Working Capital Management: Current Asset Management and Short-Term Financing Corporate Finance Dr. A. DeMaskey

2 Learning Objectives Questions to be answered: –What is working capital management? –What is the appropriate amount of current assets for the firm to carry, both in total and for each specific account? –How should current assets be financed? –What are the major sources of short-term financing? –What are the costs associated with each type of financing?

3 Working Capital Terminology Gross working capital –Total current assets Net operating working capital –Current assets - Current liabilities Working capital policy: –The level of each current asset. –How current assets are financed. (More…)

4 Working Capital Terminology Working capital management: –Includes both establishing working capital policy and then the day-to-day control of: Cash Inventories Receivables Short-term liabilities

5 Alternative Current Asset Investment Policies Current Assets ($) Sales ($) Restricted Moderate Relaxed

6 Cash Conversion Cycle The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales: –Inventory conversion period –Receivables collection period –Payables deferral period

7 Goal of Cash Management non-earning assetCash is a non-earning asset. To minimize the amount of cash in order to conduct normal business activities. To have sufficient cash in order to: –Take trade discounts. –Maintain credit rating. –Meet unexpected cash needs.

8 Reasons for Holding Cash Transactions balances Compensating balances Precautionary balances Speculative balances Primary reasons Secondary reasons

9 Cash Budget: The Primary Cash Management Tool PurposePurpose: Uses forecasts of cash inflows, outflows, and ending cash balances to predict loan needs and funds available for temporary investment. TimingTiming: Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management.

10 Data Required for Cash Budget 1.Sales forecast. 2.Information on collections delay. 3.Forecast of purchases and payment terms. 4.Forecast of cash expenses: wages, taxes, utilities, and so on. 5.Initial cash on hand. 6.Target cash balance.

11 Ways to Minimize Cash Holdings Use lockboxes. Insist on wire transfers from customers. Synchronize inflows and outflows. Use a remote disbursement account. Increase forecast accuracy to reduce the need for a cash “safety stock.” Hold marketable securities instead of a cash “safety stock.” Negotiate a line of credit (also reduces need for a “safety stock”).

12 Working Capital Financing Policies Maturity MatchingMaturity Matching: Matches the maturity of the assets with the maturity of the financing. AggressiveAggressive: Uses short-term (temporary) capital to finance some permanent assets. ConservativeConservative: Uses long-term (permanent) capital to finance some temporary assets.

13 Years $ Perm C.A. Fixed Assets Temp. C.A. What are “permanent” assets? S-T Loans L-T Fin: Stock, Bonds, Spon. C.L. Maturity Matching Financing Policy

14 Years $ Perm C.A. Fixed Assets Temp. C.A. More aggressive the lower the dashed line. S-T Loans L-T Fin: Stock, Bonds, Spon. C.L. Aggressive Financing Policy

15 Conservative Financing Policy Fixed Assets Years $ Perm C.A. L-T Fin: Stock, Bonds, Spon. C.L. Marketable Securities Zero S-T debt

16 Working Capital Policy The choice of working capital policy is a classic risk/return tradeoff. aggressive policyThe aggressive policy promises the highest return but carries the greatest risk. conservative policyThe conservative policy has the least risk but also the lowest expected return. moderatepolicyThe moderate (maturity matching) policy falls between the two extremes.

17 Marketable Securities Interest-bearingInterest-bearing short-term securities Level of liquid assets held –Interest rate –Transaction costs –Variability in cash flows Choosing marketable securities –Default risk –Marketability or liquidity –Maturity –Purchasing power risk –Rate of return

18 Short-Term Financing riskierShort-term debt is riskier than long-term debt for the borrower. rise –Short-term rates may rise. rolling debt over –May have trouble rolling debt over. Advantages of short-term debt. lower cost –Typically lower cost. quicklylow –Can get funds relatively quickly with low transactions costs. without penalty –Can repay without penalty.

19 Major Sources of Short-Term Financing Short-term creditShort-term credit: Debt requiring repayment within one year. Major sourcesMajor sources: –Accruals –Accounts payable (trade credit) –Bank loans –Commercial paper

20 Trade Credit Trade credit suppliersTrade credit is credit furnished by a firm’s suppliers. –Free trade credit –Costly trade credit largest sourceTrade credit is often the largest source of short-term credit for small firms. spontaneous easy to gethighTrade credit is spontaneous and relatively easy to get, but the cost can be high.

21 Bank Loans Mature in one year or less. Compensating balance requirement Types of bank loans: –Line of credit –Revolving credit agreement

22 Interest Cost of Bank Loans Regular, or simple, interest Discount interest Add-on interest Annual percentage rate Interest rate with compensating balance requirement

23 Effective Annual Percentage Rate To be able to compare loan cost rates and choose the alternative with the lowest cost. Because the loans have different terms, we must make the comparison on the basis of EARs.

24 Commercial Paper Unsecured promissory note Issued by large, financially sound firms Average maturity of five months Interest rate is less than prime rate but slightly more than T-Bill rate Commercial paper market is impersonal