Intermediate Financial Management, Week 7

Working Capital and GrowthPurpose of these notes is to

familiarize reader with concepts of working capital management. Details not for memorization

See Case “There is more to us than meets the eye”

• This case/exercise along with solutions goes through the basics of Financial Statement Analysis for the purposes of

• 1. Analysis of flows of funds i.e. sources and uses of funds.

• 2. Forecasting income statements and balance sheets (creating pro-forma statements)

• 3. Forecasting financing requirements

Objectives• Appreciate the relationship between sales growth and asset

growth and requirements.

• Describe the link between rapid sales growth and liquidity problems experienced by firms even though they are profitable

• Estimate and define the required financing to support different levels of sales growth

• Describe and critique inventory models as applied to cash management as well as to inventory management for producers

• The concept of float; describe major means of reducing collection times for payments and increasing clearing time for disbursements

• List available sources of short-term financing and the important characteristics of each of them

Growth and External Funding Need

Project next’s years sales while keeping income statement-, asset-to-sales and

account payables-to-sales ratios the same

External Financing Calculation• A general formula for additional external

financing needed can be developed where some liabilities spontaneously increase with sales:

• If additional financing not possible, alternative calculations indicate sales growth possible

Possible Growth Rates for Sales• If asset growth is financed exclusively by retained earnings ([1 –

payout rate] times net income), all sales growth and asset is supported by new equity

• Internal growth rate – maximum growth that can be financed by retained earnings if sales ratios stay the same (with Rosengarten example):

Sustainable Growth Rate

• Sustainable growth rate – growth rate can be sustained with D/E ratio constant:

• Substitute ROE (0.0733) for ROA (0.044) in previous formula: Result 5.14%

• Sustainable growth is higher than internal growth rate because external funds are raised to support larger total assets

Financing and Growth• Supportable sales growth depends on

available financing to support required asset growth with sales increases:

• What can change to increase sales growth with limited resources?

Working Capital• Assets

– Cash– Accounts receivable– Inventories

• Raw materials• Work in progress• Finished goods

• Liabilities– Accounts payable (or trade payables): spontaneous– Short-term borrowings (banks, commercial paper)

Cash Management

• How much cash to hold?– Inventory models– Buffer stocks

• How to limit time for collections?– Banking arrangements and other methods to

accelerate collections or delay payments

The Baumol Model (to know about the idea)

F = The fixed cost of selling securities to raise cashT =The Baumol Model = The total amount of new cash neededR = The opportunity cost of holding cash, a.k.a. the interest rateIf we start with $C, spend at a constant rate each period and replace

our cash with $C when we run out of cash, our average cash balance will be C/2 .

The opportunity cost of holding C/2 is (C/2)RAs we transfer $C each period we incur a trading cost of F each period. As we transfer $C each period we incur a trading cost of F each period.The trading cost is (T/C) × F The optimal cash balance is found where the opportunity costs equals

the trading costs

The Miller-Orr Model (to know about the idea)

• The firm allows its cash balance to wander randomly between upper and lower control limits

When the cash balance reaches the upper control limit U, cash is invested elsewhere to get us to the target cash balance Z.

• When the cash balance reaches the lower control limit, L, investments are sold to raise cash to get us up to the target cash balance.

• Given L, which is set by the firm, the Miller-Orr model solves for Z and U

• where the variance of net daily cash flows matters for Z*.• The average cash balance in the Miller-Orr model is:• (Average cash balance becomes: (4Z*-L)/3)

Implications of the Miller-Orr Model

• To use the Miller-Orr model, the manager must do four things:1.Set the lower control limit for the cash

balance.2.Estimate the standard deviation of daily cash

flows.3.Determine the interest rate. 4.Estimate the trading costs of buying and

selling securities.

Implications of the Miller-Orr Model

• The model clarifies issues of cash management:– The best return point, Z, is positively related

to trading costs, F, and negatively related to the interest rate R.

– Z and the average cash balance are positively related to the variability of cash flows.

• POINT TO REMEMBER: Factors influencing need for cash balance

Other Influences on Target Cash Balance

• Borrowing costs– Borrowing is likely to be more expensive than

selling marketable securities.– The need to borrow will depend on

management’s desire to hold low cash balances

Managing the Collection and Disbursement of Cash

• Accelerating Collections• Delaying Disbursements• Disbursement Float• Zero-Balance Accounts• Drafts• Electronic Data Interchange

Float

• The difference between bank cash and book cash is called float.

• Float management involves controlling the collection and disbursement of cash.

Delaying Disbursements

1. Write check on a distant bank.2. Hold payment for several days after

postmarked in office.3. Call supplier firm to verify statement

accuracy for large amounts.4. Mail from distant post office.5. Mail from post office that requires a great

deal of handling

Drafts• Firms sometimes use drafts instead of checks.• Drafts differ from checks because they are not

drawn on a bank but on an issuer (the firm) and are payable by the issuer.

• The bank acts only as an agent, presenting the draft to the issuer for payment.

• When the draft is transmitted to a firm’s bank for collection, the bank must present the draft to the issuing firm for acceptance before making payment.

• After the draft has been accepted, the firm must deposit the necessary cash to cover the payments.

• This allows the firm to keep less cash on hand.

Investing Idle Cash

• A firm with surplus cash can park it in the money market.– Some large firms and many small ones use

money market mutual funds.• Firms have surplus cash for three reasons:

– Seasonal or Cyclical Activities– Planned Expenditures– Different Types of Money Market Securities

Terms of the Sale• The terms of sale are composed of

– Credit period, cash discounts, credit instruments• Credit Period: Credit periods vary across

industries.• Generally a firm must consider three factors in

setting a credit period:– The probability that the customer will not pay– The size of the account– The extent to which goods are perishable

• Lengthening the credit period generally increases sales

Cash Discounts• Often part of the terms of sale• There is a tradeoff between the size of the

discount and the increased speed and rate of collection of receivables.

• An example would be “3/10, net 30”– The customer can take a 3% discount if s/he

pays within 10 days.– In any event, s/he must pay within 30 days.

Interest Rate Implicit in 3/10, net 30

• A customer that forgoes the 3% discount to pay on day 30 is borrowing $970 for 20 days and paying $30 interest:

Credit Instruments• Most credit is offered on open account—the invoice is

the only credit instrument.• Promissory notes are IOUs that are signed after the

delivery of goods.• Commercial drafts call for a customer to pay a specific

amount by a specific date. The draft is sent to the customer’s bank. When the customer signs the draft, the goods are sent.

• Banker’s acceptances allow a bank to substitute its creditworthiness for that of the customer, for a fee.

• Conditional sales contracts let the seller retain legal ownership of the goods until the customer has completed payment.

Optimal Credit Policy

• At the optimal amount of credit, the incremental cash flows from increased sales are exactly equal to the carrying costs from the increase in accounts receivable.

Optimal Credit Policy• Trade Credit is more likely to be granted if:

1.The selling firm has a cost advantage over other lenders.

2.The selling firm can engage in price discrimination.3.The selling firm can obtain favorable tax treatment.4.The selling firm has no established reputation for

quality products or services.5.The selling firm perceives a long-term strategic

relationship.• The optimal credit policy depends on the

characteristics of particular firms.

Credit Analysis• Credit Information

– Financial statements– Credit reports on customer’s payment history

with other firms– Banks– Customer’s payment history with the firm

• Credit analysis is similar to any kind of valuation: what are obligations worth?

Collection Policy• Collection refers to obtaining payment on

past-due accounts.• Collection Policy is composed of:

– The firm’s willingness to extend credit as reflected in the firm’s investment in receivables

– Collection effort

Average Collection Period• Measures the average amount of time required to collect

an account receivable:• For example, a firm with average daily sales of $20,000

and an investment in accounts receivable of $150,000 has an average collection period of

7.5 days =$150,000/$20,000/day

Accounts Receivable Aging Schedule– Shows receivables by age of account– The longer an account has been unpaid, the less likely it is to be

paid.

Collection Effort

• Most firms follow a protocol for customers that are past due

• There is a potential for a conflict of interest between the collections department and the sales department.

• You need to strike a balance between antagonizing a customer and being taken advantage of by a deadbeat.

Factoring• The sale of a firm’s accounts receivable to

a financial institution (known as a factor)• The firm and the factor agree on the basic

credit terms for each customer• The factor pays an agreed-upon

percentage of the accounts receivable to the firm. The factor bears the risk of nonpaying customers

How to Finance Trade Credit• There are three general ways of financing

accounting receivables:1.Secured Debt

– Referred to as asset-based receivables financing.– The predominant form of receivables financing.

2.Captive Finance Company– Large companies with good credit ratings often form a

finance company as a subsidiary of the firm.3.Securitization

– Occurs when the selling firm sells its accounts receivable to a financial institution, which then pools the receivables and sells securities backed by these assets.

Inventories

• Models applied to cash were developed to manage inventories of raw materials or finished goods from production runs

• “Just-in-time” has shifted inventories and holding costs of inventories to suppliers

• Excess inventory can results in costs from liquidation at below costs