Financial Management PPT Presentation

PowerPoint Presentation
prepared by
Traven Reed
Canadore College
chapter 17
Working Capital
Management and
Short-Term Financing
Corporate Valuation and
Working Capital Management
CH17
Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-3

Topics in Chapter
CH17
• Cash conversion cycle

• Alternative net operating working
capital policies
• Cash budget
• Short-term financing policies
• Trade credit
• Bank loans and their costs

Basic Definitions
CH17
• (Gross) working capital: total current

assets used in operations
• Net working capital: current assets -
current liabilities.
• Net operating working capital (NOWC):
Operating CA – Operating CL = (cash +
inventories + accounts receivable) –
(accruals + accounts payable)

Cash Conversion Cycle
CH17
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
Period
Cycle Period Period

CH17

CH17
• CCC = inventory period (73) +

receivables period (24) – accounts
payable period (30) = 67 days
• = Inventory + Receivables - Payables
sales/365 sales/365 COGS/365
• Where sales = $10m, inv = $2m, cost of
goods sold = $8m, A/R = A/P = $657,534
• Net delay = cash inflow delay – payment
delay = (73 + 24) – 30 = 67 days
Shortening
CH17
• CCC can be improved:
– By processing and selling goods
quickly (ICP↓)
– By speeding up collections (DSO↓)
– By slowing down payments (PDP↑)
• Without increasing costs or
depressing sales, firms should
make their CCC as little as possible

Benefits from shortening
CH17
CCC
Original Improved
Annual sales $10,000,000 $10,000,000
Cost of goods sold (COGS) 8,000,000 8,000,000
Inventory conversion period 73 days 65 days
Receivables collection period 24 days 23 days
Payable deferral period (30) days (31) days
Cash conversion cycle 67 days 57 days
Inventory $2,000,000 $1,780,82
Receivables 657,534 630,137
Payables (657,534) (679,452)
Net operating working capital $2,000,000 $1,731,507
• ∆NOWC = -$268,493 (improvement)

Definitions
CH17
• Net operating working capital

management includes both
establishing policy and then the
day-to-day control of cash,
inventories, receivables, accruals,
and accounts payable.
• NOWC policy deals with:
– The level of each current asset.
– How current assets are financed.

Net Working Capital Policies
CH17
• Relax working capital policy: firms

hold relatively large amounts of
each type of current asset.
• Restricted working capital policy:
firms would hold minimal amounts
of these item. Each dollar of
NOWC is forced to “work harder”.
• Moderate working capital policy:
between the two extremes.
Permanent vs. temporary
CH17
NOWC
• Permanent net operating working
capital is the NOWC that the firm
holds even during slack times.
• Temporary NOWC is the additional
NOWC needed during seasonal or
cyclical peaks.
• In reality, NOWC never drops to
zero.
Working Capital Financing
Policies
CH17
• Self-liquidating Approach: Match

the maturity of the assets with the
maturity of the financing.
• Aggressive Approach: Use short-
term financing to finance permanent
assets.
• Conservative Approach: Use
permanent capital for permanent
assets and temporary assets.
Moderate Financing Policy
CH17
$ Temp. NOWC
} S-T
Loans
L-T Fin:
Perm NOWC Stock &
Bonds,
Fixed Assets
Years
Lower dashed line, more aggressive.
Conservative Financing Policy
CH17
$ Marketable Securities
Zero S-T
debt
L-T Fin:
Perm NOWC Stock &
Bonds
Fixed Assets
Years
Illustration:
Selected Ratios for SKI
CH17
SKI Industry
Current 1.75x 2.25x
Quick 0.83x 1.20x
Debt/Assets 58.76% 50.00%
Turnover of Cash 16.67x 22.22x
DSO(365-day year) 45.63 32.00
Inv. Turnover 4.82x 7.00x
F.A. Turnover 11.35x 12.00x
T.A. Turnover 2.08x 3.00x
Profit Margin 2.07% 3.50%
ROE 10.45% 21.00%
Payables deferral 30.00 33.00

How does SKI’s NOWC policy
compare with the industry?
CH17
• Working capital policy is reflected in

a firm’s 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.
Is SKI inefficient or just
conservative?
CH17
• 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.
Cash Budget: The Primary
Cash Management Tool
CH17
• 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 budget’s purpose.
Monthly for annual planning, daily for
actual cash management.

Cash Budget: Inputs
CH17
• Sales forecast.
• Information on collections delay.
• Forecast of purchases and payment
terms.
• Forecast of cash expenses: wages,
taxes, utilities, etc.
• Initial cash on hand.
• Target cash balance.

Cash Budget: Output
CH17
• A cash budget is used mainly for

planning purposes.
• There are three major sections of a
cash budget
– Collections and purchases worksheet
– Cash gain or loss over the period
– Loan requirement or cash surplus

SKI’s Cash Budget for
January and February
CH17
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

Cash Budget (cont’d)
CH17
January February
Cash at start if no
borrowing
$3,000.00 $16,857.64
Net CF (previous 13,857.64 18,311.85
slide)
Cumulative cash $16,857.64 $35,169.49
Less: target cash 1,500.00 1,500.00
Surplus $15,357.64 $33,669.49

Implications for Cash Surplus
CH17
• Cash budget indicates the company probably is

holding too much cash.
• Company could improve its EVA by either
investing its excess cash in more productive
assets or by paying it out to the firm’s
shareholders.
• 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 excess cash may be there, in part, to fund
a planned fixed asset acquisition.
Cash Budget Issues #1
CH17
• Should depreciation be explicitly

included in the cash budget?
• No. Depreciation is a noncash
charge. Only cash payments and
receipts appear on cash budget.
• However, depreciation does affect
taxes, which do appear in the cash
budget.
CH17
• What are some other potential cash

inflows besides collections?
• Proceeds from fixed asset sales.
• Proceeds from stock and bond
sales.
• Interest earned.
• Court settlements.

CH17
• 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 from preceding month.
• Note: Interest on any other debt would
need to be incorporated as well.
Cash Budget issue #4
CH17
• 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.
Short-term Financing
CH17
• The relative amount of short-term credit

used is critical for a financing policy.
• Advantages:
– Low cost-- yield curve usually slopes upward.
– Can get funds relatively quickly.
– Can repay without penalty.
• Disadvantages:
– Higher risk. The required repayment comes
quicker, and the company may have trouble
rolling over loans.

Accruals
CH17
• Accruals arise when payments are

not yet made, but the services have
been performed.
• Accruals increase automatically as
a firm’s operations expand
• Firms use all the accruals they can,
but they have little control over the
levels and timing of these accounts.
What is trade credit?
CH17
• Trade credit is credit furnished by a

firm’s suppliers.
• Trade credit is often the largest
source of short-term credit,
especially for small firms.
• Spontaneous, easy to get, but cost
can be high.

Illustration: Find free and costly
trade credit
CH17
• A firm buys $506,985, on terms of

1/10, net 30, and pays on Day 40.
• Net daily purchases = 506,985/365
=
$1,389
• Annual gross purchases =
$506,985/(1-0.01) =$512,106
• List price = true price + finance
charge Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-33
Gross/Net Breakdown
CH17
• Company buys goods worth

$506,985 That’s the cash price.
• They must pay $5,121 more if they
don’t 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.
Free and Costly Trade Credit
CH17
Payables level if take discount:

Payables = $1,389(10) = $13,890
Payables level if don’t take discount:

Payables = $1,389(40) = $55,560
Total trade credit = $55,560
Free trade credit = 13,890
Costly trade credit = $41,670
Nominal Cost of Costly Trade Credit
CH17
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 EAR rate is higher.
Nominal Annual Cost Formula: 1/10,
net 40
CH17
rNom = Discount % × 365 days

1 - Discount % Days Discount
Taken
- Period
1 365
= × = 0.0101 × 12.1667
99 30
= 0.1229 = 12.29%
Interpretation:
Pays 1.01% 12.167 times per year.
Effective Annual Rate, 1/10, net 40
CH17
• 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%

Short Term Bank Loans
CH17
• Loan application.
• Interest rates.
• Maturity.
• Collateral.
• Covenants.
• Line of credit.
• Commercial paper.

Assessing Loan Application
CH17
• Historical financials.
• Pro forma financials.
• Income and EBITDA.
• Types of assets.

Interest Rates
CH17
• Prime rate is the lowest interest rate

at which a bank lend money to its
best customers.
• Prime rate differs from Bank rate
although they are highly correlated
• Rates on loans are generally scaled
up from the prime rate, e.g. P+2%
• Interest rate can be fixed or floating
Collateral
CH17
• The short term loan is secured by a

specific collateral item (asset).
• Banks usually have a “General
Security Agreement” written into the
agreement that covers all of the
lender’s asset
• The collateral is registered under
the Personal Property Security Act
(PPSA).
Covenants
CH17
• Designed to protect the lender.

• Specific terms written into the loans
that the borrower must adhere to for
the loan to remain in good standing.
• Examples of covenants:
– Better current ratio
– Minimum interest payment coverage
– Minimum cash balance

Line of Credit
CH17
• One year operating loan designed

to finance seasonal working capital
requirements.
• Interest rate floats based on prime.
• Interest is only paid when funds are
borrowed.
• Revolving line of credit has 3- or 4-
year of maturity.
Commercial Paper (CP)
CH17
• Short term unsecured notes issued

by large, strong companies. Small
firms cannot issue CP.
• CP trades in the market at rates just
above T-bill rate.
• CP is bought with surplus cash by
banks and other companies, then
held as a marketable security for
liquidity purposes.
Bankers’ Acceptances
CH17
• Significant source used to finance

goods sold with long payment terms
such as exports and imports
• BA is a firm’s time draft that has
been accepted by a bank
• This means the bank guarantees
payment of the amount stated on
the draft when it matures
Calculating Financing Costs
CH17
• The cost of bank loans varies

widely depending upon the terms of
the loan.
• For illustrative purposes, consider a
$10,000, 2-month (60days) loan
with a nominal interest rate of 10%.
m
 costs  benefits
EAR  1   1
 amount 

Regular (Simple) Interest
CH17
Calculation
• Cost involved is interest
• Amount of financing is $10,000
• Interest charge for period = (days in
period) × (rate per day) × (amount)
= (60) × (0.1/365) × ($10,000) =
$164.38.
365 60
 $164.38
EAR  1    1  10.43%
 $10,000 
Discount Interest Calculation
CH17
• In a discount loan, bank deducts

the interest in advance.
• Cost involved is interest = $164.38.
Amount of financing is $10,000 –
interest = $10,000 - $164.38 =
$9,835.62
365 60
 $164.38 
EAR  1    1  10.61%
 $10,000  $164.38 

Compensating Balances
CH17
Calculation
• Cost involved is interest. Amt of
financing is $10,000 – compensate
balance + normal balance.
• Given: 30% compensating balance
and firm always keeps $1,500.
365 60
 $164.38 
EAR  1  1  12.36%
 $10,000  $3,000  $1,500

Installment Loans Calculation
CH17
• Lenders typically charge add-on

interest on installment loans.
• Interest cost = $164.38. The
payment is ($10,000+$164.38)/2 =
$5,082.
1  [1 /(1  EAR ) n 
Loan  PMT  
 EAR 
1  [1 /(1  EAR ) 2 
$ 10 ,000  $ 5,082 .19    EAR  13 .95 %
 EAR 
Secured Short-Term
CH17
Financing
Secured Loans: a company will offer
assets as security.
– A/R financing
– Inventory financing
• Weaker firms can obtain financing by pledging
accounts receivable as security against a loan
or by factoring (selling) the receivables to a
finance company
• Depending on the firm’s credit-worthiness, an
inventory blanket lien, a trust receipt, or
warehouse receipt financing methods may be
used.

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PowerPoint Presentation

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-3

• Cash conversion cycle

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-4

• (Gross) working capital: total current

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-5

The cash conversion cycle focuses on the time

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-6

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-7

• CCC = inventory period (73) +

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-9

• ∆NOWC = -$268,493 (improvement)

• Net operating working capital

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-11

• Relax working capital policy: firms

• Self-liquidating Approach: Match

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-17

• Working capital policy is reflected in

• A relaxed policy may be appropriate

• Purpose: Uses forecasts of cash

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-20

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-21

• A cash budget is used mainly for

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-22

Net Cash Inflows

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-23

Less: target cash 1,500.00 1,500.00

Surplus $15,357.64 $33,669.49

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-24

• Cash budget indicates the company probably is

• Should depreciation be explicitly

• What are some other potential cash

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-27

• How can interest earned or paid on short-

• How could bad debts be worked

• The relative amount of short-term credit

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-30

• Accruals arise when payments are

• Trade credit is credit furnished by a

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-32

• A firm buys $506,985, on terms of

• Company buys goods worth

Payables level if take discount:

Payables level if don’t take discount:

Firm loses 0.01($512,106) = $5,121 of

But the $5,121 is paid all during the year,

rNom = Discount % × 365 days

• Periodic rate = 0.01/0.99 = 1.01%.

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-38

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-39

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-40

• Prime rate is the lowest interest rate

• The short term loan is secured by a

• Designed to protect the lender.

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-43

• One year operating loan designed

• Short term unsecured notes issued

• Significant source used to finance

• The cost of bank loans varies

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-47

• In a discount loan, bank deducts

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-49

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-50

• Lenders typically charge add-on