© 2004 by Nelson, a division of Thomson Canada Limited Chapter 15: Working Capital Policy and Short...

© 2004 by Nelson, a division of Thomson Canada Limited

Chapter 15:Working Capital Policy and Short Term Financing

Contemporary Financial Management

© 2004 by Nelson, a division of Thomson Canada Limited2

Introduction

This chapter deals with the management of working capital, which involves decisions about the optimal overall level of current assets and the optimal mix of short-term funds used to finance the company’s assets.

It also deals with the financing of the current assets that make up the working capital.


Working Capital

Working capital is the firm’s total investment in current assets

Net working capital equals current assets minus current liabilities

Working capital represents assets that flow through the firm Turned over at a rapid rate Usually recovered during the operating cycle when

inventory sells and receivables collected

Working capital is needed because of the time lag between cash disbursements and cash receipts


Working Capital Policy

Involves many decisions about a firm’s current assets and current liabilities

What they consist of How they are used How their mix affects the risk-return

characteristics of the company


Operating Cycle

PurchaseRaw Materials

Pay forRaw Materials

SellFinished Goods

on Credit

CollectReceivables

Operating CycleInventory Conversion PeriodReceivables Conversion PeriodPayables Deferral PeriodCash Conversion Cycle


OperatingCycle =

InventoryConversion

Period+

ReceivablesConversion

Period

InventoryConversion

Period=

Average Inventory

Cost of Sales/ 365

ReceivablesConversion

Period= Accounts Receivable

Annual Credit Sales/ 365

Operating Cycle Analysis


Cash Conversion

Cycle=

OperatingCycle +

PayablesDeferralPeriod

Operating Cycle Analysis Continued

PayablesDeferralPeriod

=

Accounts Payable +

Salaries, Benefits& Payroll Taxes

Payable

Cost ofSales

–Selling, Gen, Admin Exp( /365)


Size and Nature of Current Assets

Depends on:

Type of product manufactured or distributed

Length of operating cycle

Optimal amount of Inventory

Optimal amount of safety stock

Credit policies

Efficiency of current asset management


Appropriate Level of Working Capital

More conservative policies often result in lost sales due to restrictive credit policies.

Optimal level of working capital investment is the level which is expected to maximize shareholder wealth.

Conservative Aggressive

Current Assets More LessProfitability Lower HigherRisk Lower Higher


Optimal Mix of ST and LT Debt

Impact of term structure of interest rates Long rates usually higher than short rates Thus the interest cost of short-term debt usually

cheaper than long-term debt

Borrower incurs higher risk with short term debt Must refinance frequently Short term interest rates are highly volatile


Profitability Versus Risk

Need for financing equal to the sum of: Current assets Fixed assets

Current assets may be: Permanent - Are not affected by seasonal or

cyclical demand Fluctuating - Are affected by seasonal or cyclical

demand


Financing Strategies

Matching

Match the maturity of all assets & liabilities Reduces liquidity risk Hard to implement in practice



Conservative Approach

High proportion of long term debt Less profitable, since LT debt usually more

expensive



Aggressive Approach

High proportion of short term debt More profitable (short term debt cheaper) but

also more risky


An Optimal Financing Strategy?

No one strategy is “right” for all firms

The mix between ST and LT debt must also consider: Industry norms Variability of sales Variability of cash flows


Cost of Short Term Credit

APR = Interest + Fees

Usable funds 365

Maturity (Days)

Simple interest

Compound interestm

[ Interest + fees

Usable funds ] – 1 1 +EAR =

APR = Annual percentage rateEAR = Equivalent annual returnm = number of compounding periods per year


Sources of Short-Term Financing

Trade credit

Accrual expenses and deferred income

Loans from commercial banks

Commercial paper

Borrowing against Account Receivables


Trade Credit

Seller provides financing as part of the sales inducement

Spontaneous source of financing

Cost of trade credit is captured in the purchase price

Trade credit is never free. The cost of foregoing a cash discount is:

APR = % discount

100% – % discount

365

Credit – Disc period


Example: Cost of Foregoing a Discount

A vendor offers a discount of 2% if payment is made within ten days. If the discount is not taken, full payment is due in 30 days. What is the annual cost of not accepting the 2% discount?

Percentage Discount 365APR =

100 - % Discount Credit Period - Discount Period

2 365=

100 - 2 30 - 10

= 37.24%


Accrued Expenses & Deferred Income

Any accrued but unpaid expense is a form of short term financing

Stretching payables extends the financing period but can result in a poor credit rating

Deferred income consists of payments received for goods & services to be delivered in the future Are shown on the Balance Sheet as a liability

called Deferred Income


Short Term Bank Credit

Single loans for specific financial needs Line of credit

Agreement to borrow up to predetermined limit at any time

Revolving credit Legally commits the bank Usually secured Requires a commitment fee

APR =

Interestcosts

Usable funds

+Commitment

fee 365

Maturity ( days )


Commercial Paper

Short-term unsecured promissory notes

Issued by large well-known corporations

Maturities from a few days to 9 months

Sold at a discount

Purchasers include corporations, banks, insurance companies, pension funds, etc

Maturity ( days )

Interest costs +

Placement fee

Usable funds 365

APR =


Accounts Receivable Loans

Receivables make excellent collateral: Fairly liquid Easy to recover in the event of default

Problems with receivables includes: Subject to fraud High administrative costs

Two common forms of receivables lending Pledging–Firm retains title Factoring–Sale of A/R With recourse Without recourse


Borrowing Against Inventory

Inventory may make a good form of collateral, depending on the following characteristics:

Perishability Identifiability Marketability Price stability


Borrowing Against Inventory

When lending against inventory, the lender must decide who will hold the collateral (inventory)

If borrower holds inventory, the lender may use: Floating lien: floating charge over all current and future

acquired inventory Trust receipt: inventory and sale proceeds are held “in

trust” for the lender

A third party holds the inventory in a: Terminal warehouse: inventory is stored in a bonded

warehouse Field warehouse: secured inventory is segregated on site

and managed by a field warehouse company


Characteristics of Term Loans

Granted by a bank or other lending institution

Maturity – initial maturity of 1 to 10 years

Less expensive than a public offering

Repayment may include: Equal periodic payments of interest plus principal

(amortized) Equal principal payments plus interest on the outstanding

balance Periodic payments plus a large [balloon] payment at the

maturity date One large payment on the maturity date (bullet payment)



Interest rate varies, depending on: General level of rates in the market Size of the loan Maturity of the loan Borrower’s credit rating

Interest may be charged as a: Fixed rate Variable rate (Prime plus ___%)



Security Provisions Protect the lender in case of borrower default May include:

• Assignment of monies due under a contract• Assignment of receivables or inventory• Floating lien or debenture on firm assets• Pledge of marketable securities• Mortgage on fixed assets• Assignment of the cash surrender value on a

life insurance policy



Affirmative Covenants Things the borrower will do

• Provide periodic Financial statements• Carry insurance• Maintain minimum net working capital

Negative Covenants Things the borrower will not do

• Not to pledge certain assets as security• Not to merge or consolidate• Not to make or guarantee loans to others


Sources of Term Loans

Banks

Insurance companies

Pension funds

Government agencies

Equipment suppliers

Conditional sales contracts

Chattel mortgages


Major Points

Working capital consists of the current assets carried on the Balance Sheet and the current liabilities used to fund them.

Current assets require an investment, similar to that of a fixed asset.

Current assets are low return; therefore the firm wants to carry the minimum amount necessary.

There are many forms of short-term funding available, but each of them has a cost attached.

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© 2004 by Nelson, a division of Thomson Canada Limited Chapter 15: Working Capital Policy and Short...

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