CHAPTER 20 Working Capital Management

1. CHAPTER 20Working Capital Management • Working Capital Definitions and Policies • Cash Management • Inventory Management • Credit Management • Short-Term Financing • Trade Credit • Bank Debt and Commercial Paper • Secured Loans Finance 402

2. Basic Definitions • Gross working capital: Total current assets. • Net working capital: Current assets - Current liabilities. • Net operating working capital (NOWC): Operating CA – Operating CL = (Cash + Inv. + A/R) – (Accruals + A/P) (More…) Finance 402

3. Working capital management: Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable. • Working capital policy: • The level of each current asset. • How current assets are financed Please meet Danny the Banker. Finance 402

4. Selected Ratios for SKI 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 basis) 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 Finance 402

5. How does SKI’s working capital policy compare with the industry? • 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 amountsof working capital relative to its level of sales. Thus, SKI is following a relaxed policy. Finance 402

6. Alternative Current AssetInvestment Policies Current Assets ($) Relaxed Moderate Restricted Sales ($) Finance 402

7. Is SKI inefficient or just conservative? • A relaxed policymay be appropriate if it reduces risk more than profitability. • However, SKI is much lessprofitable than the average firm in the industry. This suggests that the company probably has excessive working capital. Finance 402

8. Cash Conversion Cycle The cash conversion cyclefocuses on the time between payments made for materials and labor and payments received from sales: Cash Inventory Receivables Payables conversion = conversion + collection - deferral . cycle period period period What does the cash conversion cycle tell us about working capital management? Finance 402

9. Payables deferral period Days per year Inv. turnover Days sales outstanding 365 4.82 Cash Conversion Cycle (Cont.) CCC = + – CCC = + 45.6 – 30 CCC = 75.7 + 45.6 – 30 CCC = 91.3 days. Finance 402

10. Shortening the Cash Conversion Cycle • Reduce the Inventory Conversion Period by processing and selling goods more quickly • Reduce the Receivables Collection Period by speeding up collections • Lengthening the Payables Deferral Period by slowing down the firm’s own payments Finance 402

11. Cash Management:Cash doesn’t earn interest,so why hold it? • Transactions:Must have some cash to pay current bills. • Precaution:“Safety stock.” But lessened by credit line and marketable securities. • Speculation:To take advantage of bargains, to take discounts, and so on. Reduced by credit line, marketable securities. • Compensating balances:For loans and/or services provided. But, Fee-Based Systems are rapidly replacing compensating balances. Finance 402

12. What is the goal of cash management? • To reduce cash held to the minimum necessary to conduct business, yet maintain sufficient cash balances to: • Make timely payments, • Take trade discounts, • Maintain firm’s credit rating, and • Meet unexpected cash needs. • However, since cash is a non-earning asset, the goal is to have not one dollar more than necessary. • The Internet and telecommunications technology have dramatically affected cash management. Finance 402

13. What are “precautionary” and “speculative” balances? • Precautionary balances:Cash reserves for unforeseen inflow/outflow fluctuations. • Speculative balances:Cash held for possible bargain purchases. • Both are better met with borrowing capacity and/or liquid securities. Finance 402

14. Two Internet Addresses for Cash Management Techniques • Bank of America • http://www.bankofamerica.com/index.cfm?page=corp • Wachovia • http://www.wachovia.com/corp_inst Finance 402

15. Ways to Minimize Cash Holdings • Use lockboxes. • Insist on wire transfersfrom customers. • Synchronizeinflows and outflows. • Use a remote disbursementaccount. (More…) Finance 402

16. Increase forecast accuracyto reduce the need for a cash “safety stock.” • Hold marketable securitiesinstead of a cash “safety stock.” • Negotiate a line of credit(also reduces need for a “safety stock”). Finance 402

17. How can a firm “synchronize” its cash flows and what good would this do? • Synchronize cash flows by arranging to bill customers and pay bills on regular “billing cycles” throughout the month. • Synchronized cash flows reduce the need for cash balances and required bank loans, thus lower interest expense and boost profits. Finance 402

18. Define disbursement float, collections float, and net float. • Float: The difference between the balance shown in a firm’s checkbook and the balance on the bank’s books. • “Red Book” Balances • Disbursement float: Amount of funds tied up in checks the firm has written but which the bank has not yet deducted from its checking account balance. (More...) Finance 402

19. Collections float:The time it takes a firm to deposit checks it has received and for the bank to process them and credit the firm’s account with “good” funds. • Ledger Balances vs. Available Balances • Net float = positive disbursement float (Good) – negative collections float (Bad) Finance 402

20. What is float and how can it be affected by cash management? • Float is the difference between the balance shown on the firm’s books and the balance on its bank’s records. • If it takes SKI 1 dayto deposit checks it receives and it takes its bank another dayto clear those checks, SKI has 2 daysof collections float. Finance 402

21. If it takes 6 days for the checks that SKI writes to clear and be deducted from SKI’s account, SKI has6 days of disbursement float. • SKI’snet float is the difference between the disbursement float and the collections float: Net float = 6 days - 2 days = 4 days. • If SKI wrote and received $1 million of checks per day, it would be able to operate with $4 million less working capital than if it had zero net float. Finance 402

22. Components of Float • Mail-Time Float • Processing Float • Clearing or Availability Float Finance 402

23. Techniques to Accelerate Inflows • Lock Box System - Post Office Box • Retail - Large Number of Consumers • Wholesale - Typically Businesses • Automatic Debit - Automated Clearing House (ACH) Debits (Preauthorized) • e.g. Utilities debit users on a monthly basis • Payment by Wires • Field System • Concentration Banking Finance 402

24. Funds transfer tools between banks are used to accelerate inflows • Electronic (ACH) depository transfer. Uses data files to transfer funds. One Day Clearing. • Wires. The concentration bank instructs the field bank to initiate a wire transfer. Finance 402

25. Techniques to Manage Disbursements • Payables Centralization • Internet Disbursement • Controlled Disbursement Accounts • Formerly Remote Disbursement • Zero-Balance Accounts • Money is moved from the Master Account to the Subsidiary Account to “zero” it out. • Breakdown by type of account and division • Payable Through Drafts • An order to pay, but not payable on demand Finance 402

26. Additional Disbursement Techniques • Automated Clearing House (ACH) Credits • e. g. Direct Deposit of Payroll • GM automatically wires funds on 13th day to regular suppliers; no float but GM gets discounts (2/10, n/30). • With lower interest rates, emphasis has shifted to increased information benefits, ethical behavior, and decreased administrative costs. Finance 402

27. Account Analysis • Bank Provides Monthly: • Summary of the Charges for Services Used • Analysis of the Balances Maintained • Credits “Earned” on the Balances Finance 402

28. Why would a firm hold low- yielding marketable securities? • Substitute for cash balances • Reduces risk and transactions costs • Available for “bargain purchases” • Temporary investment resulting from: • Seasonal or cyclical operations. • Need to meet some unknown financial requirement. • Firm has just sold long-term assets. Finance 402

29. What factors should a firm consider when building its marketable securities portfolio? • Default risk (safety first) • Interest rate (price) risk • Purchasing power (inflation) risk • Liquidity and marketability risk • Returns on securities (yield) • Taxability • When it might need funds • Alternatively negotiate a line of credit Finance 402

30. Securities suitable to hold as liquid reserves: • U.S. Treasury bills • Commercial paper • Negotiable CDs • Money market mutual funds • Eurodollar market time deposits Finance 402

31. Securities not suitable to hold as liquid reserves: • Speculative derivatives • U.S. Treasury notes, bonds • Corporate bonds • State and local government bonds • Preferred stocks • Common stocks Finance 402

32. Cash Budget: The Primary Cash Management Tool • 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. Finance 402

33. Data Required for Cash Budget • 1. Sales forecast. • 2. Information on collections delay. • 3. Forecast of purchases and payment terms. • 4. Forecast of cash expenses: wages, taxes, utilities, and so on. • 5. Initial cash on hand. • Target cash balance. • Interest rate on outstanding loans Finance 402

34. SKI’s Cash Budget for January and February 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 Finance 402

35. Cash Budget (Continued) January February Cash at start if no borrowing $ 3,000.00 $16,857.64 Net CF (slide 34) 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 Finance 402

36. Should depreciation be explicitly included in the cash budget? • No.Depreciation is a noncash charge. Only cash payments and receipts appear in the cash budget. • However, depreciation does affect taxes, which do appear in the cash budget. Finance 402

37. What are some other potential cash inflows besides collections? • Proceeds from fixed asset sales. • Proceeds from stock and bond sales. • Interest earned. • Court settlements. Finance 402

38. 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 for preceding month. • Note: Interest on any other debt would need to be incorporated as well. • Use Spreadsheet systems such as EXCEL. Finance 402

39. 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. Finance 402

40. SKI’s forecasted cash budgetindicates that the company’s cash holdings will exceed the targetedcash balance every month, except for October and November. • Cash budget indicates the company probably might be holding too muchcash. • SKI could improve its EVA by either investing its excess cash in more productive assets or by paying it out to the firm’s shareholders. Finance 402

41. What reasons might SKI have for maintaining a relativelyhigh 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 there, in part, to fund a planned fixed asset acquisition. Finance 402

42. Inventory Management:Categories of Inventory Costs • Carrying Costs: Cost of Capital tied up, storage and handling costs, insurance, property taxes, depreciation, and obsolescence. • Ordering Costs: Cost of placing orders, shipping, and handling costs. Supply Chain Management. • Costs of Running Short: Loss of sales (from stockouts), loss of customer goodwill, and the disruption of production schedules. Finance 402

43. Effect of Inventory Size on Costs • Reducing the average amount of inventory held generally: • Reduces carrying costs. • Increases ordering costs. • Increases probability of a stockout. • Air freight was stopped for a week or so after September 11, 2001 • Effects of hurricanes Finance 402

44. 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 operating costs which reduces its NOPAT. Moreover, the excess inventory must be financed, so EVA is further lowered. Finance 402

45. If SKI reduces its inventory, without adversely affecting sales, what effect will this have on its cash position? • Short run: Cash will increase as inventory purchases decline. • Long run: Company is likely to then take steps to reduce its cash holdings. Finance 402

46. Inventory Control Systems • Computerized Inventory Control Systems • Supply Chain Management • Just-In-Time (JIT) Systems • “Out-Sourcing” • Relationship between production scheduling and inventory levels • This topic will be discussed further in Chapter 22. Finance 402

47. Accounts Receivable Management:Do SKI’s customers pay more or less promptly than those of its competitors? • SKI’s days’ sales outstanding (DSO)of 45.6 daysis well above the industry average (32 days). • SKI’s customers apparently are paying less promptly. • SKI should consider tightening its credit policy to reduce its DSO. Finance 402

48. 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. Finance 402

49. 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. Finance 402

50. Credit Management • What terms of credit should the firm use? • To whom should the firm grant credit? Finance 402