Lecture 5 Francesco Baldi Advanced Corporate Finance October 19, 2017 Working Capital Management Lecture 5 Francesco Baldi

Overview of Working Capital Trade Credit Receivables Management Index Overview of Working Capital Trade Credit Receivables Management Payables Management Inventory Management Cash Management

Overview of Working Capital where:

Overview of Working Capital (2) Most projects require the firm to invest in net working capital. The main components of net working capital are cash, inventory, receivables, and payables. It does not include excess cash, which is cash that is not required to run the business and can be invested at a market rate.

Cash Cycle Cash Cycle The length of time between when a firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory. A company first buys inventory from its suppliers, in the form of either raw materials or finished goods. Even if the inventory is in the form of finished goods, it may sit on the shelf before some time before it sold.

Cash Conversion Cycle (CCC) Cash Cycle Cash Conversion Cycle (CCC) Is a measure of the cash cycle

Cash Cycle Operating Cycle The average length of time between when a firm originally purchases its inventory and when it receives the cash back from selling its product If the firm pays cash for its inventory, this period is identical to the firm’s cash cycle. However, most firms buy their inventory on credit, which reduces the amount of time between the cash investment and the receipt of cash from that investment. The longer a firm’s cash cycle, the more working capital it has, anf the more cash it needs to carry to conduct its daily operations. Because of the characteristics of different industry, working capital levels vary significantly. (next slide table)

Working Capital in Various Industries (2009) A retail grocery store typically sells on a cash-only basis, hence accounts receivables are expected to be a very small percentage of its sales. Example Kroger

The Cash and Operating Cycle for a Firm

Firm Value and Working Capital Any reduction in working capital requirements generates a positive free cash flow that the firm can distribute immediately to shareholders. Similarly, when a evaluating a project, reducing the project’s net working capital needs over the project’s life reduces the opportunity cost associated with this issue of capital. Thus, efficiently managing working capital will maximize firm value.

Example 1

Example 1

Trade Credit When a firm allows a customer to pay for goods at some date later than the date of purchase, it creates an account receivable for the firm and an account payable for the customer. The credit that the firm extends to its customers is known as TRADE CREDIT It is important to managers to determine optimal credit policies.

Trade Credit If a supplier offers its customers terms of “Net 30”: Examples of how trade credit are quoted: If a supplier offers its customers terms of “Net 30”: Payment is not due until 30 days from the date of the invoice. Note: The number of days may vary, such as Net 15 or Net 60. Sometimes the selling firm offers the buying firm a discount if payment is made early. The term “2/10 Net 30” mean that: The buying firm will receive a 2% discount if it pays within 10 days; otherwise, the full amount is due in 30 days. Firms offer discounts to encourage customers to pay early. However, the discount also represents a cost to the selling firm. Note: The discount and number of days may vary, such as 1/10 Net 20 or 2/10 Net 45.

Trade Credit and Market Frictions Cost of Trade Credit Trade credit is a loan from the selling firm to its customer. The price discount represents an interest rate. For this reason financial managers should evaluate the terms of trade credit to decide whether to use it. Assume a firm sells a product for $100 and offers its customer terms of 2 /10, net 30. The customer doesn’t have to pay anything for the first 10 days, so it effectively has a zero-interest loan for this period. If the customer takes advantage of the discount and pays within the 10-day discount period, the customer pays only $98 for the product.

Trade Credit and Market Frictions Cost of Trade Credit Rather than pay within 10 days, the customer has the option to use the $98 for an additional 20 days (30-10=20) The interest rate for the 20-day term of the loan is $2 ÷ $98 = 2.04%. With a 365-day year, this rate over 20 days corresponds to an effective annual rate of: - By not taking the discount, the firm is effectively paying 44.6% annually to finance the purchase. If the firm can obtain a bank loan at a lower interest rate, it would be better off borrowing at the lower rate on day 10 and using the cash proceeds of the loan to take advantage of the discount offered by the supplier. The firm would then repay the bank loan on day 30.

Example 2

Your firm purchases goods from its supplier on terms of 2/10, net 45. Example 2 Problem Your firm purchases goods from its supplier on terms of 2/10, net 45. What is the effective annual cost to your firm if it chooses not to take advantage of the trade discount offered? Solution 18

Trade Credit and Market Frictions Benefits of Trade Credit can be an attractive source of funds why? Trade credit is simple and convenient to use, and it therefore has lower transaction costs than alternative sources of funds. It is a flexible source of funds, and can be used as needed. It is sometimes the only source of funding available to a firm.

Trade Credit and Market Frictions Trade Credit Versus Standard Loans Why offer trade credit? 1. Providing financing at below-market rates is an indirect way to lower prices for only certain customers. For example, automobile manufacturer’s often offer low cost financing, but only for the most qualified buyers. 2. Because a supplier may have an ongoing business relationship with its customer, it may have more information about the credit quality of the customer than a bank. 3.If the buyer defaults, the supplier may be able to seize the inventory as collateral.

Receivables Management Determining the Credit Policy involves three steps: Establishing Credit Standards Determine who will qualify for credit Establishing Credit Terms Determine the “net” period and if a discount will be offered Establishing a Collection Policy Determine course of action to take if a customer does not pay as agreed

Monitoring Accounts Receivables Accounts Receivable Days The accounts receivable days is the average number of days that it takes a firm to collect on its sales. A firm can compare the accounts receivable days to the credit terms. For example, if the credit terms specify “net 30” and the accounts receivable days outstanding is 45 days, the firm can conclude that its customers are paying 15 days late, on average. A firm should look at the trend in accounts receivable days over time. - Because accounts receivables days can be calculated from the firm’s financial statement, outside investors commonly use this measure to evaluate a firm’s credit management policy.

Monitoring Accounts Receivables Aging Schedule Categorizes a firm’s accounts by the number of days they have been on the firm’s books It can be prepared using either the number of accounts or the dollar amount of the accounts receivable outstanding. If the aging schedule gets “bottom-heavy”, that is if the percentages in the lower half of the schedule begin to increase-the firm will likely need to revisit its credit policy.

Table 2

Example 3

Example 3

Example 4 Problem Marley Corporation bills its accounts on terms of 2/10, Net 30. The firm’s accounts receivable are collected as follows: Days Outstanding Percentage Outstanding 1-10 20.4% 11-30 48.9% 31-40 12.3% 41-50 9.7% 51-60 6.3% 60+ 2.4%

Example 5 Problem The company currently has $780,000 in accounts outstanding. If Marley’s average daily credit sales is $22,000, what is the company’s accounts receivable days? Prepare an accounts receivable aging table for the company. Is the accounts receivable days a true representation of the accounts receivable collection experience? Solution Based on its average daily credit sales of $22,000 and its current accounts receivable balance of $780,000, Marley’s accounts receivable days is:

Percentage Outstanding Example 5 Solution Based on its accounts receivable balance of $780,000, the aging schedule for Marley Corporation is: Days Outstanding Amount Outstanding Percentage Outstanding 1-10 $159,120 20.4% 11-30 $381,420 48.9% 31-40 $95,940 12.3% 41-50 $75,660 9.7% 51-60 $49,140 6.3% 60+ $18,720 2.4%

Example 5 Solution The company’s accounts receivable days is 35.45 days, compared to its terms of 30 days. From this, we can conclude that the company is taking too long to collect. This assessment is borne out by the aging schedule, which reflects the fact that 18.40% of the company’s sales are collected late.

Payment Pattern Monitoring Accounts Receivable Provides information on the percentage of monthly sales that the firm collects in each month after the sale For example, a firm may observe that 10% of its sales are usually collected in the month of the sale, 40% in the month following the sale, 25% two months after the sale, 20% three months after the sale, and 5% four months after the sale. Management can then watch for deviations from this pattern.

Payables Management A firm should borrow using accounts payable only if trade credit is the least expensive source of funding. The cost of the trade credit depends on the credit terms. The higher the discount percentage offered, the greater the cost of forgoing the discount. The shorter the loan period, the greater the cost of forgoing the discount. A firm should always pay on the latest day allowed.

Determining Accounts Payables: Days Outstanding A firm should monitor its accounts payable to ensure that it is making its payments at an optimal time. One method is to calculate the accounts payable days outstanding and compare it to the credit terms. If the accounts payable outstanding is 45 days and the terms are 2/10, net 30, the firm can conclude that it generally pays late and may be risking supplier difficulties. If the accounts payable days outstanding is 20 days, the firm is paying too early. It could be earning another ten days’ interest on its money.

Example 6

Stretching the Accounts Payable Stretching Accounts Payable Stretching the Accounts Payable When a firm ignores a payment due period and pays later For example: Given Net 30 terms, a firm may pay on day 45. Given 2/10 Net 30 terms, a firm may pay on day 12 and still take the 2% discount. Suppliers may react to a firm whose payments are always late by imposing late fees or terms of cash on delivery (COD) or cash before delivery (CBD).

Example 7

Inventory Management Benefits of Holding Inventory Prevent stock-outs Seasonality in demand Costs of Holding Inventory Acquisition costs Order costs Carrying costs Minimizing these costs involves trade-offs. Just-in-Time (JIT) Inventory Management When a firm acquires inventory precisely when needed so that its inventory balance is always zero, or very close to it JIT is often used to reduce carrying costs as much as possible

Working Capital Optimization Strategies A firm can pursue 3 strategies to optimize working capital management: rationalize inventory so as to find an optimal level for them by improving sales forecast, management of product life-cycle, etc; maximize accounts payables without increasing unit costs or delivery times (from suppliers); minimize accounts receivables without jeopardizing sales volumes by enhancing invoice-related cash collection processes, the monitoring of trade credit terms and embedded credit risk (of customers).

Cash Management Motivation for Holding Cash Transactions Balance The amount of cash a firm needs to be able to pay its bills Precautionary Balance The amount of cash a firm holds to counter the uncertainty surrounding its future cash needs Compensating Balance An amount a firm’s bank may require the firm to maintain in an account at the bank as compensation for services the bank may perform Thus far, it has been assumed that the firm will invest any cash in short-term securities. A firm may choose from a variety of short-term securities that differ with regard to their default risk and liquidity risk.

Table 3 Money Market Investment Options

Table 3 Money Market Investment Options

Short-Term Financing: The Matching Principle The matching principle states that: short-term needs of a firm should be financed with short-term debt; long-term needs should be financed long-term sources of funds

Short-Term Financing: Commercial Papers A commercial paper is short-term, unsecured debt used by large corporations that is usually a cheaper source of funds than a short-term bank loan. The minimum face value is $ 25,000, and most commercial paper has a face value of at least $ 100,000. The interest on commercial paper is typically paid by selling it at an initial discount. The average maturity of commercial paper is 30 days and the maximum maturity is 270 days. Extending the maturity beyond 270 days triggers a registration requirement with the Securities and Exchange Commission (SEC), which increases issue costs and creates a time delay in the sale of the issue. Commercial paper is referred to as either direct paper or dealer paper: direct paper – the firm sells the security directly to investors; dealer paper – dealers sell the commercial paper to investors in exchange for a spread (or fee) for their services. The spread decreases the proceeds that the issuing firm receives, thereby increasing the effective cost of the paper. Like long-term debt, commercial paper is rated by credit rating agencies.

Short-Term Financing: Commercial Papers (2)

Short-Term Financing: Secured Financing Firms can also obtain short-term financing by using secured loans, which are loans collateralized with short-term assets, most typically the firm’s account receivables or inventories. Commercial banks, finance companies, and factors – which are firms that purchase the receivables of other companies – are the most common sources for short-term secured loans.

Secured Financing: Accounts Receivable as Collateral Firms can use accounts receivable as security for a loan by (a) pledging or (b) factoring. Pledging of Accounts Receivable: In a pledging of account receivable agreement, the lender reviews the invoices that represent the credit sales of the borrowing firm and decides which credit accounts it will accept as collateral for the loan, based on its own credit standards. The lender then typically lends the borrower some percentage of the value of the accepted invoices (for example, 75%). If the borrowing firm’s customers default on their bills, the firm is still responsible to the lender for the money. Factoring of Accounts Receivable: In a factoring of account receivable arrangement, the firm sells receivables to the lender (i.e., the factor), and the lender agrees to pay the firm the amount due from its customers at the end of the firm’s payment period. For example, if a firm sells its goods on terms of Net 30, then the factor will pay the firm the face value of its receivables less a factor’s fee at the end of 30 days. The firm’s customers are instructed to make payments directly to the lender.

Secured Financing: Accounts Receivable as Collateral (2) Factoring of Accounts Receivable: In many cases, the firm can borrow as much as 80% of the face value of its receivables from the factor, thereby receiving its funds in advance. In such a case, the lender will charge interest on the loan in addition to the factor’s fee. The factor’s fee may range from 1% to 2% of the face value of the accounts receivable, whether or not the firm borrows any of the available funds. Both the interest rate and the factor’s fee vary depending on such issues as the size of the borrowing firm, the dollar volume of its receivables, and the creditworthiness of its customers. The dollar amounts involved in factoring agreements may be substantial. For example, as of December 2007, Mattel had sold more than $300 million of its accounts receivable under factoring arrangements. A factoring arrangement may be with recourse or without recourse: with recourse: the lender can seek payment from the borrower should the borrower’s customers default on their bills; without recourse: the lender bears the risk of bad-debt losses. In this latter case, the factor will pay the firm the amount due regardless of whether the factor receives payment from the firm’s customers.

Secured Financing: Accounts Receivable as Collateral (3) If the arrangement is with recourse, the lender may not require that it approve the customers’ accounts before sales are made. If the factoring agreement is without recourse, the borrowing firm must receive credit approval for a customer from the factor prior to shipping the goods. If the factor gives its approval, the firm ships the goods and the customer is directed to make payment directly to the lender.

Secured Financing: Inventory as Collateral Firms can use inventory as collateral for a loan in one of 3 ways: (a) floating lien; (b) trust receipt; (c) warehouse agreement. Floating Lien: In a floating (or general, or blanket) lien arrangement, all of the inventory is used to secure the loan. This arrangement is the riskiest setup from the standpoint of the lender because the value of the collateral used to secure the loan decreases as inventory is sold off by the borrower. When a firm becomes financially distressed, management may be tempted to sell the inventory without making payments on the loan. In such a case, the firm may not have enough funds to replenish its inventory. As a result, the loan may become under-collateralized. To counter this risk, this type of loan bears a higher interest rate (than the other 2 arrangements). In addition, the lender will loan a low percentage of the value of the inventory. Trust Receipt: With a trust receipts loan (or floor planning), distinguishable inventory items are held in a trust as security for the loan. As these items are sold, the firm remits the proceeds from their sale to the lender in repayment of the loan. The lender will periodically send someone to ensure that the borrower has not sold some of the specified inventory and failed to make a repayment on the loan.

Secured Financing: Inventory as Collateral (2) Car dealerships often use this type of secured financing arrangement to obtain the funds needed to purchase vehicles from the manufacturer. Warehouse Arrangement: In a warehouse arrangement, the inventory that serves as collateral for the loan is stored in a warehouse. A warehouse arrangement is the least risky collateral arrangement from the standpoint of the lender. Such an arrangement can be set up in 2 ways. The first method is to use a public warehouse, which is a business that exists for the sole purpose of storing and tracking the inflow and outflow of the inventory. The lender extends a loan to the borrowing firm, based on the value of the inventory stored. When the borrowing firm needs the inventory to sell, it returns to the warehouse and retrieves it upon receiving permission from the lender. This arrangement provides the lender with the tightest control over the inventory. Public warehouses work well for some types of inventory (wine, tobacco), which must age before they are ready to be sold. It is not practical for items that are subject to spoilage or are bulky and, therefore, difficult to transport to and from the warehouse. The second option, a field warehouse, is operated by a third party, but is set up on the borrower’s premises in a separate area so that the inventory collateralizing the loan is kept apart from the borrower’s main plant. Such an arrangement is convenient for the borrower but gives the lender the added security of having the inventory that serves as collateral controlled by a third party.

Secured Financing: Inventory as Collateral (3) Warehouse arrangements are expensive. The business operating the warehouse charges a fee on top of the interest that the borrower must pay the lender for the loan. However, the borrower may also save on the costs of storing the inventory herself. Because the warehouser is a professional at inventory control, there is likely to be little loss due to damaged goods or theft, which in turn lowers insurance costs. Because the control of the inventory remains in the hands of a third party, lenders may be willing to lend a greater % of the market value of the inventory than they would under other arrangements. The method that a firm adopts when using its inventory to collateralize a loan will affect the ultimate cost of the loan: the floating (or blanket) lien agreement exposes the lender to the most risk, and will therefore carry the highest interest rate of the 3 types of arrangements; while the warehousing arrangement provides the greatest amount of control over the inventory to the lender, resulting in a lower interest rate on the loan itself, the borrowing firm must pay the additional fees charged by the warehouser and accept the inconvenience associated with the loss of control; although a trust receipts arrangement may offer a lower interest rate than a blanket lien, and allows the firm to avoid the high fees associated with a warehouse arrangement, it can be used only with certain types of inventory.