Working capital Management

Financial Management

Prof.Raviraj Gohil

Tracing Cash and Net Working Capital

Current Assets are cash and other assets that are expected to be converted to cash within the year.
Cash Marketable securities Accounts receivable

Inventory

Current Liabilities are obligations that are expected to require cash payment within the year.
Accounts payable
Accrued wages Taxes Net working capital = Current assets- Current liabilities

Balance Sheet Model of the Firm

Current Liabilities
Net Working Capital

Current Assets

Long-Term Debt

Fixed Assets 1. Tangible

2. Intangible

How much shortterm cash flow does a company need to pay its bills?

Shareholders Equity

Defining Cash
Lets take balance sheet View Assets = Liability
Net Working Capital Fixed Assets

LongTerm Debt

Equity

Net Working Capital

Cash

Other Current Assets

Current Liabilities

Cash

Long= Term Debt

+ Equity

Net Working Capital

(excluding cash)

Fixed Assets

Defining Cash
LongNet Working Fixed Cash = Term + Equity Capital Assets (excluding cash) Debt

An increase in long-term debt and or equity leads to an increase in cashas does a decrease in fixed assets or a decrease in the non-cash components of net working capital.

The sources and uses of cash follow from this reasoning.

Operating cycle

Inventory Purchased

Cash paid for purchase

A/P Period

Inventory sold

Cash received from customer

Inventory period

Accounts Receivable period

Cash Cycle

Operating cycle

The operating cycle and Cash cycle

Accounts payable period

Cash cycle = Operating cycle

In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables, and days in payables.

Example : Mega Mart

Inventory:
Beginning = 200,000 Ending = 300,000

Accounts Receivable:
Beginning = 160,000 Ending = 200,000

Accounts Payable:
Beginning = 75,000 Ending = 100,000

Net sales = 1,150,000 Cost of Goods sold = 820,000

Operating cycle - Mega Mart

Inventory period
Average inventory = (200,000+300,000)/2 = 250,000 Inventory turnover = 820,000 / 250,000 = 3.28 times Inventory period = 365 / 3.28 = 111.3 days

Receivables period
Average receivables = (160,000+200,000)/2 = 180,000 Receivables turnover = 1,150,000 / 180,000 = 6.39 times Receivables period = 365 / 6.39 = 57.1 days
Operating cycle = 111.3 + 57.1 = 168.4 days

Payables period and Cash cycle

Payables Period
Average payables = (75,000+100,000)/2 = 87,500 Payables turnover = 820,000 / 87,500 = 9.37 times Payables period = 365 / 9.37 = 38.9 days
Cash Cycle = Operating cycle- payable period

Cash Cycle = 168.4 38.9 = 129.5 days Mega Mart will have to finance our inventory for 129.5 days. If we want to reduce our financing needs, we need to look carefully at our receivables and inventory periods they both seem excessive. Decrease inventory and receivables period and increase payables.

Short term financing policies

There are two elements of the policy that a firm adopts for short-term finance.
The size of the firms investment in current assets, usually measured relative to the firms level of total operating revenues.
Flexible Restrictive

Alternative financing policies for current assets, usually measured as the proportion of short-term debt to long-term debt.
Flexible Restrictive

Size of Investment in Current Assets

A flexible short-term finance policy would maintain a high ratio of current assets to sales.
Keeping large cash balances and investments in marketable securities Large investments in inventory Liberal credit terms

A restrictive short-term finance policy would maintain a low ratio of current assets to sales.
Keeping low cash balances, no investment in marketable securities Making small investments in inventory Allowing no credit sales (thus no accounts receivable)

Carrying cost and shortage cost

Total costs of holding current assets. Carrying costs

Minimum point

Shortage costs

CA*

Flexible policy
$ Minimum point Carrying costs Total costs of holding current assets. Shortage costs

CA*

Investment in Current Assets ($)

If Shortage cost is higher then carrying cost its better to hold More Current assets (Flexible policy)

Restrictive policy
$ Minimum point Carrying costs

Shortage costs CA* Investment in Current Assets ($)

If Carrying cost is higher then Shortage cost its better to hold less Current assets (Ristrictive policy)

Alternative financing policy

A flexible short-term finance policy means a low proportion of short-term debt relative to long-term financing. A restrictive short-term finance policy means a high proportion of short-term debt relative to long-term financing. In an ideal world, short-term assets are always financed with short-term debt, and long-term assets are always financed with long-term debt.
In this world, net working capital is zero.

The Short -Term Financial Plan

The most common way to finance a temporary cash deficit is to arrange a short-term loan. Unsecured Loans
Line of credit (at the bank) Secured Loans Accounts receivable can be either assigned or factored. Inventory loans use inventory as collateral.

Other Sources
Bankers acceptance Commercial paper

Cash Management

Cash Management: Cash doesnt earn interest , so why hold it?

Transactions: Must have some cash to pay current bills.

Precaution: Safety stock. But lessened by credit line and

marketable securities. Compensating balances: For loans and/or services provided. Speculation: To take advantage of bargains, to take discounts, and so on. Reduced by credit line, marketable

securities.

Ways to Minimize Cash Holdings

Use lockboxes. Insist on wire transfers from customers. Synchronize inflows and outflows. Use a remote disbursement account Increase forecast accuracy to reduce the need for a cash safety stock. Hold marketable securities instead of a cash safety stock. Negotiate a line of credit.

Cash Budgeting

Cash Budget: 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: Daily, weekly, or monthly, depending upon budgets purpose. Monthly for annual planning, daily for actual cash management.

Data Required for Cash Budget

Sales forecast. Information on collections delay. Forecast of purchases and payment terms. Forecast of cash expenses: wages, taxes, utilities, and so on.

Initial cash on hand.

Target cash balance.

SKIs Cash Budget for January and February

Net Cash Inflows January Collections Purchases $67,651.95 44,603.75 February $62,755.40 36,472.65

Wages
Rent Total Payments Net CF

6,690.56
2,500.00 $53,794.31 $13,857.64

5,470.90
2,500.00 $44,443.55 $18,311.85

Cash Budget
January
Cash at start if no borrowing Net CF (previous slide) Cumulative cash Less: target cash Surplus $3,000.00 13,857.64 $16,857.64 1,500.00 $15,357.64

February
$16,857.64 18,311.85 $35,169.49 1,500.00 $33,669.49

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.

What are some other potential cash inflows besides collections?

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

H o w c a n i n te re s t e a r n e d o r p a i d o n s h o r t - te r m s e c u r i t i e s o r l o a n s b e i n c o r p o ra te d i n t h e c a s h b u d g e t ?
Interest earned: Add line in the collections section.

Interest paid: Add line in the payments section.

Found as interest rate x surplus/loan line of cash budget for preceding month.

Note: Interest on any other debt would need to be incorporated as well.

How could bad debts be worked into the cash budget?

Collections would be reduced by the amount of bad debt losses. For example, if the firm had 3% bad debt losses, collections would total only 97% of sales. Lower collections would lead to lower surpluses and higher

borrowing requirements.

Cash budget forecasts the companys cash holdings to exceed targeted cash balance every month, except foOctober and November

Cash budget indicates the company probably is holding too much cash. SKI could improve its EVA by either investing its excess cash in more productive assets or by paying it out to the firms

shareholders.

Why might SKI want to maintain a relatively high amount of cash?

If sales turn out to be considerably less than expected, SKI could face a cash shortfall. A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative. The cash may be there, in part, to fund a planned fixed asset acquisition

Inventory Management: Categories of Inventory Costs

Carrying Costs: Storage and handling costs, insurance, property taxes, depreciation, and obsolescence. Ordering Costs: Cost of placing orders, shipping, and handling costs. Costs of Running Short: Loss of sales, loss of customer goodwill, and the disruption of production schedules.

Is SKI holding too much inventory?

SKIs inventory turnover (4.82) is considerably lower than the industry average (7.00). The firm is carrying a lot of inventory per dollar of sales. By holding excessive inventory, the firm is increasing its operating costs which reduces its NOPAT. Moreover, the excess inventory must be financed, so EVA is further lowered

I f S K I re d u c e s i t s i nve n to r y, w i t h o u t a dve r s e ly a f fe c t i n g s a l e s , wh a t e f fe c t w i l l t h i s h ave o n i t s c a s h p o s i t i o n ?

Short run: Cash will increase as inventory purchases decline. Long run: Company is likely to then take steps to reduce its cash holdings.

Accounts Receivable Management: Do SKIs customers pay more or less promptly than those of its competitors ?
SKIs days sales outstanding (DSO) of 45.6 days is well above the industry average (32 days). SKIs customers are paying less promptly. SKI should consider tightening its credit policy to reduce its DSO.

Elements of Credit Policy

Cash Discounts: reduces DSO. Lowers price. Attracts new customers and

Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales.
Credit Standards: Tighter standards reduce bad debt losses, but may reduce sales. Fewer bad debts reduces DSO. Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships. Does SKI face any risk if it tightens its credit policy? YES! A tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

If SKI succeeds in reducing DSO without adversely affecting sales, what effect would this have on its cash position?
Short run: If customers pay sooner, this increases cash holdings. Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase EVA.

Is there a cost to accruals? Can firms control accruals?

Accruals are free in that no explicit interest is charged. Firms have little control over the level of accruals. Levels are influenced more by industry custom, economic factors, and tax laws.

What is trade credit?

Trade credit is credit furnished by a firms suppliers. Trade credit is often the largest source of short-term credit, especially for small firms. Spontaneous, easy to get, but cost can be high.

S K I b uys $ 5 0 6 , 9 8 5 n e t , o n te r m s o f 1 / 1 0 , n e t 3 0 , a n d p ays o n D ay 4 0 . F i n d f re e a n d c o s t ly t ra d e c re d i t .
Net daily purchases = $506,985/365 = $1,389. Ann. gross purchase.= $506,985/(1-0.01) =$512,106 Gross/Net Breakdown Company buys goods worth $506,985. Thats the cash price.

They must pay $5,121 more if they dont take discounts.

Think of the extra $5,121 as a financing cost similar to the interest on a loan. Want to compare that cost with the cost of a bank loan.

Free and Costly Trade Credit Payables level if take discount: Payables = $1,389(10) = $13,890. Payables level if dont take discount: Payables = $1,389(40) = $55,560. Total trade credit Free trade credit Costly trade credit = $55,560 = 13,890 = $41,670

Nominal Cost of credit Firm loses 0.01($512,106) = $5,121 of discounts to obtain $41,670 in extra trade credit, so: rNom = $5,121 = 0.1229 = 12.29%. $41,670

But the $5,121 is paid all during the year, not at year-end, so EAR rate is higher.

Nominal Cost Formula, 1/10, net 40

rNom = Discount % 365 days Days Discount 1 - Discount % 1 = 99 365 30 Taken

Period

= 0.0101 12.1667

= 0.1229 = 12.29%

Pays 1.01% 12.167 times per year.

Effective Annual Rate, 1/10, net 40

Periodic rate = 0.01/0.99 = 1.01%. Periods/year = 365/(40 10) = 12.1667. EAR = (1 + Periodic rate)n 1.0 = (1.0101)12.1667 1.0 = 13.01%.

Working Capital Financing Policies

Moderate: Match the maturity of the assets with the maturity of the financing. Aggressive: Use short-term financing to finance permanent assets.

Conservative: Use permanent capital for permanent assets and

temporary assets.

Moderate Financing Policy

$ Temp. NOWC

}
Perm NOWC

S-T Loans L-T Fin: Stock & Bonds,

46

Fixed Assets

Lower dashed line, more aggressive.

Years

Conservative Financing Policy

$

Marketable Securities
Zero S-T debt
47

Perm NOWC

L-T Fin: Stock & Bonds

Fixed Assets Years

Commercial paper (CP)

Short term notes issued by large, strong companies. SKI couldnt issue CP--its too small. CP trades in the market at rates just above T-bill rate. CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes.

Thank You