CHAPTER 14 Working Capital Management

1
CHAPTER 14Working Capital Management

• Alternative working capital policies
• Cash management
• Inventory management
• Accounts receivable management
• Working capital financing policies
• Trade credit

2
Working capital terminology

• Gross working capital total current assets.
• Net working capital current assets minus
  non-interest bearing current liabilities.
• Working capital policy deciding the level of
  each type of current asset to hold, and how to
  finance current assets.
• Working capital management controlling cash,
  inventories, and A/R, plus short-term liability
  management.

3
Selected ratios for SKI Inc.

• 
  SKI Ind. Avg.
• Current 1.75x 2.25x
• Debt/Assets 58.76 50.00
• Turnover of cash securities 16.67x 22.22x
• DSO (days) 45.63 32.00
• Inv. turnover 4.82x 7.00x
• F. A. turnover 11.35x 12.00x
• T. A. turnover 2.08x 3.00x
• Profit margin 2.07 3.50
• ROE 10.45 21.00

4
How does SKIs working capital policy compare
with its industry?

• SKI appears to have large amounts of working
  capital given its level of sales.
• Working capital policy is reflected in current
  ratio, turnover of cash and securities, inventory
  turnover, and DSO.
• These ratios indicate SKI has large amounts of
  working capital relative to its level of sales.
  SKI is either very conservative or inefficient.

5
Is SKI inefficient or just conservative?

• A conservative (relaxed) policy may be
  appropriate if it leads to greater profitability.
• However, SKI is not as profitable as the average
  firm in the industry. This suggests the company
  has excessive working capital.

6
Working Capital Management

• Short-Term Investment
• Cash Management
• Account Receivable Management
• Inventory Management
• Short-Term Financing
• Trade Credit
• Bank Loans
• Commercial Paper
• Account Receivable and/or Inventory Financing

7
Working Capital Management

• Trade-off of Short-Term Investment
• Cost 1 Cost 2
• __________________________________________________
  _________________________________
• Short-Term Assets
• Cash and Marketable Opportunity cost Illiquidity
  and solvency Securities of funds costs
• Accounts receivable Cost of investment
  Opportunity cost of lost in accounts sales
  due to overly receivable and restrictive
  credit policy bad debts and/or terms
• Inventory Carrying costs of Order and setup
  costs
• 
  inventory, including associated with
  replenishment
• financing, and production of finished
• warehousing cost, goods
• etc.

8
Working Capital Management

• Trade-off of Short-Term Financing
• Cost 1 Cost 2
• __________________________________________________
  _______
• Short-Term Financing
• Accounts payable, Cost of reduced Financing
  costs resulting
• Accruals, and notes liquidity caused from the
  use of less
• Payable by increasing expensive short-term
• current liabilities financing rather than
• more expensive long-term
• debt and equity financing

9
Cash conversion cycle

• The cash conversion model focuses on the length
  of time between when a company makes payments to
  its creditors and when a company receives
  payments from its customers.

10
Cash conversion cycle
11
Cash doesnt earn a profit, so why hold it?

• Transactions must have some cash to operate.
• Precaution safety stock. Reduced by line of
  credit and marketable securities.
• Compensating balances for loans and/or services
  provided.
• Speculation to take advantage of bargains and
  to take discounts. Reduced by credit lines and
  marketable securities.

12
What is the goal of cash management?

• To meet above objectives, especially to have cash
  for transactions, yet not have any excess cash.
• To minimize transactions balances in particular,
  and also needs for cash to meet other objectives.

13
Ways to minimize cash holdings

• Use a lockbox.
• Insist on wire transfers from customers.
• Synchronize inflows and outflows.
• Use a remote disbursement account.
• Increase forecast accuracy to reduce need for
  safety stock of cash.
• Hold marketable securities (also reduces need for
  safety stock).
• Negotiate a line of credit (also reduces need for
  safety stock).

14
Cash budgetThe primary cash management tool

• Purpose Forecasts cash inflows, outflows, and
  ending cash balances. Used to plan loans needed
  or funds available to invest.
• Timing Daily, weekly, or monthly, depending
  upon purpose of forecast. Monthly for annual
  planning, daily for actual cash management.

15
Data Required for a Cash Budgeting

• 1. Sales forecast.
• 2. Information on collections delay.
• 3. Forecast of purchases and payment terms.
• 4. Forecast of cash expenses, taxes, etc.
• 5. Initial cash on hand.
• 6. Target cash balance.

16
SKIs cash budgetFor January and February

• Net Cash Inflows
• Jan Feb
• Collections 67,651.95 62,755.40
• Purchases 44,603.75 36,472.65
• Wages 6,690.56 5,470.90
• Rent 2,500.00 2,500.00
• Total payments 53,794.31 44,443.55
• Net CF 13,857.64 18,311.85

17
SKIs cash budget

• Net Cash Inflows
• Jan
  Feb
• Cash at start if
• no borrowing 3,000.00 16,857.64
• Net CF 13,857.64 18,311.85
• Cumulative cash 16,857.64 35,169.49
• Less target cash 1,500.00 1,500.00
• Surplus 15,357.64 33,669.49

18
Should depreciation be explicitly included in the
cash budget?

• No. Depreciation is a noncash charge. Only cash
  payments and receipts appear on cash budget.
• However, depreciation does affect taxes, which
  appear in the cash budget.

19
What are some other potential cash inflows
besides collections?

• Proceeds from the sale of fixed assets.
• Proceeds from stock and bond sales.
• Interest earned.
• Court settlements.

20
How could bad debts be worked into the cash
budget?

• Collections would be reduced by the amount of the
  bad debt losses.
• For example, if the firm had 3 bad debt losses,
  collections would total only 97 of sales.
• Lower collections would lead to higher borrowing
  requirements.

21
Analyze SKIs forecasted cash budget

• Cash holdings will exceed the target balance for
  each month, except for October and November.
• Cash budget indicates the company is holding too
  much cash.
• SKI could improve its EVA by either investing
  cash in more productive assets, or by returning
  cash to its shareholders.

22
Why might SKI want to maintain a relatively high
amount of cash?

• If sales turn out to be considerably less than
  expected, SKI could face a cash shortfall.
• A company may choose to hold large amounts of
  cash if it does not have much faith in its sales
  forecast, or if it is very conservative.
• The cash may be used, in part, to fund future
  investments.

23
Float

• Float refers t funds that have been sent by the
  payer but are not yet usable funds to the payee.
• Float increases both the firms average
  collection period and its average payment period.
• The primary role of a cash manager on the
  collection side is to minimize this float
  wherever possible and to maximize it.

24
Float

• Mail float the time delay between when payment
  is placed in the mail and when payment is
  received.
• Processing Float the time between receipt of the
  payment and its deposit into the firms account.
• Availability Float the time between deposit of
  the check and availability of the funds to the
  firm.
• Clearing Float the time between deposit of the
  check and presentation of the check back to the
  bank on which it is drawn.

25
Types of Collection Systems

• Field-Banking system collections are made either
  over the counter or at a collection office. The
  main collection problem is moving the funds from
  the local banks up to the main accounts at the
  companys primary bank.
• Mail-Based System The process center will
  receive the mail payments, open the envelopes,
  separate the check from the remittance
  information, prepare the check for deposit, and
  send the remittance information to the accounts
  receivable department application of payment.
• Electronic System In a electronic bill
  presentment and payment (EBPP) system, customers
  are sent bills in an electronic format and then
  can pay their bills via electronic means.
• Lockbox System Customers mail payments to a post
  office box, which is emptied regularly by the
  firms bank. The bank processes each payment and
  deposits the payments in the firms account.

26
Lockbox System An Example

• Firm Y believes that use of a lockbox system can
  shorten its accounts receivable collection period
  by four days. The firms annual sales, all on
  credit, are 65 million, billed on a continuous
  basis. The firms can earn 9 on its short-term
  investments. The cost of the lockbox system is
  57,500 per year. Assume a 365-day year.
• A. What amount of cash will be made available for
  other uses under the lockbox system?
• B. What net benefit (or cost) will the firm
  receive if it adopts the lockbox system? Should
  it adopt the proposed lockbox system?

27
Lockbox System An Example

• Solution
• A. Cash available (65m/365) 4 712,329
• B. Interest Income from Reinvesting the cash
  available 712,329 (9/365) 64,109.61
• Lockbox costs 57,500
• Net Benefit 64,109.61 - 57,500 6,609.61

28
Types of inventory costs

• Carrying costs storage and handling costs,
  insurance, property taxes, depreciation, and
  obsolescence.
• Ordering costs cost of placing orders,
  shipping, and handling costs.
• Costs of running short loss of sales or
  customer goodwill, and the disruption of
  production schedules.
• Reducing the average amount of inventory
  generally reduces carrying costs, increases
  ordering costs, and may increase the costs of
  running short.

29
Is SKI holding too much inventory?

• SKIs inventory turnover (4.82) is considerably
  lower than the industry average (7.00). The firm
  is carrying a lot of inventory per dollar of
  sales.
• By holding excessive inventory, the firm is
  increasing its costs, which reduces its ROE.
  Moreover, this additional working capital must be
  financed, so EVA is also lowered.

30
If SKI reduces its inventory, without adversely
affecting sales, what effect will this have on
the cash position?

• Short run Cash will increase as inventory
  purchases decline.
• Long run Company is likely to take steps to
  reduce its cash holdings and increase its EVA.

31
Accounts Receivable Management

• ARs result from credit sales. The period is the
  average length of time firm a sale on credit
  until the payment becomes usable funds for the
  firm.

32
Accounts Receivable Management

• SKIs DSO (45.6 days) is well above the industry
  average (32 days).
• SKIs customers are paying less promptly.
• SKI should consider tightening its credit policy
  in order to reduce its DSO.

33
Elements of credit policy

• Credit Period How long to pay? Shorter period
  reduces DSO and average A/R, but it may
  discourage sales.
• Cash Discounts Lowers price. Attracts new
  customers and reduces DSO.
• Credit Standards Tighter standards tend to
  reduce sales, but reduce bad debt expense. Fewer
  bad debts reduce DSO.
• Collection Policy How tough? Tougher policy
  will reduce DSO but may damage customer
  relationships.

34
Does SKI face any risk if it tightens its credit
policy?

• Yes, a tighter credit policy may discourage
  sales. Some customers may choose to go elsewhere
  if they are pressured to pay their bills sooner.

35
If SKI succeeds in reducing DSO without adversely
affecting sales, what effect would this have on
its cash position?

• Short run If customers pay sooner, this
  increases cash holdings.
• Long run Over time, the company would hopefully
  invest the cash in more productive assets, or pay
  it out to shareholders. Both of these actions
  would increase EVA.

36
Receivable Management Example

• McDowell Industries sells on terms of 3/10, net
  30. Total sales for the year are 912,500. 40
  percent of the customers pay on the 10th day and
  take discounts the other 60 pay on average, 40
  days after their purchases.
• A. What is the days sales outstanding?
• B. What is the average amount of receivables?
• C. What would happen to average receivables if
  McDowell toughed up on its collection policy with
  the result that all nondiscount customers paid on
  the 30th day?

37
Receivable Management Example

• Solution
• a. 0.4(10) 0.6(40) 28 days.
• b. 912,500/365 2,500 sales per day.
• 2,500(28) 70,000 Average receivables.
• c. 0.4(10) 0.6(30) 22 days.
• 912,500/365 2,500 sales per day.
•   2,500(22) 55,000 Average receivables.
• Sales may also decline as a result of the tighter
  credit. This would further reduce receivables.
  Also, some customers may now take discounts
  further reducing receivables.

38
Working capital financing policies

• Moderate Match the maturity of the assets with
  the maturity of the financing.
• Aggressive Use short-term financing to finance
  permanent assets.
• Conservative Use permanent capital for
  permanent assets and temporary assets.

39
Moderate financing policy
40
Conservative financing policy
41
Accrued liabilities

• Continually recurring short-term liabilities,
  such as accrued wages or taxes.
• Is there a cost to accrued liabilities?
• They are free in the sense that no explicit
  interest is charged.
• However, firms have little control over the level
  of accrued liabilities.

42
What is trade credit?

• Trade credit is credit furnished by a firms
  suppliers.
• Trade credit is often the largest source of
  short-term credit, especially for small firms.
• Spontaneous, easy to get, but cost can be high.

43
The cost of trade credit

• A firm buys 506,985 net (512,106 gross) on
  terms of 1/10, net 30.
• The firm can forego discounts and pay on Day 40,
  without penalty.
• Net daily purchases 506,985 / 365
• 1,389

44
Breaking down net and gross expenditures

• Firm buys goods worth 506,985. Thats the cash
  price.
• They must pay 5,121 more if they dont take
  discounts.
• Think of the extra 5,121 as a financing cost
  similar to the interest on a loan.
• Want to compare that cost with the cost of a bank
  loan.

45
Breaking down trade credit

• Payables level, if the firm takes discounts
• Payables 1,389 (10) 13,890
• Payables level, if the firm takes no discounts
• Payables 1,389 (40) 55,560
• Credit breakdown
• Total trade credit 55,560
• Free trade credit - 13,890
• Costly trade credit 41,670

46
Nominal cost of costly trade credit

• The firm loses 0.01(512,106) 5,121 of
  discounts to obtain 41,670 in extra trade
  credit
• kNOM 5,121 / 41,670
• 0.1229 12.29
• The 5,121 is paid throughout the year, so the
  effective cost of costly trade credit is higher.

47
Nominal trade credit cost formula
48
Effective cost of trade credit

• Periodic rate 0.01 / 0.99 1.01
• Periods/year 365 / (40-10) 12.1667
• Effective cost of trade credit
• EAR (1 periodic rate)n 1
• (1.0101)12.1667 1 13.01

49
Bank Loans

• A firm is choosing among three alternative bank
  loans. The firm wishes to minimize the borrowing
  costs on a 200,000 borrowing. Analyze the cost
  of each of these alternatives
• 1. An 18 rate of interest with interest paid at
  year-end and no compensating balance requirement.
• 2. A 16 rate of interest but carrying a 20
  compensating balance requirement. This loan also
  calls for interest to be paid at year-end.
• 3. A 14 rate of interest that is discounted,
  plus a 20 compensating balance requirement.

50
Bank Loans

• Solutions
• 1. Effective rate of interest 18.
• 2. Effective rate of interest
• 32,000/(200,000-40,000) 20.
• 3. Effective rate of interest
• 28,000/(200,000-40,000-28,000)
• 21.21

51
Commercial paper (CP)

• Short-term notes issued by large, strong
  companies. BB couldnt issue CP--its too
  small.
• CP trades in the market at rates just above
  T-bill rate.
• CP is bought with surplus cash by banks and other
  companies, then held as a marketable security for
  liquidity purposes.

52
Alternative Financing Example

• Suncoast Boats Inc. estimates that because of the
  seasonal nature of its business, it will required
  an additional 2m of cash for the month of July.
  Suncoast has the following 4 options available
  for raising the needed funds
• 1. Establish a 1-year line of credit for 2m with
  a bank. The commitment fee will be 0.5 per year
  on the unused portion, and the interest charge on
  the used funds will be 11 per annum. Assume
  that the funds are needed only in July, and that
  there are 30 days in July and 365 days in the
  year.

53
Alternative Financing Example

• 2. Forgo the trade discount of 2/10, net 40, on
  2m of purchases during July.
• 3. Issue 2m of 30-day commercial paper at a 9.5
  per annum interest rate. The total transactions
  fee, including the cost of a backup credit line,
  on using commercial paper is 0.5 of the amount
  of the issue.
• 4. Issue 2m of 60-day commercial paper at a 9
  per annum interest rate, plus a transaction cost
  of 0.5. Since the funds are required for only
  30 days, the excess funds (2m) can be invested
  in 9.4 per annum marketable securities for the
  month of August. The total transaction costs of
  purchasing and selling the marketable securities
  is 0.4 of the amount of the issue.

54
Alternative Financing Example

• A. What is the dollar cost of each financing
  arrangement?
• B. Is the source with the lowest expected cost
  necessarily the one to select? Why or why not?

55
Alternative Financing Example

• Solutions
• a. 1. Line of credit
• Commitment fee
• (0.005)(2,000,000)(335/365)
• 9,178
• Interest
• (0.11)(30/365)(2,000,000)
• 18,082
• Total 27,260

56
Alternative Financing Example

• Solutions
• 2. Trade discount
• a. 0.2483 24.83.
• Total cost 0.2483(2,000,000)(30/365)
• 40,816.
•  
• b. Effective cost (1 2/98)365/30 - 1
• 0.2786 27.86.
• Total cost 0.2786(2,000,000)(30/365)
• 45,804.

57
Alternative Financing Example

• Solutions
• 3.30-day commercial paper
• Interest (0.095)(2,000,000)(30/365)
• 15,616
• Transaction fee (0.005)(2,000,000)
• 10,000
• Total 25,616

58
Alternative Financing Example

• Solutions
• 4.60-day commercial paper
• Interest (0.09)(2,000,000)(60/365)
  29,589
• Transaction fee (0.005)(2,000,000)
  10,000
• Total Costs 39,589
• Marketable securities interest received
• (0.094)(2,000,000)(30/365) 15,452
• Transactions cost, marketable securities
• (0.004)(2,000,000) 8,000
• Total 32,137
•  
• The 30-day commercial paper has the lowest cost.