WORKING CAPITAL MANAGEMENT

Components of Working Capital

Current Assets & Current Liabilities
are collectively known as
WORKING CAPITAL

Cash & Marketable Securities:

Cash: Dollar Bills & Bank Deposits.
DEMAND DEPOSITS: Money in checking accounts that the firm can pay out immediately.
TIME DEPOSITS: Money in saving accounts that the firm can pay out only with a delay.

Marketable Securities: Commercial Paper & Tresury Bills

Accounts Receivable:
arise because of companies do not usually expect
customers to pay for their purchases immediately.
These unpaid bills are a valuable asset that companies
expect to be able to turn into cash in the near future.
TRADE CREDIT : Unpaid bills from sales to other companies.
CONSUMER CREDIT : Sales of goods to the final customers.
Components of Working Capital
Accounts Payable: Unpaid Bills
Outstanding payments due to other companies

One firm’s credit is another firm’s debit

NET WORKING CAPITAL

CURRENT ASSETS – CURRENT LIABILITIES
Generally called as

WORKING CAPITAL
 CASH

RECEIVABLES CASH CONVERSION CYCLE INVENTORY

FINISHED
GOODS

CASH CONVERSION CYCLE =

(Inventory Period + Receivables Period) – Accounts Payable Period
 CASH CONVERSION CYCLE =
(Inventory Period + Receivables Period) – Accounts Payable Period

CASH CONVERSION CYCLE :

Period between firm’s payment for materials and collection on its sales

Inventory Period = Average Inventory / [Cost of Goods Sold / 365]

Receivables Period = Average Accounts Receivables / [Sales / 365]

Payable Period = Average Payable / [Sales / 365]
 Working Capital Trade-off
Carrying Costs:
Costs of maintaining Current Assets; including opportinity cost of capital.
Investment in CASH & RECEIVABLES may cause an interest loss and
Investment in INVENTORY has opportinity cost of capital; storage & insurance costs

Carrying Costs encourage firm to hold current assets to a MINIMUM

Shortage Costs:
Costs incurred from shortages in Current Assets
Shortage in CASH may incur unnecassary transaction costs of selling marketable securities and
Shortage in RECEIVABLES may cause to lose customers because of credit sales’ restrictions
Shortage in INVENTORY may have shut down production & unable to to fill orders promptly

Shortage Costs encourage firm to hold current assets to a MAXIMUM

It’s an art to find the LEVEL of CURRENT ASSETS

that minimizes the sum of
Carrying Costs & Shortage Costs
 Links between
Total
Capital
LONG-TERM & SHORT-TERM fınancıng
Requirement

Short-Term financing

Seasonal
component of
required assets

Long -Term financing

Time

Firm’s Total Capital Requirement: The Cost of Assets

STRATEGIES:
1. Matching Maturities: Long-Lived assets with long-term debt & Current Assets with short-term
debt
2. Permanent Working Capital Requirements: A positive amount of WORKING CAPITAL
3. The Comforts of Surplus Cash:The firm is always a short-term lender (Relaxed Strategy)
 TRACING CHANGES IN CASH & NWC

Cash Budgeting:
Forecasting future sources and uses of cash
Alerts for future cash needs & provides a standart

Three Common Steps to preparing Cash Budget

1. Forecast the sources of cash

2. Forecast the uses of cash

3. Calculate whether the firm is facing a

cash shortage or plus
DETAILS:

The Steps of Calculating Sources of Cash

1. Receivables at the start of period

2. Forecast Sales
3. Forecast Collections
• Sales in current period (%?)
• Sales in last period (%?)
TOTAL COLLECTIONS
4. Receivables at the end of period
5. Other sources of cash (Dispose of land, machine, stock)

Ending Accounts Receivable = Beginning Acc. Rec. + Sales - Collections

DETAILS:

The Steps of Calculating Uses of Cash

1. Payments for Accounts Payable

2. Labor, Administrative and Other Expenses
(Regular Business Expenses)

3. Capital Expenditures (Pay for long-lived assets)

4. Taxes, Interest and Dividend Payments

Prepare SOURCES & USES CASH LIST each period

Determine Short-Term Financing Requirements

 DYNAMIC MATTRESS'S FINANCING PLAN

1. Quarter 2. Quarter 3. Quarter 4. Quarter TOTAL

Cash Inputs 86,5 80,3 121,0 128,0 415,8

Cash Outputs 131,5 95,3 95,0 93,0 414,8

Cash Balance 45,0 15,0 26,0 35,0 1,0

Marketable Securities 5,0 5,0

Bank Loan 2% 40,0 8,6 31,4 40,0

Interest Payment 0,8 1,6 0,6 3,0

Stretch 5% 15,8 15,8 0

Cash Balance 45,0 15,0 26,0 32,0 2,0

Additions to Cash
Balance 3,0 3,0
QUESTIONS:

1. Cash or Marketable Securities enough or expand?

2. Does plan cahnge Current & Quick Ratios?

3. Hidden costs to stretching payables?

4. Does plan leave DYNAMIC in good financial shape for 2005?

5. What about log-term financing and capital expenditures?

6. Can the firm’s operating and investment plans be adjusted to

make the short-term financing problem easier?

SHORT-TERM FINANCING PLANS MUST BE DEVELOPED BY

TRIAL & ERROR !...

 SOURCES OF SHORT-TERM FINANCING

Bank Loans:
Line of Credit: Aggrement by a bank that a company may borrow at
any time up to an established limit.
Revolving Credit Aggrement: If the firm wants to be sure it will able
to borrow; it can enter a RCA. ( RCA usually last for a few years and formally commit the
bank to an aggreed limit. A committment fee is required on any unused amount.)

Term Loans: Conditional Credit (Loans are paid when the goods are sold)

Syndicate Credit: Banks combined to provide cash

Commercial Paper:
Short-Term unsecured notes issued by firms
 SOURCES OF SHORT-TERM FINANCING
Secured Loans:
Accounts Receivables Financing
1. Some companies solve their financing problem by borrowing on
the strength of their current assets!...
When a loan is secured by receivables, the firm assigns the receivables
to the bank.
The risk of default on the receivables is therefore borne by the firm
2. Others solve it by selling their current assets!...
An alternative procedure is to sell the receivables at a discount to
a financial institution known as FACTOR and let it collect the
money.
Once the firm has sold receivables, the factor bears all the
responsibility for collecting on the accounts!...

Inventory Financing
Bank also lend on the security of inventory; but they are choosy
about the inventory they will accept!...
 THE COST OF BANK LOANS

Simple Interest
1. Simple Interest: The interest rate on bank loans frequently is
quoated on APR
2. Discount Interest : The interest rate on bank is often calculated on a
discount basis.
3. Interest with Compensating Balances: Occasionally, bank loans
require the firm to maintain some amount on balance at the bank,
which is called as Compensating Balance.
The reason is that borrower must pay interest on full amount borrowed
but has access only part of the funds.
In each case; the face value of the interest has to be
converted to effective interest rate in order to learn the actual
burden on the loan.
CASH & INVENTORY
MANAGEMENT
 Cash & Inventory Management
Cash Collection; Disbursement & Float
PAYMENT FLOAT: Checks written by a company that have not yet cleared.
Company’s Ledger Balance Payment Float
800,000 + 200,000

Banks Ledger Balance

1,000,000

AVAILABILITY FLOAT: Checks already deposited that have been cleared

Available Balance Availability Float
1,000,000 + 120,000

Banks Ledger Balance

1,120,000

NET FLOAT: Difference between Payment & Availability Float

NET FLOAT = 200,000 - 120,000 = 80,000

Valuing Float:
Float results from delay between your writing a check and the reduction in your bank balance.
The amounf depends on the size of check & delay in collection.
Playing the float: To hold more funds in interest earning accounts!..
 Managing Float
Delays that help the payer hurt the receipent.
Receipents try to speed up collections.
Payers try to slow down disbursements.
Both attempt to minimize NET FLOAT

Check Mailed

Mail Float
Receipents Payers
see delays a see delays as
availability Check Received payment
float float
Processing Float

Check Deposited

Check clears Check clears

Check Available to receipent Check charged to payer’s account

 SPEEDING UP COLLECTIONS
Concentration Banking:
System whereby customers make payments to a regional collection center
which transfers funds to a principal bank.

Lock-box system:
System whereby customers make send payments to a post office box and
a local bank collects and processes checks.

Controlling Disbursements
Speeding up collections is not only way to increase the net float.
You can also do this by slowing down disbursements.
•Increase Mail Time
•Remote Disbursement
•Zero Balance Account:
(Regional Bank Account to which just enough funds are transferred daily to pay each day’s bills)
•Electronic Fund Transfer
(About %14 of business to business payments, especially big companies use electronic payments)
•ACH (Automated Clearing House) :
(Bulk payments such as wages; dividends; payments to suppliers travel through ACH)
(ACH is easy, transaction costs are very low, float is drastically reduced.)
 INVENTORIES & CASH MANAGEMENT
Cash Management involves a Trade-off
If the cash is invested in securities, it would earn interest.
On the other hand, you can’t use securities everytime to pay firm’s bills.
If you had to sell those securities everytime you needed to pay a bill,
you would incur heavy transaction costs.

The art of cash management is to balance these costs and benefits!..

Managing Inventories
Total Costs = Order Costs + Carrying Costs
Carrying
costs Order costs
80
Level Orders 3 TL 3 TL Total

24 1 72 3 75 70

12 2 36 6 42 60

8 3 24 9 33 50
Total Costs
6 4 18 12 30 40
4,8 5 14,4 15 29,4 30
4 6 12 18 30 Carrying Costs
20
3,4 7 10,3 21 31,3 Order Costs
10
3 8 9 24 33
0
2,7 9 8 27 35
1 2 3 4 5 6 7 8 9 10
2,4 10 7,2 30 37,2 Number of Orders

When Orders increases; Order costs increases but Carrying costs decreases

ECONOMIC ORDER QUANTIY = Order size that minimizes total inventory costs!...
= [ ( 2 * Annual Sales * Cost Per Order * ) / Carrying Costs ]^(1/2)
 INVENTORIES & CASH MANAGEMENT
Cash Management involves a Trade-off
If the cash is invested in securities, it would earn interest.
On the other hand, you can’t use securities everytime to pay firm’s bills.
If you had to sell those securities everytime you needed to pay a bill,
you would incur heavy transaction costs.

The art of cash management is to balance these costs and benefits!..

Managing Inventories of Cash

Simple Inventory Models can tell us something about the management of Cash Balances
Total Costs = Cost of per sale of securities + Interest rates

INITIAL CASH BALANCE =

[ ( 2 * Annual Cash Outflows * Cost Per Sale of Securities ) / Interest Rates ]^(1/2)

Basic Trade-offs of Cash Management

•When the cost of selling securities is high, you should hold larger average cash balances
•When interest rates are high, you should hold smaller cash balances
•When annual cash outflows increase, the optimal level of cash incresases less than
proportionally
 Uncertain Cash Flows
If cash flows are unpredictable, the cash balance should be allowed to
meander until it hits an upper or lower limit.

Upper Limit
C
a
s
h

B Return Point
a
l
a
n Lower Limit
c
e Time

At this point the firm buys or sells securities to restore the balance to the return point.
The lower limit plus one-third of the spread between the upper and lower limits.
 INVESTING IDLE CASH
Money Market:
Market for short-term financial assets.
Only fixed income securities with maturities less than ONE year!...
These securities are highly marketable or liquid.

Managing Inventories of Cash

Simple Inventory Models can tell us something about the management of Cash Balances
Total Costs = Cost of per sale of securities + Interest rates

MAIN TYPES OF MONEY MARKET SECURITIES

COMMERCIAL PAPER: Registrated by SEC with maturities of less than 2 months
CERTIFICATES OF DEPOSIT: CDs are time deposits at bank, usually in denominations
greater than $ 100,000
REPURCHASE AGGREEMENTS : Repos, repurchase aggreements are in effect
collateralized loans and are usually very short-term, with maturities of only a few days.
CREDIT MANAGEMENT &
BANKRUPTCY
 CREDIT MANAGEMENT & BANKRUPTCY
TERMS OF SALE
Credıt, discount, and payment terms offered on a sale
In many cases payment is not made after delivery, so the buyer receives
CREDIT
To encourage the customer to pay before final date, a cash discount is
offered for prompt settlement!.. And this is expressed as
5 / 10; net 30

% discount for Number of days that Number of days before

early payment discount is available payment is due

Depending these conditions customer receives 5% discount for a

payment within 10 days, or else must pay in full within 30 days!
 CREDIT MANAGEMENT & BANKRUPTCY

CREDIT AGGREEMENTS
Open account: Aggreement whereby sales are made with no formal debt contract!..

Commercial Draft: jargon for an order to pay

The seller prepares a draft ordering payment by the customer and sends this draft to customer’s bank.
For immediate payment it is called as “sight draft”
For delay payment it is called as “time draft”
The customer tells the bank to pay and acknowledges “accepted” and “signature”
When accepted a time draft is like postdated check and is called a “trade acceptance”
This trade acceptance is forwarded to the seller, who holds it until the payment becomes due!..
In case of suspicion seller ask the customer to organize the bank whether to accept the time draft.
If the bank guarantees then is called as “banker’s acceptance”
Banker’s acceptances are actively bought and sold in money market.

Conditional sale:
to avoid any unfortunate situations; the ownership of the goods
remains with the seller until full payment is made!...
 CREDIT MANAGEMENT & BANKRUPTCY
CREDIT ANALYSIS
Procedure to determine the likelihood a customer will pay its bills !..

To carry out Credit Analysis:

•Promptly payments in the past (be aware of the high credit limit for small payments !)
•Rating Services (customer!s full credit report upon request )
•The other firms’ experience
•Your Bank
•For public companies cheque Moody’s or S&Poors
•Customer’s Stock Price

Financial Ratio Analysis

Numerical Credit Scoring (Analyzing credit risk is like a detective work )

•The Customer’s character
•The Customer’s capacity to pay
•The Customer’s capital
•The Collateral provided by customer
•The Condition of customer’s business

•Z Score: A discriminant analysis at distinguishing bankrupt and nonbankrupt

firms.
If Z < 2,7 bankrupt possibility is 94%
If Z > 2,7 nonbankrupt possibility is 97%
CREDIT ANALYSIS IS WORTHWHİLE ONLY IF THE EXPECTED SAVINGS
EXCEED THE COST!...
 CREDIT MANAGEMENT & BANKRUPTCY
CREDIT DECISION
The decision to offer credit depends on the probability of payment!..

You should grant credit

if the expected profit from doing so is greater than the profit from refusing!...
Credit Policy: Standarts set to determine the amount and nature of credit to extend to customers.
Customer pays (p) REVENUES - COST

Offer Credit

Customer defaults (1 - p) - COST

Refuse Credit

Refuse Credit : 0

Grant Credit : [p * PV(REVENUES – COST)] – [(1 - p) * PV ( COST)] if positive!...

If one sale may lead to profitable repeat sales, the firm should be inclined to grant credit on the initial
purchase.
 CREDIT MANAGEMENT & BANKRUPTCY
Some General Principles:
•Maximize Profit: Main job is not to minimize the bad accounts; it is to maximize PROFITS!
•Concentrate on the dangerous accounts: Set credit limits for each customer and WHEN THE
CUSTOMER EXCEEDS TAKE CARE!
•Look beyond the immediate order: Sometimes take care the growth in sales in the LONG-RUN.

Collection Policy:
•Procedures to collect and monitor receivables.
Account Receivable = Daily Sales X Average Collection Period
When customers stretch payables you end up a longer collection period!..
Never forget the formula and establish a COLLECTION POLICY:

Aging Schedule:
•Classification of accounts receivable by time outstanding!
Customer’s Name 1 month 1-2 months 2-3 months 3 months over TOTAL

A $10,000 $ 10,000
B $ 8,000 $3,000 $ 11,000
...
Z $ 15,000 $ 15,000
TOTAL $ 18,000 $ 3,000 $ 15,000 $ 36,000

Good collection policy balances conflicting goals. The company wants cordial relations with
customers and also wants them to pay the bills on time!...
 CREDIT MANAGEMENT & BANKRUPTCY
BANKRUPTCY:
•The reorganization or liquidation of a firm that can not pay its debts.

WORKOUT:
• Agreement between a company and its creditors establishing the steps the
company must take to avoid bankruptcy.
• The advantage of a negotiated agreement is that the costs and delays of
formal bankruptcy are avoided.
• If the firm cannot get an agreement, then it may have no alternative but to
file for bankruptcy. Then the firm’s assets are liquidated - that is, sold –
and the proceeds are used to pay creditors.

LIQUIDATION: Sale of bankrupt firm’s assets.

• Priorities:
1. No firm in bankruptcy proceedings could not continue to operate
2. Wages and employee benefits
3. Taxes and other governmental debts
4. Unsecured bonds
 CREDIT MANAGEMENT & BANKRUPTCY

REORGANIZATION
•Restructruring of financial claims on falling firm to allow it to keep operating. It is an
alternative for liquidation!...

THE REORGANIZATION PLAN

•To design a new capital structure for the firm to satisfy the creditors
•Allow the firm to solve the business problems
The reorganization plan goes into effect if it is accepted by creditors and confirmed by
the court!..
 CLEARING
INFLATIONARY EFFECTS
ON FINANCIAL STATEMENTS
 CLEARING INFLATIONARY EFFECTS

INFLATION
The continous increase in the general level of prices

Inflation distorts the historical data on financial statements

Inflation causes the asset values to be seen higher than they have in fact!...
For Example : Stocks; although the same quantity exists; monetary value seems higher

SO IT IS UNAVOIDABLE TO CLEAR UP INFLATIONARY EFFECTS.

There are two basic approach

•General Price Level (GPL)
•Current Replacement Cost (CRC)

•General Price Level (GPL):

•To correct the historical data by using an appropriate INDEX

Index Value at the end

Corrected Value = Historical Value X [ ]
Index Value at the beginning

Before correction it is needed to determine the inflationary effect on each financial item!...
 CLEARING INFLATIONARY EFFECTS
Items of Fin. Stat. Monetary Non -Monetary
Cash X
Bonds & Similiars X
Stocks & Similiars X
Recivables X
Inventory X
Fixed Assets & Accumulated Depreciation X
Short & Long-Term Debts X
Sales and all revenue accounts X
COGS and all expense accounts X
Retained Earnings X

Generally it can be said; Cash & Cash equivalents; receivables

and payables are monetary and the other s are non-monetary

The correction of inflationary effects on financial statements depends on the power of choosen
INDEX.
 CLEARING INFLATIONARY EFFECTS
(EXAMPLE)

BALANCE SHEET FOR XYZ CORPORATION (31,12,2002) 2002 Type of Item Cleared Value
Current Assets 3.000
Cash 500,00 Monetary 500,00
Receivables 1000,00 Monetary 1.000,00
Inventories 1500,00 Non-monetary X 150/125 1.800,00
Net Fixed Assets 2700,00
Gross Machinery 3000,00 Non-monetary X 150/100 4.500,00
(-) Acc. Depreciation 300,00 Non-monetary X 150/100 450,00
TOTAL ASSETS 5700,00 7.350,00

Current Liabilities 1200,00

Acc. Payable 200,00 Monetary 200,00
Notes Payable 1000,00 Monetary 1.000,00

Long-term Debt 0,00

Shareholders' equity 4000,00 Non-monetary X 150/100 6.000,00
Retained Earnings 500,00 150,00

TOTAL LIABILITIES & SHAREHOLDER'S EQUITY 5700,00 7.350,00

 CLEARING INFLATIONARY EFFECTS
(EXAMPLE)

INCOME STATEMENT FOR THE YEAR OF 2002

Net Sales 4500,00 Non-monetary X 150/125 5.400,00

Cost of Goods Sold 3000,00 Non-monetary X 150/125 3.600,00
Sales & Administrative Expenses 400,00 Non-monetary X 150/125 480,00
Depreciation 300,00 Non-monetary X 150/100 450,00
Taxable Income 800,00 Non-monetary X 150/125 870,00
Taxes 100,00 Non-monetary X 150/125 120,00
Inflationary Loss 360,00
Net Income 700,00 390,00
Dividends 200,00 Non-monetary X 150/125 240,00
To Retained Earnings 500,00 150,00

Inflation Index
31,12,2001 100
31,12,2002 150
Average for 2002 125
 CLEARING INFLATIONARY EFFECTS
(EXAMPLE)

Corrected
Calculation of Inflationary Loss
Historical Data Total Transaction Value Difference
Cash at the beginning 2200,00 X150/100 3300,00
Cash Inputs 3500,00 X150/125 4200,00
Sales 4500,00
Receivables 1000,00

Cash Outputs 5200,00 X150/125 6240,00

Cost of Goods Sold 3000,00
Inventory 1500,00
Sales & Adm. Expenses 400,00
Taxes 100,00
Dividends 200,00
Cash at the end 500,00 1260,00 760,00

Receivables 1000,00 X150/125 1200,00 200,00

Acc. Payable 200,00 X150/100 300,00 100,00

Notes Payable 1000,00 X150/100 1500,00 500,00

TOTAL (Inflation Loss) 360,00