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Working Capital Terminology Working Capital Financing Policies Cash Conversion Cycle Why hold cash? Goals of Managing Cash, Inventory and Credit Policy Cash Budgeting Sources and Costs of Short-Term Financing
Gross working capital total current assets. Net working capital current assets minus non-interest bearing current liabilities. Working capital policy deciding the level of each type of current asset to hold, and how to finance current assets. Working capital management controlling cash, inventories, and A/R, plus short-term liability management.
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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.
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Perm C.A.
Fixed Assets
16-4
Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L. Years
16-5
Perm C.A.
Fixed Assets
The cash conversion cycle focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.
Inventory Receivables Payables CCC = conversion + collection deferral . period period period
16-6
Cash doesnt earn a profit, so why should the firm hold it?
1. 2.
3.
4.
Transactions must have some cash to operate. Precaution safety stock. Reduced by line of credit and marketable securities. Compensating balances for loans and/or services provided. Speculation to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities.
16-8
To meet the above objectives, especially to have cash for transactions, yet not have any excess cash. To minimize transactions balances in particular, and also needs for cash to meet other objectives.
16-9
Use a lockbox Insist on wire transfers from customers Synchronize inflows and outflows Use a remote disbursement account Reduce need for safety stock of cash
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 or customer goodwill, and the disruption of production schedules.
Reducing inventory levels generally reduces carrying costs, increases ordering costs, and may increase the costs of running short.
16-11
Short-term credit
Debt scheduled for repayment within 1 year. Major sources of short-term credit
From the firms perspective, S-T credit is riskier than L-T debt.
Always a required payment around the corner. May have trouble rolling over loans.
16-13
Advantages
Speed Flexibility Lower cost than long-term debt Fluctuating interest expense Firm may be at risk of default as a result of temporary economic conditions
Disadvantages
16-14
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.
16-15
The firm loses 0.01($3,030,303) = $30,303 of discounts to obtain $246,575 in extra trade credit:
rNOM = $30,303 / $246,575 = 0.1229 = 12.29%
The $30,303 is paid throughout the year, so the effective cost of costly trade credit is higher.
16-16
16-17
Periodic rate = 0.01 / 0.99 = 1.01% Periods/year = 365 / (40-10) = 12.1667 Effective cost of trade credit
EAR
= (1 + periodic rate)N 1
= (1.0101)12.1667 1 = 13.01%
16-18
Add-on interest
Interest = 0.08 ($100,000) = $8,000 Face amount = $100,000 + $8,000 = $108,000 Monthly payment = $108,000/12 = $9,000 Avg loan outstanding = $100,000/2 = $50,000 Approximate cost = $8,000/$50,000 = 16.0% To find the appropriate effective rate, recognize that the firm receives $100,000 and must make monthly payments of $9,000 (like an annuity).
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30- 20
Inventory Management
Components of Inventory
Raw materials Work in process Finished goods
Goal = Minimize amount of cash tied up in inventory Tools used to minimize inventory
Just-in-time Lean manufacturing
30- 21
Inventories
As the firm increases its order size, the number of orders falls and therefore the order costs decline. However, an increase in order size also increases the average amount in inventory, so that the carrying cost of inventory rises. The trick is to strike a balance between these two costs.
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Managing Inventories
Inventory
30
Average Inventory
6
Weeks
12
30- 23
Inventories
Determination of optimal order size
Inventory costs, dollars
Total costs Carrying costs
30- 24
Inventories
Economic Order Quantity - Order size that minimizes total inventory costs.
30- 25
Inventories
Just-in-time inventory management Managing inventories of cash
Upper limit
Cash Balance
Return point
Lower limit
Time
30- 26
Inventories
The optimal amount of short term securities sold to raise cash will be higher when annual cash outflows are higher and when the cost per sale of securities is higher. Conversely, the initial cash balance falls when the interest is higher.
30- 27
Working Capital
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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Terms of Sale
Terms of Sale - Credit, discount, and payment terms offered on a sale. Example - 5/10 net 30
5 - percent discount for early payment 10 - number of days that the discount is available net 30 - number of days before payment is due
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Terms of Sale
A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier. We can calculate the implicit cost of this loan
- 1
30- 30
Terms of Sale
Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?
-1
- 1 = .454, or 45.4%
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Credit Agreements
Terminology
open account promissory note commercial draft sight draft time draft trade acceptance bankers acceptance irrevocable letter of credit conditional sale
30- 32
Credit Analysis
Numerical Credit Scoring categories
The customers character The customers capacity to pay The customers capital The collateral provided by the customer The condition of the customers business
30- 33
Credit Analysis
Credit Analysis - Procedure to determine the likelihood a customer will pay its bills. Credit agencies, such as Dun & Bradstreet provide reports on the credit worthiness of a potential customer. Financial ratios can be calculated to help determine a customers ability to pay its bills.
30- 34
Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default. Denying credit guarantees neither profit or loss.
30- 35
Customer pays = p
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PV(Cost) p = PV(Rev)
30- 37
Collection Policy
Collection Policy - Procedures to collect and monitor receivables. Aging Schedule - Classification of accounts receivable by time outstanding.
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Collection Policy
Sample aging schedule for accounts receivable
Customer' s Less than More than 1 - 2 months 2 - 3 months Total Owed Name 1 month 3 months A 10,000 0 0 0 10,000 B 8,000 3,000 0 0 11,000 * * * * * * * * * * * * * * * * * * Z 5,000 4,000 6,000 15,000 30,000 Total $200,000 $40,000 $15,000 $43,000 $298,000
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Cash
Cash does not pay interest
Move money from cash accounts into short term securities Sweep programs MMDAs Concentration banking Lock-box system
30- 40
Cash
How purchases are paid. Percentage of total by payment type for 2004.
100% 80% 60% 40% 20% 0% Direct debits Credit transfers Credit/debit cards Checks
UK
Canada
Germany
Netherlands
Switzerland
Sweden
France
USA
Italy
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Cash
Electronic Funds Transfer (EFT) Automated Clearinghouse (ACH) 2005 ACH transaction volume = $31.1 trillion International cash management Compensating balances
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Payment Methods
120
100
% of firms using
80
60
Receive payments
Make payments
40
20
30- 43
Marketable Securities
Microsoft 2006 cash investments
Investment Money market mutual funds Commercial paper Certificates of deposit US Govt and agency securities Foreign govt bonds Mortgage backed securities Corporate notes and bonds Municipal securities Other Total
Amount $723 million 3,242 364 4,904 6,034 4,285 7,605 4,008 383 31,548
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Treasury bills
U.S. government
Discount
Federal agency FHLB, "Fannie Mae," benchmark bills and Sallie Mae," Freddie Overnight to 360 discount notes Mac," etc. days
Discount
Auctioned weekly Benchmark bills by regular auction; discount notes sold through dealers Tax-anticipation notes (TANs), revenue anticipation notes (RANs), bond anticipation notes (BANs), etc. Long-term bonds with put options to demand repayment
Municipalities, Tax-exempt states, school municipal notes districts, etc. Tax-exempt variableMunicipalities, rate demand bond states, universities, (VRDBs) etc.
3 months to 1 year
10-40 years
30- 45
Commercial banks, savings and loans Industrial firms, finance companies, and bank holding Commercial paper companies; also (CP) municipalities Largely finance companies and Medium-term notes banks; also industrial (MTNs) firms Bankers' acceptances (Bas) Major commercial banks
Usually discount
1-6 months Overnight to about 3 months; also open repos (continuing contracts)
Discount
No secondary market
Repurchase price set higher than selling Sales of government price; difference securities by dealer with quoted as repo simultaneous agreement interest rate to repurchase.
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Working Capital
Example - Cash Conversion Cycle Given the aggregate balance sheet and income statement for US Manufacturing firms, calculate the cash conversion cycle.
average accounts payable Payable period = annual COGS/365 (359 + 334)/2 = 3,960 / 365 = 31.9 days
Irwin/McGraw Hill
Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved
19- 47
Working Capital
Example - Cash Conversion Cycle Given the aggregate balance sheet and income statement for US Manufacturing firms, calculate the cash conversion cycle.
Irwin/McGraw Hill
19- 48
CCC
CCC=INVENTORY PERIOD PLUS RECEIVABLE PERIOD MINUS PAYABLE PERIOD 44.8 + 41.6 31.9 = 54.5 DAYS What does the 54.5 days mean here?
Irwin/McGraw Hill
19- 49
Cash Budgeting
Steps to preparing a cash budget
Step 1 - Forecast the sources of cash. Step 2 - Forecast uses of cash. Step 3 - Calculate whether the firm is facing a cash shortage or surplus.
Irwin/McGraw Hill
19- 50
Cash Budgeting
Example - Dynamic Mattress Company
Irwin/McGraw Hill
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Cash Budgeting
Example - Dynamic Mattress Company Dynamic collections on AR
Qtr 1st 1. Beginning receivables 2. Sales 3. Collections . Sales in current Qtr (80%) . Sales in previous Qtr (20%) Total collections 4. Receivables at end of period . (4 = 1 + 2 - 3)
Irwin/McGraw Hill
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Cash Budgeting
Example - Dynamic Mattress Company
Dynamic forecasted uses of cash Payment of accounts payable Labor, administration, and other expenses Capital expenditures Taxes, interest, and dividend payments
Irwin/McGraw Hill
19- 53
Cash Budgeting
Example - Dynamic Mattress Company
Qtr
1st Sources of cash collections on AR other Total Sources Uses of cash payment of AP labor and admin expenses capital expenditures taxes, interest, & dividends Total uses of cash Net cash inflow (sources minus uses) 65.0 30.0 32.5 4.0 131.5 $45.0 85.0 1.5 86.5
2nd
3rd
4th
Irwin/McGraw Hill
19- 54
Cash Budgeting
Example - Dynamic Mattress Company Dynamic short term financing requirements
Cash at start of period + Net cash flow = Cash at end of period Min operating cash balance Cumulative short term financing required (minimum cash balance minus caash at end of period)
Irwin/McGraw Hill
Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved
5 - 45 - 40 5 $45
- 40 - 15 - 55 5 $60
- 55 + 26 - 29 5 $34
- 29 + 35 + 6 5 - $1
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Irwin/McGraw Hill
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(1 +
Irwin/McGraw Hill
)
n
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Readings
1. S. Mian and C.W. Smith, Extending Trade Credit and Financing, Journal of Applied Corporate Finance 7, (Spring 1994), pp: 75-84 2. A. Dittmar, Corporate Cash Policy and How to Manage it with Stock repurchases, Journal of Applied Corporate Finance 20, (Summer 2008), pp: 22-34 3. M.A. Petersen and R.G. Rajan, Trade Credit: Theories and Evidence, Review of Financial Studies 10, (Fall 1979), pp:661-692
Irwin/McGraw Hill