9 working capital management compatibility mode

Sources and Uses of Cash Review Balance sheet: CA + FA = CL + Long-term Debt + Equity Increasing long-term debt, equity or current liabilities Decreasing current assets other than cas

Topic Working capital

By Dr Nguyen Thu Hien

Modified from slides by Ross, Westerfield, Jordan,

Key Concepts and Skills

cycle and why it is important

short-term financing policies

short-term financing policies

financing

Sources and Uses of Cash

Review Balance sheet:

CA + FA = CL + Long-term Debt + Equity

Increasing long-term debt, equity or current liabilities

Decreasing current assets other than cash or fixed assets

Uses

Decreasing long-term debt, equity or current liabilities

Increasing current assets other than cash or fixed assets

The Operating Cycle

the inventory and collecting the cash from

selling the inventory

and sell the inventory

collect on credit sales

Operating cycle = inventory period +

Figure 19.1

Cash Cycle

Amount of time we finance our inventory

Time from receiving cash from the sale and

paying for the inventory

purchase of inventory and payment for the

inventory

payable period

Example – Operating Cycle

Example – Operating Cycle

Inventory period

Average inventory = (200,000+300,000)/2 = 250,000

Inventory turnover = 820,000 / 250,000 = 3.28 times

Inventory period = 365 / 3.28 = 112 days

Receivables period

Average receivables = (160,000+200,000)/2 = 180,000

Receivables turnover = 1,150,000 / 180,000 = 6.39 times

Receivables period = 365 / 6.39 = 58 days

Operating cycle = 112 + 58 = 170 days

Example – Cash Cycle

Payables Period

Average payables = (75,000+100,000)/2 = 87,500

Payables turnover = 820,000 / 87,500 = 9.37 times

Payables period = 365 / 9.37 = 39 days

Cash Cycle = 170 – 39 = 131 days

Cash Cycle = 170 – 39 = 131 days

We have to finance our inventory for 131 days

If we want to reduce our financing needs, we need

to look carefully at our receivables and inventory

periods – they both seem extensive

Working capital management

Carrying vs Shortage Costs

trade-off between carrying costs and shortage

costs

Carrying costs – increase with increased levels of

Carrying costs – increase with increased levels of current assets, the costs to store and finance the assets

Shortage costs – decrease with increased levels

of current assets

Trading or order costs

Costs related to safety reserves, i.e., lost sales and

Choosing the Best Policy

Cash reserves

High cash reserves mean that firms will be less likely to experience financial distress and are better able to handle emergencies or take advantage of unexpected opportunities

Cash and marketable securities earn a lower return and are zero NPV

investments

Maturity hedging

Try to match financing maturities with asset maturities

Finance temporary current assets with short-term debt

Finance permanent current assets and fixed assets with long-term debt and equity

Interest Rates

Short-term rates are normally lower than long-term rates, so it may be

cheaper to finance with short-term debt

Firms can get into trouble if rates increase quickly or if it begins to have

difficulty making payments – may not be able to refinance the short-term

Example: Compensating

Balance

compensating balance requirement The

quoted interest rate is 9% We need to

borrow $150,000 for inventory for one year

borrow $150,000 for inventory for one year

How much do we need to borrow?

150,000/(1-.15) = 176,471

What interest rate are we effectively paying?

Interest paid = 176,471(.09) = 15,882

Example: Factoring

accounts receivable of $2 million Credit

sales were $24 million You factor

receivables by discounting them 2% What is

receivables by discounting them 2% What is the effective rate of interest?

Receivables turnover = 24/2 = 12 times

APR = 12(.02/.98) = 2449 or 24.49%

EAR = (1+.02/.98) 12 – 1 = 2743 or 27.43%

Quick summary

the cash cycle?

borrowing?

borrowing?

Short-term lending

Credit Analysis

Credit Management: Key

Issues

Costs of granting credit

Chance that customers won’t pay

Financing receivables

Financing receivables

between increased sales and the costs of

granting credit

Components of Credit Policy

Terms of sale

Credit period

Cash discount and discount period

Type of credit instrument

Type of credit instrument

Credit analysis – distinguishing between

“good” customers that will pay and “bad”

customers that will default

Collection policy – effort expended on

collecting receivables

The Cash Flows from Granting

Credit

Credit Sale Check Mailed Check Deposited Cash Available

Cash Collection Accounts Receivable

Terms of Sale

2% discount if paid in 10 days

Total amount due in 45 days if discount not taken

credit terms given above

Pay $500(1 - 02) = $490 if you pay in 10 days

Pay $500 if you pay in 45 days

Example: Cash Discounts

Finding the implied interest rate when

customers do not take the discount

Credit terms of 2/10 net 45

Credit Policy Effects

Revenue Effects

Delay in receiving cash from sales

May be able to increase price

May increase total sales

Cost Effects

Cost Effects

Cost of the sale is still incurred even though the cash from the sale has not been received

Cost of debt – must finance receivables

Probability of nonpayment – some percentage of

customers will not pay for products purchased

Cash discount – some customers will pay early and pay less than the full sales price

Credit Information

history to other firms

Banks

out of operating cash flows

Capital – financial reserves

Collateral – assets pledged as security

related to customer’s business

Quick summary

credit management?

How would you analyze whether to grant

credit to a new customer?