14

Chapter 14Chapter 14

The Management of The Management of Working CapitalWorking Capital

© 2000 South-Western College Publishing

WORKING CAPITALAssets and liabilities required to operate a business on a day to day basis

Cash Payables

Receivables Accruals

Inventory

Short Term - Turn Over Continually

TRADITIONAL DEFINITIONSTRADITIONAL DEFINITIONSGross Working Capital = Current Assets

Net Working Capital = Current Assets - Current Liabilities

WORKING CAPITAL REQUIRES FUNDINGWORKING CAPITAL REQUIRES FUNDINGNet working capital reflects the funding required

to support routine operations

THE OBJECTIVE OF WORKING CAPITAL MANAGEMENTTHE OBJECTIVE OF WORKING CAPITAL MANAGEMENTRun the company effectively with as little money tied up

in the current accounts as possible.

Implies trade-offs because it's easier to run a business with

more working capital than with less TM 14-1

PERMANENT AND TEMPORARY WORKING CAPITALPERMANENT AND TEMPORARY WORKING CAPITAL

Temporary Working Capital supports seasonal operations

and need not be maintained all year

$ $ Temporary

Working Capital

Permanent Permanent Working Capital Working Capital

Fixed Assets Fixed Assets

Time Time

Stable Company Seasonal Company

Figure 14-3 Working Capital Needs of Different Firms

TM 14-4

FINANCING WORKING CAPITALFINANCING WORKING CAPITALNet Working Capital can generally be financed

with short-term borrowing

The practice is cheaper but riskier than using long-term funds

Leads to relatively aggressive or

conservative W/C financing policies

TM 14-5 Slide 1 of 3

$ Temporary

Working Capital Short-Term

Debt Financing

Long-Term Debt

Permanent and Equity

Working Capital Financing

Fixed Assets

Time

(a) Conservative Policy Using Largely Long Term Sources

Working Capital Financing Policies Figure 14-4


Time

(b) Aggressive Policy Using More Short-Term Debt

Working Capital Financing Policies Figure 14-4


$ Temporary

Working Capital

Short-Term

Debt Financing

Permanent

Working Capital Long-Term Debt

and Equity

Fixed Assets Financing

Time

WORKING CAPITAL POLICYWORKING CAPITAL POLICY

• How much working capital is used

• The extent to which working capital is supported by short-

versus long-term financing

• The nature/source of short-term financing used

• How each component of working capital is managed

SOURCES OF SHORT TERM FINANCINGSOURCES OF SHORT TERM FINANCING

• Spontaneous Financing• Unsecured Bank Loans

• Secured Loans • Commercial Paper

TM 14-6

SPONTANEOUS FINANCINGSPONTANEOUS FINANCINGACCRUALSACCRUALS

Mainly wages and salaries

Little policy latitude

ACCOUNTS PAYABLE - TRADE CREDITACCOUNTS PAYABLE - TRADE CREDIT

Credit Terms

Terms of Sale, e.g. 2/10, net 30

Net amount due within thirty days, a two percent prompt payment discount

may be taken if paid within ten days

The Prompt Payment Discount

Abuses of Trade Credit Terms

* Stretching payables or leaning on the trade

* slow payer * credit agency

* credit reports * credit rating

TM 14-7

365

202% 36 5% .

BANK LOANSBANK LOANSPromissory Note

Commitment to repay funds according to terms

Line of CreditInformal, cancelable agreement for maximum borrowing in a year

Revolving Credit AgreementBinding agreement for maximum borrowing in a year

Requires a commitment fee on unborrowed amounts


BANK LOANSBANK LOANSCompensating Balances

Part of loan must be left in bank account

Funds may be partly or entirely unusable

Raises Bank's Yield

minimum

average

Cleanup RequirementsRequires borrower to be out of short term debt for a period each year

Prevents funding long term projects with short term debt

COMMERCIAL PAPERCOMMERCIAL PAPER

Notes issued by large, strong companies to borrow for

relatively short periods


SHORT TERM CREDIT SECURED BY SHORT TERM CREDIT SECURED BY CURRENT ASSETSCURRENT ASSETS

RECEIVABLES FINANCINGRECEIVABLES FINANCING

A key issue is collectibility.

Relates to the credit worthiness of the firm's customers

rather than to its own

Pledging Accounts ReceivableUsing cash value as collateral for a loan.

With and without RECOURSE

Receivables continue to belong to the borrowing firm,

which administers collection


SHORT TERM CREDIT SECURED BY SHORT TERM CREDIT SECURED BY CURRENT ASSETS(cont.)CURRENT ASSETS(cont.)

Factoring ReceivablesSelling the receivable at a discount to a factor

Payment made directly to factor

Recourse

Interest

Other Services

Pledging and factoring tend to be expensive forms of financing

INVENTORY FINANCINGINVENTORY FINANCINGInventory as collateral for loan

Major problem is tracking

Blanket Liens

Trust Receipt or Chattel Mortgage Agreement

Warehousing - Field, Public - Secure but expensive


CASH MANAGEMENTCASH MANAGEMENTThe Motivation for Holding Cash

Transactions Demand

Precautionary Demand

Speculative Demand

Compensating Balances

The Objective of Cash ManagementCash in the bank doesn't earn a return.

butIt is easier to run a business with more cash than with less - LIQUIDITY

Good cash management minimizes the amount in the bank,

consistent with efficient operations.

Marketable SecuritiesA compromise

Good liquidity with a modest return

TM 14-10

CHECK DISBURSEMENT AND CHECK DISBURSEMENT AND COLLECTION PROCEDURESCOLLECTION PROCEDURES

1. The payer writes a check on its bank, and mails it to the payee. (2-3 days)

2. The payee receives the check, records it, and processes it internally for deposit.

3. The payee then deposits the check in its own bank. (2 days - items 2 and 3)

4. The payee's bank sends the check into the Federal Reserve's interbank clearing system at a Federal Reserve office.

5. The clearing system processes the check. This transfers money from the payer's account at its bank into the payee's account at its bank. The funds are now available for the payee's use. The canceled check is returned to the payer through its bank. (2 days - items 4 and 5)


Check in Mail

Process Notice of

Internally Available

Deposit Funds

Check

(2 days)

Banking System

(2 Days)

Check Check

$ $

Figure 14-5 The Check Clearing Process

FLOAT- Money tied up in the process: Mail Float - Check in the mail;Processing Float - In payee's office; Transit Float - In federal reserve system


Payer Payee(2-3 days)

Payer’s Bank Account

Fed Reserve Clearing Sys.

Payee’sBank Acct.

Check in Mail

Notice of

Available

Funds

Banking System

(2 Days)

Check Check

$ $

Figure 14-6 A Lock Box System

in The Check Clearing Process

TM 14-12 Slide 1

of 2

Payer Payee(1-2 days)

Payer’s Bank Account

Fed Reserve Clearing Sys.

Payee’sBank Acct.

Lock Box

ACCELERATING CASH RECEIPTS - LOCK BOX SYSTEMS: Payee rents a post office box near its bank, orders payers to mail checks to the box; bank opens the box and deposits checks in the payee’s account. Saves two or three days.

OTHER CASH MANAGEMENT CONCEPTSOTHER CASH MANAGEMENT CONCEPTS

Managing Cash OutflowZero Balance Accounts (ZBA's)

Remote Disbursing

Evaluating the Cost of Cash Management ServicesBenefit is largely the interest savings

on lower cash balances

which must exceed the cost of the system


MANAGING ACCOUNTS RECEIVABLEMANAGING ACCOUNTS RECEIVABLEMore Receivables => More Sales

But also More Carrying Cost and More Bad Debt Losses

Managing accounts receivable means striking a balance

which maximizes profitability.

(RECEIVABLES POLICY or CREDIT and COLLECTIONS POLICY)

Three broad issues are involved:

1. Who should get credit, and how much should be allowed

2. What terms (due dates and discounts) should be offered

3. How should customers who don't pay on time be handled

Who Is Responsible For Receivables PolicyReceivables policy is a joint effort between financial

and sales/marketing management.

The Conflict With Sales Over Credit and Collections PolicyCredit Standards for Accepting Sales

DunningCollection Agencies

TM 14-13

INVENTORYBENEFITS OF CARRYING INVENTORYBENEFITS OF CARRYING INVENTORY

Smoother Production Operations - Delays and Idle time

Fewer Stockouts in Filling Orders - Lost Sales

COSTS OF CARRYING INVENTORYCOSTS OF CARRYING INVENTORY

Costs: Interest Losses: Shrinkage (theft)

Storage and Spoilage

Security Breakage

Insurance Obsolescence

Taxes


INVENTORY MANAGEMENT

The overall way a company oversees its inventory and uses control systems to manage benefits against costs.

Defining an acceptable level of operating efficiency in terms of stockouts, backorders and production problems, and trying to

achieve it with minimum inventory cost.

There is no single approach to managing inventory. Success comes from reviews, attention to detail and using a variety

of control systems.


THE ECONOMIC ORDER QUANTITY (EOQ) MODEL

An approach to minimizing total inventory cost by recognizing the trade-off between carrying cost and ordering cost.

Quantity

on hand

Q

Avg Qty

Q/2 on

hand

Time

Figure 14-7 Inventory on Hand for a Steadily Used Item

TM 14-15

THE ECONOMIC ORDER QUANTITY (EOQ) MODEL

C = Yearly carrying cost per unit

Q = Order Quantity

D = Annual Demand

F = Cost Per Order

Carrying cost = C (Q/2)

N = D/Q

Ordering Cost = FN = F (D/Q)


TC CQ

FD

Q

2

Costs, $

Total Cost Carrying

Cost

Ordering Cost

EOQ Q (Order Size)

Figure 14-8 Inventory Costs and the EOQ


EOQFD

C

2 1 2/

SAFETY STOCKS - REORDER POINTS - LEAD TIMES

Quantity on Hand

Expected Usage

Q

Q/2 plus Avg QtySafety Stk on

Hand Reorder Point

Safety High Delayed Stock Usage Delivery

Time

Ordering Lead Time

Figure 14-9 Pattern of Inventory on Hand Including Safety Stock Showing Reorder Point, Lead Time, and the Effects of High Usage and Delayed Delivery


OTHER INVENTORY CONCEPTSOTHER INVENTORY CONCEPTS

ABC SystemsRecognize the relative value of pieces

and control each with appropriate effort/expense

Just In Time (JIT) SystemsEliminate manufacturing inventories by requiring vendor shipments timed

precisely to production schedules


14

Documents

management of working

component of working

capital policy

short term credit

longterm financing

credit rating tm

short periods tm

expensive tm