1. Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 15 Working Capital Management 1

2. Chapter 15 – Learning Objectives Explain what working capital is and why proper management of working capital is critical to the survival of a firm. Describe general strategies a firm should follow when managing its working capital accounts. Discuss how a firm should finance its working capital needs. Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2

3. Chapter 15 – Learning Objectives Describe the types of short-term credit firms use. Discuss why it is necessary to compute the cost of credit and show how the cost of short-term credit is determined? Discuss which assets generally are considered good security for collateralized short-term loans and the types of collateralized arrangements that exist. Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3

4. Working Capital Terminology Working capital management The management of short-term assets (investments) and liabilities (financing sources) Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4

5. Working Capital Terminology Working capital A firm’s investment in short-term assets Cash Marketable securities Inventory Accounts receivable Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5

6. Working Capital Terminology Net working capital Current assets minus current liabilities The amount of current assets financed by long-term liabilities and equity Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6

7. Working Capital Terminology Working capital policy Target levels for each current asset account How current assets will be financed Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7

8. Working Capital Terminology Working capital only includes current liabilities that are specifically used to finance current assets Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8

9. Working Capital Terminology Working capital does not include current liabilities that are 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9

10. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10

11. The Requirement for External Working Capital Financing Seasonal variations Business cycles Expansion requires more working capital Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11

12. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12

13. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13

14. 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) Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14

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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15

16. The Cash Conversion Cycle The cash conversion cycle Net the three periods Average length of time a dollar is tied up in current assets Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 Cash conversion cycle = Inventory conversion period Receivables collection period Payables deferral period + _

17. Argiles Textiles: Cash Conversion Cycle Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17

18. 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? Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18

19. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19

20. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20

21. Alternative Current Asset Investment Policies Moderate current asset investment policy A policy that is between the relaxed and restricted policies Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21

22. Alternative Current Asset Investment Policies Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 Current Assets to Support PolicySales of $100 Relaxed$30 Moderate23 Restricted16

23. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 Permanent current assets

24. Current Assets Temporary current asset Current assets that fluctuate with seasonal or economic variations in a firm’s business Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 Temporary current assets Permanent 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25

26. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26

27. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27

28. Advantages and Disadvantages of Short- Term Financing Speed A short-term loan can be obtained much more quickly than long-term credit Flexibility For cyclical needs, avoid long-term debt Cost of issuing long-term debt is higher There might be penalties for payoff prior to maturity Long-term debt generally has restrictive covenants Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28

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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29

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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30

31. Short-Term Credit Any liability originally scheduled for repayment within one year Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31

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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32

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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33

34. Sources of Short-Term Financing Short-term bank loans Compensating balances of 10 to 20 percent might be required to be maintained in a checking account Line of credit can be arranged Specified maximum amount of funds available Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 34

35. Sources of Short-Term Financing Short-term bank loans Revolving credit agreement Line of credit where funds are committed, or guaranteed by the lender Commitment fee Fee generally charged on the unused balance of a revolving credit agreement Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 35

36. Sources of Short-Term Financing Commercial paper Unsecured short-term promissory notes issued by large, financially sound firms to raise funds Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36

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 Pledging is the use of receivables as collateral for a loan The lender might seek recourse (payment) from the borrowing firm for uncollectible receivables used to secure a loan Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 37

38. Computing the Cost of Short-Term Credit Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 38 Dollar cost of borrowing Amount of usable funds r PER = Effective annual rate Annual percentage rate = EAR = [1 + r PER ] m - 1.0 = APR = r PER x m = r SIMPLE

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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 39

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; must consider the ability to: Pay suppliers Maintain its credit rating Meet unexpected cash needs Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 40

41. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 41

42. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 42

43. Cash Management Techniques Cash forecasts Predict the timing of cash flows Cash flow synchronization Cash inflows coincide with cash outflows, permitting a firm to hold low transaction balances Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 43

44. Cash Management Techniques Float The difference between the balance shown in a checkbook and the balance on the bank’s records Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 44

45. Cash Management Techniques Disbursement float The value of checks that have been written and disbursed but 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 have not yet been credited to the account in which they were deposited, because they have not cleared through the banking system Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 45

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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 46

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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 47

48. Cash Management Techniques Acceleration of receipts Preauthorized debit system Allows a customer’s bank to periodically transfer funds from a 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 48

49. 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 Controlled disbursement accounts (CDA) Checking accounts in which funds are not deposited until checks are presented for payment, usually on a daily basis Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 49

50. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 50

51. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 51

52. Credit Management Credit policy factors Credit standards Standards that indicate the minimum financial strength a customer must have to be granted credit Terms of credit Credit period The length of time for which credit is granted Length of credit period and any cash discounts offered Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 52

53. Credit Management Credit policy factors Collection policy The procedures followed by a firm to collect its accounts receivables Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 53

54. Credit Management Receivables monitoring The process of evaluating the credit policy to determine if shifts in the customers’ payment patterns occur Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 54

55. Credit Management Receivables monitoring Days sales outstanding (DSO) The average length of time required to collect accounts receivable Also called the average collection period Aging schedule Report showing how long accounts receivable have been outstanding The report divides receivables into specified periods; provides information about the proportion of receivables that is current and the proportion that is past due for given lengths of time Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 55

56. Argiles Textiles: Receivables Aging Schedule, 2012 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 56 Age of Account (days) Net Amount Outstanding ($ million) Fraction of Total Receivables Average Days 0–30$36.040%18 31–6045.05055 61–905.4677 Over 903.6497 $90.0100% DSO = 0.40(18 days) + 0.50(55 days) + 0.06(77 days) + 0.04(97 days) = 43.2 days

57. Credit Management Analyzing proposed changes in credit policy Use NPV analysis the same as for capital budgeting analysis Timings of the cash inflows and cash outflows are important to the analysis Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 57

58. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 58

59. Inventory Management Optimal inventory level Sustain operations at the lowest possible cost Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 59

60. Inventory Management Stockout When a firm runs out of inventory and customers arrive to purchase the product Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 60

61. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 61

62. Inventory Management Total inventory costs (TIC) Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 62 C= carrying cost as a percent of PP PP= purchase price of product Q= quantity ordered T= total demand for product O= fixed cost per order

63. Inventory Management Economic order quantity (EOQ) The optimal quantity that should be ordered It is the quantity that will minimize the total inventory costs Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 63

64. Inventory Management Economic Ordering Quantity Model EOQ model Formula for determining the order quantity that will minimize total inventory costs Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 64

65. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 65

66. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 66

67. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 67

68. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 68

69. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 69

70. 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 Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 70

71. Multinational Working Capital Management Inventory management Concentrate inventory or distribute? Costs versus distribution schedules Exchange rates affect inventory Threat of expropriation Tax effects Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 71

72. Chapter Principles Key Working Capital Management Concepts What is working capital and why is working capital management critical to the survival of the firm? Working capital refers to the short-term assets of a firm. Poor working capital management generally results in financial distress What general strategies should a firm follow when managing its working capital accounts? Collect funds that it is owed as quickly as possible and delay payments that it owes for as long as possible. How should the firm finance its working capital needs? Most firms follow a maturity matching approach that specifies firms should finance spontaneous, self-liquidating assets with temporary debt and finance more permanent assets with more permanent debt. Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 72

73. Chapter Principles Key Working Capital Management Concepts What types of short-tem credit do firms use? Banks offer a variety of short-term loans A note that has a maturity of less than a year A line of credit Suppliers often permit firms to purchase materials on credit (payables) Accruals—wages and taxes are the biggest How is the cost of short-term credit determined? Why is it necessary to compute the cost of credit? The percentage cost of credit per period is equal to the dollar cost of borrowing divided by the amount of funds that the borrower can use Firms must know what they pay to use credit. Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 73

74. Chapter Principles Key Working Capital Management Concepts Which assets are good security for collateralized short-term loans? What are some of the arrangements that exist with secured short-term loans? Accounts receivable and inventory make good collateral for short-term loans Receivables can be either factored (sold) or pledged (used as collateral for a loan) Inventory arrangements can be in the forms of blankets liens, trust receipts, or warehouse receipts Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 74

75. End of Chapter 15 Working Capital Management Principles of Finance 5e, Ch. 15 Working Capital Management © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 75