Working Capital Management

Alternative working capital policies Cash management Inventory and A/R management Trade credit Bank loans
16-1

Working capital terminology

Gross working capital total c rrent assets! "et working capital c rrent assets min s non#interest $earing c rrent lia$ilities! Working capital policy deciding the level o% each type o% c rrent asset to hold& and how to %inance c rrent assets! Working capital management 16-2

'elected ratios %or '(I Inc!

'(I C rrent ratio .e$t/Assets T rnover o% cash 3 sec rities .ays sales o tstanding Inventory t rnover 6i,ed assets t rnover Total assets t rnover )!*+, +/!*0 1 Ind Avg -!-+, +2!22 1

)0!0*, --!--, 4+!05 4!/-, -!2/, 5-!22 *!22, 5!22,

16-3

))!5+, )-!22,

9ow does '(I:s working capital policy compare with its ind stry;

Working capital policy is re%lected in the c rrent ratio& t rnover o% cash and sec rities& inventory t rnover& and days sales o tstanding! These ratios indicate '(I has large amo nts o% working capital relative to its level o% sales! '(I is either very conservative or ine%%icient!
16-4

Is '(I ine%%icient or conservative;

A conservative <rela,ed= policy may $e appropriate i% it leads to greater pro%ita$ility! 9owever& '(I is not as pro%ita$le as the average %irm in the ind stry!

This s ggests the company has e,cessive working capital!

16-5

Working capital %inancing policies

Moderate Match the mat rity o% the assets with the mat rity o% the %inancing! Aggressive >se short#term %inancing to %inance permanent assets! Conservative >se permanent capital %or permanent assets and temporary assets!
16-6

Working capital %inancing

R?@ A 7R?6IT MARGI" B T?TAC A''@T T>R"?D@R B C@D@RAG@ 6ACT?R <. 7ont @8 ation= A "I/'AC@' B 'AC@'/A''@T' B A''@T'/@E>ITF

16-7

Moderate %inancing policy

G Temp! C!A! '#T Coans 7erm C!A! C#T 6inH 'tock& Bonds& 'pon! C!C! Fears Cower dashed line wo ld $e more aggressive!
16-8

6i,ed Assets

Conservative %inancing policy

G
Marketa$le sec rities

Iero '#T .e$t C#T 6inH 'tock& Bonds& 'pon! C!C! Fears
16-9

7erm C!A!

6i,ed Assets

Cash conversion cycle

The cash conversion cycle %oc ses on the length o% time $etween when a company makes payments to its creditors and when a company receives payments %rom its c stomers!

Inventory Receivables Payables CCC = conversion + collection deferral . period period period
16-10

Cash conversion cycle

Inventory Receiva$le s 7aya$les CCC= conversion + collection de%erral period period period 7aya$les .aysper year .ayssales CCC= + de%erral g period Inventory t rnover o tstandin 50+ CCC= + 40 # 52 4!/CCC= *0 + 40 # 52 = J- days!
16-11

Cash doesn:t earn a pro%it& so why sho ld the %irm hold it;
)! -!

5! 4!

Transactions m st have some cash to operate! 7reca tion Ksa%ety stockL! Red ced $y line o% credit and marketa$le sec rities! Compensating $alances %or loans and/or services provided! 'pec lation to take advantage o% $argains and to take disco nts! Red ced $y credit lines and marketa$le sec rities! 16-12

The goal o% cash management

To meet the a$ove o$Mectives& especially to have cash %or transactions& yet not have any e,cess cash! To minimiNe transactions $alances in partic lar& and also needs %or cash to meet other o$Mectives!
16-13

MinimiNing cash holdings

>se a lock$o, Insist on wire trans%ers %rom c stomers 'ynchroniNe in%lows and o t%lows >se a remote dis$ rsement acco nt Red ce need %or Ksa%ety stockL o% cash

Increase %orecast acc racy 9old marketa$le sec rities "egotiate a line o% credit

16-14

Cash $ dget

6orecasts cash in%lows& o t%lows& and ending cash $alances! >sed to plan loans needed or % nds availa$le to invest! Can $e daily& weekly& or monthly& %orecasts! Monthly %or ann al planning and daily %or act al cash management!

Iss eH 9ow acc rate are the %orecasts and what wo ld $e the e%%ects o% signi%icant errors;

16-15

'(I:s cash $ dgetH 6or Oan ary and 6e$r ary

"et Cash In%lows Oan 6e$ G0*&0+)!J+ 44&025!*+ 0&0J2!+0 -&+22!22
16-16

Collections G0-&*++!42 7 rchases 50&4*-!0+ Wages +&4*2!J2 Rent -&+22!22

'(I:s cash $ dget <con:t=

"et Cash In%lows Oan 6e$ Cash at start i% no $orrowing G 5&222!22 G)0&/+*!04 "et C6 )5&/+*!04 )/&5))!/+ C m lative cash )0&/+*!04 5+&)0J!4J CessH target cash )&+22!22 )&+22!22 ' rpl s G)+&5+*!04 G55&00J!4J
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AnalyNe '(I:s %orecasted cash $ dget

Cash holdings will e,ceed the target $alance %or each month& e,cept %or ?cto$er and "ovem$er! Cash $ dget indicates the company is holding too m ch cash! '(I co ld improve its @DA $y either investing cash in more prod ctive assets& or $y ret rning cash to its shareholders!
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Why might '(I want to maintain a relatively high amo nt o% cash;

I% sales t rn o t to $e considera$ly less than e,pected& '(I co ld %ace a cash short%all! A company may choose to hold large amo nts o% cash i% it does not have m ch %aith in its sales %orecast& or i% it is very conservative! The cash may $e sed& in part& to % nd % t re investments!
16-19

9ow co ld $ad de$ts $e worked into the cash $ dget;

Collections wo ld $e red ced $y the amo nt o% the $ad de$t losses! 6or e,ample& i% the %irm had 51 $ad de$t losses& collections wo ld total only J*1 o% sales! Cower collections wo ld lead to higher $orrowing re8 irements!
16-20

Inventory costs

Types o% inventory costs

Carrying costs storage and handling costs& ins rance& property ta,es& depreciation& and o$solescence! ?rdering costs cost o% placing orders& shipping& and handling costs! Costs o% r nning short loss o% sales or c stomer goodwill& and the disr ption o% prod ction sched les!

Red cing inventory levels generally red ces carrying costs& increases ordering costs& and may increase the costs o% r nning short!

16-21

Is '(I holding too m ch inventory;

'(I:s inventory t rnover <4!/-,= is considera$ly lower than the ind stry average <*!22,=! The %irm is carrying a lot o% inventory per dollar o% sales! By holding e,cessive inventory& the %irm is increasing its costs& which red ces its R?@! Moreover& this additional working capital m st $e %inanced& so @DA is16-22

I% '(I red ces its inventory& witho t adversely a%%ecting sales& what e%%ect will this have on the cash position;

'hort r nH Cash will increase as inventory p rchases decline! Cong r nH Company is likely to take steps to red ce its cash holdings and increase its @DA!

16-23

.o '(I:s c stomers pay more or less promptly than those o% its competitors;

'(I:s .'? <4+!0 days= is well a$ove the ind stry average <5- days=!

'(I:s c stomers are paying less promptly!

'(I sho ld consider tightening its credit policy in order to red ce its .'?!
16-24

@lements o% credit policy

)!

-! 5!

4!

Credit 7eriod 9ow long to pay; 'horter period red ces .'? and average A/R& $ t it may disco rage sales! Cash .isco nts Cowers price! Attracts new c stomers and red ces .'?! Credit 'tandards Tighter standards tend to red ce sales& $ t red ce $ad de$t e,pense! 6ewer $ad de$ts red ce .'?! Collection 7olicy 9ow to gh; To gher policy will red ce .'? $ t may damage 16-25 c stomer relationships!

.oes '(I %ace any risk i% it tightens its credit policy;

Fes& a tighter credit policy may disco rage sales!

'ome c stomers may choose to go elsewhere i% they are press red to pay their $ills sooner! '(I m st $alance the $ene%its o% %ewer $ad de$ts with the cost o% possi$le lost sales!
16-26

adversely a%%ecting sales& how wo ld this a%%ect its cash position;

'hort r nH I% c stomers pay sooner& this increases cash holdings! Cong r nH ?ver time& the company wo ld hope% lly invest the cash in more prod ctive assets& or pay it o t to shareholders! Both o% these actions wo ld increase @DA! 16-27

'hort#term credit

.e$t sched led %or repayment within ) year! MaMor so rces o% short#term credit

Acco nts paya$le <trade credit= Bank loans Commercial loans Accr als Always a re8 ired payment aro nd the corner! May have tro $le rolling over loans! 16-28

6rom the %irm:s perspective& '#T credit is riskier than C#T de$t!

Advantages and disadvantages o% sing short#term %inancing

Advantages

'peed 6le,i$ility Cower cost than long#term de$t 6l ct ating interest e,pense 6irm may $e at risk o% de%a lt as a res lt o% temporary economic conditions

.isadvantages

16-29

What is trade credit;

Trade credit is credit % rnished $y a %irm:s s ppliers! Trade credit is o%ten the largest so rce o% short#term credit& especially %or small %irms! 'pontaneo s& easy to get& $ t cost can $e high!

16-30

Terms o% trade credit

A %irm $ ys G5&222&222 net <G5&252&525 gross= on terms o% )/)2& net 52! The %irm can %orego disco nts and pay on .ay 42& witho t penalty! "et daily p rchases A G5&222&222 / 50+ A G/&-)J!)/
16-31

Breaking down trade credit

7aya$les level& i% the %irm takes disco nts

7aya$les A G/&-)J!)/ <)2= A G/-&)J-

7aya$les level& i% the %irm takes no disco nts

7aya$les A G/&-)J!)/ <42= A G5-/&*0* Total trade credit G5-/&*0* 6ree trade credit # /-&)JCostly trade credit G-40&+*+

Credit $reakdown

16-32

"ominal cost o% trade credit

The %irm loses 2!2)<G5&252&525= A G52&525 o% disco nts to o$tain G-40&+*+ in e,tra trade creditH
r"?M A G52&525 / G-40&+*+ A 2!)--J A )-!-J1

The G52&525 is paid thro gho t the year& so the e%%ective cost o% costly trade credit is higher!

16-33

"ominal cost o% trade credit %orm la

r"?M .isco nt 1 50+days = ) # .isco nt 1 .aystaken# .isc!period ) 50+ = JJ 42 # )2 = 2!)--J = )-!-J1

16-34

@%%ective cost o% trade credit

7eriodic rate A 2!2) / 2!JJ A )!2)1 7eriods/year A 50+ / <42#)2= A )-!)00* @%%ective cost o% trade credit

@AR A <) P periodic rate=" ) A <)!2)2)=)-!)00* ) A )5!2)1

16-35

Bank loans

The %irm can $orrow G)22&222 %or ) year at an /1 nominal rate! Interest may $e set nder one o% the %ollowing scenariosH

'imple ann al interest Installment loan& add#on& )- months

16-36

'imple ann al interest

K'imple interestL means no disco nt or add#on!

Interest A 2!2/<G)22&222= A G/&222 r"?M A @AR A G/&222 / G)22&222 A /!21

6or a )#year simple interest loan& r"?M A @AR

16-37

Add#on interest

Interest A 2!2/ <G)22&222= A G/&222 6ace amo nt A G)22&222 P G/&222 A G)2/&222 Monthly payment A G)2/&222/)- A GJ&222 Avg loan o tstanding A G)22&222/- A G+2&222 Appro,imate cost A G/&222/G+2&222 A )0!21 To %ind the appropriate e%%ective rate& 16-38