain more restrictive covenants.
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What are the disadvantages of short-term debt vs. long-term debt?

Short-term debt is riskier than long-term debt for the borrower.

The required repayment comes quicker.
May have trouble rolling debt over.

Short-term rates may rise

With long-term debt, interest rates will be

relatively stable over time.

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Is There a Cost to Accruals, and Do Firms Have Much Control Over Them?
Accruals increase automatically as a firms operations expand. Accruals are free in the sense that no explicit interest is charged. A firm has little control over the level of accruals, They are influenced more by industry custom, economic factors, and tax laws than by managerial actions. Spontaneous source of funds.

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What Is Trade Credit?

Trade credit is credit furnished by a firms suppliers. Trade credit is often the largest source of short-term credit for small firms. Trade credit is spontaneous and relatively easy to get, but the cost can be high.

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Advantages of Trade Credit

Flexible in amount Informal - no restrictions placed on the user Very convenient and easy to obtain Easy for the small firm to obtain

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Disadvantages of Trade Credit

Limited in amount Not a direct source to pay other bills Can affect credit rating Stretching accounts payable

Pay beyond the due date -

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SKI buys $506,985 net, on terms of 1/10, net 30, and pays on Day 40. How much free and costly trade credit, and whats the cost of costly trade credit?
Net daily purchases = $506,985/365 = $1,389. Annual gross purch. = $506,985/(1-0.01) =$512,106
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Gross/Net Breakdown

Company buys goods worth $506,985. Thats the cash price. They must pay $5,121 more if they dont take discounts. Think of the extra $5,121 as a financing cost similar to the interest on a loan. Want to compare that cost with the cost of a bank loan.
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Payables level if take discount: Payables = $1,389(10) = $13,890. Payables level if dont take discount: Payables = $1,389(40) = $55,560. Credit Breakdown: Total trade credit Free trade credit Costly trade credit
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= $55,560 = 13,890 = $41,670

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Nominal [Annual Percentage Rate (APR)] Cost of Costly Trade Credit

Firm loses 0.01($512,106) = $5,121 of discounts to obtain $41,670 in extra trade credit, so $5,121 rNom = $41,670 = 0.1229 = 12.29%.
But the $5,121 is paid all during the year, not at year-end, so Effective Annual Rate (EAR) rate is higher.
Record purchases on books as net purchases and 81 Finance 402 expense. discounts lost as an interest

Nominal (APR) Cost Formula, 1/10, net 40

rNom Discount % 365 days 1 Discount % Days Discount taken period 1 365 0.0101 12.1667 99 30 0.1229 12.29%.
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Pays 1.01% 12.167 times per year.

Effective Annual Rate (EAR), 1/10, net 40

Periodic rate = 0.01/0.99 = 1.01%. Periods/year = 365/(40 10) = 12.1667.

EAR = (1 + Periodic rate)n 1.0 = (1.0101)12.1667 1.0 = 13.01%.

Normally, it is cheaper to borrow the money from the bank and take discounts.
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Stretching Accounts Payable

Effect on credit rating - reputation as a slow payer Suppliers start requiring the firm to pay cash Late payment penalties

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Choosing a Bank
(Negotiated Source of Funds)

Willingness to assume risks Advise and counsel Loyalty to customers Maximum loan size Specialization Merchant Banking capabilities Other Services
Technology and telecommunications

Discussed in Chapter 21
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Bank Short Term Credit Forms

A

Line of Credit is a informal or formal understanding between the bank and the borrower indicating the maximum credit the bank will extend to the borrower.
One year or less Can be tied to LIBOR, Prime, Fed Funds Rate Often includes a cleanup provision
more
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Bank Short Term Credit Forms - continued

A Revolving Credit Agreement (Revolver) is a formal (legal) arrangement often used by large firms.
Can be more than one year , e. g. three years.
Usually calls for a commitment fee.

We will calculate the APR and EAR of bank loans in Chapter 21.
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Promissory Note

Negotiated source of funds Amount borrowed Percentage interest rate Repayment schedule
Series of Installments or Lump sum

Collateral specified as security Other terms and conditions

Typically 90 days and renewable

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Commercial Paper

A type of unsecured (normally), discounted, large denomination, promissory note, typically issued by large, strong firms (Net Worth>$100 million)
Sold to other business firms, money market funds, pension

funds, foundations, wealthy individuals, and insurance companies Maturities vary from one to nine months Can be asset-backed

Direct Placement vs. Dealer Placement Rated by Moodys, Standard & Poors, Fitchs
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Advantages of Commercial Paper

Cheaper, as the effective interest rate is typically less than the prime rate Size of market available is large Medium-sized firms may use bank guarantees and enter the market

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Disadvantages of Commercial Paper

Impersonal market Dealers prefer to handle the paper of firms where borrowings are $10 million or more Cant pay off prior to maturity 270 day maximum maturity 100% credit line needed to back up commercial paper in most cases Amount of funds in market may be limited
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Commercial Paper (CP)

Short term notes issued by large, strong companies. SKI couldnt issue CP--its too small. CP trades in the market at rates just above Tbill rate. CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes.
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What Is a Secured Loan?

In a secured loan, the borrower pledges assets as collateral for the loan. For short-term loans, the most commonly pledged assets are receivables and inventories. Securities are great collateral, but firms needing short-term loans generally do not have securities on hand.
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Important Legal Forms

UCC form-1: filed with Secretary of State to establish collateral claim. Prospective lenders will do a claims search, and wont make the loan if a prior UCC-1 has been filed. Security Agreement: standard form under the Uniform Commercial Code. Specifies when lender can claim collateral if default occurs.
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What Are the Differences Between Pledging and Factoring Receivables?

If receivables are pledged, the lender has recourse against both the original buyer of the goods and the borrower.
Normally non-notification for remittances

When receivables are factored, they are generally sold, and the lender has no recourse to the borrower.
Normally notification for remittances
Credit Cards are an example
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Aspects of Factoring

Maturity Factoring
Continuous process Funds are received at maturity Factor performs: Credit Checking and Investigation Collections Absorbs Bad Debt Expenses (Risk Bearing)

Discount Factoring
Additional function of lending is performed as

firm receives the funds in advance Flexible financing

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Drawbacks of Factoring

Non-interest costs - e.g. 1 % to 3% of the amount of the invoice accepted by Factor Constraints imposed on the seller Administrative costs Other creditors are placed at a disadvantage because A/R is used as collateral Interest costs if Discount Factoring is used

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Shakespeare and Factoring

King Henry IV The Merchant of Venice The Comedy of Errors Othello

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What Are the Three Forms of Inventory Financing?

Blanket lien: Gives the lender a lien against all of the borrowers inventory. Trust receipt: An instrument that acknowledges goods held in trust for the lender. A specific registration number is needed. Automobile dealer financing is a widely used example. Warehouse receipt: Uses inventory as security.
Form used depends upon type of inventory and situation at hand. Provides flexible financing. 99 Finance 402

Public Vs. Field Warehouse

Public Warehouse is an independent third party engaged in the business of storing goods. Field Warehouse may be established at the borrowers place of business
Physical Control of inventory - e.g. canned

peaches Public notification Supervision by custodian of Field Warehouse company

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Inventory Financing Costs

Minimum of $5,000 plus 1 to 2 % of amount of credit extended Interest charges typically set at 2% to 3% above prime But, necessity for warehouse control may improve warehouse practices

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What Is securitization and Why Is It Used?

Pension funds and mutual funds have money to lend, but they typically dont make short term loans. Companies like GM and Ford can bundle up their receivables, use them as security for a low-risk bond, and sell the bond to pension funds, etc. This is securitization, and its purpose is to get funds at a low cost. However, the risk is substantial for the final investor.
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Sequential Method for Managing Current Debt

List all the potential sources from the lowest effective rate to the highest Start with the cheapest and proceed sequentially (typically) to the more expensive source

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Working Capital Management

Working Capital Policies Cash Management

Short-Term Investments

Inventory Management Accounts Receivable Management Short-Term Financing

Trade Credit Bank Loans Commercial Paper

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THANK YOU

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