Smart summary working capital management CFA

Strong emphasis on liquidity WCM = Working Capital Management LOC = Line Of Credit STMI = Short Term Marketable Investments CR = Current Ratio CA = Current Assets CL = Current Liabilitie

“WORKING CAPITAL MANAGEMENT”

1 INTRODUCTION

Effective WCM ⇒ adequate cash to fund

day to day necessary operations with

company’s assets invested in most

productive way

Insufficient access to cash:

Restructuring by selling of assets

Reorganization via bankruptcy proceedings

Final liquidation

Excessive investment in cash, may not be the optimum use of company resources

A careful balance is required in WCM

In effective WCM Adequate cash levels are maintained

Converting short-term assets into cash

Controlling outgoing payments to vendors, employees and others

It is done by investing in:

Short term funds

Highly liquid securities

Maintaining credit reserves in bank lines of credit

Issuing money market instruments like commercial paper

It requires reliable cash flow forecasts

Internal Factors External Factors

Company size & growth rates

Banking services Organizational structure Interest rates Sophistication of

working capital management

New technologies & new products

Borrowing & investing position / activities / capacities

The economy Competitors

SCOPE OF WCM

Transaction Relation with trading partners Analysis of WCM activities Focus

Payment for trade, financing and investment

To ensure smooth transactions To formulate appropriate

strategies

Global view point

Strong emphasis

on liquidity

WCM = Working Capital Management

LOC = Line Of Credit

STMI = Short Term Marketable Investments

CR = Current Ratio

CA = Current Assets

CL = Current Liabilities

A/R = Accounts Receivable CGS = Cost of Goods Sold SWCP = Short Term Working Capital Portfolios BEY = Bond Equivalent Yield

DSO = Days Sales Outstanding WADSO = Weighted Avg Days of Sale Outstanding

2 MANAGING & MEASURING LIQUIDITY

2.1 Defining Liquidity Management

2.1.1 Primary Sources of Liquidity

2.1.2 Secondary Sources of Liquidity

2.1.3 Drags & Pulls on Liquidity

2.2 Measuring Liquidity Liquidity ⇒ Company’s ability to meet its short term

obligations

An asset is liquid if it can be converted into cash, either

by sale or financing, quickly

Companies with liquidity ⇒ focus is on putting abundant liquidity into most effective use

In tight financial situation ⇒ effective liquidity management required ⇒ ensures solvency

If liquidity management is not done ⇒ bankruptcy or possible liquidation

2.1 Defining Liquidity Management

Ability of management to generate cash when needed

Usually it is associated with short-term assets and liabilities to provide cash

Long term assets & liabilities can be used to provide liquidity but can reduce company’s overall financial strength

Liquidity management challenges ⇒ developing, implementing and maintaining liquidity policy

Company must manage key resources that include primary sources and secondary sources

2.1.1 Primary Sources of Liquidity

Most readily available source can be held as cash or near-cash securities

Ready cash balance: available at banks against payment collection, investment income, liquidation of near cash securities (maturity < 90 days) & other cash flows

Short- term funds: trade credit, bank lines of credit, shot term investment portfolios

Cash flow management: effectiveness of company in cash management, system of cash collection, cash available to use

These funds are readily accessible at lower costs

2.1.2 Secondary Source of Liquidity

May affect company’s normal operations and in some cases alter financial and operating position

Sources include:

Negotiating debt contracts: pressure of interest or principal repayments

Liquidating assets

Filing for bankruptcy protection and re-organization

Use of such sources may signal deteriorating financial health

Bankruptcy protection may be considered a liquidity tool

Under such protection, a company generating operating cash is liquid and able to continue business operations until restructuring is approved

2.1.3 Drags & Pulls on Liquidity

2.2 Measuring Liquidity

Liquidity ensures creditworthiness ⇒ perceived ability of a borrower to make timely payments

Creditworthiness chances to obtain credit at ↓ borrowing cost ⇒ better trade credit terms profitable opportunities

Liquidity chances of financial distress ⇒ leads to insolvency & bankruptcy (extreme case)

Liquidity ratios ⇒ check company’s ability to meet short-term debt obligations

Ratio chances to cover CL

&/ ( ) = %+ # $ %*

→Measures how many times A/R created & collected on avg in one fiscal period

- ) ) = %+ %/0 1 2

→Measure how many times inventory created / acquired & sold during one fiscal period

Activity ratios can also be re-arranged to estimate no of days CA or CL are on hand

3 4 5 6 ) 78 = %+ * 29 /# 1 $ *

/#

3 4 5 6 ) = /0 /:;<% 1 2

3 4 5 6 = 78 = > $$$1 > 2 / :;<

Alternate name

No of days payable Days payable outstanding Avg days payable

No of days inventory Avg inventory period Inventory holding period

No of days receivables Days sales outstanding Days in receivables

Turnover ratios tell how company is managing its liquid assets

Ratio analysis must be done against some benchmark not in isolation

Benchmark could be industry avg or company’s own track record (past performance) or with peer group

?= @ 8 = 4 5 6 4 ) + B7 4 5 6 4 ) 78 6

Measure of time needed to convert raw material into cash from a sale

Does not account for increased cash flow by deferring payment to suppliers

3 = @ 8 = 4 5 6 4 ) + 4 5 6 4 ) 78 6 – 4 5 6 4 = 78 6

Also called cash conversion cycle

Cycles cash generating ability

For many companies cash conversion cycle is a period that requires financing

Major drags include

Uncollected receivables

→ outstanding, risk they would not be collected at all

→ Indicated by no of days receivable and bad debts

Obsolete inventory

→ Inventory stands than usual

→ Indication of no longer being usable

→ Indicated by slow inventory turnover ratios

Tight credit

→ Economic condition not favorable

→ Short term debt cost

Drags controlled by strict credit & collection practices

Major pulls on payments include Making payments early

→ Paying vendors before due date results in companies forgo use of funds

→ Effective payment management means making payment when due, not early

Reduced credit limit

→ History of late payments can lead to credit limit by suppliers

→ Can squeeze company’s liquidity

Limits on short term lines of credit

→ Liquidity squeeze occur when bank LOC

→ LOC restrictions can be:

Government mandated, market-related & company specific

→ Over-banking ⇒ approach common in emerging as well as some developed markets featuring unsound banking systems whereby companies establish lines

of credit in excess of their needs

Low liquidity positions:

→ Such situation is faced by a company in a particular industry or with a weaker financial position

→ Secured borrowing is done by such companies

→ Important for such companies to identify such assets for short term borrowings Critical to identify drags and pulls on time or before they have arisen

3 MANAGING THE CASH POSITION

3.1 Forecasting Short-Term Cash Flows

3.1.1 Minimum Cash Balance

3.1.2 Identify Typical Cash Flows

3.1.3 Cash Forecasting System

3.2 Monitoring cash uses and levels

Ensuring net cash positions not negative

Negative balance is avoided as cost of borrowing is and unacceptable

Balance = inflows-outflows

Managing short term portfolio ⇒ opportunity cost is considered acceptable

To manage cash decisions are done on latest information

Company’s treasury function uses optimum services and techniques associated with company’s payment configuration to manage cash

3.1 Forecasting Short Term Cash Flows

Necessary task

Precision in forecasting effectiveness

Forecast ⇒ precise may not be accurate

External uncertainty encourages companies to maintain minimum level of cash as a buffer

3.1.1 Minimum Cash Balance

Provides financial flexibility or protection

An opportunity to take advantages from attractive opportunities

Size of this buffer depends upon:

Variation of cash inflows & outflows

Access to liquid sources

Ability to raise funds with lead time

3.1.2 Identifying Typical Cash Flows

Cash mangers using cash flow history or organizational financial history must identify cash flow elements and collect data about them

regularly

Real cash flows should be reflected

Elements include ;

Receipts from operations, broken down by operating unit, departments, etc

Payables & payroll disbursements, broken down by operating unit, departments, etc

Funds transfers from subsidiaries, joint ventures, third parties

Funds transfer to subsidiaries

Debt proceeds (short and long term) Debt repayments

Other income items (interest, etc.) Interest and dividend payments

3.1.3 Cash Forecasting System

Must be structured as a system to be effective

Several aspects to be covered

Importance of aspects varies in between forecast horizon

Data frequency Daily / weekly for 4-6 weeks Monthly for one year Annually for 3-5 years

Format Receipts & disbursements Receipts & disbursements Projected financial statements

3.2 Monitoring Cash Uses and Levels

Financial manager in charge of managing cash position must know cash balance at real time basis

Monitoring cash flow ⇒ key aspects of cash forecasting system

It involves knowing of the transactions information in time to tackle with them

Information should be gathered from principal users and providers of cash along with cash projections

Minimum cash level is estimated in advance and steps are taken to determine the target balance for each bank

Target balance is applied to one main account (the bank where company’s transactions are concentrated)

Large companies have more concentration banks making cash management more complex

Short term investments and borrowing assist in cash management

Cyclical companies need to focus more on sources of cash in times when they produce and stock inventory for peak seasons

Company’s cash needs are also influenced by long term investment and financial activities

Predicting cyclical and non-operating activity needs is critical in managing cash

Setting aside too much cash can be costly while setting aside too little can cause penalty

to raise funds quickly ⇒ either case would be costly; a reliable forecast is necessary

4 INVESTING SHORT-TERM FUNDS

4.1 Short-Term Investment Instruments

4.1.1 Computing Yields On Short Term Investments

4.1.2 Investment Risks

4.2 Strategies 4.3 Evaluating Short Term Funds Management

4 Investing Short-Term Funds

Temporary store of funds not needed in daily transactions

Extra working capital portfolio funds must be invested in long term portfolios

SWCP include: highly liquid, less risky, and shorter maturity securities e.g U.S government securities & corporate obligation

The portfolio changes as cash is needed or more cash is available for investment

4.1 Short-Term Investment Instruments

U.S Treasury Bills (T-bills) 13, 26, and 52 weeks Obligation of U.S government (guaranteed), issued at a

discount

Active secondary market

Lowest rates for traded securities

Virtually no risk

Federal agency securities 5-30 days Obligations of U.S federal agencies (e.g., Fannie Mae, Federal

Home Loan Board) issued as interest-bearing

Slightly higher yields than T-bills

Slight liquidity risk;

insignificant credit risk

Bank certificates of

deposit (CDs)

14-365 days Bank obligations, issued interest-bearing in $100,000

increments

“Yankee” CDs offer slightly higher yields

Credit and liquidity risk (depending on bank’s credit)

Banker’s acceptances

(BAs)

30-180 days Bank obligations for trade transactions (usually foreign), issued

at a discount

Investor protected by underlying company and trade flow itself

Small secondary market

Credit and liquidity risk (depending on bank’s credit)

Eurodollar time deposits 1-180 days Time deposit with bank off-shore (outside United States, such as

Bahamas) Can be CDs or straight time deposit (TD)

Interest-bearing investment

Small secondary market for CDs, but not TDs

Credit risk (depending

on bank) very high liquidity risk for TDs

Bank sweep services 1 day Service offered by banks that essentially provides interest on

checking account balance (usually over a minimum level)

Large numbers of sweeps are for overnight

Credit and liquidity risk (depending on bank)

Repurchase agreement

(Repos)

1 day + Sale of securities with the agreement of the dealer (seller) to

buy them back at a future time

Typically over-collateralized at 102 percent

Often done for very short maturities (< 1 week)

Credit and liquidity risk (depending on dealer)

Commercial paper (CP) 1-270 days Unsecured obligations of corporations and financial institutions,

issued at discount

Secondary market for large issuers

CP issuers obtain short-term credit ratings

Credit and liquidity risk (depending on credit rating)

Mutual funds and money

market mutual funds

Varies Money market mutual funds commonly used by smaller

businesses

Low yields but high liquidity for money market funds; mutual fund liquidity dependent on underlying securities in fund

Can be linked with bank sweep arrangement

Credit and liquidity risk (depending on fund manager)

Tax-advantaged securities 7, 28, 35, 49, and 90

days

Preferred stock in many forms including adjustable rate preferred stocks (ARPs), auction rate preferred stocks, (AURPs), and convertible adjustable preferred stocks (CAPs)

Dutch auction often used to set rate

Offer higher yields

Credit and liquidity risk (depending on issuer’s credit)

Relative amounts to be invested in each type, depends upon the company

4.1.1 Computing Yield on Short Term Investments

D 6 6 = 4 ) 8 – = ℎ 6 = Investor pays less than face value but receives face value at maturity e.g T-bill, banker’s acceptance

Interest bearing securities ⇒ investor pays face amount, receives back face amount + interest

Nominal rate ⇒ rate based on securities face value

Yield ⇒ actual return if investment held till maturity

F B 85 =G $ %I $HI $ I $ I $ × 1.1L * 2 1L M:;K 2 ⇒ Annualized using 360 days

N 5 O ) 8 85 =G $ P> $HI $ > $ I $ × 1.1L * 2 1L M:;< 2

⇒Annualized using 365 days

⇒ also referred to as the investment yield basis

U.S T-bill may be quoted on discount basis or BEY

D 6 N 6 6 85 =G $ P G $ PHI $ I $ × Q1 1L * 2 1 M:;K 2

⇒ Though BEY is relevant for investment decisions but discount basis is often quoted

4.1.2 Investment Risk

Type of Risk Key Attributes Safety Measures Credit (or default) Issuer may default

Issuer could be adversely affected by economy, market

Little secondary market

Minimize amount Keep maturities short Watch for

“questionable” names Emphasize government securities

Market (or interest rate) Price or rate changes

may adversely affect return

There is no market to sell the maturity to, or there

is only a small secondary market

Keep maturities short Keep portfolio diverse in terms of maturity, issuers

Liquidity Security is difficult or

impossible to (re) sell

Security must be held to maturity and cannot be liquidated until then

Stick with government securities

Look for good secondary market

Keep maturities short

Foreign exchange Adverse general market

movement against your currency

Hedge regularly

Keep most in your currency and domestic market (avoid foreign exchange)

4.2 Strategies

Short-term investors do not want to take on substantial risk

Strategies can be active or passive

⇒ Passive: one or two decision rules for making daily investments

⇒ Active: constant monitoring may involve matching, mismatching or laddering strategies

Company must have investment guideline policy

Top priority is safety & liquidity

Less aggressive than active strategies

Roll over is required Must be monitored against some benchmark

More daily involvement & choice of investments

Active involvement with more flexible investment policy and better forecasts

Conservative & similar to passive strategies

Matching is of timing of cash outflows with

investment maturities

In b/w passive & matching Schedules maturities so that investments are distributed equally over the ladder’s term

Helpful in managing long-term portfolios

Requires reliable cash forecast

Riskier, requires liquid securities (T-bill) to meet liquidity needs

May also be accompanied by derivatives posing additional risks

4.3 Evaluating Short Term Funds Management

For portfolios that are not large or diversified ⇒ use spread sheet models

For diversified portfolios ⇒ more expensive treasury workstations

Investment returns must be expressed on BEY to allow comparability

Overall portfolio return must be weighted according to the size of the investment

5 MANAGING ACCOUNTS RECEIVABLE

5.1 Key Elements of Trade Credit Granting Process

5.2 Managing Customer’s Receipts 5.3 Evaluating Accounts Receivable

Management

5.3.2 The No of Days of Receivables

5.3.1 Account Receivable Aging

Schedule

5 Managing Accounts Receivable

Accounts receivable management ⇒ granting credit and processing transaction, monitoring credit balance, measuring performance of credit function

Efficient processing and disbursement of information to concerned departments and managers is required

Ensuring account receivable accounts are current

Co-ordination with treasury management function

Preparation of regular performance measurement reports

Captive finance subsidiary ⇒ wholly owned subsidiary established to provide financing of the sales of the parent company

Some companies outsource accounts receivable function while some may invest

in credit insurance

5.1 Key Elements of Trade Credit Granting Process

Effective credit management policy is required

Basic guidelines of such policy set boundaries for credit management function

Credit scoring model is used to classify borrowers according to credit-worthiness

Such models can be used to predict late payers

Based upon the quality of borrower the credit is granted

5.2 Managing Customer’s Receipts

Avg daily deposit = total amount of check depositedno of days.

Cash collection systems are function of types of customers and the methods they use

Nature of business ⇒ nature of customers ⇒ methods of payment

Common electronic methods:

Direct debit Electronic funds transfer POS terminals

If payments do not transfer electronically, lock box system is used

⇒Lockbox: customer payments are mailed to a post office box and the banking institution retrieves and deposits these payments several times a day

Float factor measures time it takes for checks to clear ⇒ does not measure time

it takes to receive, deposit and clear checks

48 4 = %+.* 2 * >1%+.* 2 L 1

Cash collection system must accelerate payments & information content associated with those payments

Cash concentration involves:

1) Consolidating deposits

2) Moving funds (b/w company accounts or to outside points)

⇒ Best treatments for consolidating deposits & moving funds for cash concentration may differ for

⇒ For moving funds electronic methods are cost effective

5.3 Evaluating Accounts Receivable Management

Accounts receivable management ⇒ how efficiently receivable converted into cash

Such measures can be derived from 1) general financing reports and 2) Internal financial records

5.3.1 Accounts Receivable Aging Schedule

Key report used by accounts receivables managers

It breaks down accounts into categories of days outstanding

Can be converted into percentage for comparability

5.3.2 The No of Days Receivables

Provides overall picture

Can be compared with credit management policy to gauge account collection performance

Weighted average DSO gives better idea of how long it takes

to collect from customers irrespective of sales level and ∆ in sales

Aging schedule is used to calculate weighted avg DSO

Major drawback of WADSO ⇒ requires more information ⇒ comparability across companies is difficult due to lack of information

6 MANAGING INVENTORY

6 Managing Inventory

Necessary for working capital management Careful balance is required;

⇒ more inventories can lead to obsolete inventory and losses

on selling through discount ⇒ liquidity squeeze

⇒ Fewer inventories (shortage) can lead to lost sales &

company’s inability to avoid price increase by suppliers

Motive to hold inventory

a) Transaction motive ⇒ need for inventory as a part of routine

b) Precautionary stocks ⇒ amount maintained to avoid stock out losses

c) Speculative motive ⇒ if costs to in future then benefit can be achieved Assumption ⇒ storage cost < savings from

in price

6.1 Approaches to Managing Levels of Inventory

Economic order quantity – reorder point

⇒Traditional method

⇒Reliable short term forecast is necessary

⇒Based upon expected demand and predictability of demand

⇒ Safety stock ⇒ cushion beyond anticipated needs, helps when lead time

⇒ Anticipation stock ⇒ Inventory in excess of anticipated demand

It fluctuates with sales level

Just-in-time method

⇒ System to minimize in-process inventory

6.1 Approaches to Managing Levels of Inventory 6.2 Inventory Costs 6.3 Evaluating Inventory Management