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4 The Management of Working Capital Chapter Terry Fegarty

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1 4 The Management of Working Capital Chapter Terry Fegarty
Slides Developed by: Terry Fegarty Seneca College

2 Chapter 4 – Outline (1) Working Capital Basics
Working Capital and the Current Accounts Working Capital and Funding Requirements Objective of Working Capital Management Working Capital Trade-offs Operations—The Cash Conversion Cycle The Operating Cycle and the Cash Conversion Cycle © 2006 by Nelson, a division of Thomson Canada Limited

3 Chapter 4 – Outline (2) Permanent and Temporary Working Capital
Maturity Matching Principle Financing Net working Capital Short-Term vs. Long-Term Financing Working Capital Policy © 2006 by Nelson, a division of Thomson Canada Limited

4 Chapter 4 – Outline (3) Cash Management Objectives of Cash Management
Marketable Securities Yield on a Discounted Money Market Security Components of Float Cheque Disbursement and the Cheque Clearing process Accelerating Cash Receipts Electronic Funds Transfer Managing Cash Outflow Evaluating Cash Management Services © 2006 by Nelson, a division of Thomson Canada Limited

5 Chapter 4 – Outline (4) Managing Accounts Receivable
Tradeoffs in Managing Accounts Receivable Credit Policy Terms of Sale Collections policy © 2006 by Nelson, a division of Thomson Canada Limited

6 Chapter 4 – Outline (5) Inventory Management
Benefits and Costs of Carrying Adequate Inventory Inventory Ordering Costs Inventory Control and Management Economic Order Quantity Model Safety Stocks, Reorder Points and Lead Times Inventory on Hand Including Safety Stock Tracking Inventories—The ABC System Just In Time (JIT) Inventory System © 2006 by Nelson, a division of Thomson Canada Limited

7 Working Capital Basics
Assets/liabilities required to operate business on day-to-day basis Cash Accounts Receivable Inventory Accounts Payable Accruals Short-term in nature—turn over regularly © 2006 by Nelson, a division of Thomson Canada Limited

8 Working Capital and the Current Accounts
Gross working capital = Current assets Gross Working Capital (GWC) represents investment in current assets (Net) working capital = Current assets – Current liabilities © 2006 by Nelson, a division of Thomson Canada Limited

9 Working Capital and Funding Requirements
Working Capital Requires Funds Maintaining working capital balance requires permanent commitment of funds Example: Firm will always have minimum level of Inventory, Accounts Receivable, and Cash—this requires funding © 2006 by Nelson, a division of Thomson Canada Limited

10 Working Capital and Funding Requirements
Spontaneous Financing Firm will also always have minimum level of Accounts Payable—in effect, money you have borrowed Accounts Payable (and Accruals) are generated spontaneously Arise automatically with inventory and expenses Offset the funding required to support current assets © 2006 by Nelson, a division of Thomson Canada Limited

11 Working Capital and Funding Requirements
Net working capital is Gross Working Capital – Current Liabilities (including spontaneous financing) Reflects net amount of funds needed to support routine operations © 2006 by Nelson, a division of Thomson Canada Limited

12 Objective of Working Capital Management
To run firm efficiently with as little money as possible tied up in Working Capital Involves trade-offs between easier operation and cost of carrying short-term assets Benefit of low working capital Money otherwise tied up in current assets can be invested in activities that generate higher payoff Reduces need for costly financing Cost of low working capital Risk of shortages in cash, inventory © 2006 by Nelson, a division of Thomson Canada Limited

13 Working Capital Trade-offs
Inventory High Levels Low Levels Benefit: Happy customers Few production delays (always have needed parts on hand) Cost: Expensive High storage costs Risk of obsolescence Shortages Dissatisfied customers Low storage costs Less risk of obsolescence Cash Reduces risk Increases financing costs Reduces financing costs Increases risk © 2006 by Nelson, a division of Thomson Canada Limited

14 Working Capital Trade-offs
Accounts Receivable High Levels (favourable credit terms) Low Levels (unfavourable terms) Benefit: Happy customers High sales Cost: Expensive High collection costs Increases financing costs Dissatisfied customers Lower Sales Less expensive Accounts Payable and Accruals High Levels Low Levels Reduces need for external finance--using a spontaneous financing source Unhappy suppliers Happy suppliers/employees Not using a spontaneous financing source © 2006 by Nelson, a division of Thomson Canada Limited

15 Working Capital Trade-offs
Current Assets High Level Low Level Profitability Lower Higher Risk Lower Higher © 2006 by Nelson, a division of Thomson Canada Limited

16 Operations—The Cash Conversion Cycle
Firm begins with cash which then “becomes” inventory and labour Which then becomes product for sale Eventually this will turn into cash again Firm’s operating cycle is time from acquisition of inventory until cash is collected from product sales © 2006 by Nelson, a division of Thomson Canada Limited

17 Figure 4.1: The Cash Conversion Cycle
Product is converted into cash, which is transformed into more product, creating the cash conversion cycle. © 2006 by Nelson, a division of Thomson Canada Limited

18 Figure 4.2: Time Line Representation of the Cash Conversion Cycle
© 2006 by Nelson, a division of Thomson Canada Limited

19 The Operating Cycle and the Cash Conversion Cycle
Inventory conversion period plus: Receivable collection period equals: Operating cycle minus: Payables deferral period equals: Cash conversion cycle Shortening cash conversion cycle frees up cash to reinvest in business or to reduce debt and interest © 2006 by Nelson, a division of Thomson Canada Limited

20 Cash Conversion Cycle Analysis
Inventory Conversion Period = 365 Inventory Turnover Receivables Collection Period = Accounts Receivable × 365 Annual Credit Sales Payables Deferral Period = Accounts Payable × 365 Cost of Goods Sold © 2006 by Nelson, a division of Thomson Canada Limited

21 Cash Conversion Cycle Sell Inventory Purchase on Credit Inventory
Collect Receivables Pay for Inventory Operating Cycle Inventory Conversion Period Receivables Collection Period Payables Deferral Period Cash Conversion Cycle © 2006 by Nelson, a division of Thomson Canada Limited

22 Figure 4.3: Working Capital Needs of Different Firms
© 2006 by Nelson, a division of Thomson Canada Limited

23 Permanent and Temporary Working Capital
Working capital is permanent to the extent that it supports constant or minimum level of sales Temporary working capital supports seasonal peaks in business © 2006 by Nelson, a division of Thomson Canada Limited

24 Maturity Matching Principle
Maturity (due date) of financing should roughly match duration (life) of asset being financed Then financing /asset combination becomes self-liquidating Cash inflows from asset can be used to pay off loan © 2006 by Nelson, a division of Thomson Canada Limited

25 Financing Net Working Capital
According to maturity matching principle Temporary (seasonal) should be financed with short-term borrowing Permanent working capital should be financed with long-term sources, such as long-term debt and/or equity In practice, firms may use more or less short-term funds to finance working capital © 2006 by Nelson, a division of Thomson Canada Limited

26 Figure 4.4(a): Working Capital Financing Policies
© 2006 by Nelson, a division of Thomson Canada Limited

27 Figure 4.4(b): Working Capital Financing Policies
© 2006 by Nelson, a division of Thomson Canada Limited

28 Short-Term vs. Long-Term Financing
The mix of short- or long-term working capital financing is a matter of policy Use of long-term funds is a conservative policy Use of short-term funds is an aggressive policy © 2006 by Nelson, a division of Thomson Canada Limited

29 Short-Term vs. Long-Term Financing
Short-term financing Cheap but risky Cheap—short-term rates generally lower than long-term rates Risky—because you are continually entering marketplace to borrow Borrower will face changing conditions (ex; higher interest rates and tight money) © 2006 by Nelson, a division of Thomson Canada Limited

30 Short-Term vs. Long-Term Financing
Safe but expensive Safe—you can secure the required capital Expensive—long-term rates generally higher than short-term rates © 2006 by Nelson, a division of Thomson Canada Limited

31 Working Capital Policy
Firm must set policy on following issues: How much working capital is used Extent to which working capital is supported by short- vs. long-term financing How each component of working capital is managed The nature/source of any short-term financing used © 2006 by Nelson, a division of Thomson Canada Limited

32 Cash Management Cash management—determining:
Optimal size of firm’s liquid asset balance Appropriate types and amounts of short-term investments Most efficient methods of controlling collection and disbursement of cash © 2006 by Nelson, a division of Thomson Canada Limited

33 Cash Management Why have cash on hand?
Transactions demand: need money to pay bills (employees, suppliers, utility/phone, etc.) Precautionary demand: to handle emergencies (unforeseen expenses) Speculative demand: to take advantage of unexpected opportunities (purchase of raw materials that are on sale) © 2006 by Nelson, a division of Thomson Canada Limited

34 Objectives of Cash Management
Cash doesn’t earn a return Want to maintain liquidity Take cash discounts Maintain firm’s credit rating Minimize interest costs Avoid insolvency Good cash management implies maintaining adequate liquidity with minimum cash in bank Can place portion of cash balance into marketable securities (AKA: near cash or cash equivalents) © 2006 by Nelson, a division of Thomson Canada Limited

35 Marketable Securities
Liquid investments that can be held instead of cash and earn a modest return Examples include Treasury bills, commercial paper, bankers’ acceptances Many are bought and sold at a discount in money market © 2006 by Nelson, a division of Thomson Canada Limited

36 Examples of Marketable Securities
Treasury Bills Short-term government notes issued at a discount with principal repaid at maturity Commercial Paper Short-term unsecured promissory notes issued by corporations with good credit Bankers’ Acceptances Short-term promissory notes issued by a firm and accepted (or guaranteed) by a bank © 2006 by Nelson, a division of Thomson Canada Limited

37 Yield on a Discounted Money Market Security
Annualized yield 100 – P 365 P d where P = Discounted price as a percentage of maturity value d = Number of days to maturity r = Annualized yield r = × © 2006 by Nelson, a division of Thomson Canada Limited

38 Components of Float Mail Float
delay between when cheque is sent to a payee and is received by payee Processing Float time between receipt of payment by a payee and the deposit of the payment in the payee’s account Clearing Float time between depositing a cheque and having available spendable funds © 2006 by Nelson, a division of Thomson Canada Limited

39 Cheque Disbursement and the Cheque Clearing Process
When you pay a bill, You write cheque and mail to payee (2-3 days of mail float) Payee receives cheque and performs internal processing (1 day of processing float) Payee deposits cheque in its own bank (1 day of processing float) Payee’s bank sends cheque into interbank clearing system which processes cheque (2 days of clearing float) © 2006 by Nelson, a division of Thomson Canada Limited

40 Figure 4.5: The Cheque-Clearing Process
© 2006 by Nelson, a division of Thomson Canada Limited

41 Accelerating Cash Receipts
Lock-box systems Post office box(es) located near customers in order to shorten mail and processing float Local bank empties the box, deposits payments into firm’s account, and reports payments to firm May involve significant fees More cost-effective if small number of larger deposits © 2006 by Nelson, a division of Thomson Canada Limited

42 Figure 4.6: A Lock Box System in the Cheque-Clearing Process
© 2006 by Nelson, a division of Thomson Canada Limited

43 Accelerating Cash Receipts
Concentration Banking Customers send cheques sent to firm’s local collection centres, where they are deposited Local deposits are transferred electronically into one central concentration account Reduces mail float Funds available for paying loans or investing in marketable securities © 2006 by Nelson, a division of Thomson Canada Limited

44 Electronic Funds Transfer
Electronic funds transfer mechanisms are reducing the importance of float management techniques for many companies © 2006 by Nelson, a division of Thomson Canada Limited

45 Electronic Funds Transfer
Wire Transfers Transferring money electronically Preauthorized Cheques Customer gives payee signed cheque-like documents in advance When payee ships product, it deposits preauthorized cheque in its bank account Eliminates mail float Payee must trust payer © 2006 by Nelson, a division of Thomson Canada Limited

46 Managing Cash Outflow Zero balance accounts (ZBAs) Remote disbursing
Decentralization of cash payments can lead to large number of cash balances around the country Divisions write cheques on ZBAs—funded from central account only when cheques are cleared Solves problem of idle cash in decentralized bank accounts Remote disbursing Using bank in remote location for disbursement chequing account Increases mail float © 2006 by Nelson, a division of Thomson Canada Limited

47 Evaluating Cash Management Services
Evaluation involves comparison of costs versus benefits of faster collection © 2006 by Nelson, a division of Thomson Canada Limited

48 Example 4.1: Evaluating Cash Management Services
Q: Kelso Systems Inc. has customers in British Columbia that remit about 500 cheques a year. The average cheque is for $10,000. West coast cheques currently take an average of eight days from the time they are mailed to clear into Kelso’s east coast account. A British Columbia bank has offered Kelso a lock box system for $1,000 a year plus $0.20 per cheque. The system can be expected to reduce the clearing time to six days. Is the bank’s proposal a good deal for Kelso if it borrows at 8%? Example © 2006 by Nelson, a division of Thomson Canada Limited

49 Example 4.1: Evaluating Cash Management Services
A: The cheques represent revenue of: 500 × $10,000 = $5,000,000 per year. The average amount tied up in the cheque clearing process is: 8/365 x $5,000,000 = $109,589. The proposed lockbox system will reduce this to: 6/365 x $5,000,000 = $82,192, thus freeing up $27,397 of cash. Kelso will be able to borrow $27,397 less, thus saving: $27,397 x 0.08 = $2,192 in interest The system is expected to cost: $1,000 + ($0.20 x 500) = $1,100. The net saving is: $2,192 - $1,100 = $1,092 The bank’s proposal should be accepted Example © 2006 by Nelson, a division of Thomson Canada Limited

50 Managing Accounts Receivable
Generally firms like as little money as possible tied up in receivables Reduces costs (firm has to borrow to support the receivable level) Minimizes bad debt exposure But, having good relationships with customers is important Increases sales Firm needs to strike a balance on these issues © 2006 by Nelson, a division of Thomson Canada Limited

51 Trade-offs in Receivable Management
Trade-offs in Managing Accounts Receivable Trade-offs in Receivable Management Liberal Management More sales and gross margin, but More bad debts Higher collection costs More discount expenses Higher receivables Longer collections More interest expense Strict Management Less sales and gross margin, but Less bad debts Lower collection costs Less discount expenses Lower receivables Shorter collections Less interest expense © 2006 by Nelson, a division of Thomson Canada Limited

52 Managing Accounts Receivable
Policy Decisions Influencing Accounts Receivable Credit Policy Criteria used to screen credit applications Controls quality of accounts to which credit is extended Terms of Sale Terms and conditions under which credit extended must be repaid Collections Policy Methods employed to collect payment on past due accounts © 2006 by Nelson, a division of Thomson Canada Limited

53 Credit Policy Must examine creditworthiness of potential credit customers Credit report Customer’s financial statements Bank references Customer’s reputation among other vendors Conflicts often arise between sales and credit departments Sales department’s job to generate sales Credit department may refuse credit to high risk accounts © 2006 by Nelson, a division of Thomson Canada Limited

54 Terms of Sale Credit sales are made according to specified terms of sale Example: 2/10, net 30 means customer receives 2% discount if payment is made within 10 days, otherwise entire amount is due by 30 days Customers pay quickly to save money Firm’s terms of sale generally follow industry practice © 2006 by Nelson, a division of Thomson Canada Limited

55 Collections Policy Firm’s collection policy—manner and aggressiveness with which firm pursues payment from delinquent customers Being overly aggressive can damage customer relations Function of collections department— to follow up on overdue receivables (called dunning) Mail polite letter Follow up with additional dunning letters Phone calls Collection agency Lawsuit © 2006 by Nelson, a division of Thomson Canada Limited

56 Inventory Management Inventory management— establishes a balance between carrying enough inventory to meet sales or production requirements while minimizing inventory costs Inventory usually managed by manufacturing or operations However, finance department has an oversight responsibility Monitor level of lost or obsolete inventory Supervise periodic physical inventories © 2006 by Nelson, a division of Thomson Canada Limited

57 Benefits and Costs of Carrying Adequate Inventory
Reduces stockouts and backorders Makes operations run more smoothly, improves customer relations and increases sales Carrying Costs Interest on funds used to acquire inventory Storage and security Insurance Taxes Shrinkage Spoilage Breakage Obsolescence © 2006 by Nelson, a division of Thomson Canada Limited

58 Inventory Ordering Costs
Expenses of placing orders with suppliers, receiving shipments, and processing materials into inventory Excludes vendor charges Relate to the number of orders placed rather than to the amount of inventory held Tend to vary inversely with carrying costs © 2006 by Nelson, a division of Thomson Canada Limited

59 Economic Order Quantity (EOQ) Model
EOQ model recognizes trade-offs between carrying costs and ordering costs Carrying costs increase with amount of inventory held ( from larger orders) Ordering costs increase with the number of orders placed (from more orders) EOQ minimizes total of sum of ordering and carrying costs © 2006 by Nelson, a division of Thomson Canada Limited

60 Inventory Costs and the EOQ
Total Cost Carrying Cost Ordering Cost EOQ Q (Order Size) © 2006 by Nelson, a division of Thomson Canada Limited

61 Economic Order Quantity (EOQ) Model
EOQ model is: where Q= order size in units D= annual quantity used in units F= cost of placing one order C= annual cost of carrying one unit in stock ½ denotes square root © 2006 by Nelson, a division of Thomson Canada Limited

62 Figure 4.7: Inventory on Hand for a Steadily Used Item
© 2006 by Nelson, a division of Thomson Canada Limited

63 Economic Order Quantity (EOQ) Model
Other Inventory Formulas Average Inventory = Total Carrying Cost: = Number of Orders = Total Ordering Cost = FN = Total Ordering and Carrying Cost = © 2006 by Nelson, a division of Thomson Canada Limited

64 Example 4.3: Economic Order Quantity
Q: The Galbraith Corp. buys a part that costs $5. The carrying cost of inventory is approximately 20% of the part’s dollar value per year. It costs $50 to place, process and receive an order. The firm uses 900 of the $5 parts per year. What ordering quantity minimizes inventory costs? How many orders will be placed each year if that order quantity is used? What inventory costs are incurred for the part with this ordering quantity? © 2006 by Nelson, a division of Thomson Canada Limited

65 Example 4.3: Economic Order Quantity
A: Annual carrying cost per unit is 20% x $5 = $1 EOQ = 300 units The annual number of reorders is 900 300 = 3 Ordering costs are $50 x 3 = $150 per year Average inventory is 300  2 = 150 units Carrying costs are 150 x $1 = $150 a year Total inventory cost of the part is $300 Example © 2006 by Nelson, a division of Thomson Canada Limited

66 Safety Stocks, Reorder Points and Lead Times
Safety stock provides insurance against unexpectedly rapid use or delayed delivery Additional supply of inventory that is carried at all times to be used when normal working stocks run out Rarely advisable to carry so much safety stock that stockouts never happen Carrying costs would be excessive © 2006 by Nelson, a division of Thomson Canada Limited

67 Safety Stocks, Reorder Points and Lead Times
Ordering lead time—advance notice needed so that an order placed will arrive when required Usually estimated by item’s supplier Reorder point—level of inventory at which order is placed © 2006 by Nelson, a division of Thomson Canada Limited

68 Figure 4.9: Inventory on Hand Including Safety Stock
© 2006 by Nelson, a division of Thomson Canada Limited

69 Economic Order Quantity (EOQ) Model
Other Inventory Formulas (with Safety Stock) Average Inventory = Total Carrying Cost: = Total Ordering and Carrying Cost = © 2006 by Nelson, a division of Thomson Canada Limited

70 Tracking Inventories—The ABC System
Some inventory items (A items) require great deal of attention Very expensive Critical to firm’s processes or to those of customers Some inventory items do not require great deal of attention (C items) Commonplace, easy to obtain B items fall between items A & C ABC system segregates items by value and places tighter control on higher cost (value) pieces © 2006 by Nelson, a division of Thomson Canada Limited

71 Just In Time (JIT) Inventory System
Inventory supplied At exactly the right time In exactly the right quantities Theoretically eliminates the need for factory inventory Shortens operating cycle Reduces costs Eliminate wasteful procedures But: late delivery can stop factory’s entire production line Works best with large manufacturers who are powerful with respect to supplier Supplier is willing to do almost anything to keep the manufacturer’s business © 2006 by Nelson, a division of Thomson Canada Limited


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