Chapter 15 Working Capital Management (WCM) - PowerPoint Presentation

1. Chapter 15Working Capital Management (WCM)IMAS1

2. Working Capital OverviewWorking capital is a firm’s investment in short-term assets--cash, marketable securities, inventory, and accounts receivable. Net working capital is current assets minus current liabilities. WC management is the management of all aspects of both current assets and current liabilities, to minimise the risk of insolvency while maximising the return on assets.Investing in WC has a cost which can either be expressed as: the cost of funding it, orthe opportunity cost** A company’s ideal situation is to have what they consider sufficient working capitalIMAS2

3. Objective of WCThe main objective of working capital management is to get the balance of current assets and current liabilities rightLiquidity Profitability Low inventoryEnsure sales with high stocksHigh PayablesLow receivablesExtend credit periodTrade discounts allowedIMAS3

4. WC GoalsAdequate cash flow for operationsMost productive use of resources Profitability Vs LiquidityIMAS4

5. Managing and measuring LiquidityLiquidity is the ability of the company to satisfy its short-term obligations using assets that are readily converted into cash.Liquidity management is the ability of the company to generate cash when and where needed.Liquidity management requires addressing drags and pulls on liquidity.Drags on liquidity are forces that delay the collection of cash, such as slow payments by customers and obsolete inventory.Pulls on liquidity are decisions that result in paying cash too soon, such as paying trade credit early or a bank reducing a line of credit.IMAS5

6. Sources of liquidityPrimary sources of liquidityReady cash balances (cash and cash equivalents)Short-term funds (short-term financing, such as trade credit and bank loans)Cash flow management (for example, getting customers’ payments deposited quickly)IMAS6

7. Current assets and current liabilities componentsCurrent assets Current liabilitiesInventory PayablesReceivables OverdraftMarketable securitiesCashIMAS7

8. IMASExamples of Marketable SecuritiesTreasury BillsShort-term government notes issued at a discount with principal repaid at maturityCommercial PaperShort-term unsecured promissory notes issued by corporations with good creditBankers’ AcceptancesShort-term promissory notes issued by a firm and accepted (or guaranteed) by a bank8

9. Liquidity Vs ProfitabilityDiscuss the advantages of keeping the following components of working capital high:InventoryReceivablesCashCurrent liabilitiesIMAS9

10. Liquidity Vs ProfitabilityDiscuss the advantages of keeping the following components of working capital low:InventoryReceivablesCashCurrent liabilitiesIMAS10

11. Operating cycle and the cash cycleOperating cycle Is the length of time it takes to acquire inventory, sell it, and collect the receivables resulting from the sale (describes how product moves through the current asset account) Inventory period + Accounts receivable periodIt describes how a product moves through the current asset accounts. It begins life as inventory, it is converted to receivables when it is sold, and it finally converted to cash when we collect the saleCash CycleIs the number of days that pass until we collect the cash from sale, measured from when we actually pay for the inventory Operating cycle – payables periodIMAS11

12. Cash conversion cycleThe operating and cash conversion cycle can be visualized as shown below:IMAS12

13. Factors affecting length of working capitalLiquidity versus profitabilityManagement efficiencyIndustry normsActivity/sales Length of cycle Funds needed increase in proportion to:Stays constant increase days in cycleIncrease Stays constant sales**The optimum level of working capital is the amount that results in no idle cash or unused inventory, but does not put a strain on liquid resourcesIMAS13

14. Level of working capital is affected by the following factors:Nature of business (manufacturing VS service entities)Uncertainty in supplier deliveryOverall activityEntity’s credit policyLength of working capital cycleCredit policy of suppliersIMAS14

15. IMASWorking Capital PolicyFirms must set policy on following issues:How much working capital is usedExtent to which working capital is supported by short- vs. long-term financingHow each component of working capital is managedThe nature/source of any short-term financing used15

16. IMASShort-Term vs. Long-Term FinancingShort-term financingCheap but riskCheap—short-term rates generally lower than long-term ratesRisky—because you are continually entering marketplace to borrowBorrower will face changing conditions (ex; higher interest rates and tight money)Long-term financing Safe but expensiveSafe—you can secure the required capital Expensive—long-term rates generally higher than short-term rates16

17. IMASWorking Capital Needs of Different Firms 17

18. Permanent and Temporary Working CapitalWorking capital is permanent to the extent that it supports constant or minimum level of salesTemporary working capital supports seasonal peaks in businessTemporary investments in assets include current assets that will be liquidated and not replaced within the current year. IMAS18

19. IMASMaturity Matching PrincipleMaturity (due date) of financing should roughly match duration (life) of asset being financedThen financing /asset combination becomes self-liquidating Cash inflows from asset can be used to pay off loan19

20. Financing Net Working CapitalAccording to maturity matching principleTemporary (seasonal) should be financed with short-term borrowingPermanent working capital should be financed with long-term sources, such as long-term debt and/or equityIn practice, firms may use more or less short-term funds to finance working capitalIMAS20

21. IMASWorking Capital Financing Policies 21

22. Working Capital Financing PoliciesIMAS22

23. OvertradingOvertrading – a company is growing its sales faster than it can finance them ( transacting more than the firm’s working capital can normally sustain)Typical indicatorsRapid increase in turnoverRapid increase in the volume of current assetsMost of the increase in assets being financed by creditA dramatic drop in liquidity rationsPotential solutionsRaising more long term capitalSlowing down growth to reduce increase in working capitalImproving working capitalIMAS23

24. RatiosLiquidity RatiosCurrent ratioQuick ratio IMAS24

25. Efficiency ratiosInventory days Raw material daysReceivables days WIP daysPayable daysIMAS25

26. Turnover ratiosInventory turnoverDiscuss if the turnover ratios are useful?IMAS26

27. Operating cycle and firm’s organisation chartIt is useful to understand people involved in managing working capital before we go into further detail.Always bear in mind the potential conflict if managers concentrate only on one part of the pictureCash manager Credit managerMarketing manager Purchasing managerProduction manager Payables managerFinancial managerIMAS27