Chapter 16 Working Capital

Working Capital Basics

Working Capital
Assets and liabilities required to operate a
business on a day-to-day basis
Assets:
Cash
Accounts Receivable
Inventory
Liabilities:
Accounts Payable
Accruals
2
Working Capital, Funding Requirements, and
the Current Accounts
Gross Working Capital represents an
investment in assets
Capital funds committed to support
assets
Working short term, day-to-day
operations
Working Capital Requires Funds
Maintaining a working capital balance
requires a permanent funds commitment
3
The Short-Term Liabilities
Spontaneous Financing
Operating activities automatically
create payables & accruals -
essentially debts
These liabilities spontaneously offset the
funding required to support current
assets
4
Working Capital and the Current
Accounts
Net Working Capital the difference
between gross working capital and
spontaneous financing
Generally:
Gross working capital = current assets
Net working capital =
current assets current liabilities
People often say working capital when
they actually mean net working capital
5
Objective of Working
Capital Management
To run the firm with as little money
tied up in the current accounts as
possible
Working capital elements
Inventory
Receivables
Cash
Payables
Accruals
6
Objective of Working Capital Management
7
Inventory
High Levels Low Levels
Benefit:
Happy customers supplied quickly
Few production delays (parts always on hand)
Cost:
High financing costs
High storage costs
Shrinkage (theft)
Risk of obsolescence
Cost:
Shortages
Dissatisfied customers
product not available
Benefit:
Low financing and storage
costs
Less risk of obsolescence

Cash
High Levels Low Levels
Benefit:
Reduces risk of being unable to pay bills
Cost:
Increases financing costs
Benefit:
Reduces financing costs
Cost:
Increases transaction risk
Objective of Working Capital Management
8
Accounts Receivable
High Levels Low Levels
Benefit:
Happy customers can pay slowly
High credit sales
Cost:
More bad debts
High collection costs
Increased financing costs
Cost:
Customers unhappy with
payment terms
Lower Credit Sales
Benefit:
Less financing cost

Payables and Accruals
High Levels Low Levels
Benefit:
Spontaneous financing reduces need to borrow
Cost:
Unhappy suppliers because paid slowly
Benefit:
Happy suppliers/employees
Cost:
Not using spontaneous financing

Figure 16-1 Cash Conversion Cycle
9

Figure 16-2 Timeline Representation of Cash
Conversion Cycle

10
Permanent and Temporary
Working Capital
Need for working capital varies with
sales level
Temporary working capital supports
seasonal peaks in business
Working capital is permanent to the
extent that it supports a constant,
minimum level of sales
11
Figure 16-3 Working Capital Needs of
Different Firms
12
Financing Net Working Capital
Short-term working capital should be
financed with short-term sources

Maturity Matching Principle the
term of financing should match the
term or duration of the project or item
supported

13
Short-Term vs. Long-Term Financing in
Support of Working Capital
Long-term financing

Safe but expensive
Safe funds are
committed and
cant be withdrawn
Expensive - long-
term rates are
generally higher
Short-term financing

Cheap but risky
Cheap - short-term
interest rates are
generally lower
Risky - must
continually renew
borrowing
14
Alternative Financing Policies
The mix of short/long-term financing
supporting working capital
Heavier use of longer term funds is
conservative
Using more short-term funding is
aggressive
15
Figure 16-4a Working Capital
Financing Policies
16
Figure 16-4b Working Capital
Financing Policies
17
Working Capital Policy
A firms Working Capital Policy refers
to its handling the following issues:
How much working capital is used
Extent supported by short or long term
financing
The nature and source of any short-term
financing used
How each component is managed
18
Sources of Short-term Financing
Spontaneous financing
payables and accruals
Unsecured bank loans
Commercial paper
Secured loans
19
Spontaneous Financing
Accruals
Interestfree loans
from whoever
provides services
deferring payment
Wage Accrual
Money owed to
employees for
work performed
but not yet paid

Accounts Payable
Effectively loans from
suppliers selling on
credit
Credit Terms:
Specify details of
payment
E.g. 2/10, net 30
2% discount if pay
within 10 days,
otherwise entire amount
due in 30 days
20
Prompt Payment Discount
Passing up prompt payment
discounts is an expensive source of
financing
21
If terms are 2/10, net 30, and dont pay by the 10th day,
essentially paying 2% for 20 days use of money

The implied annual rate is

(365 / 20) x 2% = 36.5%


Abuses of Trade Credit Terms
Trade credit, originally a service to
customers, is now expected
Paying beyond the due date is a
common abuse of trade credit
Called stretching payables or leaning on
the trade
Slow paying companies receive poor credit
ratings
May lose the ability to buy on credit in future
22
Unsecured Bank Loans
Represent the primary source of
short-term financing for most
companies
Unsecured Repayment is not
guaranteed by the pledge of a specific
asset
Promissory Note Written promise to
repay amount borrowed plus interest
23
Unsecured Bank Loans
Line of credit
Informal, non-binding agreement
between a bank and a borrowing firm
specifying the maximum amount that
can be borrowed during a period
24
Revolving Credit Agreement
Similar to a line of credit except bank
guarantees availability of funds up to
a maximum amount
Borrower pays a commitment fee on the
unborrowed balance

25
Concept Connection Example 16-2
Revolving Credit Agreements
26
Arcturus has a $10M revolver at prime plus 2.5%.

Prior to June 1, it took down $4M that remained outstanding for
the month. On June 15, it took down another $2M which
remained outstanding through June 30.

Prime is 9.5% and the banks commitment fee is 0.25%.

What bank charges will Arcturus incur for the month of June?

Concept Connection Example 16-2
Revolving Credit Agreements
27

Monthly interest rate: (Prime + 2.5%) 12 = 1%
Monthly commitment fee: 0.25% 12 = 0.0208%

$4M was outstanding for the entire month of June and $2M was
outstanding for 15 days, so the total interest charges are:
($4,000,000 .01) + ($2,000,000 [15/30] .01) = $50,000

The unused balance was $6M for 15 days and $4M for 15 days
($6,000,000 .000208 [15/30]) = $ 624
($4,000,000 .000208 [15/30]) = $ 416
$1,040
So, total bank charges for June are $51,040
Compensating Balances
Minimum Balance
Requirement

A percentage of the
loan amount must be
left in the borrowers
account at all times
and is not available
for use


Average Balance
Requirement

Average daily balance
over a month cannot
fall below a specified
level
Entire balance can be
used but not all at
once
28
Clean-Up Requirements
Borrowers are required to be out of
short-term debt for a period once a
year
Usually 30-45 days
Prevents funding long-term needs and
projects with short-term borrowing



29
Commercial Paper
Notes issued by large, financially-
strong firms and sold to investors
Basically a very short-term corporate
bond
Unsecured
Buyers are usually institutions
Maturity less than 270 days
Considered a very safe investment
Interest is discounted no coupon
Rigid and formal - no flexibility in repayment
terms
30
Short-Term Credit Secured
by Current Assets
Debt is secured by the current asset
being financed
Accounts receivable
Inventory
Self liquidating nature of current
assets makes loans very safe
31
Short-Term Credit Secured
by Current Assets
Receivables Financing
Accounts receivable - money to be collected in
the near future
Banks are willing to lend on A/R if the
borrowing firms customers have good
financial ratings
Pledging AR: using A/R as collateral for loan
Factoring AR: selling receivables at a discount
directly to a financing source
32
Concept Connection Example 16-4
Pledging Accounts Receivables
33
Kilraines $100,000 receivables balance of turns over
every 45 days. The firm pledges all receivables to a finance
company, which advances 75% of the total at prime plus 4%
plus a 1.5% administrative fee.
Prime is 8%, what interest rate is Kilraine effectively
paying for its receivables financing?

Concept Connection Example 16-4
Pledging Accounts Receivables
34
Solution:
Traditional interest
8% + 4% = 12%
Administrative charge
Average loan balance
$100,000 .75 = $75,000

Accounts offered to finance company
$100,000 x 360/45 = $800,000
The administrative fee at 1.5%
1.5% x $800,000 = $12,000
Fee as a percentage of loan balance
$12,000 $75,000 = 16%
Total financing charges
16% + 12% = 28%.
Factoring Receivables
Firm sells receivables at a discount to a
factor that takes control of accounts
Accounts Receivable are paid directly to factor
Factor accepts only creditworthy customer
accounts
Factors offer a wide range of services all for fees
Perform credit checks on potential customers
Advance cash on accounts before collection or
remit cash after collection
Collect cash from problem customers
Assume bad-debt risk when customers dont pay
Factoring is usually very expensive financing

35
Inventory Financing
Inventory Financing
Inventory is collateral for loans
Repossessed items may be difficult for
lender to sell
Inventory in borrowers hands is hard for
lender to control
Blanket liens
Chattel mortgage agreements
Warehousing
Field and public
36
Cash Management
Motivation for Holding Cash

Transactions demand
Precautionary demand
Speculative demand
Compensating balances
37
Objective of Cash Management
Business cash balances earn little or
no interest
Firms generally borrow to support cash
balances
But it is easier to do business with
plenty of cash - Liquidity
Objective: Strike a balance
Operate efficiently at a reasonable cost
38
Marketable Securities
Some assets are only slightly less
liquid than cash, and earn a return
Treasury bills
Other short term securities issued by
stable organizations
Held as a substitute for cash


39
Figure 16-5 The Check-Clearing
Process

40
Check Disbursement and
Collection Procedures
Float: money tied up in the check
clearing process
Mail float
Transit float
Processing float
Use of Cash - Payers versus Payees
Payers want to extend float periods
Payees want to reduce float periods
41
Check 21
Traditional check processing shipped
paper checks around the country
Check Clearing for the 21st Century
Act Known as Check 21
Banks may now truncate checks
Replaced with electronic checks
Paper facsimiles available when needed
Has sped up clearing process
Fed paper check processing locations
reduced from 45 to 1
42
Accelerating Cash Receipts
Lock-box systems
Service provided by banks to accelerate
collections
Concentration Banking
Sweep excess balances in distant
depository accounts into central
locations daily
43
Figure 16-6 A Lock Box System in the
Check-Clearing Process

44
Accelerating Cash Receipts
Wire Transfers
Transfers money
electronically
Preauthorized Checks
Customer gives the payee
signed check-like documents
in advance
Payee deposits it in its bank
account once product is
shipped
45
Managing Cash Outflow
Control Issues
Centralized/decentralized
Zero Balance Accounts (ZBAs)
Empty disbursement account at firms
concentration bank for its divisions
Remote Disbursing
A way to extend mail float
46
Concept Connection Example 16-7
Evaluating Lock-Box Systems
47
Kelso is located on the East Coast, but has
California customers that remit 5,000, $1,000
checks a year that take eight days to clear.

A California bank offers a lock box system for
$2,000 a year plus $0.20 per check, which will
reduce clearing time to six days. Is the proposal
a good deal if Kelso borrows at 12%?

Concept Connection Example 16-7
Evaluating Lock-Box Systems
Solution:
Kelsos float now
[(8 / 365) x $5,000,000] = $109,589
Float under proposed lockbox system
[(6 / 365) x $5,000,000] = $82,192
Interest on cash freed up
[$27,397 x 0.12] = $3,288
System cost
[$2,000 + ($0.20 x 5,000)] = $3,000,
Conclusion: Proposal is marginally worth doing.
Managing Accounts Receivable
Objectives and Policy
Higher receivables means selling to
financially weaker customers and not
pressuring them to pay promptly
Higher sales but also more bad debts
Objective is to max profit, not revenue
Receivables Policy involves:
Credit Policy
Terms of Sale
Collections Policy
49
Determinants of
Receivables Balance
Credit Policy
Examine creditworthiness of potential
credit customers
Tight credit policy = lower sales
Loose credit policy = high bad debts
Conflict between sales and credit
departments
50
Terms of Sale
Credit sales are subject to specific payment terms
2/10, net 30 - The most common terms
2% discount for paying within 10 days,
otherwise entire amount due within 30 days
Prompt payment discounts are usually effective
tools for managing receivables
Customers pay quickly to save money
May backfire if customers are very cash poor
Discount taken only by those who pay anyway

51
Collections Policy
Collections Department - follows up on overdue
receivables - called dunning
Mail polite letter
Follow up with additional increasingly
aggressive dunning letters
Phone calls
Collection agency
Lawsuit

Collection policy: manner and aggressiveness
with which a firm pursues payment from
delinquent customers
52
Inventory Management
Inventory: product held for sale
Inventory mismanagement can ruin a
company
Finance department has only an
oversight responsibility
Monitor level of lost or obsolete
inventory
Supervise periodic physical inventories
53
Benefits and Costs of Carrying
Adequate Inventory
Benefits
Reduces
stockouts and
backorders
Makes operations
run more
smoothly
Improves
customer relations
Increases sales

Costs
Interest on funds used to
acquire inventory
Storage and security
Insurance
Taxes
Shrinkage - theft
Spoilage
Breakage
Obsolescence

54
Inventory Control and Management
Inventory Management - overall way a firm
controls inventory and its cost
Define an acceptable level of operating
efficiency with regard to inventory
Achieve that level with the minimum inventory
cost
EOQ An inventory cost minimization model
C = Annual Carrying Cost per Unit
F = Fixed Cost per Order
D = Annual Demand in Units
Q = Order Quantity
55
Figure 16-7 Inventory on Hand for a
Steadily Used Item
56
Figure 16-8 Inventory Costs and the EOQ
Total Inventory Cost:

Q
D
F
2
Q
C TC + =
Economic Order Quantity
(EOQ) Model
1
2
2 Fixed Cost per Order Annual Demand
EOQ =
Annual Carrying Cost per Unit
(
(

EOQ minimizes the sum of ordering and carrying costs
C = Annual Carrying Cost per Unit
F = Fixed Cost per Order
D = Annual Demand in Units


2
1
C
2FD
EOQ
(

=
Concept Connection Example 16-9
Economic Order Quantity (EOQ) Model
59
Galbraith buys a $5 part. Its carrying cost is 20% of
that value per year.
It costs $45 to place, process and receive an order.
1,000 parts are used per year.

What order quantity minimizes inventory costs?

How many orders will be placed each year if that
order quantity is used?

What annual inventory costs are incurred for the
part with this ordering quantity?
Concept Connection Example 16-9
Economic Order Quantity (EOQ) Model
60
Solution: C = $5 .20 = $1
F = $45
D = 1,000


Annual number of orders = 1,000 / 300 = 3.33.
Carrying costs = $5 .2 (300/2) = $150 per year
Ordering costs = $45 x 3.333, = $150 per year
Total inventory cost = $150 + $150 = $300 per year

1
2
2 $45 1,000
EOQ = = 300 units
$1

(
(

Safety Stocks, Reorder Points
and Lead Times
Safety stock: Additional inventory, carried at
all times, used when normal working stocks
run out
Quantity on hand diminishes until reorder
point is reached
Ordering lead time is the advance notice
needed so an order will arrive on time
61
Figure 16-9 Pattern of Inventory
on Hand
62
Safety Stock and the EOQ
Inclusion of safety stocks does not
change EOQ
Cost trade-off: extra inventory
increases carrying cost, but avoids
losses from production delays and
missed sales
63
Tracking Inventories
The ABC System
The ABC system segregates items by
value and places tighter control on
higher-cost pieces
A items very expensive or critical
B items moderate value
C items cheap and plentiful
Effort and spending on control
diminishes from A to B to C
64
Just In Time (JIT)
Inventory Systems
JIT virtually eliminates manufacturing
inventory by pushing it back on suppliers
Suppliers deliver goods just in time for use
in production
Works best with large manufacturers
Works poorly where firm has little control
over distant suppliers
65