Lecture 7_Working Capital Management_13

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Working Capital Managent

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Working Capital Terminology

Working Capital Management

The management of short-term assets

(investments) and short-term liabilities

(financing sources)

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Working Capital

A firm’s investment in ST assets:

Cash

Marketable securities

Inventory

Accounts receivable


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Working capital includes only current

liabilities that are specifically used to

finance current assets

Working capital does not include

current liabilities that may be due in the

current period if they are due from long-

term capital decisions, even though

these must be considered when

assessing the firm’s ability to meet its

current obligations


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Net Working Capital

= Current assets - current liabilities

= amount of current assets financed by long-term liabilities

• NWC is usually growing with the firm.


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Net Working Capital and Liquidity

• Net Working Capital – Current Assets – Current Liabilities

– Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out

– Usually positive in a healthy firm

• Liquidity – Ability to convert to cash quickly without a significant

loss in value

– Liquid firms are less likely to experience financial distress

– But, liquid assets earn a lower return

– Trade to find balance between liquid and illiquid assets

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The Relationships of Working

Capital Accounts

A decision affecting one working capital

account (e.g. inventory) will have an impact

on other working capital accounts (e.g.

receivables and payables).

If a firm’s operations are stable, the balance

in accounts receivable and accounts payable

can be computed using this equation:

( ) ( ) Account

balance Amount of

daily activity

Average life of

the account X =

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Examples of impact on working

capital accounts.…

• Purchase of raw materials determine an increase of both inventories and accounts payable;

• As we transform these raw materials into final products, the total amount of inventories increase with the cost of the services used to transform the raw materials into final products and we have an increase of accrued expenses;

• As we pay our suppliers the accounts payable are reduced;

• As we sell our products (decrease in inventories) the accounts receivable increase;

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The length of time from the payment for

purchases of raw materials, to

manufacture a product, until the

collection of accounts receivable

associated with the sale of the product

The Cash Conversion Cycle

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The Inventory Period –Length of time required to convert materials into

finished goods and then sell those goods

–The amount of time the product remains in

inventory in various stages of completion

period

365

sold goods of cost Annual

Inventory

day per sold

goods of Cost

Inventory

Inventory

=

=


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The Receivables Period –Average length of time required to convert the

firm’s receivables into cash. Also called days

sales outstanding (DSO)


Receivables =

Receivables

Average daily credit sales =

Receivables

Annual credit sales

365

period

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The Payables Period –Average length of time between the

purchase of raw materials and labor and the

payment of cash for them

period

365

Cost of goods sold

Accounts payable

Credit purchases per day

Accounts payable

Payables

= =


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–Average length of time a dollar is tied up in current assets

Cash

conversion

cycle =

Inventory

period

Receivables

period

Payables

period + _


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The Efficient Management of Cash

The Operating Cycle (OC) is the time between

ordering materials and collecting cash from

receivables.

The Cash Conversion Cycle (CCC) is the time

between when a firm pays it’s suppliers (payables)

for inventory and collecting cash from the sale of

the finished product.

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Both the OC and CCC may be computed

mathematically as shown below.

Operating Cycle (OC) = Inventory conversion period (ICP) +

Receivable Collection Period (RCP)

Cash Conversion Cycle (CCC) = Operating Cycle (OC) -

Payable Period (PP)


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MAX Company, a producer of dinnerware, sells all its

merchandise on credit. The credit terms require

customers to pay within 70 days of a sale. On average, it

takes 85 days to manufacture, warehouse, and ultimately

sell a finished good. In other words, the average age of

Inventory (IP) is 85 days. It also takes an average of 70

days to collect on its accounts receivable (RP).

Substituting IP = 85 days and RP = 70 days into the into

the OC equation (OC = ICP + RP), we get OC = 85 + 70 =

155 days.


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Continuing with the example, assume that the credit

terms for MAX’s raw material purchases currently

require payment within 40 days and employees are paid

every 15 days. The firm’s weighted average payment

period (PP) for raw materials and labor is 35 days.

Substituting APP days into the CCC equation (CCC = OC

- PP), we get CCC = 155 - 35 = 120 days.


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The Working Capital Management

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Managing the Cash Conversion Cycle

• In this example, MAX (like most companies) has a

positive CCC.

• As a result, the company will have to finance this period

using some combination of short-term financing such as

a line of credit or revolving credit agreement.

The Working Capital Management

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Ways of improving CCC

• shortening the IP;

• shortening the RP;

• lengthening the PP;

• some combination of the above.

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Ways of short term financing

“collect early and pay late”

• Spontaneous Financing

– accounts payable that arise spontaneously

in day-to-day operations (trade credit,

wages payable, accrued interest and

taxes)

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Ways of short term financing

• Trade credit (increasing the account payable)

• Increase the other accruals;

• Factoring (finance 90% of the invoice value);

• Credit on commercial papers;

• Seasonal working capital loans (inventory loans);

• Open credit lines

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Short-Term Financing

- Accrued liabilities -

• Continually recurring short-term liabilities,

such as accrued wages or taxes.

• Is there a cost to accrued liabilities?

– They are free in the sense that no explicit

interest is charged.

– However, firms have little control over the

level of accrued liabilities.

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-Trade credit -

• Trade credit is credit furnished by a firm’s

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.

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- Commercial paper (CP) -

• Short-term notes issued by large companies with a good credit rating.

• CP trades in the market at rates just above T-bill rate (depends on the issuing company’s risk).

• CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes.

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Advantages of Short-Term Financing

Speed –A short-term loan can be obtained much

faster than long-term credit

Flexibility –For cyclical needs, avoid long-term debt

•Cost of issuing long-term debt is higher

•Penalties for payoff prior to maturity

•Restrictive covenants

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Cost of Long-Term versus

Short-Term Debt –Yield curve is generally upward sloping

–Short term interest rates are generally lower

than long-term rates

Advantages of Short-Term Financing

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Risk of Long-Term versus

Short-Term Debt –Short-Term Debt subjects the firm to more

risk than long-term debt

•Short-term interest expenses fluctuate

•Firm may not be able to repay short-term debt and

be forced into bankruptcy

Disadvantages of Short-Term Financing

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The cost of trade credit

- example-

• A firm buys within a financial year raw materials

of $550000 and can get 1% financial discount if

it pays within 10 days.

• The firm can forego discounts and pay on Day

40, without penalty.

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The cost of trade credit

- example- • Firm buys goods worth $550000. That’s the cash

price.

• If the firm pays in 10 days it can pay 550000 less

55000 the financial discount it gets, if not the firm will

pay the cash price 550000.

• Think of the $55000 extra payed if the payment is

made after 10 days as a financing cost similar to the

interest on a loan.

• In order to compare the cost of a bank loan and a

trade credit we should anualize the cost of the trade

credit.

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Nominal trade credit cost formula

12.29% 10010 - 40

365

99

1100

10 - 40

365

55000-550000

55000

100periodDiscount - periodPayment

days 365

%Discount - 1

%Discount

100periodDiscount - periodPayment

days 365

PriceCash %Discount - PriceCash

PriceCash %Discount kTC

===

=

=

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The cost of credit on commercial papers

- Example -

A company has $300000 commercial papers.

The bank it offers a credit for 30 days (including

three bank’s days) with an annual interest rate of

13,2%.

The interest to be payed for the credit on

commercial paper

The cost of the credit

3254,8$ 365

3030000013,2%=

=Interest

%83,141003-30

365

3254,8-300000

3254,8==CPk

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Quick Quiz (I)

Which is the significance of the length of

operational cycle and cash conversion

cycle?

What means a negative cash conversion

cycle? It is a good situation for the

company?

Which are the factors that determine the

cost of trade credit?

Quick Quiz (II)

• Wich firm is more likely to have a longer

cash conversion cycle: a car

manufacturer, a retailer, a software

company?

• Do you think a firm is more likely to

receive a loan to cover its working capital

needs if increases in working capital result

from increases in receivables or increases

in inventories? Explain. 34

Quick Quiz (III)

The company’s policy was not to take the discount

offered by its suppliers if it pays its invoices in 15 days from

delivery.

The suppliers offer was the following: if Topeka pays

in 15 day from delivery will get 3% discount at its invoices,

otherwise the payment of the whole amount of invoices can

be made in 80 day from delivery.

The company’s management made a good decision

by not accepting the discount and paying at term the

company’s invoices if the interest rate for a bank loan is

9.5%? Make calculus and justify your answer! 35

Quick Quiz (IV)

• The firm ABC when got offers from its

supliers to pay its invoices in terms 2/10,

net 30 the firm was always taken the

discount. Does this makes financial sense,

if the interest rate for short term credits is

10%?

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Documents

Lecture 7_Working Capital Management_13