Supply chains and Working capital management

• Two basic questions: (1) what is the appropriate amount of working capital, in both total and for each specific account? (2) how should working capital be financed?

1. Overview of working capital management• Daily business operation involving production

and sales generates cash, A/R (accounts payable), Inventory, A/P (accounts payable) and accruals (unpaid wage or taxes).

• Net operating working capital = current asset – A/P-accruals

• In addition to these accounts, there are short term investment and short term debt (N/P, notes payable).

• Difference between cash and short term investment: cash is the short term financial asset to support ongoing operation whereas short term investment is for future purpose.

• Working capital (or gross working capital): current assets used in operation.

• Net working capital= current asset – current liabilities.

2. Using and financing operating current assets •Operating current assets are used to support sale. Due to seasonal or growing sales, many firms have various operating current assets and related financing.

1) Efficient use of operating current assets•Relaxed policy: a lot of cash, receivables and inventories•Restricted policy: minimum level of current assets•Moderate policy: between relaxed and restricted

Optimal strategy: policy that will maximize the firm’s long run free cash flow and stock’s intrinsic value.

2) Financing operating current assets.•Primary financing source: bank loans, credit from suppliers, accrued liabilities, long term debt and common equity.•Depending on seasonality or economic condition, firms need to maintain varying levels of current assets to support sales.•Permanent operating current assets: the current assets needed even at the low point of the business cycle.•Temporary operating current asset: extra current asset due to increased sales.

3) Approaches•Maturity matching or self liquidity approach: call for matching assets and liabilities maturity. All of fixed assets plus permanent current assets are financed with long term capital. But temporary current assets are financed with short term debt. For example inventory that will be sold in 30 days is financed with a 30 day bank loan. •Problem: not easy to exactly match.•Aggressive approach: It takes advantage of low interests of short term debts. In addition to temporary current assets, permanent and part of fixed assets are financed with short term credit.•Problem: loan renewal as well as rising interest rate problem.•Conservative approach: In addition to permanent and fixed assets, part of temporary current asset is financed with long term capital or marketable securities.

3. Short term financingAdvantages: •Low interest rate•Fast negotiating •Flexible – low/no prepayment penalty•Fewer restriction (covenants)

Disadvantages:•Renewal•Unstable interest expense•Bankruptcy

4. Cash conversion cycle (working capital cycle): firm purchases or produces inventory, hold it for a time and then sell it and receive cash. This process is known as cash conversion cycle (CCC).

•CCC = Inventory conversion period + average collection period – payable deferral period= period in which a firm needs to pay interest if he or she borrows to purchase materials. •Inventory conversion = Inventory / (COGS/365)•Average collection period = A/R / (Sales/365)•Payable deferral period = A/P / (COGS/365)

1) Benefits of reducing CCC

•A firm tends to strengthen sales by providing discount for early payment. Large amounts of working capitals means large interest payment because working capitals are financed with debts.•CCC reduction has several benefits- reduced interest payment and improved free cash flow.

4. Cash budget (Figure 16-5): monthly cash in and out.(1) Cash in: - Sales forecast- Credit policy: e.g) 2/10 net 60. It means a 2% discount is given if payment is made within 10 days. Otherwise the full amount is due in 60 days. E.g) net 30. It means no discount but required to pay within 30 days. (2) Cash out: Cost of purchasing raw materials, wages and salaries, lease payments, other payments, etc. (3) Cash balance (= net cash flow) = cash in – cash out.(4) Cumulative net cash flow = cash balance in the previous month + cash balance.(5) Minimum balance: how much cash is needed to maintain a minimum balance requirement.

1) Target cash balance(1) Transaction balance: cash balance associated with routine payments and collections.(2) Precautionary balance: cash to meet random and unforeseen fluctuations in inflows and outflows.•If the firm’s cash balances are less predictable and the firm’s needs to take large trade discount, cash balance should be large enough.(3) Compensating balance: if a bank is providing services to a customer, then it may require that customer to leave a minimum balance on deposit to help offset the cost of providing these services.

2) Cash management techniques•Synchronization of cash flow: by timing cash receipts to coincide when their cash outlays, firms can hold their transaction balance to minimum.3) Speeding up the check-clearing process•With the passage of a federal law in 2004 known as “Check 21,” banks can exchange digital images of checks and most checks clear in a single day.

4) Float: difference between the balance shown in a firm’s check book and the balance on the bank’s records. This difference happens due to the period of check clearing.•Disbursement float: when a firm write a check, firm balance < bank balance.•Collection float: when a firm receives a check, firm balance > bank balance.•Net float = disburse float – collection float.•Collection float is bad but discount float is good. And positive net float is even better.

Why float happens?• Time for checks to travel through the mail, (2) be processed by the receiving firm, and (3) clear through the banking system.•How to make a big and positive net float? speeding up collection the firm receives and slowing down collection on checks the firm writes.

5) Speeding up collections: lock boxes and electronic transfer.•Lock boxes: incoming checks are sent to post office boxes rather than to the firm’s corporate head-quarters. A local bank with the firm’s account will clear checks in lockboxes. Compared to regular system, lock box saves 2 to 5 days.•Payment by wire or automatic transfer: Eliminating the time of clearing checks.

5. Inventory management•Financial management needs to raise capital needed to carry inventory and for overseeing the firm’s overall profitability.•Twin goals of inventory management: (1) ensuring that the inventories and (2) holding the costs of ordering and carrying inventories to the lowest possible level.•Before computer age, Red line was used. After computer age, Just in Time is used.

e.g) sales of $120 million and an inventory turnover ratio of 3. How much inventory may be needed to maintain current business? •Inventory turnover ratio = sales / average inventory.•Thus an average inventory = sales / inventory turnover = 120/3 =40. If the company can improve its inventory turnover ratio to 4, the inventory needed is 30 and free cash flow saved is 10 (=40-30).•However the low level of inventory may cause other costs such as frequently ordering costs, lost sale opportunities, etc.

6. Receivable management•A/R (accounts receivable): A/Rs are caused by sales on credit/accounts. They are indirect or direct costs to firms. However sales on credit improve sales volume.

1)Credit policy

•Sales are influenced by two factors: •Exogenous: state of economy•Endogenous (under the firm’s control): price, product quality, adverting and credit policy, etc.

Credit policy consists of the four variables: •Credit period: “net 30” which means that the customer must pay within 30 days.•Discount: “2/10, net 30” which means that buyers may deduct 2% of the purchase price if payment is made within 10 days. Otherwise the full amount must be paid within 30 days.•Credit standard: how much financial strength must a customer show to qualify for credit? Lower credit standard boost sales but they also increase bad debts. •Collection policy: how tough or lax is a company in attempting to collect slow-paying accounts?

2) Accumulation of receivables•The total amount of A/R outstanding is determined by two factors.•A/R = credit sales per day * length of collection period

3) Monitoring the receivable position•When a bank loan is approved, the agreement is executed by signing a promissory note. The promissory note specifies the amount borrowed, the interest rate, the repayment schedule, any collateral, any other terms and conditions.

Bankers and investors pay attention to A/Rs. Credit sales reduces inventory by cost of goods sold, increase sales, report as a profit the difference between sales and cost of goods sold. But credit sales are not cash transaction…..

(1)Day sales outstanding (DSO) = receivables / sales per day.(e.g) Super set’s sales under 2/10, net 30Assume that 70% of the customers take the discount and pay on Day 10 and the other 30% pay on Day 30. Annual sales = 200,000*198.

DSO = ACP (average collection period) = 0.7*10 days + 0.3*30 days = 16 days

• ADS (average daily sales) = annual sale/365= 200000*198/365 = 108493A/R = 108493*16 =1735888.DSO = (A/R) / ADS = (A/R) /(sales/365) DSO is compared to an industry average or its

own credit terms.

(2) Aging schedules is a schedule table breaking down receivables by age of account.

• A change in DSO or the aging scheduling should be taken as a signal to investigate further: it is not necessarily a sign that the firm’s credit policy has weakened.

• 7. Accruals and A/P (trade credit)Two major types of operating liabilities: accruals

and account payable. 1)Accruals: unpaid or accrued wages or taxes. They

are interest free and automatically increase as a firm’s operations expand.

2)Account payable (trade credit): purchase on credit. Typically, 40% of current liabilities for nonfinancial corporations are A/P.

e.g) a firm has an average purchase of $2000 a day on terms of net 30. It means that firm owes 30*2,000 = 60,000 to its suppliers. If credit terms changes to net 40, the firm owes 40*2000 = 80,000.

(1) cost of trade creditUnder terms of 2/10, net 30true price = net price = list price * (1-2%). Or list price = true price/ (1-2%) list price = true price + discount (2%)discount = list price – true price

e.g) PPC buys $11,923,333 of memory ships from Microchip each year at the net price. The amounts to $11,923,333/365 =32666.67 per day.

a) IF PPC decides to use 10 days, its payables will be 10*32666.67 =326667.

b) Now assume that PPC decides to take additional 20 days credit. PPC will pay on the 30th day. Total payable will be 30*32666.67=980,000. Thus Microchip will provide 653,333 (=980,000-326,667) of credit at the true or net price. •But the additional 20 days credit will cost to PPC 243,333 [=11,923,333/(1-2%)-11,923,333]. Here 11,823,333 is a true price.

c) Nominal annual cost =243333/653333 =37.2%= Discount percentage /(100-discount percentage) * 365/(days credit is outstanding – discount period)= 2/(100-2) * 365 /(30-10) = 37.2%.If PPC can borrow from its banks at an interest rate less than 37.2%, then it should use the bank loan. It means that PPC should take 2% discount and forgo the additional trade credit.

If you consider a compounding schedule, (1+discount rate/(100-discount rate))^(number of periods in a year)-1 = (1+0.0204)^18.23-1 =44.6%.

• If PCC could get away with paying in 60 days rather than the specified 30 days, then number of periods per year changes from 18.25 to 7.3 (=365/50).

• In this example, trade credit could be categorized into free trade credit (trade credit in 10 days) and costly trade credit ( trade credit in additional 20 days). Firm should use free trade credit and use the costly trade credit after analyzing the cost of costly trade credit.

• 8. Management of short term investment: T-Bill, CP, Time deposit, etc.

• Three reasons companies hold short term investments: (1) for liquidation just prior to scheduled transaction, (2) unexpected speculation or opportunities, (3) to reduce company’s risk.

9.Short term financing 1)Advantages of short tern financing- Obtained much faster than a long term loans

- less expensive in flotation costs and prepayment penalty - less restrictive in provisions or covenants

2) Disadvantages-Fluctuating interest payment-Possible financial distress if a firm heavily relies on a short term loan

• 3) short term bank loan• Banks provide funds/loans to firms and are very

important in running business.• Loans from commercial banks generally appear on

balance sheets as notes payable. • (1) maturity• Bank loans to business are frequently written as 90

day notes.

• (2) Promissory notes• When a bank loan is approved, the agreement

is executed by signing a promissory notes. This promissory note specifies the amount borrowed, the interest rate, the repayment schedule, any collateral, any other terms and conditions.

(3) Compensating balance•An average demand deposit (checking amount) balance required to maintain by borrowers. •e.g) 20% compensation balance means if a loan of $100,000 is issued, the 20% of 100000 must stay in a checking account. A borrower will receive only $80,000. If the stated annual rate is 8%, the effective cost is 10% (=100000*0.08/(100000-20000)). Compensating balance is less common now than earlier.

(4) Informal line of credit•An informal agreement between a bank and a borrower indicating the maximum credit the bank will extend to the borrower.•“taking down”: an action of using a portion of line of credit.•(e.g) financial manager signs a 90 day promissory note for $15000. This would be called “ taking down” $15000 of total line of credit.

(5) Revolving credit agreement•A formal line of credit often used by large firms. •e.g) assume that Texas petroleum negotiated a revolving credit agreement for $100 million with a group of banks. The banks were formally committed for 4 years to lend the firm up to $100 million if the funds were needed. Texas Petroleum, in turn, paid an annual commitment fee of 0.25% on unused balance of the commitment to compensate the banks for making commitment. A used portion of credit will be charged at a different interest rate.

• The interest rate on revolvers is pegged to the London Interbank Offered Rate (LIBOR), the T-bill rate or some other market rate.

• Major difference between line of credit and revolving credit: Revolving credit has a legal obligation to honor a revolving credit agreement and receive a commitment fee. But a legal obligation or a fee do not exist under the informal line of credit.

• Cleanup clause that requires the borrower to reduce the loan balance to zero. In general, line of credit will have a cleanup clause because it is not a source of permanent capital.

(6) Costs of bank loans•Interest rates are higher for riskier borrowers and an smaller loans because of fixed costs involved in making and servicing loans. They are scaled up from the prime rate (which at one time was the lowest rate bank charged) or LIBOR, depending on size, or financial soundness. •(e.g) The rate to smaller and riskier borrower is generally stated something like “prime plus 1.0%”; The rate to larger borrower is stated like LIBOR plus 1.5%.•

a) Calculating bank’s interest charges: regular (or simple) interest for typically for business loans.•e.g) Borrowing $10,000 for 30 days at 3.25% nominal rate (APR). Here one year is assumed to have 360 days. •Monthly interest = rate per day (= daily periodic rate, DPR) * total loan amount * days used in a month = 0.0325/360 * 10000*30 =27.08. •EAR = (1+0.0325/12)12 – 1 = 3.2989%

b) Calculating bank’s interest charges: add-on interest. It is typically for automobile and other types of installment loans (amortized loans). The interest is calculated and then added to the amount borrowed to determine the loan’s face value.

E.g) you borrow $10,000 on an add-on basis at a nominal rate of 7.25% to buy a car with the loan to be repaid in 12 monthly installments. •How to find APR? •Per month payment = (10000+725)/12 = 893.75•N = 12•PV = 10000•PMT = -893.75•FV=0, Then I/YR = 1.093585%•APR = 12* 1.093585 = 13.12%•EAR = (1+1.093585)12 – 1 = 13.94%

(7) Commercial paper•Unsecured promissory note issued by large, strong, firms and sold primarily to other business firms such as insurance firms, pension funds, money market mutual funds, and other funds.•Maturity : 1 day to 9 months•Dealers prefer to handle the commercial paper of firms whose net worth is $100 million or more and whose annual borrowing exceeds $10 million.

8. Use of security in short term financing•Most secured short term business borrowing involves the use of A/R and inventories as collateral.