Chapter 16 Working Capital

Working Capital Basics

Working Capital – Assets and liabilities required to operate a

business on a day-to-day basis

Assets:– Cash– Accounts Receivable– Inventory

Liabilities:– Accounts Payable– Accruals

2

Working Capital, Funding Requirements, and the Current Accounts

Gross Working Capital represents an investment in assets– Capital – funds committed to support

assets– Working – short term, day-to-day

operations

Working Capital Requires Funds– Maintaining a working capital balance

requires a permanent funds commitment

3

The Short-Term Liabilities Spontaneous Financing

Operating activities automatically create payables & accruals - essentially debts– These liabilities spontaneously offset the

funding required to support current assets

4

Working Capital and the Current Accounts

Net Working Capital – the difference between gross working capital and spontaneous financingGenerally:– Gross working capital = current assets– Net working capital =

current assets – current liabilities

People often say working capital when they actually mean net working capital

5

Objective of Working Capital Management

To run the firm with as little money tied up in the current accounts as possible

Working capital elements– Inventory– Receivables– Cash– Payables – Accruals

6

Objective of Working Capital Management

7

InventoryHigh Levels Low Levels

Benefit: Happy customers – supplied quicklyFew production delays (parts always on hand)

Cost: High financing costsHigh storage costsShrinkage (theft)Risk of obsolescence

Cost: ShortagesDissatisfied customers – product not available

Benefit: Low financing and storage costsLess risk of obsolescence

CashHigh Levels Low Levels

Benefit:Reduces risk of being unable to pay bills

Cost:Increases financing costs

Benefit:Reduces financing costs

Cost:Increases transaction risk

Objective of Working Capital Management

8

Accounts Receivable

High Levels Low Levels

Benefit: Happy customers –can pay slowlyHigh credit sales

Cost: More bad debtsHigh collection costsIncreased financing costs

Cost: Customers unhappy with payment termsLower Credit Sales

Benefit: Less financing cost

Payables and AccrualsHigh Levels Low Levels

Benefit:Spontaneous financing reduces need to borrow

Cost:Unhappy suppliers because paid slowly

Benefit:Happy suppliers/employees

Cost:Not using spontaneous financing

Figure 16-1 Cash Conversion Cycle

9

Figure 16-2 Timeline Representation of Cash Conversion Cycle

10

Permanent and Temporary Working Capital

Need for working capital varies with sales level

Temporary working capital supports seasonal peaks in business

Working capital is permanent to the extent that it supports a constant, minimum level of sales

11

Figure 16-3 Working Capital Needs of Different Firms

12

Financing Net Working Capital

Short-term working capital should be financed with short-term sources

Maturity Matching Principle – the term of financing should match the term or duration of the project or item supported

13

Short-Term vs. Long-Term Financing in Support of Working Capital

Long-term financing

Safe but expensive– Safe – funds are

committed and can’t be withdrawn

– Expensive - long-term rates are generally higher

Short-term financing

Cheap but risky– Cheap - short-term

interest rates are generally lower

– Risky - must continually renew borrowing

14

Alternative Financing Policies

The mix of short/long-term financing supporting working capital – Heavier use of longer term funds is

conservative– Using more short-term funding is

aggressive

15

Figure 16-4a Working Capital Financing Policies

16

Figure 16-4b Working Capital Financing Policies

17

Working Capital Policy

A firm’s Working Capital Policy refers to its handling the following issues: – How much working capital is used– Extent supported by short or long term

financing– The nature and source of any short-term

financing used– How each component is managed

18

Sources of Short-term Financing

Spontaneous financing – payables and accruals

Unsecured bank loans

Commercial paper

Secured loans

19

Spontaneous Financing

Accruals– Interest–free loans

from whoever provides services deferring payment

– Wage Accrual Money owed to employees for work performed but not yet paid

Accounts Payable – Effectively loans from

suppliers selling on credit

– Credit Terms: Specify details of payment

E.g. 2/10, net 30

2% discount if pay within 10 days, otherwise entire amount due in 30 days

20

Prompt Payment Discount

Passing up prompt payment discounts is an expensive source of financing

21

If terms are 2/10, net 30, and don’t pay by the 10th day, essentially paying 2% for 20 days’ use of money

The implied annual rate is

(365 / 20) x 2% = 36.5%

Abuses of Trade Credit Terms

Trade credit, originally a service to customers, is now expected– Paying beyond the due date is a common

abuse of trade creditCalled “stretching” payables or “leaning on the trade”

Slow paying companies receive poor credit ratings

– May lose the ability to buy on credit in future

22

Unsecured Bank LoansRepresent the primary source of short-term financing for most companies

Unsecured Repayment is not guaranteed by the pledge of a specific asset

Promissory Note – Written promise to repay amount borrowed plus interest

23

Unsecured Bank Loans

Line of credit– Informal, non-binding agreement

between a bank and a borrowing firm specifying the maximum amount that can be borrowed during a period

24

Revolving Credit Agreement

Similar to a line of credit except bank guarantees availability of funds up to a maximum amount – Borrower pays a commitment fee on the

unborrowed balance

25

Concept Connection Example 16-2 Revolving Credit Agreements

26

Arcturus has a $10M “revolver” at prime plus 2.5%.

Prior to June 1, it took down $4M that remained outstanding for the month. On June 15, it took down another $2M which remained outstanding through June 30.

Prime is 9.5% and the bank’s commitment fee is 0.25%.

What bank charges will Arcturus incur for the month of June?

Concept Connection Example 16-2 Revolving Credit Agreements

27

Monthly interest rate: (Prime + 2.5%) 12 = 1%Monthly commitment fee: 0.25% 12 = 0.0208%

$4M was outstanding for the entire month of June and $2M was outstanding for 15 days, so the total interest charges are:

($4,000,000 × .01) + ($2,000,000 × [15/30] × .01) = $50,000

The unused balance was $6M for 15 days and $4M for 15 days

($6,000,000 × .000208 × [15/30]) = $ 624 ($4,000,000 × .000208 × [15/30]) = $ 416

$1,040So, total bank charges for June are $51,040

Compensating Balances

Minimum Balance Requirement

A percentage of the loan amount must be left in the borrower’s account at all times and is not available for use

Average Balance Requirement

Average daily balance over a month cannot fall below a specified level

Entire balance can be used – but not all at once

28

Clean-Up Requirements

Borrowers are required to be out of short-term debt for a period once a year– Usually 30-45 days– Prevents funding long-term needs and

projects with short-term borrowing

29

Commercial PaperNotes issued by large, financially-strong firms and sold to investors– Basically a very short-term corporate

bondUnsecured

Buyers are usually institutions

Maturity less than 270 days

Considered a very safe investment

Interest is discounted – no coupon

Rigid and formal - no flexibility in repayment terms

30

Short-Term Credit Secured by Current Assets

Debt is secured by the current asset being financed– Accounts receivable– Inventory

Self liquidating nature of current assets makes loans very safe

31

Short-Term Credit Secured by Current Assets

Receivables Financing – Accounts receivable - money to be collected in

the near future– Banks are willing to lend on A/R if the

borrowing firm’s customers have good financial ratings

Pledging AR: using A/R as collateral for loan Factoring AR: selling receivables at a discount directly to a financing source

32

Concept Connection Example 16-4 Pledging Accounts Receivables

33

Kilraine’s $100,000 receivables balance of turns over

every 45 days. The firm pledges all receivables to a finance

company, which advances 75% of the total at prime plus 4%

plus a 1.5% administrative fee.

Prime is 8%, what interest rate is Kilraine effectively

paying for its receivables financing?

Concept Connection Example 16-4 Pledging Accounts Receivables

34

Solution: Traditional interest

8% + 4% = 12%

Administrative chargeAverage loan balance

$100,000 × .75 = $75,000

Accounts offered to finance company

$100,000 x 360/45 = $800,000

The administrative fee at 1.5%1.5% x $800,000 = $12,000

Fee as a percentage of loan balance

$12,000 $75,000 = 16%

Total financing charges 16% + 12% = 28%.

Factoring Receivables

Firm sells receivables at a discount to a factor that takes control of accounts

– Accounts Receivable are paid directly to factor– Factor accepts only creditworthy customer

accounts– Factors offer a wide range of services all for fees

Perform credit checks on potential customers

Advance cash on accounts before collection or remit cash after collection

Collect cash from problem customers

Assume bad-debt risk when customers don’t pay

– Factoring is usually very expensive financing

35

Inventory Financing

Inventory Financing– Inventory is collateral for loans– Repossessed items may be difficult for

lender to sell– Inventory in borrower’s hands is hard for

lender to controlBlanket liens

Chattel mortgage agreements

Warehousing– Field and public

36

Cash Management

Motivation for Holding Cash

– Transactions demand– Precautionary demand– Speculative demand – Compensating balances

37

Objective of Cash Management

Business cash balances earn little or no interest– Firms generally borrow to support cash

balances

But it is easier to do business with plenty of cash - Liquidity

Objective: Strike a balance – Operate efficiently at a reasonable cost

38

Marketable Securities

Some assets are only slightly less liquid than cash, and earn a return– Treasury bills– Other short term securities issued by

stable organizations

Held as a substitute for cash

39

Figure 16-5 The Check-Clearing Process

40

Check Disbursement and Collection Procedures

Float: money tied up in the check clearing process – Mail float – Transit float – Processing float

Use of Cash - Payers versus Payees– Payers want to extend float periods– Payees want to reduce float periods

41

“Check 21”Traditional check processing shipped paper checks around the country

Check Clearing for the 21st Century Act – Known as “Check 21”– Banks may now “truncate” checks

Replaced with electronic checks

Paper facsimiles available when needed

Has sped up clearing process– Fed paper check processing locations

reduced from 45 to 1

42

Accelerating Cash Receipts

Lock-box systems– Service provided by banks to accelerate

collections

Concentration Banking– Sweep excess balances in distant

depository accounts into central locations daily

43

Figure 16-6 A Lock Box System in the Check-Clearing Process

44

Accelerating Cash Receipts

Wire Transfers– Transfers money

electronically

Preauthorized Checks– Customer gives the payee

signed check-like documents in advance

– Payee deposits it in its bank account once product is shipped

45

Managing Cash Outflow

Control Issues– Centralized/decentralized

Zero Balance Accounts (ZBAs)– Empty disbursement account at firm’s

concentration bank for its divisions

Remote Disbursing– A way to extend mail float

46

Concept Connection Example 16-7 Evaluating Lock-Box Systems

47

Kelso is located on the East Coast, but has California customers that remit 5,000, $1,000 checks a year that take eight days to clear.

A California bank offers a lock box system for $2,000 a year plus $0.20 per check, which will reduce clearing time to six days. Is the proposal a good deal if Kelso borrows at 12%?

Concept Connection Example 16-7 Evaluating Lock-Box Systems

Solution:Kelso’s float now

[(8 / 365) x $5,000,000] = $109,589

Float under proposed lockbox system[(6 / 365) x $5,000,000] = $82,192

Interest on cash freed up [$27,397 x 0.12] = $3,288

System cost [$2,000 + ($0.20 x 5,000)] = $3,000,Conclusion: Proposal is marginally worth doing.

Managing Accounts Receivable

Objectives and Policy– Higher receivables means selling to

financially weaker customers and not pressuring them to pay promptly

Higher sales but also more bad debts

Objective is to max profit, not revenue

Receivables Policy involves:– Credit Policy – Terms of Sale – Collections Policy

49

Determinants of Receivables Balance

Credit Policy– Examine creditworthiness of potential

credit customers– Tight credit policy = lower sales– Loose credit policy = high bad debts– Conflict between sales and credit

departments

50

Terms of Sale

Credit sales are subject to specific payment terms– 2/10, net 30 - The most common terms

2% discount for paying within 10 days, otherwise entire amount due within 30 days

– Prompt payment discounts are usually effective tools for managing receivables

Customers pay quickly to save money

May backfire if customers are very cash poor– Discount taken only by those who pay anyway

51

Collections Policy

Collections Department - follows up on overdue receivables - called dunning– Mail polite letter– Follow up with additional increasingly aggressive

dunning letters– Phone calls– Collection agency– Lawsuit

Collection policy: manner and aggressiveness with which a firm pursues payment from delinquent customers

52

Inventory Management

Inventory: product held for sale– Inventory mismanagement can ruin a

company

Finance department has only an oversight responsibility– Monitor level of lost or obsolete

inventory– Supervise periodic physical inventories

53

Benefits and Costs of Carrying Adequate Inventory

Benefits– Reduces

stockouts and backorders

– Makes operations run more smoothly

– Improves customer relations

– Increases sales

Costs– Interest on funds used to

acquire inventory– Storage and security– Insurance– Taxes– Shrinkage - theft– Spoilage– Breakage– Obsolescence

54

Inventory Control and Management

Inventory Management - overall way a firm controls inventory and its cost– Define an acceptable level of operating

efficiency with regard to inventory– Achieve that level with the minimum inventory

cost

EOQ – An inventory cost minimization model

C = Annual Carrying Cost per Unit

F = Fixed Cost per Order

D = Annual Demand in Units

Q = Order Quantity

55

Figure 16-7 Inventory on Hand for a Steadily Used Item

56

Figure 16-8 Inventory Costs and the EOQ

Total Inventory Cost:Q

DF

2

QCTC

Economic Order Quantity (EOQ) Model

1

22 Fixed Cost per Order Annual DemandEOQ =

Annual Carrying Cost per Unit

EOQ minimizes the sum of ordering and carrying costsC = Annual Carrying Cost per UnitF = Fixed Cost per OrderD = Annual Demand in Units

21

C2FD

EOQ

Concept Connection Example 16-9 Economic Order Quantity (EOQ) Model

59

Galbraith buys a $5 part. Its carrying cost is 20% of that value per year. It costs $45 to place, process and receive an order. 1,000 parts are used per year.

What order quantity minimizes inventory costs?

How many orders will be placed each year if that order quantity is used?

What annual inventory costs are incurred for the part with this ordering quantity?

Concept Connection Example 16-9 Economic Order Quantity (EOQ) Model

60

Solution: C = $5 × .20 = $1F = $45D = 1,000

Annual number of orders = 1,000 / 300 = 3.33.

Carrying costs = $5 × .2 × (300/2) = $150 per year

Ordering costs = $45 x 3.333, = $150 per year

Total inventory cost = $150 + $150 = $300 per year

1

22 $45 1,000EOQ = = 300 units

$1

Safety Stocks, Reorder Points and Lead Times

Safety stock: Additional inventory, carried at all times, used when normal working stocks run out

Quantity on hand diminishes until reorder point is reached

Ordering lead time is the advance notice needed so an order will arrive on time

61

Figure 16-9 Pattern of Inventory on Hand

62

Safety Stock and the EOQ

Inclusion of safety stocks does not change EOQ

Cost trade-off: extra inventory increases carrying cost, but avoids losses from production delays and missed sales

63

Tracking InventoriesThe ABC System

The ABC system segregates items by value and places tighter control on higher-cost pieces – “A” items – very expensive or critical– “B” items – moderate value– “C” items – cheap and plentiful

Effort and spending on control diminishes from A to B to C

64

Just In Time (JIT) Inventory Systems

JIT virtually eliminates manufacturing inventory by pushing it back on suppliers

Suppliers deliver goods just in time for use in production

Works best with large manufacturers

Works poorly where firm has little control over distant suppliers

65