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

Copyright © 2014 by Nelson Education Ltd. 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 Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd. 1

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Copyright © 2014 by Nelson Education Ltd. 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) Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd. 2

Copyright © 2014 by Nelson Education Ltd. 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 Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd. 2

RAW MATERIALS INVENTORY FINISHED GOODS INVENTORY Working Capital A simple cycle of operations: CASH RECEIVABLES RAW MATERIALS INVENTORY FINISHED GOODS INVENTORY Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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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 Copyright © 2014 by Nelson Education Ltd.

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 = Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. 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 Copyright © 2014 by Nelson Education Ltd.

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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 Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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, Copyright © 2014 by Nelson Education Ltd.

Conservative Financing Policy Fixed Assets Years $ Perm NOWC L-T Fin: Stock & Bonds Marketable Securities Zero S-T debt Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. 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. Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd. 11

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 Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd. 12

Microdrive Inc.: Cash Budget (I) Copyright © 2014 by Nelson Education Ltd.

Microdrive Inc.: Cash Budget (II) Copyright © 2014 by Nelson Education Ltd.

Microdrive Inc.: Cash Budget (III) Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd. 15

Copyright © 2014 by Nelson Education Ltd. 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 Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd. 16

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. Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd. 17

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. Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd. 18

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. Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd. 19

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. Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd. 20

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. Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Short-Term Financing Spontaneous financing Short-term bank loans Copyright © 2014 by Nelson Education Ltd.

Accruals and Accounts Payable (Trade Credit): Spontaneous Financing Arise automatically, or spontaneously, from a firm’s operations Two types: Accruals Accounts payable (trade credit) Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Cost of Trade Credit Trade credit is not free! 0 10 30 |-----------------|---------------------------------------------------| pay $98 pay $100 |--get to use $98 for 20 days at $2-| 2 / 10, net 30 Copyright © 2014 by Nelson Education Ltd.

Cost of Not Taking Discounts Nominal annual cost of trade credit = Effective annual rate = (1 + 2.04%) 365/20 – 1 = 44.6% Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Short-Term Bank Loans Loan application Interest rates Maturity Collateral Covenants Line of credit Commercial paper Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Loan Application Historical financials Pro forma financials Income and EBITDA Types of assets Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Interest Rates Prime rate is the lowest interest rate that a bank lends money at. Prime rate can swing very quickly in either direction. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Collateral The short-term loan is secured by a specific collateral item (asset). The item is registered under the Personal Property Security Act (PPSA). Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. 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 Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Line of Credit One-year operating loan Interest rate floats based on prime. Interest is only paid when funds are borrowed. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. 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. Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

Secured Short-Term Financing Accounts receivable financing Inventory financing Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Inventory Financing Blanket liens Trust receipts Warehouse receipt Acceptable products Costs of financing Evaluation of inventory financing Copyright © 2014 by Nelson Education Ltd.