CHAPTER 16 WORKING CAPITAL MANAGEMENT

1. Mario David Lela Muda2. Dian Rahma Puspitasari

Basic Definitions

• Gross working capital: Total current assets

• Net working capital (NWC):Current assets - Current liabilities

• Net operating working capital (NOWC):Operating CA – Operating CL =(Cash + Inv. + A/R) – (Accruals + A/P)

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Working Capital Management

• Day-to-day control• Cash• Inventories• Accounts receivable• Accruals• Accounts payable

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Working Capital Management• Working capital policy

• Moderate = Match the maturity of the assets with the maturity of the financing• “Maturity matching”• “Self-liquidating”

• Aggressive = Use short-term financing to finance permanent assets

• Conservative = Use permanent capital for permanent assets and temporary assets

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Cash Conversion Cycle

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The time between payments made for materials and labor and payments received from sales: Cash Conversion = Cycle

InventoryConversion + Period

Receivables Collection − Period

Payables Deferral Period

Inventory Conversion Period

• Average time required to convert materials into finished goods and to sell those goods:

dayper SalesInventory Period ConversionInventory

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dayper SalesInventory Period ConversionInventory

Receivables Collection Period

• Average length of time required to convert the firm’s receivables into cash:

365 / SalessReceivable Period Collection sReceivable

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Receivables Collection Period = DSO = Days Sales Outstanding

365 / SalessReceivable Period Collection sReceivable

Payables Deferral Period

• Average length of time between the purchase of materials and labor and the payment of cash for them:

365 / sold goods ofCost Payables

Day per PurchasesPayables Period Deferral Payable

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365 / sold goods ofCost Payables

Day per PurchasesPayables Period Deferral Payable

Calculating the Target CCC

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Calculating the Target CCC

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Cash Budget: The Primary Cash Management Tool

• Projected cash inflows, outflows, and ending cash balances forecast loan needs and funds available for temporary investment

• Daily, weekly, or monthly, depending upon budget’s purpose• Monthly for annual planning• Daily for actual cash management

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Data Required for Cash Budget• Sales forecast• Information on collections delay• Forecast of purchases and payment terms• Forecast of cash expenses: wages, taxes, utilities, and so on• Initial cash on hand• Target cash balance

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Cash Management Techniques

• Synchronize inflows and outflows• Billing cycle = Payment cycle

• Lockbox Plan

• Payment by wire transfer or automatic debit

• Reduce the need for a cash “safety stock”:• Increase forecast accuracy• Hold marketable securities instead of a cash • Negotiate a line of credit

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Inventory Management Goals

1. Ensure that the inventory needed to sustain operations is available

2. Minimize the costs of ordering and carrying inventory

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Receivables Management

A/R = Credit sales/day X Collection PeriodDepends on volume of credit salesAverage time from credit sale to collection of cash

• Credit policy• Receivables monitoring

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Elements of Credit Policy

• Credit Period = How long to pay?• Reduces average A/R• May discourage sales

• Cash Discounts • Lowers price• Attracts new customers

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Elements of Credit Policy

• Credit Standards • Tighter standards reduce bad debt losses,• May reduce sales

• Collection Policy• Tougher policy will reduce DSO• May damage customer relationships

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Receivables MonitoringCredit sale events:

1. Inventories reduced by COGS2. A/R increased by sales price3. Price – COGS = Profit

Profit Retained Earnings

DSO = Days Sales OutstandingDSO = Average Collection Period

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Days Sales Outstanding

Sales/365sReceivable

Day per SalessReceivable DSO

(DSO)(ADS) sReceivable

365

Price) (SalesSold) (Units365

Sales AnnualADS

SalesDaily AverageADS

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Sales/365sReceivable

Day per SalessReceivable DSO

(DSO)(ADS) sReceivable

365

Price) (SalesSold) (Units365

Sales AnnualADS

SalesDaily AverageADS

Receivables Aging Schedule• Breaks down firm’s receivables by age

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Accruals• Accrued wages and accrued taxes• Increase spontaneously• Accruals are free in that no explicit interest is

charged• Firms have little control over the level of accruals• Levels influenced by industry custom, economic factors,

and tax laws

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Effective Annual Rate (EAR) 2/10, net 30

• Periodic rate = 0.02/0.98 = 2.04%• Periods/year = 365/(30 – 10)

= 18.25• EAR = (1 + Periodic rate)n – 1.0

= (1.0204)18.25 – 1.0 = 44.6%

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Trade Credit

• Two components:• Free trade credit = discount period credit• Costly trade credit = cost implied by foregone discount

Firms should always use the free creditUse the costly credit only after careful analysis and comparison with other sources

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Short-term Investments

• Marketable securities• Lower yields than operating assets• Held for same reasons as cash• Benefits:

• Reduces risk and transactions costs• Won’t need to issue securities or borrow as frequently• Ready cash for opportunities = “speculative balances”

• Disadvantages• Low after-tax return

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Short-term Financing

•Advantages• Funds available relatively quickly• Lower cost

• Yield curve usually upward sloping• Lower flotation costs

• Can repay early without penalty• Less restrictive loan covenants

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Short-term Financing

•Disadvantages• Higher risk• Interest expense fluctuates • Required repayment comes quicker• Firm may have trouble rolling over loans

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Short-term Bank Loans

• = Notes payable• Maturity

• 2/3 are for less than 1 year• Frequently 90 days

• Promissory Note• Signed when bank loan approved• Specifies:

• Amount• Interest rate• Repayment schedule• Collateral

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Short-term Bank Loans

• Compensating Balances• Raises the effective loan rate• Illegal in many states

• Informal Line of Credit• Maximum amount bank will extend

• Revolving Credit Agreement• Formal line of credit• Periodic commitment fee• Bank legally obligated to honor agreement

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Commercial Paper (CP)• Short term, unsecured promissory notes issued by large, strong companies

• Maturity = 1-9 months; average 5 months• Interest rates fluctuate daily just above the T-bill rate

• Less personal than bank relationships

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Security in Short-term Financing

• Commercial paper is never secured• Better to borrow on an unsecured basis

• Lower bookkeeping costs• Collateral options:

• Marketable securities• Land or buildings• Equipment• Inventory• Receivables

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