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FMGT 3510 Chapter 17 Page 1

Working Capital Management & Short-Term Financing

(Chapter 17)
Working capital management involves two questions:
o What is the right amount of operating working capital? ==> WC= CA- CL
Examples of working capital management decisions:
o Amount of short term debt
o Amount of cash on hand
o How soon to pay payables Defer as long as possible without
jeopardizing your discounts and credit rating
o Credit terms for your customers
Some definitions:
o Working Capital: current assets (cash, A/R, inventory)
o Net Working Capital: current assets less current liabilities
o Net Operating Working Capital (NOWC):
NOWC = Operating CA-Operating CL (see Ch 2)
FMGT 3510 Chapter 17 Page 2

The Cash Conversion Cycle CCC

Firms follow a cycle in which they:
o Purchase inventory
o Sell finished goods
o Pay payables and Collect receivables
We measure this Cash Conversion Cycle (CCC) in days:
o CCC= Inventory conversion period + receivables collection period -
payable deferral period.
FMGT 3510 Chapter 17 Page 3

The Inventory Conversion Period (ICP): the average time required to convert
materials into finished goods and then sell them

ICP=Inventory/Sales (or COGS) per day

The Receivables Collection Period, also known as the Days Sales Outstanding
(DSO): the average time required to convert A/R into cash.

DSO=Accounts Receivable/credit sales per day

The Payables Deferral Period (PDP): the average time period between the
purchase of materials and the cash payment for them.

PDP =Accounts Payable/COGS per day

The Cash Conversion Cycle CCC:


FMGT 3510 Chapter 17 Page 4

Example 1: Calculate the CCC using average balances for receivables,

inventory and payables.

Item End of year Average
of year
Accounts $515,068 $800,000 $657,534
Inventory $1,500,000 $2,500,000 $2,000,000
Accounts $415,068 $910,000 $662,534

Sales (all credit) were $10 million and cost of goods sold were $8 million
Determine the CCC.
ICP= Inventory Conversion Period = Inventory / Sales
2,000,000/(10,000,000/365) = 73 days using SALES (as the text does)
If we use COGS, ICP = 2,000,000 /( 8,000,000 / 365) and get ICP=91 days
DSO= Days Sales Outstanding = Accounts Receivable / Credit Sales per day
657,534/(10,000,000/365) = 24 days
PDP= Payables Deferral Period = Accounts Payable / COGS per day
662,534/(8,000,000/365) =30 days
CCC= cash conversion cycle 73+24-30.2=66.8 days On average, 2 months
FMGT 3510 Chapter 17 Page 5

Example 2: Shortening the CCC the better, the shorter

If the ICP (using sales) is cut to 65 days and the DSO to 23 days and the PDP
increases to 31 days what is the new CCC? By how much is free cash flow
increased in the year of these changes? In the next year if sales increase by
New CCC=65+23-31=57 days
Inventory drops by 8 days:(10,000,000/365) x 8 = $219,178
A/R drops by 1 day: 10,000,000/365 X 1= $27,397
A/P increase by 1 day: (8,000,000/365) x 1 = $21,918
improvement in FCF in
year of change
FMGT 3510 Chapter 17 Page 6

Impact of shorter CCC if Sales

increase by 10%
10% Sales increase
Original CCC Improved CCC
Sales $11,000,000 $11,000,000 10% increase in sales
COGS $8,800,000 $8,800,000 10% increase in COGS
ICP 73.0 65
DSO 24.0 23
PDP 30.2 31
CCC 66.8 57

Inventory $2,200,000 $1,958,904 IHP x Sales per day

A/R $723,288 $693,151 DSO x Sales per day
A/P -$728,110 -$747,397 PDP x COGS per day
NOWC $2,195,178 $1,904,658 Inv + A/R-A/P

Required increase in NOWC with 10% sales growth

NOWC after NOWC before
10% increase increase
CCC $2,195,178 - $2,000,000 = $195,178
CCC $1,904,658 - $1,731,507 = $173,151
Annual increase in FCF = $22,027
FMGT 3510 Chapter 17 Page 7
FMGT 3510 Chapter 17 Page 8

Net Operating Working Capital Policies

A businesss NOWC policy determines the amount of NOWC used in
There are three general types of policy:
o Relaxed policy: large holding of Current Assets
such as large amounts of cash, inventory and A/R and minimal levels
of A/P and accruals, for a given level of operations.
o Restricted policy: low amounts of Current Assets and high levels of
A/P and accruals, for a given level of operations.
o Moderate policy: matching of maturities of assets and liabilities
How do you decide what policy to use? You must balance the trade-offs:
o A relaxed policy means that you are less likely to run out of inventory
or lose sales because of tight credit policies. However you will need to
finance a large amount of NOWC, which will lower your ROI. Low risk,
low return.
o A restricted policy means higher risk of stock outs and lost sales but
higher ROI. You will need to finance a lower amount of NOWC. Higher
risk, higher returns.
What sort of business should have a relaxed policy? A restricted policy?
FMGT 3510 Chapter 17 Page 9

Short Term Financing Policies

Once we have decided on the amount of NOWC we must then decide
how to finance it.
We must first distinguish between temporary NOWC and permanent
See Figure 17-2 page 503.
What businesses have a high level of temporary NOWC?
o Ski manufacturer
o Movie theatres
Who might have mostly permanent NOWC?
o Supermarkets
Does the level of permanent NOWC stay the same?

There are three general approaches to financing permanent and

temporary NOWC:
o Maturity matching (or self-liquidating): Moderate 1st chart on page 503
Permanent NOWC financed with long term debt and/or equity
Temporary NOWC financed with short term debt
Match asset term and financing term
FMGT 3510 Chapter 17 Page 10

Would you use a 1-year loan to finance a mine with a 30-year

Should you finance 50 days of inventory with a 5-year loan?
o Aggressive policy middle graph
Use short term debt to finance some or all of your temporary
NOWC and some or all of your permanent NOWC.
Might save interest expense because short term interest rates
are usually lower then long term rates.
Risk that your short term loan may not be renewed: rollover risk
o Conservative policy bottom graph
Use long term debt to finance all of your permanent NOWC and
some or all of your temporary NOWC.
Rollover risk is reduced but likely face higher interest costs.
Need to invest excess cash when temporary NOWC is at low
FMGT 3510 Chapter 17 Page 11

Jan Feb Mar Apr
Temp NOWC - 30,000 20,000 -
Perm NOWC 50,000 50,000 50,000 50,000
50,000 80,000 70,000 50,000
Short Term Debt - - - -
Long Term Debt 80,000 80,000 80,000 80,000

Cash Surplus/(Deficit) 30,000 - 10,000 30,000

Jan Feb Mar Apr
Temp NOWC - 30,000 20,000 -
Perm NOWC 50,000 50,000 50,000 50,000
50,000 80,000 70,000 50,000

Short Term Debt 20,000 50,000 40,000 20,000

Long Term Debt 30,000 30,000 30,000 30,000

Cash Surplus/(Deficit) - - - -

What would a matching policy look like?

FMGT 3510 Chapter 17 Page 12

Review of Cash Budgeting

The cash budget is the primary tool for short-term financial planning. It helps
to identify short-term financial needs (i.e. borrowing) and opportunities.
Cash inflows:
o Collection of cash sales and accounts receivable
o Sale of capital assets
o Issuance of additional debt (bonds) and equity (common & pref shares)
Cash outflows
o Payment of accounts payable
o Payment of wages, taxes and other cash expenses
o Capital expenditures
o Long-term financing expenditures
Cash dividends
Repayment of debt principal
Table 17-2 on page 506 provides an example of a cash budget
o This budget is available as an Excel spreadsheet from the text website
under Excel Tool Kit
In order to construct a cash budget we need to make some assumptions about
the inflows and outflows of cash:
FMGT 3510 Chapter 17 Page 13

Collections during month of sale 20% The 2% discount is taken by customers on these sales
Collections during 1st month after sale 70%
Collections during 2nd month after sale 10%
Discount on first month collections 2% The company's credit policy is 2/10, net 40
Purchases as a % of next month's sales 70% Materials are purchased based on the expected sales next month
Lease payments $15
Construction cost for new plant (Oct) $100
Target cash balance $10 The company does not want to go below this amount
Payments during month after purchases 100%

Use these assumptions to construct a cash budget.

[See Excel sheet for solution]
FMGT 3510 Chapter 17 Page 14

Short-Term Financing
Advantages of short term financing
o Faster/easier to obtain.
o Appropriate for temporary NOWC needs caused by seasonality.
o Not locked in to an amount or an interest rate for a long time.
o Fewer covenants than for long term debt.
o D/E= debt to equity
o D/E =<.5, (debt to equity) restrictive covenant
o TIE times interest earned
o Usually cheaper.

Disadvantages of short term financing

o Volatile interest cost as rates change.
o No long term commitment by lenders-face roll over risk if loan not
What are the different types of short term financing? How do we choose
between them?
FMGT 3510 Chapter 17 Page 15

Accounts Payable (Trade credit)

Most common form of short-term financing. It is usually easy to obtain and it is
a source of spontaneous financing (expands and contracts along with sales).
The terms of credit usually provide for a discount for early payment e.g. 2% if
paid in the first 10 days and payable in full after 30 days or 2/10, net 30
The cost of trade credit is the cost of not taking the discount offered.
The annual percent rate of not taking the discount (Nominal annual cost of
trade credit) is:

Discount percent 365

APR = x
100 discount percent Days credit discount period

Days credit = 30 days (2/10, n= 30)

Discount period= 10 days qualify for discount in that period
Compounding periods per year = 365 / (days credit Discount period)
(Cycles per year) = 365/(30 10) = 18.25
2 365
APR = x = 37.2 %
1002 20


FMGT 3510 Chapter 17 Page 16

The Effective Annual Rate (EAR) takes into account the compounding
Actual, real percent cost given the frequency of compounding
If Frequency of compounding periods = 1,that is 1 cycle per year
then it is an annual cycle and APR= EAR
If the terms are 2/10, net 30 then
Discount Days credit - discountperiod
EAR 1 1
1 - Discount

= ( + ) -1 = 44.6%==> Effective cost of missed
opportunity of not taking the discount offered on your AP invoice.

APR = 37.2%
EAR = 44.6%

Compute EAR by using your calculator:

N= 365/20 day cycle= 18.25 compounding frequency per one year
FMGT 3510 Chapter 17 Page 17

2ndf ICONV
C/Y 18.25 ENTER no of compounding periods per year
EAR = 44.52%
Enter what is given
Compute (CPT) what is wanted

Example 1:
You purchase goods on terms of 2/10, net 30.
Cost of financing if you pay on day 35?

N = 365 / (35 10) = 14.6 cycles per year

APR = [2/ (100 2)] * [365 / 25] = 29.8%
EFF (EAR) = effective annual cost of trade credit = (1+2/98)(365/25)-1=34.31%
FMGT 3510 Chapter 17 Page 18

C/Y = N = 14.6 Enter
NOM = APR = 29.8 Enter
EFF [CPT] = 34.31

Example 2
Cost of financing if you pay on day 45?
N = 365 /(45 10) = 10.43 = Cycles Per Year
APR = [2/ (100 2)] * [365 / 35] = 21.28
EFF = (1+2/98)(365/35) -1 =23.45%

C/Y = N = 10.43 Enter
NOM = APR = 21.28 Enter
EFF [CPT] = 23.45
FMGT 3510 Chapter 17 Page 19

Example 3:
A company has credit terms of 2/12, net 28.
What is the annual cost of trade credit (APR)? What is the effective cost (EAR)?

Discount percent 365

APR = x
100discount percent Days creditdiscount period

= 2 / (100 2) * 365 /(28 -12) = 2/98 * 365/16 = 46.6%

Discount Days credit - discountperiod
EAR 1 1
1 - Discount

= ( + ) = 58.5%

Annual Percent Rate Effective Annual Rate
N=1 N = 16/365 = 0.0438
PV = 100 2 = 98 PV = 98
PMT = 0 PMT = 0
FV = -100 FV = -100
CPT I/Y = 2.04 ( 1Cycle) CPT I/Y = 58.6%
APR = 2.04 * ( 365 / 16) = 46.53%
FMGT 3510 Chapter 17 Page 20

Short Term Bank Loans

The main source of non-spontaneous financing. The business must first
apply for a loan and then negotiate a loan agreement with the bank.
o The loan will have a maturity of 1 year or less.
o The bank wants to know how and when it will be repaid.
o It will analyze the companys historical and projected financial statements.
o What ratios will the bank focus on?
The interest rate will usually be floating rate based on the prime rate or
Prime + 1
Loan can be interest only or amortized (both principal and interest are paid)
o There will also be fees.
The firm will likely have to provide collateral security. Examples are:
o A/R
o Inventory
o Personal guarantee Personal covenant Mortgages
The loan agreement will include covenants
o Covenants are promises made by the borrower to do certain things (and to
not do certain other things i.e. negative covenants)
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The typical loan is a one-year line of credit. The loan will state a maximum
amount that can be borrowed and the business can borrow any amount up to
this amount during the term of the loan.
o A revolving line of credit is similar but has a longer term.
o Credit lines can be committed vs. noncommitted
Money market financing
Large firms with excellent credit records can obtain financing directly from the
money markets by issuing short-term debt securities.
o Commercial paper: short-term notes with maturities ranging from 30 to
365 days, offered in denominations of $100 thousand and up. Usually
backed by a bank line of credit. Commercial paper is usually less costly
than bank loans.
o Bankers acceptances: variant of commercial paper where for a fee, a bank
guarantees the papers principal and interest.
Disadvantage of money market financing: the risk that the market may
temporarily dry up (as during the 2008 credit crisis) when it comes time to roll
over the paper.
FMGT 3510 Chapter 17 Page 22

Calculating financing costs

The effective cost on a loan depends on how often the interest is paid (the
more frequently, the higher the rate).
The general approach is to determine the loans cash flows and then
calculate the IRR, making sure to convert it to the EAR.

Interest Paid Annually

Example 4
This is the simplest case: you borrow PV= $10,000 for one year at an APR
of 12% (nominal percent rate of borrowing)

0 0.25 0.50 0.75 1.0

10,000 -1,200 interest

-10,000 principal
N=1 PV=10,000 FV=-11,200 PMT=0 I/Y=12
FV= PV (borrowed amount) + cost of interest due
= 10,000 +1200= 11,200 due payable back
FMGT 3510 Chapter 17 Page 23

Example 5
What if APR is 12%, paid quarterly? Lets assume that each quarter is the
same length.

0 0.25 0.50 0.75 1.00

10,000 -300 -300 -300 -300

N=4 PV=10,000 PMT= -300 FV= -10,000 I=3% per quarter
APR/4= per quarter int rate APR converted to per period int rate
Int cost = amount borrowed X per period int rate X period
10,000 X .12/4 (quarters) = 300 per quarter interest paid

EAR = (1+ APR/m) m-1

m= # of compounding periods per year
12 % APR= 3 % per quarter interest rate

Effective (EAR) cost of borrowing = [1 + .12/4]4 1 = 12.55%

ICONV NOM = 12, C/Y = 4, CPT EFF = 12.55%
FMGT 3510 Chapter 17 Page 24

Example 6
What if interest rate is APR= 12% but paid on a discount basis? This
means that the interest amount is paid at the beginning of the loan period.
0 0.25 0.50 0.75 1.0

10,000 loan -10,000 payback

-1,200 discount collected by the bank in advance
8,800= net proceeds to company
N=1 PV=8,800 PMT= 0 FV= -10,000 CPT I/Y=13.64%
12 % discount loan yields an actual cost of int of 13.64 %==> elevated
The cost of interest called DISCOUNT LOANS
FMGT 3510 Chapter 17 Page 25

Example 7
Sometimes a compensating balance (CP) is required. This provision means
that the borrower must keep a minimum amount on deposit at the bank,
stated as a percentage of the loan amount e.g. 20%. If this amount exceeds
what the borrower would normally have on deposit then we must take it into
account when calculating the loan cost. The loan is still a 12% discount loan.
0 0.25 0.50 0.75 1.0

10,000 -10,000
-1,200 discount amount 2,000
-2,000 compensating balance kept at the bank as security
6,800 Net proceeds to Company ` -8,000
N=1 PV=6,800 PMT= 0 FV= -8,000 I/Y=17.65%
Effective cost of borrowing given the discount + compensating balance
FMGT 3510 Chapter 17 Page 26

Secured Short Term Financing

Secured loans most operating loans are secured with assets of the borrower
o Pledging Accounts Receivable
Accounts receivable are pledged to the lender as security.
Borrower is responsible for collecting the receivables.
Lender may actually review all invoices, if the number is not large,
and determine which to take as security.
The size of the loan is a function of the margin percentage (usually
75% of current receivables).
The lender retains recourse against the borrower: if the A/R becomes
a bad debt the borrower must still pay back the loan.
AR is the collateral
o Factoring receivables
Borrower actual sells the receivables to a factor who is then
responsible for collecting them.
Factor will charge a fee for collecting the receivables and assuming
the credit risk. The factor will also charge interest on funds advanced
to the seller before collection.
FMGT 3510 Chapter 17 Page 27

The seller may realize cost savings by transferring the credit and
collection functions to the factor.

Example 8
The factor charges a fee of 2.5% of A/R sold to it, plus interest of 9% APR
and a deposit equal to 5% of A/R. What is the EAR of factoring a 1 month
A/R of $10,000?

0 1 month

+10,000 loan -10,000

-500 deposit (5%) 500 deposit
-75 interest .09/12 X 10,000= 75 int per month
-250 fee 10,000 X.0250= 250
PV=9,175 Net proceeds to borrower FV= -9,500 pay back

N=1 PV=9,175 (received) PMT= 0 FV= -9,500 (paid back),

P/Y 1, C/Y 1, CPT I/Y=3.542% Nominal rate (per month bases) X 12= 42.50681199 NOMINAL

= [1 + .4250681199/12]12 1 = 51.84%==> Annual Effective cost of borrowing EAR

EAR must be computed as ANNUAL, exponent is = 12

FMGT 3510 Chapter 17 Page 28

EAR = (1+ APR/m) ^m-1

m= # of compounding periods per year

Per month interest rate= 3.542 % X 12= APR


Go from APR to EAR

EAR = ((1+ 0.4250681199/12)^12 -1) X 100 % Actual, annual percent cost of
Per period interest APR EAR

3.54223433 X 12 = APR = 42.51%

Apply the EAR formula or USE ICONV function.


C/Y 12 ent

FMGT 3510 Chapter 17 Page 29

o Inventory financing
Inventory is assigned to lender as security based on a predetermined
margin percentage (usually a lower percentage than the one used for
Form of charge:
o Blanket lien (covering all inventory)
o Trust receipts (covering specific, high value items such as
o Warehouse receipt financing: goods are held in either a third
party public warehouse or at a field warehouse at the
borrowers premises but segregated.