— CHAPTER ADDRESSING WORKING CAPITAL POLICIES AND MANAGEMENT OF SHORT-TERM ASSETS AND LIABILITITIES Expected, Learning Outcomes After studying Chapter 11, you should be able to: 1, Understand the concept of working capital management. 2. Know the importance of working capital management. 3. Identify and understand the factors affecting the firm's working capital policy. 4. Appreciate the need of knowing how to trace cash movement through the firm's operation. 5, Understand and calculate the operating cycle and cash conversion cycle of a business firm. 6. Know how operating cycle can be shortened. 7. Distinguish the alternative policies as to the amount of investment in current assets. 8. Identify and distinguish between the costs relevant to investment in current assets i.e. carrying costs versus shortage costs. 9. Know the alternative policies in financing investment in current assets. 4o4CHAPTER 11 ADDRESSING WORKING CAPITAL POLICIES AND MANAGEMENT OF ES SHORT-TERM ASSETS AND LIABILITI INTRODUCTION Working capital management is associated with short-term financial decision making. Short-term financial decisions typically involve cash inflows and outflows that occur within a year or less. For instance, short-term financial decisions are involved when a firm orders raw materials or merchandise, pays in cash and anticipates selling finished goods in one year for cash. In contrast, /ong- term financial decisions are involved when a firm purchases a special equipment that will reduce operating costs over, say, the next five years. Working capital management also involves finding the optimal levels of cash, marketable securities, accounts receivable, and inventory and then financing that working capital at the least cost. Effective working capital management can generate considerable amounts of cash. REASONS WHY WORKING CAPITAL MANAGEMENT IS IMPORTANT 1. Working capital comprises a large portion of the firm’s total assets, Although the level of working capital varies widely among different industries, firms in manufacturing and trading industries more often than not, keep more than half of their assets in current assets. 2. The financial manager has considerable responsibility and control in managing the level of current assets and current liabilities, 3. Working capital management directly affects the firm’s long-term growth and survival because higher levels of current assets are needed to support production and sales growth, 4. Liquidity and profitability are likewise directly affected by working capital management. Without sufficient liquidity, a firm may be unable to Pay its liabilities as they mature, The firm’s profitability ic also affected because current assets must be financed and finan: cing involves inter rest expense.FACTORS AFFECTING There is no single workin, single firm in all situatio develop in practice becau significant factors affectir 1 Addressing Working Capital Policies and Management .._253 THE FIRM’S WORKING CAPITAL POLICY 'g capital policy that is optimal for all firms or for any ns. The optimal working capital policy is difficult to Se not all factors are controllable by management. The Ng a firm’s working capital position are as follows: The Nature of Operations. Working capital requirements differ greatly among manufacturing, retailing and service organizations. For example, retailing firms have a high proportion of total assets in the current category because they earn their return from current assets stich as inventory. The Volume of Sales. More current assets such as, accounts receivables and inventories, are needed to support a higher level of sales. The Variation of Cash Flows. The greater the fluctuations in the firm’s cash inflows and outflows, the greater the level of net working capital required. The Operating Cycle Period. The operating cycle is the length of time cash is tied up in a firm’s operating process. For example, the operating - cycle of a manufacturing firm is the length of time required to purchase Taw materials on credit, produce and sell a product, collect the sales receipts and repay the credit. Shortening the operating cycle reduces the amount of time funds are tied up in working capital and thus lowers the level of working capital required, Some questions that will fall under the general heading of working capital management are: 1. 2. a 4. What is a reasonable level of cash to keep on hand and in a bank to pay bills? How much credit should the firm extend to customers? How much inventory should the company hold? How much should the firm borrow in the short-term? Working capital management has become particularly difficult in the declining ‘economic environment following the recent financial crisis. Some companies have been stuck with unused inventory while others refrain from purchasing additional254 Chapter 11 : i start spending inventory until they see sufficient evidence that consumers would star i x compa edit from their suppliers again. Also, some companies have relied more on trade cre fr as a substitute form of financing rather than obtaining short-term loan {701 financial institutions. Suppliers on the other hand worry that because of weal economy, customers will not be able to pay them back on time. because the level Working capital management involves risk-return tradeoffs e a firm’s risk and composition and financing of working capital always affect both its profitability. TRACING CASH AND NET WORKING CAPITAL To trace cash movement through the firm's operation, we must measure the operating éycle as well as the firm’s cash conversion cycle. Understanding the following time periods is necessary in monitoring the working capital movement. 1. Operating Cycle. The length of time in which the firm purchases or produce inventory, sell it and receive cash. 2. Cash Conversion Cycle. The length of time funds are tied up in working capital or the length of time between paying for working capital and ‘collecting cash from the sale of inventory. © Inventory Conversion Period. The average time required to purchase merchandise or to purchase raw materials and convert them into finished goods and then sell them. * Average Collection Period. The average length of time required to convert the firm’s receivables into cash, that is, to collect cash following a sale. © Payables Deferral Period. The average length of time between the purchase of materials and labor or merchandise and the payment of cash for them. Figure 11-1 shows the relationship between operating and cash conversion cyele.Addressing Working Capital Policies and Management ..._ 255 7 >< > Inventory Conversion Period Average Collection Period L Operating Cycle < - >< > Average Payment Period Cash Conversion Cycle Figure 11-1, Operating and Cash Conversion Cycle Illustration THE OPERATING CYCLE The operating cycle of a company consists of the time period between the procurement of inventory of raw materials and turns them into finished goods (for manufacturing concerns), sell them and receive payment for them. To measure the firm’s operating cycle, the following formula can be used: Operating, Inventory n Average Cycle "Conversion Period Collection Period Operating _ _—Inventory x 365, Accounts Receivable_x 365 Cycle Costs of Sales Credit Sales Calculation of Operating Cycle s that Mermaid Industries has annual sales of PI million, cost of goods sold of P6S0,000, average inventories of P1 16,000, and average accounts receivable of P150,000, Assuming that all Mermaid Industries sales are on credit, what will be the firm’s operating cycle?256 Chapter 11 Solution: The operating cycle will be equal to: Operating _ Inventory x_365 ‘Accounts Receivable x 365 Cycle ~~ Costs of Sales. * Credit Sales = P116,000 x 365 + P150,000 x 365 650,000 P 1,000,000 = 65.14days + += 54.75 days = 119.89 days So it will take Mermaid Industries almost 120 days from the time they receive raw materials, to produce, market, sell and collect the cash for their finished goods. THE CASH CONVERSION CYCLE The firm’s cash conversion cycle is determined by subtracting the average payment period from the operating cycle. Cash Conversion _ Operating Average Cycle Cycle Payment Period Cash Conversion _ Operating _— Accounts Payable x 365 Cycle Cycle Cost of Sales Calculation of Cash Conversion Cycle Using the data from the previous example Mermaid Industries and a: the average accounts payable balance is P120,000, what will be th conversion cycle? ssuming that fe firm’s cash257 Addressing Working Capital Policies and Management .._257_ Solution: The cash conversion cycle will be equal to: Cash Conversion = Operating Accounts Payable_X Cycle Cycle - Cost of Sales = 119,89 — £120,000.x 365 650,000 = 32.5 days The cash conversion cycle (CCC) may also be calculated as follows: Conversion Period * Collection Period Deferral Period lccc= Inventory Average Payables Inventory _ Average Inventory _ P116,000 Conversion = — CostofSales = ~ 650,000 = 65.14 days Period 365 days 365 days Average Accounts Average Receivable _ 150,000 _ . Collection = ——Creait Sales ~ 21,000,000 ~ 5475 days Period 365 days 365 days Payables _Average Payables _P120,000__ Deferral = ~ CostofSales = —_650,000 = 67.38 days Period 365 days 365 days Cash Conversion _ 65.14 + S475 - 67.38 Cycle (CCC)258. _Chapter II bs >< > Inventory Conversion Period (65 days) Average Collection Period (55 days) Operating Cycle (120 days) Ss > < Average Payment Period (67 days) Cash Conversion Cycle (53 days) > Figure 11-2. Operating and Cash Conversion Cycle Illustration Discussion: On Day 1, Mermaid buys merchandise and expects to sell the goods and thus convert them to accounts receivable in 65 days. It should take 55 days to collect the receivables, making a total of 120 days between receiving merchandise and collecting cash. However, Mermaid is able to defer its own payments for only 67 days. Although Mermaid must pay its suppliers after 67 days, it will not receive any cash until 120 days into the eycle. Therefore, it may have to borrow from its bank on day 67 and it will not be able to repay the loan until it collects from customers on Day 120. Thus, for 53 days which is the cash conversion cycle (CCC), it will owe the bank and will be paying interest on this debt. Thus, the shorter the cash conversion cycle, the better because that will lower interest charges. Therefore, if Mermaid could (a) sell the goods faster, (b) collect receivables faster, or (c) defer its payables longer without hurting sales or increasing operating costs, its cash conversion cycle would decline, its interest charges would be reduced, and its profits and stock price would be improved. How CAN OPERATING CYCLE BE REDUCED The aim of every management should be to reduce the length of operating cycle or the number of operating cycles in a year in order to reduce the need'for working capital. It is therefore necessary that the financial managers be able to identify the reasons for prolonged operation cycle and how it could be reduced,Addressing Working Capital Policies and Management .._ 259 The following could be the reasons for longer operating cycle period: 1. Defecti ing poli fective purchasing policy and practices that could lead to turchase of raw materials or merchandise in excess/short of requirements Buying inferior, defective materials thus lengthening the production time Failure to get credit from suppliers Failure to get trade/cash discount, and Inability to purchase goods due to seasonal swings 2. Lack of proper production planning, coordination and control that could result to protracted manufacturing cycle 3. Defective inventory policy 4. Use of outdated machinery, technology as well, poor maintenance and upkeep of plant, equipment and infrastructure facilities 5. Defective credit policy and receivable collection procedures 6. Lack of proper monitoring of external environment Remedies that may be adopted to reduce the length of operating cycle period are as follows: 1. Production Management There should be proper production planning and coordination at all levels of activity. Also, a continuing assessment of the manufacturing cycle, proper maintenance of plant, equipment and infrastructure facilities and improvement of manufacturing system, technology would help shorten manufacturing cycle thus shortening the operating cycle. 2. Purchasing Management ‘The purchasing manager should ensure the availability of the right type, quantity and quality of materials/merchandise obtained at the right price, time and place through proper logistics management. Further, efforts exerted towards lengthening the credit period of the suppliers, increasing260 Chapter 11 the rates of trade discount and cash discount would certainly bring favorable outcome to the company’s deferral payment period. 3. Marketing Management The sale and production policies should be synchronized. Production of quality products at lower costs enhances their marketability and saleability. Storage costs would likewise be minimized. The marketing People should strive to continually develop effective advertisement, sales promotion activities, effective salesmanship and appropriate distribution channels, 4. Credit and Collections Policies Sound credit and collection policies will enable the finance manager to minimize investment in working capital particularly on inventory and receivables. 5. External Environment The length of operating cycle is equally influenced by external environment. The financial manager should be aware and sensitive to fluctuations in demand, entrants of new competitors, government fiscal and monetary policies, price fluctuations, etc. to be able to anticipate and minimize any adverse impact of the changes to the company. SOME ASPECTS OF SHORT-TERM FINANCIAL POLICY The working capital or short-term financial policy that a firm adopts involves answering two basic questions. 1. What'is the appropriate size of the firm’s investment in current assets? 2. How should the current assets be financed?Addressing ALTERNATIVE POLICY CURRENT ASSETS ES AS TO THE SIZE OF INVESTMENT IN There are at least thres a alternative aes a assets cartied: Policies regarding the total amount of 1, Relaxed Current Asset Investm nt Policy This is a policy under which relatively large amounts of cash, marketable Securities and inventories are carried and under which sales are stimulated by granting liberal credit terms resulting in a high level of receivables. In this policy, marginal carrying costs of current assets will increase while marginal shortage costs will decrease. 2. Restricted Current Asset Investment Policy This is a policy under which holdings of cash, securities, inventories and receivables are minimized. Marginal carrying costs of current assets will decrease while marginal shortage costs will increase. wo Moderate Current Asset Investment Policy This is a policy. that is between the relaxed and restricted policies. This policy dictates that the firm will have just enough current assets so that the marginal carrying costs and marginal shortage costs are equal, thereby minimizing total cost. Figure 11-3 shows three alternative policies regarding the total amount of current assets carried in relation to sales.262 Chapter 11 Figure 17-3. Alternative Current Assets Policies Current assets (P millions) Relaxed Moderate Restricted 50° 100 150 Sales (P millions) Policy Current Assets to Support Sales of PISO Relaxed 60 Moderate 46 Restricted 32 Note: The sales/current assets relationship is shown here as being linear, but the relationship is often curvilinear.Addressing Working Capital Policies and Management .._263 Costs RELEVANT TO INVESTMENT IN CURRENT ASSETS Carrying costs are the cost asso consist of (a) opportuni assets instead of ciated with having current assets. Generally, they ly costs associated with having capital tied up in current More productive fixed assets and (6) explicit costs which are costs necessary to maintain the value of the current assets (¢.g., storage costs). Shortage costs are the costs associated with not having current assets and can include (a) opportunity costs such as, sales lost due to not having enough inventory on hand and (b) explicit transaction fees paid (e.g., extra shipping costs, interest expense for money borrowed) to replenish the particular type of current asset. Figures 11-4, 11-5.and 11-6 show the behavior and trade off between carrying costs and shortage costs in relation to amount of current assets. On the vertical axis, we have costs measured in pesos and on the horizontal axis, we have the amount of current assets. Figure 11-4, Relaxed Policy Minimum Point Total Costs Carrying Costs Shortage Costs “Amount of Current Assets (CA) Current asset holdings are highest under the relaxed policy. A relaxed policy is most appropriate when carrying costs are low relative to shortage costs.264 Chapter 11 Figure 11-5, Restricted Policy Minimum Point y Total Costs 7 «——_ carrying Costs +-Shortage Costs Amount of Current Assets (CA) Current asset holdings are low. A restricted policy is most appropriate when carrying costs are high relative to shortage costs. Figure 11-6. Moderate Policy Minimum Point Total Costs of holding Current Assets Carrying Costs Shortage Costs ‘Amount of Current Assets (CA) Current asset holdings are optimized, Holding this amount minimizes total costs. Carrying costs increase with the level of investment in current assets. They include the costs of maintaining economic value and opportunity costs. Shortage costs decrease with increases in the level of investment in current assets.————_—_____4daressing Wi 265 ng Capital Policies and Management ALTERNATIVE STRATEGIES IN FINANCING WORKING CAPITAL In previous section, we looked atthe basic determinants of the level of investment in current assets. Now we turn to the financing side ofthe question. Eitective working capital management requires a set of strategies to manage the fevel, composition and financing of a fiem’s current assets. Decisions should be based on the simultaneous analysis of their joint impact on return and risk. In addition, consideration should be given on the broad categories of assets. These are: 1. Long-Term/Permanent Assets. These consist of property, plant and equipment, long-term investments and the portion of a firm’s current assets that remain unchanged over the year. 2. Fluctuating or Seasonal Assets. These are current assets that vary over the year due to seasonal or cyclical needs. Figure 11-7 shows the Total Assets Requirement over Time. Figure 11-7. The Total Assets Requirement over Time Seasonal Variation Total Assets Require- ment General growth in fixed assets and permanent current assets,266 Chapter 11 Figures 11-8, 11-9 and 11-10 show the different policies for financing current assets. Figure 11-8. Policy T FLEXIBLE FINANCING POLICY Total Assets Requirement Seasonal Variation Long-term Debt and Equity Figure 11-9. Policy II RESTRICTED FINANCING POLICY Total Assets Requirement Short-term Seasonal Financing Variation 7 Long-term General growth in fixed Debt and assets and permanent |] Equity current assets——__Aidressing Working Capital Policies and Management _267_ Figure 11-10. Policy 11 Short-term Seasonal Variation Long-term General growth |{ Debt and in fixed assets || Equity Marketable] and permanent Securities current assets Discussioi Policy I Flexible Financing Policy (Figure 11-8) This involves the decision to finance the peaks of asset requirement with long-term debt and equity. It provides the firm with a large investment surplus in cash and marketable securities most of the time. For example, for a school supplies firm, the peaks might represent inventory building prior to the opening of classes. The valleys would come about because of lower off-season inventories. The firm could keep a relatively large pool of cash and marketable securities. As the need for inventory and other current assets began to rise, the firm would sell off marketable securities and use the cash to purchase whatever was needed. Once the inventory was sold and inventory holdings began to decline, the firm would reinvest in marketable securities. Here, the firm essentially uses a pool of marketable securities as a buffer against changing current asset needs and never does any short-term borrowing except in unusually very high peak asset demand.268 Chapter 11 Policy I Restricted Financing Policy (Figure 11-9) This involves a decision to finance the valleys or troughs of asset, with long-term debt and equity but will have to seek short-term financing for all peak demand fluctuations for current assets as well as for in between demand situations. This policy is considered the most “conservative” but the least convenient because it involves seeking some level of short-term financing almost all of the time. Policy INI Compromise Financing Policy (Figure 11-10) This involves a firm financing the seasonally adjusted average level of asset demand with long-term debt and equity. It uses both short-term financing and short-term investing as needed. With this compromise approach, the firm borrows in the short-term to cover peak financing needs but it maintains a cash reserve in the form of marketable securities during slow period. As current assets build up, the firm draws down this reserve before doing any short-term borrowing. This allows for some run-up in current assets before the firm has to resort to short-term borrowing. WHICH FINANCING POLICY SHOULD BE CHOSEN On the question as to what is the most appropriate financing working capital strategy? There is no definitive answer. However, the following should be considered in analyzing the advantages/disadvantages of the alternative financing policy for working capital. 1, Maturity Hedging. Most firms attempt to match the maturities of assets and liabilities. They finance inventories with short-term bank loans and long-term assets with long-term financing. Firms tend to avoid financing long-lived assets with short-term borrowing. This type of maturity mismatching would necessitate frequent refinancing and is inherently risky because short-tem interest rates are more volatile than longer-term rates. 2. Cash Reserves. The flexible financing policy implies surplus cash and a little short-term borrowing, This policy reduces the probability that a firm will experience financial distress. Firms may not have to worry as much about meeting recurring, short-run obligations. However, investments in cash and marketable securities are zero net present value investments at best.ing Working Capital Policies and Management ». 269 3. Relative Interest Rates, long-term rates. This impl on long-term borrowing Short-term interest rates are usually lower than ies that it is, on the average, more costly to relv as compared to short-term borrowing. If * expect rates to rise in the future, the firm may want to lock in fixed ra’ for a longer time by shifting towards a flevible financing policy. Wau falling rates, the opposite would of course hold true. Availability and Costs of Alternative Financing. Firms with easy and Sustained access to alternative sources will want to shift toward more restricted policy. 5. Impact on Future Sales. A more restricted short-term financial policy probably could reduce future sales to level that would be achieved under Alexible policy. It is also possibi2 that prices can be charged to customers under flexible working capital policy. Customers may be willing to pay higher prices for the quick delivery service and more liberal credit terms implicit in flexible policy.