Chapter 1

Working Capital
Management
To Thi Thanh Truc
Faculty of Finance and Banking
University of Economics and Law

1-1
 Learning outcomes
After finishing this chapter you should be able to:
 Understand the operating cycle and the cash conversion
cycle.
 Explain how different amounts of current assets and
current liabilities affect firms’ profitability and thus their
stock prices.
 Discuss how the cash budget is constructed, and how
each is used in working capital management.

1-2
 Learning outcomes
After finishing this chapter you should be able to:
 Explain how companies decide on the proper amount of
each current asset—cash, marketable securities, accounts
receivable, and inventory.
 Discuss how companies set their credit policies and
explain the effect of credit policy on sales and profits.
 Describe how the costs of trade credit, bank loans, and
commercial paper are determined and how that
information impacts decisions for financing working
capital.
 Explain how companies use security to lower their costs
of short-term credit.

1-3
 Materials
 Handout
 Brigham & Houston, Fundamentals of financial
management, chapter 16.
 Brealey, Myers, Marcus, Fundamentals of Corporate finance,
Section 2, page 165.
 Jim DeMello, 2006, Cases in Finance, Mc Graw- Hill (Case
19, 20)

1-4
Outline

 Working capital definitions

 Working capital policy
 Cash budget
 Current assets management
 Short term financing sources

1-5
Working Capital Definitions

1-6
 Working capital definition

 Short-term, or current, assets and liabilities are

collectively known as working capital
 Gross working capital: current assets.
 Net working capital: current assets minus current
liabilities.
 Net operating working capital: operating current
assets – operating current liabilities. NOWC
represents the working capital that is used for
operating purposes.
1-7
 Working capital definition
 Net operating working capital represents a firm’s
investment in its operating current assets.

 Net operating working capital is usually positive,

that is firms have to invest in working capital.

 The four key dates in the operating cycle that

influence the firm’s investment in working capital:
raw materials purchased, payment for raw materials,
sale of finished goods, cash collected.
1-8
 Working Capital and Cash
Conversion Cycle
Simple Cycle of operations
Cash

Raw materials
Receivables inventory

Finished goods
inventory

1-9
 Why firms have to invest in
working capital?
It take a period of time for firms to eventually
collect the cash that they have paid for their
materials.

Firms need to have available funds enough for

them to disburse during the operating cycle to
ensure that operations is not disrupted. That is
gross working capital.

1-10
 Why firms have to invest in
working capital?

Firms usually buy on credit, so they can wait until

the last day of the credit term to pay cash.
The period of time from making payments to
suppliers to receiving payments from customers
is called cash conversion cycle (CCC) and it is
usually shorter than the operating cycle. Thus,
the funds needed is smaller, only enough for
disbursement during the cash conversion cycle,
this amount is NOWC.

1-11
 Why firms have to invest in
working capital?
 The longer the production process, the more cash
the firm must keep tied up in inventories.
 Similarly, the longer it takes customers to pay
their bills, the higher the value of accounts
receivable.
 On the other hand, if a firm can delay paying for
its own materials, it may reduce the amount of
cash it needs. In other words, accounts payable
reduce net operating working capital.
1-12
 Working Capital and Cash
conversion cycle

 Firms buy raw materials for cash

 Then processes them into finished goods

 And then sells these goods on credit

 Finally, they collect receivable from their

customers.
This process is called operating cycle.

1-13
 Working Capital and Cash
Conversion Cycle
Inventory Cash
sold received
Inventory
purchased

Inventory conversion Receivable collection

period period
Time
payable
Deferral period
Cash paid
for inventory

Operating cycle

Cash conversion cycle

The operating cycle is the time period from inventory purchase until the receipt of
cash. The cash conversion cycle is the time period from when cash is paid out, to
when cash is received. 1-14
 The Operating Cycle
 Operating cycle – time between purchasing the
inventory and collecting the cash from sale of the
inventory
 Inventory conversion period – time required to
purchase and sell the inventory
 Receivable Collection period – time required to
collect on credit sales
 Operating cycle = Inventory conversion period +
Receivable collection period

1-15
 Cash conversion Cycle
 Cash conversion cycle: The length of time between
when a company makes payments to its creditors and
when a company receives payments from its
customers.
 Cash conversion cycle is the difference between the
operating cycle and the payables deferral period.
 Payable deferral period: time between purchase of
inventory and payment for the inventory

Inventory Receivables Payables

CCC = conversion + collection – deferral .
period period period
1-16
 Calculate CCC
Average inventory
Inventory conversion period =
Annual costs of goods sold/365

Average accounts receivable

Receivable collection period =
Annual sales/365

Average accounts payable

Payables deferral period =
Annual costs of goods sold/365

1-17
 Example Information
 Inventory:
 Beginning = 200,000

 Ending = 300,000

 Accounts Receivable:
 Beginning = 160,000

 Ending = 200,000

 Accounts Payable:
 Beginning = 75,000

 Ending = 100,000

 Net sales = 1,150,000

 Cost of Goods sold = 820,000

1-18
 Example – Operating Cycle
 Inventory conversion period
 Average inventory = (200,000+300,000)/2 = 250,000

 Inventory turnover = 820,000 / 250,000 = 3.28 times

 Inventory period = 365 / 3.28 = 111 days

 Receivables collection period

 Average receivables = (160,000+200,000)/2 = 180,000

 Receivables turnover = 1,150,000 / 180,000 = 6.39

times
 Receivables period = 365 / 6.39 = 57 day

 Operating cycle = 111 + 57 = 168 days

1-19
Example – Cash Conversion Cycle
 Payables deferral Period
 Average payables = (75,000+100,000)/2 = 87,500

 Payables turnover = 820,000 / 87,500 = 9.37 times

 Payables deferral period = 365 / 9.37 = 39 days

 Cash Conversion Cycle = 168 – 39 = 129 days

 We have to finance our inventory for 129 days

 If we want to reduce our financing needs, we need to

look carefully at our receivables and inventory periods –
they both seem extensive
1-20
 Significance of Working
Capital Management
 In a typical manufacturing firm, current assets
exceed one-half of total assets.
 Excessive levels can result in a substandard
Return on Assets (ROA).
 Current liabilities are the principal source of
external financing for small firms.
 Requires continuous, day-to-day managerial
supervision.
 Working capital management affects the
company’s risk, return, and share price.
1-21
Working capital Policy

Deciding the level of each type of current

asset to hold, and how to finance current
assets.

1-22
Working capital Policy

Deciding the level of each type of current

asset to hold, and how to finance current
assets.

1-23
 Current assets investment policies
 Relaxed investment policy: the firm holds
relatively large amounts of cash, marketable
securities, receivables and inventories relative
to its sales
 Restricted investment policy: holdings of
current assets are minimized.
 Moderate investment policy lies between the
two extremes

1-24
 Costs of holding current assets
 Carrying costs: opportunity cost of capital invested in
current assets. Carrying costs encourage firms to hold
current assets to a minimum. The smaller the amount
of current assets the higher the expected return on
investment.
 Shortage costs: too low a level of current assets
makes it more likely that the firm will face shortage
costs. This policy also exposes the firm to risks
because shortages can lead to work stoppages,
unhappy customers, and serious long-run problems
1-25
 Costs and benefits of Investment
Policies
 A restricted policy results in a high ROE. However,
this policy also exposes the firm to risks.
 The relaxed policy minimizes such operating
problems, but it results in a low turnover,
which in turn lowers ROE.
 The moderate policy falls between the two
extremes.

1-26
An important job of the financial manager is
to strike a balance between the costs and
benefits of current assets, that is, to find the
level of current assets that minimizes the sum
of carrying costs and shortage costs.

The optimal strategy is the one that

maximizes the firm’s long-run earnings and
value.

1-27
Selected ratios for SKI Inc.
SKI Ind Avg
Current ratio 1.75x 2.25x
Debt/Assets 58.76% 50.00%
Turnover of cash & securities 16.67x 22.22x
Days sales outstanding 45.63 32.00
Inventory turnover 4.82x 7.00x
Fixed assets turnover 11.35x 12.00x
Total assets turnover 2.08x 3.00x
Profit margin 2.07% 3.50%
Return on equity 10.45% 21.00%
1-28
How does SKI’s working capital
policy compare with its industry?
 Working capital policy is reflected in the
current ratio, turnover of cash and
securities, inventory turnover, and days
sales outstanding.
 These ratios indicate SKI has large
amounts of working capital relative to its
level of sales.
 SKI is either very conservative or
inefficient.

1-29
Is SKI inefficient or conservative?
 A conservative (relaxed) policy may be
appropriate if it leads to greater
profitability.
 However, SKI is not as profitable as the
average firm in the industry.
 This suggests the company has excessive
working capital.

1-30
Working capital Policy

Deciding the level of each type of current

asset to hold, and how to finance current
assets.

1-31
 Classifications of Working
Capital

 Components

 Cash, marketable securities,

receivables, and inventory.
 Time
 Permanent
 Temporary

1-32
 Permanent current assets
The amount of current assets required to
meet a firm’s long-term minimum needs.
DOLLAR AMOUNT

Permanent current assets

TIME
1-33
 Temporary Current assets
The amount of current assets that varies with
seasonal requirements.

Temporary current assets

DOLLAR AMOUNT

Permanent current assets

TIME
1-34
 Working capital financing need

Spontaneous Financing: Trade credit, and

other payables and accruals, that arise
spontaneously in the firm’s day-to-day
operations.
 Based on policies regarding payment for
purchases, labor, taxes, and other expenses.
 We are concerned with managing non-
spontaneous financing of assets.
1-35
 Working capital financing need
 A proportion of current assets are financed
automatically with spontaneous financing (trade
credit, and other payables and accruals, that
arise spontaneously in the firm’s day-to-day
operations).
 The remainder part, the difference between
operating current assets and operating liabilities
(NOWC) needs to be financed.
 Working capital financing requirement = NOWC

1-36
Working capital financing policies
 Moderate (Hedging) – Match the
maturity of the assets with the maturity
of the financing.
 Aggressive – Use short-term financing
to finance permanent assets.
 Conservative – Use permanent capital
for permanent assets and temporary
assets.

1-37
 Moderate policy - Hedging (or
Maturity Matching) Approach
A method of financing where each asset would be offset with a financing
instrument of the same approximate maturity.
$ Temporary NWC.

Short term Loan

Permanent NWC Long term financing:

Stock,
Bond.
Fixed Assets
Time
1-38
 Financing Needs and
the Hedging Approach
 Fixed assets and the non-seasonal portion of
working capital are financed with long-term
debt and equity (long-term profitability of
assets to cover the long-term financing costs of
the firm).
 Seasonal needs are financed with short-term
loans (under normal operations sufficient cash
flow is expected to cover the short-term
financing cost).
1-39
 Self-Liquidating Nature
of Short-Term Loans
 Seasonal orders require the purchase of
inventory beyond current levels.
 Increased inventory is used to meet the
increased demand for the final product.
 Sales become receivables.
 Receivables are collected and become cash.
 The resulting cash funds can be used to pay
off the seasonal short-term loan and cover
associated long-term financing costs.
1-40
 Conservative Policy
$ Short term security Temporary NWC.
No short term
loan

Long term financing:

Permanent NWC
Stock,
Bond.

Fixed Assets

Time
1-41
 Risks vs. Costs Trade-Off
(Conservative policy)
 Long-Term Financing Benefits
 Less worry in refinancing short-term obligations
 Less uncertainty regarding future interest costs
 Long-Term Financing Risks
 Borrowing more than what is necessary
 Borrowing at a higher overall cost (usually)
 Result
 Manager accepts less expected profits in exchange for
taking less risk.

1-42
 Aggressive Policy
$ Temporary NWC.
Short term Loans

Permanent NWC
Long term financing:
Stock,
Bond.
Fixed Asset
Time
Firm increases risks associated with short-term borrowing by using
a larger proportion of short-term financing.
1-43
 Aggressive Approach
 Short-Term Financing Benefits
 Financing long-term needs with a lower interest cost
than long-term debt
 Borrowing only what is necessary
 Short-Term Financing Risks
 Refinancing short-term obligations in the future
 Uncertain future interest costs
 Result
 Manager accepts greater expected profits in exchange
for taking greater risk.
1-44
 Summary of Short- vs. Long-
Term Financing
Financing
Maturity
SHORT-TERM LONG-TERM
Asset
Maturity

SHORT-TERM Moderate Low

(Temporary) Risk-Profitability Risk-Profitability

High
LONG-TERM Moderate
Risk-Profitability
(Permanent) Risk-Profitability

1-45
 Financing policy example: ABC
Inc.
Peak Bottom Peak Bottom
Cash $ 100 $ 60 Accounts Payable $ 60 $ 20
Marketable securities 0 40 Note Payables 100 0
Accounts Receivable 80 40 Long-term Debt 600 600
Inventory 200 100 Common Equity 620 620
Net fixed assets 1,000 1,000 Total $1,380 $1,240
Total $1,380 $1240

1-46
 Working capital policy and
firm’s value
Risk/ Return Tradeoff

Investment E(ROIC)
decision s
Level of current Financial Vs ROIC
assets Distress
Risk
Working Firm
capital Value
policy
Financing Risk/Return Tradeoff
Decisions
S-T Vs L-T Excess Uncertain
Debt Debt L-T Vs S-T
Financing Financing

1-47
The cash budget

1-48
 Cash budget
 Forecasts cash inflows, outflows, and ending
cash balances.
 Used to plan loans needed or funds available to
invest.
 Allows a company to plan ahead and begin the
search for financing before the money is
actually needed
 Can be daily, weekly, or monthly, forecasts.
 Monthly for annual planning and daily for
actual cash management.
1-49
Example: Cash Budget
Information
 Pet Treats Inc. specializes in gourmet pet treats and receives all income
from sales
 Sales estimates (in millions)
 Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550
 Accounts receivable
 Beginning receivables = $250
 Average collection period = 30 days
 Accounts payable
 Purchases = 50% of next quarter’s sales
 Beginning payables = 125
 Accounts payable period is 45 days
 Other expenses
 Wages, taxes, and other expense are 30% of sales
 Interest and dividend payments are $50
 A major capital expenditure of $200 is expected in the second
quarter
 The initial cash balance is $80 and the company maintains a minimum
balance of $50 1-50
 Example: Cash Budget – Cash
Collections
 ACP = 30 days, this implies that 2/3 of sales are
collected in the quarter made and the remaining 1/3
are collected the following quarter
 Beginning receivables of $250 will be collected in the
first quarter
Q1 Q2 Q3 Q4
Beginning Receivables 250 167 200 217
Sales 500 600 650 800
Cash Collections 583 567 633 750
Ending Receivables 167 200 217 267

1-51
 Example: Cash Budget – Cash Disbursements

 Payables period is 45 days, so half of the purchases

will be paid for each quarter and the remaining will
be paid the following quarter
 Beginning payables = $125
Q1 Q2 Q3 Q4
Payment of accounts 275 313 362 338
Wages, taxes and other expenses 150 180 195 240
Capital expenditures 200
Interest and dividend payments 50 50 50 50
Total cash disbursements 475 743 607 628

1-52
 Example: Cash Budget – Net Cash
Flow and Cash Balance
Q1 Q2 Q3 Q4
Total cash collections 583 567 633 750
Total cash disbursements 475 743 607 628
Net cash inflow 108 -176 26 122
Beginning Cash Balance 80 188 12 38
Net cash inflow 108 -176 26 122
Ending cash balance 188 12 38 160
Minimum cash balance -50 -50 -50 -50
Cumulative surplus (deficit) 138 -38 -12 110
1-53
SKI’s cash budget:
For January and February
Net Cash Inflows
Jan Feb
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
1-54
SKI’s cash budget (con’t)
Net Cash Inflows
Jan Feb
Cash at start if
no borrowing $ 3,000.00 $16,857.64
Net CF 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

1-55
How could bad debts be
worked into the cash budget?
 Collections would be reduced by the
amount of the 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
higher borrowing requirements.

1-56
Analyze SKI’s forecasted cash budget
 Cash holdings will exceed the target
balance for each month, except for
October and November.
 Cash budget indicates the company is
holding too much cash.
 SKI could improve its EVA by either
investing cash in more productive assets,
or by returning cash to its shareholders.

1-57
Why might SKI want to maintain 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 used, in part, to fund future
investments.

1-58
Current assets
management

1-59
Cash management

1-60
Reasons for Holding Cash
1. Transactions – must have some cash to
operate.
2. Precaution – “safety stock”. Reduced by
line of credit and marketable securities.
3. Compensating balances – for loans and/or
services provided.
4. Speculation – to take advantage of
bargains and to take discounts. Reduced
by credit lines and marketable securities.

1-61
The goal of cash management
 To meet the above objectives, especially to
have cash for transactions, yet not have
any excess cash.
 To minimize transactions balances in
particular, and also needs for cash to meet
other objectives.
 Trade-off between opportunity cost of
holding cash relative to the transaction
cost of converting marketable securities to
cash for transactions
1-62
 Setting the Target Cash
Balance
 Theoretical models such as the Baumol model
have been developed for use in setting target
cash balances. The Baumol model is similar to
the EOQ model, which will be discussed later.
 Today, companies strive for zero cash balances
and use borrowings or marketable securities as
a reserve.
 Monte Carlo simulation can be helpful in setting
the target cash balance.

1-63
Minimizing cash holdings
 Insist on wire transfers from customers
 Synchronize inflows and outflows
 Use a remote disbursement account
 Reduce need for “safety stock” of cash
 Increase forecast accuracy
 Hold marketable securities
 Negotiate a line of credit

1-64
 Investing Cash
 Money market – financial instruments with an original
maturity of one year or less
 Temporary Cash Surpluses
 Seasonal or cyclical activities – buy marketable securities

with seasonal surpluses, convert securities back to cash

when deficits occur
 Planned or possible expenditures – accumulate

marketable securities in anticipation of upcoming

expenses

1-65
 Characteristics of Short-Term
Securities
 Maturity – firms often limit the maturity of short-term
investments to 90 days to avoid loss of principal due to
changing interest rates
 Default risk – avoid investing in marketable securities
with significant default risk
 Marketability – ease of converting to cash
 Taxability – consider different tax characteristics when
making a decision

1-66
Receivables Management

1-67
 Elements of credit policy
1. Credit Standards: The minimum quality of credit
worthiness of a credit applicant that is acceptable to
the firm.
2. Credit Period – How long to pay? The total length of
time over which credit is extended to a customer to
pay a bill. For example, “net 30” requires full
payment to the firm within 30 days from the invoice
date.
3. Cash Discounts – Lowers price. A percent (%)
reduction in sales or purchase price allowed for early
payment of invoices. For example, “2/10” allows the
customer to take a 2% cash discount during the
cash discount period.
4. Collection Policy – How tough?
1-68
 How does the credit policy
have affect on receivables?

Quality of Length of
Trade Account Credit Period
(1) Average
Collection Period
(2) Bad-debt
Losses
Firm
Possible Cash Collection
Discount Program

1-69
 How does the credit policy
affect receivables
1. Credit Standards:– Tighter standards tend to
reduce sales, but reduce bad debt expense.
Fewer bad debts reduce days sales outstanding
(DSO).
2. Credit Period – The longer the credit period, the
longer the days sales outstanding.
3. Cash Discounts – Lowers price. Attracts new
customers and reduces DSO.
4. Collection Policy – How tough? Tougher policy
will reduce DSO but may damage customer
relationships.

1-70
Costs arising from relaxing credit policy

 A larger credit department

 Additional clerical work
 Servicing additional accounts
 Bad-debt losses
 Opportunity costs

1-71
 Example of Relaxing Credit
Standards
Basket Wonders is not operating at full capacity
and wants to determine if a relaxation of
their credit standards will enhance
profitability.

 The firm is currently producing a single

product with variable costs of $20 and selling
price of $25.
 Relaxing credit standards is not expected to
affect current customer payment habits.
1-72
 Example of Relaxing
Credit Standards
 Additional annual credit sales of $120,000 and an
average collection period for new accounts of 3 months is
expected.
 The before-tax opportunity cost for each dollar of funds
“tied-up” in additional receivables is 20%.

Ignoring any additional bad-debt losses

that may arise, should Basket Wonders
relax their credit standards?

1-73
 Example of Relaxing
Credit Standards
Profitability of ($5 contribution) x (4,800 units) =
additional sales $24,000

Additional ($120,000 sales) / (4 Turns) =

receivables $30,000
Investment in ($20/$25) x ($30,000) =
add. receivables $24,000

Req. pre-tax return (20% opp. cost) x $24,000 =

on add. investment $4,800

Yes! Profits > Required pre-tax return

1-74
 Example of Relaxing the
Credit Period

Basket Wonders is considering changing its credit

period from “net 30” (which has resulted in 12 A/R
“Turns” per year) to “net 60” (which is expected to
result in 6 A/R “Turns” per year).
 The firm is currently producing a single product
with variable costs of $20 and a selling price of $25.
 Additional annual credit sales of $250,000 from new
customers are forecasted, in addition to the current
$2 million in annual credit sales.
1-75
 Example of Relaxing the
Credit Period
 The before-tax opportunity cost for each dollar of
funds “tied-up” in additional receivables is 20%.

Ignoring any additional bad-debt losses that

may arise, should Basket Wonders relax their
credit period?

1-76
 Example of Relaxing the
Credit Period
Profitability of ($5 contribution)x(10,000 units) =
additional sales $50,000

Additional ($250,000 sales) / (6 Turns) =

receivables $41,667

Investment in add. ($20/$25) x ($41,667) =

receivables (new sales) $33,334

Previous ($2,000,000 sales) / (12 Turns) =

receivable level $166,667

1-77
 Example of Relaxing the
Credit Period
New ($2,000,000 sales) / (6 Turns) =
receivable level $333,333

Investment in $333,333 - $166,667 =

add. receivables $166,666
(original sales)

Total investment in $33,334 + $166,666 =

add. receivables $200,000
Req. pre-tax return (20% opp. cost) x $200,000 =
on add. investment $40,000

Yes! Profits > Required pre-tax return 1-78

Total Cost of Granting Credit
 Carrying costs
 Required return on receivables

 Losses from bad debts

 Costs of managing credit and collections

 Shortage costs
 Lost sales due to a restrictive credit policy

 Total cost curve

 Sum of carrying costs and shortage costs

 Optimal credit policy is where the total cost

curve is minimized
1-79
 Credit Analysis
Process of deciding which customers receive
credit:
 Obtaining information on the credit
applicant
 Analyzing this information to determine the
applicant’s creditworthiness
 s5 Cs of Credit
 Credit Scoring
 Making the credit decision

1-80
 Sources of Information
The company must weigh the amount of
information needed versus the time and
expense required.
 Financial statements
 Credit ratings and reports
 Bank checking
 Trade checking
 Company’s own experience
1-81
 Credit Analysis
A credit analyst is likely to utilize
information regarding:

 The financial statements of the firm (ratio

analysis)
 The character of the company
 The character of management
 The financial strength of the firm
 Other individual issues specific to the firm

1-82
 Five Cs of Credit
 Character – willingness to meet financial
obligations
 Capacity – ability to meet financial obligations
out of operating cash flows
 Capital – financial reserves
 Collateral – assets pledged as security
 Conditions – general economic conditions related
to customer’s business

1-83
 Credit – Scoring System

A system used to decide whether to grant

credit by assigning numerical scores to
various characteristics related to
creditworthiness.

1-84
Collection Policy
 Monitoring receivables
 Keep an eye on average collection period relative
to your credit terms
 Use an aging schedule to determine percentage of
payments that are being made late
 Collection policy
 Delinquency letter

 Telephone call

 Collection agency

 Legal action

1-85
Inventory Management

1-86
 Inventory Management
 Inventory can be a large percentage of a firm’s
assets
 There can be significant costs associated with
carrying too much inventory
 There can also be significant costs associated
with not carrying enough inventory
 Inventory management tries to find the optimal
trade-off between carrying too much inventory
versus not enough

1-87
 Types of Inventory
 Manufacturing firm
 Raw material – starting point in production process

 Work-in-progress

 Finished goods – products ready to ship or sell

 Remember that one firm’s “raw material” may be

another firm’s “finished goods”
 Different types of inventory can vary dramatically in
terms of liquidity

1-88
Inventory costs
 Types of inventory costs
 Carrying costs – storage and handling costs,
insurance, property taxes, depreciation, and
obsolescence.
 Ordering costs – cost of placing orders, shipping,
and handling costs.
 Costs of running short – loss of sales or
customer goodwill, and the disruption of
production schedules.
 Reducing inventory levels generally reduces
carrying costs, increases ordering costs, and
may increase the costs of running short.
1-89
Short term financing

1-90
 Short-Term Financing

 Spontaneous Financing
 Negotiated Financing
 Factoring Accounts Receivable

1-91
Spontaneous Financing

1-92
 Spontaneous Financing

Types of spontaneous
financing
 Accounts Payable (Trade Credit from
Suppliers)
 Accrued Expenses

1-93
 Trade Credit as a Means
of Financing
What happens to accounts payable if a
firm purchases $1,000/day at “net 30”?
$1,000 x 30 days = $30,000 account balance
What happens to accounts payable if a
firm purchases $1,500/day at “net 30”?
$1,500 x 30 days = $45,000 account balance
A $15,000 increase from operations!
1-94
 Cost to Forgo a Discount
What is the approximate annual cost to
forgo the cash discount of “2/10, net
30” after the first ten days?
Approximate annual interest cost =
% discount 365 days
X
(100% - % discount) (payment date -
discount period)

1-95
 Cost to Forgo a Discount
What is the approximate annual cost to forgo
the cash discount of “2/10, net 30,” and pay
at the end of the credit period?

Approximate annual interest cost =

2% 365 days
X
(100% - 2%) (30 days - 10 days)

= (2/98) x (365/20) = 37.2%

1-96
 Cost to Forgo a Discount
The approximate interest cost over a
variety of payment decisions for “2/10,
net ____.”
Payment Date* Annual rate of interest
11 744.9%
20 74.5
30 37.2
60 14.9
90 9.3
* days from invoice date 1-97
 S-t-r-e-t-c-h-i-n-g Account
Payables
Postponing payment beyond the end of the net
period is known as “stretching accounts
payable” or “leaning on the trade.”
Possible costs of “stretching
accounts payable”
 Cost of the cash discount (if any) forgone
 Late payment penalties or interest
 Deterioration in credit rating
1-98
Effective cost of trade credit
 Periodic rate = 0.02 / 0.98 = 2.04%
 Periods/year = 365 / (30-10) = 18.25
 Effective cost of trade credit
 EAR = (1 + periodic rate)N – 1
= (1.0204)18.25 – 1 = 44.56%

1-99
Negotiated Financing

1-100
 Negotiated Financing
Types of negotiated financing:

 Money Market Credit

 Loans

1-101
 “Stand-Alone” Commercial
Paper
Commercial Paper -- Short-term, unsecured
promissory notes, generally issued by large
corporations (unsecured corporate IOUs).
 Commercial paper market is composed of the
(1) dealer and (2) direct-placement markets.
 Advantage: Cheaper than a short-term business
loan from a commercial bank.
 Dealers require a line of credit to ensure that
the commercial paper is paid off.

1-102
 “Bank-Supported”
Commercial Paper
 A bank provides a letter of credit, for a fee,
guaranteeing the investor that the company’s
obligation will be paid.
 Letter of credit (L/C) -- A promise from a

third party (usually a bank) for payment in

the event that certain conditions are met.
It is frequently used to guarantee payment
of an obligation.
 Best for lesser-known firms to access lower

cost funds.
1-103
 Bankers’ Acceptances

Bankers’ Acceptances -- Short-term

promissory trade notes for which a bank (by
having “accepted” them) promises to pay the
holder the face amount at maturity.
 Used to facilitate foreign trade or the
shipment of certain marketable goods.
 Liquid market provides rates similar to
commercial paper rates.
1-104
 Short-Term Business Loans
 Unsecured Loans -- A form of debt for
money borrowed that is not backed by
the pledge of specific assets.

 Secured Loans -- A form of debt for

money borrowed in which specific assets
have been pledged to guarantee payment.

1-105
 Unsecured Loans
 Line of Credit (with a bank) -- An informal
arrangement between a bank and its customer
specifying the maximum amount of unsecured
credit the bank will permit the firm to owe at any
one time.
 One-year limit that is reviewed prior to renewal to
determine if conditions necessitate a change.
 Credit line is based on the bank’s assessment of the
creditworthiness and credit needs of the firm.
 “Cleanup” provision requires the firm to owe the
bank nothing for a period of time.
1-106
 Unsecured Loans
Revolving Credit Agreement -- A formal, legal
commitment to extend credit up to some
maximum amount over a stated period of time.
 Firm receives revolving credit by paying a
commitment fee on any unused portion of the
maximum amount of credit.
 Commitment fee -- A fee charged by the lender for
agreeing to hold credit available.
 Agreements frequently extend beyond 1 year.
1-107
 Unsecured Loans
 Transaction Loan -- A loan agreement that
meets the short-term funds needs of the
firm for a single, specific purpose.
 Each request is handled as a separate transaction
by the bank, and project loan determination is
based on the cash-flow ability of the borrower.
 The loan is paid off at the completion of the
project by the firm from resulting cash flows.

1-108
 Cost of Borrowing
Interest Rates
 Prime Rate -- Short-term interest rate
charged by banks to large, creditworthy
customers.
Differential from prime depends on:
 Cash balances

 Other business with the bank

 Cost of servicing the loan

1-109
 Cost of Borrowing
Computing Interest Rates
 Collect Basis -- interest is paid at maturity of the
note.
Example: $100,000 loan at 10%
stated interest rate for 1 year.

$10,000 in interest
= 10.00%
$100,000 in usable funds
1-110
 Cost of Borrowing
Computing Interest Rates
 Discount Basis -- interest is deducted from
the initial loan.
Example: $100,000 loan at 10%
stated interest rate for 1 year.

$10,000 in interest
= 11.11%
$90,000 in usable funds
1-111
 Cost of Borrowing
Compensating Balances
 Non-interest-bearing demand deposits maintained by
a firm to compensate a bank for services provided,
credit lines, or loans.
Example: $1,000,000 loan at 10% stated interest rate for
1 year with a required $150,000 compensating balance.

$100,000 in interest
= 11.76%
$850,000 in usable funds
1-112
 Example: Compensating
Balance
 We have a $500,000 line of credit with a 15%
compensating balance requirement. The
quoted interest rate is 9%. We need to borrow
$150,000 for inventory for one year.
 How much do we need to borrow?
 150,000/(1-.15) = 176,471
 What interest rate are we effectively paying?
 Interest paid = 176,471(.09) = 15,882
 Effective rate = 15,882/150,000 = .1059 or 10.59%

1-113
 Cost of Borrowing
Commitment Fees
 The fee charged by the lender for agreeing to hold
credit available is on the unused portions of credit.
Example: $1 million revolving credit at 10% stated
interest rate for 1 year; borrowing for the year was
$600,000; a required 5% compensating balance on
borrowed funds; and a .5% commitment fee on
$400,000 of unused credit.
What is the cost of borrowing?
1-114
 Cost of Borrowing
Interest: ($600,000) x (10%) = $ 60,000
Commitment Fee: ($400,000) x (0.5%) = $ 2,000
Compensating
Balance: ($600,000) x (5%) = $ 30,000

Usable Funds: $600,000 – $30,000 = $570,000

$60,000 in interest +
$2,000 in commitment fees
= 10.88%
$570,000 in usable funds

1-115
Cost of Borrowing - example
 The firm can borrow $100,000 for 1
year at an 8% nominal rate.
 Interest may be set under one of the
following scenarios:
 Simple annual interest
 Installment loan, add-on, 12 months

1-116
Simple annual interest
 “Simple interest” means no discount or
add-on.

Interest = 0.08($100,000) = $8,000

rNOM = EAR = $8,000 / $100,000 = 8.0%

For a 1-year simple interest loan, rNOM = EAR

1-117
 Add-on interest
 Interest = 0.08 ($100,000) = $8,000
 Face amount = $100,000 + $8,000 = $108,000
 Monthly payment = $108,000/12 = $9,000
 Avg loan outstanding = $100,000/2 = $50,000
 Approximate cost = $8,000/$50,000 = 16.0%
 To find the appropriate effective rate, recognize
that the firm receives $100,000 and must make
monthly payments of $9,000 (like an annuity).

1-118
Add-on interest
From the calculator output below, we have:

rNOM = 12 (0.012043)
= 0.1445 = 14.45%

EAR = (1.012043)12 – 1 = 15.45%

INPUTS 12 100 -9 0
N I/YR PV PMT FV
OUTPUT 1.2043

1-119
 Secured
(or Asset-Based) Loans
 Security (collateral) -- Asset (s) pledged by a
borrower to ensure repayment of a loan. If
the borrower defaults, the lender may sell the
security to pay off the loan.
Collateral value depends on:
 Marketability
 Life
 Riskiness
1-120
 Accounts-Receivable-
Backed Loans
 One of the most liquid asset accounts.
 Loans by commercial banks or finance
companies (banks offer lower interest rates).
Loan evaluations are made on:
 Quality: not all individual accounts have to be
accepted (may reject on aging).
 Size: small accounts may be rejected as
being too costly (per dollar of loan) to handle
by the institution. 1-121
 Accounts-Receivable-
Backed Loans
Types of receivable loan arrangements:
 Nonnotification -- firm customers are not
notified that their accounts have been pledged
to the lender. The firm forwards all payments
from pledged accounts to the lender.

 Notification -- firm customers are notified that

their accounts have been pledged to the lender
and remittances are made directly to the
lending institution.
1-122
 Inventory-Backed Loans
 Relatively liquid asset accounts
Loan evaluations are made on:
 Marketability
 Perishability
 Price stability
 Difficulty and expense of selling for loan
satisfaction
 Cash-flow ability
1-123
 Types of
Inventory-Backed Loans
 Floating Lien -- A general, or blanket, lien
against a group of assets, such as
inventory or receivables, without the
assets being specifically identified.
 Chattel Mortgage -- A lien on specifically
identified personal property (assets other
than real estate) backing a loan.

1-124
 Types of
Inventory-Backed Loans
 Trust Receipt -- A security device
acknowledging that the borrower holds
specifically identified inventory and
proceeds from its sale in trust for the
lender.
 Terminal Warehouse Receipt -- A receipt
for the deposit of goods in a public
warehouse that a lender holds as
collateral for a loan.
1-125
 Types of
Inventory-Backed Loans
 Field Warehouse Receipt -- A receipt
for goods segregated and stored on
the borrower’s premises (but under
the control of an independent
warehousing company) that a lender
holds as collateral for a loan.

1-126
Factoring Account
Receivables

1-127
 Factoring
Accounts Receivable
Factoring -- The selling of receivables to a financial
institution, the factor, usually “without
recourse.”
 Factor is often a subsidiary of a bank holding
company.
 Factor maintains a credit department and performs
credit checks on accounts.
 Allows firm to eliminate their credit department and
the associated costs.
 Contracts are usually for 1 year, but are renewable.
1-128
 Factoring
Accounts Receivable
Factoring Costs
 Factor receives a commission on the face value of the
receivables.
 Cash payment is usually made on the actual or average
due date of the receivables.
 If the factor advances money to the firm, then the firm
must pay interest on the advance.
 Total cost of factoring is composed of a factoring fee
plus an interest charge on any cash advance.
 Although expensive, it provides the firm with substantial
flexibility.
1-129
 Example: Factoring
 Last year your company had average accounts
receivable of $2 million. Credit sales were $24
million. You factor receivables by discounting
them 2%. What is the effective rate of
interest?
 Receivables turnover = 24/2 = 12 times

 APR = 12(.02/.98) = .2449 or 24.49%

 EAR = (1+.02/.98)
12 – 1 = .2743 or 27.43%

1-130