Chapter 21 and 22: Working Capital Management

precautionary balance

A cash balance held in reserve for random, unforeseen fluctuations in cash inflows and outflows. amount of cash a firm holds to counter the uncertainty surrounding its future cash needs

cleanup clause

A clause in a line of credit that requires the borrower to reduce the loan balance to zero at least once a year. A requirement that is often written into the contracts of annually renewable lines of credit. Clean-up requirements can require the borrower to pay off any outstanding balance on the line of credit and then cease to use the line of credit for a specified period of time. Clean-up requirements are usually implemented as a means of preventing borrowers from using lines of credit as ongoing permanent financing. Clean-up requirements are becoming less common in banks today. Lenders do not see the need to make their customers "clean up" their lines of credit as long as principal and interest payments are received on time. This requirement is also known as "annual clean-up".

promissory note

A document specifying the terms and conditions of a loan, including the amount, interest rate, and repayment schedule. A written contract with a promise to pay a lessor a specific sum of money at a definite time.

working capital

A firm's investment in short-term assets—cash, marketable securities, inventory, and accounts receivable. A measure of both a company's efficiency and its short-term financial health. The working capital ratio (Current Assets/Current Liabilities) indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient.Also known as "net working capital". - If the ratio is less than one then they have negative working capital. - A high working capital ratio isn't always a good thing, it could indicate that they have too much inventory or they are not investing their excess cash. If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations.

revolving credit agreement

A formal, committed line of credit extended by a bank or other lending institution. - A line of credit where the customer pays a commitment fee (or invitation fee for opening the line of credit) and is then allowed to use the funds when they are needed. - It is usually used for operating purposes (if a company can't pay it's short term liabilities) , fluctuating each month depending on the customer's current cash flow needs. - Will be charged a monthly interest rate for what is taken out (think of it as a sophisticated credit card) - Often referred to as "revolver." - Revolving lines of credit can be taken out by both corporations and individuals. - The bank that is in agreement with the customer guarantees a maximum amount that can be loaned to the customer (this is usually 80% of it's assets i.e. 80% of accounts receivables or 80% of inventory. If the company can't pay back this loan, the bank will take all of the company's current assets and sell it to pay back the loan). - it is considered a secured loan because it is backed by inventory or receivables or both

secured loan

A loan backed by collateral, which is often in the form of inventories or receivables.

payments pattern approach

A method of monitoring accounts receivable that looks for changes in a customers' payment pattern. This takes into account the seasonal nature of customer orders.

compensating balance

A minimum checking account balance that a firm must maintain with a bank to compensate the bank for services rendered or for making a loan; generally equal to 10%-20% of the loans outstanding. Investopedia: A minimum balance that must be maintained in an account. The compensating balance is often used to offset a portion of the cost that a bank faces when extending a loan or credit to an individual or business, and is usually calculated as a percentage of the loan outstanding. The account where the funds are held are typically non-interest bearing, and the bank is free to use the money in other investment opportunities. By requiring money to be deposited to offset some of a loan's cost the bank is able to extend other loans and pursue other investment opportunities, while the individual or business will generally see a lower interest rate. If the deposit falls below a certain level the interest rate on the loan may adjust upward to compensate.

Capital Asset Pricing Model (CAPM)

A model based on the proposition that any stock's required rate of return is equal to the risk-free rate of return plus a risk premium reflecting only the risk remaining after diversification. The CAPM equation is ri = rRF + bi(rM − rRF).

self-liquidating approach

A policy that matches asset and liability maturities. It is also referred to as maturity matching or the self-liquidating approach.

maturity matching (or moderate or self-liquidating approach) short-term financing policy

A policy that matches asset and liability maturities. It is also referred to as the moderate, or self—liquidating, approach. A policy where liability maturities matches assets. For example, a machine that is expected to last for 5 year will be financed with a 5-year loan. Is this a good idea? The biggest advantage is that it will lower interest costs because interest is paid only for the amount and time for which money is used. However, risk still persists because the lives of assets are uncertain. You don't know if the machine will last 4 years or 6 years. Still, if the firm does attempt to match and can come close to matching asset and liability maturities, it is defined as moderate current asset financing policy and is a good idea to try and implement.

restricted net operating working capital policy

A policy under which holdings of cash, securities, inventories, and receivables are minimized. low level of assets & high assets turnover ratio resulting in a high ROE - minimum current assets - the firm's policy is tight or "lean and mean" (think low inventory = lean) - exposes firm to risk because shortages can lead to work stoppages, unhappy customers, serious long-run problems

relaxed net operating working capital policy

A policy under which relatively large amounts of cash, marketable securities, and inventories are carried and under which sales are stimulated by a liberal credit policy, resulting in a high level of receivables. high level of assets & low assets turnover ratio resulting in a low ROE

cost of common equity, re

A project financed with external equity must earn a higher rate of return because it must cover the flotation costs. Thus, the cost of new common equity is higher than that of common equity raised internally by reinvesting earnings.

annual report

A report issued annually by a corporation to its stockholders. It contains basic financial statements as well as management's opinion of the past year's operations and the firm's future prospects.

cash budget

A schedule showing cash flows (receipts, disbursements, and cash balances) for a firm over a specified period.

commercial paper

A short-term debt instrument issued by a corporation, typically for the financing of accounts receivable/accounts payable, inventories and meeting short-term liabilities. - Maturities on commercial paper rarely range any longer than 270 days. - The debt is usually issued at a discount, reflecting prevailing market interest rates. - Commercial paper is not usually backed by any form of collateral (it is unsecured meaning buyers have no claim on a company's assets if the company fails to pay up at maturity), so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue. - A major benefit of commercial paper is that it does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before nine months (270 days), making it a very cost-effective means of financing. - The proceeds from this type of financing can only be used on current assets (inventories) and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement. - If more than 270 days, it must be registered with the SEC - Eliminates the need to apply for business loans - Buyers include wealthy individuals and large institutions (becoming more available to retail investors as well) - minimum $100,000

line of credit (LOC)

An arrangement in which a bank agrees to lend up to a specified maximum amount of funds during a designated period. Investopedia: An arrangement between a financial institution, usually a bank, and a customer that establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement. The advantage of a line of credit over a regular loan is that interest is not usually charged on the part of the line of credit that is unused, and the borrower can draw on the line of credit at any time that he or she needs to. Depending on the agreement with the financial institution, the line of credit may be classified as a demand loan, which means that any outstanding balance will have to be paid immediately at the financial institution's request. Example: You have a business and want $10,000 "safety" money just in case. You open a LOC for $10,000 but only take out $1,000 in the first year. You will be charge the interest on the $1,000 and not the full $10,000. It is like a credit card with a maximum amount you can charge.

aging schedule

Breaks down accounts receivable according to how long they have been outstanding. This gives the firm a more complete picture of the structure of accounts receivable than that provided by days sales outstanding.

accounts receivable

Created when a good is shipped or a service is performed and payment for that good is made on a credit basis, not on a cash basis.

free trade credit

Credit received during the discount period.

costly trade credit

Credit taken (in excess of free trade credit) whose cost is equal to the discount lost.

net working capital

Current assets minus current liabilities.

trade credit

Debt arising from credit sales and recorded as an account receivable by the seller and as an account payable by the buyer. Investopedia: An agreement where a customer can purchase goods on account (without paying cash), paying the supplier at a later date. Usually when the goods are delivered, a trade credit is given for a specific amount of days - 30, 60 or 90 (think of buying something on a credit card and not paying the credit card until a later date). Jewelry businesses sometimes extend credit to 180 days or longer. Basically, this is a credit a company gives to another for the purchase of goods and services. The amount of days for which a credit is given is determined by the company allowing the credit, and is agreed upon by both the company allowing the credit and the company receiving it. With the extension of the payment date, the company receiving the credit essentially could sell the goods and use the net proceeds to pay back the debt. This type of credit is sometimes given to encourage sales. At times, a supplier may give a discount, if the customer pays within a certain period of time. For example, a 2% discount if payment is received within 10 days of issuing a 30-day credit.

credit enhancement

Enables a bond's rating to be upgraded to AAA when the issuer purchases bond insurance. The bond insurance company guarantees that bondholders will receive the promised interest and principal payments. Therefore, the bond carries the credit rating of the insurance company rather than that of the issuer.

disbursement float

Float created before checks written by a firm have cleared and been deducted from the firm's account; disbursement float causes the firm's own checkbook balance to be smaller than the balance on the bank's records. The period of time from when the payor puts a check in the mail until the funds are deducted from the payor's account. In an effort to stretch disbursement float, a firm may mail checks to its vendors while being unsure that sufficient funds will be available to cover them all

collections float

Float created while funds from customers' checks are being deposited and cleared through the check collection process. Amount of time that elapses between your depositing of debtor's check in your account and the check's clearing.

speculative balances

Funds held by a firm in order to have cash for taking advantage of bargain purchases or growth opportunities. i.e. small cap investments held by firms DEFINITION OF 'SPECULATION' The act of trading in an asset, or conducting a financial transaction, that has a significant risk of losing most or all of the initial outlay, in expectation of a substantial gain. With speculation, the risk of loss is more than offset by the possibility of a huge gain; otherwise, there would be very little motivation to speculate. While it is often confused with gambling, the key difference is that speculation is generally tantamount to taking a calculated risk and is not dependent on pure chance, whereas gambling depends on totally random outcomes or chance.

uncollected balances schedule

Helps a firm monitor its receivables better and also forecast future receivables balances; an integral part of the payments pattern approach.

discount interest

Interest that is calculated on the face amount of a loan but is paid in advance.

synchronization of cash flows

Occurs when firms are able to time cash receipts to coincide with cash requirements.

net operating working capital (NOWC)

Operating current assets minus operating current liabilities. Operating current assets are the current assets used to support operations, such as cash, accounts receivable, and inventory (assets necessary to operate the business). They do not include short-term investments. Operating current liabilities are the current liabilities that are a natural consequence of the firm's operations, such as accounts payable and accruals. They do not include notes payable or any other short-term debt that charges interest. equation = operating current assets - operating current liabilities

trade discounts or cash discounts

Price reductions that suppliers offer customers for early payment of bills. i.e. 2/10 net 30 -- suppliers will give the customers 2% discount if paid within 10 days of purchase

aggressive short-term financing policy

Refers to a policy in which a firm finances all of its fixed assets with long-term capital but part of its permanent current assets with short-term, nonspontaneous credit.

conservative short-term financing policy

Refers to using permanent capital to finance all permanent asset requirements as well as to meet some or all of the seasonal demands.

credit terms

Statements of the credit period and any discounts offered—for example, 2/10, net 30.

payable deferral period

The average length of time between a firm's purchase of materials and labor and the payment of cash for them. It is calculated by dividing accounts payable by credit purchases per day (i.e., cost of goods sold ÷ 365). = accounts payable / (cost of sales / 365) the length of time it takes the company to pay it's suppliers (think: J&J paying Kolmar)

inventory conversion period

The average length of time to convert materials into finished goods and then to sell them; calculated by dividing total inventory by sales per day. the time it takes to sell the product and receive the money (accounts receivable) (think: J&J selling product to Wal Mart) = inventory / cost of goods sold per day

transactions balance

The cash balance associated with payments and collections; the balance necessary for day-to-day operations. a cash balance necessary for day-to-day operations; the balance associated with routine payments and collections. cash held to cover day-to-day operations

free cash flow (FCF)

The cash flow actually available for distribution to all investors after the company has made all investments in fixed assets and working capital necessary to sustain ongoing operations. calculated by EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditures

net float

The difference between a firm's disbursement float and collections float. ---- The steady decline in the number of checks written each year, combined with the rapid adoption of innovative and convenient payment services, may make float a thing of the past.

effective (or equivalent) annual rate (EAR or EFF%)

The effective annual rate is the rate that, under annual compounding, would have produced the same future value at the end of 1 year as was produced by more frequent compounding, say quarterly. If the compounding occurs annually, then the effective annual rate and the nominal rate are the same. If compounding occurs more frequently, then the effective annual rate is greater than the nominal rate.

credit standards

The financial strength and creditworthiness that qualifies a customer for a firm's regular credit terms.

credit policy

The firm's policy on granting and collecting credit. There are four elements of credit policy, or credit policy variables: credit period, credit standards, collection policy, and discounts.

cash conversion cycle

The length of time between the firm's actual cash expenditures on 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). Thus, the cash conversion cycle equals the length of time the firm has funds tied up in current assets. equation = inventory conversion period + average collection period - payables deferral period the shorter the better because the faster the company can get its money and the lower interest charges on loans

collection period

The length of time for which credit is extended. If the credit period is lengthened then sales will generally increase, as will accounts receivable. This will increase the firm's financing needs and possibly increase bad debt losses. A shortening of the credit period will have the opposite effect. average collection period (ACP) - the length of time it takes the customers to pay for goods following a sale, also known as days sales outstanding (DSO) or receivables conversion period - it is supposed to take that time to receive the money (receivables) and convert to cash (think: receiving the check and cashing the check) average collection period = ACP (or DSO) = receivables / sales/365 or average daily sales

stretching accounts payable

The practice of deliberately paying accounts late. Companies must strike a delicate balance with days payable outstanding (DPO). The longer they take to pay their creditors, the more money the company has on hand, which is good for working capital and free cash flow. But if the company takes too long to pay its creditors, the creditors will be unhappy. They may refuse to extend credit in the future, or they may offer less favorable terms. Also, because some creditors give companies a discount for timely payments, the company may be paying more than it needs to for its supplies. If cash is tight, however, the cost of increasing DPO may be less than the cost of foregoing that cash earlier and having to borrow the shortfall to continue operations. - shortening the DPO will make vendors happy but it can make it hard for the company to meet its cash flow needs

collection policy

The procedure for collecting accounts receivable. A change in _______ will affect sales, days sales outstanding, bad debt losses, and the percentage of customers taking discounts.

nominal (quoted) interest rate or annual percentage rate (APR)

The rate of interest stated in a contract. If the compounding occurs annually, the effective annual rate and the nominal rate are the same. If compounding occurs more frequently, the effective annual rate is greater than the nominal rate. The interest rate before taking inflation into account. The nominal interest rate is the rate quoted in loan and deposit agreements.

cost of common stock, rs

The return required by the firm's common stockholders. It is usually calculated using Capital Asset Pricing Model or the dividend growth model.

simple interest

The situation when interest is not compounded; that is, interest is not earned on interest. Also called regular interest. Divide the nominal interest rate by 365 and multiply by the number of days the funds are borrowed to find the interest for the term borrowed. = price of loan (p) X duration of loan in periods (n) X interest rate (i)

days sales outstanding (DSO)

Used to appraise accounts receivable and indicates the length of time the firm must wait after making a sale before receiving cash. It is found by dividing receivables/ average sales per day

check-clearing process

When a customer's check is written upon one bank and a company deposits the check in its own bank, the company's bank must verify that the check is valid before the company can use those funds. Checks are generally cleared through the Federal Reserve System or through a clearinghouse set up by the banks in a particular city.