Finance Chapter # 15 working capital.pptx

Finance chapter 15 working capital

1. Working Capital Management Lecture 25

2. What Is Working Capital Working capital, also known as net working capital (NWC), is the difference between a company’s current assets—such as cash, accounts receivable/customers’ unpaid bills, and inventories of raw materials and finished goods—and its current liabilities, such as accounts payable and debts. It's a commonly used measurement to gauge the short-term health of an organization.

3. Overview of Working Capital Management Working Capital Concepts Working Capital Issues Financing Current Assets : Short-Term and Long-Term Mix Combining Liability Structure and Current Asset Decisions

4. Working capital terminology Gross working capital – total current assets. Net working capital – current assets minus non-interest bearing current liabilities . Working capital policy – deciding the level of each type of current asset to hold, and how to finance current assets. Working capital management : C ontrolling cash, inventories, and A/R, plus short-term liability management.

5. Basic Definitions Net operating working capital (NOWC): Operating CA – Operating CL = (Cash + Inv. + A/R) – (Accruals + A/P) Working capital: Total current assets used in operations. Net working capital: Current assets – Current liabilities. (More…)

6. Key Takeaways  Working capital, also called net working capital, represents the difference between a company’s current assets and current liabilities. Working capital is a measure of a company’s liquidity and short-term financial health. A company has negative working capital if its ratio of current assets to liabilities is less than one (or if it has more current liabilities than current assets). Positive working capital indicates that a company can fund its current operations and invest in future activities and growth. High working capital isn’t always a good thing. It might indicate that the business has too much inventory, not investing its excess cash, or not capitalizing on low-expense debt opportunities.

7. Working Capital Concepts Net Working Capital Current Assets - Current Liabilities. Gross Working Capital The firm’s investment in current assets. Working Capital Management The administration of the firm’s current assets and the financing needed to support current assets.

8. Significance of Working Capital Management In a typical manufacturing firm, current assets exceed one-half of total assets. Excessive levels can result in a substandard Return on Investment (ROI). Current liabilities are the principal source of external financing for small firms. Requires continuous, day-to-day managerial supervision. Working capital management affects the company’s risk, return, and share price.

9. Cash Conversion Cycle The amount of time period a company’s resources are tied up in current assets Formula:

10. Cash Conversion Cycle Consider a company that has AAI of 60 days, ACP of 40 days and APP of 30 days. Calculate Operating Cycle and Cash Conversion Cycle

11. Working Capital Policies Relaxed WC Policy: Huge Amount of CA Low risk and return Moderate WC Policy: Moderate amount of CA Moderate risk and return Aggressive/Restricted WC Policy: Few CA High risk and return

12. Working Capital Issues Assumptions 50,000 maximum units of production Continuous production Three different policies for current asset levels are possible Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

13. Impact on Liquidity Liquidity Analysis Policy Liquidity A High B Average C Low Greater current asset levels generate more liquidity; all other factors held constant. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

14. Impact on Expected Profitability Return on Investment = Net Profit Total Assets Let Current Assets = (Cash + Rec. + Inv.) Return on Investment = Net Profit Current + Fixed Assets Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

15. Impact on Expected Profitability Profitability Analysis Policy Profitability A Low B Average C High As current asset levels decline, total assets will decline and the ROI will rise. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

16. Impact on Risk Decreasing cash reduces the firm’s ability to meet its financial obligations. More risk! Stricter credit policies reduce receivables and possibly lose sales and customers. More risk! Lower inventory levels increase stockouts and lost sales. More risk! Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

17. Impact on Risk Risk Analysis Policy Risk A Low B Average C High Risk increases as the level of current assets are reduced. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

18. Summary of the Optimal Amount of Current Assets S UMMARY O F O PTIMAL C URRENT A SSET A NALYSIS Policy Liquidity Profitability Risk A High Low Low B Average Average Average C Low High High 1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk. (risk and return go hand in hand!)

19. Classifications of Working Capital Time Permanent Temporary Components Cash, marketable securities, receivables, and inventory

20. Permanent Working Capital The amount of current assets required to meet a firm’s long-term minimum needs.

21. Temporary Working Capital The amount of current assets that varies with seasonal requirements.

22. Financing Current Assets: Short-Term and Long-Term Mix Spontaneous Financing : Trade credit, and other payables and accruals, that arise spontaneously in the firm’s day-to-day operations. Based on policies regarding payment for purchases, labor, taxes, and other expenses. We are concerned with managing non-spontaneous financing of assets.

23. Hedging (or Maturity Matching) Approach A method of financing where each asset would be offset with a financing instrument of the same approximate maturity.

24. Financing Needs and the Hedging Approach Fixed assets and the non-seasonal portion of current assets are financed with long-term debt and equity (long-term profitability of assets to cover the long-term financing costs of the firm). Seasonal needs are financed with short-term loans (under normal operations sufficient cash flow is expected to cover the short-term financing cost).

25. Self-Liquidating Nature of Short-Term Loans Seasonal orders require the purchase of inventory beyond current levels. Increased inventory is used to meet the increased demand for the final product. Sales become receivables. Receivables are collected and become cash. The resulting cash funds can be used to pay off the seasonal short-term loan and cover associated long-term financing costs.

26. Risks vs. Costs Trade-Off (Conservative Approach) Long-Term Financing Benefits Less worry in refinancing short-term obligations Less uncertainty regarding future interest costs Short-Term Financing Risks Borrowing more than what is necessary Borrowing at a higher overall cost (usually) Result Manager accepts less expected profits in exchange for taking less risk.

27. Comparison with an Aggressive Approach Short-Term Financing Benefits Financing long-term needs with a lower interest cost than short-term debt Borrowing only what is necessary Short-Term Financing Risks Refinancing short-term obligations in the future Uncertain future interest costs Result Manager accepts greater expected profits in exchange for taking greater risk.

28. Summary of Short- vs. Long-Term Financing Financing Maturity Asset Maturity SHORT-TERM LONG-TERM Low Risk-Profitability Moderate Risk-Profitability Moderate Risk-Profitability High Risk-Profitability SHORT-TERM ( Temporary ) LONG-TERM ( Permanent )

29. Combining Liability Structure and Current Asset Decisions The level of current assets and the method of financing those assets are interdependent . A conservative policy of “high” levels of current assets allows a more aggressive method of financing current assets. A conservative method of financing (all-equity) allows an aggressive policy of “low” levels of current assets.

30. Summary Working capital management WC policies Cash Conversion Cycle WC issues Impact of Risk and Profitability Permanent and Temporary WC

31. CHAPTER 15 Managing Current Assets Alternative working capital policies Cash management Inventory management Accounts receivable management

32. Selected ratios for SKI Inc. SKI Ind. Avg. Current 1.75x 2.25x Debt/Assets 58.76% 50.00% Turnover of cash & securities 16.67x 22.22x DSO (days) 45.63 32.00 Inv. turnover 4.82x 7.00x F. A. turnover 11.35x 12.00x T. A. turnover 2.08x 3.00x Profit margin 2.07% 3.50% ROE 10.45% 21.00%

33. How does SKI’s working capital policy compare with its industry? SKI appears to have large amounts of working capital given its level of sales. Working capital policy is reflected in current ratio, turnover of cash and securities, inventory turnover, and DSO. These ratios indicate SKI has large amounts of working capital relative to its level of sales. SKI is either very conservative or inefficient.

34. Is SKI inefficient or just conservative? A conservative (relaxed) policy may be appropriate if it leads to greater profitability. However, SKI is not as profitable as the average firm in the industry. This suggests the company has excessive working capital.

35. Cash conversion cycle The cash conversion model focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers. CCC = + – . Inventory conversion period Receivables collection period Payables deferral period

36. Cash conversion cycle CCC = + – CCC = + – CCC = + 46 – 30 CCC = 76 + 46 – 30 CCC = 92 days. Inventory conversion period Receivables collection period Payables deferral period Days per year Inv. turnover Payables deferral period Days sales outstanding 365 4.82

37. Cash doesn’t earn a profit, so why hold it? Transactions – must have some cash to operate. Precaution – “safety stock”. Reduced by line of credit and marketable securities. Compensating balances – for loans and/or services provided. Speculation – to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities.

38. What is the goal of cash management? To meet above objectives, especially to have cash for transactions, yet not have any excess cash. To minimize transactions balances in particular, and also needs for cash to meet other objectives.

39. Ways to minimize cash holdings Use a lockbox. Insist on wire transfers from customers. Synchronize inflows and outflows. Use a remote disbursement account. Increase forecast accuracy to reduce need for “safety stock” of cash. Hold marketable securities (also reduces need for “safety stock”). Negotiate a line of credit (also reduces need for “safety stock”).

40. What is “float”, and how is it affected by the firm’s cash manager? Float is the difference between cash as shown on the firm’s books and on its bank’s books. If SKI collects checks in 2 days but those to whom SKI writes checks don’t process them for 6 days, then SKI will have 4 days of net float. If a firm with 4 days of net float writes and receives $1 million of checks per day, it would be able to operate with $4 million less capital than if it had zero net float.

41. Cash budget: The primary cash management tool Purpose: Forecasts cash inflows, outflows, and ending cash balances. Used to plan loans needed or funds available to invest. Timing: Daily, weekly, or monthly, depending upon purpose of forecast. Monthly for annual planning, daily for actual cash management.

42. SKI’s cash budget: For January and February Net Cash Inflows Jan Feb Collections $67,651.95 $62,755.40 Purchases 44,603.75 36,472.65 Wages 6,690.56 5,470.90 Rent 2,500.00 2,500.00 Total payments $53,794.31 $44,443.55 Net CF $13,857.64 $18,311.85

43. SKI’s cash budget Net Cash Inflows Jan Feb Cash at start if no borrowing $ 3,000.00 $16,857.64 Net CF 13,857.64 18,311.85 Cumulative cash 16,857.64 35,169.49 Less: target cash 1,500.00 1,500.00 Surplus $15,357.64 $33,669.49

44. Should depreciation be explicitly included in the cash budget? No. Depreciation is a noncash charge. Only cash payments and receipts appear on cash budget. However, depreciation does affect taxes, which appear in the cash budget.

45. What are some other potential cash inflows besides collections? Proceeds from the sale of fixed assets. Proceeds from stock and bond sales. Interest earned. Court settlements.

46. 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.

47. Analyze SKI’s forecasted cash budget Cash holdings will exceed the target balance for each month, except for October and November. Cash budget indicates the company is holding too much cash. SKI could improve its EVA by either investing cash in more productive assets, or by returning cash to its shareholders.

48. Why might SKI want to maintain a relatively high amount of cash? If sales turn out to be considerably less than expected, SKI could face a cash shortfall. A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative. The cash may be used, in part, to fund future investments.

49. 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 the average amount of inventory generally reduces carrying costs, increases ordering costs, and may increase the costs of running short.

50. Is SKI holding too much inventory? SKI’s inventory turnover (4.82) is considerably lower than the industry average (7.00). The firm is carrying a lot of inventory per dollar of sales. By holding excessive inventory, the firm is increasing its costs, which reduces its ROE. Moreover, this additional working capital must be financed, so EVA is also lowered.

51. 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 increase its EVA.

52. 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.

53. Elements of credit policy Credit Period – How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. Cash Discounts – Lowers price. Attracts new customers and reduces DSO. Credit Standards – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO. Collection Policy – How tough? Tougher policy will reduce DSO but may damage customer relationships.

54. Does SKI face any risk if it tightens its credit policy? Yes, a tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

55. If SKI succeeds in reducing DSO without adversely affecting sales, what effect would this have on its cash position? Short run: If customers pay sooner, this increases cash holdings. Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase EVA.

56. CHAPTER 16 Financing Current Assets

57. Working capital financing policies Moderate – Match the maturity of the assets with the maturity of the financing. Aggressive – Use short-term financing to finance permanent assets. Conservative – Use permanent capital for permanent assets and temporary assets.

58. Moderate financing policy Years Lower dashed line would be more aggressive. $ Perm C.A. Fixed Assets Temp. C.A. S-T Loans L-T Fin: Stock, Bonds, Spon. C.L.

59. Conservative financing policy $ Years Perm C.A. Fixed Assets Marketable securities Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L.

60. Short-term credit Any debt scheduled for repayment within one 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 more risky than L-T debt. Always a required payment around the corner. May have trouble rolling over loans.

61. Advantages and disadvantages of using short-term financing Advantages Speed Flexibility Lower cost than long-term debt Disadvantages Fluctuating interest expense Firm may be at risk of default as a result of temporary economic conditions

62. Accrued liabilities Continually recurring short-term liabilities, such as accrued wages or taxes. Is there a cost to accrued liabilities? They are free in the sense that no explicit interest is charged. However, firms have little control over the level of accrued liabilities.

63. What is trade credit? Trade credit is credit furnished by a firm’s 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.

64. The cost of trade credit A firm buys $3,000,000 net ($3,030,303 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 = $8,219.18

65. Breaking down net and gross expenditures Firm buys goods worth $3,000,000. That’s the cash price. They must pay $30,303 more if they don’t take discounts. Think of the extra $30,303 as a financing cost similar to the interest on a loan. Want to compare that cost with the cost of a bank loan.

66. Breaking down trade credit Payables level, if the firm takes discounts Payables = $8,219.18 (10) = $82,192 Payables level, if the firm takes no discounts Payables = $8,219.18 (40) = $328,767 Credit breakdown Total trade credit $328,767 Free trade credit - 82,192 Costly trade credit $246,575

67. Nominal cost of costly trade credit The firm loses 0.01($3,030,303) = $30,303 of discounts to obtain $246,575 in extra trade credit: k NOM = $30,303 / $246,575 = 0.1229 = 12.29% The $30,303 is paid throughout the year, so the effective cost of costly trade credit is higher.

68. Nominal trade credit cost formula

69. Effective cost of trade credit Periodic rate = 0.01 / 0.99 = 1.01% Periods/year = 365 / (40-10) = 12.1667 Effective cost of trade credit EAR = (1 + periodic rate) n – 1 = (1.0101) 12.1667 – 1 = 13.01%

70. Commercial paper (CP) Short-term notes issued by large, strong companies. B&B couldn’t issue CP--it’s too small. CP trades in the market at rates just above T-bill rate. CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes.

71. Bank loans The firm can borrow $100,000 for 1 year at an 8% nominal rate. Interest may be set under one of the following scenarios: Simple annual interest Discount interest Discount interest with 10% compensating balance Installment loan, add-on, 12 months

72. Must use the appropriate EARs to evaluate the alternative loan terms Nominal (quoted) rate = 8% in all cases. We want to compare loan cost rates and choose lowest cost loan. We must make comparison on EAR = Equivalent (or Effective) Annual Rate basis.

73. Simple annual interest “Simple interest” means no discount or add-on. Interest = 0.08($100,000) = $8,000 k NOM = EAR = $8,000 / $100,000 = 8.0% For a 1-year simple interest loan, k NOM = EAR

74. Raising necessary funds with a discount interest loan Under the current scenario, $100,000 is borrowed but $8,000 is forfeited because it is a discount interest loan. Only $92,000 is available to the firm. If $100,000 of funds are required, then the amount of the loan should be: Amt borrowed = Amt needed / (1 – discount) = $100,000 / 0.92 = $108,696

75. Discount interest loan with a 10% compensating balance Interest = 0.08 ($121,951) = $9,756 Effective cost = $9,756 / $100,000 = 9.756%

76. Add-on interest on a 12-month installment loan Interest = 0.08 ($100,000) = $8,000 Face amount = $100,000 + $8,000 = $108,000 Monthly payment = $108,000/12 = $9,000 Avg loan outstanding = $100,000/2 = $50,000 Approximate cost = $8,000/$50,000 = 16.0% To find the appropriate effective rate, recognize that the firm receives $100,000 and must make monthly payments of $9,000. This constitutes an annuity.

77. Installment loan From the calculator output below, we have: k NOM = 12 (0.012043) = 0.1445 = 14.45% EAR = (1.012043) 12 – 1 = 15.45% INPUTS OUTPUT N I/YR PMT PV FV 12 1.2043 -9 100

78. What is a secured loan? In a secured loan, the borrower pledges assets as collateral for the loan. For short-term loans, the most commonly pledged assets are receivables and inventories. Securities are great collateral, but generally not available.