CHAPTER 15 Working Capital Management

1
CHAPTER 15Working Capital Management

• Alternative working capital policies
• Cash management
• Inventory and A/R management
• Trade credit
• Bank loans

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

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

5
Is SKI inefficient or 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 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.

7
Moderate financing policy
8
Conservative financing policy
9
Cash conversion cycle

• The cash conversion cycle 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 should the
firm 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.

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The goal of cash management

• To meet the 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
Minimizing cash holdings

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

14
Cash budget

• Forecasts cash inflows, outflows, and ending cash
  balances.
• Used to plan loans needed or funds available to
  invest.
• Can be daily, weekly, or monthly, forecasts.
• Monthly for annual planning and daily for actual
  cash management.

15
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

16
SKIs cash budget (cont)

• 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

17
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.

18
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.

19
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.

20
Inventory costs

• 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 inventory levels generally reduces
  carrying costs, increases ordering costs, and may
  increase the costs of running short.

21
Is SKI holding too much inventory?

• SKIs inventory turnover (4.82x) is considerably
  lower than the industry average (7.00x).
• 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 Economic Value Added (EVA) is also
  lowered.

22
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.

23
Do SKIs customers pay more or less promptly than
those of its competitors?

• 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.

24
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.

25
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.
• SKI must balance the benefits of fewer bad debts
  with the cost of possible lost sales.

26
If SKI reduces its DSO without adversely
affecting sales, how would this affect 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.

27
Short-term credit

• Debt scheduled for repayment within 1 year.
• Major sources of short-term credit
• Accounts payable (trade credit)
• Bank loans
• Commercial loans
• Accruals
• From the firms perspective, S-T credit is
  riskier than L-T debt.
• Always a required payment around the corner.
• May have trouble rolling over loans.

28
Advantages and disadvantages of using short-term
financing

• Advantages
• Speed
• Flexibility
• Lower cost than long-term debt
• Disadvantages
• Fluctuating interest expense
• Firm may be at risk of default as a result of
  temporary economic conditions

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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.

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Terms of trade credit

• A firm buys 3,000,000 net (3,030,303 gross) on
  terms of 1/10, net 30.
• The firm can forego discounts and pay on Day 40,
  without penalty.
• Net daily purchases 3,000,000 / 365
• 8,219.18

31
Breaking down trade credit

• Payables level, if the firm takes discounts
• Payables 8,219.18 (10) 82,192
• Payables level, if the firm takes no discounts
• Payables 8,219.18 (40) 328,767
• Credit breakdown
• Total trade credit 328,767
• Free trade credit - 82,192
• Costly trade credit 246,575

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Nominal cost of trade credit

• The firm loses 0.01(3,030,303) 30,303 of
  discounts to obtain 246,575 in extra trade
  credit
• rNOM 30,303 / 246,575
• 0.1229 12.29
• The 30,303 is paid throughout the year, so the
  effective cost of costly trade credit is higher.

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Nominal cost of trade credit formula
1/10 net 30 NOTE PAID IN 40 DAYS Not exactly
on the 30th day
34
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

35
Bank loans

• The firm can borrow 100,000 for 1 year at an 8
  nominal rate.
• Interest may be set under one of the following
  scenarios
• Simple annual interest
• Installment loan, add-on, 12 months

36
Simple annual interest

• Simple interest means no discount or add-on.
• Interest 0.08(100,000) 8,000
• rNOM EAR 8,000 / 100,000 8.0
• For a 1-year simple interest loan, rNOM EAR

37
Add-on interest

• Interest 0.08 (100,000) 8,000
• Face amount 100,000 8,000 108,000
• Monthly payment 108,000/12 9,000
• Avg loan outstanding 100,000/2 50,000
• Approximate cost 8,000/50,000 16.0
• To find the appropriate effective rate, recognize
  that the firm receives 100,000 and must make
  monthly payments of 9,000 (like an annuity).

38
Add-on interest, monthly pmt

• From the calculator output below, we have
• rNOM 12 (0.012043)
• 0.1445 14.45
• EAR (1.012043)12 1 15.45

12
-9
0
100
INPUTS
N
I/YR
PMT
PV
FV
OUTPUT
1.2043