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Chapter 16 Working Capital
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Working Capital Basics
Working Capital Assets and liabilities required to operate a
business on a day-to-day basis
Assets: Cash Accounts Receivable Inventory
Liabilities: Accounts Payable Accruals
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Working Capital, Funding Requirements, andthe Current Accounts
Gross Working Capital represents aninvestment in assets
Capitalfunds committed to support
assets Workingshort term, day-to-day
operations
Working Capital Requires Funds Maintaining a working capital balance
requires a permanent funds commitment
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The Short-Term LiabilitiesSpontaneous Financing
Operating activities automaticallycreate payables & accruals -essentially debts
These liabilities spontaneously offset thefunding required to support currentassets
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Working Capital and the CurrentAccounts
Net Working Capitalthe differencebetween gross working capital andspontaneous financing
Generally:
Gross working capital = current assets
Net working capital =
current assetscurrent liabilities
People often say working capital whenthey actually mean net working capital
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Objective of WorkingCapital Management
To run the firm with as little moneytied up in the current accounts aspossible
Working capital elements Inventory
Receivables
Cash Payables
Accruals
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Objective of Working Capital Management
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Accounts ReceivableHigh Levels Low Levels
Benefit:
Happy customers can pay slowly
High credit sales
Cost:
More bad debtsHigh collection costs
Increased financing costs
Cost:
Customers unhappy withpayment terms
Lower Credit Sales
Benefit:Less financing cost
Payables and Accruals
High Levels Low Levels
Benefit:Spontaneous financing reduces need to borrow
Cost:
Unhappy suppliers because paid slowly
Benefit:Happy suppliers/employees
Cost:
Not using spontaneous financing
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Figure 16-1 Cash Conversion Cycle
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Figure 16-2 Timeline Representation of Cash
Conversion Cycle
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Permanent and TemporaryWorking Capital
Need for working capital varies withsales level
Temporary working capital supportsseasonal peaks in business
Working capital is permanent to theextent that it supports a constant,minimum level of sales
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Figure 16-3 Working Capital Needs ofDifferent Firms
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Financing Net Working Capital
Short-term working capital should befinanced with short-term sources
Maturity Matching Principle theterm of financing should match theterm or duration of the project or item
supported
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Short-Term vs. Long-Term Financing inSupport of Working Capital
Long-term financing
Safe but expensive Safefunds are
committed andcant be withdrawn
Expensive - long-term rates aregenerally higher
Short-term financing
Cheap but risky Cheap - short-term
interest rates aregenerally lower
Risky - mustcontinually renewborrowing
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Alternative Financing Policies
The mix of short/long-term financingsupporting working capital
Heavier use of longer term funds is
conservative
Using more short-term funding isaggressive
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Figure 16-4a Working CapitalFinancing Policies
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Figure 16-4b Working CapitalFinancing Policies
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Working Capital Policy
A firms Working Capital Policy refersto its handling the following issues:
How much working capital is used
Extent supported by short or long termfinancing
The nature and source of any short-term
financing used How each component is managed
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Sources of Short-term Financing
Spontaneous financing
payables and accruals
Unsecured bank loans
Commercial paper
Secured loans
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Spontaneous Financing
Accruals
Interestfree loansfrom whoeverprovides servicesdeferring payment
Wage AccrualMoney owed toemployees for
work performedbut not yet paid
Accounts Payable
Effectively loans fromsuppliers selling oncredit
Credit Terms:
Specify details ofpayment
E.g. 2/10, net 30
2% discount if paywithin 10 days,otherwise entire amountdue in 30 days
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Prompt Payment Discount
Passing up prompt paymentdiscounts is an expensive source offinancing
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If terms are 2/10, net 30, and dont pay by the 10th day,essentially paying 2% for 20 days use of money
The implied annual rate is
(365 / 20) x 2% = 36.5%
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Abuses of Trade Credit Terms
Trade credit, originally a service tocustomers, is now expected
Paying beyond the due date is acommon abuse of trade credit
Called stretching payables or leaning onthe trade
Slow paying companies receive poor creditratings
May lose the ability to buy on credit in future
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Unsecured Bank Loans
Represent the primary source ofshort-term financing for mostcompanies
Unsecured Repayment is notguaranteed by the pledge of a specificasset
Promissory NoteWritten promise torepay amount borrowed plus interest
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Unsecured Bank Loans
Line of credit
Informal, non-binding agreement
between a bank and a borrowing firmspecifying the maximum amount thatcan be borrowed during a period
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Revolving Credit Agreement
Similar to a line of credit except bankguarantees availability of funds up toa maximum amount
Borrower pays a commitment fee on theunborrowed balance
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Concept Connection Example 16-2Revolving Credit Agreements
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Arcturus has a $10M revolver at prime plus 2.5%.
Prior to June 1, it took down $4M that remained outstanding forthe month. On June 15, it took down another $2M whichremained outstanding through June 30.
Prime is 9.5% and the banks commitment fee is 0.25%.
What bank charges will Arcturus incur for the month of June?
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Concept Connection Example 16-2Revolving Credit Agreements
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Monthly interest rate: (Prime + 2.5%) 12 = 1%
Monthly commitment fee: 0.25% 12 = 0.0208%
$4M was outstanding for the entire month of June and $2M was
outstanding for 15 days, so the total interest charges are:($4,000,000 .01) + ($2,000,000 [15/30] .01) = $50,000
The unused balance was $6M for 15 days and $4M for 15 days
($6,000,000 .000208 [15/30]) = $ 624
($4,000,000 .000208 [15/30]) = $ 416
$1,040So, total bank charges for June are $51,040
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Compensating Balances
Minimum BalanceRequirement
A percentage of theloan amount must beleft in the borrowersaccount at all timesand is not availablefor use
Average BalanceRequirement
Average daily balanceover a month cannotfall below a specifiedlevel
Entire balance can beusedbut not all atonce
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Clean-Up Requirements
Borrowers are required to be out ofshort-term debt for a period once ayear
Usually 30-45 days
Prevents funding long-term needs andprojects with short-term borrowing
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Commercial Paper
Notes issued by large, financially-strong firms and sold to investors Basically a very short-term corporate
bond
UnsecuredBuyers are usually institutions
Maturity less than 270 days
Considered a very safe investment
Interest is discountedno couponRigid and formal - no flexibility in repaymentterms
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Short-Term Credit Securedby Current Assets
Debt is secured by the current assetbeing financed
Accounts receivable
Inventory
Self liquidating nature of currentassets makes loans very safe
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Short-Term Credit Securedby Current Assets
Receivables Financing
Accounts receivable - money to be collected inthe near future
Banks are willing to lend on A/R if theborrowing firms customers have goodfinancial ratings
Pledging AR: using A/R as collateral for loan
Factoring AR: selling receivables at a discountdirectly to a financing source
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Concept Connection Example 16-4Pledging Accounts Receivables
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Kilraines $100,000 receivables balance of turns over
every 45 days. The firm pledges all receivables to a finance
company, which advances 75% of the total at prime plus 4%
plus a 1.5% administrative fee.
Prime is 8%, what interest rate is Kilraine effectively
paying for its receivables financing?
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Concept Connection Example 16-4Pledging Accounts Receivables
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Solution:Traditional interest8% + 4% = 12%
Administrative chargeAverage loan balance
$100,000 .75 = $75,000
Accounts offered to finance company$100,000 x 360/45 = $800,000
The administrative fee at 1.5%1.5% x $800,000 = $12,000
Fee as a percentage of loan balance$12,000 $75,000 = 16%
Total financing charges16% + 12% = 28%.
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Factoring Receivables
Firm sells receivables at a discount to afactor that takes control of accounts
Accounts Receivable are paid directly to factor
Factor accepts only creditworthy customer
accounts Factors offer a wide range of services all for fees
Perform credit checks on potential customers
Advance cash on accounts before collection orremit cash after collection
Collect cash from problem customers
Assume bad-debt risk when customers dont pay
Factoring is usually very expensive financing
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Inventory Financing
Inventory Financing Inventory is collateral for loans
Repossessed items may be difficult forlender to sell
Inventory in borrowers hands is hard forlender to control
Blanket liens
Chattel mortgage agreementsWarehousing Field and public
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Cash Management
Motivation for Holding Cash
Transactions demand
Precautionary demand Speculative demand
Compensating balances
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Objective of Cash Management
Business cash balances earn little orno interest
Firms generally borrow to support cash
balances
But it is easier to do business withplenty of cash - Liquidity
Objective: Strike a balance Operate efficiently at a reasonable cost
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Marketable Securities
Some assets are only slightly lessliquid than cash, and earn a return
Treasury bills
Other short term securities issued bystable organizations
Held as a substitute for cash
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Figure 16-5 The Check-ClearingProcess
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Check Disbursement andCollection Procedures
Float: money tied up in the checkclearing process
Mail float
Transit float
Processing float
Use of Cash - Payers versus Payees
Payers want to extend float periods Payees want to reduce float periods
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Check 21
Traditional check processing shippedpaper checks around the country
Check Clearing for the 21st CenturyActKnown as Check 21
Banks may now truncate checks
Replaced with electronic checks
Paper facsimiles available when needed
Has sped up clearing process Fed paper check processing locations
reduced from 45 to 1
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Accelerating Cash Receipts
Lock-box systems
Service provided by banks to acceleratecollections
Concentration Banking Sweep excess balances in distant
depository accounts into central
locations daily
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Figure 16-6 A Lock Box System in theCheck-Clearing Process
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Accelerating Cash Receipts
Wire Transfers
Transfers money
electronically
Preauthorized Checks
Customer gives the payee
signed check-like documents
in advance
Payee deposits it in its bank
account once product is
shipped
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Managing Cash Outflow
Control Issues
Centralized/decentralized
Zero Balance Accounts (ZBAs)
Empty disbursement account at firmsconcentration bank for its divisions
Remote Disbursing
A way to extend mail float
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Concept Connection Example 16-7Evaluating Lock-Box Systems
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Kelso is located on the East Coast, but hasCalifornia customers that remit 5,000, $1,000checks a year that take eight days to clear.
A California bank offers a lock box system for$2,000 a year plus $0.20 per check, which willreduce clearing time to six days. Is the proposala good deal if Kelso borrows at 12%?
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Concept Connection Example 16-7Evaluating Lock-Box Systems
Solution:Kelsos float now
[(8 / 365) x $5,000,000] = $109,589
Float underproposed lockbox system
[(6 / 365) x $5,000,000] = $82,192Interest on cash freed up
[$27,397 x 0.12] = $3,288
System cost
[$2,000 + ($0.20 x 5,000)] = $3,000,Conclusion: Proposal is marginally worth doing.
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Managing Accounts Receivable
Objectives and Policy Higher receivables means selling to
financially weaker customers and notpressuring them to pay promptly
Higher sales but also more bad debtsObjective is to max profit, not revenue
Receivables Policy involves: Credit Policy
Terms of Sale
Collections Policy
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Determinants ofReceivables Balance
Credit Policy
Examine creditworthiness of potentialcredit customers
Tight credit policy = lower sales Loose credit policy = high bad debts
Conflict between sales and credit
departments
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Terms of Sale
Credit sales are subject to specific payment terms
2/10, net 30 - The most common terms
2% discount for paying within 10 days,otherwise entire amount due within 30 days
Prompt payment discounts are usually effectivetools for managing receivables
Customers pay quickly to save money
May backfire if customers are very cash poor
Discount taken only by those who pay anyway
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Collections Policy
Collections Department - follows up on overdue
receivables - called dunning Mail polite letter Follow up with additional increasingly
aggressive dunning letters Phone calls Collection agency Lawsuit
Collection policy: manner and aggressiveness
with which a firm pursues payment fromdelinquent customers
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Inventory Management
Inventory: product held for sale Inventory mismanagement can ruin a
company
Finance department has only anoversight responsibility Monitor level of lost or obsolete
inventory
Supervise periodic physical inventories
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Benefits and Costs of CarryingAdequate Inventory
Benefits
Reducesstockouts and
backorders Makes operations
run moresmoothly
Improvescustomer relations
Increases sales
Costs
Interest on funds used toacquire inventory
Storage and security Insurance
Taxes
Shrinkage - theft
Spoilage Breakage
Obsolescence
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Inventory Control and Management
Inventory Management - overall way a firmcontrols inventory and its cost
Define an acceptable level of operatingefficiency with regard to inventory
Achieve that level with the minimum inventorycost
EOQAn inventory cost minimization model
C = Annual Carrying Cost per Unit
F = Fixed Cost per OrderD = Annual Demand in Units
Q = Order Quantity
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Figure 16-7 Inventory on Hand for aSteadily Used Item
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Figure 16-8 Inventory Costs and the EOQ
Total Inventory Cost:QDF
2QCTC
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Economic Order Quantity(EOQ) Model
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22 Fixed Cost per Order Annual DemandEOQ =Annual Carrying Cost per Unit
EOQ minimizes the sum of ordering and carrying costs
C = Annual Carrying Cost per Unit
F = Fixed Cost per Order
D = Annual Demand in Units
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C
2FDEOQ
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Concept Connection Example 16-9Economic Order Quantity (EOQ) Model
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Galbraith buys a $5 part. Its carrying cost is 20% ofthat value per year.
It costs $45 to place, process and receive an order.
1,000 parts are used per year.
What order quantity minimizes inventory costs?
How many orders will be placed each year if thatorder quantity is used?
What annual inventory costs are incurred for thepart with this ordering quantity?
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Concept Connection Example 16-9Economic Order Quantity (EOQ) Model
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Solution: C = $5 .20 = $1
F = $45
D = 1,000
Annual number of orders = 1,000 / 300 = 3.33.
Carrying costs = $5 .2 (300/2) = $150 per year
Ordering costs = $45 x 3.333, = $150 per year
Total inventory cost = $150 + $150 = $300 per year
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22 $45 1,000EOQ = = 300 units$1
S f t St k R d P i t
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Safety Stocks, Reorder Pointsand Lead Times
Safety stock: Additional inventory, carried atall times, used when normal working stocksrun out
Quantity on hand diminishes until reorderpoint is reached
Ordering lead time is the advance noticeneeded so an order will arrive on time
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Figure 16-9 Pattern of Inventoryon Hand
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Safety Stock and the EOQ
Inclusion of safety stocks does notchange EOQ
Cost trade-off: extra inventory
increases carrying cost, but avoidslosses from production delays andmissed sales
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Tracking Inventories
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Tracking InventoriesThe ABC System
The ABC system segregates items byvalue and places tighter control onhigher-cost pieces
A items very expensive or critical
B items moderate value
C items cheap and plentiful
Effort and spending on controldiminishes from A to B to C
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Just In Time (JIT)
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Just In Time (JIT)Inventory Systems
JIT virtually eliminates manufacturinginventory by pushing it back on suppliers
Suppliers deliver goods just in time for use
in productionWorks best with large manufacturers
Works poorly where firm has little controlover distant suppliers