CHAPTER 14 Working Capital Management

1. CHAPTER 14Working Capital Management Alternative working capital policies Cash management Inventory management Accounts receivable management Working capital financing policies Trade credit

2. Working capital terminology Gross working capital – total current assets. Net working capital – current assets minus non-interest bearing current liabilities. Working capital policy – deciding the level of each type of current asset to hold, and how to finance current assets. Working capital management – controlling cash, inventories, and A/R, plus short-term liability management.

3. Selected ratios for SKI Inc. SKI Ind. Avg. Current 1.75x 2.25x Debt/Assets 58.76% 50.00% Turnover of cash & securities 16.67x 22.22x DSO (days) 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%

4. How does SKI’s working capital policy compare with its industry? SKI appears to have large amounts of working capital given its level of sales. Working capital policy is reflected in current 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. SKI is either very conservative or inefficient.

5. Is SKI inefficient or just 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.

6. Working Capital Management Short-Term Investment Cash Management Account Receivable Management Inventory Management Short-Term Financing Trade Credit Bank Loans Commercial Paper Account Receivable and/or Inventory Financing

7. Working Capital Management Trade-off of Short-Term Investment Cost 1 Cost 2 ___________________________________________________________________________________ Short-Term Assets Cash and Marketable Opportunity cost Illiquidity and solvency Securities of funds costs Accounts receivable Cost of investment Opportunity cost of lost in accounts sales due to overly receivable and restrictive credit policy bad debts and/or terms Inventory Carrying costs of Order and setup costs inventory, including associated with replenishment financing, and production of finished warehousing cost, goods etc.

8. Working Capital Management Trade-off of Short-Term Financing Cost 1 Cost 2 _________________________________________________________ Short-Term Financing Accounts payable, Cost of reduced Financing costs resulting Accruals, and notes liquidity caused from the use of less Payable by increasing expensive short-term current liabilities financing rather than more expensive long-term debt and equity financing

9. Cash conversion cycle The cash conversion model focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.

10. Cash conversion cycle

11. Cash doesn’t earn a profit, so why hold it? Transactions – must have some cash to operate. Precaution – “safety stock”. Reduced by line of credit and marketable securities. Compensating balances – for loans and/or services provided. Speculation – to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities.

12. What is the goal of cash management? To meet 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.

13. Ways to minimize cash holdings Use a lockbox. Insist on wire transfers from customers. Synchronize inflows and outflows. Use a remote disbursement account. Increase forecast accuracy to reduce need for “safety stock” of cash. Hold marketable securities (also reduces need for “safety stock”). Negotiate a line of credit (also reduces need for “safety stock”).

14. Cash budget:The primary cash management tool Purpose: Forecasts cash inflows, outflows, and ending cash balances. Used to plan loans needed or funds available to invest. Timing: Daily, weekly, or monthly, depending upon purpose of forecast. Monthly for annual planning, daily for actual cash management.

15. Data Required for a Cash Budgeting 1. Sales forecast. 2. Information on collections delay. 3. Forecast of purchases and payment terms. 4. Forecast of cash expenses, taxes, etc. 5. Initial cash on hand. 6. Target cash balance.

16. 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

17. SKI’s cash budget 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

18. 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 appear in the cash budget.

19. What are some other potential cash inflows besides collections? Proceeds from the sale of fixed assets. Proceeds from stock and bond sales. Interest earned. Court settlements.

20. 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.

21. 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.

22. 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.

23. Float Float refers t funds that have been sent by the payer but are not yet usable funds to the payee. Float increases both the firm’s average collection period and its average payment period. The primary role of a cash manager on the collection side is to minimize this float wherever possible and to maximize it.

24. Float Mail float: the time delay between when payment is placed in the mail and when payment is received. Processing Float: the time between receipt of the payment and its deposit into the firm’s account. Availability Float: the time between deposit of the check and availability of the funds to the firm. Clearing Float: the time between deposit of the check and presentation of the check back to the bank on which it is drawn.

25. Types of Collection Systems Field-Banking system: collections are made either over the counter or at a collection office. The main collection problem is moving the funds from the local banks up to the main accounts at the company’s primary bank. Mail-Based System: The process center will receive the mail payments, open the envelopes, separate the check from the remittance information, prepare the check for deposit, and send the remittance information to the accounts receivable department application of payment. Electronic System: In a electronic bill presentment and payment (EBPP) system, customers are sent bills in an electronic format and then can pay their bills via electronic means. Lockbox System: Customers mail payments to a post office box, which is emptied regularly by the firm’s bank. The bank processes each payment and deposits the payments in the firm’s account.

26. Lockbox System: An Example Firm Y believes that use of a lockbox system can shorten its accounts receivable collection period by four days. The firms’ annual sales, all on credit, are $65 million, billed on a continuous basis. The firms can earn 9% on its short-term investments. The cost of the lockbox system is $57,500 per year. Assume a 365-day year. A. What amount of cash will be made available for other uses under the lockbox system? B. What net benefit (or cost) will the firm receive if it adopts the lockbox system? Should it adopt the proposed lockbox system?

27. Lockbox System: An Example Solution: A. Cash available = ($65m/365) *4 = $712,329 B. Interest Income from Reinvesting the cash available = $712,329 *(9%/365) = $64,109.61 Lockbox costs = $57,500 Net Benefit = $64,109.61 - $57,500 = $6,609.61

28. 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 the average amount of inventory generally reduces carrying costs, increases ordering costs, and may increase the costs of running short.

29. Is SKI holding too much inventory? SKI’s inventory turnover (4.82) is considerably lower than the industry average (7.00). The firm is carrying a lot of inventory per dollar of sales. By holding excessive inventory, the firm is increasing its costs, which reduces its ROE. Moreover, this additional working capital must be financed, so EVA is also lowered.

30. If SKI reduces its inventory, without adversely affecting sales, what effect will this have on the cash position? Short run: Cash will increase as inventory purchases decline. Long run: Company is likely to take steps to reduce its cash holdings and increase its EVA.

31. Accounts Receivable Management ARs result from credit sales. The period is the average length of time firm a sale on credit until the payment becomes usable funds for the firm.

32. Accounts Receivable Management SKI’s DSO (45.6 days) is well above the industry average (32 days). SKI’s customers are paying less promptly. SKI should consider tightening its credit policy in order to reduce its DSO.

33. Elements of credit policy Credit Period – How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. Cash Discounts – Lowers price. Attracts new customers and reduces DSO. Credit Standards – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO. Collection Policy – How tough? Tougher policy will reduce DSO but may damage customer relationships.

34. Does SKI face any risk if it tightens its credit policy? Yes, a tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

35. If SKI succeeds in reducing DSO without adversely affecting sales, what effect would this have on its cash position? Short run: If customers pay sooner, this increases cash holdings. Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase EVA.

36. Receivable Management Example McDowell Industries sells on terms of 3/10, net 30. Total sales for the year are $912,500. 40% percent of the customers pay on the 10th day and take discounts; the other 60% pay on average, 40 days after their purchases. A. What is the days sales outstanding? B. What is the average amount of receivables? C. What would happen to average receivables if McDowell toughed up on its collection policy with the result that all nondiscount customers paid on the 30th day?

37. Receivable Management Example Solution: a. 0.4(10) + 0.6(40) = 28 days. b. $912,500/365 = $2,500 sales per day. $2,500(28) = $70,000 = Average receivables. c. 0.4(10) + 0.6(30) = 22 days. $912,500/365 = $2,500 sales per day.   $2,500(22) = $55,000 = Average receivables. Sales may also decline as a result of the tighter credit. This would further reduce receivables. Also, some customers may now take discounts further reducing receivables.

38. Working capital financing policies Moderate – 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.

39. Moderate financing policy

40. Conservative financing policy

41. Accrued liabilities Continually recurring short-term liabilities, such as accrued wages or taxes. Is there a cost to accrued liabilities? They are free in the sense that no explicit interest is charged. However, firms have little control over the level of accrued liabilities.

42. What is trade credit? 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.

43. The cost of trade credit A firm buys $506,985 net ($512,106 gross) on terms of 1/10, net 30. The firm can forego discounts and pay on Day 40, without penalty. Net daily purchases = $506,985 / 365 = $1,389

44. Breaking down net and gross expenditures Firm 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.

45. Breaking down trade credit Payables level, if the firm takes discounts Payables = $1,389 (10) = $13,890 Payables level, if the firm takes no discounts Payables = $1,389 (40) = $55,560 Credit breakdown Total trade credit $55,560 Free trade credit - 13,890 Costly trade credit $ 41,670

46. Nominal cost of costly trade credit The firm loses 0.01($512,106) = $5,121 of discounts to obtain $41,670 in extra trade credit: kNOM = $5,121 / $41,670 = 0.1229 = 12.29% The $5,121 is paid throughout the year, so the effective cost of costly trade credit is higher.

47. Nominal trade credit cost formula

48. Effective cost of trade credit Periodic rate = 0.01 / 0.99 = 1.01% Periods/year = 365 / (40-10) = 12.1667 Effective cost of trade credit EAR = (1 + periodic rate)n – 1 = (1.0101)12.1667 – 1 = 13.01%

49. Bank Loans A firm is choosing among three alternative bank loans. The firm wishes to minimize the borrowing costs on a $200,000 borrowing. Analyze the cost of each of these alternatives: 1. An 18% rate of interest with interest paid at year-end and no compensating balance requirement. 2. A 16% rate of interest but carrying a 20% compensating balance requirement. This loan also calls for interest to be paid at year-end. 3. A 14% rate of interest that is discounted, plus a 20% compensating balance requirement.

50. Bank Loans Solutions: 1. Effective rate of interest = 18%. 2. Effective rate of interest = $32,000/($200,000-$40,000) = 20%. 3. Effective rate of interest = $28,000/($200,000-$40,000-$28,000) = 21.21%

51. Commercial paper (CP) Short-term notes issued by large, strong companies. B&B couldn’t issue CP--it’s too small. 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.

52. Alternative Financing: Example Suncoast Boats Inc. estimates that because of the seasonal nature of its business, it will required an additional $2m of cash for the month of July. Suncoast has the following 4 options available for raising the needed funds: 1. Establish a 1-year line of credit for $2m with a bank. The commitment fee will be 0.5% per year on the unused portion, and the interest charge on the used funds will be 11% per annum. Assume that the funds are needed only in July, and that there are 30 days in July and 365 days in the year.

53. Alternative Financing: Example 2. Forgo the trade discount of 2/10, net 40, on $2m of purchases during July. 3. Issue $2m of 30-day commercial paper at a 9.5% per annum interest rate. The total transactions fee, including the cost of a backup credit line, on using commercial paper is 0.5% of the amount of the issue. 4. Issue $2m of 60-day commercial paper at a 9% per annum interest rate, plus a transaction cost of 0.5%. Since the funds are required for only 30 days, the excess funds ($2m) can be invested in 9.4% per annum marketable securities for the month of August. The total transaction costs of purchasing and selling the marketable securities is 0.4% of the amount of the issue.

54. Alternative Financing: Example A. What is the dollar cost of each financing arrangement? B. Is the source with the lowest expected cost necessarily the one to select? Why or why not?

55. Alternative Financing: Example Solutions: a. 1. Line of credit: Commitment fee = (0.005)($2,000,000)(335/365) = $ 9,178 Interest = (0.11)(30/365)($2,000,000) = 18,082 Total = $27,260

56. Alternative Financing: Example Solutions: 2. Trade discount: a. = = 0.2483 = 24.83%. Total cost = 0.2483($2,000,000)(30/365) = $40,816.   b. Effective cost = (1 + 2/98)365/30 - 1 = 0.2786 = 27.86%. Total cost = 0.2786($2,000,000)(30/365) = $45,804.

57. Alternative Financing: Example Solutions: 3.30-day commercial paper: Interest = (0.095)($2,000,000)(30/365) = $15,616 Transaction fee = (0.005)($2,000,000) = 10,000 Total = $25,616

58. Alternative Financing: Example Solutions: 4.60-day commercial paper: Interest = (0.09)($2,000,000)(60/365) = $29,589 Transaction fee = (0.005)($2,000,000) = 10,000 Total Costs = $39,589 Marketable securities interest received = (0.094)($2,000,000)(30/365) = $15,452 Transactions cost, marketable securities = (0.004)($2,000,000) = $8,000 Total = $32,137   The 30-day commercial paper has the lowest cost.