The Management of Working Capital - PowerPoint Presentation

1. The Management of Working CapitalChapter 16(Ch. 15 in the 4th edition)

2. 2BasicsWorking Capital BasicsThe assets/liabilities that are required to operate a business on a day-to-day basisCashAccounts ReceivableInventoryAccounts PayableAccrualsSometimes short term debtThese assets/liabilities are short-term in nature and turn over regularly

3. 3Working Capital, Funding Requirements, and the Current AccountsGross Working Capital (GWC) represents the investment in current assetsWorking Capital Requires FundsMaintaining a working capital balance requires a permanent commitment of fundsExample: Your firm will always have a minimum level of Inventory, Accounts Receivable, and Cash—this requires funding

4. 4Working Capital, Funding Requirements, and the Current Accounts Spontaneous Financing Your firm will also always have a minimum level of Accounts Payable—in effect, money you have borrowed from suppliersAccounts Payable (and Accruals) are generated spontaneouslyOffset the funding required to support assetsNet working capital is Gross Working Capital – Current Liabilities (or sometimes just subtract spontaneous financing)Reflects the net amount of funds needed to support routine operations

5. 5Objective of Working Capital ManagementTo run the firm efficiently which generally means as little money as economical tied up in Working CapitalInvolves trade-offs between easier operation and the cost of carrying short-term assetsBenefit of low working capitalLess capital invested for the level of business (higher rate of return and lower cost)Cost of low working capitalLost salesrisk

6. 6Objective of Working Capital ManagementInventoryHigh LevelsLow LevelsBenefit: Happy customersFew production delays (always have needed parts on hand)Cost: ExpensiveHigh storage costsRisk of obsolescenceCost: ShortagesDissatisfied customersBenefit: Low storage costsLess risk of obsolescenceCashHigh LevelsLow LevelsBenefit:Reduces riskCost:Increases financing costsBenefit:Reduces financing costsCost:Increases risk

7. 7Objective of Working Capital ManagementAccounts ReceivableHigh Levels (favorable credit terms)Low Levels (unfavorable terms)Benefit: Happy customersHigh salesCost: ExpensiveHigh collection costsIncreases financing costsCost: Dissatisfied customersLower SalesBenefit: Less expensivePayables and AccrualsHigh LevelsLow LevelsBenefit:Reduces need for external finance--using a spontaneous financing sourceCost:Unhappy suppliersBenefit:Happy suppliers/employeesCost:Not using a spontaneous financing source

8. 8Operations—Cash Conversion CycleA firm begins with cash which then “becomes” inventoryWhich then becomes a product which is soldEventually this will turn into cash againThe firm’s operating cycle is the time from the acquisition of inventory until cash is collected from product sales

9. 9Figure 15.2: Time Line Representation of the Cash Conversion Cycle

10. 10Example CCC from earlier in semesterCompanyICPACPAP defCCCM175.863.2683.7795.35AMZN43.7517.870.46-8.91WMT51.374.1940.3115.24COST36.084.0836.323.84TGT (2015)62.482.6354.9610.16TGT (2012)58.6131.5650.9439.23Data ttm on 1/21/2016 from Morningstar

11. 11Permanent and Temporary Working CapitalTemporary working capital supports seasonal peaks in businessWorking capital is permanent to the extent that it supports a constant of minimum level of sales

12. 12Figure 15.3: Working Capital Needs of Different Firms

13. 13Financing Net Working CapitalSince working capital is of a short-term nature, it is often financed with short-term sourcesThis is known as the maturity-matching principlePermanent working capital can be financed either long or short termTemporary working capital needs should be supported with short-term funds

14. 14Short-Term vs. Long-Term FinancingLong-term financingSafe but expensiveSafe because you don’t have re-issue riskExpensive because long-term rates are generally higher than short-term ratesShort-term financingCheap but riskyCheap because short-term rates are generally lower than long-term ratesRisky because you are continually entering marketplace to borrow—borrower will face changing conditions

15. 15Alternative PoliciesMatching maturity of assets and financing is a logical point of referenceThe mix of short- or long-term working capital financing is a matter of policyDeviations from maturity matching are consideredUse of longer term funds reflects conservatism

16. 16Figure 15.4—Working Capital Financing Policies

17. 17Working Capital PolicyFirm must set policy on following issues:How much working capital is usedThe extent to which working capital is supported by short- vs. long-term financingThe nature/source of any short-term financing usedHow each component of working capital is managed

18. 18Sources of Short-term FinancingSpontaneous financingAccounts payable and accrualsUnsecured bank loansCommercial paperSecured loans

19. 19Spontaneous FinancingAccrualsMoney you owe employees (for example) for work they have performed but not yet been paid Tend to be very short-termAccounts payable (AKA trade credit)Money you owe suppliers for goods you bought on creditCredit Terms: Terms of trade specify when you are to repay the debtExample of terms of trade: 2/10, net/30You must pay the entire amount by 30 daysIf you pay within 10 days, you will receive a 2% discount

20. 20Spontaneous FinancingThe prompt payment discountPassing up prompt payment discounts is generally a very expensive source of financing If the terms of trade are 2/10, net 30, and you elect to not pay by the 10th day, you are essentially paying 2% interest for 20 days’ use of money. There are 18.25 20-day periods in one year (365 days  20). We can convert the 2% foregone discount into an annual rate by multiplying 2% by 18.25 to obtain 36.5%. Most prompt payment discounts are very attractive.Example

21. 21Spontaneous FinancingAbuses of Trade Credit TermsTrade credit, while originally a service to a firm’s customers, has become so commonplace it is now expectedCompanies offer it because they have toStretching payables is a common abuse of trade creditPaying payables beyond the due date Slow paying companies receive poor credit ratings in credit reports issued by credit agencies

22. 22Unsecured Bank LoanRepresent the primary source of short-term loans for most companiesPromissory note (AKA Notes Payable)Note signed promising to repay the amount borrowed plus interestBank usually credits the amount to borrower’s checking account

23. 23Unsecured Bank LoansLine of creditInformal, non-binding agreement between bank and firm that specifies the maximum amount firm can borrow over a specific time frame (usually a year)Borrower pays interest only on the amount borrowedRevolving credit agreementSimilar to a line of credit except bank guarantees the availability of funds up to a maximum amount (effectively a binding agreement)Borrower pays a commitment fee on the unborrowed funds (whether they are used or not)

24. 24Unsecured Bank Loans: example of a commitment feeQ: The Arcturus Company has a $10 million revolving credit agreement with its bank at prime plus 2.5% based on a calendar year. Prior to the month of June, it had taken down $4 million that was outstanding for the entire month. On June 15, it took down another $2 million (assume the funds were available on June 16). Prime is 9.5% and the bank’s commitment fee is 0.25% annually. What bank charges will Arcturus incur for the month of June?A: Arcturus will have to pay both interest on the money borrowed and a commitment fee on the unused balance of the revolving agreement.Monthly interest rate: (Prime + 2.5%)  12 = 1%Monthly commitment fee: 0.25%  12 = 0.0208%$4 million was outstanding for the entire month of June and $2 million was outstanding for 15 days of June, so the total dollar interest charges are:ExampleThe commitment fee must be paid on an average of $5,000,000 that was unused during June ($6 million the first half, $4 million the second half), or:$5,000,000  (0.0025/12) = $1,041.67Total interest payment = $51,041.67

25. 25Unsecured Bank LoansCompensating balancesA minimum amount by which the borrower’s bank account cannot drop below (therefore it is unavailable for use)Increases the effective interest rate on a loanTypically between 10% and 20% of amounts loanedFCS stock purchase requirements are like a compensating balance

26. 26Unsecured Bank LoansClean-Up RequirementsTheoretically a firm can constantly roll-over its short-term debtBorrow on a new note to pay off an old noteRisky for both the firm and the bankSome banks require that borrowers clean up short-term loans once a yearRemain out of short-term debt for a certain time period

27. 27Commercial PaperNotes issued by large, financially-strong firms and sold to investorsBasically a short-term corporate bondUnsecured (usually)Buyers are usually other institutions (insurance companies, mutual funds, banks, pension funds)Maturity is less than 270 daysConsidered a very safe investment, therefore pays a relatively low interest rateRather than paying a coupon rate, interest is discountedCommercial paper market is rigid and formal—no flexibility in repayment terms

28. 28Short-Term Credit Secured by Current AssetsDebt is secured by the current asset being financedMore popular in some industries than in othersCommon in seasonal businesses such as agriculture and agribusiness

29. 29Short-Term Credit Secured by Current AssetsReceivables Financing: Accounts receivable represent money that is to be collected in the near futureBanks recognize that this money will be collected soon are are willing to lend money based on this soon-to-be-collected moneyPledging AR: firm promises to use the money paid from the collected AR to pay off bank loan (but AR still belong to firm which still collects the accounts)If firm doesn’t repay, lender has recourse to borrowerFactoring AR: firm sells AR to lender (at a severe discount) and the lending firm (factor) takes control of the accountsAR are now paid directly to lender

30. 30Short-Term Credit Secured by Current AssetsPledging Accounts ReceivableFirm promises to use the money paid from the collected accounts to pay off bank loan Accounts Receivable still belong to firm which still collects the accountsIf firm doesn’t repay, lender has recourse to borrowerLender can provideGeneral line of credit tied to all receivablesLender likely to advance at most 75% of the balance of accountsSpecific line of credit tied to individual accounts receivableEvaluates based on creditworthiness of accountLender likely to advance as much as 90% of the balance of accepted accountsExpensive form of financing

31. 31Short-Term Credit Secured by Current AssetsFactoring Accounts ReceivableFirm sells Accounts Receivable to lender (at a severe discount) and the lending firm (factor) takes control of the accountsAccounts Receivable are now paid directly to lenderFactor usually reviews accounts and only accepts accounts it deems creditworthyFactors offer a wide range of servicesPerform credit checks on potential customersAdvance cash on accounts it accepts or remit cash after collectionCollect cash from customersAssume the bad-debt risk when customers don’t pay

32. 32Short-Term Credit Secured by Current AssetsInventory FinancingUse a firm’s inventory as collateral for a short-term loanPopular but subject to a number of problemsLenders aren’t usually equipped to sell inventorySpecialized inventories and perishable goods are difficult to marketTypes of methods usedBlanket liens—lender has a lien (claim) against all inventories of the borrower but borrower remains in physical control of inventoryChattel mortgage agreement—collateralized inventory is identified by serial number and can’t be sold without lender’s permission (but borrower remains in physical control of inventory)Warehousing—collateralized inventory is removed from borrower’s premises and placed in a warehouse (borrower’s access controlled by third party)When inventory is sold a paper trail is generated and copy sent to lender (signaling lender to expect money from borrower soon)

33. 33Cash ManagementWhy have cash on hand?Transactions demand: need money to pay bills (employees, suppliers, utility/phone, etc.)Precautionary demand: to handle emergencies (unforeseen expenses)Speculative demand: to take advantage of unexpected opportunities (purchase of raw materials that are on sale)Compensating balances

34. 34Objective of Cash ManagementCash doesn’t earn a returnWant to maintain liquidity without losing too much in returnCan place a portion of cash balance into marketable securities (AKA: near cash or cash equivalents)Liquid investments that can be held instead of cash and earn a modest returnExamples include Treasury bills, commercial paper

35. 35Check Disbursement and Collection ProceduresWhen you pay a bill, the process generally works like this:You write a check and place it in the mail to payee (2-3 days of mail float)Payee receives check and performs internal processing (1 day of processing float)Payee deposits check in its own bank (1 day of processing float)Payee’s bank sends check into Federal Reserve’s interbank clearing system which processes the check (2 days of transit float)As a payer, you want to extend this time periodAs a payee, you want to reduce this time period

36. 36Accelerating Cash ReceiptsLock-box systemsA post office box(es) located near customers in order to shorten mail and processing floatPayee rents post office box(es) in strategic locations and hires a bank to check the box and deposit payments received into accountAfter deposits are made, copies are send to payee’s office and internal processing completedConcentration BankingA single concentration bank manages balances in multiple remote accounts, sweeping excess cash into a central location for investment in marketable securitiesFunds can be moved electronically or via a depository transfer check

37. 37Managing Accounts ReceivableGenerally firms like as little money as economical tied up in receivablesReduces costs (firm has to borrow to support the receivable level)Minimizes bad debt exposureBut, having good relationships with customers is importantIncreases SalesFirm needs to strike a balance on these issues

38. 38Managing Accounts ReceivableObjective: Maximize profitability (not Sales)Questions that need to be answered:Credit Policy—what type of customer will you lend to? How financially viable must that customer be?Terms of sale (Trade)—What terms will the firm offer to credit customers?Collections Policy—How will the firm collect from those customers who don’t pay?

39. 39Credit PolicyMust examine the creditworthiness of potential credit customersCredit reportCustomer’s financial statementsBank referencesCustomer’s reputation among other vendorsHaving a tight credit policy means you’ll probably have lower SalesHaving a loose credit policy means you’ll probably have high bad debtsConflicts often arise between the sales and credit departmentsSales department’s job is to generate sales and if salespeople are paid on commission it can get personal

40. 40Terms of SaleCredit sales are made according to specified terms of salesExample: 2/10, net 30 means the customer receives a 2% discount if payment is made within 10 days, otherwise the entire amount is due by 30 days Prompt payment discount is usually an effective tool for managing receivablesCustomers pay quickly to save moneyGenerally follow industry standard

41. 41Collections PolicyCollections department’s function is to follow up on overdue receivables (called dunning)Mail a polite letterFollow up with additional dunning lettersPhone callsCollection agencyLawsuitA firm’s collection policy is the manner and aggressiveness with which a firm pursues payment from delinquent customersBeing overly aggressive can damage customer relations

42. 421. Days Sales Outstanding (DSO)The average length of time required to collect accounts receivableAlso called the average collection periodReceivables Monitoring

43. 432. Aging ScheduleReport showing how long accounts receivable have been outstandingThe report divides receivables into specified periods, which provides information about the proportion of receivables that are current and proportion that are past due for given lengths of timeReceivables Monitoring

44. 44Aging Schedule

45. Inventory ManagementMismanagement of inventory has the potential to ruin a companyInventory is not the direct responsibility of the finance departmentUsually managed by a functional area such as manufacturing or operationsHowever, finance department has an oversight responsibility for inventory managementMonitor level of lost of obsolete inventorySupervise periodic physical inventories

46. Benefits and Costs of Carrying Adequate InventoryBenefitsReduces stockouts and backordersMakes operations run more smoothly, improves customer relations and increases salesCostsInterest on funds used to acquire inventoryStorage and securityInsuranceTaxesShrinkage SpoilageBreakageObsolescence

47. Inventory Control and ManagementInventory management refers to the overall way a firm controls inventory and its costDefine an acceptable level of operating efficiency with regard to inventoryTry to achieve that level with the minimum inventory costExtremely important for many businesses. I don’t know much about actual techniques to manage inventory

48. Safety Stocks, Reorder Points and Lead TimesSafety stock provides a buffer against unexpectedly rapid use or delayed deliveryAn additional supply of inventory that is carried at all times to be used when normal working stocks run outRarely advisable to carry so much safety stock that stockouts never happenCarrying costs would be excessiveOrdering lead time is the advance notice needed so that an order placed will arrive at the needed timeUsually estimated by the item’s supplier