1. Prepared by Ken Hartviksen INTRODUCTION TO CORPORATE FINANCE Laurence Booth W. Sean Cleary

2. CHAPTER 23 Working Capital Management: General Issues

3. CHAPTER 23 – Working Capital Management – General Issues23 - 3 Lecture Agenda Learning ObjectivesLearning Objectives Important TermsImportant Terms An integrated approach to working capital managementAn integrated approach to working capital management Analyzing cash inflows and outflowsAnalyzing cash inflows and outflows Working capital managementWorking capital management Summary and ConclusionsSummary and Conclusions –Concept Review Questions

4. CHAPTER 23 – Working Capital Management – General Issues23 - 4 Learning Objectives You should understand: Why the management of net working capital is critical for the survival of the firmWhy the management of net working capital is critical for the survival of the firm How managing receivables, inventory, and payables is related in an integrated approach to net working capital managementHow managing receivables, inventory, and payables is related in an integrated approach to net working capital management How the financing and current asset investment decisions interact to determine a company’s overall working capital positionHow the financing and current asset investment decisions interact to determine a company’s overall working capital position How some key financial ratios can be used to analyze a firm’s net working capital policiesHow some key financial ratios can be used to analyze a firm’s net working capital policies

5. CHAPTER 23 – Working Capital Management – General Issues23 - 5 Important Chapter Terms Break-even sales growthBreak-even sales growth Cash budgetCash budget Cash conversion cycleCash conversion cycle Credit policyCredit policy Inventory policyInventory policy Net working capitalNet working capital Operating cycleOperating cycle Payment policyPayment policy Trade creditTrade credit Working capital managementWorking capital management

6. CHAPTER 23 – Working Capital Management – General Issues23 - 6 Working Capital Management The way in which a firm manages both its current assets and its current liabilities.The way in which a firm manages both its current assets and its current liabilities.

7. CHAPTER 23 – Working Capital Management – General Issues23 - 7 Good Working Capital Management Characterized by:Characterized by: 1.The maintenance of optimal cash balances 2.The investment of any excess liquid funds in marketable securities that provide the best return possible, considering any liquidity or default-risk constraints 3.Proper management of accounts receivable 4.An efficient inventory management system 5.Maintaining an appropriate level of short-term financing, in the least expensive and most flexible manner possible.

8. CHAPTER 23 – Working Capital Management – General Issues23 - 8 Working Capital Management Importance of Cash Flow Management Management of the firm’s cash flow is one of the greatest challenges facing the financial manager:Management of the firm’s cash flow is one of the greatest challenges facing the financial manager: –Exhaustion of liquid resources can leave the firm unable to pay it’s maturing obligations as they come due (a state of technical insolvency…an Act of Bankruptcy)

9. CHAPTER 23 – Working Capital Management – General Issues23 - 9 Working Capital Management Exhaustion of Liquid Resources Firms can ‘run out’ of liquid financial resources in a number of ways:Firms can ‘run out’ of liquid financial resources in a number of ways: –Rapid growth in production and sales, can cause the firm to use up all of its cash pursuing growth, leaving it invested in illiquid assets such as inventories, accounts receivable and net fixed assets. The surprising thing about this state is that the firm may be highly profitable in an accounting sense, but be on the verge of bankruptcy as it pursues uncontrolled growth in sales.The surprising thing about this state is that the firm may be highly profitable in an accounting sense, but be on the verge of bankruptcy as it pursues uncontrolled growth in sales. –Continuing to produce inventory in the face of falling sales revenue. –Selling products/services for less than their variable cost to produce.

10. CHAPTER 23 – Working Capital Management – General Issues23 - 10 An Integrated Approach to Net Working Capital Management The Cash Budget The monthly cash budget is a management tool used to forecast the timing, magnitude and duration of both cash surpluses as well as deficits.The monthly cash budget is a management tool used to forecast the timing, magnitude and duration of both cash surpluses as well as deficits.

11. CHAPTER 23 – Working Capital Management – General Issues23 - 11 An Integrated Approach to Net Working Capital Management Knowledge of the cash flow cycle of a firm gives the manager an awareness of the dynamics involved in working capital management.Knowledge of the cash flow cycle of a firm gives the manager an awareness of the dynamics involved in working capital management. The cash flow cycle helps the manager visualize the impact of changes in variables on the cash account:The cash flow cycle helps the manager visualize the impact of changes in variables on the cash account: –How increasing sales requires additional investment in inventory –How increasing accounts receivable reduces cash –How delaying payables preserves cash –How speeding collections on A/R improves the cash position

12. CHAPTER 23 – Working Capital Management – General Issues23 - 12 Cash and Net Working Capital The cash flow cycle – where cash comes from…how it is used to finance the operations of the firm…and how it is recovered and how it grows over time is a crucially- important part of understanding how a business functions.The cash flow cycle – where cash comes from…how it is used to finance the operations of the firm…and how it is recovered and how it grows over time is a crucially- important part of understanding how a business functions.

13. CHAPTER 23 – Working Capital Management – General Issues23 - 13 Cash and Net Working Capital Activities that Increase Cash Increasing long-term debtIncreasing long-term debt Increasing equityIncreasing equity Increasing current liabilitiesIncreasing current liabilities Decreasing current assets other than cashDecreasing current assets other than cash Decreasing fixed assetsDecreasing fixed assets

14. CHAPTER 23 – Working Capital Management – General Issues23 - 14 Cash and Net Working Capital Activities that Decrease Cash Decreasing long-term debtDecreasing long-term debt Decreasing equityDecreasing equity Decreasing current liabilitiesDecreasing current liabilities Increasing current assets other than cashIncreasing current assets other than cash Increasing fixed assetsIncreasing fixed assets Paying dividendsPaying dividends

15. Example of Exhaustion of the Liquid Resources of a New Firm A simple example of a $1.0 million equity investment in a business levering additional financial resources and the need to finance the growth of the business leaving it exhausted of cash resources. 7 steps to technical insolvency for an otherwise profitable firm.

16. CHAPTER 23 – Working Capital Management – General Issues23 - 16 This Exercise This exercise reinforces the classic working capital problem illustrated in the text.This exercise reinforces the classic working capital problem illustrated in the text. Demonstrates:Demonstrates: –How cash is utilized over time in the firm. –How investment in assets such as accounts receivable and inventory deplete cash resources. –How the delays in receipt of cash from sales can leave a firm without cash, despite overall profitability.

17. CHAPTER 23 – Working Capital Management – General Issues23 - 17 Cash Flow Cycle Start Cash Account Balance = $0 The entrepreneur opens a current account in the name of the business. Step 1

18. CHAPTER 23 – Working Capital Management – General Issues23 - 18 Cash Flow Cycle Initial Equity Investment Cash Account Balance = $1,000,000 Owner/Shareholders invest and receive common stock = $1,000,000 Balance Sheet Cash$1mCommon Stock$1 m _____________________________________ T. Assets$1mT. Claims$1m The entrepreneur invests $1,000,000 in equity. Step 2

19. CHAPTER 23 – Working Capital Management – General Issues23 - 19 Cash Flow Cycle Purchase of $500,000 Fixed Assets Balance Sheet Cash$0.5 F. Assets0.5Common Stock$1 m ___________________________________ T. Assets$1mT. Claims$1m Cash Account Balance = $500,000 Owner/Shareholders invest and receive common stock = $1,000,000 Fixed Assets The firm purchases fixed assets. Step 3

20. CHAPTER 23 – Working Capital Management – General Issues23 - 20 Cash Flow Cycle Buy $300,000 of inventory on trade credit Balance Sheet Cash$0.5A/P$0.3 Inventory0.3 F. Assets0.5Common Stock$1 m _____________________________________ T. Assets$1.3mT. Claims$1.3m Cash Account Balance = $500,000 Owner/Shareholders invest and receive common stock = $1,000,000 Fixed Assets Inventory The firm purchases $300,000 inventory from suppliers. Step 4

21. CHAPTER 23 – Working Capital Management – General Issues23 - 21 Cash Flow Cycle Further Work-in-process plus finished goods Balance Sheet Cash$0.5A/P$0.3 Inventory0.7Accruals0.3 F. Assets0.4Common Stock$1 m _____________________________________ T. Assets$1.6mT. Claims$1.6m Cash Account Balance = $500,000 Owner/Shareholders invest and receive common stock = $1,000,000 Fixed Assets Inventory Work-in-process inventory Labour/utilities Depreciation Finished goods inventory Value is added to inventory through labour ($300,000) and equipment ($100,000). Step 5

22. CHAPTER 23 – Working Capital Management – General Issues23 - 22 Cash Flow Cycle Payment of initial A/P and Accruals Balance Sheet Cash$0.0A/P$0.0 Inventory0.7Accruals0.1 F. Assets0.4Common Stock$1 m _____________________________________ T. Assets$1.0mT. Claims$1.1m Cash Account Balance = $0 Owner/Shareholders invest and receive common stock = $1,000,000 Fixed Assets Inventory Work-in-process inventory Labour/utilities Depreciation Finished goods inventory Suppliers of initial inventory are paid ($0.3m). Labour costs ($0.2m in accruals) are paid – resulting in a $0 cash balance. Step 6 $200,000 paid $300,000 paid

23. CHAPTER 23 – Working Capital Management – General Issues23 - 23 Cash Flow Cycle Goods sold on A/R for a profit Balance Sheet Cash$0.0A/P$0.0 A/R0.5 Inventory0.3Accruals0.1 F. Assets0.4Common Stock$1 m R/E0.1 ____________________________________ T. Assets$1.2mT. Claims$1.2m Cash Account Balance = $0 Owner/Shareholders invest and receive common stock = $1,000,000 Fixed Assets Inventory Work-in-process inventory Labour/utilities Depreciation Finished goods inventory Sold $400,000 of F.G. Inventory for $500,000 Sale of inventory occurs. Accounts receivable created. Cash = $0. There are 30 days till A/R collected. Step 7

24. CHAPTER 23 – Working Capital Management – General Issues23 - 24 Summary of the Exercise This firm is left at the stage where it is waiting to collect on accounts receivable, but should be ordering more inventory and converting that inventory into saleable products.This firm is left at the stage where it is waiting to collect on accounts receivable, but should be ordering more inventory and converting that inventory into saleable products. The firm could move forward if it had additional financing:The firm could move forward if it had additional financing: –Sale of additional shares to investors –Borrow funds –Delay payment of wages to employees until collection of accounts receivable –Collect on accounts receivable.

25. CHAPTER 23 – Working Capital Management – General Issues23 - 25 The Cash Budget Sample

26. CHAPTER 23 – Working Capital Management – General Issues23 - 26 The Cash Budget Purpose The cash budget is a planning tool used to forecast cash inflows and outflows (usually each month) out into the future.The cash budget is a planning tool used to forecast cash inflows and outflows (usually each month) out into the future. The purpose of the cash budget is to forecast the timing, magnitude and duration of cash flow surpluses and deficits.The purpose of the cash budget is to forecast the timing, magnitude and duration of cash flow surpluses and deficits. The cumulative impact of the cash inflows/outflows will be forecast through the cash budget.The cumulative impact of the cash inflows/outflows will be forecast through the cash budget.

27. CHAPTER 23 – Working Capital Management – General Issues23 - 27 Forecast Cash Balances Timing $ Cash Jan Feb Mar Apr May Jun Jul Aug Predicting when forecast deficits start and end allow the manager to communicate with the bank and eventually becomes a control-mechanism for the bank when monitoring the evolving financial condition of the firm.

28. CHAPTER 23 – Working Capital Management – General Issues23 - 28 Forecast Cash Balances Magnitude $ Cash Jan Feb Mar Apr May Jun Jul Aug How much the firm is likely to need to borrow to cover a projected deficit.

29. CHAPTER 23 – Working Capital Management – General Issues23 - 29 Forecast Cash Balances Duration $ Cash Jan Feb Mar Apr May Jun Jul Aug The length of time that the projected cash deficit will last is useful in choosing the right financing solution, but is also an important control mechanism for monitoring after the fact.

30. CHAPTER 23 – Working Capital Management – General Issues23 - 30 The Cash Budget Use The Cash Budget:The Cash Budget: –Allows management to change plans before they are implemented to produce a more favourable cash result –Allows management to choose the most correct investment option in the case of forecast surpluses –Allows management to arrange the most appropriate financing solution in the case of forecast deficits.

31. CHAPTER 23 – Working Capital Management – General Issues23 - 31 Cash Budgets Dealing with Forecast Surpluses Knowing the timing, magnitude and duration of cash surpluses allows management to choose the most appropriate management response:Knowing the timing, magnitude and duration of cash surpluses allows management to choose the most appropriate management response: –Small Amount of Surplus available for a short period of time (ie. less than $100,000) Keep in current accountKeep in current account –Small Sum available for a long period time Consider dispersing as cash dividendsConsider dispersing as cash dividends Potentially retire debtPotentially retire debt –Large Sum available for a short period of time 30 – 90 days (ie. greater than $100,00) Invest in money market securities such as T-billsInvest in money market securities such as T-bills –Large Sum available for a long period time Consider dispersing excess funds as cash dividendsConsider dispersing excess funds as cash dividends Alternatively invest in longer-time, higher yielding investmentsAlternatively invest in longer-time, higher yielding investments

32. CHAPTER 23 – Working Capital Management – General Issues23 - 32 Cash Budgets Dealing with Forecast Deficits Knowing the timing, magnitude and duration of cash deficits allows management to choose the most appropriate management response:Knowing the timing, magnitude and duration of cash deficits allows management to choose the most appropriate management response: –Small deficit persisting for a short period of time (ie. less than $100,000) Delay purchases, speed collections and try to synchronize cash flows to eliminate or minimize, orDelay purchases, speed collections and try to synchronize cash flows to eliminate or minimize, or Negotiate an operating line of credit with the financial institutionNegotiate an operating line of credit with the financial institution –Small deficit available for a long period time Explore more permanent solutions to the under-fundingExplore more permanent solutions to the under-funding –Large deficit forecast to last a short period of time 30 – 90 days (ie. greater than $100,00) Operating line of credit, orOperating line of credit, or Seek longer term permanent capital solutions if large cash flow deficits are likely to reoccur.Seek longer term permanent capital solutions if large cash flow deficits are likely to reoccur. –Large Sum available for a long period time Seek permanent capital increases in the form of debt, equity or combination.Seek permanent capital increases in the form of debt, equity or combination.

33. CHAPTER 23 – Working Capital Management – General Issues23 - 33 Analysis of the impact of sales growth on the firm’s cash position can be done using Equation 23 -1:Analysis of the impact of sales growth on the firm’s cash position can be done using Equation 23 -1: Where:Where: g = monthly sales growth b = the cash production cost and (1 – b ) = unit contribution margin, and S t-1 = Sales at time minus 1 When this relationship is graphed we get a straight line.When this relationship is graphed we get a straight line. Analyzing Cash Inflows and Outflows Cash Changes and Sales Growth [ 23-1] The sensitivity of cash to sales growth will be strongly related to the firm’s inventory and accounts receivable policies.

34. CHAPTER 23 – Working Capital Management – General Issues23 - 34 Analyzing Cash Inflows and Outflows Credit, Inventory and Payables We can create a formula to explore the sensitivity of the firm’s cash position with respect to the firms credit, inventory and payables policies.We can create a formula to explore the sensitivity of the firm’s cash position with respect to the firms credit, inventory and payables policies. Let:Let: α = the firm’s credit policy as the percentage of sales collected this month 1 – α = the balance of sales collected in the month following sales β = the proportion of this month’s production costs paid in this month 1 - β= the proportion of production costs paid next month. Γ = perecentage of the firm’s monthly sales tied up in inventory

35. CHAPTER 23 – Working Capital Management – General Issues23 - 35 Analyzing Cash Inflows and Outflows Credit, Inventory and Payables Equation 23 -2 shows that the change in cash each month depends on:Equation 23 -2 shows that the change in cash each month depends on: –Credit policy – how much sales revenue is collected in the month of sale –Inventory management practices –Trade credit – how much of current production is paid this month versus next month: [ 23-2]

36. CHAPTER 23 – Working Capital Management – General Issues23 - 36 Analyzing Cash Inflows and Outflows Credit, Inventory and Payables We can simplify Equation 23 -2 by including the sales growth rate and removing the different sales levels:We can simplify Equation 23 -2 by including the sales growth rate and removing the different sales levels: [ 23-3] We can now graph the change in cash against the sales growth rate:

37. CHAPTER 23 – Working Capital Management – General Issues23 - 37 Analyzing Cash Inflows and Outflows Change in Cash and Sales Growth 23 - 1 FIGURE g “Break-even” Sales Growth Rate Cash S b-1 (1-b) The slope of this line is determined by the firm’s credit, inventory and payables policies and practices.

38. CHAPTER 23 – Working Capital Management – General Issues23 - 38 Analyzing Cash Inflows and Outflows Change in Cash and Sales Growth 23 - 1 FIGURE g “Break-even” Sales Growth Rate Cash S b-1 (1-b) A lower slope for this line will reduce the firm’s cash sensitivity to changes in sales.

39. CHAPTER 23 – Working Capital Management – General Issues23 - 39 Analyzing Cash Inflows and Outflows Change in Cash and Sales Growth A lower slope can be achieved by: Collecting on A/R more quickly Delaying payments on A/P longer Increasing the inventory turnover rate. 23 - 1 FIGURE g “Break-even” Sales Growth Rate Cash S b-1 (1-b)

40. CHAPTER 23 – Working Capital Management – General Issues23 - 40 Analyzing Cash Inflows and Outflows Credit, Inventory and Payables We can solve for the monthly sales growth rate where the firm can grow without needing or generating cash:We can solve for the monthly sales growth rate where the firm can grow without needing or generating cash: The firm can grow faster if:The firm can grow faster if: –It has a higher gross margin (1 – b) –Lower production costs (b) –Collects is receivables more quickly (higher α) –Pays its bills more slowly (lower β) –Has less inventory (lower γ) [ 23-4]

41. CHAPTER 23 – Working Capital Management – General Issues23 - 41 Use of Ratios in Working Capital Management Ratios are commonly used to assess or to summarize a firm’s working capital management.Ratios are commonly used to assess or to summarize a firm’s working capital management. The focus of such an assessment is:The focus of such an assessment is: –Liquidity management –The firm’s efficiency in asset utilization –Current liability management

42. CHAPTER 23 – Working Capital Management – General Issues23 - 42 Working Capital Management Liquidity Ratios Ratios used to assess the firm’s liquidity include the current and quick ratios:Ratios used to assess the firm’s liquidity include the current and quick ratios: Excessive liquidity will reduce ROI and ROE. It can also mean the firm is too lenient in terms of credit policy, or may have excessive inventories that may be subject to technological obsolescence.Excessive liquidity will reduce ROI and ROE. It can also mean the firm is too lenient in terms of credit policy, or may have excessive inventories that may be subject to technological obsolescence. [ 23-5] [ 23-6]

43. CHAPTER 23 – Working Capital Management – General Issues23 - 43 Working Capital Management Working Capital Ratios Changes in these ratios can indicate growing problems with credit policy and/or a need to improve collections efforts.Changes in these ratios can indicate growing problems with credit policy and/or a need to improve collections efforts. The shorter the collection period, the lower the cash sensitivity to changes in sales.The shorter the collection period, the lower the cash sensitivity to changes in sales. [ 23-7] [ 23-8]

44. CHAPTER 23 – Working Capital Management – General Issues23 - 44 Working Capital Management Working Capital Ratios CGS is not likely to be comparable across different firms, so alternative is to use Sales in the numerator as illustrated in Equation 23 - 10.CGS is not likely to be comparable across different firms, so alternative is to use Sales in the numerator as illustrated in Equation 23 - 10. The higher the inventory turnover, the lower the sensitivity of cash to changes in sales.The higher the inventory turnover, the lower the sensitivity of cash to changes in sales. [ 23-9] [ 23-10]

45. CHAPTER 23 – Working Capital Management – General Issues23 - 45 Working Capital Management Working Capital Ratios Dividing 364 days by inventory turnover (IT) gives ADSI:Dividing 364 days by inventory turnover (IT) gives ADSI: The higher IT the lower ADSI showing more efficient inventory management and a reduced sensitivity of cash to changes in sales.The higher IT the lower ADSI showing more efficient inventory management and a reduced sensitivity of cash to changes in sales. [ 23-11] [ 23-10]

46. CHAPTER 23 – Working Capital Management – General Issues23 - 46 Working Capital Management Working Capital Ratios On the liability side of the balance payable management ratios include:On the liability side of the balance payable management ratios include: PT shows how many times a year a firm pays off its suppliers on average.PT shows how many times a year a firm pays off its suppliers on average. ADSP shows how long a firm defers payments to its suppliers.ADSP shows how long a firm defers payments to its suppliers. [ 23-12] [ 23-13]

47. CHAPTER 23 – Working Capital Management – General Issues23 - 47 Operating Cycle (OC) –Operating cycle is the time period between the acquisition of inventory and when cash is collected from receivables.

48. CHAPTER 23 – Working Capital Management – General Issues23 - 48 Working Capital Management Operating and Cash Conversion Cycles Operating Cycle is defined by Equation 23 -14:Operating Cycle is defined by Equation 23 -14: Operating cycle is a function of average days sales in inventory and the average collection period.Operating cycle is a function of average days sales in inventory and the average collection period. [ 23-14]

49. CHAPTER 23 – Working Capital Management – General Issues23 - 49 Cash Conversion Cycle (CCC) Cash cycle is the time between cash disbursement and cash collection.Cash cycle is the time between cash disbursement and cash collection. An estimate of the average time between when a firm pays cash for its inventory purchases and when it receives cash for its sales; the average number of days of sales that firm must finance outside the use of trade credt.An estimate of the average time between when a firm pays cash for its inventory purchases and when it receives cash for its sales; the average number of days of sales that firm must finance outside the use of trade credt.

50. CHAPTER 23 – Working Capital Management – General Issues23 - 50 Working Capital Management Operating and Cash Conversion Cycles The Cash Conversion Cycle is defined by Equation 23 – 15:The Cash Conversion Cycle is defined by Equation 23 – 15: The estimated time between when a firm pays cash for inventory purchases and when it receives cash from sales.The estimated time between when a firm pays cash for inventory purchases and when it receives cash from sales. [ 23-15]

51. CHAPTER 23 – Working Capital Management – General Issues23 - 51 Cash Conversion Cycle (CCC) Operating and Cash Conversion Cycles Cash Conversion Cycle=Inventory conversion period + Receivables conversion period - Payables deferral period Management of the cash cycle can make an important difference in the amount of financing required, assets employed to generate a given level of sales...and therefore, can affect ROA and ROE.

52. CHAPTER 23 – Working Capital Management – General Issues23 - 52 Cash Flow Time Line Operating and Cash Conversion Cycles Inventory period Inventory sold Cash received Inventory purchased Accounts receivable period Operating cycle (OC) Cash Conversion Cycle (CCC) Cash paid for inventory Accounts payable period Time

53. CHAPTER 23 – Working Capital Management – General Issues23 - 53 Importance of Cash Flow Planning to have cash available to pay bills of the business as they become due is a critical aspect of business survival…it is a management skill.Planning to have cash available to pay bills of the business as they become due is a critical aspect of business survival…it is a management skill. Understanding the cash flow cycle of a firm can help you manage those elements that are critical to ensuring you can pay your bills.Understanding the cash flow cycle of a firm can help you manage those elements that are critical to ensuring you can pay your bills. Cash flow forecasting through a cash budget provides important information to you and to your potential funding partners about your operating financial needs and most particularly, the timing and magnitude of any projected cash deficits or surpluses.Cash flow forecasting through a cash budget provides important information to you and to your potential funding partners about your operating financial needs and most particularly, the timing and magnitude of any projected cash deficits or surpluses.

54. CHAPTER 23 – Working Capital Management – General Issues23 - 54 The Cash Budget The purpose of the cash budget is to forecast the timing and magnitude of expected cash deficits and surpluses so that, before the fact, you (the manager) can arrange appropriate financing or plan an appropriate investment strategy.The purpose of the cash budget is to forecast the timing and magnitude of expected cash deficits and surpluses so that, before the fact, you (the manager) can arrange appropriate financing or plan an appropriate investment strategy.

55. CHAPTER 23 – Working Capital Management – General Issues23 - 55 Short-term Credit short-term loans can be secured much more quickly than long-term creditshort-term loans can be secured much more quickly than long-term credit short-term credit is generally more flexibleshort-term credit is generally more flexible –low flotation costs –generally no prepayment penalties –fewer restrictive covenants with an upward sloping yield curve - short-term credit is normally less expensive than long-term debtwith an upward sloping yield curve - short-term credit is normally less expensive than long-term debt short-term credit may be more risky than long-term debt:short-term credit may be more risky than long-term debt: –interest rate risk exposure –renegotiation risk

56. CHAPTER 23 – Working Capital Management – General Issues23 - 56 Sources of Short-term Financing AccrualsAccruals –spontaneous source of financing –no explicit cost to these sources –examples: accrued wagesaccrued wages accrued taxesaccrued taxes

57. CHAPTER 23 – Working Capital Management – General Issues23 - 57 Sources of Short-term Financing Accounts Payable / Trade CreditAccounts Payable / Trade Credit –there may be no explicit cost (eg. Net 30) –if there is a discount for early payment, then there is an implicit cost for not taking the discount. –discounts lost - an expense on the income statement can reduce net income more than taking a loan in order to take the discount.

58. CHAPTER 23 – Working Capital Management – General Issues23 - 58 Approximate Cost of A/P Approximate percentage cost = [Discount percentage/(100 - Discount percentage)] [365/(Days credit is outstanding - Discount period)] EAR = (1 + periodic interest rate) (number of times/year such an activity can occur) - 1 Example: assume (2/10 net 30) Approximate percentage cost = (2/98)(365/20) = 37.2% EAR = (1 +.0204082) 18.25 - 1 = 1.4458539 - 1 = 44.6% (This, of course, assumes that the company pays on the 30th day. The costs will change if the firm pays later or earlier.)

59. CHAPTER 23 – Working Capital Management – General Issues23 - 59 Sources of Short-term Financing Bank LoansBank Loans –types: operating loansoperating loans line of creditline of credit revolving credit agreementrevolving credit agreement –costs: Effective rate simple = interest/amount received = $800/$10,000 = 8%

60. CHAPTER 23 – Working Capital Management – General Issues23 - 60 Costs of Bank Loans Discount Interest Interest is deducted in advance, reducing the principal amount available to to borrower. Effective rate discount = interest/amount received = interest/(Face value - interest) = $800/($10,000 - $800) = 8.7% or Effective rate discount = 8%/(1-.08) = 8%/(.92) = 8.7%

61. CHAPTER 23 – Working Capital Management – General Issues23 - 61 Cost of Bank Loans Compensating Balances Reduce the the amount of the loan available to the borrower and effectively increase the cost of the loan. Effective rate simple/CB = Nominal Rate(%)/ (1.0 - CB stated as a fraction) = 8%/(1.0 - 0.10) = 8%/.9 = 8.9%

62. CHAPTER 23 – Working Capital Management – General Issues23 - 62 Commercial Paper short-term unsecured promissory note issued only by the most credit-worthy of corporate issuersshort-term unsecured promissory note issued only by the most credit-worthy of corporate issuers by-passes banks and allows the firm direct access to the money marketby-passes banks and allows the firm direct access to the money market is a negotiable security that does not carry a stated rate of interest, rather, it trades at a discount from par value.is a negotiable security that does not carry a stated rate of interest, rather, it trades at a discount from par value.

63. CHAPTER 23 – Working Capital Management – General Issues23 - 63 Banker’s Acceptances an alternative to commercial paper for smaller firms that don’t have the credit-worthiness to secure commercial paper financing.an alternative to commercial paper for smaller firms that don’t have the credit-worthiness to secure commercial paper financing. a money market instrumenta money market instrument the bank “accepts” the promissory note by stamping it “accepted”....the note therefore is secured by the Bank’s promise to pay.the bank “accepts” the promissory note by stamping it “accepted”....the note therefore is secured by the Bank’s promise to pay.

64. CHAPTER 23 – Working Capital Management – General Issues23 - 64 Pledging of A/R lender has claims against the receivables as well as recourse to the borrower.lender has claims against the receivables as well as recourse to the borrower. the risk of default on the receivable stays with the borrower.the risk of default on the receivable stays with the borrower. the buyer of the goods does not know that the receivables have been pledged as collateral for a loan.the buyer of the goods does not know that the receivables have been pledged as collateral for a loan.

65. CHAPTER 23 – Working Capital Management – General Issues23 - 65 Factoring (Selling) A/R legally binding agreement between the seller of the goods and the financial institution.legally binding agreement between the seller of the goods and the financial institution. the factoring institution receives a credit approval slip...the institution does a credit check...if approved, shipment is made and the buyer is instructed to make payment directly to the factoring company.the factoring institution receives a credit approval slip...the institution does a credit check...if approved, shipment is made and the buyer is instructed to make payment directly to the factoring company. the factor - credit check - lends - bears risk - in the process of performing these functions, the firm that sells its receivables to a factor, eliminates the need for an accounts receivable department and receives a net amount of cash immediately following the sale...these funds are advanced by the factor.the factor - credit check - lends - bears risk - in the process of performing these functions, the firm that sells its receivables to a factor, eliminates the need for an accounts receivable department and receives a net amount of cash immediately following the sale...these funds are advanced by the factor. the factor is compensated for its services and protects its interests by charging interest, charging a commission and maintaining a hold-back(reserve) in the case of disputes between buyer and seller over damaged goods, returns, etc.the factor is compensated for its services and protects its interests by charging interest, charging a commission and maintaining a hold-back(reserve) in the case of disputes between buyer and seller over damaged goods, returns, etc. once this arrangement is in place - the financing is spontaneous.once this arrangement is in place - the financing is spontaneous.

66. CHAPTER 23 – Working Capital Management – General Issues23 - 66 Inventory Financing Blanket Liens - gives the lending institution a lien against all of the borrower’s inventories.Blanket Liens - gives the lending institution a lien against all of the borrower’s inventories. Trust Receipts - issued for specific items of inventory. The lending institution sends someone to the borrower’s premises to periodically check that the numbers are correctly listed.Trust Receipts - issued for specific items of inventory. The lending institution sends someone to the borrower’s premises to periodically check that the numbers are correctly listed. Warehouse Receipts - either an independent third party warehouses the goods, or the goods are secured in a separate location on the borrower’s property. Warehouse financing involves:Warehouse Receipts - either an independent third party warehouses the goods, or the goods are secured in a separate location on the borrower’s property. Warehouse financing involves: public notificationpublic notification physical control of the inventoryphysical control of the inventory supervision by a custodiansupervision by a custodian - used to finance the seasonal buildup of inventory. - ensures proper warehousing practices...and inventory control. - because of the foregoing, inventory becomes more acceptable as collateral.

67. CHAPTER 23 – Working Capital Management – General Issues23 - 67 Balance Sheet Accounts over time

68. CHAPTER 23 – Working Capital Management – General Issues23 - 68 Selecting the Fiscal Year End tax considerationstax considerations –for smaller, owner/managed enterprises, there are greater tax-planning opportunities if the corporate fiscal year end is set sometime after the calendar year end –the firm’s financial position –firms will look most healthy if the fiscal year end is set sometime after the seasonal sales peak....long enough afterward to see receivables collected. –auditors preferences –auditors are busy around the calendar year end...with firms and individuals that have selected Dec 31 as their year end. –auditors are busy from February through May with income tax

69. CHAPTER 23 – Working Capital Management – General Issues23 - 69 Key Topics Reasons for holding CashReasons for holding Cash Advantages of holding CashAdvantages of holding Cash Cash BudgetsCash Budgets Cash Management TechniquesCash Management Techniques Marketable Securities ManagementMarketable Securities Management Criteria for selecting marketable securitiesCriteria for selecting marketable securities Balancing Cash and Marketable Security HoldingsBalancing Cash and Marketable Security Holdings

70. CHAPTER 23 – Working Capital Management – General Issues23 - 70 Reasons for Holding Cash transactionstransactions compensation to banks for providing services and loanscompensation to banks for providing services and loans precautionary balances/speculative balances vs. reserve borrowing capacity.precautionary balances/speculative balances vs. reserve borrowing capacity.

71. CHAPTER 23 – Working Capital Management – General Issues23 - 71 Advantages of Holding Cash take advantage of trade discountstake advantage of trade discounts maintain adequate liquidity...and therefore a strong credit ratingmaintain adequate liquidity...and therefore a strong credit rating take advantage of special offers and unexpected opportunitiestake advantage of special offers and unexpected opportunities have sufficient liquid resources in times of emergencyhave sufficient liquid resources in times of emergency

72. CHAPTER 23 – Working Capital Management – General Issues23 - 72 Marketable Securities holding M/Sholding M/S –conservative working capital management strategy –finance seasonal/cyclical needs –build funds for a major investment/acquisition/cash outflow –productive precautionary balance criteria used to select M/Scriteria used to select M/S –default risk –interest rate risk –purchasing power risk –liquidity or marketability risk –overall rate of return

73. CHAPTER 23 – Working Capital Management – General Issues23 - 73 In summary you have … gained an understanding the management of short-term financegained an understanding the management of short-term finance learned that short-term cash flow management involves the minimizing of costs while ensuring there are adequate liquid resources available to meet the anticipated needslearned that short-term cash flow management involves the minimizing of costs while ensuring there are adequate liquid resources available to meet the anticipated needs learned that in the real world, the firm must keep additional working capital resources as a buffer against unexpected needs and opportunitieslearned that in the real world, the firm must keep additional working capital resources as a buffer against unexpected needs and opportunities learned how to prepare a cash budget and how to use it.learned how to prepare a cash budget and how to use it.

74. CHAPTER 23 – Working Capital Management – General Issues23 - 74 Summary and Conclusions In this chapter you have learned: –The importance of effective working capital management and the classic cash flow challenges faced by growing firms. –That an integrative approach to working capital management reveals the relationships and interdependency among working capital accounts –How to generate and use cash budgets –How to use some common ratios to assess a firm’s overall approach to working capital management.

75. CHAPTER 23 – Working Capital Management – General Issues23 - 75 Copyright Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.