CHAPTER16
WorkingCapital
Management
1
TopicsinChapter
n
n
n
n
n
Alternativecurrentoperatingassets
investmentandfinancingpolicies
Cash,inventory,andA/Rmanagement
Accountspayablemanagement
Shorttermfinancing
Bankloans,theircosts,andcommercial
paper
2
BasicDefinitions
n
n
n
Workingcapital:
Totalcurrentassetsusedinoperations.
Networkingcapital:
CurrentassetsCurrentliabilities.
Netoperatingworkingcapital(NOWC):
OperatingCAOperatingCL=
(Cash+Inv.+A/R)(Accruals+A/P)
(More)
3
Definitions(Continued)
Workingcapitalmanagement:
Includesbothestablishingworking
capitalpolicyandthenthedaytoday
controlofcash,inventories,receivables,
accruals,andaccountspayable.
n Workingcapitalpolicy:
n
n
n
Thelevelofeachcurrentasset.
Howcurrentassetsarefinanced.
4
Whatareoperatingcurrent
assets?
n
n
Operatingcurrentassetsarecashplus
marketablesecuritiesheldasa
substituteforoperatingcash,
inventories,andA/R.Theseassetsare
necessarytooperatethebusiness.
Focusofthissection.
5
Whatarenonoperating
currentassets?
n
Consistofanyothercurrentassets,
principallyshorttermsecuritiesin
excessofwhatisrequiredinoperations,
fundsheldincaseofamerger
opportunityarising,cashfromsaleof
stockorbondissuebeforebeinginvest
infixedassts,orfundsheldforpotential
lossfromlawsuit.
6
Amountofcurrentassetsheld
isapolicydecision
n
n
n
Figure161,p.644showsalternative
policiesregardingthesizeofthefirms
operatingcurrentassets.
Toplineisarelaxedpolicyandindicates
firmholdsalotofcash,marketable
securities,receivablesandinventory
relativetosales.
Producesalowtotalassetsturnover
7
andalowROE.
Restrictedandmoderate
operatingcurrentassetpolicy
n
n
n
n
Ifafirmhasarestrict,tight,orleanand
meanpolicy,holdingsofcurrentassets
areminimized.
Indicateslowcurrentassets,ahigh
turnover,andrelativelyhighROE.
Canleadtoshortages,whichexpose
firmtorisk.
Amoderatepolicyliesbetweenthetwo
8
extremes.
SkiEquipmentInc.(SKI)case,
pp.686689
n
n
n
n
n
Newowneroffirmwantstoreward
managersforimprovingEVA.
EVA=NOPATCapitalCosts=
=EBIT(1T)WACC
IfEVAispositive,thefirms
managementiscreatingvalue.
IfEVAisnegative,firmisnotcoveringit
WACCandshareholdersvalueis
eroded.Seepp.6870.
9
SelectedRatiosforSKI
SKI
Industry
Current
1.75
2.25
Quick
0.92
1.16
Total
58.76%
50.00%
TurnoverofCash
16.67
22.22
DSO(365dayyear)
45.63
32.00
Inv.Turnover
6.00
8.00
F.A.Turnover
7.75
13.22
T.A.Turnover
2.08
ProfitMargin
2.07%
3.00
10
3.50%
Liabilities/Assets
a.HowdoesSKIsworking
capitalpolicycomparewiththe
industry?
n
n
Workingcapitalpolicyisreflectedina
firmscurrentratio,quickratio,turnover
ofcashandsecurities,inventory
turnover,andDSO.
TheseratiosindicateSKIhaslarge
amountsofworkingcapitalrelativetoits
levelofsales.Thus,SKIisfollowinga
relaxedpolicy.
11
b.IsSKIinefficientorjust
conservative?
n
n
Arelaxedpolicymaybeappropriateifit
reducesriskmorethanprofitability.
However,SKIismuchlessprofitable
thantheaveragefirmintheindustry.
Thissuggeststhatthecompany
probablyhasexcessiveworkingcapital.
12
Whatistheinventory
conversionperiod?
n
n
n
n
Averagetimerequiredtoconvert
materialsintofinishedgoodsandthen
tosellthosegoods.
Goodsarecarriedatcost,whichiswhy
denominatorisCOGSperday,notdaily
sales.
Inventoryconversionperiod=
Inventory/Costofgoodssoldperday
13
Equation162,p.650.
Whatistheaveragecollection
period?
n
n
n
n
Averagelengthoftimerequiredto
convertthefirmsreceivablesintocash
thatistocollectcashfollowingasale.
Receivablesarerecordedatsalesprice,
andweusedailysalesratherthan
COGS.
Averagecollectionperiod=DSO=
Receivables/(Sales/365).
Equation163,p.650.
14
Whatisthepayablesdeferral
period?
n
n
n
n
Averagelengthoftimebetweenthe
purchaseofmaterialsandlaborandthe
paymentofcashforthem.
Payablesarerecordedatcostand
COGSusedindenominator.
Payablesdeferralperiod=Payables/
Costsofgoodssoldperday.
Equation164,p.650.
15
CashConversionCycle,
Equation161&Figure163,
p.649
Thecashconversioncyclefocusesonthetime
betweenpaymentsmadeformaterialsand
laborandpaymentsreceivedfromsales:
Cash
Inventory
Average
Payables
Conversion= Conversion+ Collection Deferral
Cycle
Period
Period
Period
16
c.CashConversionCycle
(Cont.)
n
Data:
n
n
n
n
n
n
n
Annualsales=$660,000
COGS/Sales=90%
Inventoryturnover=Sales/Inventory=6.
Inventory=$660,000/6=$110,000.
COGS=(0.9)($660,000)=$594,000.
Inv.Conv.=$110,000/($594,000/365)
=67.6days.
17
CashConversionCycle
(Cont.)
Payables
Inventory
Dayssales
CCC=+ deferral
outstanding
conversion
period
period
CCC=67.6+45.630
CCC=83.2days.
18
CashManagement:Cashdoesntearn
interest,sowhyholdit?
n
n
n
n
Transactions(Routine):Musthavesomecash
topaycurrentbills.
Transactions(Precaution):Safetystock.But
lessenedbycreditlineandmarketable
securities.
Compensatingbalances:Forloansand/or
servicesprovided.
Essentialthatthefirmhavesufficientcashto
taketradediscounts.
19
Whatsthegoalofcash
management?
Minimizethecashamountthefirmmust
holdforconductingitsnormalbusiness
activities,yet,atthesametime,havea
sufficientcashreserveto:
n taketradediscounts.
n paypromptlyandmaintainitscredit
rating.
n meetanyunexpectedcashneeds.
20
WaystoMinimizeCash
Holdings
n
n
n
n
Uselockboxes.
Insistonwiretransfersorautomatic
debitfromcustomers.
Synchronizeinflowsandoutflows.
Usefloatdifferencebetweenthe
balanceshownonfirmscheckbookand
thebalanceonthebanksrecords.
(More)
21
MinimizingCash(Continued)
n
n
n
Increaseforecastaccuracytoreduce
theneedforacashsafetystock.
Holdmarketablesecuritiesinsteadofa
cashsafetystock.
Negotiatealineofcredit(alsoreduces
needforasafetystock).
22
CashBudget:ThePrimary
CashManagementTool
n
n
Purpose:Usesforecastsofcashinflows,
outflows,andendingcashbalancestopredict
loanneedsandfundsavailablefortemporary
investment.
Timing:Daily,weekly,ormonthly,depending
uponbudgetspurpose.Monthlyforannual
planning,dailyforactualcashmanagement.
23
DataRequiredforCash
Budget
n
n
n
n
n
n
Salesforecast.
Informationoncollectionsdelay.
Forecastofpurchasesandpayment
terms.
Forecastofcashexpenses:wages,
taxes,utilities,andsoon.
Initialcashonhand.
Targetcashbalance.
24
d.SKIsCashBudgetfor
JanuaryandFebruary
NetCashInflows
January
February
Collections
$67,651.95
$62,755.40
Purchases
44,603.75
36,472.65
Wages
6,690.56
5,470.90
Rent
2,500.00
2,500.00
$53,794.31
$44,443.55
TotalPayments
25
CashBudget(Continued)
January
February
Cashonhandat
startofforecast
$3,000.00
NetCF(CollPymt)
13,857.64
18,311.85
$16,857.64
$35,169.49
1,500.00
1,500.00
$15,357.64
$33,669.49
CumulativeNCF
Targetcash
Surpluscash
26
e.Shoulddepreciationbe
explicitlyincludedinthecash
budget?
n
n
No.Depreciationisanoncashcharge.
Onlycashpaymentsandreceipts
appearoncashbudget.
However,depreciationdoesaffect
taxes,whichdoappearinthecash
budget.
27
Whataresomeotherpotential
cashinflowsbesidescollections?
n
n
n
n
Proceedsfromfixedassetsales.
Proceedsfromstockandbondsales.
Interestearned.
Courtsettlements.
28
f.Howcouldbaddebtsbe
workedintothecashbudget?
n
n
n
Collectionswouldbereducedbythe
amountofbaddebtlosses.
Forexample,ifthefirmhad3%bad
debtlosses,collectionswouldtotalonly
97%ofsales.
Lowercollectionswouldleadtolower
surplusesandhigherborrowing
requirements.
29
g.Cashbudgetforecaststhecompanyscash
holdingstoexceedtargetedcashbalanceevery
month,exceptforOctoberandNovember.
n
n
Cashbudgetindicatesthecompany
probablyisholdingtoomuchcash.
SKIcouldimproveitsEVAbyeither
investingitsexcesscashinmore
productiveassetsorbypayingitoutto
thefirmsshareholders.
30
h.WhymightSKIwantto
maintainarelativelyhighamount
ofcash?
n
n
n
Ifsalesturnouttobeconsiderablylessthan
expected,SKIcouldfaceacashshortfall.
Acompanymaychoosetoholdlarge
amountsofcashifitdoesnothavemuchfaith
initssalesforecast,orifitisvery
conservative.
Thecashmaybethere,inpart,tofunda
plannedfixedassetacquisition.
31
i.IsSKIholdingtoomuch
inventory?
n
n
SKIsinventoryturnover(6.00)is
considerablylowerthantheindustryaverage
(8.00).Thefirmiscarryingalotofinventory
perdollarofsales.
Byholdingexcessiveinventory,thefirmis
increasingitsoperatingcostswhichreduces
itsNOPAT.Moreover,theexcessinventory
mustbefinanced,soEVAisfurtherlowered.
32
j.IfSKIreducesitsinventory,without
adverselyaffectingsales,whateffectwill
thishaveonitscashposition?
n
n
Shortrun:Cashwillincreaseas
inventorypurchasesdecline.
Longrun:Companyislikelytothen
takestepstoreduceitscashholdings.
33
k.AccountsReceivableManagement:Do
SKIscustomerspaymoreorless
promptlythanthoseofitscompetitors?
n
n
n
SKIsdayssalesoutstanding(DSO)of
45.6daysiswellabovetheindustry
average(32days).
SKIscustomersarepayingless
promptly.
SKIshouldconsidertighteningitscredit
policytoreduceitsDSO.
34
ElementsofCreditPolicy
n
n
CashDiscounts:Lowersprice.Attracts
newcustomersandreducesDSO.
CreditPeriod:Howlongtopay?
ShorterperiodreducesDSOand
averageA/R,butitmaydiscourage
sales.
35
(More)
CreditPolicy(Continued)
n
n
CreditStandards:Tighterstandards
reducebaddebtlosses,butmayreduce
sales.FewerbaddebtsreducesDSO.
CollectionPolicy:Tougherpolicywill
reduceDSO,butmaydamage
customerrelationships.
36
l.DoesSKIfaceanyriskifit
tightensitscreditpolicy?
n
YES!Atightercreditpolicymay
discouragesales.Somecustomers
maychoosetogoelsewhereiftheyare
pressuredtopaytheirbillssooner.
37
m.IfSKIsucceedsinreducingDSO
withoutadverselyaffectingsales,what
effectwouldthishaveonitscash
position?
n Shortrun:Ifcustomerspaysooner,this
increasescashholdings.
n Longrun:Overtime,thecompany
wouldhopefullyinvestthecashinmore
productiveassets,orpayitoutto
shareholders.Bothoftheseactions
wouldincreaseEVA.
38
Isthereacosttoaccruals?
Canfirmscontrolaccruals?
n
n
Accrualsarefreeinthatnoexplicit
interestischarged.
Firmshavelittlecontroloverthelevelof
accruals.Levelsareinfluencedmore
byindustrycustom,economicfactors,
andtaxlaws.
39
Whatistradecredit?
n
n
n
n
Tradecreditiscreditfurnishedbya
firmssuppliers.
Tradecreditisoftenthelargestsource
ofshorttermcredit,especiallyforsmall
firms.
Spontaneous,easytoget,butcostcan
behigh.
SeeFigure167,p.670.
40
o.SKIbuys$200,000ofmaterialsnet,on
termsof1/10,net30butpaysonDay40.
Findfreeandcostlytradecredit.
n
n
Netdailypurchases=$200,000/365
=$547.94.
Ann.grosspurch.=$200,000/(10.01)
=$202,020.
41
Gross/NetBreakdown
n
n
n
n
Companybuysequipworth$200,000.
Thatstheequipmentscashprice.
Thefirmmustpay$2,020moreifit
doesnttakediscounts.
Thinkoftheextra$2,020asafinancing
costsimilartotheinterestonaloan.
Wanttocomparethatcostwiththecost
ofabankloan.
42
FreeandCostlyTradeCredit
Payableslevelforequipmentiftakediscount:
Payables=$547.94(10)=$5,479.
Payableslevelifdonttakediscount:
Payables=$547.94(40)=$21,918.
Totaltradecredit
Freetradecredit
Costlytradecredit
=$21,918
=5,479
=$16,439
43
NominalCostofCostlyTrade
Credit,rNOM
Firmloses0.01($202,020)=$2,020of
discountstoobtain$16,439inextra
tradecredit,so:
$2,020
rNOM==0.1229=12.29%
$16,439
Butthe$2,020ispaidallduringtheyear,
notatyearend,soeffectiveannualrate
ishigher.
44
NominalCostFormula,1/10,
net40
rNOM=Discount%
1Discount%
1
=
99
365
30
365days
Days
Discount
Take
Period
n
=0.010112.1667
=0.1229=12.29%
Pays1.01%12.167timesperyear.
45
EffectiveAnnualRate(EAR),
1/10,net40
n
n
n
Periodicrate=0.01/0.99=1.01%.
Periods/year=365/(4010)
=12.1667.
EAR =(1+Periodicrate)n1.0
=(1.0101)12.16671.0
=13.01%.
46
CurrentOperatingAssets
FinancingPolicies
n
n
n
Moderate:Matchthematurityofthe
assetswiththematurityofthefinancing.
Aggressive:Useshorttermfinancingto
financepermanentassets.
Conservative:Usepermanentcapital
forpermanentassetsandtemporary
assets.
47
ModerateFinancingPolicy
$
Temp. NOWC
}
Perm NOWC
S-T
Loans
L-T Fin:
Stock &
Bonds,
Fixed Assets
Years
Lower dashed line, more aggressive. 48
ConservativeFinancingPolicy
$
Marketable Securities
Perm NOWC
Fixed Assets
Zero S-T
debt
L-T Fin:
Stock &
Bonds
Years
49
Whataretheadvantagesofshort
termdebtvs.longtermdebt?
n
n
n
Lowcostyieldcurveusuallyslopes
upward.
Cangetfundsrelativelyquickly.
Canrepaywithoutpenalty.
50
Whatarethedisadvantagesofshort
termdebtvs.longtermdebt?
n
Higherrisk.Therequiredrepayment
comesquicker,andthecompanymay
havetroublerollingoverloans.
51
Shorttermbankloans
n
n
n
n
Whenabankloanisapproved,the
agreementisexecutedbysigninga
promissorynote.
Alineofcreditisaninformalagreement
betweenabankandaborrower
indicatingthemaximumcreditthebank
willextendtotheborrower.
Arevolvingcreditagreementisaform
lineofcreditoftenusedbylargefirms.
Bankhasalegalobligationtohonorthe
52
revolvingcreditagreement.
CommercialPaper(CP)
n
n
n
Shorttermnotesissuedbylarge,strong
companies.SKIcouldntissueCPits
toosmall.
CPtradesinthemarketatratesjust
aboveTbillrate.
CPisboughtwithsurpluscashby
banksandothercompanies,thenheld
asamarketablesecurityforliquidity
53
purposes.