Working Capital Management:Working Capital Management:Current Asset ManagementCurrent Asset Managementand Short-Term Financingand Short-Term Financing

Corporate FinanceDr. A. DeMaskey

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Learning Objectives

• Questions to be answered:– What is working capital management?

– What is the appropriate amount of current assets for the firm to carry, both in total and for each specific account?

– How should current assets be financed?

– What are the major sources of short-term financing?

– What are the costs associated with each type of financing?

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Working Capital Terminology

• Gross working capital– Total current assets

• Net operating working capital– Current assets - Current liabilities

• Working capital policy:– The level of each current asset.– How current assets are financed.

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Working Capital Terminology

• Working capital management: – Includes both establishing working capital

policy and then the day-to-day control of:• Cash

• Inventories

• Receivables

• Short-term liabilities

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Alternative Current AssetInvestment Policies

Current Assets ($)

Sales ($)

Restricted

Moderate

Relaxed

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Cash Conversion Cycle

• The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales:– Inventory conversion period– Receivables collection period– Payables deferral period

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Goal of Cash Management

• Cash is a non-earning assetnon-earning asset.

• To minimize the amount of cash in order to conduct normal business activities.

• To have sufficient cash in order to:– Take trade discounts.– Maintain credit rating.– Meet unexpected cash needs.

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Reasons for Holding Cash

• Transactions balances

• Compensating balances

• Precautionary balances

• Speculative balances

Primary reasons

Secondary reasons

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Cash Budget: The Primary Cash Management Tool

• PurposePurpose: Uses forecasts of cash inflows, outflows, and ending cash balances to predict loan needs and funds available for temporary investment.

• TimingTiming: Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management.

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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.

6. Target cash balance.

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Ways to Minimize Cash Holdings

• Use lockboxes.• Insist on wire transfers from customers.• Synchronize inflows and outflows.• Use a remote disbursement account.• Increase forecast accuracy to reduce the need for a

cash “safety stock.”• Hold marketable securities instead of a cash “safety

stock.”• Negotiate a line of credit (also reduces need for a

“safety stock”).

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Working Capital Financing Policies

• Maturity MatchingMaturity Matching: Matches the maturity of the assets with the maturity of the financing.

• AggressiveAggressive: Uses short-term (temporary) capital to finance some permanent assets.

• ConservativeConservative: Uses long-term (permanent) capital to finance some temporary assets.

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Years

$

Perm C.A.

Fixed Assets

Temp. C.A.

What are “permanent” assets?

S-TLoans

L-T Fin:Stock,Bonds,Spon. C.L.

Maturity Matching Financing Policy

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Years

$

Perm C.A.

Fixed Assets

Temp. C.A.

More aggressive the lower the dashed line.

S-TLoans

L-T Fin:Stock,Bonds,Spon. C.L.

Aggressive Financing Policy

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Conservative Financing Policy

Fixed Assets

Years

$

Perm C.A.L-T Fin:Stock,Bonds,Spon. C.L.

Marketable Securities

Zero S-Tdebt

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Working Capital Policy

• The choice of working capital policy is a classic risk/return tradeoff.

• The aggressive policyaggressive policy promises the highest return but carries the greatest risk.

• The conservative policyconservative policy has the least risk but also the lowest expected return.

• The moderatemoderate (maturity matching) policypolicy falls between the two extremes.

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Marketable Securities

• Interest-bearingInterest-bearing short-term securities• Level of liquid assets held

– Interest rate– Transaction costs– Variability in cash flows

• Choosing marketable securities– Default risk– Marketability or liquidity– Maturity– Purchasing power risk– Rate of return

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Short-Term Financing

• Short-term debt is riskierriskier than long-term debt for the borrower. – Short-term rates may riserise.

– May have trouble rolling debt overrolling debt over.

• Advantages of short-term debt.– Typically lower costlower cost.

– Can get funds relatively quicklyquickly with lowlow transactions costs.

– Can repay without penaltywithout penalty.

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Major Sources of Short-Term Financing

• Short-term creditShort-term credit: Debt requiring repayment within one year.

• Major sourcesMajor sources:– Accruals– Accounts payable (trade credit)– Bank loans– Commercial paper

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Trade Credit

• Trade creditTrade credit is credit furnished by a firm’s supplierssuppliers.– Free trade credit– Costly trade credit

• Trade credit is often the largest sourcelargest source of short-term credit for small firms.

• Trade credit is spontaneousspontaneous and relatively easy to geteasy to get, but the cost can be highhigh.

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Bank Loans

• Mature in one year or less.

• Compensating balance requirement

• Types of bank loans:– Line of credit– Revolving credit agreement

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Interest Cost of Bank Loans

• Regular, or simple, interest

• Discount interest

• Add-on interest

• Annual percentage rate

• Interest rate with compensating balance requirement

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Effective Annual Percentage Rate

• To be able to compare loan cost rates and choose the alternative with the lowest cost.

• Because the loans have different terms, we must make the comparison on the basis of EARs.

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Commercial Paper

• Unsecured promissory note

• Issued by large, financially sound firms

• Average maturity of five months

• Interest rate is less than prime rate but slightly more than T-Bill rate

• Commercial paper market is impersonal