1. 1 The Balance-Sheet Model of the Firm How much short- term cash flow does a company need to pay its bills? The Net Working Capital Investment Decision Net Working Capital Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

2. 2 Current Assets and current liabilities Current Assets are cash and other assets that are expected to be converted to cash with the year. CashMarketable securities Accounts receivableInventory Current Liabilities are obligations that are expected to require cash payment within the year. Accounts payableAccrued wages Taxes

3. 3 Working Capital Net Working Capital - Current assets minus current liabilities. Often called working capital. Cash Cycle - Period between firm’s payment for materials and collection on its sales. Carrying Costs - Costs of maintaining current assets, including opportunity cost of capital. Shortage Costs - Costs incurred from shortages in current assets.

4. 4 Working capital tension

5. 5 Working Capital Simple Cycle of operations Finished goods inventory Receivables Cash Raw materials inventory

6. 6 The Operating Cycle and the Cash Cycle Time Accounts payable period Cash cycle Operating cycle Cash received Accounts receivable periodInventory period Finished goods sold Firm receives invoiceCash paid for materials Order Placed Stock Arrives Raw material purchased

7. 7 Operation cycle raw material turnover period - trade credit given period + production period + finished goods turnover period + trade credit taken period

8. 8 Operating cycle Raw material turnover period = Average raw material stock Purchase of raw material per day Trade credit given period =Creditors Purchase of raw material per day Production period=Work in progress Cost of goods sold per day Finished goods turnover period =Finished goods stock Cost of goods sold per day Trade credit taken period=Debtors Sales per day

9. 9 Operating cycle SupermarketManufacturer (1) Raw material turnover17 (2) Trade credit taken(6) (3) Production period03 (4) Finished goods turnover04 (5) Trade credit given06 (5)14

10. 10 The Operating Cycle and the Cash Cycle In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables and days in payables. Cash cycle=Operating cycle– Accounts payable period

11. 11 Short Term Financial Policy Determining the amount of current assets Financing of current assets How? Trade-off between carrying costs and shortage costs

12. 12 The Amount of the Investment in Current Assets A flexible policy short-term finance policy would maintain a high ratio of current assets to sales. Keeping large cash balances and investments in marketable securities. Large investments in inventory. Liberal credit terms. A restrictive short-term finance policy would maintain a low ratio of current assets to sales. Keeping low cash balances, no investment in marketable securities. Making small investments in inventory. Allowing no credit sales (thus no accounts receivable).

13. 13 Carrying Costs and Shortage Costs Total costs of holding current assets. $ Investment in Current Assets ($) Shortage costs Carrying costs CA* Minimum point

14. 14 Alternative Financing Policies for Current Assets A flexible short-term finance policy means low proportion of short-term debt relative to long-term financing. A restrictive short-term finance policy means high proportion of short-term debt relative to long-term financing.

15. 15 Matching for Current Assets In an ideal world, short-term assets are always financed with short-term debt and long-term assets are always financed with long-term debt. In this world, net working capital is always zero.

16. 16 Capital Requirement Lines A, B, and C show alternative amounts of long-term finance. Dollars A B C Year 2Year 1Time Cumulative capital requirement Strategy A: A permanent cash surplus Strategy B: Short-term lender for part of year and borrower for remainder Strategy C: A permanent short-term borrower

17. 17 Flexible and Restrictive Policy ProfitabilityLiquidity FlexibleLowerHigher (conservative) RestrictiveHigherLower (aggressive) Carriage cost Vs Shortage cost

18. 18 Inventory management

19. 19 Inventory Model F = The fixed ordering cost T = The total amount of inventories needed K = The carrying cost Time C If we start with $C, spend at a constant rate each period and replace our inventories with $C when we run out of stock, our average inventories balance will be. 1 2 3 The carrying cost of holding is

20. 20 The Inventory Model F = The fixed cost of ordering cost T = The total amount of inventories needed K = The carrying cost. Time C As we buy $C each period we incur a trading cost of F each period. If we need T in total over the planning period we will pay $F, T ÷ C times. 1 2 3 The total carrying cost is

21. 21 Costs of Holding Cash & Inventories Holding Costs Ordering costs Total cost of holding inventories C*C* Costs in dollars of holding inventories Size of order Ordering costs decrease when the firm increases the ordering size

22. 22 Inventories & Cash Balances Value of re-order quantity = Q = 2 x annual demand x cost per order carrying cost 2 x 1260 x 20.08 Weeks 0 25 12.5 balance Inventory Average inventory = = 25 12345

23. 23 The cash trade-off

24. 24 Cash doesn ’ t earn a profit, so why hold it? 1.Transactions: Must have some cash to operate. 2.Precaution: “ Safety stock. ” But lessened by line of credit, marketable securities. 3.Compensating balances: For loans and/or services provided. 4.Speculation: To take advantage of bargains, to take discounts, etc. Reduced by credit lines, securities.

25. 25 Terms of Sale - Credit, discount, and payment terms offered on a sale. Example - 5/10 net 30 5 - percent discount for early payment 10 - number of days that the discount is available net 30 - number of days before payment is due

26. 26 Estimation of the Cost of Short Term Credit Interest = principal x rate x time Annual % rate = interest x 1 principal time NOTE: Estimation only, not accurate

27. 27 Terms of Sale A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier. We can calculate the implicit cost of this loan

28. 28 The Interest Rate Implicit in 3/10 net 30 A firm offering credit terms of 3/10 net 30 is essentially offering their customers a 20-day loan. To see this, consider a firm that makes a $1,000 sale on day 0 Some customers will pay on day 10 and take the discount. Other customers will pay on day 30 and forgo the discount. 01030 $970 01030 $1,000

29. 29 01030 +$970 -$1,000 A customer that forgoes the 3% discount to pay on day 30 is borrowing $970 for 20 days and paying $30 interest: The Interest Rate Implicit in 3/10 net 30

30. 30 Average Collection Period Measures the average amount of time required to collect an account receivable. For example, a firm with average daily sales of $20,000 and an investment in accounts receivable of $150,000 has an average collection period of

31. 31 Factoring The sale of a firm ’ s accounts receivable to a financial institution (known as a factor). The firm and the factor agree on the basic credit terms for each customer. Firm Factor Customer Customers send payment to the factor The factor pays an agreed- upon percentage of the accounts receivable to the firm. The factor bears the risk of nonpaying customers Goods

32. 32 How to Decide the Working Capital Policy Amount of cash reserves Maturity hedging (long with long) Term structure (interest rate trend)