Raising Entrepreneurial Capital

Chapter 10: Internal Financial Management

Working capital per dollar sales, WC/Sales

Working Capital defined as Current Assets – Current Liabilities.

a company that generates sales with a smaller investment in working capital is managing its current assets and current liabilities more efficiently.

On average the Fortune 500 companies use $0.20 in working capital to generate $1.00 in sales. Efficient companies use in the $0.07 - $0.17 range.

Importance of Working Capital Management

Careful management of current assets and liabilities should be a priority in any business start up.

Focus should be on cash flow not profits

Access to assets not ownership is critical

Working capital managementin smaller firms

Preserve cash by leasing fixed assets Relatively higher reliance on short-

term debt

Small firm is much more likely to be unable to withstand a cash flow crisis than its larger, more established counterpart

Tools

Non-interest earning current asset balances should be kept to a minimum.

Accounts Receivable should be minimized by expediting collections from customers.

Inventories at all levels should be minimized to reduce costs.

On the liability side, Accounts Payable should be managed so that payments to suppliers take advantage of any free credit provided.

Cash Conversion Cycle (CCC)

calculates the time that money is tied up in the normal business cycle of the company.

The CCC calculates the number of day’s cash which is invested in inventory and accounts receivable, and the extent to which this cash outflow is covered by the financing provided by a firm’s creditors.

CCC calculation

CCC = ACP + ICP – DPO ACP, Average Collection Period =

Accounts Receivable/(Sales/365) ICP, Inventory Conversion Period =

Inventory/(Cost of Goods Sold/365) DPO, Days Payables Outstanding =

Accounts Payable/(Cost of Goods Sold/365).

CCC usage

Highlights the flow of dollars into current assets and from current liabilities, used to better manage those accounts to reduce the firm’s need for external financing.

Reduction in the CCC leads to: A one-time increase in cash as cash is

converted from current assets. An ongoing increase in efficiency as the firm

speeds up collections and inventory conversion.

The goal of working capital management is to get the CCC to zero.

Trade credit

Never pay early, except to get discount Example terms of 2/10 net 30 mean the

buyer may subtract 2% (the finance charge) from the invoice amount if paying by day 10, otherwise the full amount on the invoice is due on day 30.

Here is an opportunity to obtain vendor financing for twenty days. What is the cost of foregoing the discount and paying on day 30? In this case a finance charge of 2% is charged for 20 days of financing.

Effective cost of trade credit

Periodic rate = Discount Percentage/(1-Discount

Percentage)

Effective rate = (1+ periodic rate)n - 1

Where n = the number of compounding periods in a year and is calculated as 365/(payment date – discount date).

Cost of foregoing the discount

On terms of 2/10 net 30: Periodic Rate = 2%/(1.0-2%) =

0.02/0.98 = .0204

N = 365/ (30-10) = 18.25

Effective Rate = (1 + .0204) 18.25 – 1 = 44.56%.

Cash Budget

The Cash Conversion Cycle indicates how many days of financing are needed but does not indicate the amount of external financing needed.

To predict the amount of external financing needed, the financial manager must prepare a Cash Budget.

The Cash Budget is a forecast of cash inflows and outflows, monthly over the next year or daily over the next month.

Daily Budget

A daily cash budget is critical because cash inflows and outflows do not occur uniformly throughout the month. While sales may occur uniformly (or may not) expenses almost certainly will be congregated on certain days, throwing off the validity of the monthly cash budget on certain days.

The format of the daily cash budget is the same as the monthly budget except that cash flows are assigned to the actual days on which they occur.

Financing Issues

How should external financing be split between short-term and long-term sources of financing?

“Finance current assets with short-term loans and fixed assets with long-term sources of funds”

ignores the fact that all firms carry some permanent levels of current assets. It is unlikely that a firm will ever carry zero receivables or zero inventory.

permanent level of current assets may be more efficiently financed with longer term sources of funds, either equity or long-term debt.

Short-Term Alternatives

Lines of Credit Asset Backed Loans Factoring Customers

Lines of Credit

for cyclical current asset needs use a revolving line of credit (LOC). A line of credit is essentially a pre-approved loan, available on demand in part or whole, up to the preapproved limit.

As cash deficits occur, a check can be written against the line, drawing on it to a predetermined maximum.

should you end up not needing the funds there is no charge. Also, unlike a term loan, there are no scheduled repayments of principal.

Asset Backed Loans

In the early stages of a company’s life the bank may not be willing to extend an unsecured line of credit to the company and a secured loan may be the only option for obtaining financing.

What assets are appropriate for securing a short-term loan? Personal assets are always an option. If the firm has a marketable securities portfolio, it would be good security for a loan. More likely assets to use as collateral are the firm’s inventories or accounts receivable.

Collateral To be acceptable collateral, inventory items

must be finished goods with a ready market for liquidation. The key is, would the bank be able to find a ready buyer for the asset in its current state?

Accounts Receivable may also be used as collateral, but a bank is much more likely to accept your receivables as collateral if your customers are large corporate accounts. A business selling to individual consumers would not provide the type of receivables that a bank would typically accept.

Factoring

A firm can sell its accounts receivable to a third party, the factor. The factor may be a bank or a specialized factoring company.

As with pledging, a factor will examine your receivables and only accept quality, current receivables. The difference is that you sell the receivables to the factor, realizing cash from the sale immediately and removing the receivables from your balance sheet.

The factor may only advance 70-95% of the face value of receivables depending on their quality.

Customers

If your business provides a new or customized product or service, it may be in the customer’s best interest to help get your firm up to scale through a direct investment; if there are no good substitutes for what you offer, the chance of direct investment by your customers rises substantially.

Another option for customer financing is to demand full or partial payment in advance. This strategy works best when the service is ongoing (consulting) or the product takes some time to develop or is highly customized.

Cash management techniques A basic goal of cash management is to get

access to incoming funds as quickly as possible. Invoices should accompany goods out the door.

Discounts may provide enticement to customers to pay sooner.

All firms need a competent credit department. Credit standards must be set and enforced before credit is extended. Collections must be timely and forceful to ensure payment. Occasionally customers may need to be “fired” for nonpayment and no further credit extended.