1. Working Capital Management
Chapter 15

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

3. Working Capital Terminology
a firm’s investment in short-term assets
cash
marketable securities
inventory
accounts receivable

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

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

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

7. Working Capital Terminology
Working capital does not include current liabilities that may be due in the current period if they are due from long-term capital decisions, even though these must be considered when assessing the firm’s ability to meet its current obligations

8. 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

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

10. The Cash Conversion Cycle
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

11. 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

12. The Cash Conversion Cycle
1. The inventory conversion period

13. 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)

14. The Cash Conversion Cycle

15. 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

16. 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 _ = +

17. 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?

18. Alternative Current Asset Investment Policies
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

19. Alternative Current Asset Investment Policies
Restricted current asset investment policy
holdings of cash and marketable securities and inventories are minimized

20. Alternative Current Asset Investment Policies
Moderate current asset investment policy
a policy that is between the relaxed and restricted policies

21. 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

22. Current Assets
Permanent current asset
Permanent current assets

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

24. Current Assets
Temporary current asset
Temporary current assets

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

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

32. 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

33. 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

34. Sources of Short-Term Financing
Short-term bank loans (cont.)
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

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

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

37. 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
the lender may seek recourse (payment) from the borrowing firm for uncollectible receivables used to secure a loan

38. Computing the Cost of Short-Term Credit
Interest rate =
Dollar cost of borrowing
Amount of usable funds

39. 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

40. 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, but sufficient to:
pay suppliers
maintain its credit rating
meet unexpected cash needs

41. Firms Hold Cash For: 1. Transaction balance 2. Compensating 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

42. Firms Hold Cash For: 3. Precautionary balance 4. Speculative 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

43. 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

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

45. Cash Management Techniques
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

46. 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

47. 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

48. 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

49. Cash Management Techniques
Acceleration of receipts
concentration banking
a technique used to move funds from many bank accounts to a more central cash pool in order to more effectively manage cash

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

51. Cash Management Techniques
Disbursement control
centralized disbursement system
more control, but can delay payments
zero-balance account (ZBA)
special account used for disbursements that has a balance of zero when there is no disbursement activity

52. Cash Management Techniques
Disbursement control
controlled disbursement accounts (CDA)
checking accounts in which funds are not deposited until checks are presented for payment, usually on a daily basis

53. 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

54. 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

55. Credit Management Credit standards
standards that indicate the minimum financial strength a customer must have to be granted credit

56. Credit Management Terms of credit
the payment conditions offered to credit customers
length of credit period and any cash discounts offered

57. Credit Management Credit period
the length of time for which credit is granted
after that time, the credit account is considered delinquent

58. Credit Management Cash discount
a reduction in the invoice price of goods offered by the seller to encourage early payment

59. Credit Management Collection policy
the procedures followed by a firm to collect its accounts receivables

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

61. 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

62. Credit Management Receivables monitoring 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

63. Aging Schedule

64. 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

65. Inventory Management Raw materials Work in-process
inventories purchased from suppliers that will ultimately be transformed into finished goods
Work in-process
inventory in various stages of completion

66. Inventory Management Finished goods Optimal inventory level
inventories that have completed the production process and are ready for sale
Optimal inventory level
sustain operations at the lowest possible cost

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

68. Inventory Management Inventory costs carrying costs ordering 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

69. Inventory Management Total inventory costs (TIC) Total carrying costs
ordering
costs = +

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

71. Inventory Management EOQ model
formula for determining the order quantity that will minimize total inventory costs

72. Inventory Management EOQ model extensions reorder point
the level of inventory at which an order should be placed

73. Inventory Management EOQ model extensions reorder point safety stocks
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

74. 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

75. 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 level

76. Inventory Management Inventory control systems
computerized inventory control system
a system of inventory control in which a computer is used to determine reorder points and to adjust inventory balances

77. 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

78. Inventory Management Inventory control systems out-sourcing
the practice of purchasing components rather than making them in-house

79. 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

80. 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

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

82. End of Chapter 15
Working Capital Management