Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights...

Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 15

Working Capital

Management

1

Chapter 15 – Learning Objectives

Explain what working capital is and why proper management of working capital is critical to the survival of a firm.

Describe general strategies a firm should follow when managing its working capital accounts.

Discuss how a firm should finance its working capital needs.

Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2

Chapter 15 – Learning Objectives

Describe the types of short-term credit firms use. Discuss why it is necessary to compute the cost

of credit and show how the cost of short-term credit is determined?

Discuss which assets generally are considered good security for collateralized short-term loans and the types of collateralized arrangements that exist.


Working Capital Terminology

Working capital managementThe management of short-term assets

(investments) and liabilities (financing sources)



Working capitalA firm’s investment in short-term assets

CashMarketable securities InventoryAccounts receivable



Net working capitalCurrent assets minus current liabilitiesThe amount of current assets financed by

long-term liabilities and equity



Working capital policyTarget levels for each current asset accountHow current assets will be financed



Working capital only includes current liabilities that are specifically used to finance current assets



Working capital does not include current liabilities that are due in the current period as a result of long-term capital decisions, even though these must be considered when assessing the firm’s ability to meet its current obligations



Not working capital:Current maturities of long-term debtFinancing 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


The Requirement for External Working Capital Financing

Seasonal variationsBusiness cyclesExpansion requires more working capital


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



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



2. The receivables collection period Average length of time required to convert

the firm’s receivables into cash Also called days sales outstanding (DSO)



3. The payables deferral period Average length of time between the

purchase of raw materials and labor and the payment of cash for them



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

+ _

Argiles Textiles: Cash Conversion Cycle


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?


Alternative Current Asset Investment Policies

Relaxed current asset investment policyRelatively 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



Restricted current asset investment policyHoldings of cash and marketable securities

and inventories are minimized, and a restrictive accounts receivable policy is followed



Moderate current asset investment policyA policy that is between the relaxed and

restricted policies




Current Assets to SupportPolicy Sales of $100Relaxed $30Moderate 23Restricted 16

Current Assets

Permanent current assetCurrent asset balances that do not change

due to seasonal or economic conditionsThese balances exist even at the trough of

a firm’s business cycle


Permanent current assets

Current Assets

Temporary current assetCurrent assets that fluctuate with seasonal

or economic variations in a firm’s business


Temporary current assets

Permanent current assets

Alternative Current Asset Financing Policies

Maturity matching, or “self-liquidating” approachA financing policy that matches asset and

liability maturitiesThis would be considered a moderate

current asset financing policy



Conservative approachA 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



Aggressive approachA 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


Advantages and Disadvantages of Short-Term Financing

Speed A short-term loan can be obtained much more

quickly than long-term credit

Flexibility For cyclical needs, avoid long-term debt

Cost of issuing long-term debt is higher There might be penalties for payoff prior to maturity Long-term debt generally has restrictive covenants



Cost of long-term versus short-term debtYield curve is generally upward slopingShort term interest rates are generally

lower than long-term rates



Risk of long-term versus short-term debtShort-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


Short-Term Credit

Any liability originally scheduled for repayment within one year


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



Short-term bank loansMaturity typically 90 daysPromissory note specifies terms and

conditionsAmount, interest rate, repayment schedule,

collateral, and any other agreements



Short-term bank loans Compensating balances of 10 to 20 percent

might be required to be maintained in a checking account

Line of credit can be arrangedSpecified maximum amount of funds

available



Short-term bank loansRevolving credit agreement

Line of credit where funds are committed, or guaranteed by the lender

Commitment feeFee generally charged on the unused

balance of a revolving credit agreement



Commercial paperUnsecured short-term promissory notes

issued by large, financially sound firms to raise funds



Secured loans Loan backed by collateral For short-term loans, the collateral is often either

inventory or receivables Factoring is the sale of receivables Pledging is the use of receivables as collateral for

a loan The lender might seek recourse (payment) from

the borrowing firm for uncollectible receivables used to secure a loan


Computing the Cost of Short-Term Credit


Dollar cost of borrowingAmount of usable fundsrPER =Effective

annual rate

Annualpercentage rate

= EAR = [1 + rPER]m - 1.0

= APR = rPER x m = rSIMPLE

Computing the Cost of Short-Term Credit

Discount interest loanA 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


Managing Cash and Marketable Securities

Cash managementGoal of minimizing the amount of cash the

firm must hold for use in conducting its normal business activities; must consider the ability to: Pay suppliers Maintain its credit rating Meet unexpected cash needs


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


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


Cash Management Techniques

Cash forecastsPredict the timing of cash flows

Cash flow synchronizationCash inflows coincide with cash

outflows, permitting a firm to hold low transaction balances



FloatThe 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 have not fully cleared through the banking system and thus have not been deducted from the account on which they were written

Collection float The amount of checks that have been received

and deposited but have not yet been credited to the account in which they were deposited, because they have not cleared through the banking system



Net floatThe difference between disbursement

float and collection floatThe difference between the balance

shown in the checkbook and the balance shown on the bank’s books



Acceleration of receiptsLockbox 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



Acceleration of receiptsPreauthorized debit system

Allows a customer’s bank to periodically transfer funds from a customer’s account to a selling firm’s bank account for the payment of bills

Concentration banking A technique used to move funds from many

bank accounts to a more central cash pool to more effectively manage cash



Disbursement control Centralized disbursement system

More control, but can delay payments Zero-balance account (ZBA)

Special account used for disbursements that has a balance of zero when there is no disbursement activity

Controlled disbursement accounts (CDA) Checking accounts in which funds are not

deposited until checks are presented for payment, usually on a daily basis



Marketable securitiesSecurities that can be sold on short notice

without loss of principal or original investment Substitute for cash balances Temporary investment

Finance seasonal or cyclical operations Amass funds to meet financial requirements in the

near future


Credit Management

Credit policyA set of decisions that include a firm’s

credit standards, credit terms, methods used to collect credit accounts, and credit monitoring procedures


Credit Management

Credit policy factorsCredit standards

Standards that indicate the minimum financial strength a customer must have to be granted credit

Terms of credit Credit period

The length of time for which credit is granted Length of credit period and any cash discounts

offered


Credit Management

Credit policy factorsCollection policy

The procedures followed by a firm to collect its accounts receivables


Credit Management

Receivables monitoringThe process of evaluating the credit policy

to determine if shifts in the customers’ payment patterns occur


Credit Management

Receivables monitoring Days sales outstanding (DSO)

The average length of time required to collect accounts receivable

Also called the average collection period Aging schedule

Report showing how long accounts receivable have been outstanding

The report divides receivables into specified periods; provides information about the proportion of receivables that is current and the proportion that is past due for given lengths of time


Argiles Textiles: Receivables Aging Schedule, 2012


Age of Account(days)

Net AmountOutstanding

($ million)

Fraction ofTotal

Receivables

AverageDays

0–30 $36.0 40% 18

31–60 45.0 50 55

61–90 5.4 6 77

Over 90 3.6 4 97

$90.0 100%

DSO = 0.40(18 days) + 0.50(55 days) + 0.06(77 days) + 0.04(97 days) = 43.2 days

Credit Management

Analyzing proposed changes in credit policyUse NPV analysis the same as for capital

budgeting analysisTimings of the cash inflows and cash

outflows are important to the analysis


Inventory Management

Raw materials Inventories purchased from suppliers that will

ultimately be transformed into finished goods

Work in-process Inventory in various stages of completion

Finished goods Inventories that have completed the production

process and are ready for sale



Optimal inventory levelSustain operations at the lowest

possible cost



StockoutWhen a firm runs out of inventory and

customers arrive to purchase the product



Inventory costsCarrying costs

Storage, insurance, use of funds, depreciation, etc…

Ordering costs Costs of placing an order The cost of each order is generally fixed

regardless of the average size of inventory



Total inventory costs (TIC)


C = carrying cost as a percent of PPPP = purchase price of productQ = quantity ordered T = total demand for productO = fixed cost per order


Economic order quantity (EOQ)The optimal quantity that should be ordered It is the quantity that will minimize the total

inventory costs



Economic Ordering Quantity ModelEOQ modelFormula for determining the order quantity

that will minimize total inventory costs



EOQ model extensionsReorder point

The level of inventory at which an order should be placed

Safety stocksAdditional inventory carried to guard

against changes in sales rates or production/shipping delays



EOQ model extensionsQuantity discount

A discount from the purchase price offered for inventory ordered in large quantities

Seasonal adjustmentsEOQ computed separately for each season

to account for sales variations



Inventory control systemsRed-line method

An inventory control procedure in which a red line is drawn around the inside of an inventory-stocked bin to indicate the reorder point

Computerized inventory control system A system of inventory control in which a

computer is used to determine reorder points and to adjust inventory balances



Inventory control systems Just-in-time system

A system of inventory control in which a manufacturer coordinates production with suppliers so that raw materials or components arrive just as they are needed in the production process

Out-sourcing The practice of purchasing components

rather than making them in-house


Multinational Working Capital Management

Cash managementSpeed up collections and slow down

disbursementsShift cash as rapidly as possible to those

areas where it is neededPut temporary cash balances to work

earning positive returns



Credit managementCredit policy is more important

Risk of default Political and legal collection constraints Exchange rate changes between sale and time

receivable is collected



Inventory managementConcentrate inventory or distribute?

Costs versus distribution schedules

Exchange rates affect inventoryThreat of expropriationTax effects



Chapter PrinciplesKey Working Capital Management Concepts

What is working capital and why is working capital management critical to the survival of the firm? Working capital refers to the short-term assets of a firm. Poor

working capital management generally results in financial distress

What general strategies should a firm follow when managing its working capital accounts? Collect funds that it is owed as quickly as possible and delay

payments that it owes for as long as possible. How should the firm finance its working capital needs?

Most firms follow a maturity matching approach that specifies firms should finance spontaneous, self-liquidating assets with temporary debt and finance more permanent assets with more permanent debt.


What types of short-tem credit do firms use? Banks offer a variety of short-term loans

A note that has a maturity of less than a year A line of credit

Suppliers often permit firms to purchase materials on credit (payables)

Accruals—wages and taxes are the biggest

How is the cost of short-term credit determined? Why is it necessary to compute the cost of credit? The percentage cost of credit per period is equal to the dollar

cost of borrowing divided by the amount of funds that the borrower can use

Firms must know what they pay to use credit.



Which assets are good security for collateralized short-term loans? What are some of the arrangements that exist with secured short-term loans? Accounts receivable and inventory make good

collateral for short-term loans Receivables can be either factored (sold) or

pledged (used as collateral for a loan) Inventory arrangements can be in the forms of

blankets liens, trust receipts, or warehouse receipts


End of Chapter 15

Working Capital Management


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