Finance - 08 Topic - Working capital management

What does firm's credit policy consists of ?

It consists of four elements: (1) credit period, (2) discounts given for early payment, (3) credit standards, and (4) collection policy.

what is purpose of working capital management?

It has two main decisions at two consecutive stages. They are as follows: 1. The level of Current Assets - How much to invest in Current Assets to achieve the Targeted Revenue? 2. Means of Financing Current Assets - How should the above Current Asset Investment be financed i.e. the mix of long and short term finance?

What is a revolving credit?

It is agreement is a formal line of credit often used by large firms; it involves a commitment fee.

What is A line of credit?

It is an informal agreement between the bank and the borrower indicating the maximum amount of credit the bank will extend to the borrower.

What is net operating working capital?

It is equal to cash, accounts receivables, and inventories less accounts payable and accruals.

What are Accounts payable, or trade credit?

It is money owed by a business to its suppliers shown as a liability on a company's balance sheet. It is distinct from notes payable liabilities, which are debts created by formal legal instrument documents.

What is an add-on interest loan

It is one in which interest is calculated and added to the funds received to determine the face amount of the installment loan.

What is a simple interest loan

It is one in which interest must be paid monthly and the principal is payable "on demand" if and when the bank wants to end the loan.

What is the 'Average Collection Period'?

It is the approximate amount of time that it takes for a business to receive payments owed in terms of accounts receivable. Average collection period = DSO = Receivables / (Sales/365) The average collection period represents the average number of days between the date a credit sale is made and the date payment is received from the credit sale.

what is secured loan?

Secured loans are those loans that are protected by an asset or collateral of some sort. The item purchased, such as a home or a car, can be used as collateral, and a lien is placed on such item.

The cash conversion cycle CCC?

The calculation measures how fast a company can convert cash on hand into inventory and accounts payable, through sales and accounts receivable, and then back into cash. *is the length of time between the firm's actual cash expenditures to pay for productive resources (materials and labor) and its own cash receipts from the sale of products (that is, the length of time between paying for labor and materials and collecting on receivables):

What's the difference between free trade credit and costly trade credit?

Trade credit can be divided into two components: (1) free trade credit, which involves credit received during the discount period, and (2) costly trade credit, which involves credit in excess of the free trade credit and whose cost is an implicit one based on the forgone discounts.

What are 4 elements of credit policy?

(1) credit period, (2) discounts given for early payment, (3) credit standards, and (4) collection policy.

What are The advantages of short-term credit ?

(1) the speed with which short-term loans can be arranged, (2) increased flexibility, and (3) generally lower interest rates than with long-term credit.

What are goals of inventory management and how many of them is there?

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

What is a cash budget and what is it used for?

A cash budget is a schedule showing projected cash inflows and outflows over some period. The cash budget is used to predict cash surpluses and deficits, and it is the primary cash management planning tool.

Would it ever make sense to borrow on a short-term basis if short-term rates were above long-term rates?

A firm might borrow short-term if it thought that interest rates were going to fall and, therefore, that the long-term rate would go even lower. A firm might also borrow short-term if it were only going to need the money for a short while and the higher interest would be offset by lower administration costs and no prepayment penalty. Thus, firms do consider factors other than interest rates when deciding on the maturity of their debt.

What is Net working capital ?

Net working capital is the aggregate amount of all current assets and current liabilities. -It is used to measure the short-term liquidity of a business, and can also be used to obtain a general impression of the ability of company management to utilize assets in an efficient manner. current assets minus all current liabilities

What is formula for Nominal Cost of trade credit?

Nominal cost = Discount percentage / (100 - DP) * 365 / (Days credit outstanding - Discount period)

What are features of restricted policy aka aggressive working capital policy.?

The estimation of current assets for achieving targeted revenue is done very aggressively without considering for any contingencies and provisions for any unforeseen event. After deciding, these policies are forcefully implemented in the organization without tolerating any deviations. In the diagram, point R represents the restricted policy which attains the same level of revenues with lowest current assets. the firm would hold minimal amounts of these items. the disadvantage in the form of high risk due to very aggressive policy. Under an aggressive approach, some permanent operating current assets, and perhaps even some fixed assets, are financed with short-term debt.

What is short-term financing policy?

The methods used to finance permanent and temporary operating current assets.

What kind of the working capital policies can we have?

They are -restricted, -relaxed and -moderate

What are Permanent operating current assets ?

They are the operating current assets the firm holds even during slack times

Is this correct statement "Firms can control their accruals within fairly wide limits."

This statement is false. A firm cannot ordinarily control its accruals since payrolls and the timing of wage payments are set by economic forces and by industry custom, while tax payment dates are established by law.

What is an aggressive working capital policy ?

is one in which you try to squeeze by with a minimal investment in current assets coupled with an extensive use of short-term credit.

What are disadvantage of short-term credit ?

short-term credit carries extra risk the borrower must bear because (1) the lender can demand payment on short notice, and (2) the cost of the loan will increase if interest rates rise.

What is working capital ?

the capital of a business which is used in its day-to-day trading operations, calculated as the current assets minus the current liabilities.

what are relaxed working capital policies

the estimation of current assets for achieving the targeted revenue is prepared after careful consideration of uncertain events such as seasonal fluctuations, a sudden change in the level of activities or sales etc. a firm would hold relatively large amounts of each type of current asset *Use long-term sources to finance all permanent operating capital and some of the temporary operating current assets *It's disadvantage of lower return on investment because higher investment in the current assets attracts higher interest cost which in turn reduces profitability.

What are temporary operating current assets ?

they are the additional operating current assets needed during seasonal or cyclical peaks.

From the standpoint of the borrower, is long-term or short-term credit riskier?

From the standpoint of the borrower, short-term credit is riskier because short-term interest rates fluctuate more than long-term rates, and the firm may be unable to repay the debt. If the lender will not extend the loan, the firm could be forced into bankruptcy.

what are moderate working capital policies? hedging (Maturity Matching).

It assumes risk which is lower than restricted and higher than conservative. In profitability front also, it lies between the two. -The biggest benefit of this policy is that it has reasonable assurance of smooth operation of working operating capital cycle with moderate profitability. *It's disadvantage of lower return on investment because higher investment in the current assets attracts higher interest cost which in turn reduces profitability. *Approach to short-term financing involves matching, to the extent possible, the maturities of assets and liabilities, so that temporary operating current assets are financed with short-term debt and permanent operating current assets and fixed assets are financed with long-term debt or equity.

What is A permanent current asset ?

It is the minimum amount of current assets a company needs to continue operations. Permanent current assets are current assets that are always replaced with like assets within one year. Inventory, depreciating assets, cash and accounts receivable are examples of this. *the operating current assets the firm holds even during slack times, whereas temporary operating current assets are the additional operating current assets needed during seasonal or cyclical peaks.

What is commercial paper?

It is unsecured short-term debt issued by large, financially strong corporations. Although the cost of commercial paper is lower than the cost of bank loans, it can be used only by large firms with exceptionally strong credit ratings. Sometimes a borrower will find it is necessary to borrow on a secured basis, in which case the borrower pledges assets such as real estate, securities, equipment, inventories, or accounts receivable as collateral for the loan.

what is Accounts receivable?

It refers to the outstanding invoices a company has or the money the company is owed from its clients.

What is Payables deferral period ?

It shows the management's ability to delay payment to vendor. is the average length of time between the purchase of materials and labor and the payment of cash for them Payables deferral period = Payables /Cost of goods sold per day

What does promissory note contain?

It specifies: (1) the amount borrowed, (2) the percentage interest rate, (3) the repayment schedule, (4) the collateral, and (5) any other conditions to which the parties have agreed.

Whata is A compensating balance ?

It's a minimum checking account balance that a bank requires as compensation either for services provided or as part of a loan agreement.

What is The transactions balance?

It's the cash necessary to conduct routine day-to-day business; * precautionary balances are cash reserves held to meet random, unforeseen needs. * A compensating balance a minimum checking account balance that a bank requires as compensation either for services provided or as part of a loan agreement.

The inventory conversion period?

It's the time required to obtain materials for a product, manufacture it, and sell it. The inventory conversion period is essentially the time period during which a company must invest cash while it converts materials into a sale. The calculation is: Inventory ÷ (Cost of sales ÷ 365) *Inventory conversion period = Inventory \Cost of goods sold per day

What is the primary goal of cash management

It's to minimize the amount of cash the firm must hold for conducting its normal business activities while at the same time maintaining a sufficient cash reserve to take discounts, pay bills promptly, and meet any unexpected cash needs.

What are Days sales outstanding (DSO), also called the "average collection period" (ACP), used for?

It's used to appraise accounts receivable, and it is calculated by dividing accounts receivable by average daily sales to find the number of days' sales that are tied up in receivables. *A firm can use an aging schedule and the days sales outstanding (DSO) to monitor its receivables balance and to help avoid an increase in bad debts. DSO = ACP =Annual Sales/365= ((Units sold)*(Sales Price))/365 or DSO = Accounts Receivables \Sales Per Day DSO = Accounts Receivables \(Annual Sales /365) = ??Days

Is it true that most firms are able to obtain some free trade credit and that additional trade credit is often available, but at a cost?

Yes. If a firm is able to buy on credit at all, if the credit terms include a discount for early payment, and if the firm pays during the discount period, it has obtained "free" trade credit. However, taking additional trade credit by paying after the discount period can be quite costly.

What is lien?

a right to keep possession of property belonging to another person until a debt owed by that person is discharged.

What kind of the working capital strategies can we have?

aggressive, conservative and hedging (Maturity Matching).