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Chapter 16 Working Capital

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Working Capital Basics

Working Capital Assets and liabilities required to operate a

business on a day-to-day basis

Assets: Cash Accounts Receivable Inventory

Liabilities: Accounts Payable Accruals

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Working Capital, Funding Requirements, andthe Current Accounts

Gross Working Capital represents aninvestment in assets

Capitalfunds committed to support

assets Workingshort term, day-to-day

operations

Working Capital Requires Funds Maintaining a working capital balance

requires a permanent funds commitment

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The Short-Term LiabilitiesSpontaneous Financing

Operating activities automaticallycreate payables & accruals -essentially debts

These liabilities spontaneously offset thefunding required to support currentassets

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Working Capital and the CurrentAccounts

Net Working Capitalthe differencebetween gross working capital andspontaneous financing

Generally:

Gross working capital = current assets

Net working capital =

current assetscurrent liabilities

People often say working capital whenthey actually mean net working capital

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Objective of WorkingCapital Management

To run the firm with as little moneytied up in the current accounts aspossible

Working capital elements Inventory

Receivables

Cash Payables

Accruals

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Objective of Working Capital Management

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Accounts ReceivableHigh Levels Low Levels

Benefit:

Happy customers can pay slowly

High credit sales

Cost:

More bad debtsHigh collection costs

Increased financing costs

Cost:

Customers unhappy withpayment terms

Lower Credit Sales

Benefit:Less financing cost

Payables and Accruals

High Levels Low Levels

Benefit:Spontaneous financing reduces need to borrow

Cost:

Unhappy suppliers because paid slowly

Benefit:Happy suppliers/employees

Cost:

Not using spontaneous financing

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Figure 16-1 Cash Conversion Cycle

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Figure 16-2 Timeline Representation of Cash

Conversion Cycle

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Permanent and TemporaryWorking Capital

Need for working capital varies withsales level

Temporary working capital supportsseasonal peaks in business

Working capital is permanent to theextent that it supports a constant,minimum level of sales

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Figure 16-3 Working Capital Needs ofDifferent Firms

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Financing Net Working Capital

Short-term working capital should befinanced with short-term sources

Maturity Matching Principle theterm of financing should match theterm or duration of the project or item

supported

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Short-Term vs. Long-Term Financing inSupport of Working Capital

Long-term financing

Safe but expensive Safefunds are

committed andcant be withdrawn

Expensive - long-term rates aregenerally higher

Short-term financing

Cheap but risky Cheap - short-term

interest rates aregenerally lower

Risky - mustcontinually renewborrowing

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Alternative Financing Policies

The mix of short/long-term financingsupporting working capital

Heavier use of longer term funds is

conservative

Using more short-term funding isaggressive

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Figure 16-4a Working CapitalFinancing Policies

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Figure 16-4b Working CapitalFinancing Policies

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Working Capital Policy

A firms Working Capital Policy refersto its handling the following issues:

How much working capital is used

Extent supported by short or long termfinancing

The nature and source of any short-term

financing used How each component is managed

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Sources of Short-term Financing

Spontaneous financing

payables and accruals

Unsecured bank loans

Commercial paper

Secured loans

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Spontaneous Financing

Accruals

Interestfree loansfrom whoeverprovides servicesdeferring payment

Wage AccrualMoney owed toemployees for

work performedbut not yet paid

Accounts Payable

Effectively loans fromsuppliers selling oncredit

Credit Terms:

Specify details ofpayment

E.g. 2/10, net 30

2% discount if paywithin 10 days,otherwise entire amountdue in 30 days

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Prompt Payment Discount

Passing up prompt paymentdiscounts is an expensive source offinancing

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If terms are 2/10, net 30, and dont pay by the 10th day,essentially paying 2% for 20 days use of money

The implied annual rate is

(365 / 20) x 2% = 36.5%

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Abuses of Trade Credit Terms

Trade credit, originally a service tocustomers, is now expected

Paying beyond the due date is acommon abuse of trade credit

Called stretching payables or leaning onthe trade

Slow paying companies receive poor creditratings

May lose the ability to buy on credit in future

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Unsecured Bank Loans

Represent the primary source ofshort-term financing for mostcompanies

Unsecured Repayment is notguaranteed by the pledge of a specificasset

Promissory NoteWritten promise torepay amount borrowed plus interest

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Unsecured Bank Loans

Line of credit

Informal, non-binding agreement

between a bank and a borrowing firmspecifying the maximum amount thatcan be borrowed during a period

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Revolving Credit Agreement

Similar to a line of credit except bankguarantees availability of funds up toa maximum amount

Borrower pays a commitment fee on theunborrowed balance

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Concept Connection Example 16-2Revolving Credit Agreements

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Arcturus has a $10M revolver at prime plus 2.5%.

Prior to June 1, it took down $4M that remained outstanding forthe month. On June 15, it took down another $2M whichremained outstanding through June 30.

Prime is 9.5% and the banks commitment fee is 0.25%.

What bank charges will Arcturus incur for the month of June?

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Concept Connection Example 16-2Revolving Credit Agreements

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Monthly interest rate: (Prime + 2.5%) 12 = 1%

Monthly commitment fee: 0.25% 12 = 0.0208%

$4M was outstanding for the entire month of June and $2M was

outstanding for 15 days, so the total interest charges are:($4,000,000 .01) + ($2,000,000 [15/30] .01) = $50,000

The unused balance was $6M for 15 days and $4M for 15 days

($6,000,000 .000208 [15/30]) = $ 624

($4,000,000 .000208 [15/30]) = $ 416

$1,040So, total bank charges for June are $51,040

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Compensating Balances

Minimum BalanceRequirement

A percentage of theloan amount must beleft in the borrowersaccount at all timesand is not availablefor use

Average BalanceRequirement

Average daily balanceover a month cannotfall below a specifiedlevel

Entire balance can beusedbut not all atonce

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Clean-Up Requirements

Borrowers are required to be out ofshort-term debt for a period once ayear

Usually 30-45 days

Prevents funding long-term needs andprojects with short-term borrowing

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Commercial Paper

Notes issued by large, financially-strong firms and sold to investors Basically a very short-term corporate

bond

UnsecuredBuyers are usually institutions

Maturity less than 270 days

Considered a very safe investment

Interest is discountedno couponRigid and formal - no flexibility in repaymentterms

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Short-Term Credit Securedby Current Assets

Debt is secured by the current assetbeing financed

Accounts receivable

Inventory

Self liquidating nature of currentassets makes loans very safe

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Short-Term Credit Securedby Current Assets

Receivables Financing

Accounts receivable - money to be collected inthe near future

Banks are willing to lend on A/R if theborrowing firms customers have goodfinancial ratings

Pledging AR: using A/R as collateral for loan

Factoring AR: selling receivables at a discountdirectly to a financing source

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Concept Connection Example 16-4Pledging Accounts Receivables

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Kilraines $100,000 receivables balance of turns over

every 45 days. The firm pledges all receivables to a finance

company, which advances 75% of the total at prime plus 4%

plus a 1.5% administrative fee.

Prime is 8%, what interest rate is Kilraine effectively

paying for its receivables financing?

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Concept Connection Example 16-4Pledging Accounts Receivables

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Solution:Traditional interest8% + 4% = 12%

Administrative chargeAverage loan balance

$100,000 .75 = $75,000

Accounts offered to finance company$100,000 x 360/45 = $800,000

The administrative fee at 1.5%1.5% x $800,000 = $12,000

Fee as a percentage of loan balance$12,000 $75,000 = 16%

Total financing charges16% + 12% = 28%.

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Factoring Receivables

Firm sells receivables at a discount to afactor that takes control of accounts

Accounts Receivable are paid directly to factor

Factor accepts only creditworthy customer

accounts Factors offer a wide range of services all for fees

Perform credit checks on potential customers

Advance cash on accounts before collection orremit cash after collection

Collect cash from problem customers

Assume bad-debt risk when customers dont pay

Factoring is usually very expensive financing

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Inventory Financing

Inventory Financing Inventory is collateral for loans

Repossessed items may be difficult forlender to sell

Inventory in borrowers hands is hard forlender to control

Blanket liens

Chattel mortgage agreementsWarehousing Field and public

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Cash Management

Motivation for Holding Cash

Transactions demand

Precautionary demand Speculative demand

Compensating balances

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Objective of Cash Management

Business cash balances earn little orno interest

Firms generally borrow to support cash

balances

But it is easier to do business withplenty of cash - Liquidity

Objective: Strike a balance Operate efficiently at a reasonable cost

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Marketable Securities

Some assets are only slightly lessliquid than cash, and earn a return

Treasury bills

Other short term securities issued bystable organizations

Held as a substitute for cash

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Figure 16-5 The Check-ClearingProcess

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Check Disbursement andCollection Procedures

Float: money tied up in the checkclearing process

Mail float

Transit float

Processing float

Use of Cash - Payers versus Payees

Payers want to extend float periods Payees want to reduce float periods

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Check 21

Traditional check processing shippedpaper checks around the country

Check Clearing for the 21st CenturyActKnown as Check 21

Banks may now truncate checks

Replaced with electronic checks

Paper facsimiles available when needed

Has sped up clearing process Fed paper check processing locations

reduced from 45 to 1

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Accelerating Cash Receipts

Lock-box systems

Service provided by banks to acceleratecollections

Concentration Banking Sweep excess balances in distant

depository accounts into central

locations daily

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Figure 16-6 A Lock Box System in theCheck-Clearing Process

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Accelerating Cash Receipts

Wire Transfers

Transfers money

electronically

Preauthorized Checks

Customer gives the payee

signed check-like documents

in advance

Payee deposits it in its bank

account once product is

shipped

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Managing Cash Outflow

Control Issues

Centralized/decentralized

Zero Balance Accounts (ZBAs)

Empty disbursement account at firmsconcentration bank for its divisions

Remote Disbursing

A way to extend mail float

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Concept Connection Example 16-7Evaluating Lock-Box Systems

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Kelso is located on the East Coast, but hasCalifornia customers that remit 5,000, $1,000checks a year that take eight days to clear.

A California bank offers a lock box system for$2,000 a year plus $0.20 per check, which willreduce clearing time to six days. Is the proposala good deal if Kelso borrows at 12%?

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Concept Connection Example 16-7Evaluating Lock-Box Systems

Solution:Kelsos float now

[(8 / 365) x $5,000,000] = $109,589

Float underproposed lockbox system

[(6 / 365) x $5,000,000] = $82,192Interest on cash freed up

[$27,397 x 0.12] = $3,288

System cost

[$2,000 + ($0.20 x 5,000)] = $3,000,Conclusion: Proposal is marginally worth doing.

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Managing Accounts Receivable

Objectives and Policy Higher receivables means selling to

financially weaker customers and notpressuring them to pay promptly

Higher sales but also more bad debtsObjective is to max profit, not revenue

Receivables Policy involves: Credit Policy

Terms of Sale

Collections Policy

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Determinants ofReceivables Balance

Credit Policy

Examine creditworthiness of potentialcredit customers

Tight credit policy = lower sales Loose credit policy = high bad debts

Conflict between sales and credit

departments

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Terms of Sale

Credit sales are subject to specific payment terms

2/10, net 30 - The most common terms

2% discount for paying within 10 days,otherwise entire amount due within 30 days

Prompt payment discounts are usually effectivetools for managing receivables

Customers pay quickly to save money

May backfire if customers are very cash poor

Discount taken only by those who pay anyway

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Collections Policy

Collections Department - follows up on overdue

receivables - called dunning Mail polite letter Follow up with additional increasingly

aggressive dunning letters Phone calls Collection agency Lawsuit

Collection policy: manner and aggressiveness

with which a firm pursues payment fromdelinquent customers

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Inventory Management

Inventory: product held for sale Inventory mismanagement can ruin a

company

Finance department has only anoversight responsibility Monitor level of lost or obsolete

inventory

Supervise periodic physical inventories

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Benefits and Costs of CarryingAdequate Inventory

Benefits

Reducesstockouts and

backorders Makes operations

run moresmoothly

Improvescustomer relations

Increases sales

Costs

Interest on funds used toacquire inventory

Storage and security Insurance

Taxes

Shrinkage - theft

Spoilage Breakage

Obsolescence

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Inventory Control and Management

Inventory Management - overall way a firmcontrols inventory and its cost

Define an acceptable level of operatingefficiency with regard to inventory

Achieve that level with the minimum inventorycost

EOQAn inventory cost minimization model

C = Annual Carrying Cost per Unit

F = Fixed Cost per OrderD = Annual Demand in Units

Q = Order Quantity

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Figure 16-7 Inventory on Hand for aSteadily Used Item

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Figure 16-8 Inventory Costs and the EOQ

Total Inventory Cost:QDF

2QCTC

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Economic Order Quantity(EOQ) Model

1

22 Fixed Cost per Order Annual DemandEOQ =Annual Carrying Cost per Unit

EOQ minimizes the sum of ordering and carrying costs

C = Annual Carrying Cost per Unit

F = Fixed Cost per Order

D = Annual Demand in Units

21

C

2FDEOQ

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Concept Connection Example 16-9Economic Order Quantity (EOQ) Model

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Galbraith buys a $5 part. Its carrying cost is 20% ofthat value per year.

It costs $45 to place, process and receive an order.

1,000 parts are used per year.

What order quantity minimizes inventory costs?

How many orders will be placed each year if thatorder quantity is used?

What annual inventory costs are incurred for thepart with this ordering quantity?

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Concept Connection Example 16-9Economic Order Quantity (EOQ) Model

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Solution: C = $5 .20 = $1

F = $45

D = 1,000

Annual number of orders = 1,000 / 300 = 3.33.

Carrying costs = $5 .2 (300/2) = $150 per year

Ordering costs = $45 x 3.333, = $150 per year

Total inventory cost = $150 + $150 = $300 per year

1

22 $45 1,000EOQ = = 300 units$1

S f t St k R d P i t

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Safety Stocks, Reorder Pointsand Lead Times

Safety stock: Additional inventory, carried atall times, used when normal working stocksrun out

Quantity on hand diminishes until reorderpoint is reached

Ordering lead time is the advance noticeneeded so an order will arrive on time

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Figure 16-9 Pattern of Inventoryon Hand

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Safety Stock and the EOQ

Inclusion of safety stocks does notchange EOQ

Cost trade-off: extra inventory

increases carrying cost, but avoidslosses from production delays andmissed sales

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Tracking Inventories

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Tracking InventoriesThe ABC System

The ABC system segregates items byvalue and places tighter control onhigher-cost pieces

A items very expensive or critical

B items moderate value

C items cheap and plentiful

Effort and spending on controldiminishes from A to B to C

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Just In Time (JIT)

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Just In Time (JIT)Inventory Systems

JIT virtually eliminates manufacturinginventory by pushing it back on suppliers

Suppliers deliver goods just in time for use

in productionWorks best with large manufacturers

Works poorly where firm has little controlover distant suppliers