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2. WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING
CHAPTER 17
WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING

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CHAPTER 17 OUTLINE
The Cash Conversion Cycle
Alternative Net Operating Working Capital Policies
Alternative Short-Term Financing Policies
The Cash Budget
Short-Term Financing
Accruals and Accounts Payable (Trade Credit)
Short-Term Bank Loans
Calculating Financing Costs
Secured Short-Term Financing
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Basic Definitions
(Gross) working capital: Total current assets
Net working capital:
Current assets – Current liabilities
Net operating working capital (NOWC):
Operating CA – Operating CL =
(Cash + A/R + Inv.) – (A/P + Accruals)
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Definitions (cont’d)
Working capital management:
Establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable
Working capital policy:
The level of each current asset
How current assets are financed
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7. RAW MATERIALS INVENTORY FINISHED GOODS INVENTORY
Working Capital
A simple cycle of operations:
CASH
RECEIVABLES
RAW MATERIALS INVENTORY
FINISHED GOODS INVENTORY
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8. The Cash Conversion Cycle
The cash conversion cycle focuses on the time between payments made for materials and labour and payments received from sales:
Cash
Conversion =
Cycle
Inventory
Conversion +
Period
Receivables
Collection –
Payables
Deferral
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10. Inventory Conversion Period (ICP)
Measures the average time required to process materials into finished goods and then to sell them
Can be calculated as ICP = Inventory / Sales per day
Alternatively, ICP = 365 / Inventory Turnover
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11. Receivables Collection Period
Measures the average length of time required to collect cash following a sale
Also called the days sales outstanding (DSO)
Can be calculated as
Receivables
Collection
Period
Receivables
Sales / 365
= DSO =
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12. Payables Deferral Period (PDP)
Measures the average length of time between the purchase of materials and labour and the payment of cash for them
Can be calculated as PDP = Payables / Purchases per day
Alternatively,
PDP =
Payables
Cost of goods sold / 365
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13. Cash Conversion Cycle (CCC)
The cycle starts with cash paid out for productive resources till cash is received from the sale of products.
It represents the average length of time a dollar is tied up.
It measures management effectiveness.
The shorter, the better.
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Shortening CCC
CCC = ICP + DSO – PDP
Processing and selling goods more quickly
Speeding up A/R collections
Slowing down A/P payments
Any combination of the above
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16. Alternative Net Operating Working Capital Policies
Relaxed:
Current assets maximized while A/P and accruals minimized
Restricted:
Current assets minimized while A/P and accruals maximized; NOWC turned over more frequently
Moderate:
Between the two extremes
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17. Alternative Short-Term Financing Policies
Maturity matching (or “self-liquidating”): Match the maturity of the assets with the maturity of the financing
Aggressive: Use short-term financing to finance permanent assets
Conservative: Use permanent capital for permanent assets and temporary assets
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18. Maturity-Matching vs. Aggressive Financing Policy
Years $
Perm NOWC
Fixed Assets
Temp. NOWC
Lower dashed line, more aggressive. }
S-T
Loans
L-T Fin:
Stock &
Bonds,
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19. Conservative Financing Policy
Fixed Assets
Years $
Perm NOWC
L-T Fin:
Stock &
Bonds
Marketable Securities
Zero S-T
debt
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The Cash Budget
Purpose: Uses forecasts of cash flows to predict loan needs and funds available for temporary investment
Timing: Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management.
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21. Data Required for Cash Budget
Sales forecast
Information on collections delay
Forecast of purchases and payment terms
Forecast of cash expenses: wages, taxes, utilities, and so on
Initial cash on hand
Target cash balance
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22. Microdrive Inc.: Cash Budget (I)
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23. Microdrive Inc.: Cash Budget (II)
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24. Microdrive Inc.: Cash Budget (III)
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25. Cash Budget Issue: Depreciation
Only cash payments and receipts appear on cash budget.
As depreciation is a noncash charge, it is not explicitly included in cash budget.
However, depreciation does affect taxes, which do appear in the cash budget.
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Cash Budget Issue: Other Potential Cash Inflows in Addition to Collections
Proceeds from fixed asset sales
Proceeds from stock and bond sales
Interest earned
Court settlements
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27. Cash Budget Issue: Interest Earned or Paid
Interest earned: Add line in the collections section
Interest paid: Add line in the payments section
Found as interest rate x surplus/loan line of cash budget for preceding month.
Note: Interest on any other debt would need to be incorporated as well.
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28. Cash Budget Issue: Bad Debts
Collections would be reduced by the amount of bad debt losses.
For example, if the firm had 3% bad debt losses, collections would total only 97% of sales.
Lower collections would lead to lower surpluses and higher borrowing requirements.
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29. Microdrive Inc.: Cash Balance
Cash budget indicates the company is going to incur net cash loss in the first three months but to have net cash gain in the latter three months
To maintain a monthly target cash balance of $10 million, MicroDrive will have to borrow in the first three months, and the total loan requirement is expected to peak at the end of September.
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30. Microdrive Inc.: Cash Balance (cont’d)
As sales increase steadily in the first few months and peak in September, increased payments for purchases, wages, and other items will exceed receipts from sales, leading to net cash outflow in the first few months.
In the latter 3 months, sales, purchases, and payments for past purchases will fall sharply, while collections will increase following strong sales in the previous months, resulting in net cash gain.
The cash surplus can be used to pay off the loans taken out in the first few months.
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31. Cash Budgeting Applications
Estimating short-term borrowing needs
Assessing minimum cash balance requirements
Planning for business expansion
Don’t confuse a cash budget with an income statement or free cash flows.
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32. Advantages and Disadvantages of Short-Term Debt
Can be obtained much faster than long-term credit
May not be appropriate for seasonal or cyclical needs for funds
Normally carry lower interest rates
Disadvantages:
Interest rates fluctuate widely over time
May not be renewed due to tight credit condition
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Short-Term Financing
Spontaneous financing
Short-term bank loans
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34. Accruals and Accounts Payable (Trade Credit): Spontaneous Financing
Arise automatically, or spontaneously, from a firm’s operations
Two types:
Accruals
Accounts payable (trade credit)
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Cost of Trade Credit
Trade credit is not free!
| | |
pay $ pay $100
|--get to use $98 for 20 days at $2-|
2 / , net 30
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36. Cost of Not Taking Discounts
Nominal annual cost of trade credit =
Effective annual rate =
( %) 365/20 – 1 = 44.6%
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Short-Term Bank Loans
Loan application
Interest rates
Maturity
Collateral
Covenants
Line of credit
Commercial paper
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Loan Application
Historical financials
Pro forma financials
Income and EBITDA
Types of assets
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Interest Rates
Prime rate is the lowest interest rate that a bank lends money at.
Prime rate can swing very quickly in either direction.
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Collateral
The short-term loan is secured by a specific collateral item (asset).
The item is registered under the Personal Property Security Act (PPSA).
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Covenants
Designed to protect the lender
Specific terms written into the loans
Examples of covenants:
Better current ratio
Minimum interest payment coverage
Minimum cash balance
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Line of Credit
One-year operating loan
Interest rate floats based on prime.
Interest is only paid when funds are borrowed.
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Commercial Paper (CP)
Short-term unsecured promissory notes issued by large, strong companies
CP trades in the market at rates just above the T-bill rate.
CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes.
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44. Bankers’ Acceptances (BAS)
Commonly used to finance goods with long payment terms – typically exports and imports
A term draft written by the purchasing firm/importer and “accepted” by a major bank
The bank is the ultimate guarantor for payment.
BAs are bought and sold on the market before being redeemed from the firm or the bank.
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45. Calculating Financing Costs
Regular, or simple, interest
Interest-only loan
Simple vs. effective interest rate
Discount interest
Effects of compensating balances
Installment loans: Add-on interest
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46. Secured Short-Term Financing
Accounts receivable financing
Inventory financing
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47. Accounts Receivable Financing
Pledging A/R
A/R used as security for a loan
Lender not only has a claim against A/R but also has recourse to the borrower
Factoring or Selling A/R
Lender/buyer has no recourse to the borrower/seller
Providing not only money but also a credit department for the borrower
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Inventory Financing
Blanket liens
Trust receipts
Warehouse receipt
Acceptable products
Costs of financing
Evaluation of inventory financing
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