Chapter 24 - Working Capital Management - Current Assets and Current Liabilities

8/3/2019 Chapter 24 - Working Capital Management - Current Assets and Current Liabilities

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Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO

CORPORATE FINANCECORPORATE FINANCE

Laurence BoothLaurence Booth W. Sean ClearyW. Sean Cleary

Chapter 24Chapter 24 Working CapitalWorking CapitalManagement: Current Assets and CurrentManagement: Current Assets and CurrentLiabilitiesLiabilities


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CHAPTER 24CHAPTER 24

Working Capital Management:Working Capital Management:

Current Assets and CurrentCurrent Assets and Current

LiabilitiesLiabilities


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CHAPTER 24 Working Capital Management Current Assetsand Current Liabilities

24 - 3

Lecture AgendaLecture Agenda

Learning ObjectivesLearning Objectives

Important TermsImportant Terms

Cash ManagementCash Management Reasons for Holding CashReasons for Holding Cash D

etermining the Optimal Cash BalanceD

etermining the Optimal Cash Balance Cash Management TechniquesCash Management Techniques

Accounts Receivable ManagementAccounts Receivable Management The Credit DecisionThe Credit Decision Credit PoliciesCredit Policies The Collection ProcessThe Collection Process

Inventory ManagementInventory Management

Inventory Management ApproachesInventory Management Approaches Evaluating Inventory ManagementEvaluating Inventory Management

Short Short--Term Financing ConsiderationsTerm Financing Considerations

Summary and ConclusionsSummary and Conclusions Concept Review QuestionsConcept Review Questions


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Learning ObjectivesLearning Objectives

You should understand the following:You should understand the following: How to manage individual asset items, such as cash,How to manage individual asset items, such as cash,

receivables, and inventoryreceivables, and inventory

The nature of the major sources of shortThe nature of the major sources of short--term financing, suchterm financing, such

as trade credit, bank loans, factoring arrangements, andas trade credit, bank loans, factoring arrangements, and

money market securitiesmoney market securities

The fact that in evaluating current asset and current liabilityThe fact that in evaluating current asset and current liability

decisions, the final decision rests on the standard problem ofdecisions, the final decision rests on the standard problem of

trading off expected benefits and potential coststrading off expected benefits and potential costs


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Important Chapter TermsImportant Chapter Terms

ABC approachABC approach

CapacityCapacity

CharacterCharacter

ConditionsConditions

Credit analysisCredit analysis

Credit enhancementsCredit enhancements

Economic Order QuantityEconomic Order Quantity

Factoring arrangementsFactoring arrangements

Finance motiveFinance motive Float Float

Just Just--inin--time inventorytime inventorysystemssystems

Materials requirementMaterials requirementplanningplanning

Open accountOpen account

Optimal cash balanceOptimal cash balance

Precautionary motivePrecautionary motive

PrepaymentsPrepayments

SecuritizationSecuritization

Special purpose vehiclesSpecial purpose vehicles

Speculative motiveSpeculative motive

Terms of creditTerms of credit

Transactions motiveTransactions motive


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Cash and Marketable SecuritiesCash and Marketable Securities

Working Capital ManagementWorking Capital Management

Current Assets and Current LiabilitiesCurrent Assets and Current Liabilities


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Cash and Marketable SecuritiesCash and Marketable SecuritiesReasons for Holding CashReasons for Holding Cash

1.1. Transactions motiveTransactions motive

2.2. Precautionary motivePrecautionary motive

3.3. Finance motiveFinance motive4.4. Speculative motiveSpeculative motive


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Cash and Marketable SecuritiesCash and Marketable SecuritiesDetermining the Optimal Cash BalanceDetermining the Optimal Cash Balance

The optimal cash balance is the amount of cashThe optimal cash balance is the amount of cash

that balances the risks of illiquidity against thethat balances the risks of illiquidity against the

sacrifice in expected return that is associatedsacrifice in expected return that is associatedwith maintaining cash.with maintaining cash.

Differs substantially across firmsDiffers substantially across firms Firms with predictable cash flows will have lower optimalFirms with predictable cash flows will have lower optimal

cash balance requirementcash balance requirement

Firms with excess borrowing capacity (unused line of creditFirms with excess borrowing capacity (unused line of creditfor example) can hold less cash.for example) can hold less cash.


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Cash and Marketable SecuritiesCash and Marketable SecuritiesCash Management TechniquesCash Management Techniques

Cash flow synchronization can free up cash (and lowerCash flow synchronization can free up cash (and lowerthe amount of capital a firm requires)the amount of capital a firm requires)

This is done by:This is done by:

Speeding up cash inflows:Speeding up cash inflows: Bill clients earlier each monthBill clients earlier each month

Increase cash sales through incentivesIncrease cash sales through incentives

Encourage customers to pay using electronic payments systemsEncourage customers to pay using electronic payments systemssuch as direct deposit, automatic debit, debit card, rather thansuch as direct deposit, automatic debit, debit card, rather thancheque.cheque.

Delaying outflows:Delaying outflows: Arrange with suppliers for more liberal trade credit terms (net 40Arrange with suppliers for more liberal trade credit terms (net 40

rather than net 30 for example)rather than net 30 for example)

Paying employees once a month rather than twice.Paying employees once a month rather than twice.


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Cash ManagementsCash ManagementsFloatFloat

Float is the time that elapses between the time theFloat is the time that elapses between the time thepaying firm initiates payment, and the time the fundspaying firm initiates payment, and the time the fundsare available for use by the receiving firm.are available for use by the receiving firm.

It has three major sources:It has three major sources:

1.1. The time it takes the cheque to reach the firm after it is mailed byThe time it takes the cheque to reach the firm after it is mailed bythe customer.the customer.2.2. The time it takes the receiving firm to process the cheque andThe time it takes the receiving firm to process the cheque and

deposit in an account, anddeposit in an account, and3.3. The time it takes the cheque to clear through the banking systemThe time it takes the cheque to clear through the banking system

so that the funds are available to the firm.so that the funds are available to the firm.

Float has been reduced or eliminated through:Float has been reduced or eliminated through: Debit cardsDebit cards Preauthorized paymentsPreauthorized payments Electronic funds transfer (EFT) and electronic data interchangeElectronic funds transfer (EFT) and electronic data interchange

(EDI) systems.(EDI) systems.


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AccountsR

eceivableAccountsR

eceivable




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Accounts ReceivableAccounts Receivable

1.1. The decision to extend credit to customers hasThe decision to extend credit to customers has

significant cash flow and credit risk implications for thesignificant cash flow and credit risk implications for the

firm.firm.

Firms often dont have a choice, if the availability of credit is anFirms often dont have a choice, if the availability of credit is an

important factor in the customers purchase decision process (ifimportant factor in the customers purchase decision process (ifcompetitors offer credit, then the firm must at least match thosecompetitors offer credit, then the firm must at least match thosecredit terms, and then choose to compete on another basis.)credit terms, and then choose to compete on another basis.)

2.2. The second decision (once the firm has decided toThe second decision (once the firm has decided to

extend credit) is to determine which customers will beextend credit) is to determine which customers will be

granted credit.granted credit.3.3. The credit terms must be established.The credit terms must be established.

4.4. The collection process must be decided.The collection process must be decided.


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Accounts ReceivableAccounts ReceivableThe Credit DecisionThe Credit Decision

The decision to extend credit is determined:The decision to extend credit is determined:

Nature of the product sold,Nature of the product sold,

The industryThe industry Practices of competitors.Practices of competitors.


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CHAPTER 24 Working Capital Management Current Assetsand Current Liabilities 24 - 14

Accounts ReceivableAccounts ReceivableCredit AnalysisCredit Analysis

The process designed to assess the risk of nonThe process designed to assess the risk of non--paymentpayment

by potential customers, which involves collectingby potential customers, which involves collecting

information about potential customers with respect toinformation about potential customers with respect to

their credit history, their ability to make payments astheir credit history, their ability to make payments asreflected in their expected cash flows, and their overallreflected in their expected cash flows, and their overall

financial stability.financial stability.

From the firms point of view:From the firms point of view:

Often willing to extend credit on terms better than a bankOften willing to extend credit on terms better than a bank

because:because: The potential for the firm developing a good customer into theThe potential for the firm developing a good customer into the

future, andfuture, and

Losses are limited to production costs in the case of default.Losses are limited to production costs in the case of default.


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Accounts ReceivableAccounts ReceivableCredit PoliciesCredit Policies

The firm must choose what terms of credit toThe firm must choose what terms of credit tooffer its customers.offer its customers.

Terms of credit include:Terms of credit include:

The due dateThe due date The discount amount (if any)The discount amount (if any)

Options include:Options include:

Cash on delivery (COD)Cash on delivery (COD)

Cash before delivery (CBD)Cash before delivery (CBD) Net 30, net 40Net 30, net 40 -- no incentive for early paymentno incentive for early payment

2/10 net 302/10 net 30 -- a 2% discount for early paymenta 2% discount for early payment


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Accounts ReceivableAccounts ReceivableChange in Credit Policy AnalysisChange in Credit Policy Analysis

When extending more lenient credit terms the firm hopes toWhen extending more lenient credit terms the firm hopes to

increase revenues through the sale of more units, andincrease revenues through the sale of more units, and

perhaps even charge higher prices.perhaps even charge higher prices.

These benefits are offset by financing costs and the increasedThese benefits are offset by financing costs and the increasedrisk of nonrisk of non--payment.payment.

Evaluation of these decisions can use an NPV framework:Evaluation of these decisions can use an NPV framework:

CF-CFs)PV(FutureNPV 0![ 24-1]


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Accounts ReceivableAccounts ReceivableThe Collection ProcessThe Collection Process

The firm must monitor outstanding A/R by customer andThe firm must monitor outstanding A/R by customer andby category.by category.

The firm must then determine what action it will takeThe firm must then determine what action it will takewhen late payments occur.when late payments occur.

Charge interest on outstanding balancesCharge interest on outstanding balances Notify customer of arrears (email, mail, telephone)Notify customer of arrears (email, mail, telephone)

Actions on unpaid amounts:Actions on unpaid amounts:

Allow no further purchases on creditAllow no further purchases on credit

Choose from a number of additional options to collect:Choose from a number of additional options to collect:

1.1. Take legal actionTake legal action2.2. Sell receivable to a collection agencySell receivable to a collection agency

3.3. Write off the debt as uncollectable.Write off the debt as uncollectable.


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Evaluating Receivables ManagementEvaluating Receivables Management

Use of productivity ratios introduced in ChapterUse of productivity ratios introduced in Chapter

4 can give a tool for evaluating the firms ability4 can give a tool for evaluating the firms ability

to manage its accounts receivable.to manage its accounts receivable.


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Evaluating Receivables ManagementEvaluating Receivables ManagementReceivables TurnoverReceivables Turnover

Measures the sales generated by every dollar ofMeasures the sales generated by every dollar of

receivables.receivables.

ReceivableAccounts

Sales

turnoversReceivable

!

!

RT

AR

S

[4- 16]


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Evaluating Receivables ManagementEvaluating Receivables ManagementAverage Collection PeriodAverage Collection Period

Estimates the number of days it takes a firm to collect onEstimates the number of days it takes a firm to collect onits accounts receivable.its accounts receivable.

If ACP is 40 days, and the firms credit policy is net 30,If ACP is 40 days, and the firms credit policy is net 30,clearly, customers are not paying in keeping with theclearly, customers are not paying in keeping with thefirms policy, and there may be concerns about thefirms policy, and there may be concerns about thequality of the firms customers, and what might happen ifquality of the firms customers, and what might happen ifeconomic conditions deteriorate.economic conditions deteriorate.

turnoversReceivable

AR

TurnoversReceivable

365

PeriodCollectionAverage

!

!!

ACP

ADS

AR

[4- 17]


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InventoryInventory




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InventoryInventory

The level of inventory a firm holds is a trade off betweenThe level of inventory a firm holds is a trade off between

benefits and costs:benefits and costs:

Benefits of Holding Inventory:Benefits of Holding Inventory:

Take advantage of largeTake advantage of large--volume discountsvolume discounts Reduce the probability of production disruptions because of lack ofReduce the probability of production disruptions because of lack of

inventoryinventory

Minimize lost sales because of stockMinimize lost sales because of stock--outsouts

Costs of Holding Inventory:Costs of Holding Inventory:

Financing costs associated with inventory investmentFinancing costs associated with inventory investment Storage, handling, insurance, spoilage and obsolescence costs.Storage, handling, insurance, spoilage and obsolescence costs.


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InventoryInventoryInventory Management ApproachesInventory Management Approaches

ABC ApproachABC Approach

Economic Order Quantity (EOQ) ModelEconomic Order Quantity (EOQ) Model

Materials Requirement Planning (MRP)Materials Requirement Planning (MRP) Just Just--inin--time (JIT) Inventory systems.time (JIT) Inventory systems.


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InventoryInventoryEvaluating Inventory ManagementEvaluating Inventory Management

Use of financial ratios can give some indicationUse of financial ratios can give some indication

of the effectiveness of a firms inventoryof the effectiveness of a firms inventory

management.management.

Ratios, however, do not measure shortageRatios, however, do not measure shortage

costs, financing costs, etc.costs, financing costs, etc.

These ratios include:These ratios include:

Inventory turnoverInventory turnover Average days sales in inventory.Average days sales in inventory.


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Productivity RatiosProductivity RatiosInventory TurnoverInventory Turnover

Estimates the number of times, ending inventory wasEstimates the number of times, ending inventory wasturned over (sold) in the year.turned over (sold) in the year.

A ratio that involves both stock and flow valuesA ratio that involves both stock and flow values

Is strongly a function of ending inventoryIs strongly a function of ending inventoryvaluemanagers often try to improve this ratio as theyvaluemanagers often try to improve this ratio as theyapproach year end through inventory reductionapproach year end through inventory reductionstrategies (cash and carry sales/inventory clearance,strategies (cash and carry sales/inventory clearance,etc.)etc.)

TurnoverInventoryINV

CGS!

[4- 18]


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Productivity RatiosProductivity RatiosInventory TurnoverInventory Turnover

When Cost of Goods Sold is not available, it may beWhen Cost of Goods Sold is not available, it may be

necessary to estimate inventory turnover using sales.necessary to estimate inventory turnover using sales.

Use of the sales figure is less valid than Cost of GoodsUse of the sales figure is less valid than Cost of Goods

Sold because Cost of Goods Sold is based on inventoriedSold because Cost of Goods Sold is based on inventoriedcost, but Sales includes a profit margin on top ofcost, but Sales includes a profit margin on top of

inventoried cost.inventoried cost.

TurnoverInventoryINV

Sales!

[4- 19]


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CHAPTER 24 Working Capital Management Current Assets

and Current Liabilities

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Productivity RatiosProductivity RatiosAverage Days Sales in Inventory (ADSI)Average Days Sales in Inventory (ADSI)

Estimates the number of days of sales tied up inEstimates the number of days of sales tied up in

inventory (based on ending inventory values)inventory (based on ending inventory values)

turnoverInventory

ADS

INV

365

(ADSI)inventoryinsalesdaysAverage

!

! [4- 20]


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ShortShort--Term Financing ConsiderationsTerm Financing Considerations




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Investment in current assets tend to rise andInvestment in current assets tend to rise and

fall with the volume of activity.fall with the volume of activity.

Accruals and accounts payable (trade credit)Accruals and accounts payable (trade credit)are spontaneous liabilities.are spontaneous liabilities.

Other sources of financing must be negotiatedOther sources of financing must be negotiated

and before using the firm must evaluate theand before using the firm must evaluate the

cost effectiveness of alternative financingcost effectiveness of alternative financingmechanisms.mechanisms.


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To estimate the annual effective rate of return or cost (k) ofTo estimate the annual effective rate of return or cost (k) of

any financing alternative:any financing alternative:

1cos

1365

-)ricePurchase p

tfinancingn-Day(k

/n![ 24-2]


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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsTrade CreditTrade Credit

Often a very important source of shortOften a very important source of short--term financing.term financing.

Offers a number of advantages:Offers a number of advantages:

Readily availableReadily available

ConvenientConvenient FlexibleFlexible

Usually does not entail any restrictive covenants or pledges ofUsually does not entail any restrictive covenants or pledges ofsecurity.security.

There is no explicit cost associated with credit termsThere is no explicit cost associated with credit terms

such as:such as: Net 30Net 30

Net 40Net 40


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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsTrade CreditTrade Credit

There is usually a high implicit cost to a firm that forgoesThere is usually a high implicit cost to a firm that forgoes

discounts on early payment such as:discounts on early payment such as:

2/10 Net 302/10 Net 30

Example: assume (2/10 net 30)Example: assume (2/10 net 30)

Approximate percentage cost = (2/98)(365/20) = 37.2%Approximate percentage cost = (2/98)(365/20) = 37.2%

The firm is being charged 2% for the use of funds from day 10 toThe firm is being charged 2% for the use of funds from day 10 today 30 (20 days).day 30 (20 days).


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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsBank Loans and Factor ArrangementsBank Loans and Factor Arrangements

Options include:Options include:

Operating loans / lines of creditOperating loans / lines of credit Secured by accounts receivable and inventory to a maximumSecured by accounts receivable and inventory to a maximum

percent of those assetspercent of those assets

Interest only paymentsInterest only payments

Balance can be retired at the firms discretionBalance can be retired at the firms discretion

Factor arrangementsFactor arrangements


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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsMoney Market InstrumentsMoney Market Instruments

Large firms with high credit ratings may be able toLarge firms with high credit ratings may be able tobyby--pass financial institutions and borrow directlypass financial institutions and borrow directly

from the money market.from the money market.

Two forms of money market instruments:Two forms of money market instruments: Commercial paperCommercial paper

Bankers acceptancesBankers acceptances The firm pays a stamping fee, and is able to borrow based on theirThe firm pays a stamping fee, and is able to borrow based on their

banks credit rating.banks credit rating.

Money market securities:Money market securities: Sold at a discount from face valueSold at a discount from face value

Maturities at time of issue of 30, 60, 90 daysMaturities at time of issue of 30, 60, 90 days

Face amounts of $100,000 or more.Face amounts of $100,000 or more.


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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsMoney Market InstrumentsMoney Market Instruments

The annualized yield on a money market instrument:The annualized yield on a money market instrument:

365

yieldannualeApproximatturityDaysto mapriceMarket

Discountv![ 24-3]


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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsSecuritizationsSecuritizations

Special purpose vehicles (SPVs) are conduits forSpecial purpose vehicles (SPVs) are conduits forpackaging portfolios of receivables and selling them topackaging portfolios of receivables and selling them toinvestors in the money market; a recent innovation ininvestors in the money market; a recent innovation in

financing trade credit.financing trade credit.

Credit enhancements are actions taken to reduce creditCredit enhancements are actions taken to reduce creditrisk, such as requiring collateral, insurance or otherrisk, such as requiring collateral, insurance or otheragreements.agreements.

Asset Asset--backed commercial paper (ABCP) is an example.backed commercial paper (ABCP) is an example. The subThe sub--prime mortgage problems in the U.S. has exposed theprime mortgage problems in the U.S. has exposed the

problems with ABCP where investors have become concernedproblems with ABCP where investors have become concerned

about the underlying asset values (packages of receivables) andabout the underlying asset values (packages of receivables) andthe market is actively repricing these money market instrumentsthe market is actively repricing these money market instruments

In some cases the market has disappeared for some of theseIn some cases the market has disappeared for some of thesemoney market instruments.money market instruments.


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Summary and ConclusionsSummary and Conclusions

In this chapter you have learned:In this chapter you have learned:

That the optimal level of investment in cash,That the optimal level of investment in cash,receivables and inventory occurs when thereceivables and inventory occurs when thebenefits balance the costsbenefits balance the costs

The advantages, the disadvantages andThe advantages, the disadvantages andassociated effective annual costs of the mostassociated effective annual costs of the mostcommon shortcommon short--term financing options available toterm financing options available tocompanies.companies.


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Concept Review QuestionsConcept Review Questions


Current Assets and LiabilitiesCurrent Assets and Liabilities


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Concept Review Question 1Concept Review Question 1Motives for Holding CashMotives for Holding Cash

Why do firms hold cash?Why do firms hold cash?


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Concept Review Question 1Concept Review Question 1FloatFloat

What is float and why is it important to the firm?What is float and why is it important to the firm?


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Internet LinksInternet Links

Securitization NetSecuritization Net -- http://www.securitization.net/http://www.securitization.net/

Dun & Bradstreet Small Business solutionsDun & Bradstreet Small Business solutions --

http://smallbusiness.dnb

.com/credithttp://smallbusiness

.dnb

.com/credit--reports/browsereports/browse--products.aspproducts.asp


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CopyrightCopyright

Copyright 2007 JohnWiley & SonsCopyright 2007 JohnWiley & Sons

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these files or programs or from thethese files or programs or from the

use of the information containeduse of the information contained

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Chapter 24 - Working Capital Management - Current Assets and Current Liabilities

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