Working capital introduction

WORKING CAPITAL

Short-Term Finance

What Is (Net) Working Capital?

2011 gbemiga adeosun

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Current Assets – Current Liabilities

What Does It Mean to be Current?


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Convertible to cash with a year

What Are Current Assets?


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Cash Very liquid short-term securities - like T-

bills, repurchase agreements, and commercial paper – are usually included here

Marketable securities Less liquid and longer-term investments

made out of current assets Inventory Accounts receivable

What Are Current Liabilities?


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Accounts payable Accruals of wages and salaries All payments on long-term debt that are

payable within a year

What Is Non-Cash Working Capital?


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Remove cash and marketable securities from current assets Cash and marketable securities are held for

reasons beyond just working capita They also pay interest, reducing their

opportunity cost to something much closer to zero than can reasonably be expected from non-cash working capital

Remove debt as well – it gets counted in cost of capital

Inventory+receivables-payables-accruals

What Is the Pitfall in Thinking About Non-Cash Working Capital?


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Increases in inventory and receivables bleed cash out of the firm

Increases in payables and accruals yield cash for the firm

What Are the Economics of Non-Cash Working Capital?


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Non-cash working capital is a derived demand You need it because of projects You often need it before the project is

generating cash flow It is subject to

Economies of scale Economies of scope

What Is the Non-Cash Working Capital Tradeoff?


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Non-cash working capital is subtracted out of the present value of the project

Thus, present value and non-cash working capital are traded off The higher present value is traded off with

the higher risk due to potential loss of customers, and higher default risk

What Are the Cons of the Tradeoff Between Cash and Non-Cash Working Capital?


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Holding less cash: Is less of an issue if the firm has access to

ready outside financing Is harder if the economy tanks Increases uncertainty about meeting debt

obligations

What Are the Pros of the Tradeoff Between Cash and Non-Cash Working Capital?


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Holding less cash: Makes it easier to satisfy the customer out

of inventory Makes it easier to entice the customer with

easy credit

Is There An Optimal Level of Non-Cash Working Capital?


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Probably, but there are a lot of difficulties getting the data to figure out the tradeoff

What Industries Use the Most and Least Non-Cash Working Capital?


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Most: Shoes, textiles, office equipment,

homebuilding, auto manufacturing Least:

Advertising, cable TV, restaurants, hotels/gaming, railroads

What Are the Benefits of Holding Inventory?


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Raw materials Works in progress Finished items

More if it takes time to fill an order More if the product line is diverse More if competitors are ready with

substitutes

What Are the Costs of Holding Inventory?


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Foregone interest Increases with the size of inventory Increased with interest rates

Carrying costs Storage Tracking

What Is EOQ (Economic Order Quantity)?


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A solution to a simple optimization problem for minimizing the costs of inventory EOQ = sqrt(2 x demand x ordering cost/carrying

cost) This yields a graph of inventory that looks like a

series of “capital N’s” through time A cushion can be added above zero inventory for

safety Similar to the Baumol model for cash

(presented later)

What Are the Weaknesses of Using EOQ?


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It assumes constant demand It assumes that inventories can be

replenished without a time delay It assumes that ordering costs do not

depend on the size of the order (i.e., there are no volume discounts)

How Can Optimal Inventories Be Determined?


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Ideally you want to measure the change in the value of the firm due to a marginal change in inventory This is difficult in practice

Most firms look at similar firms for guidance

What Industries Hold the Most and Least Inventory?


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Most: Pharmacies, textiles, aerospace, apparel,

homebuilding Least

Healthcare information systems, medical services, telecommunications, hotels/gaming, restaurants

How Does Trade Credit Relate to Non-Cash Working Capital?


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Leads to an accounts receivable Product is shipped, leading to a need to

replenish inventory Payment may not be made immediately This can create cash flow problems

What Are the Costs of Offering Trade Credit?


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Default risk Interest foregone on the revenue

What Are the Benefits of Offering Trade Credit?


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Locks in a sale that the buyer can afford out of cash flows but not out of cash on hand

It’s also more of an additional general enticement to the buyer While trade credit is being “sold” to the

prospective buyer you are keeping them on the line for the item you actually want to sell

How Do You Decide Whether or Not to Offer Trade Credit?


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Present value analysis

How Do We Evaluate Trade Credit Policy?


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Similar to inventory policy? The problem is too murky to be solved

directly. So we ask: Does it increase the value of the firm? Is it consistent with what similar firms are

offering?

How To Construct a Scoring System for Offering Trade Credit?


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Define characteristics associated with default

Obtain data legally Weight the data in a way consistent with

the default risk Test fly the system Put it into practice

How Are Terms of Trade Credit Expressed?


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a/b net c a% discount Lasting for b days The full undiscounted amount due within c

days

How Do You Figure Out the Rate You Are Offering?


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[1+discount/(1-discount)}^(365/discount length) = 1+effective rate

If the customer delays payment, they are effectively increasing the discount length – and reducing your interest rate

Who Has the Most and Least Accounts Receivable?


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Most Telecommunications, newspapers, energy,

semiconductors, petroleum Least

Restaurants, industrial services, healthcare information services, tobacco, trailers and RVs

What About Accepting Trade Credit?


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This creates an accounts payable It also tends to increase cash flows The costs and benefits of this are the

opposite of extending trade credit, but … Don’t forget that the interest you pay is

deductible, while the interest you receive is not – so they are not quite mirror images of each other

Who Accepts Trade Credit?


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Surprisingly, the same industries that extend lots of trade credit also tend to accept a lot of it Restaurants and tobacco firms use little of

both Defense and auto firms use a lot of both The biggest exploiters of longer payables

and shorter receivables are auto firms

What About Cash?


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Cash Money in accounts bearing rates lower

than the risk-free rate Short-term securities

Why Hold Operating Cash?


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Transactions motive Precautionary motive Compensating balances

This is what you hold in the bank to get access to lines of credit and other services

What Determines Cash Holdings?


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Size Sophistication of the firm’s finances Availability of investments Most U.S. firms hold 1-2% of revenues as

cash

What Is the Baumol Model?


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Similar to the EOQ for inventory Optimal cash balances = sqrt[(2 x

annual cash usage x cost per security sale)/(interest rate)]

What Is the Miller-Orr Model?


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Firm sets upper and lower limits on cash, and it only buys or sells securities when it reaches these thresholds. This requires us To assume a minimum balance To know the variance of cash flows

Spread = 3[(3/4)(transactions cost x variance/interest rate)]^(1/3)

How Does Holding Cash Affect the Firm’s Value?


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Holding operating cash is much like holding non-cash working capital It reduces the flow of cash that can be paid

out to investors

How Can Cash Be Reduced?


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Float managing Increase your disbursement float and

decrease your processing float Better banking

Lockboxes Concentration banking Have the bank control disbursements so

they are made immediately after deposits

What Near-Cash Investments Are Possible?


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In order of increasing risk and return (there is usually a less than 1% difference in this group) Treasury bills Repurchase agreements

On T-Bills On non-mortgage securities On mortgage-backed securities

Commercial paper From financial institutions From non-financial instititutions

How to Choose Between Cash and Near-Cash?


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Benefits of near-cash Earn interest

Costs of near-cash Transactions costs Default risk (admittedly, this is minimal)

Choosing to park some cash in near-cash is an investment decision whose hurdle rate is the risk-free rate You need to be able to beat this after

transactions costs and default risk

When Can Investments In Cash and Near-Cash Reduce Firm Value?


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Not earning the market rate This is not much of a problem in the U.S. This can be a big problem with overseas

investments where local markets may be overregulated or too thin to offer reasonable risk-free rates

Lousy management The value of cash will be discounted in the

market if the firm has few viable projects Cash is a payment that has not been

made to equity yet Thus, hording cash is the same as being

underleveraged

Are There Good Reasons to Hold Lots of Cash?


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High growth industries High volatility industries Industries in which viable projects appear

unexpectedly

What About Riskier Investments In the Short-Term?


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Pros Higher returns You can take advantage of undervalued

securities issued by other firms Strategic investment

Push other firms decisions in your direction It’s the nature of some businesses

Cons Higher risk Higher transactions costs

Who Holds Cash?


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Most Coal, copper, air transport, autos, steel

Least Retail building supply, water utilities,

pharmacies, groceries, retail Cash holdings are positively associated

with revenue growth and negatively associated with revenue

Education

Working capital introduction