INTRODUCTION TO WORKING CAPITAL MANAGEMENT

OutlineWorking Capital DefinedGoals of working capital managementCash Conversion CycleWorking capital policies

WORKING CAPITAL MANAGEMENTNet Working Capital = Current Assets - Current Liabilities

Sheet1

XYZ Distributors Inc.

Balance Sheet

December 31, 2002

AssetsLiabilities

Cash10Accounts Payable30

Accounts Receivable20Short-term Bank Loan20

Inventory40Current Liabilities50

Current Assets70Long-term Loan20

Fixed Assets30Shareholders Equity30

Total Assets100Total Liabilities and Shareholders Equity100

Sheet2

Sheet3

WORKING CAPITAL MANAGEMENTGoals of Working Capital Management:

Stimulate sales by offering customers credit (accounts receivable) and ready goods for sale (inventory) Increase ProfitsMinimize costs by balancing production and sales levels through inventory Increase ProfitsSecure low cost financing Increase ProfitsReach above 3 goals but never run out of cash by having enough cash and marketable securities on hand and/or by limiting use of short-term debt

WORKING CAPITAL MANAGEMENTIssues to Study:

What types and amounts of current assets should a firm hold?

What types and amounts of short-term financing should a firm employ?

How do firms ensure they have enough cash to meet on-going obligations?

How do firms forecast their cash needs?

Cash Conversion Cycle for a Manufacturing FirmPurchase of RawMaterialsSale onCreditCash Received From Credit SaleInventoryConversion PeriodAverageCollection PeriodOperating CycleCash Conversion CyclePayableDeferral PeriodCash Outlay

MANAGEMENT OF CASH CONVERSION CYCLECash Conversion Cycle = (Operating Cycle) - (Accounts Payable Deferral Period)1.Operating Cycle = The time between ordering or raw materials and receiving cash from credit sales2.Inventory conversion period = time required to order, produce and sell final products on credit3.Average collection period = time required to collect cash from credit sales4.Accounts payable deferral period = time firm is able to delay payment for raw materials, wages and other accounts5.Cash conversion cycle = time between payments for raw materials and and labour (resources) and cash collection from sales

OPERATING AND CASH CYCLES FOR XYZ DISTRIBUTORS INC.(In this example, we use average balance but could also use year-end figures for inventory, accounts receivable and accounts payable)Inventory Conversion Period

- Assume that beginning of year inventory balance was Rs.30 and cost of goods sold was Rs.350

OPERATING AND CASH CYCLES FOR XYZ DISTRIBUTORS INC.Receivables Conversion Period or Average Collection Period

- Assume 100% of sales are on credit

- Assume that beginning of year accounts receivable was Rs.20 and sales was Rs.500

OPERATING AND CASH CYCLES FOR XYZ DISTRIBUTORS INC.3.Payables Deferral Period assume beginning of Year accounts payable wasRs.20

4.Operating Cycle= Inventory Conversion Period + Receivables Conversion Period=36.50 days + 18.25 days=54.25 days5.Cash Cycle = Operating Cycle - Accounts Payable Deferral Period =54.25 days 26.07 days =28.18 days

Working Capital Policies and the Current RatioCurrent Ratio is a measure of the extent to which current Assets are financed by current liabilities

Current Ratio = Current Assets / Current Liabilities

XYZ Distributors has a current ratio of 70/50 or 1.4

A current ratio of 1.40 means that for every Rs.1.40 of current assets there is one dollar of current liabilities

Working Capital Policies(Relative to Industry)

Working Capital PolicyLevels of Current AssetsHow Current Assets are FinancedCurrent RatioOperating and Cash CyclesTrade-off Between Profitability and RiskConservativeHighWith Long-term Debt and EquityHigher than Industry AverageLonger than Industry AverageLower Profits / Lower RiskAggressiveLowWith Short-term DebtLower than Industry AverageShorter than Industry AverageHigher Profits / Higher Risk

How a Conservative Working Capital PolicyLowers Profitability and Risk (Vice-versa for Aggressive Policy)

ImpactHigher Level of Cash and Marketable SecuritiesHigher Level of Accounts ReceivableHigher Level of InventoryLess Short-term Debt /Greater Long-term Liabilities and EquitiesLower ReturnLiquid assets earn lower returns than less liquid assetsGreater cost of financing and possibly more write-offs.Higher carrying costs and higher obsolescenceWith upward-sloping yield curve, interest costs are higher. Equity costs are normally higherLess RiskLess Risk Because Cash is Readily AvailableWont miss a potentially profitable sale.Fewer Stock-outsLess short-term debt payments to meet.

Working Capital PoliciesUnderstanding LiquidityTo understand how well a company can meet its ongoing cash obligations (its liquidity), you need to understand whether the firm is using or generating cash flowTo help you understand the nature of cash flows, you need to know how to develop and interpret a statement of cash flowsBefore developing a statement of cash flows, let us review how the balance sheet and income statements are created

SummaryWorking Capital = Short-term Assets Short-term liabilitiesCash Conversion CycleOperating cycleCash cyclePoliciesAggressiveConservative

CASH- motives for holding cash:

Transactions: to meet cash needs that arise from doing business.Precautionary: having cash on hand for unexpected needs.Speculative: to take advantage of potential profit-making situations.

CASH:

Trade Off: cash decreases risk of insolvency, but earns no returns!

Managing Cash InflowLockbox SystemInstead of mailing checks to the firm, customers mail checks to a nearby P.O. Box. A commercial bank collects and deposits the checks.

Managing Cash InflowLockbox SystemInstead of mailing checks to the firm, customers mail checks to a nearby P.O. Box. A commercial bank collects and deposits the checks.This reduces mail float, processing float and transit float.

Managing Cash InflowPreauthorized Checks (PACs)Arrangement that allows firms to create checks to collect payments directly from customer accounts.

Managing Cash InflowPreauthorized Checks (PACs)Arrangement that allows firms to create checks to collect payments directly from customer accounts.

This reduces mail float and processing float.

Managing Cash InflowDepository Transfer Checks (DTCs)Moves cash from local banks to concentration bank accounts. Firms avoid having idle cash in multiple banks in different regions of the country.

Managing Cash InflowWire TransfersMoves cash quickly between banks.Eliminates transit float.

Managing Cash OutflowZero Balance Accounts (ZBAs) Different divisions of a firm may write checks from their own ZBA.Division accounts then have negative balances.Cash is transferred daily from the firms master account to restore the zero balance.Allows more control over cash outflows.

Managing Cash OutflowPayable-Through Drafts (PTDs) Allows the firm to examine checks written by the firms regional units.Checks are passed on to the firm, which can stop payment if necessary.

Managing Cash OutflowRemote Disbursing Firm writes checks on a bank in a distant town.This extends disbursing float.(Discouraged by the Federal Reserve System)

Considerations

Financial Risk - uncertainty of expected returns due to changes in issuers ability to pay.Interest rate risk - uncertainty of expected returns due to changes in interest rates.

Considerations

Liquidity - ability to transform securities into cash.Taxability - Taxability of interest income and capital gains. Yield - Influenced by the previous 4 considerations.

Types

Treasury Bills - short term securities issued by the U.S. government.

TypesGOI Agency Securities - Debt issued by agencies, including:National Mortgage Association Central Home Loan Banks (HDFC)Central Land Banks (NABARD)Intermediate Credit BanksBanks for the Cooperatives

Types

Bankers Acceptances - short term securities used in international trade. Sold on discount basis.Negotiable CDs - short-term securities issued by banks, with typical deposits of $100,000, $500,000 and $1 million.

TypesCommercial Paper - short-term unsecured IOUs sold by large reputable firms to raise cash. Repurchase Agreements - an investor acquires short-term securities subject to a commitment from a bank to repurchase the securities on a specific date.

TypesMoney Market Mutual Funds - a pool of money market securities, divided into shares, which are sold to investors.