16 Working Capital Management ©2006 Thomson/South-Western

2 Introduction This chapter deals with the management of working capital, which involves decisions about the optimal overall level of current assets and the optimal mix of short-term funds used to finance the company’s assets. It also discusses short-term credit sources of funding available to a company. These sources include trade credit and bank loans.

3 Working Capital Policy Involves decisions about a company’s current assets (C/A) and current liabilities (C/L)  What they consist of  How they are used  How their mix affects the risk-return characteristics of the company Working capital  Total investment in C/A Net working capital  C/A – C/L

4 Working Capital Management Firm’s optimal level of C/A Optimal mix of S-T and L-T debt Level of investment in each type of C/A Specific sources and mix of S-T credit the firm should employ For extensive information on working capital: ml

5 Working Capital Represents assets that flow through the firm  Turned over at a rapid rate  Usually recovered during the operating cycle when inventories are sold and receivables are collected Made necessary by the asynchronous nature of cash receipts and disbursements

6 Financing Working Capital This Web site helps small business obtain working capital to produce and market U.S. products and services for export:

7 Operating Cycle Operating cycle Characterized by the time intervals between the following dates: Date 1 Purchase of resources Date 2 Pay for resource purchases Date 3 Sell product on credit Date 4 Collect receivables 1234

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9 Decomposing the Operating Cycle Payables deferral period Receivables conversion period 1234 Cash conversion cycle

10 Operating Cycle = Inventory Conversion Period + Receivables Conversion Period Inventory Conversion Period = Average Inventory Cost of Sales/ 365 Receivables Conversion Period = Accounts Receivable Annual Credit Sales/ 365 Operating Cycle Analysis

11 Cash Conversion Cycle = Operating Cycle + Payables Deferral Period Operating Cycle Analysis, Continued Payables Deferral Period = Accounts Payable + Salaries, Benefits & Payroll Taxes Payable Cost of Sales – Selling, Gen, Admin Exp ( / 365 )

12 Size and Nature of a Firm’s Investment in C/A Type of product Length of operating cycle Inventory size Safety stock Probability of running out Credit policies Efficiency of C/A management

13 Appropriate Level of Working Capital More conservative policies often result in lost sales due to restrictive credit policies. Optimal level of working capital investment is the level which is expected to maximize shareholder wealth.

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15 Optimal Level of S-T and L-T Debt Term structure of interest rates Higher risk with S-T debt  Refund  Fluctuating S-T interest rates Permanent C/A  Are not affected by seasonal or cyclical demand Fluctuating C/A  Are affected by seasonal or cyclical demand Matching maturity of debt and assets Conservative Moderate Aggressive

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20 Sources of Short-Term Financing Trade credit Accruals and deferred income  Legal and practical considerations Loans from commercial banks Commercial paper Collateral for S-T loans  A/R  Inventory

21 Cost of S-T Credit AFC = Interest + Fees Usable funds  365 Maturity (Days) Simple interest Compounded interest m [ Interest + fees Usable funds ] – APR =

22 Trade Credit (T/C) Extended on open account as A/P Spontaneous source of financing Cost of T/C is contained in the purchase price Lost discounts T/C is never free AFC = % discount 100% – % discount 365 Credit – Disc period 

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24 Commercial Bank Loans Single loans for specific financial needs Line of credit  Agreement to borrow up to predetermined limit at any time Revolving credit  Legally commits the bank  Usually secured  Requires a commitment fee AFC = Interest costs Usable funds + Commitment fee  365 Maturity ( days )

25 Tying Bank Loans to Other Services Happens when finance executives are pressured by commercial banks to purchase other financial services in exchange for obtaining loans Recent rise in practice due to:  Concentration in the banking industry (Citigroup, JP Morgan Chase, Bank of America)  Repeal of laws that prevented commercial banks from engaging in various investment banking services

26 Commercial Paper S-T unsecured promissory notes Issued by large well-known corporations Maturities from a few days to 9 months Sold at a discount Purchasers Individuals Corporations Banks Insurance companies Pension funds Money market funds Maturity ( days ) Interest costs + Placement fee Usable funds  365 AFC =

27 A/R as Collateral Fairly liquid Easy to handle Subject to fraud High administrative costs Two common forms  Pledging–Firm retains title  Factoring–Sale of A/R

28 Information on Factoring Do a search at this Web site for “factoring accounts receivable”: Investigate factoring at this Web site:

29 Financing From Foreign A/R Insured by the Export-Import Bank Contracts guaranteed by  Foreign bank  Government Trading companies

30 Inventory as Collateral Stability Characteristics  Perishability  Identifiability  Marketability  Price stability

31 Inventory as Collateral, Continued Possession of the collateral  Floating lien  Trust receipt  Terminal warehouse  Field warehouse