16-1

CHAPTER 15Working Capital Management

Alternative working capital policies Cash management Inventory and A/R management Trade credit Bank loans

15-2

Working capital terminology Gross working capital – total current

assets

Net working capital Current Assets Non-interest bearing current liabilities

15-3

Working Capital terminology Working Capital Policy

Level of each type of current asset to hold

How to finance current assets

15-4

Working Capital terminology

Working capital management Control

Cash Inventories Accounts Receivables

Short-term liability management.

15-8

Examples

15-10

Moderate financing policy

Years

Lower dashed line would be more aggressive.

$

Perm Current Assets

Fixed Assets

Temp. C.A.

S-TLoans

L-T Fin:Stock,Bonds,Spon. C.L.

15-11

Conservative financing policy

$

Years

Perm Current Assets

Fixed Assets

Marketable securities Zero S-T

Debt

L-T Fin:Stock,Bonds,Spon. C.L.

15-12

Cash Conversion Cycle Page 522

15-13

Cash Conversion Cycle Length of time between when a company

makes payments to its creditors and when a company receives payments from its customers

CCC = + – .Inventory

conversionperiod

Receivablescollection

period

Payablesdeferralperiod

15-14

Inventory Conversion

= Inventory Cost Goods Sold per day

(Cost Goods Sold / 365)

15-15

Average Collection

= Receivables Sales on credit per day

(Sales / 365)

15-16

Payable Deferral Period

= PayablesPurchases per day

(Cost Goods Sold / 365)

15-18

Cash doesn’t earn a profit, so why should the firm hold it?

1. Transactions – some cash necessary to operate

2. Precaution – “safety stock”. Reduced by line of credit and marketable securities

3. Compensating balances – for loans and/or services provided

4. Speculation – to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities

15-19

Goal of cash management Meet objectives

Cash for transactions Yet not have excess cash Minimize transactions balances in

particular, and also needs for cash to meet other objectives

15-20

Minimizing cash holdings Use a lockbox Insist on wire transfers from

customers Synchronize inflows and outflows Use a remote disbursement account Reduce need for “safety” cash

Increase forecast accuracy Hold marketable securities Negotiate a line of credit

15-21

Cash Budget

Forecasts cash inflows, outflows, and ending cash balances

Plan loans needed or funds available to invest

Can be daily, weekly, or monthly, forecasts Monthly for annual planning and daily for

actual cash management

15-22

Cash Budget:For January and February

Net Cash Inflows Jan Feb

Collections $67,652 $62,755Purchases 44,604 36,473Wages 6,690 5,471Rent 2,500 2,500Total payments $53,794 $44,444Net CF $13,858 $18,311

15-23

SKI’s cash budget (con’t) Net Cash Inflows Jan FebCash at start if no borrowing $ 3,000 $16,857Net CF 13,858 18,312Cumulative cash 16,858 35,169Less: target cash 1,500 1,500Surplus $15,358 $33,669

15-24

EXCEL MODEL Page 526

15-25

How could bad debts be worked into the cash budget?

Collections would be reduced by the amount of the bad debt losses

For example, if the firm had 3% bad debt losses, collections would total only 97% of sales

Lower collections would lead to higher borrowing requirements

15-28

Inventory Costs Types of inventory costs

Carrying costs – storage and handling costs, insurance, property taxes, depreciation, and obsolescence

Ordering costs – cost of placing orders, shipping, and handling costs

Costs of running short – loss of sales or customer goodwill, and the disruption of production schedules

Reducing inventory levels generally reduces carrying costs, increases ordering costs, and may increase the costs of running short

15-29

Is SKI holding too much inventory?

SKI’s inventory turnover (4.82x) is considerably lower than the industry average (7.00x) Firm is carrying a lot of inventory per

dollar of sales Excessive inventory increases cost, reduces

ROE Additional working capital must be

financed

15-30

If SKI reduces its inventory, without adversely affecting sales, what effect will this have on the cash position?

Short run: Cash will increase as inventory purchases decline

Long run: Company is likely to take steps to reduce its cash holdings (and costs)

15-31

Do SKI’s customers pay more or less promptly than those of its competitors?

SKI’s DSO (45.6 days) is well above the industry average (32 days) SKI’s customers are paying less promptly

SKI should consider tightening its credit policy in order to reduce its DSO

15-32

Elements of credit policy

1. Credit Period – How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales

2. Cash Discounts – Lowers price. Attracts new customers and reduces DSO

3. Credit Standards – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO

4. Collection Policy – How tough? Tougher policy will reduce DSO but damage customer relationships

15-33

Does SKI face any risk if it tightens its credit policy?

Tighter credit policy may discourage sales Some customers may choose to go

elsewhere if they are pressured to pay their bills sooner

SKI must balance the benefits of fewer bad debts with the cost of possible lost sales

15-35

Short-term credit Debt scheduled for repayment within 1

year Major sources of short-term credit

Accounts payable (trade credit) Bank loans Commercial loans Accruals

From the firm’s perspective, S-T credit is riskier than L-T debt Required payment around the corner Possible trouble rolling over loans

15-36

Advantages and disadvantages of using short-term financing

Advantages Speed Flexibility Lower cost than long-term debt

Disadvantages Fluctuating interest expense Risk of default as a result of temporary economic

conditions

15-37

What is trade credit? Trade credit is credit furnished by

suppliers

Trade credit is often the largest source of short-term credit, especially for small firms

Spontaneous, easy to get, but cost can be high

15-38

Terms of trade credit A firm buys $2,970,000 net ($3,000,000

gross) on terms of 1/10, net 30. The firm can forego discounts and pay on

Day 40, without penalty.

Net daily purchases = $3,000,000 / 365 = $8,137

15-39

Breaking down trade credit Payables level, if the firm takes discounts

Payables = $8,137 (10) = $81,370 Payables level, if the firm takes no

discounts Payables = $8,137 (40) = $325,479

Credit breakdownTotal trade credit $325,497Free trade credit - 81,370Costly trade credit $244,127

15-40

The firm loses 0.01($3,000,000) = $30,000 of discounts to obtain $ 244,127 in extra trade credit:

rNOM = $30,000 / $244,127

= 0.1229 = 12.3%

$30,000 is paid throughout the year, so the effective cost of costly trade credit is higher

Nominal cost of trade credit

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Nominal cost of trade credit formula

12.29%

0.1229

10 - 40

365

991

period Disc. - taken Daysdays 365

%Discount - 1

%Discount rNOM