1. copyright © 2003 McGraw Hill Ryerson Limited 19-1 prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology Fundamentals of Corporate Finance Second Canadian Edition

2. copyright © 2003 McGraw Hill Ryerson Limited 19-2 Chapter 19 Working Capital Management and Short-Term Plannings Chapter Outline  Working Capital  Links Between Long-Term and Short-Term Financing  Tracing Changes in Cash and Working Capital  Cash Budgeting  A Short-Term Financing Plan  Sources of Short-Term Financing  The Cost of Bank Loans

3. copyright © 2003 McGraw Hill Ryerson Limited 19-3 Working Capital The Components of Working Capital  Net Working Capital equals current assets minus current liabilities. It is often called working capital. Usually current assets exceed current liabilities so firms have positive net working capital.  Firms need working capital as part of their cycle of operations. Although the amount of working capital is fixed, the components of working capital constantly change with the cycle of operations.

4. copyright © 2003 McGraw Hill Ryerson Limited 19-4 Working Capital A Simple Cycle of Operations:  Firms go through a cycle in which cash is reduced to purchase inventory. CASH RAW MATERIALS INVENTORY FINISHED GOODS INVENTORY RECEIVABLES  Inventory is sold to become A/R.  Collection of A/R increases the firm’s cash holdings.

5. copyright © 2003 McGraw Hill Ryerson Limited 19-5 Working Capital The Cash Conversion Cycle  The cash conversion cycle is the amount of time between a firm’s payment for materials and its collection on its sales.  In other words, it measures how much time passes from the moment the firm lays out cash on its inventories until it gets that cash back through collection from its customers.

6. copyright © 2003 McGraw Hill Ryerson Limited 19-6 Working Capital The Cash Conversion Cycle  If a firm paid cash for its inventories, then the total time between the initial payment for the raw materials and collection from the customers would be the cash conversion period.  However, most firms purchase their inventories on account.  If the firm buys its materials on Accounts Payable, then the net time the firm is out of cash must be reduced by the time it takes the firm to pay its own bills.

7. copyright © 2003 McGraw Hill Ryerson Limited 19-7 Working Capital The Cash Conversion Cycle  If the firm starts the cycle by purchasing raw materials, but it does not pay for them immediately, the time between acquisition and payment is called the accounts payable period.  The number of days between the initial investment in inventory and its sale date is called the inventory period.  The number of days between the date of sale and the date at which the firm gets paid is called the accounts receivable period.

8. copyright © 2003 McGraw Hill Ryerson Limited 19-8 Working Capital The Cash Conversion Cycle  To summarize: Inventory Period + Receivables Period - Accounts Payable Period = Cash Conversion Cycle  Key Question: How is each of the periods measured?

9. copyright © 2003 McGraw Hill Ryerson Limited 19-9 Average Inventory Working Capital The Cash Conversion Cycle  In Chapter 17, you learned: Inventory Period = Annual Cost of Goods Sold/365 Average A/R Accounts Receivable Period = Annual Sales/365 Average Accounts Payable Accounts Payable Period = Annual Cost of Goods Sold/365

10. copyright © 2003 McGraw Hill Ryerson Limited 19-10 Working Capital The Working Capital Trade-Off  Working capital can be managed, meaning that the length of the cash conversion cycle can be altered.  Note that there are costs and benefits associated with the firm’s investment in working capital.  Carrying costs are the costs of maintaining current assets and includes the opportunity cost of capital.  Shortage costs are costs incurred from shortages in current assets.

11. copyright © 2003 McGraw Hill Ryerson Limited 19-11 Working Capital The Working Capital Trade-Off  An important job of the financial manager is to strike a balance between the costs and benefits of current assets. That is, to find the level of current assets which minimizes the sum of carrying costs and shortage costs.

12. copyright © 2003 McGraw Hill Ryerson Limited 19-12 Long-Term and Short-Term Financing Links between Long-Term and Short- Term Financing  Businesses must have assets in order to run efficiently.  The total cost of these assets is called the firm’s total capital requirement.  In a growing firm the amount of the total capital requirement will grow over the long-term, showing a steady up-trend.  The total capital requirement will also fluctuate over the short-term, particularly if the firm is in a seasonal business.

13. copyright © 2003 McGraw Hill Ryerson Limited 19-13 Long-Term and Short-Term Financing Links between Long-Term and Short- Term Financing  If you look at Figure 19.4 on page 578 of your text, you will see this concept depicted graphically: Note the straight upward trending line.  This represents a growing firm’s steadily increasing investment in assets over the long-term. Superimposed on this is a wavy solid line which shows the firm’s seasonal requirement for assets.

14. copyright © 2003 McGraw Hill Ryerson Limited 19-14 Long-Term and Short-Term Financing Links between Long-Term and Short- Term Financing  For example, if this were a retail firm, you would expect the maximum quantity of assets to be held at Christmas. The firm would be carrying its cash, inventories and accounts receivable at a seasonal high in December. Note that the dashed line for December 2001, shows where the firm’s total capital requirement is at its highest for the year. For the rest of the year, the firm’s need for capital varies around this seasonal maximum. Note also that this pattern is repeated in 2000 and 2002.

15. copyright © 2003 McGraw Hill Ryerson Limited 19-15 Long-Term and Short-Term Financing Strategies for Long-Term and Short-Term Financing  This leads to the question of how to finance the firm’s total capital requirement: Should all the long-lived assets be funded with long-term financing and all the seasonal assets be funded with short-term? Or should all the assets be funded with long-term financing? Or should all the assets be funded with short- term financing? Or, should some of the assets be funded long-term and some short-term?

16. copyright © 2003 McGraw Hill Ryerson Limited 19-16 Long-Term and Short-Term Financing Strategies for Long-Term and Short-Term Financing  Figure 19.5 on page 579 shows three possible strategies a financial manager could pursue: Panel (a) shows all the assets funded with long- term financing.  As a result, the firm is always sitting on excess capital.  That is, it has enough financing to cover all its asset needs, even at the seasonal high.  At other times of the year, the firm will have fewer assets and hence, a surplus of cash.

17. copyright © 2003 McGraw Hill Ryerson Limited 19-17 Long-Term and Short-Term Financing Strategies for Long-Term and Short- Term Financing Panel (c) shows the matching principal. Long-term assets are funded using long- term financing, while short-term assets are financed with short-term financing.  That is, the firm borrows short-term to meet its short-term seasonal requirements.  Its long-lived assets are funded using long- term financing.

18. copyright © 2003 McGraw Hill Ryerson Limited 19-18 Long-Term and Short-Term Financing Strategies for Long-Term and Short- Term Financing Panel (b) shows a policy in which some of the assets (both long and short-term) are financed with long-term funding. The remaining short-term assets are funded using short-term financing.  Thus the firm is a borrower only during those periods when its capital requirements are relatively high.

19. copyright © 2003 McGraw Hill Ryerson Limited 19-19 Long-Term and Short-Term Financing Strategies for Long-Term and Short-Term Financing  Which strategy is the best financing alternative?  It is hard to say. Panel (a) shows a conservative, very relaxed policy, in which the managers always have a comfortable cushion of cash. Panel (c) is a more aggressive, restrictive policy in which the firm’s financial managers must always be prepared to arrange short-term financing. Panel (b) is a middle of the road policy.

20. copyright © 2003 McGraw Hill Ryerson Limited 19-20 Cash and Working Capital Tracing Changes in Cash and Working Capital  If you look at Table 19.3 to 19.5 in your text, you will see the financial statements for Dynamic Mattress Company (DMC). Notice that DMC’s cash balance increased from $4 million to $5 million in 2001. What caused this increase? Did the extra cash come from:  Additional borrowing?  Reinvested earnings?  A reduction in inventories?  Extra credit from DMC’s suppliers?

21. copyright © 2003 McGraw Hill Ryerson Limited 19-21 Cash and Working Capital Tracing Changes in Cash and Working Capital  If you look at Table 19.5, you will see the firm’s sources and uses of its cash.  The correct answer to the question of where the additional cash came from is: All of the above!

22. copyright © 2003 McGraw Hill Ryerson Limited 19-22 Cash Budgeting Forecasting Sources and Uses of Cash  Forecasts of future sources and uses of cash serve two essential purposes: They alert the financial manager to future cash needs. They provide a standard, or budget, against which subsequent performance can be judged.  There are several methods of preparing a cash budget, but no matter what method is chosen, there are three common steps to preparing a cash budget.

23. copyright © 2003 McGraw Hill Ryerson Limited 19-23 Cash Budgeting Creating a Cash Budget 1. Forecast the sources of cash. The largest inflow comes from payments by the firm’s customers. 2. Forecast the uses of cash. 3. Calculate whether the firm is facing a cash shortage or surplus. The financial plan then sets out a strategy for investing a cash surplus or for financing a deficit.

24. copyright © 2003 McGraw Hill Ryerson Limited 19-24 Cash Budgeting Forecasting Sources of Cash  DMC’s cash inflows come from the sale of mattresses.  The managers have forecasted that quarterly sales for 2002 will be: Quarter1 st 2 nd 3 rd 4 th Sales ($ millions)87.578.5116131  Not all of these sales would be for cash: Assume 20% of each quarter’s sales are collected in the next quarter.

25. copyright © 2003 McGraw Hill Ryerson Limited 19-25 Cash Budgeting Forecasting Sources of Cash  DMC’s collections on its sales would be as follows: Quarter1 st 2 nd 3 rd 4 th Sales ($ millions)87.578.5116131 70.080% collected now: 17.5 62.8 20% in next period:15.715.0* * Sales collected from the 4 th quarter of the previous year. 23.2 92.8104.8

26. copyright © 2003 McGraw Hill Ryerson Limited 19-26 Cash Budgeting Forecasting Sources of Cash  We can combine this information with DMC’s receivables to calculate its period end A/R: 70.0 80% collected now: 17.5 62.8 20% in next period:15.715.023.2 92.8104.8 Quarter1 st 2 nd 3 rd 4 th 2. Sales ($ millions)87.578.5116131 32.51. A/R (start of period):30.730.038.2 30.74. A/R (end of period):*38.232.541.2 80.33. Total collections:108.585.0128.0 * 4 = 1 + 2 - 3 (Ending A/R = Beginning A/R + Sales – Collections)

27. copyright © 2003 McGraw Hill Ryerson Limited 19-27 Cash Budgeting Combining Sources and Uses of Cash  DMC’s receivables are its primary source of cash.  However, it is not the only one. If you look at Table 19.7 on page 583, you will see that DMC has other sources of cash. Assume that this other source of cash does not represent an issue of debt or equity.  We can now combine our information about DMC’s total sources of cash with its uses of cash to create the firm’s forecasted cash budget.

28. copyright © 2003 McGraw Hill Ryerson Limited 19-28 Cash Budgeting Combining Sources and Uses of Cash  If you look at the bottom line of Table 19.7, you will see that DMC has a net cash outflow in the first two quarters of the year.  This is followed by substantial cash inflows in the final two quarters.  Cash outflows must always be financed. Now that DMC’s financial managers have advance warning of the negative cash flows, they can plan how they will finance the expected deficit.  A cash budget allows a financial manager to be proactive with respect to the firm’s financing needs.

29. copyright © 2003 McGraw Hill Ryerson Limited 19-29 Cash Budgeting The Cash Balance  Assume that DMC started the year with $5 million in cash.  There is a $45 million cash outflow in the first quarter, so DMC will have to find financing for at least a $40 million deficit.  However, this would leave the firm with a forecast cash balance of zero at the start of the second quarter. What do you think of this as a financial strategy?

30. copyright © 2003 McGraw Hill Ryerson Limited 19-30 Cash Budgeting The Cash Balance  Most financial managers would see starting a period with a cash balance of zero as a very risky operating position!  Generally, they establish a minimum operating cash balance to cope with surprises.  Assume that DMC’s minimum operating cash balance is $5 million. How much financing will DMC have to arrange in the first and second quarter to maintain this desired minimum cash balance?

31. copyright © 2003 McGraw Hill Ryerson Limited 19-31 Cash Budgeting The Cash Balance  If it wants a minimum cash balance of $5 million in the 1 st quarter, DMC will need $45 million of financing, not $40 million.  In the second quarter, they will have to arrange an additional $15 million of financing.  In total, the firm will need $60 million of financing for the first half of the year. This is the peak need. The cash inflows for the 2 nd half of the year will offset the cash outflows of the first half.  See Table 19.8 on page 584 for details.

32. copyright © 2003 McGraw Hill Ryerson Limited 19-32 Cash Budgeting Options for Short-Term Financing  Now that DMC’s financial managers have estimated how much financing the firm will need, they must decide on the best route(s) for raising those funds. For a healthy firm, multiple options will be available for covering a temporary cash short-fall.  The financial managers do a cost-benefit analysis of the options and try to choose the one(s) which are optimal.

33. copyright © 2003 McGraw Hill Ryerson Limited 19-33 Cash Budgeting Options for Short-Term Financing  If you look at Table 19.9 on page 567, you will see the solution chosen by DMC’s financial managers: In the 1 st quarter, they will arrange a $40 million loan and sell $5 million of securities. In the second quarter, they will stretch their payables.  Stretching payables means delaying payment of bills and allowing accounts payable to build up.  In effect, DMC is taking a loan from its suppliers.

34. copyright © 2003 McGraw Hill Ryerson Limited 19-34 Cash Budgeting Evaluating the Plan  The plan in Table 19.9 is feasible, but DMC’s financial managers can probably do a lot better. The most glaring weakness is the plan to rely on stretching payables. This is an extremely expensive source of financing!  However, the purpose of the first plan is to get the managers thinking about options and questions they should be addressing.

35. copyright © 2003 McGraw Hill Ryerson Limited 19-35 Cash Budgeting Evaluating the Plan  Short-term financial plans are developed by trial and error.  You lay out one plan, think about it, and then try again with different assumptions about the financing and investment alternatives.  You continue until you can think of no further improvements.

36. copyright © 2003 McGraw Hill Ryerson Limited 19-36 Sources of Short-Term Financing Alternative Sources of Financing  Bank Loans These are the simplest and most common source of short-term financing. A bank loan is an unsecured loan. A line of credit is an agreement by a bank that a company may borrow at any time up to an established limit. A revolving credit agreement is a long-term commitment by the bank which allows the firm to borrow up to the agreed limit.

37. copyright © 2003 McGraw Hill Ryerson Limited 19-37 Sources of Short-Term Financing Alternative Sources of Financing  Bank Loans If the bank commits to a multi-year agreement, in return it will charge a commitment fee.  This is a fee charged by the bank on the unused portion of a line of credit. Most bank loans have a duration of a few months and are designed to cover short-term working capital needs such as a seasonal increase in inventory. Banks also make term loans.  These loans last for several years and may involve very large sums of money.

38. copyright © 2003 McGraw Hill Ryerson Limited 19-38 Sources of Short-Term Financing Alternative Sources of Financing  Commercial Paper Commercial paper is a short-term unsecured note issued by a firm. Commercial paper is issued by large, well-known companies which regularly need to borrow large amounts of cash. Instead of a bank loan, they borrow directly from investors at rate which is less than what a bank would charge.

39. copyright © 2003 McGraw Hill Ryerson Limited 19-39 Sources of Short-Term Financing Alternative Sources of Financing  Banker’s Acceptance A banker’s acceptance is a firm’s time draft that has been accepted by a bank. This means the bank guarantees payment of the amount stated on the draft when it matures. This guarantee means that the draft may be sold to investors as a short-term note issued by the firm.

40. copyright © 2003 McGraw Hill Ryerson Limited 19-40 Sources of Short-Term Financing Alternative Sources of Financing  Secured Loans Many short-term loans are unsecured, but sometimes a company will offer assets as security. Generally, they offer their A/R or their inventory as security on the loan.  The former is known as A/R financing. Or it may involve factoring, in which the firm sells its A/R at a discount to get short-term financing.  The latter is called inventory financing.

41. copyright © 2003 McGraw Hill Ryerson Limited 19-41 The Cost of Bank Loans Comparing Rates  Bank loans of less than a year almost invariably have a stated rate which is fixed for the term of the loan. However, you must be careful when comparing rates on short-term loans, for rates may be calculated in different ways.

42. copyright © 2003 McGraw Hill Ryerson Limited 19-42 The Cost of Bank Loans Comparing Rates  The interest rate on bank loans is frequently quoted as a simple interest rate. You would calculate such interest on a loan as follows: Annual Interest Rate Amount of Loan x Number of Periods in the Year

43. copyright © 2003 McGraw Hill Ryerson Limited 19-43 The Cost of Bank Loans Comparing Rates  The interest rate on bank loans may be quoted as a compound interest rate. You would calculate the effective annual rate (EAR) on a loan as follows: Quoted Annual Interest Rate EAR = m 1+-1 () m

44. copyright © 2003 McGraw Hill Ryerson Limited 19-44 The Cost of Bank Loans Comparing Rates  The interest rate on bank loans may be quoted on a discount basis. You would calculate such interest on a loan as follows: Quoted Annual Interest Rate EAR = 1 - - 1 () m m 1

45. copyright © 2003 McGraw Hill Ryerson Limited 19-45 The Cost of Bank Loans Comparing Rates  A bank loan may be quoted with a compensating balance. You would calculate such interest on a loan as follows: Actual Interest Paid EAR = Borrowed Funds Available 1 + - 1 () m

46. copyright © 2003 McGraw Hill Ryerson Limited 19-46 Summary of Chapter 19  Short-term financial planning is concerned with the management of the firm’s short-term or current assets.  The difference between current assets and current liabilities is called net working capital. Net working capital arises because of lags between the time a firm obtains raw materials and the time it finally collects from customers.  The cash conversion cycle is the length of time between the firm’s payment for materials and the date it gets paid by its customers.  The cash conversion cycle is partly within the control of management.

47. copyright © 2003 McGraw Hill Ryerson Limited 19-47 Summary of Chapter 19  The nature of a firm’s short-term financial planning is determined by the amount of long- term capital it raises.  Issuing large amounts of long-term debt or equity, or retaining earnings, may mean a firm has permanent excess cash.  Other firms raise very little long-term financing and end-up as permanent short-term debtors.  Most firms take a middle of the road approach, investing cash surpluses during part of the year and borrowing during the rest of the year.

48. copyright © 2003 McGraw Hill Ryerson Limited 19-48 Summary of Chapter 19  The starting point for short-term financial planning is forecasting the sources and uses of cash. From this the firm’s net financing requirement can be estimated.  The search for the best method of financing a temporary cash short-fall is a trial and error process. The financial manager explores assumptions about the inputs to the process and the various kinds of short-term financing which are available. These include: bank loans, banker’s acceptances, secured loans, commercial paper, stretching receivables, etc.