1. © 2004 by Nelson, a division of Thomson Canada Limited Chapter 15: Working Capital Policy and Short Term Financing Contemporary Financial Management

2. © 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  This chapter deals with the management of working capital, which involves decisions about the optimal overall level of current assets and the optimal mix of short-term funds used to finance the company’s assets.  It also deals with the financing of the current assets that make up the working capital.

3. © 2004 by Nelson, a division of Thomson Canada Limited 3 Working Capital  Working capital is the firm’s total investment in current assets  Net working capital equals current assets minus current liabilities  Working capital represents assets that flow through the firm Turned over at a rapid rate Usually recovered during the operating cycle when inventory sells and receivables collected  Working capital is needed because of the time lag between cash disbursements and cash receipts

4. © 2004 by Nelson, a division of Thomson Canada Limited 4 Working Capital Policy  Involves many decisions about a firm’s current assets and current liabilities What they consist of How they are used How their mix affects the risk-return characteristics of the company

5. © 2004 by Nelson, a division of Thomson Canada Limited 5 Operating Cycle Purchase Raw Materials Pay for Raw Materials Sell Finished Goods on Credit Collect Receivables Operating Cycle Inventory Conversion Period Receivables Conversion Period Payables Deferral Period Cash Conversion Cycle

6. © 2004 by Nelson, a division of Thomson Canada Limited 6 Operating Cycle = Inventory Conversion Period + Receivables Conversion Period Inventory Conversion Period = Average Inventory Cost of Sales/ 365 Receivables Conversion Period = Accounts Receivable Annual Credit Sales/ 365 Operating Cycle Analysis

7. © 2004 by Nelson, a division of Thomson Canada Limited 7 Cash Conversion Cycle = Operating Cycle + Payables Deferral Period Operating Cycle Analysis Continued Payables Deferral Period = Accounts Payable + Salaries, Benefits & Payroll Taxes Payable Cost of Sales – Selling, Gen, Admin Exp ( / 365 )

8. © 2004 by Nelson, a division of Thomson Canada Limited 8 Size and Nature of Current Assets  Depends on: Type of product manufactured or distributed Length of operating cycle Optimal amount of Inventory Optimal amount of safety stock Credit policies Efficiency of current asset management

9. © 2004 by Nelson, a division of Thomson Canada Limited 9 Appropriate Level of Working Capital  More conservative policies often result in lost sales due to restrictive credit policies.  Optimal level of working capital investment is the level which is expected to maximize shareholder wealth. ConservativeAggressive Current Assets More Less Profitability Lower Higher Risk Lower Higher

10. © 2004 by Nelson, a division of Thomson Canada Limited 10 Optimal Mix of ST and LT Debt  Impact of term structure of interest rates Long rates usually higher than short rates Thus the interest cost of short-term debt usually cheaper than long-term debt  Borrower incurs higher risk with short term debt Must refinance frequently Short term interest rates are highly volatile

11. © 2004 by Nelson, a division of Thomson Canada Limited 11 Profitability Versus Risk  Need for financing equal to the sum of: Current assets Fixed assets  Current assets may be: Permanent - Are not affected by seasonal or cyclical demand Fluctuating - Are affected by seasonal or cyclical demand

12. © 2004 by Nelson, a division of Thomson Canada Limited 12 Financing Strategies  Matching Match the maturity of all assets & liabilities Reduces liquidity risk Hard to implement in practice

13. © 2004 by Nelson, a division of Thomson Canada Limited 13 Financing Strategies  Conservative Approach High proportion of long term debt Less profitable, since LT debt usually more expensive

14. © 2004 by Nelson, a division of Thomson Canada Limited 14 Financing Strategies  Aggressive Approach High proportion of short term debt More profitable (short term debt cheaper) but also more risky

15. © 2004 by Nelson, a division of Thomson Canada Limited 15 An Optimal Financing Strategy?  No one strategy is “right” for all firms  The mix between ST and LT debt must also consider: Industry norms Variability of sales Variability of cash flows

16. © 2004 by Nelson, a division of Thomson Canada Limited 16 Cost of Short Term Credit APR = Interest + Fees Usable funds  365 Maturity (Days) Simple interest Compound interest m [ Interest + fees Usable funds ] – 1 1 +EAR = APR = Annual percentage rate EAR = Equivalent annual return m = number of compounding periods per year

17. © 2004 by Nelson, a division of Thomson Canada Limited 17 Sources of Short-Term Financing  Trade credit  Accrual expenses and deferred income  Loans from commercial banks  Commercial paper  Borrowing against Account Receivables

18. © 2004 by Nelson, a division of Thomson Canada Limited 18 Trade Credit  Seller provides financing as part of the sales inducement  Spontaneous source of financing  Cost of trade credit is captured in the purchase price  Trade credit is never free. The cost of foregoing a cash discount is: APR = % discount 100% – % discount 365 Credit – Disc period 

19. © 2004 by Nelson, a division of Thomson Canada Limited 19 Example: Cost of Foregoing a Discount  A vendor offers a discount of 2% if payment is made within ten days. If the discount is not taken, full payment is due in 30 days. What is the annual cost of not accepting the 2% discount?

20. © 2004 by Nelson, a division of Thomson Canada Limited 20 Accrued Expenses & Deferred Income  Any accrued but unpaid expense is a form of short term financing  Stretching payables extends the financing period but can result in a poor credit rating  Deferred income consists of payments received for goods & services to be delivered in the future Are shown on the Balance Sheet as a liability called Deferred Income

21. © 2004 by Nelson, a division of Thomson Canada Limited 21 Short Term Bank Credit  Single loans for specific financial needs  Line of credit Agreement to borrow up to predetermined limit at any time  Revolving credit Legally commits the bank Usually secured Requires a commitment fee APR = Interest costs Usable funds + Commitment fee  365 Maturity ( days )

22. © 2004 by Nelson, a division of Thomson Canada Limited 22 Commercial Paper  Short-term unsecured promissory notes  Issued by large well-known corporations  Maturities from a few days to 9 months  Sold at a discount  Purchasers include corporations, banks, insurance companies, pension funds, etc Maturity ( days ) Interest costs + Placement fee Usable funds  365 APR =

23. © 2004 by Nelson, a division of Thomson Canada Limited 23 Accounts Receivable Loans  Receivables make excellent collateral: Fairly liquid Easy to recover in the event of default  Problems with receivables includes: Subject to fraud High administrative costs  Two common forms of receivables lending Pledging–Firm retains title Factoring–Sale of A/R With recourse Without recourse

24. © 2004 by Nelson, a division of Thomson Canada Limited 24 Borrowing Against Inventory  Inventory may make a good form of collateral, depending on the following characteristics: Perishability Identifiability Marketability Price stability

25. © 2004 by Nelson, a division of Thomson Canada Limited 25 Borrowing Against Inventory  When lending against inventory, the lender must decide who will hold the collateral (inventory)  If borrower holds inventory, the lender may use: Floating lien: floating charge over all current and future acquired inventory Trust receipt: inventory and sale proceeds are held “in trust” for the lender  A third party holds the inventory in a: Terminal warehouse: inventory is stored in a bonded warehouse Field warehouse: secured inventory is segregated on site and managed by a field warehouse company

26. © 2004 by Nelson, a division of Thomson Canada Limited 26 Characteristics of Term Loans  Granted by a bank or other lending institution  Maturity – initial maturity of 1 to 10 years  Less expensive than a public offering  Repayment may include: Equal periodic payments of interest plus principal (amortized) Equal principal payments plus interest on the outstanding balance Periodic payments plus a large [balloon] payment at the maturity date One large payment on the maturity date (bullet payment)

27. © 2004 by Nelson, a division of Thomson Canada Limited 27 Characteristics of Term Loans  Interest rate varies, depending on: General level of rates in the market Size of the loan Maturity of the loan Borrower’s credit rating  Interest may be charged as a: Fixed rate Variable rate (Prime plus ___%)

28. © 2004 by Nelson, a division of Thomson Canada Limited 28 Characteristics of Term Loans  Security Provisions Protect the lender in case of borrower default May include: Assignment of monies due under a contract Assignment of receivables or inventory Floating lien or debenture on firm assets Pledge of marketable securities Mortgage on fixed assets Assignment of the cash surrender value on a life insurance policy

29. © 2004 by Nelson, a division of Thomson Canada Limited 29 Characteristics of Term Loans  Affirmative Covenants Things the borrower will do Provide periodic Financial statements Carry insurance Maintain minimum net working capital  Negative Covenants Things the borrower will not do Not to pledge certain assets as security Not to merge or consolidate Not to make or guarantee loans to others

30. © 2004 by Nelson, a division of Thomson Canada Limited 30 Sources of Term Loans  Banks  Insurance companies  Pension funds  Government agencies  Equipment suppliers Conditional sales contracts Chattel mortgages

31. © 2004 by Nelson, a division of Thomson Canada Limited 31 Major Points  Working capital consists of the current assets carried on the Balance Sheet and the current liabilities used to fund them.  Current assets require an investment, similar to that of a fixed asset.  Current assets are low return; therefore the firm wants to carry the minimum amount necessary.  There are many forms of short-term funding available, but each of them has a cost attached.