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Chapter 16 Working Capital

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1 Chapter 16 Working Capital

2 Working Capital Basics
Assets and liabilities required to operate a business on a day-to-day basis Assets: Cash Accounts Receivable Inventory Liabilities: Accounts Payable Accruals

3 Working Capital, Funding Requirements, and the Current Accounts
Gross Working Capital represents an investment in assets Capital – funds committed to support assets Working – short term, day-to-day operations Working Capital Requires Funds Maintaining a working capital balance requires a permanent funds commitment

4 The Short-Term Liabilities Spontaneous Financing
Operating activities automatically create payables & accruals - essentially debts These liabilities spontaneously offset the funding required to support current assets

5 Working Capital and the Current Accounts
Net Working Capital – the difference between gross working capital and spontaneous financing Generally: Gross working capital = current assets Net working capital = current assets – current liabilities People often say working capital when they actually mean net working capital

6 Objective of Working Capital Management
To run the firm with as little money tied up in the current accounts as possible Working capital elements Inventory Receivables Cash Payables Accruals

7 Objective of Working Capital Management
Inventory High Levels Low Levels Benefit: Happy customers – supplied quickly Few production delays (parts always on hand) Cost: High financing costs High storage costs Shrinkage (theft) Risk of obsolescence Shortages Dissatisfied customers – product not available Low financing and storage costs Less risk of obsolescence Cash Reduces risk of being unable to pay bills Increases financing costs Reduces financing costs Increases transaction risk

8 Objective of Working Capital Management
Accounts Receivable High Levels Low Levels Benefit: Happy customers –can pay slowly High credit sales Cost: More bad debts High collection costs Increased financing costs Customers unhappy with payment terms Lower Credit Sales Less financing cost Payables and Accruals Spontaneous financing reduces need to borrow Unhappy suppliers because paid slowly Happy suppliers/employees Not using spontaneous financing

9 Figure 16-1 Cash Conversion Cycle

10 Figure 16-2 Timeline Representation of Cash Conversion Cycle

11 Permanent and Temporary Working Capital
Need for working capital varies with sales level Temporary working capital supports seasonal peaks in business Working capital is permanent to the extent that it supports a constant, minimum level of sales

12 Figure 16-3 Working Capital Needs of Different Firms

13 Financing Net Working Capital
Short-term working capital should be financed with short-term sources Maturity Matching Principle – the term of financing should match the term or duration of the project or item supported

14 Short-Term vs. Long-Term Financing in Support of Working Capital
Safe but expensive Safe – funds are committed and can’t be withdrawn Expensive - long-term rates are generally higher Short-term financing Cheap but risky Cheap - short-term interest rates are generally lower Risky - must continually renew borrowing

15 Alternative Financing Policies
The mix of short/long-term financing supporting working capital Heavier use of longer term funds is conservative Using more short-term funding is aggressive

16 Figure 16-4a Working Capital Financing Policies

17 Figure 16-4b Working Capital Financing Policies

18 Working Capital Policy
A firm’s Working Capital Policy refers to its handling the following issues: How much working capital is used Extent supported by short or long term financing The nature and source of any short-term financing used How each component is managed

19 Sources of Short-term Financing
Spontaneous financing payables and accruals Unsecured bank loans Commercial paper Secured loans

20 Spontaneous Financing
Accruals Interest–free loans from whoever provides services deferring payment Wage Accrual Money owed to employees for work performed but not yet paid Accounts Payable Effectively loans from suppliers selling on credit Credit Terms: Specify details of payment E.g. 2/10, net 30 2% discount if pay within 10 days, otherwise entire amount due in 30 days

21 Prompt Payment Discount
Passing up prompt payment discounts is an expensive source of financing If terms are 2/10, net 30, and don’t 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%

22 Abuses of Trade Credit Terms
Trade credit, originally a service to customers, is now expected Paying beyond the due date is a common abuse of trade credit Called “stretching” payables or “leaning on the trade” Slow paying companies receive poor credit ratings May lose the ability to buy on credit in future

23 Unsecured Bank Loans Represent the primary source of short-term financing for most companies Unsecured  Repayment is not guaranteed by the pledge of a specific asset Promissory Note – Written promise to repay amount borrowed plus interest

24 Unsecured Bank Loans Line of credit
Informal, non-binding agreement between a bank and a borrowing firm specifying the maximum amount that can be borrowed during a period

25 Revolving Credit Agreement
Similar to a line of credit except bank guarantees availability of funds up to a maximum amount Borrower pays a commitment fee on the unborrowed balance

26 Concept Connection Example 16-2 Revolving Credit Agreements
Arcturus has a $10M “revolver” at prime plus 2.5%. Prior to June 1, it took down $4M that remained outstanding for the month. On June 15, it took down another $2M which remained outstanding through June 30. Prime is 9.5% and the bank’s commitment fee is 0.25%. What bank charges will Arcturus incur for the month of June?

27 Concept Connection Example 16-2 Revolving Credit Agreements
Monthly interest rate: (Prime + 2.5%)  12 = 1% Monthly commitment fee: 0.25%  12 = % $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 × × [15/30]) = $ 624 ($4,000,000 × × [15/30]) = $ 416 $1,040 So, total bank charges for June are $51,040

28 Compensating Balances
Minimum Balance Requirement A percentage of the loan amount must be left in the borrower’s account at all times and is not available for use Average Balance Requirement Average daily balance over a month cannot fall below a specified level Entire balance can be used – but not all at once

29 Clean-Up Requirements
Borrowers are required to be out of short-term debt for a period once a year Usually days Prevents funding long-term needs and projects with short-term borrowing

30 Commercial Paper Notes issued by large, financially-strong firms and sold to investors Basically a very short-term corporate bond Unsecured Buyers are usually institutions Maturity less than 270 days Considered a very safe investment Interest is discounted – no coupon Rigid and formal - no flexibility in repayment terms

31 Short-Term Credit Secured by Current Assets
Debt is secured by the current asset being financed Accounts receivable Inventory Self liquidating nature of current assets makes loans very safe

32 Short-Term Credit Secured by Current Assets
Receivables Financing Accounts receivable - money to be collected in the near future Banks are willing to lend on A/R if the borrowing firm’s customers have good financial ratings Pledging AR: using A/R as collateral for loan Factoring AR: selling receivables at a discount directly to a financing source

33 Concept Connection Example 16-4 Pledging Accounts Receivables
Kilraine’s $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?

34 Concept Connection Example 16-4 Pledging Accounts Receivables
Solution: Traditional interest 8% + 4% = 12% Administrative charge Average 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 charges 16% + 12% = 28%.

35 Factoring Receivables
Firm sells receivables at a discount to a factor 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 or remit cash after collection Collect cash from problem customers Assume bad-debt risk when customers don’t pay Factoring is usually very expensive financing

36 Inventory Financing Inventory Financing
Inventory is collateral for loans Repossessed items may be difficult for lender to sell Inventory in borrower’s hands is hard for lender to control Blanket liens Chattel mortgage agreements Warehousing Field and public

37 Cash Management Motivation for Holding Cash Transactions demand
Precautionary demand Speculative demand Compensating balances

38 Objective of Cash Management
Business cash balances earn little or no interest Firms generally borrow to support cash balances But it is easier to do business with plenty of cash - Liquidity Objective: Strike a balance Operate efficiently at a reasonable cost

39 Marketable Securities
Some assets are only slightly less liquid than cash, and earn a return Treasury bills Other short term securities issued by stable organizations Held as a substitute for cash

40 Figure 16-5 The Check-Clearing Process

41 Check Disbursement and Collection Procedures
Float: money tied up in the check clearing 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

42 “Check 21” Traditional check processing shipped paper checks around the country Check Clearing for the 21st Century Act – Known 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

43 Accelerating Cash Receipts
Lock-box systems Service provided by banks to accelerate collections Concentration Banking Sweep excess balances in distant depository accounts into central locations daily

44 Figure 16-6 A Lock Box System in the Check-Clearing Process

45 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

46 Managing Cash Outflow Control Issues Zero Balance Accounts (ZBAs)
Centralized/decentralized Zero Balance Accounts (ZBAs) Empty disbursement account at firm’s concentration bank for its divisions Remote Disbursing A way to extend mail float

47 Concept Connection Example 16-7 Evaluating Lock-Box Systems
Kelso is located on the East Coast, but has California customers that remit 5,000, $1,000 checks 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 will reduce clearing time to six days. Is the proposal a good deal if Kelso borrows at 12%?

48 Concept Connection Example 16-7 Evaluating Lock-Box Systems
Solution: Kelso’s float now [(8 / 365) x $5,000,000] = $109,589 Float under proposed lockbox system [(6 / 365) x $5,000,000] = $82,192 Interest 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.

49 Managing Accounts Receivable
Objectives and Policy Higher receivables means selling to financially weaker customers and not pressuring them to pay promptly Higher sales but also more bad debts Objective is to max profit, not revenue Receivables Policy involves: Credit Policy Terms of Sale Collections Policy

50 Determinants of Receivables Balance
Credit Policy Examine creditworthiness of potential credit customers Tight credit policy = lower sales Loose credit policy = high bad debts Conflict between sales and credit departments

51 Terms of Sale Credit sales are subject to specific payment terms
2/10, net The most common terms 2% discount for paying within 10 days, otherwise entire amount due within 30 days Prompt payment discounts are usually effective tools 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

52 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 from delinquent customers

53 Inventory Management Inventory: product held for sale
Inventory mismanagement can ruin a company Finance department has only an oversight responsibility Monitor level of lost or obsolete inventory Supervise periodic physical inventories

54 Benefits and Costs of Carrying Adequate Inventory
Interest on funds used to acquire inventory Storage and security Insurance Taxes Shrinkage - theft Spoilage Breakage Obsolescence Benefits Reduces stockouts and backorders Makes operations run more smoothly Improves customer relations Increases sales

55 Inventory Control and Management
Inventory Management - overall way a firm controls inventory and its cost Define an acceptable level of operating efficiency with regard to inventory Achieve that level with the minimum inventory cost EOQ – An inventory cost minimization model C = Annual Carrying Cost per Unit F = Fixed Cost per Order D = Annual Demand in Units Q = Order Quantity

56 Figure 16-7 Inventory on Hand for a Steadily Used Item

57 Figure 16-8 Inventory Costs and the EOQ
Total Inventory Cost:

58 Economic Order Quantity (EOQ) Model
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

59 Concept Connection Example 16-9 Economic Order Quantity (EOQ) Model
Galbraith buys a $5 part. Its carrying cost is 20% of that 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 that order quantity is used? What annual inventory costs are incurred for the part with this ordering quantity?

60 Concept Connection Example 16-9 Economic Order Quantity (EOQ) Model
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

61 Safety Stocks, Reorder Points and Lead Times
Safety stock: Additional inventory, carried at all times, used when normal working stocks run out Quantity on hand diminishes until reorder point is reached Ordering lead time is the advance notice needed so an order will arrive on time

62 Figure 16-9 Pattern of Inventory on Hand

63 Safety Stock and the EOQ
Inclusion of safety stocks does not change EOQ Cost trade-off: extra inventory increases carrying cost, but avoids losses from production delays and missed sales

64 Tracking Inventories The ABC System
The ABC system segregates items by value and places tighter control on higher-cost pieces “A” items – very expensive or critical “B” items – moderate value “C” items – cheap and plentiful Effort and spending on control diminishes from A to B to C

65 Just In Time (JIT) Inventory Systems
JIT virtually eliminates manufacturing inventory by pushing it back on suppliers Suppliers deliver goods just in time for use in production Works best with large manufacturers Works poorly where firm has little control over distant suppliers


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