Working Capital Management

What is working capital management?

Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable.

Short term bank loans: cost of bank loan How does the cost of a bank loan work?

Cost of bank loans are different for different types of borrowers and vary over time. Bank publishes prime rate (rate a bank charges its strongest customer: small firms might receive a loan with a rate of "prime plus 1.0%) but loans to very large and good customers are often tied to LIBOR (e.g., LIBOR plus 1.5%, below the prime rate)

*What are the 3 policies of efficient investment in operating current assets?

Relaxed policy Restricted policy Moderate policy

Should depreciation be explicitly included in the cash budget?

No. Depreciation is a noncash charge. Only cash payments and receipts appear on cash budget. However, depreciation does affect taxes, which do appear in the cash budget.

If GBM reduces its inventory, without adversely affecting sales, what effect will this have on free cash flow?

Short run: A one-time reduction in inventory causes an identical one-time increase in free cash flows. Long run: If sales grow and inventory improvement processes are maintained, future FCF each year will be greater than it otherwise would have been. An improvement in a working capital process is a gift that keeps on giving.

If GBM succeeds in reducing DSO without adversely affecting sales, what effect would this have on its free cash flows?

Similar to the situation with inventory Short run: A one-time reduction in DSO causes an identical one-time increase in free cash flows. Long run: If sales grow and DSO remains at it new level, then future FCF each year will be greater than it otherwise would have been.

What are the two goals of inventory management?

To ensure that the inventories needed to sustain operations are available. To hold the costs of ordering and carrying inventories to the lowest possible level.

What are some other potential cash inflows besides collections?

Proceeds from fixed asset sales/Proceeds from stock and bond sales/ Interest earned/Court settlements

*Increases in aging schedule or DSO do not necessarily indicate that firm's credit policy has weakened. Why?

*16

What are the four components of a firms credit policy?

1. Credit period 2. Cash discounts 3. Credit standards - financial strength customer must show 4. Collection policy - How aggressive company is in collecting slow-paying accounts

Example - Cost of trade credit 1. Microchip Electronics sells on terms of 2/10, net 30. True price of Microchip's product is the net price, 0.98 times the list price. Why? 2. What is the total annual cost of credit? How does the financing/discounting effect the accounts payable balance? 3. Should PCC turn down the discount to obtain the additional 20 days of credit?

1. If PCC wants an additional 20 days of credit beyond the 10-day discount period, it must incur a finance charge of $2 per chip for that credit. So, the list price is composed of two components: List price=$98 true price+$2 finance charge 2. PCC takes the credit: PCC must pay a finance charge (=$2 discount) it is forgoing for each unit it purchases. PCC purchases 73,000 chips per year. So, total annual cost of financing: =$2(73,000)=$146,000 PCC takes the discount: PCC's daily purchases are equal to daily units multiplied by the true price: =(73,000/365)*$98=$19,600. PCC with discount: Account payable balance will be $19,600*10=$196,000. (Free Trade Credit) PCC with credit: Account payable balance will be $19,600*30=$588,000. So, the AP increase by $392,000 (Costly Trade Credit) 3. Nominal Cost of Costly Trade Credit, rNOM Firm loses $146,000 of discounts to obtain $392,000 in extra trade credit, so: (pictured) If PCC can borrow from its bank at an interest rate less than 37.2%, then it should take the 2% discount and forgo the additional trade credit.

What are two types of short term bank loans?

1. Informal Line of Credit 2. Revolving Credit agreement - A formal line of credit (often used by large firms) - Formal commitment by banks (for specific amount and period of the loan) - Commitment fee (0.25%) paid on the unused balance of the commitment to compensate banks for their commitment.

What six data points are required to form a cash budget?

1. Sales forecast. 2. Information on collections delay. 3. Forecast of purchases and payment terms. 4. Forecast of cash expenses: wages, taxes, utilities, and so on. 5. Initial cash on hand. 6. Target cash balance.

What are four ways to minimize target cash balance?

1. Synchronize inflows and outflows. - Timing cash receipts to coincide with their cash outlays. 2. Use float (Disbursement float vs. Collection float) - Difference between the balance shown in a firm's checkbook and the balance on the bank's records. 3. Use lockboxes. - Incoming checks are sent to local post office boxes rather than to the firm's corporate headquarters. Checks are deposited into firm's local accounts. 4. Insist on wire transfers or automatic debit from customers. - Clearing and settlement occur much more quickly

What are the two goals of inventory management?

1. To ensure that the inventories needed to sustain operations are available. 2. To hold the costs of ordering and carrying inventories to the lowest possible level.

Cash doesn't earn any interest, so what are 3 reasons that companies should hold onto it?

1. Transactions balances - Must have some cash to pay current bills. - Cash balances associated with routine payments and collections. 2. Precautionary balances (i.e.,"Safety stock") - Firms with volatile/unpredictable cash flows should hold higher cash balances. - Not as much needed if company has credit line or other holdings of short-term securities. - Essential that the firms have sufficient cash to take trade discounts. 3. Compensating balances (vs. Direct fee): For loans and/or services provided, bank may require that customers to leave a minimum balance on deposit.

What is the equation for ACP?

AR/(Sales/Day)

Example: Suppose BLC, a wholesales distributor of lumber products, had always collected at the time of the purchase (Average collection period of 0 days). Its sales were lower than they would have been if it offered credit sales. So, BLC began offering credit sales on Jan 1 with the term "net 30" and all customers bought on credit. Sales increased to $1,000 each day, but what impact did this have on AR?

Account receivable=Sales per day x Average collection period 1000 x 30 = 3000

*What are the advantages and disadvantages of

Advantages of short-term debt and long-term debt Disadvantages of short-term debt and long-term debt

Short term bank loans: Promissory note

Amount borrowed/interest rate/repayment schedule/collateral/other agreed terms or condition

What is a disbursement float?

Amount of time it takes to transfer money. This is like "available balance" vs. checking account balance

Monitoring Receivables Position - Credit terms, Customer Behavior, and the Days Sales Outstanding (DSO) Example: Suppose Super Set Inc., a manufacturer of ultra-thin televisions, sells 219,000 sets a year at a price of $200 each. Assume that all sales are on credit under the terms 2/10, net 30. Finally, assume that 70% of the customers take the discount and pay on Day 10 and 30% pay on Day 30. What would be Super Set's accounts receivable at any point in time?

Average collection period=DSO=0.7*(10 days)+0.3*(30 days)=16 days Sales per day=Annual dales/365= (Units sold)*(Sales price)/365=$120,000

What are 3 characteristics of accruals?

Balance sheets typically show some accrued wages and taxes. Increase automatically (spontaneously) as firm's operation expands. Firm cannot ordinarily control its accruals.

Short term bank loans: Compensating balances

Banks often require borrowers to maintain an average demand deposit balance of 10% to 20% of the loan's face amount. This increases the effective interest rate on the loan.

*How do expanding sales and lengthening credit both effect business operations? (e.g., Suppose a firm makes purchase of $2,000 a day on terms of net 30. What happens if either sales increase or credit period is extended?)

Both expanding sales and lengthening the credit period adds additional amounts of financing via trade credit.

Short term bank loans: Maturity

Bulk of their lending is on a short-term basis (approx. 2/3 mature in a year or less; frequently written as 90-day notes)

What is the equation for Cash Conversion Cycle?

CCC = ICP + ACP - PDP Where each component of CCC is defined as: -Inventory conversion period (ICP): Length of time between purchasing materials or merchandise from suppliers and recording sales to customers (this creates an account receivable if the firm offers credit to its customers) -Average collection period (ACP): Length of time customers are given to pay for goods following a sale (Also called Days sales outstanding (DSO) or receivables conversion period). -Payable deferral period (PDP): Length of time a supplier allows customer to defer payment after making a purchase.

What is the inventory turnover ratio equation?

COGS/Inventory

Example: Targeted cash conversion cycle GBM Inc. buys medical devices from manufacturers in China and sells them in the U.S. -50 days from the time GBM purchases merchandise ($10 million a month) until the time it sells to its customers. -GBM's suppliers requires payment within 40 days. -GBM gives its customers 60 days to pay for their purchases. What is the GBM's target Cash Conversion Cycle (CCC)?

Cash conversion Cycle= Inventory conversion period + Average collection period - Payables deferral period =50+60-40=70 days. What does this indicate? Would the firm prefer shorter CCC?

What is the cash conversion cycle?

Cash conversion cycle is a "working capital cycle". The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales and is defined as the following:

Calculating Bank's interest charges: Regular, Simple, and Effective interest Assume a loan of $10,000 at 5.25% with 365-day year. Interest must be paid monthly, and the principal is payable "on demand" if and when the bank wants to end the loan.

Compute simple interest rate per day =(𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒)/(𝐷𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟) =0.0525/365=0.0001438356. Compute interest charge for month using the rate in the 1st step Interest charge for month: =(rate per day)(amount of loan)(days in month) =(0.0001438356)($10,000)(30.4167) =$43.75 Effective interest rate: =(1+0.0525/12)12-1 =5.378%

What are some of the exogenous factors and controllable factors to boost sales?

Exogenous: State of the economy Controlled: 1. Sale price 2. Product Quality 3. 4. Credit Policy

Suppose a firm's inventory turnover ratio is 3 and its COGS is $120 million. What's its inventory level? If the firm can improve the turnover ratio to 4, what would be resulting impact on FCF?

ITR = 3 COGS = 120 INV = 40 ITR = 4 COGS = 120 INV = 30 (10 Million increase in FCF)

How can interest earned or paid on short-term securities or loans be incorporated in the cash budget?

Interest earned: Add line in the collections section. Interest paid: Add line in the payments section.

Example - Actual CCC from balance sheet Using the data taken from GBM's financial statements (millions) Annual Sales = 150 COGS = 122 Inventories = 17 Account receivable = 51 Account payable = 13

Inventory conversion period (ICP) =𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦/(𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦) =$17/($122/365) =50.9 days Average collection period (ACP or DSO) =𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠/(𝑆𝑎𝑙𝑒𝑠/365) =$51/($150/365)=124.1 days Payable deferral period (PDP) =𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠/(𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 𝑝𝑒𝑟 𝑑𝑎𝑦) =$13/($122/365) =38.9 days Then, CCC=50.9 days+124.1 days-38.9 days =136.1 days

What is an aging schedule?

It breaks down a firm's receivables by age of account. Consider these factors and look at the data table Aging schedules for two television manufacturers: Super Set: All of customers pay on time VS. Wonder Vision: many customers are not paying on time. - Both firms offer same credit terms & have the same total receivables. If the schedule exhibits an increasing percent of past due accounts or DSO, credit managers should examine the reasons for such changes.

What is the result of improvement in inventory conversion period?

It can lead to inventory reduction Analysts also use inventory turnover ratio (COGS/Inventory) as a performance measure: we can calculate inventory reduction due to improvements in turnover.

What is a cash budget? What is the purpose and how does timing effect it?

It is the primary cash management tool. Purpose: Uses forecasts of cash inflows, outflows, and ending cash balances to predict loan needs and funds available for temporary investment. Timing: Can be of any length: Daily, weekly, or monthly, depending upon budget's purpose. Monthly budget is used for annual planning. Daily cash budget is also prepared for actual cash management.

*What are the 3 approaches to financing operating current assets?

Maturity matching approach (self-liquidating approach) Aggressive approach Conservative approach

What is working capital policy?

The level of each current asset. How current assets are financed.

*18.25?*What is the nominal cost of trade credit formula?

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑇𝑟𝑎𝑑𝑒 𝐶𝑟𝑒𝑑𝑖𝑡: =𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 ×𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 =𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡/(100−𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 )×365/(𝐷𝑎𝑦𝑠 𝑐𝑟𝑒𝑑𝑖𝑡 𝑖𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔−𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑) Using PCC's term (2/10, net 30), the nominal cost is Nominal cost of trade credit = 2/(100−2 )×365/(30−10) =2.04%×18.25 =37.2% If compounding of interest is considered, the cost of trade credit is even higher, Effective annual rate: =(1.0204)^18.25−1 =1.4459-1.0 =44.6%