reading 35 - Working Capital Management

HPR

(face value - purchase price) / purchase price

money market yield

= HPR * (360/days until maturity)

the number of days of payables, which provides a measure of how long it takes the company to pay its own suppliers:

Average accounts payable / Average days purchases (Purchases/365)

The number of days of inventory gives us an indication of how well the inventory acquisition, process, and distribution is managed

Average inventory / Average days ' cost of goods sold

external factors affecting working capital needs

Banking services ■ Interest rates ■ New technologies and new products ■ The economy ■ Competitors

The operating cycle is a measure of the time needed to convert raw materials into cash from a sale

Operating cycle = Number of days of inventory + Number of days of receivables

Market (or interest rate) risk

Price or rate changes may adversely affect return ■ There is no market to sell the maturity to, or there is only a small secondary market

Holding Period Return (HPR)

Rate of return over a given investment period. HPR = (Ending Price - Beginning Price) / Beginning Price

Credit or Default Risk

Risk that the borrower will default on an interest or principal payment. ■ Issuer may default ■ Issuer could be adversely affected by economy, market ■ Little secondary market

the number of days of receivables, also referred to as the day's sales outstanding and days in receivables

average accounts receivable / Average days sales on credit

inventory turnover

cost of goods sold/average inventory

accounts receivable turnover

credit sales/average receivables

current ratio

current assets divided by current liabilities

U.S. Treasury bills (T-bills)

short-term marketable IOUs issued by the U.S. federal government; ■ Obligations of US government (guaranteed), issued at a discount ■ Active secondary market ■ Lowest rates for traded securities; maturities: 13, 26, and 52 weeks

foreign exchange risk

■ Adverse general market movement against your currency

Banker's acceptances (BAs)

■ Bank obligations for trade transactions (usually foreign), issued at a discount ■ Investor protected by underlying company and trade flow itself ■ Small secondary market; 30-180 days; Credit and liquidity risk (depending on bank's credit)

Bank certificates of deposit (CDs)

■ Bank obligations, issued interest- bearing in $100,000 increments ■ "Yankee" CDs offer slightly higher yields; 14-365 days; Credit and liquidity risk (depending on bank's credit)

internal factors affecting working capital needs

■ Company size and growth rates ■ Organizational structure ■ Sophistication of working capital management ■ Borrowing and investing positions/ activities/capacities

safety measures for foreign exchange risk

■ Hedge regularly ■ Keep most in your currency and domestic market (avoid foreign exchange)

Safety measures for Market (or interest rate) risk

■ Keep maturities short ■ Keep portfolio diverse in terms of maturity, issuers

Safety measures to credit or default risk

■ Minimize amount ■ Keep maturities short ■ Watch for "questionable" names ■ Emphasize government securities

Mutual funds and money market mutual funds

■ Money market mutual funds commonly used by smaller businesses ■ Low yields but high liquidity for money market funds; mutual fund liquidity dependent on underlying securities in fund ■ Can be linked with bank sweep arrangement

Federal agency securities

■ Obligations of US federal agencies (e.g., Fannie Mae, Federal Home Loan Board) issued as interest- bearing ■ Slightly higher yields than T- bills; 5-30 days maturities; Slight liquidity risk; insignificant credit risk

Tax- advantaged securities

■ Preferred stock in many forms, including adjustable rate preferred stocks (ARPs), auction rate preferred stocks (AURPs), and convertible adjustable preferred stocks (CAPs) ■ Dutch auction often used to set rate ■ Offer higher yields; 7, 28, 35, 49, and 90 days

repurchase agreements (repos)

■ Sale of securities with the agreement of the dealer (seller) to buy them back at a future time ■ Typically over- collateralized at 102 percent ■ Often done for very short maturities (< 1 week); 1 day+

Liquidity risk

■ Security is difficult or impossible to (re)sell ■ Security must be held to maturity and cannot be liquidated until then

Bank sweep services

■ Service offered by banks that essentially provides interest on checking account balance (usually over a minimum level) ■ Large number of sweeps are for overnight; 1 day

Safety measures for liquidity risk

■ Stick with government securities ■ Look for good secondary market ■ Keep maturities short

Eurodollar time deposits

■ Time deposit with bank off- shore (outside United States, such as Bahamas) ■ Can be CD or straight time deposit (TD) ■ Interest- bearing investment ■ Small secondary market for CDs, but not TDs; 1-180 days; Credit risk (depending on bank) Very high liquidity risk for TDs

Commercial paper (CP)

■ Unsecured obligations of corporations and financial institutions, issued at discount ■ Secondary market for large issuers ■ CP issuers obtain short- term credit ratings; 1-270 days