© 2004 by Nelson, a division of Thomson Canada Limited Chapter 15: Working Capital Policy and Short Term Financing Contemporary Financial Management

© 2004 by Nelson, a division of Thomson Canada Limited 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 deals with the financing of the current assets that make up the working capital.

© 2004 by Nelson, a division of Thomson Canada Limited 3 Working Capital  Working capital is the firm’s total investment in current assets  Net working capital equals current assets minus current liabilities  Working capital represents assets that flow through the firm Turned over at a rapid rate Usually recovered during the operating cycle when inventory sells and receivables collected  Working capital is needed because of the time lag between cash disbursements and cash receipts

© 2004 by Nelson, a division of Thomson Canada Limited 4 Working Capital Policy  Involves many decisions about a firm’s current assets and current liabilities What they consist of How they are used How their mix affects the risk-return characteristics of the company

© 2004 by Nelson, a division of Thomson Canada Limited 5 Operating Cycle Purchase Raw Materials Pay for Raw Materials Sell Finished Goods on Credit Collect Receivables Operating Cycle Inventory Conversion Period Receivables Conversion Period Payables Deferral Period Cash Conversion Cycle

© 2004 by Nelson, a division of Thomson Canada Limited 6 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

© 2004 by Nelson, a division of Thomson Canada Limited 7 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 )

© 2004 by Nelson, a division of Thomson Canada Limited 8 Size and Nature of Current Assets  Depends on: Type of product manufactured or distributed Length of operating cycle Optimal amount of Inventory Optimal amount of safety stock Credit policies Efficiency of current asset management

© 2004 by Nelson, a division of Thomson Canada Limited 9 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. ConservativeAggressive Current Assets More Less Profitability Lower Higher Risk Lower Higher

© 2004 by Nelson, a division of Thomson Canada Limited 10 Optimal Mix of ST and LT Debt  Impact of term structure of interest rates Long rates usually higher than short rates Thus the interest cost of short-term debt usually cheaper than long-term debt  Borrower incurs higher risk with short term debt Must refinance frequently Short term interest rates are highly volatile

© 2004 by Nelson, a division of Thomson Canada Limited 11 Profitability Versus Risk  Need for financing equal to the sum of: Current assets Fixed assets  Current assets may be: Permanent - Are not affected by seasonal or cyclical demand Fluctuating - Are affected by seasonal or cyclical demand

© 2004 by Nelson, a division of Thomson Canada Limited 12 Financing Strategies  Matching Match the maturity of all assets & liabilities Reduces liquidity risk Hard to implement in practice

© 2004 by Nelson, a division of Thomson Canada Limited 13 Financing Strategies  Conservative Approach High proportion of long term debt Less profitable, since LT debt usually more expensive

© 2004 by Nelson, a division of Thomson Canada Limited 14 Financing Strategies  Aggressive Approach High proportion of short term debt More profitable (short term debt cheaper) but also more risky

© 2004 by Nelson, a division of Thomson Canada Limited 15 An Optimal Financing Strategy?  No one strategy is “right” for all firms  The mix between ST and LT debt must also consider: Industry norms Variability of sales Variability of cash flows

© 2004 by Nelson, a division of Thomson Canada Limited 16 Cost of Short Term Credit APR = Interest + Fees Usable funds  365 Maturity (Days) Simple interest Compound interest m [ Interest + fees Usable funds ] – 1 1 +EAR = APR = Annual percentage rate EAR = Equivalent annual return m = number of compounding periods per year

© 2004 by Nelson, a division of Thomson Canada Limited 17 Sources of Short-Term Financing  Trade credit  Accrual expenses and deferred income  Loans from commercial banks  Commercial paper  Borrowing against Account Receivables

© 2004 by Nelson, a division of Thomson Canada Limited 18 Trade Credit  Seller provides financing as part of the sales inducement  Spontaneous source of financing  Cost of trade credit is captured in the purchase price  Trade credit is never free. The cost of foregoing a cash discount is: APR = % discount 100% – % discount 365 Credit – Disc period 

© 2004 by Nelson, a division of Thomson Canada Limited 19 Example: Cost of Foregoing a Discount  A vendor offers a discount of 2% if payment is made within ten days. If the discount is not taken, full payment is due in 30 days. What is the annual cost of not accepting the 2% discount?

© 2004 by Nelson, a division of Thomson Canada Limited 20 Accrued Expenses & Deferred Income  Any accrued but unpaid expense is a form of short term financing  Stretching payables extends the financing period but can result in a poor credit rating  Deferred income consists of payments received for goods & services to be delivered in the future Are shown on the Balance Sheet as a liability called Deferred Income

© 2004 by Nelson, a division of Thomson Canada Limited 21 Short Term Bank Credit  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 APR = Interest costs Usable funds + Commitment fee  365 Maturity ( days )

© 2004 by Nelson, a division of Thomson Canada Limited 22 Commercial Paper  Short-term unsecured promissory notes  Issued by large well-known corporations  Maturities from a few days to 9 months  Sold at a discount  Purchasers include corporations, banks, insurance companies, pension funds, etc Maturity ( days ) Interest costs + Placement fee Usable funds  365 APR =

© 2004 by Nelson, a division of Thomson Canada Limited 23 Accounts Receivable Loans  Receivables make excellent collateral: Fairly liquid Easy to recover in the event of default  Problems with receivables includes: Subject to fraud High administrative costs  Two common forms of receivables lending Pledging–Firm retains title Factoring–Sale of A/R With recourse Without recourse

© 2004 by Nelson, a division of Thomson Canada Limited 24 Borrowing Against Inventory  Inventory may make a good form of collateral, depending on the following characteristics: Perishability Identifiability Marketability Price stability

© 2004 by Nelson, a division of Thomson Canada Limited 25 Borrowing Against Inventory  When lending against inventory, the lender must decide who will hold the collateral (inventory)  If borrower holds inventory, the lender may use: Floating lien: floating charge over all current and future acquired inventory Trust receipt: inventory and sale proceeds are held “in trust” for the lender  A third party holds the inventory in a: Terminal warehouse: inventory is stored in a bonded warehouse Field warehouse: secured inventory is segregated on site and managed by a field warehouse company

© 2004 by Nelson, a division of Thomson Canada Limited 26 Characteristics of Term Loans  Granted by a bank or other lending institution  Maturity – initial maturity of 1 to 10 years  Less expensive than a public offering  Repayment may include: Equal periodic payments of interest plus principal (amortized) Equal principal payments plus interest on the outstanding balance Periodic payments plus a large [balloon] payment at the maturity date One large payment on the maturity date (bullet payment)

© 2004 by Nelson, a division of Thomson Canada Limited 27 Characteristics of Term Loans  Interest rate varies, depending on: General level of rates in the market Size of the loan Maturity of the loan Borrower’s credit rating  Interest may be charged as a: Fixed rate Variable rate (Prime plus ___%)

© 2004 by Nelson, a division of Thomson Canada Limited 28 Characteristics of Term Loans  Security Provisions Protect the lender in case of borrower default May include: Assignment of monies due under a contract Assignment of receivables or inventory Floating lien or debenture on firm assets Pledge of marketable securities Mortgage on fixed assets Assignment of the cash surrender value on a life insurance policy

© 2004 by Nelson, a division of Thomson Canada Limited 29 Characteristics of Term Loans  Affirmative Covenants Things the borrower will do Provide periodic Financial statements Carry insurance Maintain minimum net working capital  Negative Covenants Things the borrower will not do Not to pledge certain assets as security Not to merge or consolidate Not to make or guarantee loans to others

© 2004 by Nelson, a division of Thomson Canada Limited 30 Sources of Term Loans  Banks  Insurance companies  Pension funds  Government agencies  Equipment suppliers Conditional sales contracts Chattel mortgages

© 2004 by Nelson, a division of Thomson Canada Limited 31 Major Points  Working capital consists of the current assets carried on the Balance Sheet and the current liabilities used to fund them.  Current assets require an investment, similar to that of a fixed asset.  Current assets are low return; therefore the firm wants to carry the minimum amount necessary.  There are many forms of short-term funding available, but each of them has a cost attached.