Copyright © 2003 McGraw Hill Ryerson Limited 19-1 prepared by: Carol Edwards BA, MBA, CFA...

copyright © 2003 McGraw Hill Ryerson Limited

19-119-1

prepared by:Carol EdwardsBA, MBA, CFA

Instructor, FinanceBritish Columbia Institute of Technology

Fundamentals

of Corporate

Finance

Second Canadian Edition


19-219-2

Chapter 19Working Capital Management and Short-Term Plannings

Chapter Outline Working Capital Links Between Long-Term and Short-Term

Financing Tracing Changes in Cash and Working

Capital Cash Budgeting A Short-Term Financing Plan Sources of Short-Term Financing The Cost of Bank Loans


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Working Capital• The Components of Working Capital

Net Working Capital equals current assets minus current liabilities. It is often called working capital. Usually current assets exceed current liabilities

so firms have positive net working capital. Firms need working capital as part of their

cycle of operations.Although the amount of working capital is fixed,

the components of working capital constantly change with the cycle of operations.


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Working Capital• A Simple Cycle of Operations:

Firms go through a cycle in which cash is reduced to purchase inventory.

CASHCASH

RAW MATERIALS INVENTORY

FINISHED GOODS INVENTORY

RECEIVABLESRECEIVABLES

Inventory is sold to become A/R. Collection of A/R increases the firm’s cash holdings.


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Working Capital• The Cash Conversion Cycle

The cash conversion cycle is the amount of time between a firm’s payment for materials and its collection on its sales.

In other words, it measures how much time passes from the moment the firm lays out cash on its inventories until it gets that cash back through collection from its customers.


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If a firm paid cash for its inventories, then the total time between the initial payment for the raw materials and collection from the customers would be the cash conversion period.

However, most firms purchase their inventories on account.

If the firm buys its materials on Accounts Payable, then the net time the firm is out of cash must be reduced by the time it takes the firm to pay its own bills.


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If the firm starts the cycle by purchasing raw materials, but it does not pay for them immediately, the time between acquisition and payment is called the accounts payable period.

The number of days between the initial investment in inventory and its sale date is called the inventory period.

The number of days between the date of sale and the date at which the firm gets paid is called the accounts receivable period.


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Working Capital•The Cash Conversion Cycle

To summarize:

Inventory Period

+ Receivables Period

- Accounts Payable Period

= Cash Conversion Cycle

Key Question:How is each of the periods measured?


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Average Inventory


In Chapter 17, you learned:

Inventory Period = Annual Cost of Goods Sold/365

Average A/RAccounts Receivable Period =

Annual Sales/365

Average Accounts PayableAccounts Payable Period =

Annual Cost of Goods Sold/365


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Working Capital• The Working Capital Trade-Off

Working capital can be managed, meaning that the length of the cash conversion cycle can be altered.

Note that there are costs and benefits associated with the firm’s investment in working capital.

Carrying costs are the costs of maintaining current assets and includes the opportunity cost of capital.

Shortage costs are costs incurred from shortages in current assets.


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Working Capital•The Working Capital Trade-Off

An important job of the financial manager is to strike a balance between the costs and benefits of current assets.That is, to find the level of current assets

which minimizes the sum of carrying costs and shortage costs.


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Long-Term and Short-Term Financing

• Links between Long-Term and Short-Term Financing Businesses must have assets in order to run

efficiently. The total cost of these assets is called the

firm’s total capital requirement. In a growing firm the amount of the total capital

requirement will grow over the long-term, showing a steady up-trend.

The total capital requirement will also fluctuate over the short-term, particularly if the firm is in a seasonal business.


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• Links between Long-Term and Short-Term Financing If you look at Figure 19.4 on page 578 of your

text, you will see this concept depicted graphically:Note the straight upward trending line.

This represents a growing firm’s steadily increasing investment in assets over the long-term.

Superimposed on this is a wavy solid line which shows the firm’s seasonal requirement for assets.


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• Links between Long-Term and Short-Term FinancingFor example, if this were a retail firm, you would expect the maximum quantity of assets to be held at Christmas. The firm would be carrying its cash, inventories and

accounts receivable at a seasonal high in December. Note that the dashed line for December 2001, shows

where the firm’s total capital requirement is at its highest for the year.

For the rest of the year, the firm’s need for capital varies around this seasonal maximum.

Note also that this pattern is repeated in 2000 and 2002.


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• Strategies for Long-Term and Short-Term FinancingThis leads to the question of how to finance the firm’s total capital requirement:Should all the long-lived assets be funded with

long-term financing and all the seasonal assets be funded with short-term?

Or should all the assets be funded with long-term financing?

Or should all the assets be funded with short-term financing?

Or, should some of the assets be funded long-term and some short-term?


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• Strategies for Long-Term and Short-Term FinancingFigure 19.5 on page 579 shows three possible strategies a financial manager could pursue:Panel (a) shows all the assets funded with long-

term financing. As a result, the firm is always sitting on

excess capital. That is, it has enough financing to cover all its

asset needs, even at the seasonal high. At other times of the year, the firm will have

fewer assets and hence, a surplus of cash.


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•Strategies for Long-Term and Short-Term Financing

Panel (c) shows the matching principal. Long-term assets are funded using long-term financing, while short-term assets are financed with short-term financing.

That is, the firm borrows short-term to meet its short-term seasonal requirements.

Its long-lived assets are funded using long-term financing.


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•Strategies for Long-Term and Short-Term Financing

Panel (b) shows a policy in which some of the assets (both long and short-term) are financed with long-term funding.

The remaining short-term assets are funded using short-term financing.

Thus the firm is a borrower only during those periods when its capital requirements are relatively high.


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• Strategies for Long-Term and Short-Term FinancingWhich strategy is the best financing alternative?It is hard to say.

Panel (a) shows a conservative, very relaxed policy, in which the managers always have a comfortable cushion of cash.

Panel (c) is a more aggressive, restrictive policy in which the firm’s financial managers must always be prepared to arrange short-term financing.

Panel (b) is a middle of the road policy.


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Cash and Working Capital• Tracing Changes in Cash and Working Capital If you look at Table 19.3 to 19.5 in your text,

you will see the financial statements for Dynamic Mattress Company (DMC).Notice that DMC’s cash balance increased from

$4 million to $5 million in 2001.What caused this increase? Did the extra cash

come from: Additional borrowing? Reinvested earnings? A reduction in inventories? Extra credit from DMC’s suppliers?


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Cash and Working Capital• Tracing Changes in Cash and Working Capital If you look at Table 19.5, you will see the firm’s

sources and uses of its cash. The correct answer to the question of where

the additional cash came from is:

All of the above!


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Cash Budgeting• Forecasting Sources and Uses of Cash

Forecasts of future sources and uses of cash serve two essential purposes:They alert the financial manager to future cash

needs.They provide a standard, or budget, against

which subsequent performance can be judged. There are several methods of preparing a cash

budget, but no matter what method is chosen, there are three common steps to preparing a cash budget.


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Cash Budgeting• Creating a Cash Budget

1. Forecast the sources of cash. The largest inflow comes from payments by

the firm’s customers.

2. Forecast the uses of cash.3. Calculate whether the firm is facing a cash

shortage or surplus.

The financial plan then sets out astrategy for investing a cash surplus

or for financing a deficit.


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Cash Budgeting• Forecasting Sources of Cash

DMC’s cash inflows come from the sale of mattresses.

The managers have forecasted that quarterly sales for 2002 will be:

Quarter 1st 2nd 3rd 4th

Sales ($ millions) 87.5 78.5 116 131

Not all of these sales would be for cash:Assume 20% of each quarter’s sales are

collected in the next quarter.


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DMC’s collections on its sales would be as follows:


Sales ($ millions) 87.5 78.5 116 131

70.080% collected now:

17.5

62.8

20% in next period: 15.715.0*

* Sales collected from the 4th quarter of the previous year.

23.2

92.8 104.8


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We can combine this information with DMC’s receivables to calculate its period end A/R:

70.0 80% collected now:17.562.8

20% in next period: 15.715.0 23.292.8 104.8


2. Sales ($ millions) 87.5 78.5 116 13132.51. A/R (start of period): 30.730.0 38.2

30.74. A/R (end of period):* 38.232.5 41.280.33. Total collections: 108.585.0 128.0

* 4 = 1 + 2 - 3 (Ending A/R = Beginning A/R + Sales – Collections)


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Cash Budgeting• Combining Sources and Uses of Cash

DMC’s receivables are its primary source of cash.

However, it is not the only one. If you look at Table 19.7 on page 583, you will see

that DMC has other sources of cash. Assume that this other source of cash does not

represent an issue of debt or equity. We can now combine our information about DMC’s

total sources of cash with its uses of cash to create the firm’s forecasted cash budget.


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Cash Budgeting• Combining Sources and Uses of Cash

If you look at the bottom line of Table 19.7, you will see that DMC has a net cash outflow in the first two quarters of the year.

This is followed by substantial cash inflows in the final two quarters.

Cash outflows must always be financed. Now that DMC’s financial managers have advance

warning of the negative cash flows, they can plan how they will finance the expected deficit. A cash budget allows a financial manager to be

proactive with respect to the firm’s financing needs.


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Cash Budgeting•The Cash Balance

Assume that DMC started the year with $5 million in cash.

There is a $45 million cash outflow in the first quarter, so DMC will have to find financing for at least a $40 million deficit.

However, this would leave the firm with a forecast cash balance of zero at the start of the second quarter.

What do you think of thisas a financial strategy?


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Most financial managers would see starting a period with a cash balance of zero as a very risky operating position!

Generally, they establish a minimum operating cash balance to cope with surprises.

Assume that DMC’s minimum operating cash balance is $5 million.

How much financing will DMC have to arrange in the first and second quarter to maintain

this desired minimum cash balance?


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If it wants a minimum cash balance of $5 million in the 1st quarter, DMC will need $45 million of financing, not $40 million.

In the second quarter, they will have to arrange an additional $15 million of financing.

In total, the firm will need $60 million of financing for the first half of the year.This is the peak need.The cash inflows for the 2nd half of the year will

offset the cash outflows of the first half. See Table 19.8 on page 584 for details.


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Cash Budgeting•Options for Short-Term Financing

Now that DMC’s financial managers have estimated how much financing the firm will need, they must decide on the best route(s) for raising those funds.For a healthy firm, multiple options will be

available for covering a temporary cash short-fall.

The financial managers do a cost-benefit analysis of the options and try to choose the one(s) which are optimal.


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Cash Budgeting•Options for Short-Term Financing

If you look at Table 19.9 on page 567, you will see the solution chosen by DMC’s financial managers: In the 1st quarter, they will arrange a $40 million

loan and sell $5 million of securities. In the second quarter, they will stretch their

payables. Stretching payables means delaying payment of

bills and allowing accounts payable to build up. In effect, DMC is taking a loan from its suppliers.


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Cash Budgeting•Evaluating the Plan

The plan in Table 19.9 is feasible, but DMC’s financial managers can probably do a lot better. The most glaring weakness is the plan to rely

on stretching payables.This is an extremely expensive source of

financing! However, the purpose of the first plan is to

get the managers thinking about options and questions they should be addressing.


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Cash Budgeting•Evaluating the Plan

Short-term financial plans are developed by trial and error.

You lay out one plan, think about it, and then try again with different assumptions about the financing and investment alternatives.

You continue until you can think of no further improvements.


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Sources of Short-Term Financing

• Alternative Sources of Financing Bank Loans

These are the simplest and most common source of short-term financing.

A bank loan is an unsecured loan. A line of credit is an agreement by a bank that

a company may borrow at any time up to an established limit.

A revolving credit agreement is a long-term commitment by the bank which allows the firm to borrow up to the agreed limit.


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Sources of Short-Term Financing• Alternative Sources of Financing

Bank Loans If the bank commits to a multi-year agreement,

in return it will charge a commitment fee. This is a fee charged by the bank on the unused

portion of a line of credit.Most bank loans have a duration of a few

months and are designed to cover short-term working capital needs such as a seasonal increase in inventory.

Banks also make term loans. These loans last for several years and may

involve very large sums of money.


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•Alternative Sources of Financing Commercial Paper

Commercial paper is a short-term unsecured note issued by a firm.

Commercial paper is issued by large, well-known companies which regularly need to borrow large amounts of cash.

Instead of a bank loan, they borrow directly from investors at rate which is less than what a bank would charge.


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•Alternative Sources of Financing Banker’s Acceptance

A banker’s acceptance is a firm’s time draft that has been accepted by a bank.

This means the bank guarantees payment of the amount stated on the draft when it matures.

This guarantee means that the draft may be sold to investors as a short-term note issued by the firm.


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•Alternative Sources of Financing Secured Loans

Many short-term loans are unsecured, but sometimes a company will offer assets as security.

Generally, they offer their A/R or their inventory as security on the loan.The former is known as A/R financing. Or it

may involve factoring, in which the firm sells its A/R at a discount to get short-term financing.

The latter is called inventory financing.


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The Cost of Bank Loans•Comparing Rates

Bank loans of less than a year almost invariably have a stated rate which is fixed for the term of the loan.However, you must be careful when

comparing rates on short-term loans, for rates may be calculated in different ways.


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The interest rate on bank loans is frequently quoted as a simple interest rate.You would calculate such interest on a

loan as follows:Annual Interest Rate

Amount of Loan x Number of Periods in the Year


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The interest rate on bank loans may be quoted as a compound interest rate.You would calculate the effective annual

rate (EAR) on a loan as follows:

Quoted Annual Interest RateEAR =

m1+ -1( )m


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The interest rate on bank loans may be quoted on a discount basis.You would calculate such interest on a

loan as follows:

Quoted Annual Interest RateEAR = 1 -

- 1( )m

m

1


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A bank loan may be quoted with a compensating balance.You would calculate such interest on a

loan as follows:

Actual Interest PaidEAR =

Borrowed Funds Available1 + - 1( )m


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Summary of Chapter 19 Short-term financial planning is concerned with

the management of the firm’s short-term or current assets.

The difference between current assets and current liabilities is called net working capital.

Net working capital arises because of lags between the time a firm obtains raw materials and the time it finally collects from customers.

The cash conversion cycle is the length of time between the firm’s payment for materials and the date it gets paid by its customers.

The cash conversion cycle is partly within the control of management.


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Summary of Chapter 19 The nature of a firm’s short-term financial

planning is determined by the amount of long-term capital it raises.

Issuing large amounts of long-term debt or equity, or retaining earnings, may mean a firm has permanent excess cash.

Other firms raise very little long-term financing and end-up as permanent short-term debtors.

Most firms take a middle of the road approach, investing cash surpluses during part of the year and borrowing during the rest of the year.


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Summary of Chapter 19 The starting point for short-term financial planning

is forecasting the sources and uses of cash. From this the firm’s net financing requirement can

be estimated. The search for the best method of financing a

temporary cash short-fall is a trial and error process. The financial manager explores assumptions about

the inputs to the process and the various kinds of short-term financing which are available.

These include: bank loans, banker’s acceptances, secured loans, commercial paper, stretching receivables, etc.

Copyright © 2003 McGraw Hill Ryerson Limited 19-1 prepared by: Carol Edwards BA, MBA, CFA...

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Transcript of Copyright © 2003 McGraw Hill Ryerson Limited 19-1 prepared by: Carol Edwards BA, MBA, CFA...