Practical financial management lasher 7th ed chapter 016

Objective of Working Capital ManagementTo run the firm with as little money tied up in the current accounts as possible Working capital elements... Objective of Working Capital Managem

Working Capital Basics

Working Capital, Funding Requirements, and

the Current Accounts

Gross Working Capital represents an

The Short-Term Liabilities Spontaneous Financing

Operating activities automatically

create payables & accruals -

essentially debts

– These liabilities spontaneously offset the

funding required to support current

assets

Working Capital and the Current

– Gross working capital = current assets

– Net working capital =

current assets – current liabilities

Objective of Working Capital Management

To run the firm with as little money tied up

in the current accounts as possible

Working capital elements

Objective of Working Capital Management

Inventory

Benefit:

Happy customers – supplied quickly

Few production delays (parts always on hand)

Cost:

High financing costs

High storage costs

Shrinkage (theft)

Risk of obsolescence

Cost:

Shortages Dissatisfied customers – product not available

Objective of Working Capital Management

Accounts Receivable

Benefit:

Happy customers –can pay slowly

High credit sales

Cost:

More bad debts

High collection costs

Increased financing costs

Less financing cost

Payables and Accruals

Figure 16-1 Cash Conversion Cycle

Figure 16-2 Timeline Representation of Cash Conversion

Cycle

Permanent and Temporary

Figure 16-3 Working Capital Needs of

Different Firms

Financing Net Working Capital

Short-term working capital should be financed with short-term sources

Maturity Matching Principle – the

term of financing should match the term or duration of the project or

item supported

Short-Term vs Long-Term Financing in Support of Working Capital

Long-term financing

Safe but expensive

– Safe – funds are

committed and can’t

Alternative Financing Policies

The mix of short/long-term financing supporting working capital

– Heavier use of longer term funds is

conservative

– Using more short-term funding is

aggressive

Figure 16-4a Working Capital

Financing Policies

Figure 16-4b Working Capital

Financing Policies

Working Capital Policy

A firm’s Working Capital Policy refers

to its handling the following issues:

– How much working capital is used

– Extent supported by short or long term

Sources of Short-term Financing

Spontaneous financing

– payables and accruals

Unsecured bank loans

Commercial paper

Secured loans

Spontaneous Financing

Accruals

– Interest–free loans

from whoever provides services deferring payment

– Wage Accrual

Money owed to employees for work performed but not yet paid

Accounts Payable

– Effectively loans from

suppliers selling on credit

Prompt Payment Discount

Passing up prompt payment

discounts is an expensive source of financing

If terms are 2/10, net 30, and don’t 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%

Abuses of Trade Credit Terms

Trade credit, originally a service to

customers, is now expected

– Paying beyond the due date is a common

abuse of trade credit

Called “stretching” payables or “leaning on the trade”

Slow paying companies receive poor credit ratings

– May lose the ability to buy on credit in future

Unsecured Bank Loans

Represent the primary source of

short-term financing for most

companies

Unsecured  Repayment is not

guaranteed by the pledge of a specific asset

Promissory Note – Written promise

Unsecured Bank Loans

Line of credit

– Informal, non-binding agreement

between a bank and a borrowing firm specifying the maximum amount that can be borrowed during a period

Revolving Credit Agreement

Similar to a line of credit except bank guarantees availability of funds up to

a maximum amount

– Borrower pays a commitment fee on the

unborrowed balance

Concept Connection Example 16-2

Revolving Credit Agreements

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

Prior to June 1, it took down $4M that remained outstanding for the month On June 15, it took down another $2M which

remained outstanding through June 30

Prime is 9.5% and the bank’s commitment fee is 0.25%

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

Concept Connection Example 16-2

Revolving Credit Agreements

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

Compensating Balances

Minimum Balance

Requirement

A percentage of the

loan amount must be

left in the borrower’s

account at all times

and is not available

for use

Average Balance Requirement

Average daily balance over a month cannot fall below a specified level

Entire balance can be used – but not all at once

Clean-Up Requirements

Borrowers are required to be out of short-term debt for a period once a year

– Usually 30-45 days

– Prevents funding long-term needs and

projects with short-term borrowing

Buyers are usually institutions

Maturity less than 270 days

Considered a very safe investment

Interest is discounted – no coupon

Rigid and formal - no flexibility in repayment terms

Short-Term Credit Secured

Self liquidating nature of current

assets makes loans very safe

Short-Term Credit Secured

by Current Assets

Receivables Financing

– Accounts receivable - money to be collected in

the near future

– Banks are willing to lend on A/R if the

borrowing firm’s customers have good

financial ratings

Pledging AR: using A/R as collateral for loan Factoring AR: selling receivables at a discount directly to a financing source

Concept Connection Example 16-4 Pledging Accounts Receivables

Kilraine’s $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?

Concept Connection Example 16-4 Pledging Accounts ReceivablesSolution:

Factoring Receivables

Firm sells receivables at a discount to a factor 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 or remit cash after collection

Collect cash from problem customers

Inventory Financing

Inventory Financing

– Inventory is collateral for loans

– Repossessed items may be difficult for lender

Cash Management Motivation for Holding Cash

– Transactions demand

– Precautionary demand

– Speculative demand

– Compensating balances

Objective of Cash Management

Business cash balances earn little or

no interest

– Firms generally borrow to support cash balances

But it is easier to do business with

plenty of cash - Liquidity

Objective: Strike a balance

– Operate efficiently at a reasonable cost

Figure 16-5 The Check-Clearing

Process

Check Disbursement and

“Check 21”

Traditional check processing shipped

paper checks around the country

Check Clearing for the 21st Century Act – Known 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

Accelerating Cash Receipts

Lock-box systems

– Service provided by banks to accelerate

collections

Concentration Banking

– Sweep excess balances in distant

depository accounts into central

locations daily

Figure 16-6 A Lock Box System in the

Check-Clearing Process

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

Managing Cash Outflow

Control Issues

– Centralized/decentralized

Zero Balance Accounts (ZBAs)

– Empty disbursement account at firm’s

concentration bank for its divisions

Remote Disbursing

– A way to extend mail float

Concept Connection Example 16-7

Evaluating Lock-Box Systems

Kelso is located on the East Coast, but has

California customers that remit 5,000, $1,000

checks 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 will

reduce clearing time to six days Is the proposal

a good deal if Kelso borrows at 12%?

Concept Connection Example 16-7

Evaluating Lock-Box Systems

Solution:

Kelso’s float now

[(8 / 365) x $5,000,000] = $109,589 Float under proposed lockbox system

[(6 / 365) x $5,000,000] = $82,192 Interest 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 .

Managing Accounts Receivable

Objectives and Policy

– Higher receivables means selling to financially

weaker customers and not pressuring them to pay promptly

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

Receivables Policy involves:

– Credit Policy

Determinants of Receivables Balance

Credit Policy

– Examine creditworthiness of potential

credit customers

– Tight credit policy = lower sales

– Loose credit policy = high bad debts – Conflict between sales and credit

departments

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 effective

tools for managing receivables

Customers pay quickly to save money

May backfire if customers are very cash poor

Collections Policy

Collections Department - follows up on overdue

receivables - called dunning

– Mail polite letter

– Follow up with additional increasingly aggressive

Inventory Management

Inventory: product held for sale

– Inventory mismanagement can ruin a

Benefits and Costs of Carrying

– Breakage – Obsolescence

Inventory Control and Management

Inventory Management - overall way a firm controls inventory and its cost

– Define an acceptable level of operating efficiency

with regard to inventory

– Achieve that level with the minimum inventory

cost

EOQ – An inventory cost minimization model

C = Annual Carrying Cost per Unit

Figure 16-7 Inventory on Hand for a

Steadily Used Item

Figure 16-8 Inventory Costs and the

EOQ

Total Inventory Cost:

Q

DF2

QC

TC = +

Economic Order Quantity

(EOQ) Model

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

1 2

2 Fixed Cost per Order Annual Demand EOQ =

Annual Carrying Cost per Unit

2 1

C

2FD EOQ

Concept Connection Example 16-9

Economic Order Quantity (EOQ) Model

Galbraith buys a $5 part Its carrying cost is 20% of that 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 that

order quantity is used?

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

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 2

Safety Stocks, Reorder Points

and Lead Times

Safety stock: Additional inventory, carried at all times, used when normal working stocks run out

Quantity on hand diminishes until reorder point is reached

Ordering lead time is the advance notice

needed so an order will arrive on time

Figure 16-9 Pattern of Inventory

on Hand

Safety Stock and the EOQ

Inclusion of safety stocks does not change EOQ

Cost trade-off: extra inventory

increases carrying cost, but avoids losses from production delays and missed sales

Tracking Inventories The ABC System

The ABC system segregates items by value and places tighter control on

higher-cost pieces

– “A” items – very expensive or critical

– “B” items – moderate value

– “C” items – cheap and plentiful

Effort and spending on control

diminishes from A to B to C

Just In Time (JIT) Inventory Systems

JIT virtually eliminates manufacturing

inventory by pushing it back on suppliers Suppliers deliver goods just in time for use

in production

Works best with large manufacturers

Works poorly where firm has little control over distant suppliers