Chapter 19Working Capital Management

Chapter 19 Outline

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19.1 Analyzing Working Capital

•What Constitutes Good Working Capital Management?

•Cash Flow Analysis

•The Cash Budget

•Working Capital Ratios

•Operating and Cash Conversion Cycles

19.2 Managing Cash and Cash

Equivalents•Company Motives for Holding Cash

•Determining the Optimal Cash Balance

•Cash Management Techniques

19.3 Managing Accounts

Receivable•The Credit Decision

•Credit Policies•The Collection Process

19.4 Managing Inventory

•Inventory Management Approaches

19.5 Short-Term Financing

Considerations•Bank Loans•Factor Arrangements: Example

•Money Market Instruments

•Securitizations

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19.1 Analyzing Working Capital

Working capital is the sum of the company’s current assets, whereas net working capital (NWC) is the difference between a company’s current assets and its current liabilities.

Working capital management refers to the way in which a company manages both its current assets (i.e., cash and marketable securities, accounts receivable, and inventories) and its current liabilities (i.e., accounts payable, notes payables, and short-term borrowing arrangements).

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1. The maintenance of optimal cash balances.2. The investment of any excess liquid funds in marketable

securities that provide the best return possible, considering any liquidity or default-risk constraints.

3. The proper management of accounts receivables.4. The development and maintenance of an efficient

inventory management system.5. The selection of the appropriate level of short-term

financing in the least expensive and most flexible manner possible.

What Constitutes Good Working Capital Management?

Companies produce four statements: 1. the income statement, 2. the balance sheet, 3. the cash flow statement, and 4. the statement of owners’ equity. Of the three, financial analysts tend to focus on the cash flow statement because the other statements frequently have accounting adjustments that make it difficult to find the company’s problems.

Cash Flow Analysis

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Companies create a cash budget, which is essentially a cash flow statement projected for each month.

The key components of a cash budget are sales forecasts, estimated production schedules, and estimates of the size and timing of any other major inflows (e.g., from the sale of an asset) or outflows (e.g., capital expenditures, dividend payments) that the company expects.

The Cash Budget

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The cash budget is the basic tool for forecasting the cash inflows and outflows through a company. Although it helps financial managers identify key items, unfortunately, it does not explain the cause of the problem. Instead, we can look at the drivers of cash flow.

These drivers include the company’s: credit policy, which is the terms under which the company grants credit to its

customers; payment policy, which is how quickly the company pays off the credit it

receives from other companies; and inventory policy, which is determining how much and of what type of

inventory to have on hand.

The Cash Budget (continued)

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Two common measures of company liquidity are the current ratio and the quick (or acid test) ratio.

The current ratio measures a company’s ability to repay current obligations from current assets, whereas the quick ratio is a more conservative estimate of liquidity that reflects the fact that inventory is generally not as liquid as other current assets and that prepaid expenses are virtually worthless in the event of company liquidation.

Working Capital Ratios

To gain better insight into a company’s strengths and weaknesses, we need to look at how it arrived at these levels of current assets and current liabilities. Several efficiency ratios are specifically related to working capital items. We begin by looking at two ratios related to accounts receivables, assuming that all sales are on credit:

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Working Capital Ratios: Accounts Receivable

The receivables turnover ratio is a measure of the sales generated for each dollar in receivables, whereas the days sales outstanding (DSO) is a measure of how long it takes the average customer to pay his or her account.

Similar to our derivation of the DSO, we can divide 365 days by the inventory turnover ratio to find the days sales in inventory (DSI):

Working Capital Ratios: Accounts Receivable

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Working Capital Ratios: Accounts Payable The following two ratios pertain to a company’s management of its

accounts payable, the accounts payable turnover and the days payables outstanding. The accounts payable turnover is the number of times in a year, on average, the company has a complete cycle of generating payable accounts and paying on these accounts:

The days payables outstanding (DPO) is the length of time, in days, it takes for the company to pay its suppliers.

The operating cycle, also known as the days working capital, DWC, is the average time it takes the company to acquire inventory, sell it, and collect the sale proceeds. As such, we estimate the operating cycle as the sum of the average days of sales in inventory (DSI) and the average collection period (DSO):

Operating cycle = DSI + DSO The cash conversion cycle (CCC) is a measure of the average time

between when a company pays cash for its inventory purchases and when it receives cash for its sales.

CCC = DSI + DSO - DPO

Operating and Cash Conversion Cycles

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19.2 Managing Cash and Cash Equivalents

• Holding cash to pay for normal operations, such as bills

Transactions motive

• Holding cash to take care of unanticipated required outlays of cash, such as unexpected repairs on equipment

Precautionary motive

• Holding cash in anticipation of major outlays, such as lump-sum loan repayments and dividend payments

Finance motive

• Holding cash to take advantage of “bargains,” such as the opportunity to purchase raw materials very cheaply

Speculative motive

The optimal cash balance is the one that balances the risks of illiquidity against the sacrifice in expected return that is associated with maintaining cash.

Determining the Optimal Cash Balance

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Cash Management Techniques

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The general approach to good cash management is to speed up inflows as much as possible and delay outflows as much as possible.

Float: the funds that are due the company yet not received

Float time: the time that elapses between the time the paying company initiates payment, for example, mails the check, and when the funds are available for use by the receiving company

Cash Management Techniques (continued)

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Ways to eliminate or reduce float: Debit cards Preauthorized payments Electronic collection systems like EFT and EDI Arrangements with banks

Lock-box system: arrangement of local post office boxes for customers to mail their payments to and authorizing the local bank to empty these boxes and deposit the checks into the company’s account

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19.3 Managing Accounts Receivable

Credit analysis: process designed to assess the risk of nonpayment by potential customers Four Cs of credit:

Capacity: customer’s ability to pay Character: how willing the

company is to pay and how reliable and trustworthy the company is

Collateral: real estate, investments, and other property of the borrower

Conditions: state of the economy

Once a company has decided to grant credit, it then chooses the terms of credit to offer its customers, such as the due date, and the discount date and discount amount, where applicable.

Effective annual cost of trade credit:

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Credit Policies

d is the discount, as a percentage of the sales pricec is the cash price, as a percentage of the sales pricen is the number of days payment is made beyond the discount period

Suppose a company that currently does not grant credit is considering adopting a credit policy that permits its customers to pay the full price for purchases (with no penalties) within 40 days of the purchase (i.e., the credit terms are net 40). The company estimates that it can increase the price of the product by $1 per unit with the new policy, which results in a new price per unit of $111. The company expects that unit sales will increase by 1,000 units per year (to 11,000 units) and that variable costs will remain at $99 per unit. It also estimates that bad debt losses will amount to $6,000 per year. The company will finance the additional investment in receivables by using its line of credit, which charges 6 percent interest. The company’s tax rate is 40 percent. Should the company begin extending credit under the terms described?

Example

19 Profit per unit = $111-99 = $12

Because the company did not previously have any receivables, the initial investment is the amount of additional funds tied up in receivables, which equals the number of days that the company finances sales, multiplied by the estimated sales per day:

Example

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Now, we need to estimate the present value of future cash flows, which equals the present value of the incremental after-tax cash flows generated by extending credit.

Example

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Item Calculation Cash Flow

Profit per unit sold, current price

1,000 extra units sold × $12 $12,000

Profit from price increase 10,000 units × $1 10,000Bad debt expense -6,000Incremental before tax annual cash flow

$16,000

We can estimate the change in the value of the company by capitalizing the additional cash flows (after-tax cash flows).

Capitalizing means to determine the value today. If we assume that these cash flows are received each year, then we divide the after-tax cash flows by the after-tax cost of funds.The appropriate after-tax discount rate = 6% x (1 – 0.40) = 3.6%.

If we assume the company reaps the benefits of this change in policy indefinitely, we can find the present value of the future benefits by viewing the incremental after-tax annual cash flows as a perpetuity:

Example

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Decision: Cost v. benefit

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Cost of funds(borrowing)$133,808

Increase in value from increase in cash flow$266,667

Sometimes a company avoids the collection process by entering into a factoring arrangement:

Factoring arrangement: sale of a company’s receivables, at a discount, to a financial company specializing in collections; outsourcing of the collections to a factora.k.a. AR finance

Factor: financial company that buys receivables and collects on these accountsExample of a factor: GE Capital

Factoring

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The factoring process

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Business sells credit-worthy receivables to factor at a discount•Business receives cash

Factor collects on the accounts•Customers know accounts are factored.

Invoice discounting is a loan that uses the receivables accounts as collateral.

The business that created the receivable collects on the receivables

Invoice discounting

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Financial institution lends money to the business •Business receives cash•Receivables are collateral

Business collects on the accounts•Funds deposited in trust for lender

•Customers do not know accounts are factored.

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19.4 Managing InventoryInventory Management Approaches ABC approach: division of inventory into several

categories based on the value of the inventory items, their overall level of importance to the company’s operations, and their profitability, to determine the time and effort devoted to their management

Economic Order Quantity (EOQ) Model: determines the optimal inventory level as the level that minimizes the total of shortage costs and carrying costs

Inventory Management Approaches (continued)

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Materials Requirement Planning (MRP): detailed computerized system that orders inventory in conjunction with production schedules to determine the level of raw materials and work-in-process that must be on hand to meet finished goods demand

Just-in-time (JIT) inventory system: inventory management approach that fine-tunes the receipt of raw materials so that they arrive exactly when they are required in the production process and thereby reduce inventory to its lowest possible level

Cost of carrying inventory

(e.g., storage, taxes, opportunity

cost, financing)

Cost of ordering(e.g., cost of

placing order, inspecting items, documentation)

EOQ

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Cost of carry

Cost of ordering

Smaller, more

frequent orders

Low High

Larger, less frequent orders

High Low

Summary

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Assume, for simplicity, that the company has one type of inventory, which we will refer to as screens. Suppose that the company uses 1 million screens during a fiscal year. Every time the company orders screens from its supplier, the supplier charges $10,000 in shipping and handling. The cost of keeping screens on hand, in terms of storage and maintenance costs, is $0.50 per screen. The question then arises: When the company orders screens, what quantity should they order?

How Inventory Models Work: Example

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The EOQ model specifies that the optimal order quantity is:

In our example,

How Inventory Models Work: Example (continued)

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19.5 Short-Term Financing Considerations

Trade credit: financing provided to customers for the purchase of a product or service

Trade credit provides companies with many advantages: It is generally readily available, convenient, and flexible, and it usually does not entail any restrictive covenants or pledges of security. In addition, it is usually inexpensive.

Extending credit to customers may enhance sales, but increases a company’s costs:

Collection Bad debts (write-offs as not collectible) Cost of funds

Cost of trade credit

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Bank Loans

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The most common arrangement for businesses is to establish operating loans (or lines of credit).

The cost of the short-term bank loan, without any additional fees is:

Suppose a bank offers a company a 1-year variable rate loan at a rate of prime plus 1 percent at a time when the bank’s prime lending rate is 5.25 percent. The company must repay the loan in monthly installments. Assuming there are no other fees associated with this loan, what is the effective annual cost of this loan? The annual quoted rate = 5.25% + 1% = 6.25%.

The effective annual rate associated with this arrangement:

Cost of bank loan

36Rate = (1+0.062512 )

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−1  = 6.432%

Factor Arrangements: Example

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Suppose a company has daily credit sales of $40,000 and an average collection period of 45 days. A factor offers a 45-day accounts receivable loan equal to 75 percent of accounts receivable. The quoted interest rate is 10 percent, and there is a commission fee of 1 percent of accounts receivable.

The company estimates that it will save $2,000 in collection costs and will experience a 0.5 percent reduction in bad debt losses (as a percentage of sales) as a result of the factoring arrangement. What is the effective annual cost of the arrangement?

Factor Arrangements: Example (continued)

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First, estimate the accounts receivable that the company can factor:

Second, calculate the amount of the loan (which is 75 percent of the accounts receivable):

Third, calculate the commission and interest on this arrangement:

Factor Arrangements: Example (continued)

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Fourth, calculate the savings on the arrangement:

Assemble the pieces, minus the cost and savings, and get, on net, cost of $23,644:

Net cost = $18,000 + 16,644 – 11,000 = $23,644 Translate this into an effective cost and find that the

cost is 15.12% per year:

Money market instrument: security with less than one year in maturity that trades in markets or can be privately placed

Commercial paper (CP): A short-term promissory note issued by companies, which is rated by external debt agencies in a similar fashion as bonds.

Bankers’ acceptance (BA): Differs from commercial paper because it is “stamped” by a bank as accepted in return for a fee The fee is usually 0.25 percent to 1 percent of the face value of the bankers’

acceptances. In return for the fee, the bank guarantees the payments associated with

these instruments.

Money Market Instruments

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The yield on commercial paper and bankers’ acceptances is most often based on the bond equivalent yield, ibey, which is the annualized rate per period:

FV = amount paid at end of loanPV = amount borrowedm = loan term, in days

Yields on CP and BA

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Special purpose vehicle (SPV) or special purpose entity (SPE): Conduits, usually formed as limited partnerships or limited companies, for packaging portfolios of receivables and selling them to investors in the money market. In this way, the purchaser relies on the credit of the SPV.

Securitization: Process in which companies sell the loans directly to the capital market through an SPV so that neither the loans nor the financing appear on its balance sheet.

Securitizations

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The essence of securitization is that the credit risk of the seller of the receivables or loans is not directly involved.

If a portfolio of receivables or loans is simply sold to investors, in all likelihood the credit quality would not be high enough to get an investment-grade rating. As a result, investors demand a credit enhancement, such as requiring collateral, insurance, or other agreements, to reduce credit risk.

Securitizations (continued)

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Credit rating services consider history of default rates on loans and of prepayment: payment of a debt before its due date.

They also perform stress tests: “what-if” examinations of the value of an asset under challenging conditions, such as an increase in interest rates or declining economic conditions.

The most important aspects of the SPV are usually the credit enhancements because the SPV may need to enhance the credit quality of the underlying asset’s need to get an AAA credit rating.

Securitizations (continued)

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Cash budgets are useful in working capital management because these budgets are a means for companies to forecast their cash requirements.

We can use some common ratios to assess a company’s overall approach to working capital management.

The optimal level of investment in cash, receivables, and inventory occurs when the benefits balance the costs. In the case of cash, the benefit is the reduced risk of insolvency, whereas the cost is the opportunity costs of having funds tied up in assets that provide a relatively low return.

Summary

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Managing receivables requires considering the benefits of extending credit (increased sales), whereas the costs include the financing costs and the increased risk of nonpayment by customers.

When managing inventory, the benefits may be improved production processes or reduced risk of stock-outs, which result in forgone revenue and can also damage customer goodwill. The costs include financing, storage, spoilage, obsolescence, and insurance.

Common short-term financing options available to companies include trade credit, bank loans, factoring arrangements, and money market instruments. Each method has advantages and disadvantages. Key to managing short-term financing is to estimate the effective annual cost of each alternative.

Summary (continued)

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