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Working capital management the management of short-term assets (investments) and liabilities (financing sources) Working Capital Terminology

Working capital a firm’s investment in short-term assets cash marketable securities inventory accounts receivable

Working Capital Terminology Net working capital Current assets minus current liabilities the amount of current assets financed by long-term liabilities

Working Capital Terminology Working capital policy target levels for each current asset account how current assets will be financed

Working Capital Terminology Working capital only includes current liabilities that are specifically used to finance current assets

Working Capital Terminology Working capital does not include current liabilities that may be due in the current period as a result of long-term capital decisions, even though these must be considered when assessing the firm’s ability to meet its current obligations

Working Capital Terminology Not working capital: current maturities of long-term debt financing associated with a construction program that will be funded with the proceeds of a long-term security issue after the project is completed use of short-term debt to finance fixed assets

Seasonal variations Business cycles Expansion requires more working capital The Requirement for External Working Capital Financing

The length of time from the payment for the purchase of raw materials to manufacture a product until the collection of accounts receivable associated with the sale of the product The Cash Conversion Cycle

1.The inventory conversion period length of time required to convert materials into finished goods and then to sell those goods the amount of time the product remains in inventory in various stages of completion

1.The inventory conversion period The Cash Conversion Cycle

2.The receivables collection period average length of time required to convert the firm’s receivables into cash also called days sales outstanding (DSO) The Cash Conversion Cycle

3.The payables deferral period average length of time between the purchase of raw materials and labor and the payment of cash for them

The cash conversion cycle net the three periods average length of time a dollar is tied up in current assets Cash conversion cycle = Inventory conversion period Receivables collection period Payables deferral period + _ The Cash Conversion Cycle

Working Capital Investment and Financing Policies Two basic questions: 1. What is the appropriate level for current assets, both in total and by specific accounts? 2. How should current assets be financed?

Relaxed current asset investment policy relatively large amounts of cash and marketable securities and inventories are carried and sales are stimulated by a liberal credit policy that results in a high level of receivables Alternative Current Asset Investment Policies

Restricted current asset investment policy holdings of cash and marketable securities and inventories are minimized, and a restrictive accounts receivable policy is followed Alternative Current Asset Investment Policies

Moderate current asset investment policy a policy that is between the relaxed and restricted policies

Current Assets Permanent current asset current asset balances that do not change due to seasonal or economic conditions these balances exist even at the trough of a firm’s business cycle Permanent current assets

Temporary current asset current assets that fluctuate with seasonal or economic variations in a firm’s business Current Assets Temporary current assets Permanent current assets

Alternative Current Asset Financing Policies Maturity matching, or “self-liquidating” approach a financing policy that matches asset and liability maturities this would be considered a moderate current asset financing policy

Alternative Current Asset Financing Policies Aggressive approach a policy where all of the fixed assets of a firm are financed with long-term capital, but some of the firm’s permanent current assets are financed with short-term nonspontaneous sources of funds

Alternative Current Asset Financing Policies Conservative approach a policy where all of the fixed assets, all of the permanent current assets, and some of the temporary current assets of a firm are financed with long-term capital

Advantages and Disadvantages of Short- Term Financing Speed a short-term loan can be obtained much faster than long-term credit Flexibility for cyclical needs, avoid long-term debt cost of issuing long-term debt is higher penalties for payoff prior to maturity restrictive covenants

Advantages and Disadvantages of Short- Term Financing Cost of long-term versus short-term debt yield curve is generally upward sloping short term interest rates are generally lower than long-term rates

Advantages and Disadvantages of Short- Term Financing Risk of long-term versus short-term debt short-term debt subjects the firm to more risk than long-term debt short-term interest expenses fluctuate firm may not be able to repay short-term debt, thus might be forced into bankruptcy

Short-Term Credit Any liability originally scheduled for repayment within one year

Sources of Short-Term Financing Accruals continually recurring short-term liabilities liabilities such as wages and taxes that increase spontaneously with operations Accounts payable (trade credit) credit created when one firm buys on credit from another firm

Sources of Short-Term Financing Short-term bank loans maturity typically 90 days promissory note specifies terms and conditions amount, interest rate, repayment schedule, collateral, and any other agreements

Sources of Short-Term Financing Short-term bank loans compensating balances of 10 to 20 percent may be required to be maintained in a checking account line of credit may be arranged specified maximum amount of funds available

Sources of Short-Term Financing Short-term bank loans revolving credit agreement line of credit where funds are committed, or guaranteed commitment fee fee generally charged on the unused balance of a revolving credit agreement

Sources of Short-Term Financing Commercial paper unsecured short-term promissory notes issued by large, financially sound firms to raise funds

Sources of Short-Term Financing Secured loans loan backed by collateral for short-term loans, the collateral is often either inventory or receivables factoring is the sale of receivables pledging is the use of receivables as collateral for a loan the lender may seek recourse (payment) from the borrowing firm for uncollectible receivables used to secure a loan

Cost per period = Dollar cost of borrowing Amount of usable funds k PER = Computing the Cost of Short-Term Credit

Discount interest loan a loan in which the interest, which is calculated on the amount borrowed (principal), is paid at the beginning of the loan period interest is paid in advance

Managing Cash and Marketable Securities Cash management goal of minimizing the amount of cash the firm must hold for use in conducting its normal business activities; must consider the ability to: pay suppliers maintain its credit rating meet unexpected cash needs

Firms Hold Cash For: 1.Transaction balance cash balance necessary for day-to-day operations the balance associated with routine payments and collections 2.Compensating balance deposit to meet bank loan requirements

Firms Hold Cash For: 3.Precautionary balance cash balance held in reserve for unforeseen fluctuations in cash flows access to line of credit can reduce the need for precautionary balances 4.Speculative balance cash balance that is held to enable the firm to take advantage of any bargain purchases that might arise easy access to borrowed funds can reduce the need for speculative balances

Cash Management Techniques Cash forecasts predict the timing of cash flows Synchronized cash flows cash inflows coincide with cash outflows, permitting a firm to hold low transaction balances

Cash Management Techniques Float the difference between the balance shown in a checkbook and the balance on the bank’s records

Cash Management Techniques Disbursement float the value of checks that have been written and disbursed but that have not fully cleared through the banking system and thus have not been deducted from the account on which they were written Collection float the amount of checks that have been received and deposited but that have not yet been credited to the account in which they were deposited, because they have not cleared through the banking system

Cash Management Techniques Net float the difference between disbursement float and collection float the difference between the balance shown in the checkbook and the balance shown on the bank’s books

Cash Management Techniques Acceleration of receipts lockbox arrangement reduce float by having payments sent to post office boxes located near customers faster mail delivery faster check clearing within the same Federal Reserve district

Cash Management Techniques Acceleration of receipts preauthorized debit system allows a customer’s bank to periodically transfer funds from that customer’s account to a selling firm’s bank account for the payment of bills concentration banking a technique used to move funds from many bank accounts to a more central cash pool to more effectively manage cash

Cash Management Techniques Disbursement control centralized disbursement system more control, but can delay payments

Cash Management Techniques Disbursement control zero-balance account (ZBA) special account used for disbursements that has a balance of zero when there is no disbursement activity controlled disbursement accounts (CDA) checking accounts in which funds are not deposited until checks are presented for payment, usually on a daily basis

Cash Management Techniques Marketable securities securities that can be sold on short notice without loss of principal or original investment substitute for cash balances temporary investment finance seasonal or cyclical operations amass funds to meet financial requirements in the near future

Credit Management Credit policy a set of decisions that include a firm’s credit standards, credit terms, methods used to collect credit accounts, and credit monitoring procedures Credit standards standards that indicate the minimum financial strength a customer must have to be granted credit

Credit Management Terms of credit the payment conditions offered to credit customers length of credit period and any cash discounts offered Credit period the length of time for which credit is granted after that time, the credit account is considered delinquent

Credit Management Cash discount a reduction in the invoice price of goods offered by the seller to encourage early payment Collection policy the procedures followed by a firm to collect its accounts receivables

Credit Management Receivables monitoring the process of evaluating the credit policy to determine if a shift in the customers’ payment patterns occurs

Credit Management Receivables monitoring 1.Days sales outstanding (DSO) the average length of time required to collect accounts receivable also called the average collection period 2.Aging schedule report showing how long accounts receivable have been outstanding the report divides receivables into specified periods, which provides information about the proportion of receivables that is current and the proportion that is past due for given lengths of time

Argiles Textiles: Receivables Aging Schedule, 2007

Credit Management Analyzing proposed changes in credit policy Use NPV analysis the same as for capital budgeting analysis (Chapter 13) Timing of the cash inflows and cash outflows is important to the analysis

Inventory Management Raw materials inventories purchased from suppliers that will ultimately be transformed into finished goods Work in-process inventory in various stages of completion Finished goods inventories that have completed the production process and are ready for sale

Inventory Management Optimal inventory level sustain operations at the lowest possible cost

Inventory Management Stockout when a firm runs out of inventory and customers arrive to purchase the product

Inventory Management Inventory costs carrying costs storage, insurance, use of funds, depreciation, etc… ordering costs costs of placing an order the cost of each order is generally fixed regardless of the average size of inventory

Total inventory costs (TIC) Inventory Management

Economic order quantity (EOQ) the optimal quantity that should be ordered it is the quantity that will minimize the total inventory costs Inventory Management

Economic Ordering Quantity Model EOQ model formula for determining the order quantity that will minimize total inventory costs Inventory Management

EOQ model extensions reorder point the level of inventory at which an order should be placed safety stocks additional inventory carried to guard against changes in sales rates or production/shipping delays

Inventory Management EOQ model extensions quantity discount a discount from the purchase price offered for inventory ordered in large quantities seasonal adjustments EOQ computed separately for each season to account for sales variations

Inventory Management Inventory control systems red-line method an inventory control procedure in which a red line is drawn around the inside of an inventory-stocked bin to indicate the reorder point computerized inventory control system a system of inventory control in which a computer is used to determine reorder points and to adjust inventory balances

Inventory Management Inventory control systems just-in-time system a system of inventory control in which a manufacturer coordinates production with suppliers so that raw materials or components arrive just as they are needed in the production process out-sourcing the practice of purchasing components rather than making them in-house

Multinational Working Capital Management Cash management speed up collections and slow down disbursements shift cash as rapidly as possible to those areas where it is needed put temporary cash balances to work earning positive returns

Multinational Working Capital Management Credit management credit policy is more important risk of default political and legal collection constraints exchange rate changes between sale and time receivable is collected

Multinational Working Capital Management Inventory management concentrate inventory or distribute ? costs versus distribution schedules exchange rates affect inventory threat of expropriation tax effects

End of Chapter 15 Working Capital Management