Presentation on theme: "Chapter 9 Working Capital Policy. Importance of Working Capital Policy “Working capital”: a firm’s investment in current assets Net working capital: the."— Presentation transcript:
Importance of Working Capital Policy “Working capital”: a firm’s investment in current assets Net working capital: the excess of current assets over current liabilities; circulating capital of a business
Importance of Working Capital Policy Why working capital management (effective control of circulating capital) is important: 1.Working capital decisions are urgent Growth in current assets (specifically, receivables) occurs spontaneously with increases in sales, which must be financed from current liabilities, or external sources of capital, or reinvested earnings in order to maintain control of firm’s asset structure 2.Current assets (accounts receivable and inventory) often represent largest single category of asset investment Particularly true for small and rapidly growing businesses
Importance of Working Capital Policy Why working capital management is important (continued): 3.Working capital management represents firm’s first line of defense against sales decline In face of “credit crunch,” firm can reduce inventory or tighten up accounts receivable to provide increased liquidity Accounts payable payments may be slowed to provide additional source of financing Cannot do much about fixed asset commitments or long-term debt arrangements 4.Inability to control growth of working capital accounts is a major cause of business failures Since current assets grow spontaneously with growth in sales, control is important, especially for small, rapidly growing firms
Importance of Working Capital Policy Working capital policy issues 1.Short-term versus long-term financing 2.Relative magnitude of working capital investment 3.Inventory control policy 4.Credit policy 5.Accounts payable policy
Short-term versus Long-term Financing Very definite risk-return tradeoff: – Short-term financing is a riskier form of financing than long-term financing, but it is less costly Lower cost of short-term financing: short-term interest rates are generally lower than long-term interest rates Rate risk: future short-term interest rates cannot be known with certainty, whereas cost of long-term debt is fixed in advance for life of loan Renewal risk: always possibility that firm may not be able to renew short-term debt obligation when it comes due
Short-term versus Long-term Financing To add to the trade-off between short-term financing and long-term financing: – Added flexibility Once long-term loan is negotiated or bond issue is sold, firm is locked in to terms of note over its life span (unless note is callable) If firm has cyclical needs for funds (i.e. need to finance seasonal inventory buildup), long-term obligation is highly undesirable or may be inappropriate
Short-term versus Long-term Financing Firms strive to match their loan maturities with their asset maturities. Short-term fund requirements (i.e. seasonal buildups of inventory, growth of accounts receivable) should be financed with short-term financing sources (i.e. accounts payable, short-term loans). Long-term fund requirements (new plant and equipment) should be financed from long-term financing sources (i.e. long-term loans, leases, equity capital) “Borrow short and invest long”: using short-term financing sources to fund long-term needs can lead to financial insolvency because when short-term note comes due, funds are still needed and therefore unavailable to repay note. Borrower therefore becomes dependant on forbearance or “rollover” by lender.
Short-term versus Long-term Financing Listing an asset as “current” on balance sheet does not necessarily mean the need to finance this asset is short-term. – As current assets grow with sales, the overall level of currents assets will increase permanently. This increase is financed by permanent increase in level of accounts payable, other permanent increases in short-term liabilities, and permanent sources of capital (i.e. long-term debt, reinvested earnings, and new equity capital). – As firm grows, current assets will grow faster than current liabilities. – Difference between current assets and current liabilities (net working capital) will grow permanently, which requires a source of permanent financing.
Short-term versus Long-term Financing Term Structure of Interest Rates – Interest rates are measured by yield to maturity of debt agreement. Yield to maturity: average annual compound rate of return earned by lender – For short-term loans, debt agreement is evidenced by written loan agreement between borrower and bank or other source of funds. – For long-term loans, agreement is publicly or privately placed bond issue or long-term loan agreement between borrower and bank or other supplier of long- term capital
Short-term versus Long-term Financing Term Structure of Interest Rates – Term of maturity of the debt: number of years over which debt is to be repaid – Structure of interest rates: relationship between yield to maturity and term to maturity of debt issues – Yield curve: graph that shows yield to maturity as a function of term to maturity Each category of debt will have its own yield curve relationships; base curve uses the Treasury market
Short-term versus Long-term Financing Term Structure of Interest Rates – Normal yield curve: (see exhibit 9.1) upward- sloping, or “positive,” yield curve where long-term rates are higher than short-term rates Represents normal condition of capital markets Short-term debt is less costly than long-term debt, but riskier due to interest rate risk and renewal risk. – Negative yield curve: (see exhibit 9.2) downward sloping, or “negative,” yield curve where short- term rates are higher than long-term rates Occurs during periods of “tight” monetary policy
Short-term versus Long-term Financing Term Structure of Interest Rates – Liquidity preference theory: long-term interest rates should be higher than short-term interest rates due to liquidity preferences of lenders and borrowers – Lenders’ and investors’ side: Prefer to lend short-term rather than long-term because of greater liquidity of short-term debt. May get locked in to long-term debt agreements during periods of rising interest rates, suffering losses as their cost of funds rises but their loan portfolios continue to provide relatively low rates of return. Short-term debt is subject to less fluctuation in principal value as interest rates fluctuate. Thus, long-term debt is riskier than short-term debt. Suppliers of long-term debt demand higher interest rates on long-term debt than on short-term debt. Additional interest charged on long-term debt is a premium for lack of liquidity.
Short-term versus Long-term Financing Term Structure of Interest Rates – Liquidity preference theory (continued) – Borrowers’ side: Prefer to avoid renewal and interest-rate risk and therefore prefer to borrow long-term rather than short-term. Willing to pay higher interest rates for long-term debt than for short-term debt. – Interaction of borrowers’ and lenders’ liquidity preferences normally results in an upward-sloping yield curve. – But the yield curve is not always positive! There must be forces other than liquidity preference at work.
Short-term versus Long-term Financing Term Structure of Interest Rates – Expectations hypothesis: capital market competition forces long-term rates to be equal to average annual compound rate of return that participants expect to earn on short-term debt over life of long-term issue – Ex. Yield to maturity on ten-year bond should be equal to yield investors expect to earn by continually investing and reinvesting in one-year bonds over each of next ten years Positive yield curve: current long-term (ten-year) rate would be higher than current short-term (one-year) rate – If investors expect future one-year interest rates to rise (during periods of low interest rates), they would expect to reinvest in one- year bonds at higher and higher rates over next ten years.
Short-term versus Long-term Financing Term Structure of Interest Rates – Expectations hypothesis (continued) – Ex. (continued) Negative yield curve: current long-term rates would be lower than short-term rates – If investors expect to see future one-year rates decline (during periods of high interest rates), they would expect to reinvest in one- year bonds at lower and lower interest rates over next ten years. – They would except long-term rates to decline in future and anxious to lock in current high rates available on long-term bonds. If investors expect stable future interest rates, then yield curve will be flat. If investors expect to see future interest rates rising and then falling (or falling and then rising), then yield curve will have one or more “humps.”
Short-term and Long-term Financing Term Structure of Interest Rates – Market-segmentation theory (or institutional or hedging-pressure theory): various market participants have distinct maturity preferences Interest rates are determined by the supply and demand for money in each market segment, where a market segment is defined by debt maturities Yield curve may assume any shape, depending on supply and demand conditions
Short-term and Long-term Financing Term Structure of Interest Rates – Market-segmentation theory (continued) Pension funds and insurance companies prefer to invest in long-term securities. Federal government, through Federal Reserve, may seek to purchase long-term bonds to put downward pressure on long-term interest rates. Commercial banks prefer to invest in short-term loans Borrowers have distinct maturity preferences according to needs they are attempting to finance.
Short-term and Long-term Financing Term Structure of Interest Rates – The term structure of interest rates is affected by liquidity preferences, future expectations, and supply and demand conditions. – The shape of the yield curve is the result of the interaction of all three forces, any one of which may be primary at any given time.
Relative Magnitude of Working Capital Investment Aggressive working capital policy: firm maintains relatively low levels of current assets and relatively high levels of current liabilities – Attempts to minimize cash balances, maximize inventory turnover, and minimize level of investment in accounts receivable – Net effect: minimizes firm’s overall investment in investment in working capital
Relative Magnitude of Working Capital Investment Aggressive working capital policy has implications for sales and profitability: – By minimizing investment in net working capital: Sales may be lost – To customers who find competitor's credit terms more agreeable – Because aggressive firm is more selective in granting credit than its competitors – Because desired items are out of stock due to high level of inventory turnover Extensive use of trade credit may result in missed discounts (discounts from face amount of invoice are commonly allowed for prompt payment) Extensive use of short-term credit may result in incurring relatively high interest costs – Also subjects firm to renewal and interest rate risks
Relative Magnitude of Working Capital Investment Cost of aggressive working capital policy has two major benefits: 1.Firm’s investment in current assets is minimized If net income levels can be maintained, return on assets can be increased through reduction in firm’s total asset base 2.Overall financing costs are reduced: 1.Lower level of assets requires less financing to begin with 2.Cost of short-term debt may be lower than long-term debt (when yield curve is positive)
Relative Magnitude of Working Capital Investment Conservative working capital policy: firm is less aggressive in minimizing current assets and employing short-term debt Ex. Kyle Manufacturing Company follows conservative policy – Total assets: $2,700,000 – Sales: $5,000,000 – Net income (after-tax): $425,000 – ROA: 15.7% ($425,000/$2,700,000) – Return on sales: 8.5% ($425,000/$5,000,000) – Tom Kyle is considering shifting to more aggressive policy. Total assets: $2,200,000 Sales: $4,500,000 Net income (after-tax): $391,500 (8.7% x $4,500,000) ROA: 17.8% Savings in interest expenses to increase return on sales: 8.7% If assets freed up by shift can be employed elsewhere at comparable ROAR, increase in ROA argues for change to more aggressive policy. However…
Relative Magnitude of Working Capital Investment There are uncertainties and questions to be considered in switching policies: 1.How accurate are revised sales, earnings, and asset estimates? 2.What is the probable impact of the shift to more short-term financing on the riskiness of the firm? 3.What is the likely impact of this shift on the long term growth and profitability of the company? 4.Can the assets freed up by this change be employed elsewhere at a comparable ROA? Analytical techniques and “what if” exercises can turn expectations and speculations into dollars and percentages, but answers to these questions are ultimately a matter of judgment.
Inventory Control Policy Each item in inventory normally is assigned: – High limit: maximum quantity that should be held – Low limit: minimum quantity that should be held – Reorder point: quantity at which a replenishment order should be placed – Reorder quantity: quantity that should be ordered when reorder point is reached Economic order quantity model (EOQ): determines optimal average inventory level that should be carried and the optimal quantity that should be ordered each time an order is placed
Credit Policy Credit policy: requires establishment of major policy variables within which accounts receivable will be managed – Variables include: Deciding to whom credit should be extended Length of time to be allowed for payment of invoices Whether discounts will be offered for prompt payment
Credit Policy Aspects of accounts receivable management: 1.Firm must establish terms under which credit will be granted and to whom credit will be offered. Requires an analysis of potential impact of credit policy terms on sales and profits. 2.Firm must consider relationship of accounts receivable to short-term liability structure. Possible to use accounts receivable as collateral for short- term loans. Factoring: possible to sell accounts receivable at discount to commercial bank or commercial factor – No need to make additional credit policy decisions because once policy of factoring is established, factor dictates credit terms.
Accounts Payable Payment Policy Suppliers commonly offer discounts on accounts payable to prompt payment by customers. Ex. “2/10, net 60”: 2% discount off face amount of invoice is allowed if payment is made within 10 days of receipt of invoice. If discount is not taken, then total amount is due within 60 days.
Accounts Payable Payment Policy Two concerns in establishing payment policy: 1.Cost and availability of money 2.Impact of policy on firm’s credit rating
Accounts Payable Payment Policy 1.Cost and availability of money 1.Cost of missing discount can be translated easily into approximate annual percentage rate of interest – Ex. (see previous slide) Discount terms allows 2% reduction in amount payable if payment is made within 10 days, but require full amount to be paid if payment is not made until 60 days have passed. Missing discount results in 50-day loan from supplier to purchaser. Cost of loan is 2% per period for 7.3 periods per year (365 days/50 days) Approximate annual percentage rate, or imputed interest rate on missed discounts, is approximately 14.6% (2% x 7.3 period, ignoring compounding) If firm’s cost of money is less than 14.6%, then discount terms are financially attractive.
Accounts Payable Payment Policy 1.Cost and availability of money (continued) 2.Availability If cash flow or credit capacity is strained, it may not be possible to take advantage of discounts even if terms are financially attractive. If firm is unable to obtain funds necessary to take discounts, cost of money is infinite (money is unavailable at any cost). If funds can be obtained only at relatively high cost, discount terms are unattractive.
Accounts Payable Payment Policy 1.Cost and availability of money (continued) – The shorter the lending period, the higher the cost of missed discounts. Ex. “2/10, net 30”: terms increase cost of missed discounts to 36.5% per year (2% times 365/20) – High short-term financing costs dictate that, once discount is missed, payment should be delayed until latest allowable payment date. – General rule: Firm should not make an early payment after discount is missed or if no discount is allowed.
Accounts Payable Payment Policy 2.Impact of policy on firm’s credit rating – Some firms pay their payables promptly and take discounts even though discounts are not particularly attractive strictly on cost basis because record of prompt payments may enhance credit reputation of firm. – Though not necessarily economically rational at the moment, maintenance of good credit rating improves firm’s future access to and cost of external financing.