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Working Capital Management

©2006 Thomson/South-Western

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Introduction

This chapter deals with the management of working capital, which involves decisions about the optimal overall level of current assets and the optimal mix of short-term funds used to finance the company’s assets.

It also discusses short-term credit sources of funding available to a company. These sources include trade credit and bank loans.

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Working Capital Policy

Involves decisions about a company’s current assets (C/A) and current liabilities (C/L) What they consist of How they are used How their mix affects the risk-return

characteristics of the company Working capital

Total investment in C/A Net working capital

C/A – C/L

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Working Capital Management Firm’s optimal level of C/A

Optimal mix of S-T and L-T debt

Level of investment in each type of C/A

Specific sources and mix of S-T credit the firm

should employ

For extensive information on working capital:

http://strategis.gc.ca/sc_mangb/sources/engdoc/

homepage.html

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Working Capital

Represents assets that flow through the firm Turned over at a rapid rate Usually recovered during the operating cycle

when inventories are sold and receivables are collected

Made necessary by the asynchronous nature of cash receipts and disbursements

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Financing Working Capital

This Web site helps small business obtain working capital to produce and market U.S. products and services for export:http://www.exim.gov/press/jan2496b.html

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Operating Cycle

Operating cycle

• Characterized by the time intervals between the following dates:

Date 1 Purchase of resourcesDate 2 Pay for resource purchasesDate 3 Sell product on creditDate 4 Collect receivables

1 2 3 4

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Decomposing the Operating Cycle

Payables deferral period Receivables conversion period

1 2 3 4

Cash conversion cycle

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OperatingCycle =

InventoryConversion

Period+

ReceivablesConversion

Period

InventoryConversion

Period=

Average Inventory

Cost of Sales/ 365

ReceivablesConversion

Period= Accounts Receivable

Annual Credit Sales/ 365

Operating Cycle Analysis

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Cash Conversion

Cycle=

OperatingCycle +

PayablesDeferralPeriod

Operating Cycle Analysis, Continued

PayablesDeferralPeriod

=

Accounts Payable +

Salaries, Benefits& Payroll Taxes

Payable

Cost ofSales

–Selling, Gen, Admin Exp( /365)

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Size and Nature of a Firm’s Investment in C/A Type of product Length of operating cycle Inventory size Safety stock Probability of running out Credit policies Efficiency of C/A management

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Appropriate Level of Working Capital

Conservative Aggressive

C/A More Less

Profitability Lower Higher

Risk Lower Higher

More conservative policies often result in lost sales due to restrictive credit policies.Optimal level of working capital investment is the levelwhich is expected to maximize shareholder wealth.

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Optimal Level of S-T and L-T Debt Term structure of interest rates Higher risk with S-T debt

Refund Fluctuating S-T interest rates

Permanent C/A Are not affected by seasonal or cyclical demand

Fluctuating C/A Are affected by seasonal or cyclical demand

Matching maturity of debt and assets Conservative Moderate Aggressive

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Sources of Short-Term Financing Trade credit Accruals and deferred income

Legal and practical considerations Loans from commercial banks Commercial paper Collateral for S-T loans

A/R Inventory

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Cost of S-T Credit

AFC = Interest + Fees

Usable funds 365

Maturity (Days)

Simple interest

Compounded interest

m

[ Interest + fees

Usable funds ] – 1 1 + APR =

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Trade Credit (T/C)

Extended on open account as A/P Spontaneous source of financing Cost of T/C is contained in the purchase

price Lost discounts T/C is never free

AFC = % discount

100% – % discount

365

Credit – Disc period

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Commercial Bank Loans

Single loans for specific financial needs Line of credit

Agreement to borrow up to predetermined limit at any time

Revolving creditLegally commits the bankUsually securedRequires a commitment fee

AFC =

Interestcosts

Usable funds

+Commitment

fee 365

Maturity ( days )

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Tying Bank Loans to Other Services Happens when finance executives are

pressured by commercial banks to purchase other financial services in exchange for obtaining loans

Recent rise in practice due to: Concentration in the banking industry

(Citigroup, JP Morgan Chase, Bank of America)

Repeal of laws that prevented commercial banks from engaging in various investment banking services

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Commercial Paper

S-T unsecured promissory notes Issued by large well-known corporations Maturities from a few days to 9 months Sold at a discount Purchasers

Individuals • Corporations • Banks • Insurance companies Pension funds • Money market funds

Maturity ( days )

Interest costs +

Placement fee

Usable funds 365

AFC =

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A/R as Collateral

Fairly liquid Easy to handle Subject to fraud High administrative costs Two common forms

Pledging–Firm retains title Factoring–Sale of A/R

http://www.factoring.org/

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Information on Factoring

Do a search at this Web site for “factoring accounts receivable”:http://www.google.com/

Investigate factoring at this Web site:http://www.21stcapital.com/

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Financing From Foreign A/R Insured by the Export-Import Bank

Contracts guaranteed by Foreign bank Government

Trading companies

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Inventory as Collateral

Stability

Characteristics

Perishability

Identifiability

Marketability

Price stability

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Inventory as Collateral, Continued Possession of the collateral

Floating lien

Trust receipt

Terminal warehouse

Field warehouse