Practical financial managment 7e LASHER chapter 16

1. Foundations. 2. Financial Background: A Review of Accounting, Financial Statements, and Taxes. 3. Cash Flows and Financial Analysis. 4. Financial Planning. 5. The Financial System, Corporate Governance, and Interest. Part II: DISCOUNTED CASH FLOW AND THE VALUE OF SECURITIES. 6. Time Value of Money. 7. The Valuation and Characteristics of Bonds. 8. The Valuation and Characteristics of Stock. 9. Risk and Return. Part III: BUSINESS INVESTMENT DECISIONS--CAPITAL BUDGETING. 10. Capital Budgeting. 11. Cash Flow Estimation. 12. Risk Topics and Real Options in Capital Budgeting. 13. Cost of Capital. Part IV: LONG-TERM FINANCING ISSUES. 14. Capital Structure and Leverage. 15. Dividends. Part V: OPERATIONS ISSUES--WORKING CAPITAL MANAGEMENT AND PLANNING. 16. The Management of Working Capital. 17. Corporate Restructuring. 18. International Finance.

Working Capital Basics

Working Capital, Funding Requirements, and the Current Accounts

Gross Working Capital represents an investment in assets

– Capital – funds committed to support assets

– Working – short term, day-to-day operations

Working Capital Requires Funds

– Maintaining a working capital balance requires a permanent funds commitment

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

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Working Capital and the Current Accounts

Net Working Capital – the difference between gross working capital and spontaneous financing

Generally:

– Gross working capital = current assets

– Net working capital =

current assets – current liabilities

People often say working capital when they actually mean net working capital

Objective of Working Capital Management

To run the firm with as little money tied up in the current accounts

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

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Accounts Receivable

Benefit:

Happy customers –can pay slowly

High credit sales

Cost:

More bad debts

High collection costs

Increased financing costs

Cost:

Customers unhappy with payment terms Lower Credit Sales

Benefit:

Less financing cost

Payables and Accruals

Figure 16-1 Cash Conversion Cycle

Figure 16-2 Timeline Representation of Cash Conversion Cycle

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Permanent and Temporary

Working Capital

Need for working capital varies with sales level

Temporary working capital supports seasonal peaks in business Working capital is permanent to the extent that it supports a

constant, minimum level of sales

Figure 16-3 Working Capital Needs of Different Firms

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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

can’t be withdrawn

generally higher

Short-term financing

Cheap but risky

generally lower

borrowing

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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

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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 financing

– 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

Spontaneous Financing

Accruals

whoever provides services deferring payment

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

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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 to repay amount borrowed plus interest

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

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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

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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 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

$4M was outstanding for the entire month of June and $2M was outstanding for 15 days, so the total interest charges are:

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

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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

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Short-Term Credit Secured

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

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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 Receivables

Fe e a s a pe rcenta ge of loan balance $12,000 ÷ $75,000 = 16%

Total financing charges

16% + 12% = 28%.

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

Assume bad-debt risk when customers don’t pay

Inventory Financing

Inventory Financing

– Inventory is collateral for loans

– Repossessed items may be difficult for lender to sell

– Inventory in borrower’s hands is hard for lender to control

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

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Marketable Securities

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

– Treasury bills

– Other short term securities issued by stable organizations

Held as a substitute for cash

Figure 16-5 The Check-Clearing Process

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Check Disbursement and Collection Procedures

Float: money tied up in the check clearing 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

“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

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Accelerating Cash Receipts

Figure 16-6 A Lock Box System in the

Check-Clearing Process

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Accelerating Cash Receipts

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

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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

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

– Terms of Sale

– Collections 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

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Terms of Sale

Credit sales are subject to specific payment terms

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

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 dunning letters

Inventory Management

Inventory: product held for sale

– Inventory mismanagement can ruin a company

Finance department has only an oversight responsibility

– Monitor level of lost or obsolete inventory

– Supervise periodic physical inventories

Benefits and Costs of Carrying

Inventory Control and Management

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

EOQ – An inventory cost minimization model

C = Annual Carrying Cost per Unit

F = Fixed Cost per Order

D = Annual Demand in Units

Q = Order Quantity

Figure 16-7 Inventory on Hand for a Steadily Used Item

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Figure 16-8 Inventory Costs and the EOQ

Total Inventory Cost:

Q

D F 2

Q C

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?

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

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

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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

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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

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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