Working Capital Management

1. Working Capital Management Chapter 15

2. Working Capital Terminology • Working capital management • the management of short-term assets (investments) and liabilities (financing sources)

3. Working Capital Terminology • Working capital • a firm’s investment in short-term assets • cash • marketable securities • inventory • accounts receivable

4. Working Capital Terminology • Net working capital • Current assets minus current liabilities • the amount of current assets financed by long-term liabilities

5. Working Capital Terminology • Working capital policy • target levels for each current asset account • how current assets will be financed

6. Working Capital Terminology • Working capital only includes current liabilities that are specifically used to finance current assets

7. Working Capital Terminology • Working capital does not include current liabilities that may be due in the current period if they are due from long-term capital decisions, even though these must be considered when assessing the firm’s ability to meet its current obligations

8. Working Capital Terminology • Not working capital: • current maturities of long-term debt • financing associated with a construction program that will be funded with the proceeds of a long-term security issue after the project is completed • use of short-term debt to finance fixed assets

9. The Requirement for External Working Capital Financing • Seasonal variations • Business cycles • Expansion requires more working capital

10. The Cash Conversion Cycle • The length of time from the payment for the purchase of raw materials to manufacture a product until the collection of accounts receivable associated with the sale of the product

11. The Cash Conversion Cycle • 1. The inventory conversion period • length of time required to convert materials into finished goods and then to sell those goods • the amount of time the product remains in inventory in various stages of completion

12. The Cash Conversion Cycle • 1. The inventory conversion period

13. The Cash Conversion Cycle • 2. The receivables collection period • average length of time required to convert the firm’s receivables into cash • also called days sales outstanding (DSO)

14. The Cash Conversion Cycle

15. The Cash Conversion Cycle • 3. The payables deferral period • average length of time between the purchase of raw materials and labor and the payment of cash for them

16. The Cash Conversion Cycle • 4. The cash conversion cycle • net the three periods • average length of time a dollar is tied up in current assets Cash conversion cycle Inventory conversion period Receivables collection period Payables deferral period _ = +

17. Working Capital Investment and Financing Policies • Two basic questions: • 1. What is the appropriate level for current assets, both in total and by specific accounts? • 2. How should current assets be financed?

18. Alternative Current Asset Investment Policies • Relaxed current asset investment policy • relatively large amounts of cash and marketable securities and inventories are carried and sales are stimulated by a liberal credit policy that results in a high level of receivables

19. Alternative Current Asset Investment Policies • Restricted current asset investment policy • holdings of cash and marketable securities and inventories are minimized

20. Alternative Current Asset Investment Policies • Moderate current asset investment policy • a policy that is between the relaxed and restricted policies

21. Current Assets • Permanent current asset • current asset balances that do not change due to seasonal or economic conditions • these balances exist even at the trough of a firm’s business cycle

22. Current Assets • Permanent current asset Permanent current assets

23. Current Assets • Temporary current asset • current assets that fluctuate with seasonal or economic variations in a firm’s business

24. Current Assets • Temporary current asset Temporary current assets

25. Alternative Current Asset Financing Policies • Maturity matching, or “self-liquidating” approach • a financing policy that matches asset and liability maturities • this would be considered a moderate current asset financing policy

26. Alternative Current Asset Financing Policies • Aggressive approach • a policy where all of the fixed assets of a firm are financed with long-term capital, but some of the firm’s permanent current assets are financed with short-term nonspontaneous sources of funds

27. Alternative Current Asset Financing Policies • Conservative approach • a policy where all of the fixed assets, all of the permanent current assets, and some of the temporary current assets of a firm are financed with long-term capital

28. Advantages and Disadvantages of Short-Term Financing • Speed • a short-term loan can be obtained much faster than long-term credit • Flexibility • for cyclical needs, avoid long-term debt • cost of issuing long-term debt is higher • penalties for payoff prior to maturity • restrictive covenants

29. Advantages and Disadvantages of Short-Term Financing • Cost of long-term versus short-term debt • yield curve is generally upward sloping • short term interest rates are generally lower than long-term rates

30. Advantages and Disadvantages of Short-Term Financing • Risk of long-term versus short-term debt • short-term debt subjects the firm to more risk than long-term debt • short-term interest expenses fluctuate • firm may not be able to repay short-term debt, thus might be forced into bankruptcy

31. Short-Term Credit • Any liability originally scheduled for repayment within one year

32. Sources of Short-Term Financing • Accruals • continually recurring short-term liabilities • liabilities such as wages and taxes that increase spontaneously with operations • Accounts payable (trade credit) • credit created when one firm buys on credit from another firm

33. Sources of Short-Term Financing • Short-term bank loans • maturity typically 90 days • promissory note specifies terms and conditions • amount, interest rate, repayment schedule, collateral, and any other agreements

34. Sources of Short-Term Financing • Short-term bank loans (cont.) • compensating balances of 10 to 20 percent may be required to be maintained in a checking account • line of credit may be arranged • specified maximum amount of funds available

35. Sources of Short-Term Financing • Short-term bank loans (cont.) • revolving credit agreement • line of credit where funds are committed, or guaranteed • commitment fee • fee charged on the unused balance of a revolving credit agreement

36. Sources of Short-Term Financing • Commercial paper • unsecured short-term promissory notes issued by large, financially sound firms to raise funds

37. Sources of Short-Term Financing • Secured loans • loan backed by collateral • for short-term loans, the collateral is often either inventory or receivables • factoring is the sale of receivables • the lender may seek recourse (payment) from the borrowing firm for uncollectible receivables used to secure a loan

38. Computing the Cost of Short-Term Credit • Interest rate Dollar cost of borrowing Amount of usable funds =

39. Computing the Cost of Short-Term Credit • Discount interest loan • a loan in which the interest, which is calculated on the amount borrowed (principal), is paid at the beginning of the loan period • interest is paid in advance

40. Managing Cash and Marketable Securities • Cash management • goal of minimizing the amount of cash the firm must hold for use in conducting its normal business activities, but sufficient to: • pay suppliers • maintain its credit rating • meet unexpected cash needs

41. Firms Hold Cash For: • 1. Transaction balance • cash balance necessary for day-to-day operations • the balance associated with routine payments and collections • 2. Compensating balance • deposit to meet bank loan requirements

42. Firms Hold Cash For: • 3. Precautionary balance • cash balance held in reserve for unforeseen fluctuations in cash flows • access to line of credit can reduce the need for precautionary balances • 4. Speculative balance • cash balance that is held to enable the firm to take advantage of any bargain purchases that might arise • easy access to borrowed funds can reduce the need for speculative balances

43. Cash Management Techniques • Cash forecasts • predict the timing of cash flows • Synchronized cash flows • cash inflows coincide with cash outflows, permitting a firm to hold low transaction balances

44. Cash Management Techniques • Float • the difference between the balance shown in a checkbook and the balance on the bank’s records • Disbursement float • the value of checks that have been written and disbursed but that have not fully cleared through the banking system and thus have not been deducted from the account on which they were written

45. Cash Management Techniques • Collection float • the amount of checks that have been received and deposited but that have not yet been credited to the account in which they were deposited, because they have not cleared through the banking system

46. Cash Management Techniques • Net float • the difference between disbursement float and collection float • the difference between the balance shown in the checkbook and the balance shown on the bank’s books

47. Cash Management Techniques • Acceleration of receipts • lockbox arrangement • reduce float by having payments sent to post office boxes located near customers • faster mail delivery • faster check clearing within the same Federal Reserve district

48. Cash Management Techniques • Acceleration of receipts • preauthorized debit system • allows a customer’s bank to periodically transfer funds from that customer’s account to a selling firm’s bank account for the payment of bills

49. Cash Management Techniques • Acceleration of receipts • concentration banking • a technique used to move funds from many bank accounts to a more central cash pool in order to more effectively manage cash

50. Cash Management Techniques • Disbursement control • centralized disbursement system • more control, but can delay payments