Session 03 Principles of Working Capital Management

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OBJECTIVES
Understand the need for investing in current assets and elaborate the concept of operating cycle Highlight the necessity of managing current assets and current liabilities Explain the principles of current assets investment and financing Focus on proper mix of short-term and long-term financing for current assets

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COVERAGE
Basic Definitions Need for Working capital Operating cycle

Permanent and variable working capital

Determinants of working capital Issues in framing working capital policies Working Capital financing policies Working capital investment policies Estimating working capital needs Financing current assets Summary 5-3

BASIC DEFINITIONS
Gross working capital: Total current assets. Net working capital: Current assets minus Current liabilities. Often called working capital. Cash Conversion Cycle: Period between firms payment for materials and collection on its sales. Carrying Costs: Costs of maintaining current assets, including opportunity cost of capital.

Shortage Costs:
Costs incurred from shortages in current assets.

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WORKING CAPITAL MANAGEMENT

Includes both establishing working capital policy and then the day-to-day control of: Cash Inventories Receivables Short-term liabilities Accounts payable

Accruals
These are short-term in nature and turnover regularly.

Copyright 2002 South-Western

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WORKING CAPITAL MANAGEMENT

Working Capital Requires Funds Maintaining a working capital balance requires a permanent commitment of funds Example: Your firm will always have a minimum level of Inventory, Accounts Receivable, and Cashthis requires funding

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WORKING CAPITAL MANAGEMENT

Spontaneous Financing Your firm will also always have a minimum level of Accounts Payablein effect, money you have borrowed Accounts Payable (and Accruals) are generated spontaneously Offset the funding required to support assets
Net working capital is Gross Working Capital Current Liabilities (or spontaneous financing) Reflects the net amount of funds needed to support routine operations

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WORKING CAPITAL MANAGEMENT

Importance Current assets typically comprise 30-50% of a firms assets

Main day-to-day focus of financial managers

Mismatch between current assets and financingcash crunch, bankruptcy possibilities

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WORKING CAPITAL MANAGEMENT Objectives

To run the firm efficiently with as little money as possible tied up in Working Capital Involves trade-offs between easier operation and the cost of carrying short-term assets Benefit of low working capital
Able to funnel money into accounts that generate a higher payoff

Cost of low working capital

Risky

To maintain liquidity To realize the above 2 objectives at the least cost i.e. to minimize investment in Net Working Capital 5-9

OBJECTIVE OF WORKING CAPITAL MANAGEMENT

Inventory
High Levels
Benefit: Happy customers Few production delays (always have needed parts on hand) Expensive High storage costs Risk of obsolescence Cost: Shortages Dissatisfied customers Low storage costs Less risk of obsolescence

Low Levels

Cost:

Benefit:

Cash
High Levels
Benefit: Reduces risk Increases financing costs Cost: Benefit: Reduces financing costs Increases risk Cost:

Low Levels

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OBJECTIVE OF WORKING CAPITAL MANAGEMENT

Accounts Receivable
High Levels (favorable credit terms) Benefit: Happy customers High sales Expensive High collection costs Increases financing costs Cost: Dissatisfied customers Lower Sales Less expensive Low Levels (unfavorable terms)

Cost:

Benefit:

Payables and Accruals

High Levels Benefit: Reduces need for external finance--using a spontaneous financing source Unhappy suppliers Benefit: Happy suppliers/employees Not using a spontaneous financing source Cost: Low Levels

Cost:

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DETERMINANTS OF WORKING CAPITAL

Nature of industry / market Objectives/ Policies of the company Operating Efficiency

Trade or Business Cycles

Stage of the lifecycle of the products Variety Vs standard offering to customers

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OPERATIONS - OPERATING CYCLE AND CASH CONVERSION CYCLE

A firm begins with cash which then becomes inventory and labor Which then becomes a product which is sold Eventually this will turn into cash again The firms operating cycle is the time from the acquisition of inventory until cash is collected from product sales
Operating cycle Inventory conversion period Receivables conversion period Payables deferral period Cash conversion cycle = 1 to 4 = 1 to 3 = 3 to 4 = 1 to 2 = 2 to 4

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OPERATING CYCLE

Cash

Materials Orders

Collection Period
Manufacturing Process

Accounts Receivable

Selling Effort

Finished Inventory 5 - 15

OPERATING CYCLE ANALYSIS Inventory Conversion Period Receivables Conversion Period

Operating = Cycle Inventory Conversion Period Receivables Conversion Period

Average Inventory Cost of Sales/ 365 Accounts Receivable Annual Credit Sales/ 365
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CASH CONVERSION CYCLE

The time between paying cash to suppliers for material and collecting cash from customers from their subsequent sale =Operating cycle - Average payment period where APP = Accounts Payable / (COGS/360)

The cash conversion cycle measures the financing gap in terms of time.
As the cash conversion cycle increases, the firms financing needs grow larger. 5 - 17

TIME LINE REPRESENTATION OF OPERATING CYCLE AND THE CASH CONVERSION CYCLE

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MANAGING THE CASH CONVERSION CYCLE

The resources Justin has invested in the cash conversion cycle assuming a 360-day year are:

Obviously, reducing AAI or ACP or lengthening APP will reduce the cash conversion cycle, thus reducing the amount of resources the firm must commit to support operations.

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SEASONAL VS. LEVEL PRODUCTION ISSUES FOR FIRMS WITH SEASONAL SALES
Seasonal Production:
Raw materials purchased shortly before sales occur Lower inventories Idle plant, laid-off workers in slow season Production bottlenecks in busy season

Level Production Issues

Produce equal amounts each month to meet annual sales forecast Inventory build up prior to selling season Cash outflows during year with little cash inflow

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ISSUES IN WORKING CAPITAL MANAGEMENT

The main aspects of WCM are: Time Investment Criticality Growth In the context of above, the finance manager has to pay particular attention to the levels of Current Assets and their financing in the light of risk-return implications: Working capital financing policies viz. how current assets are financed. Working capital investment policies viz. the level of each current asset

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ALTERNATIVE CURRENT ASSET INVESTMENT POLICIES

Current Assets ($)
Conservative
Moderate Aggressive

Sales ($)
Copyright 2002 South-Western

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ALTERNATIVE CURRENT ASSET INVESTMENT POLICIES Parameters one look into while fixing the level of current assets
Current Assets to Fixed Assets Ratio Current Assets policy of most firms fall between the Aggressive and the moderate policy.

Liquidity Vs. Profitability

The Cost Trade-off Striking balance between cost of liquidity and cost of illiquidity

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FUNDING REQUIREMENTS OF THE CCC

Permanent versus Seasonal Funding Needs If a firms sales are constant, then its investment in operating assets should also be constant, and the firm will have only a permanent funding requirement. If sales are cyclical, then investment in operating assets will vary over time, leading to the need for seasonal funding requirements in addition to the permanent funding requirements for its minimum investment in operating assets.

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FUNDING REQUIREMENTS OF THE CCC

Permanent versus Seasonal Funding Needs Crone Paper has seasonal funding needs. Crone has seasonal sales, with its peak sales driven by back-to-school purchases. Crone holds a minimum of $25,000 in cash and marketable securities, $100,000 in inventory, and $60,000 in account receivable. At peak times, inventory increases to $750,000 and accounts receivable increase to $400,000. To capture production efficiencies, Crone produces paper at a constant rate throughout the year. Thus accounts payable remain at $50,000 throughout the year. 5 - 25

FUNDING REQUIREMENTS OF THE CCC

Permanent versus Seasonal Funding Needs Based on this data, Crone has a permanent funding requirement for its minimum level of operating assets of $135,000 ($25,000 + $100,000 + $60,000 - $50,000 = $135,000) and peak seasonal funding requirements in excess of its permanent need of $990,000 [($25,000 + $750,000 + $400,000 - $50,000) - $135,000 = $990,000].

Crones total funding requirements for operating assets vary from a minimum of $135,000 (permanent) to a seasonal peak of $1,125,000 ($135,000 + 990,000) as shown in Figure 15.2 on the following slide.

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FUNDING REQUIREMENTS OF THE CCC

Figure 15.2

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FUNDING REQUIREMENTS OF THE CCC

Aggressive versus Conservative Funding Strategies Crone Paper has a permanent funding requirement of $135,000 and seasonal requirements that vary between $0 and $990,000 and average $101,250. If Crone can borrow short-term funds at 6.25% and long term funds at 8%, and can earn 5% on any invested surplus, then the annual cost of the aggressive strategy would be:

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FUNDING REQUIREMENTS OF THE CCC

Aggressive versus Conservative Funding Strategies Alternatively, Crone can choose a conservative strategy under which surplus cash balances are fully invested. In Figure 15.2, this surplus would be the difference between the peak need of $1,125,000 and the total need, which varies between $135,000 and $1,125,000 during the year.

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FUNDING REQUIREMENTS OF THE CCC

Aggressive versus Conservative Funding Strategies Clearly, the aggressive funding strategys heavy reliance on short-term financing makes it riskier than the conservative strategy because of interest rate swings and possible difficulties in obtaining needed funds quickly when the seasonal peaks occur. The conservative funding strategy avoids these risks through the locked-in interest rate and long-term financing, but is more costly. Thus the final decision is left to management. 5 - 30

WORKING CAPITAL NEEDS OF DIFFERENT FIRMS

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FINANCING NET WORKING CAPITAL

Long-term financing Safe but expensive Safe because you can raise lots of capital

Expensive because long-term rates are generally higher than short-term rates
Short-term financing Cheap but risky

Cheap because short-term rates are generally lower than long-term rates
Risky because you are continually entering marketplace to borrowborrower will face changing conditions

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FINANCING NET WORKING CAPITAL

Maturity Matching: Matches the maturity of the assets with the maturity of the financing. Aggressive: Uses short-term (temporary) capital to finance some permanent assets. Conservative: Uses long-term (permanent) capital to finance some temporary assets.

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MATURITY MATCHING FINANCING POLICY

$

Temp. C.A.

S-T Loans
Perm C.A. L-T Fin: Stock, Bonds, Spon. C.L.

Fixed Assets

What are permanent assets?

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AGGRESSIVE FINANCING POLICY

$

Temp. C.A. S-T Loans Perm C.A. L-T Fin: Stock, Bonds, Spon. C.L.

Fixed Assets

More aggressive the lower the dashed line.

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Years

CONSERVATIVE FINANCING POLICY

Marketable Securities Zero S-T debt L-T Fin: Stock, Bonds, Spon. C.L.

Perm C.A.

Fixed Assets

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FIRMS CUMULATIVE CAPITAL REQUIREMENT

Dollars A B C Cumulative capital requirement

Year 1

Year 2

Time

Lines A, B, and C show alternative amounts of long-term finance.

Strategy A: A permanent cash surplus Strategy B: Short-term lender for part of year and borrower for remainder Strategy C: A permanent short-term borrower 5 - 37

WHICH WORKING CAPITAL FINANCING POLICY TO CHOOSE?

The choice of working capital policy is a classic risk/return tradeoff.

The aggressive policy promises the highest return but carries the greatest risk.
The conservative policy has the least risk but also the lowest expected return. The moderate (maturity matching) policy falls between the two extremes.

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WORKING CAPITAL POLICY

Firm must set policy on following issues: How much working capital is used

The extent to which working capital is supported by short- vs. long-term financing
The nature/source of any short-term financing used How each component of working capital is managed

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SELECTED RATIOS FOR PEI INCORPORATED

Current Quick Debt/Assets Turnover of cash & securities DSO (days) Inv. turnover F.A. turnover T.A. turnover Profit margin ROE Pay. deferral period
Copyright 2002 South-Western

PEI 1.75x 0.83x 58.76%

.

Industry 2.25x 1.20x 50.00% 22.22x 32.00 7.00x 12.00x 3.00x 3.50% 21.00% 33.00 5 - 40

16.67x 45.00 4.82x 11.35x 2.08x 2.07% 10.45% 30.00

HOW DOES PEIS WORKING CAPITAL POLICY COMPARE WITH THE INDUSTRY?
Working capital policy is reflected in a firms current ratio, quick ratio, turnover of cash and securities, inventory turnover, and DSO. These ratios indicate PEI has large amounts of working capital relative to its level of sales. Thus, PEI is following a relaxed (fat cat) policy.

Copyright 2002 South-Western

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IS PEI INEFFICIENT OR JUST CONSERVATIVE?

A relaxed policy may be appropriate if it reduces risk more than profitability.

However, PEI is much less profitable than the average firm in the industry. This suggests that the company probably has excessive working capital.

Copyright 2002 South-Western

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WORKING CAPITAL NEEDS

Working capital requirements are affected if sales change or if the cash conversion cycle components change. Receivables investment = net sales per day x ACP Inventory investment = COGS per day x inventory conversion period Payables financing = COGS per day x average payment period 5 - 43

EFFECT OF 10 PERCENT INCREASE IN SALES AND COGS

Assumptions: Average Collection Period = 52 days

Inventory Period
Average Payment Period

= 101 days
= 63 days

Net sales per day Cost of goods sold per day

= $1,918 = $1,233

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EFFECT ON INVESTMENT, FINANCING

Base Case 10% increase in sales Investment Accounts Receivable Inventories Total Financing Accounts payable Net investment 100,000 125,000 225,000 78,000 147,000 110,000 138,000 248,000 85,000 163,000

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EFFECT OF 10 PERCENT INCREASE IN SALES AND COGS

Shorter cash conversion cycle assumptions: Average Collection Period Inventory Period Average Payment Period Net sales per day Cost of goods sold per day = 50 days = 90 days = 70 days = $1,918 = $1,233

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EFFECT ON INVESTMENT, FINANCING

Base Case 10% increase in sales Investment Accounts Receivable Inventories Total Financing Accounts payable Net investment 100,000 125,000 225,000 78,000 147,000 106,000 122,000 228,000 94,920 133,080

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SUMMARY
Some of the long-term finances is blocked in operating assets to ensure smooth production and sales. The operating cycle is the duration taken by a firm to manufacture, sell the products and receive cash. When adjusted for payment deferment period, one gets net operating cycle. The manufacturing cycle and the credit policy of the firm are two major determinants of duration of gross operating cycle. Each of them are influenced by various factors. The level of investment in Current Assets involves a trade-off between risk and return. A balanced approach is to finance permanent CA from LT sources while temporary CA to be financed from spontaneous and ST sources.

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