Management & Financing of Working Capital

Koray ErdoğanFIN603

Okan University

21.04.2012

What Is Working Capital ?• Working capital typically means the available current or short-

term assets of a firm such as cash, receivables, inventory and marketable securities that are used to finance its day-to-day operations.

• These items are also referred to as «circulating capital».

• Corporate executives devote a considerable amount of attention to the management of working capital. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.

Working Capital Formula

• Gross working capital = Current assets• Gross Working Capital (GWC) represents investment in current

assets

• (Net) working capital = Current assets – Current liabilities

Example Company

Balance Sheet December 31, 2010

ASSETS LIABILITIES Current Assets Current Liabilities Cash $ 2,100 Notes Payable $ 5,000 Petty Cash 100 Accounts Payable 35,900 Temporary Investments 10,000 Wages Payable 8,500 Accounts Receivable - net 40,500 Interest Payable 2,900 Inventory 31,000 Taxes Payable 6,100 Supplies 3,800 Warranty Liability 1,100 Prepaid Insurance 1,500 Unearned Revenues 1,500 Total Current Assets 89,000 Total Current Liabilities 61,000 - Investments 36,000 Long-term Liabilities Notes Payable 20,000 Property, Plant & Equipment Bonds Payable 400,000 Land 5,500 Total Long-term Liabilities 420,000 Land Improvements 6,500 Buildings 180,000 Equipment 201,000 Total Liabilities 481,000 Less: Accum Depreciation (56,000) Prop, Plant & Equip - net 337,000 - Intangible Assets STOCKHOLDERS' EQUITY Goodwill 105,000 Common Stock 110,000 Trade Names 200,000 Retained Earnings 229,000 Total Intangible Assets 305,000 Less: Treasury Stock (50,000) Total Stockholders' Equity 289,000 Other Assets 3,000 - Total Assets $770,000 Total Liab. & Stockholders' Equity $770,000

The notes to the sample balance sheet have been omitted.

Working Capital Management• Decisions relating to working capital and short term financing are

referred to as working capital management. Short term financial management is concerned with decisions regarding to CA and CL.

• Management of Working Capital refers to management of CA as well as CL.

• If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.

• These involve managing the relationship between a firm's short-term assets and its short-term liabilities.

Working Capital Management

An increase in working capital indicates that the business has either increased current assets (that is received cash, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors.

The fundamental principles of working capital management are reducing the capital employed and improving efficiency in the areas of receivables, inventories, and payables.

Working Capital Management

• The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

• Businesses face ever increasing pressure on costs and financing requirements as a result of intensified competition on globalized markets. When trying to attain greater efficiency, it is important not to focus exclusively on income and expense items, but to also take into account the capital structure, whose improvement can free up valuable financial resources

Working Capital Management

• Active working capital management is an extremely effective way to increase enterprise value. Optimising working capital results in a rapid release of liquid resources and contributes to an improvement in free cash flow and to a permanent reduction in inventory and capital costs, thereby increasing liquidity for strategic investment and debt reduction. Process optimisation then helps increase profitability.

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Objective of Working Capital Management

• To run firm efficiently with as little money as possible tied up in Working Capital

• Involves trade-offs between easier operation and cost of carrying short-term assets

• Benefit of low working capital• Money otherwise tied up in current assets can be invested in activities

that generate higher payoff• Reduces need for costly financing

• Cost of low working capital• Risk of shortages in cash, inventory

Working Capital Trade-offsInventory

High Levels Low LevelsBenefit: • Happy customers• Few production delays (always have needed parts

on hand)Cost: • Expensive• High storage costs• Risk of obsolescence

Cost: • Shortages• Dissatisfied customersBenefit: • Low storage costs• Less risk of obsolescence

CashHigh Levels Low Levels

Benefit:• Reduces riskCost:• Increases financing costs

Benefit:• Reduces financing costsCost:• Increases risk

Working Capital Trade-offsAccounts Receivable

High Levels (favorable credit terms) Low Levels (unfavorable terms)

Benefit: • Happy customers• High salesCost: • Expensive• High collection costs• Increases financing costs

Cost: • Dissatisfied customers• Lower SalesBenefit: • Less expensive

Accounts Payable and Accruals

High Levels Low Levels

Benefit:• Reduces need for external finance--using a

spontaneous financing sourceCost:• Unhappy suppliers

Benefit:• Happy suppliers/employeesCost:• Not using a spontaneous

financing source

Need for Working Capital

• As profits earned depend upon magnitude of sales and they do not convert into cash instantly, thus there is a need for working capital in the form of CA so as to deal with the problem arising from lack of immediate realization of cash against goods sold.

• This is referred to as “Operating or Cash Cycle” .

• It is defined as «The continuing flow from cash to suppliers, to inventory , to accounts receivable & back into cash».

Need for Working Capital

• Therefore needs for working capital arises from cash or operating cycle of a firm.

• Which refers to length of time required to complete the sequence of events.

• Thus operating cycle creates the need for working capital. Its length in terms of time span required to complete the cycle is the major determinant of the firm’s working capital needs.

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The Cash Conversion Cycle (Operating Cycle)

• Firm begins with cash which then becomes inventory and labour• Which then becomes product for sale• Eventually this will turn into cash again

• Firm’s operating cycle is time from acquisition of inventory until cash is collected from product sales

Product is converted into cash, which is

transformed into more product,

creating the cash conversion cycle.

The Cash Conversion Cycle (Operating Cycle)

Time Line Representation of the Cash Conversion Cycle

Equity Capital vs Debt Capital

DEBT CAPITAL

EQUITY CAPITAL

Operating cycle with borrowed money

Cash is borrowed from banks Cash is used to buy raw materials Raw materials become products and services Products and services become trade receivables Receivables become cash again

Raw Materials

Banks CashFinished Goods

Accounts Receivable

Equity Capital vs Debt Capital

Time & Money Concepts in Operating Cycle

• Each component of working capital (namely inventory, receivables and payables) has two dimensions ........TIME ......... and MONEY, when it comes to managing working capital.

• You can get money to move faster around the cycle or reduce the amount of money tied up. Then, business will generate more cash or it will need to borrow less money to fund working capital.

• As a consequence, you could reduce the cost of bank interest or you'll have additional free money available to support additional sales growth or investment.

• Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit, you effectively create free finance to help fund future sales.

If you Then .......

Collect receivables (debtors) faster

You release cash from the cycle

Collect receivables (debtors) slower

Your receivables soak up cash

Get better credit (in terms of duration or amount) from suppliers

You increase your cash resources

Shift inventory (stocks) faster

You free up cash

Move inventory (stocks) slower

You consume more cash

While a company has usually a quitestable level of Fixed Assets(buildings, machines…) thelevel of Inventories, Receivablesand Payables is volatile and has sometimes a typical seasonal pattern.

Working Capital levelsshrink and expand.

The only way to flexibly financethe WC cycle is to adjust the Net Debt. Conclusion:Rising Working Capital sucks out cash from the company !Lowering Working Capital frees up cash for the company !

Fixed Assets

Working Capital

Equity

Provisions

Net Debt(FinancialPosition)

Invested Capital

Financing

Working Capital Management means

Cash Management

Management Of CashImportance of Cash

When planning the short or long-term funding requirements of a business, it is more important to forecast the likely cash requirements than to project profitability etc.

Bear in mind that more businesses fail for lack of cash than for want of profit.

Cash vs Profit

Sales and costs and, therefore, profits do not necessarily coincide with their associated cash inflows and outflows.

The net result is that cash receipts often lag cash payments and while profits may be reported, the business may experience a short-term cash shortfall.

For this reason it is essential to forecast cash flows as well as project likely profits.

Calculating Cash Flows

A projection should be made about whether to expect a cumulative positive net cash flow over several periods or, conversely, a cumulative negative cash flow.

Cash flow planning entails forecasting and tabulating all significant cash inflows relating to sales, new loans, interest received etc., and then analyzing in detail the timing of expected payments relating to suppliers, wages, other expenses, capital expenditure, loan repayments, dividends, tax, interest payments etc.

Income Statement:Income Statement: Month 1Month 1

Sales ($000)Sales ($000) 7575

Costs ($000)Costs ($000) 6565

Profit ($000)Profit ($000) 1010

CFs relating to Month 1:CFs relating to Month 1:Amount in ($000)Amount in ($000)

Month 1Month 1 Month 2Month 2 Month 3Month 3 TotalTotal

Receipts from salesReceipts from sales 2020 3535 2020 7575

Payments to suppliers etc. Payments to suppliers etc. 4040 2020 55 6565

Net cash flowNet cash flow (20)(20) 1515 1515 1010

Cumulative net cash flowCumulative net cash flow(20)(20) (5)(5) 1010 1010

MANAGING CASH FLOWS

After estimating cash flows, efforts should be made to adhere to the estimates of receipts and payments of cash.

Cash Management will be successful only if cash collections are accelerated and cash payments (disbursements), as far as possible, are delayed.

Methods of ACCELERATING CASH INFLOWS• Prompt payment from customers (Debtors)• Quick conversion of payment into cash• Decentralized collections• Lock Box System (collecting centers at different locations) Methods of DECELERATING CASH OUTFLOWS• Paying on the last date• Payment through Cheques and Drafts• Adjusting Payroll Funds (Reducing frequency of payments)• Centralization of Payments• Inter-bank transfers• Making use of Float (Difference between balance in Bank

Pass Book and Bank Column of Cash Book)

MANAGING CASH FLOWS

FACTORS DETERMINING WORKING CAPITAL

1. Nature of the Industry2. Demand of Industry3. Cash requirements4. Nature of the Business5. Manufacturing time6. Volume of Sales7. Terms of Purchase and Sales8. Inventory Turnover9. Business Turnover10. Business Cycle11. Current Assets requirements12. Production Cycle

contd…

Working Capital Determinants (Continued…)

13. Credit control14. Inflation or price level changes15. Profit planning and control16. Repayment ability17. Cash reserves18. Operation efficiency19. Changes in technology20. Firm’s finance and dividend policy 21. Attitude towards risk

Working Capital Needs of Different Firms

Permanent and Temporary Working Capital

• Working capital is permanent to the extent that it supports constant or minimum level of sales

• There is always a minimum level of CA which is continuously required by a firm to carry on its business operations.

• Therefore , the minimum level of investment in CA that is required to continue the business without interruption is referred as permanent working capital.

• Temporary working capital supports seasonal peaks in business

• This is the amount of investment required to take care of fluctuations in business activity or needed to meet fluctuations in demand consequent upon changes in production and sales as a result of seasonal changes.

Permanent and Temporary Working Capital

DISTINCTION• Permanent is stable over time whereas variable is fluctuating

according to seasonal demands. • Investment in permanent portion can be predicted with some

profitability but investment in variable can not be predicted easily.

• While permanent reflects the need for a certain irreducible level of current assets on a continuous and uninterrupted basis, the temporary portion is needed to meet seasonal and other temporary requirements.

• Also, permanent capital requirements should be financed from L-T sources, but, S-T funds should be used to finance temporary working capital needs of a firm.

Financing Net Working CapitalAccording to «maturity matching» principle;

Maturity (due date) of financing should roughly match duration (life) of asset being financed

• Then financing /asset combination becomes self-liquidating• Cash inflows from asset can be used to pay off loan

Therefore;• Temporary (seasonal) should be financed with short-term

borrowing• Permanent working capital should be financed with long-term

sources, such as long-term debt and/or equity

Working Capital Financing Policies

Working Capital Financing Policies

Short-Term vs. Long-Term Financing

• The mix of short- or long-term working capital financing is a matter of policy• Use of long-term funds is a conservative policy• Use of short-term funds is an aggressive policy

• Short-term financing• Cheap but risky

• Cheap—short-term rates generally lower than long-term rates

• Risky—because you are continually entering marketplace to borrow• Borrower will face changing conditions (ex; higher interest rates and tight

money)

Short-Term vs. Long-Term Financing

• Long-term financing • Safe but expensive

• Safe—you can secure the required capital

• Expensive—long-term rates generally higher than short-term rates

• Firm must set policy on following issues:• How much working capital is used• Extent to which working capital is supported by short- vs. long-

term financing• How each component of working capital is managed• The nature/source of any short-term financing used

Short-Term Financing

• Spontaneous Financing• Negotiated Financing• Factoring Accounts Receivable• Composition of Short-Term Financing

Spontaneous Financing

• Accounts Payable (Trade Credit from Suppliers)• Accrued Expenses

Trade CreditTrade Credit -- credit granted from one business to another

Spontaneous Financing

• Open Accounts: the seller ships goods to the buyer with an invoice specifying goods shipped, total amount due, and terms of the sale.

• Notes Payable: the buyer signs a note that evidences a debt to the seller.

• Trade Acceptances: the seller draws a draftdraft on the buyer that orders the buyer to pay the draft at some future time period.

Examples of trade credit are:

S-t-r-e-t-c-h-i-n-g Accounts Payable

• Cost of the cash discount (if any) forgone• Late payment penalties or interest• Deterioration in credit rating

Postponing payment beyond the end of the net (credit) period is known as “stretching accounts payable” or

“leaning on the trade.”

Possible costs of “stretching accounts payable

Who Bears the Cost of Funds for Trade Credit?

• BuyersBuyers -- when costs can be fully passed on through higher prices to the buyer by the seller.

• BothBoth -- when costs can partially be passed on to buyers by sellers.

• SuppliersSuppliers -- when trade costs cannot be passed on to buyers because of price competition and demand.

Accrued Expenses

• WagesWages -- Benefits accrue via no direct cash costs, but costs can develop by reduced employee morale and efficiency.

• TaxesTaxes -- Benefits accrue until the due date, but costs of penalties and interest beyond the due date reduce the benefits.

Accrued ExpensesAccrued Expenses -- Amounts owed but not yet paid for wages, taxes, interest, and dividends. The accrued expenses account is a short-term liability.

Negotiated Financing

• Money Market CreditMoney Market Credit• Commercial Paper• Bankers’ Acceptances

• Unsecured Loans*Unsecured Loans*• Line of Credit• Revolving Credit Agreement• Transaction Loan

Types of negotiated financingTypes of negotiated financing:

* * Secured Secured versions of these three loans versions of these three loans also exist.also exist.

“Stand-Alone” Commercial Paper

• Commercial paper market is composed of the Commercial paper market is composed of the (1) dealer and (2) direct-placement markets.

• AdvantageAdvantage: Cheaper than a short-term business loan from a commercial bank.

• Dealers require a line of creditline of credit to ensure that the commercial paper is paid off.

Commercial Paper -- Short-term, unsecured promissory notes, generally issued by large corporations (unsecured corporate IOUs).

“Bank-Supported” Commercial Paper

• Letter of credit (L/C)Letter of credit (L/C) -- A promise from a third party (usually a bank) for payment in the event that certain conditions are met. It is frequently used to guarantee payment of an obligation.

• Best for lesser-known firms to access lower cost funds.

A bank provides a letter of creditletter of credit, for a fee, guaranteeingguaranteeing the investor that the company’s obligation will be paid.

Bankers’ Acceptances

• Used to facilitate foreign trade or the shipment of certain marketable goods.

• Liquid market provides rates similar to commercial paper rates.

Bankers’ AcceptancesBankers’ Acceptances -- Short-term promissory trade notes for which a bank (by having “accepted” them) promises to pay the holder the face amount at maturity.

Short-Term Business Loans

Secured LoansSecured Loans -- A form of debt for money borrowed in which specific assets have been pledged to guarantee payment.

Unsecured LoansUnsecured Loans -- A form of debt for money borrowed that is not backed by the pledge of specific assets.

Unsecured Loans

• One-year limit that is reviewed prior to renewal to determine if conditions necessitate a change.

• Credit line is based on the bank’s assessment of the creditworthiness and credit needs of the firm.

• “Cleanup” provision requires the firm to owe the bank nothing for a period of time.

Line of Credit (with a bank)Line of Credit (with a bank) -- An informal arrangement between a bank and its customer specifying the maximum amount of credit the bank will permit the firm to owe at any one time.

Unsecured Loans

• Firm receives revolving credit by paying a commitment feecommitment fee on any unused portion of the maximum amount of credit.• Commitment feeCommitment fee -- A fee charged by the lender for

agreeing to hold credit available.

• Agreements frequently extend beyond 1 year.

Revolving Credit Agreement -- A formal, legal commitment to extend credit up to some maximum amount over a stated period of time.

Unsecured Loans

• Each request is handled as a separate transaction by the bank, and project loan determination is based on the cash-flow ability of the borrower.

• The loan is paid off at the completion of the project by the firm from resulting cash flows.

Transaction LoanTransaction Loan -- A loan agreement that meets the short-term funds needs of the firm for a single, specific purpose.

Secured (or Asset-Based) Loans

• Marketability• Life• Riskiness

Security (collateral)Security (collateral) -- Asset (s) pledged by a borrower to ensure repayment of a loan. If the borrower defaults, the lender may sell the security to pay off the loan.

Collateral value depends onCollateral value depends on:

Accounts-Receivable-Backed Loans

• Quality: not all individual accounts have to be accepted (may reject on agingaging).

• Size: small accounts may be rejected as being too costly (per dollar of loan) to handle by the institution.

One of the most liquid asset accounts.

Loans by commercial banks or finance companies (banks offer lower interest rates).

Loan evaluations are made onLoan evaluations are made on:

Accounts-Receivable-Backed Loans

NotificationNotification -- firm customers are notified that their accounts have been pledged to the lender and remittances are made directly to the lending institution.

Types of receivable loan arrangementsTypes of receivable loan arrangements:

NonnotificationNonnotification -- firm customers are not notified that their accounts have been pledged to the lender. The firm forwards all payments from pledged accounts to the lender.

Inventory-Backed Loans

• Marketability• Perishability• Price stability• Difficulty and expense of selling for loan

satisfaction• Cash-flow ability

Relatively liquid asset accounts

Loan evaluations are made onLoan evaluations are made on:

Types of Inventory-Backed Loans

Floating LienFloating Lien -- A general, or blanket, lien against a group of assets, such as inventory or receivables, without the assets being specifically identified.

Chattel MortgageChattel Mortgage -- A lien on specifically identified personal property (assets other than real estate) backing a loan.

Types of Inventory-Backed Loans

Trust ReceiptTrust Receipt -- A security device acknowledging that the borrower holds specifically identified inventory and proceeds from its sale in trust for the lender.

Terminal Warehouse ReceiptTerminal Warehouse Receipt -- A receipt for the deposit of goods in a public warehouse that a lender holds as collateral for a loan.

Types of Inventory-Backed Loans

Field Warehouse ReceiptField Warehouse Receipt -- A receipt for goods segregated and stored on the borrower’s premises (but under the control of an independent warehousing company) that a lender holds as collateral for a loan.

Factoring Accounts Receivable

• FactorFactor is often a subsidiary of a bank holding company.• FactorFactor maintains a credit department and performs credit

checks on accounts.• Allows firm to eliminate their credit department and the

associated costs.• Contracts are usually for 1 year, but are renewable.

FactoringFactoring -- The selling of receivables to a financial institution, the factorfactor, usually “without recourse.”

Composition of Short-Term Financing

• Cost of the financing method• Availability of funds• Timing• Flexibility• Degree to which the assets are encumbered

The best mix of short-term financing The best mix of short-term financing depends on:depends on:

Raising Long Term Finance

• Initial Public Offering (IPO)• Secondary Public Offering• Rights Issue• Obtaining a Term Loan• Debentures• Private Placement• Leasing• Venture Capital or Private Equity transactions

Term Loans• Provided by banks or financial institutions• Can be in domestic or foreign currency• Are typically secured against fixed assets or

hypothecation of movable properties, prime security or collateral security

• Carrying definite obligations on interest and principal repayment; interest is paid periodically; based on credit risk and also based on a floor rate

• Have restrictive covenants for future financial and operational decisions of the company, its management, future fund raising and projects

Term LoansPros

• Interest on debt is tax deductible

• Does not result in dilution of control

• Do not partake in value created by the firm

• Issue costs of debt is lower• Interest cost is normally fixed,

protection against high unexpected inflation

• Has a disciplining effect on management

Cons• Entails fixed obligation for

interest and principal, non payment can even lead to bankruptcy and legal action

• Debt contracts impose restrictions on firm’s financial and operational flexibility

• Increases financial leverage, excess raises cost of equity to the firm

• If inflation rate dips, cost of debt higher than expected

Debentures• Like promissory notes, are instruments for raising Long Term

debt• More flexible compared to term loans as they offer variety of

choices with regards to maturity, interest rate, security, repayment and other special features

• Interest rate can be fixed or floating• Warrants : Can have warrants attached, detachable or non

detachable, detachable traded separately• Option : Can be with call or put option• Redemption: Bullet payment or redeemed in installments• Security: Secured or unsecured• Credit rating: Need to have a credit rating by a credit rating

agency• Trustee: Need to appoint a trustee to ensure fulfillment of

contractual obligations by company

Leasing vs. Hire PurchaseLeasing

• Ownership not transferred to lessee

• Depreciation benefit to lessor• Magnitude of funds are high for

big volume items• No margin money or down

payment required• Maintenance of asset by lessor in

operating lease• Tax benefits of depreciation

taken by lessor; lessee gets tax shield on lease rentals

• Considered off balance sheet mode of financing, as no asset or liability figures in balance sheet

Hire-Purchase• Ownership transferred to hirer

on payment of all installments• Depreciation shield available to

hirer• Maybe for smaller value capital

goods• Some down payment required• Maintenance cost borne by hirer• Hirer allowed depreciation claim

and finance charge for taxation; seller may claim interest on amount borrowed to acquire asset

• Asset figures in balance sheet on complete of purchase

Initial Public OfferingPros

• Access to larger amount of funds

• Further growth limited companies not using this route

• Listing: provides exit route to promoters; ensures marketability of existing shares

• Recognition in market• Stock prices provide useful

indicators to management• Sometimes stipulated by

private investors in the company

Cons• Pricing may have to be

attractive to lure investors• Loss of flexibility• Higher accountability• More disclosure requirements

to be met• Visibility in market• Cost of making a public issue

quite high

Rights Issue• Issue of capital to existing shareholders• Offer made on a pro rata basis• Offer document called Letter of Offer• Option given to apply for additional shares• Rights renunciation: are tradable, may be sold off in

the market• Comparison with Public issue: with familiar investors,

hence likely to be more successful, less floatation costs since no underwriting but lower pricing to benefit shareholders

Private Placement

Pros• Less expensive mode• Easier to market the issue to a

few investors• Entry of wholesale financially

sophisticated investors in company’s profile

• May use this route until IPO decision taken

• Less administrative maintenance

Cons• Does not qualify for listing in

an unlisted company• Restrictive covenants may be

imposed by the investors• May call for management

participation• Issue pricing more tight

Sale of securities directly to wholesale investors like financial institutions, banks, private equity funds, etc.

Venture Capital & Private Equity

• Reasonably long to medium term commitment• Hands on management approach, active participation in

management• Considered value add investor• Exit route to be defined at the time of investment• Restrictive clauses on promoters’ holding sell off and other

financial & operational issues• Detailed memorandum on company, its financials to be

prepared• Shareholders agreement to be signed by both parties• Valuation of Company key issue• Leads to dilution of control by existing promoters

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Listening!