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CHAPTER 15Working Capital Management
Alternative working capital policies Cash management Inventory and A/R management Trade credit Bank loans
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Working capital terminology Gross working capital – total current
assets
Net working capital Current Assets Non-interest bearing current liabilities
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Working Capital terminology Working Capital Policy
Level of each type of current asset to hold
How to finance current assets
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Working Capital terminology
Working capital management Control
Cash Inventories Accounts Receivables
Short-term liability management.
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Examples
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Moderate financing policy
Years
Lower dashed line would be more aggressive.
$
Perm Current Assets
Fixed Assets
Temp. C.A.
S-TLoans
L-T Fin:Stock,Bonds,Spon. C.L.
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Conservative financing policy
$
Years
Perm Current Assets
Fixed Assets
Marketable securities Zero S-T
Debt
L-T Fin:Stock,Bonds,Spon. C.L.
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Cash Conversion Cycle Page 522
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Cash Conversion Cycle Length of time between when a company
makes payments to its creditors and when a company receives payments from its customers
CCC = + – .Inventory
conversionperiod
Receivablescollection
period
Payablesdeferralperiod
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Inventory Conversion
= Inventory Cost Goods Sold per day
(Cost Goods Sold / 365)
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Average Collection
= Receivables Sales on credit per day
(Sales / 365)
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Payable Deferral Period
= PayablesPurchases per day
(Cost Goods Sold / 365)
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Cash doesn’t earn a profit, so why should the firm hold it?
1. Transactions – some cash necessary to operate
2. Precaution – “safety stock”. Reduced by line of credit and marketable securities
3. Compensating balances – for loans and/or services provided
4. Speculation – to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities
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Goal of cash management Meet objectives
Cash for transactions Yet not have excess cash Minimize transactions balances in
particular, and also needs for cash to meet other objectives
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Minimizing cash holdings Use a lockbox Insist on wire transfers from
customers Synchronize inflows and outflows Use a remote disbursement account Reduce need for “safety” cash
Increase forecast accuracy Hold marketable securities Negotiate a line of credit
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Cash Budget
Forecasts cash inflows, outflows, and ending cash balances
Plan loans needed or funds available to invest
Can be daily, weekly, or monthly, forecasts Monthly for annual planning and daily for
actual cash management
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Cash Budget:For January and February
Net Cash Inflows Jan Feb
Collections $67,652 $62,755Purchases 44,604 36,473Wages 6,690 5,471Rent 2,500 2,500Total payments $53,794 $44,444Net CF $13,858 $18,311
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SKI’s cash budget (con’t) Net Cash Inflows Jan FebCash at start if no borrowing $ 3,000 $16,857Net CF 13,858 18,312Cumulative cash 16,858 35,169Less: target cash 1,500 1,500Surplus $15,358 $33,669
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EXCEL MODEL Page 526
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How could bad debts be worked into the cash budget?
Collections would be reduced by the amount of the bad debt losses
For example, if the firm had 3% bad debt losses, collections would total only 97% of sales
Lower collections would lead to higher borrowing requirements
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Inventory Costs Types of inventory costs
Carrying costs – storage and handling costs, insurance, property taxes, depreciation, and obsolescence
Ordering costs – cost of placing orders, shipping, and handling costs
Costs of running short – loss of sales or customer goodwill, and the disruption of production schedules
Reducing inventory levels generally reduces carrying costs, increases ordering costs, and may increase the costs of running short
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Is SKI holding too much inventory?
SKI’s inventory turnover (4.82x) is considerably lower than the industry average (7.00x) Firm is carrying a lot of inventory per
dollar of sales Excessive inventory increases cost, reduces
ROE Additional working capital must be
financed
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If SKI reduces its inventory, without adversely affecting sales, what effect will this have on the cash position?
Short run: Cash will increase as inventory purchases decline
Long run: Company is likely to take steps to reduce its cash holdings (and costs)
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Do SKI’s customers pay more or less promptly than those of its competitors?
SKI’s DSO (45.6 days) is well above the industry average (32 days) SKI’s customers are paying less promptly
SKI should consider tightening its credit policy in order to reduce its DSO
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Elements of credit policy
1. Credit Period – How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales
2. Cash Discounts – Lowers price. Attracts new customers and reduces DSO
3. Credit Standards – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO
4. Collection Policy – How tough? Tougher policy will reduce DSO but damage customer relationships
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Does SKI face any risk if it tightens its credit policy?
Tighter credit policy may discourage sales Some customers may choose to go
elsewhere if they are pressured to pay their bills sooner
SKI must balance the benefits of fewer bad debts with the cost of possible lost sales
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Short-term credit Debt scheduled for repayment within 1
year Major sources of short-term credit
Accounts payable (trade credit) Bank loans Commercial loans Accruals
From the firm’s perspective, S-T credit is riskier than L-T debt Required payment around the corner Possible trouble rolling over loans
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Advantages and disadvantages of using short-term financing
Advantages Speed Flexibility Lower cost than long-term debt
Disadvantages Fluctuating interest expense Risk of default as a result of temporary economic
conditions
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What is trade credit? Trade credit is credit furnished by
suppliers
Trade credit is often the largest source of short-term credit, especially for small firms
Spontaneous, easy to get, but cost can be high
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Terms of trade credit A firm buys $2,970,000 net ($3,000,000
gross) on terms of 1/10, net 30. The firm can forego discounts and pay on
Day 40, without penalty.
Net daily purchases = $3,000,000 / 365 = $8,137
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Breaking down trade credit Payables level, if the firm takes discounts
Payables = $8,137 (10) = $81,370 Payables level, if the firm takes no
discounts Payables = $8,137 (40) = $325,479
Credit breakdownTotal trade credit $325,497Free trade credit - 81,370Costly trade credit $244,127
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The firm loses 0.01($3,000,000) = $30,000 of discounts to obtain $ 244,127 in extra trade credit:
rNOM = $30,000 / $244,127
= 0.1229 = 12.3%
$30,000 is paid throughout the year, so the effective cost of costly trade credit is higher
Nominal cost of trade credit
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Nominal cost of trade credit formula
12.29%
0.1229
10 - 40
365
991
period Disc. - taken Daysdays 365
%Discount - 1
%Discount rNOM