Chapter 23 - Working Capital Management - General Issues

Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean Cleary W. Sean Cleary

Chapter 23 – Working Capital Chapter 23 – Working Capital Management: General IssuesManagement: General Issues

CHAPTER 23CHAPTER 23 Working Capital Working Capital

Management: General IssuesManagement: General Issues

CHAPTER 23 – Working Capital Management – General Issues 23 - 3

Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• An integrated approach to working capital An integrated approach to working capital

managementmanagement• Analyzing cash inflows and outflowsAnalyzing cash inflows and outflows• Working capital managementWorking capital management• Summary and ConclusionsSummary and Conclusions

– Concept Review QuestionsConcept Review Questions


Learning ObjectivesLearning Objectives

You should understand:You should understand:• Why the management of net working capital is critical for Why the management of net working capital is critical for

the survival of the firmthe survival of the firm• How managing receivables, inventory, and payables is How managing receivables, inventory, and payables is

related in an integrated approach to net working capital related in an integrated approach to net working capital managementmanagement

• How the financing and current asset investment decisions How the financing and current asset investment decisions interact to determine a company’s overall working capital interact to determine a company’s overall working capital positionposition

• How some key financial ratios can be used to analyze a How some key financial ratios can be used to analyze a firm’s net working capital policiesfirm’s net working capital policies


Important Chapter TermsImportant Chapter Terms

• Break-even sales growthBreak-even sales growth• Cash budgetCash budget• Cash conversion cycleCash conversion cycle• Credit policyCredit policy• Inventory policyInventory policy

• Net working capitalNet working capital• Operating cycleOperating cycle• Payment policyPayment policy• Trade creditTrade credit• Working capital Working capital

managementmanagement

An Integrated Approach to Net Working An Integrated Approach to Net Working Capital ManagementCapital Management

Working Capital Management - Working Capital Management - General IssuesGeneral Issues


Working Capital ManagementWorking Capital Management

• The way in which a firm manages both its The way in which a firm manages both its current assets and its current liabilities.current assets and its current liabilities.


Good Working Capital ManagementGood Working Capital Management

• Characterized by:Characterized by:1.1. The maintenance of optimal cash balancesThe maintenance of optimal cash balances2.2. The investment of any excess liquid funds in marketable The investment of any excess liquid funds in marketable

securities that provide the best return possible, considering any securities that provide the best return possible, considering any liquidity or default-risk constraintsliquidity or default-risk constraints

3.3. Proper management of accounts receivableProper management of accounts receivable4.4. An efficient inventory management systemAn efficient inventory management system5.5. Maintaining an appropriate level of short-term financing, in the Maintaining an appropriate level of short-term financing, in the

least expensive and most flexible manner possible.least expensive and most flexible manner possible.


Working Capital ManagementWorking Capital ManagementImportance of Cash Flow ManagementImportance of Cash Flow Management

• Management of the firm’s cash flow is one of Management of the firm’s cash flow is one of the greatest challenges facing the financial the greatest challenges facing the financial manager:manager:– Exhaustion of liquid resources can leave the firm Exhaustion of liquid resources can leave the firm

unable to pay it’s maturing obligations as they come unable to pay it’s maturing obligations as they come due (a state of technical insolvency…an Act of due (a state of technical insolvency…an Act of Bankruptcy)Bankruptcy)


Working Capital ManagementWorking Capital ManagementExhaustion of Liquid ResourcesExhaustion of Liquid Resources

• Firms can ‘run out’ of liquid financial resources in a Firms can ‘run out’ of liquid financial resources in a number of ways:number of ways:– Rapid growth in production and sales, can cause the firm to Rapid growth in production and sales, can cause the firm to

use up all of its cash pursuing growth, leaving it invested in use up all of its cash pursuing growth, leaving it invested in illiquid assets such as inventories, accounts receivable and net illiquid assets such as inventories, accounts receivable and net fixed assets.fixed assets.• The surprising thing about this state is that the firm may be highly The surprising thing about this state is that the firm may be highly

profitable in an accounting sense, but be on the verge of profitable in an accounting sense, but be on the verge of bankruptcy as it pursues uncontrolled growth in sales.bankruptcy as it pursues uncontrolled growth in sales.

– Continuing to produce inventory in the face of falling sales Continuing to produce inventory in the face of falling sales revenue.revenue.

– Selling products/services for less than their variable cost to Selling products/services for less than their variable cost to produce.produce.


An Integrated Approach to Net Working Capital An Integrated Approach to Net Working Capital ManagementManagement

The Cash BudgetThe Cash Budget

• The monthly cash budget is a management tool used to The monthly cash budget is a management tool used to forecast the timing, magnitude and duration of both cash forecast the timing, magnitude and duration of both cash surpluses as well as deficits.surpluses as well as deficits.

$ 1 2 3 4 5 6Sales 1,000 1,500 2,000 2,500 3,000 3,500

Cash inflow 1,000 1,000 1,500 2,000 2,500 3,000

Cash outflow

Current sales 750 1,125 1,500 1,875 2,250 2,625

Inventory 0 375 375 375 375 375

Operating cash 250 -500 -375 -250 -125 0

Start cash 1,000 1,250 750 375 125 0

End cash 1,250 750 375 125 0 0

Required cash 200 300 400 500 600 700

Surplus/deficit 1,050 450 -25 -375 -600 -700

Table 23-2 ABC's Six-Month Cash Budget


An Integrated Approach to Net Working An Integrated Approach to Net Working Capital ManagementCapital Management

• Knowledge of the cash flow cycle of a firm gives the Knowledge of the cash flow cycle of a firm gives the manager an awareness of the dynamics involved in manager an awareness of the dynamics involved in working capital management.working capital management.

• The cash flow cycle helps the manager visualize the The cash flow cycle helps the manager visualize the impact of changes in variables on the cash account:impact of changes in variables on the cash account:– How increasing sales requires additional investment in inventoryHow increasing sales requires additional investment in inventory– How increasing accounts receivable reduces cashHow increasing accounts receivable reduces cash– How delaying payables preserves cashHow delaying payables preserves cash– How speeding collections on A/R improves the cash positionHow speeding collections on A/R improves the cash position

The Cash Flow CycleThe Cash Flow Cycle



Cash and Net Working CapitalCash and Net Working Capital

• The cash flow cycle – where cash comes from…how it The cash flow cycle – where cash comes from…how it is used to finance the operations of the firm…and is used to finance the operations of the firm…and how it is recovered and how it grows over time is a how it is recovered and how it grows over time is a crucially-important part of understanding how a crucially-important part of understanding how a business functions.business functions.


Cash and Net Working CapitalCash and Net Working CapitalActivities that Increase CashActivities that Increase Cash

• Increasing long-term debtIncreasing long-term debt• Increasing equityIncreasing equity• Increasing current liabilitiesIncreasing current liabilities• Decreasing current assets other than cashDecreasing current assets other than cash• Decreasing fixed assetsDecreasing fixed assets


Cash and Net Working CapitalCash and Net Working CapitalActivities that Decrease CashActivities that Decrease Cash

• Decreasing long-term debtDecreasing long-term debt• Decreasing equityDecreasing equity• Decreasing current liabilitiesDecreasing current liabilities• Increasing current assets other than cashIncreasing current assets other than cash• Increasing fixed assetsIncreasing fixed assets• Paying dividendsPaying dividends

Example of Exhaustion of the Liquid Example of Exhaustion of the Liquid Resources of a New FirmResources of a New Firm

A simple example of a $1.0 million equity investment in a business levering additional financial resources and the need to finance

the growth of the business leaving it exhausted of cash resources.

7 steps to technical insolvency for an otherwise profitable firm.


This ExerciseThis Exercise

• This exercise reinforces the classic working This exercise reinforces the classic working capital problem illustrated in the text.capital problem illustrated in the text.

• Demonstrates:Demonstrates:– How cash is utilized over time in the firm.How cash is utilized over time in the firm.– How investment in assets such as accounts How investment in assets such as accounts

receivable and inventory deplete cash resources.receivable and inventory deplete cash resources.– How the delays in receipt of cash from sales can How the delays in receipt of cash from sales can

leave a firm without cash, despite overall profitability.leave a firm without cash, despite overall profitability.


Cash Flow CycleCash Flow CycleStartStart

Cash Account

Balance = $0

The entrepreneur opens a current account in the name of the business. Step 1


Cash Flow CycleCash Flow CycleInitial Equity InvestmentInitial Equity Investment

Cash Account

Balance = $1,000,000

Owner/Shareholders invest and receive

common stock

= $1,000,000

Balance Sheet

Cash $1m Common Stock$1 m

_____________________________________

T. Assets $1m T. Claims $1m

The entrepreneur invests $1,000,000 in equity. Step 2


Cash Flow CycleCash Flow CyclePurchase of $500,000 Fixed AssetsPurchase of $500,000 Fixed Assets

Balance Sheet

Cash $0.5F. Assets 0.5 Common Stock$1 m___________________________________T. Assets $1m T. Claims $1m

Cash Account

Balance = $500,000


common stock

= $1,000,000

Fixed Assets

The firm purchases fixed assets. Step 3


Cash Flow CycleCash Flow CycleBuy $300,000 of inventory on trade creditBuy $300,000 of inventory on trade credit

Balance Sheet

Cash $0.5 A/P $0.3Inventory 0.3F. Assets 0.5 Common Stock$1 m_____________________________________T. Assets $1.3m T. Claims $1.3m

Cash Account

Balance = $500,000


common stock

= $1,000,000

Fixed Assets

Inventory

The firm purchases $300,000 inventory from suppliers. Step 4


Cash Flow CycleCash Flow CycleFurther Work-in-process plus finished goodsFurther Work-in-process plus finished goods

Balance Sheet

Cash $0.5 A/P $0.3Inventory 0.7 Accruals 0.3F. Assets 0.4 Common Stock$1 m_____________________________________T. Assets $1.6m T. Claims $1.6m

Cash Account

Balance = $500,000


common stock

= $1,000,000

Fixed Assets

Inventory

Work-in-process inventory

Labour/utilities

Depreciation

Finished goods inventory

Value is added to inventory through labour ($300,000) and equipment ($100,000).

Step 5


Cash Flow CycleCash Flow CyclePayment of initial A/P and AccrualsPayment of initial A/P and Accruals

Balance Sheet

Cash $0.0 A/P $0.0Inventory 0.7 Accruals 0.1F. Assets 0.4 Common Stock $1 m_____________________________________T. Assets $1.0m T. Claims$1.1m

Cash Account

Balance = $0


common stock

= $1,000,000

Fixed Assets

Inventory


Labour/utilities

Depreciation


Suppliers of initial inventory are paid ($0.3m). Labour costs ($0.2m in accruals) are paid – resulting in a $0 cash balance.

Step 6

$200,000 paid

$300,000 paid


Cash Flow CycleCash Flow CycleGoods sold on A/R for a profitGoods sold on A/R for a profit

Balance Sheet

Cash $0.0 A/P $0.0A/R 0.5Inventory 0.3 Accruals 0.1F. Assets 0.4 Common Stock$1 m

R/E 0.1____________________________________T. Assets $1.2m T. Claims $1.2m

Cash Account

Balance = $0


common stock

= $1,000,000

Fixed Assets

Inventory


Labour/utilities

Depreciation


Sold $400,000 of F.G. Inventory for $500,000

Sale of inventory occurs. Accounts receivable created. Cash = $0. There are 30 days till A/R collected.

Step 7


Summary of the ExerciseSummary of the Exercise

• This firm is left at the stage where it is waiting This firm is left at the stage where it is waiting to collect on accounts receivable, but should to collect on accounts receivable, but should be ordering more inventory and converting be ordering more inventory and converting that inventory into saleable products.that inventory into saleable products.

• The firm could move forward if it had The firm could move forward if it had additional financing:additional financing:– Sale of additional shares to investorsSale of additional shares to investors– Borrow funds Borrow funds – Delay payment of wages to employees until collection Delay payment of wages to employees until collection

of accounts receivableof accounts receivable– Collect on accounts receivable.Collect on accounts receivable.




The Cash BudgetThe Cash BudgetSampleSample

$ 1 2 3 4 5 6 7 8 9 10 11 12Sales 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500

Cash inflow 1,000 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000

Cash outflow

Current sales 750 1,125 1,500 1,875 2,250 2,625 3,000 3,375 3,750 4,125 4,500 4,875

Inventory 0 375 375 375 375 375 375 375 375 375 375 375

Operating cash 250 -500 -375 -250 -125 0 0 250 375 500 625 750

Start cash 1,000 1,250 750 375 125 0 0 125 375 750 1,250 1,875

End cash 1,250 750 375 125 0 0 0 375 750 1,250 1,875 2,625

Required cash 200 300 400 500 600 700 700 900 1,000 1,100 1,200 1,300

Surplus/deficit 1,050 450 -25 -375 -600 -700 -700 -525 -250 150 675 1,325

Table 23-3 ABC's 12-Month Cash Budget


The Cash BudgetThe Cash BudgetPurposePurpose

• The cash budget is a planning tool used to The cash budget is a planning tool used to forecast cash inflows and outflows (usually forecast cash inflows and outflows (usually each month) out into the future.each month) out into the future.

• The purpose of the cash budget is to forecast The purpose of the cash budget is to forecast the timing, magnitude and duration of cash the timing, magnitude and duration of cash flow surpluses and deficits.flow surpluses and deficits.

• The cumulative impact of the cash The cumulative impact of the cash inflows/outflows will be forecast through the inflows/outflows will be forecast through the cash budget.cash budget.


Forecast Cash BalancesForecast Cash BalancesTimingTiming

$ Cash

Jan Feb Mar Apr May Jun Jul Aug

Predicting when forecast deficits start and end allow the manager to communicate with the bank and eventually becomes a control-mechanism for the bank when monitoring the evolving financial condition of the firm.


Forecast Cash BalancesForecast Cash BalancesMagnitudeMagnitude

$ Cash


How much the firm is likely to

need to borrow to cover a projected

deficit.


Forecast Cash BalancesForecast Cash BalancesDurationDuration

$ Cash


The length of time that the projected cash deficit will last is useful in choosing the right financing solution, but is also an important control mechanism for monitoring after the fact.


The Cash BudgetThe Cash BudgetUseUse

• The Cash Budget:The Cash Budget:– Allows management to change plans before they are Allows management to change plans before they are

implemented to produce a more favourable cash implemented to produce a more favourable cash resultresult

– Allows management to choose the most correct Allows management to choose the most correct investment option in the case of forecast surplusesinvestment option in the case of forecast surpluses

– Allows management to arrange the most appropriate Allows management to arrange the most appropriate financing solution in the case of forecast deficits.financing solution in the case of forecast deficits.


Cash BudgetsCash BudgetsDealing with Forecast SurplusesDealing with Forecast Surpluses

• Knowing the timing, magnitude and duration of cash surpluses allows Knowing the timing, magnitude and duration of cash surpluses allows management to choose the most appropriate management response:management to choose the most appropriate management response:

– Small Amount of Surplus available for a short period of time (ie. less than Small Amount of Surplus available for a short period of time (ie. less than $100,000)$100,000)

• Keep in current accountKeep in current account– Small Sum available for a long period time Small Sum available for a long period time

• Consider dispersing as cash dividendsConsider dispersing as cash dividends• Potentially retire debtPotentially retire debt

– Large Sum available for a short period of time 30 – 90 days (ie. greater than Large Sum available for a short period of time 30 – 90 days (ie. greater than $100,00)$100,00)

• Invest in money market securities such as T-billsInvest in money market securities such as T-bills– Large Sum available for a long period timeLarge Sum available for a long period time

• Consider dispersing excess funds as cash dividendsConsider dispersing excess funds as cash dividends• Alternatively invest in longer-time, higher yielding investmentsAlternatively invest in longer-time, higher yielding investments


Cash BudgetsCash BudgetsDealing with Forecast DeficitsDealing with Forecast Deficits

• Knowing the timing, magnitude and duration of cash deficits allows Knowing the timing, magnitude and duration of cash deficits allows management to choose the most appropriate management management to choose the most appropriate management response:response:

– Small deficit persisting for a short period of time (ie. less than $100,000)Small deficit persisting for a short period of time (ie. less than $100,000)• Delay purchases, speed collections and try to synchronize cash flows to eliminate Delay purchases, speed collections and try to synchronize cash flows to eliminate

or minimize, oror minimize, or• Negotiate an operating line of credit with the financial institutionNegotiate an operating line of credit with the financial institution

– Small deficit available for a long period time Small deficit available for a long period time • Explore more permanent solutions to the under-fundingExplore more permanent solutions to the under-funding

– Large deficit forecast to last a short period of time 30 – 90 days (ie. greater Large deficit forecast to last a short period of time 30 – 90 days (ie. greater than $100,00)than $100,00)

• Operating line of credit, orOperating line of credit, or• Seek longer term permanent capital solutions if large cash flow deficits are likely Seek longer term permanent capital solutions if large cash flow deficits are likely

to reoccur.to reoccur.– Large Sum available for a long period timeLarge Sum available for a long period time

• Seek permanent capital increases in the form of debt, equity or combination.Seek permanent capital increases in the form of debt, equity or combination.


• Analysis of the impact of sales growth on the firm’s cash Analysis of the impact of sales growth on the firm’s cash position can be done using Equation 23 -1:position can be done using Equation 23 -1:

• Where:Where:gg = monthly sales growth = monthly sales growthbb = the cash production cost and (1 – = the cash production cost and (1 – bb ) = unit contribution margin, and ) = unit contribution margin, andSSt-1t-1

= Sales at time minus 1= Sales at time minus 1• When this relationship is graphed we get a straight line.When this relationship is graphed we get a straight line.

Analyzing Cash Inflows and OutflowsAnalyzing Cash Inflows and OutflowsCash Changes and Sales GrowthCash Changes and Sales Growth

)]21(1[1 g-bSCash t [ 23-1]

The sensitivity of cash to sales growth will be strongly related to the firm’s inventory and accounts receivable policies.


Analyzing Cash Inflows and OutflowsAnalyzing Cash Inflows and OutflowsCredit, Inventory and PayablesCredit, Inventory and Payables

• We can create a formula to explore the sensitivity of We can create a formula to explore the sensitivity of the firm’s cash position with respect to the firms the firm’s cash position with respect to the firms credit, inventory and payables policies.credit, inventory and payables policies.

• Let:Let:αα = = the firm’s credit policy as the percentage of sales collected the firm’s credit policy as the percentage of sales collected

this monththis month1 – 1 – αα = the balance of sales collected in the month following sales = the balance of sales collected in the month following salesββ = the proportion of this month’s production costs paid in this = the proportion of this month’s production costs paid in this

monthmonth1 - 1 - ββ= = the proportion of production costs paid next month.the proportion of production costs paid next month.ΓΓ = perecentage of the firm’s monthly sales tied up in inventory = perecentage of the firm’s monthly sales tied up in inventory



• Equation 23 -2 shows that the change in cash each month depends Equation 23 -2 shows that the change in cash each month depends on:on:– Credit policy – how much sales revenue is collected in the month of saleCredit policy – how much sales revenue is collected in the month of sale– Inventory management practicesInventory management practices– Trade credit – how much of current production is paid this month versus Trade credit – how much of current production is paid this month versus

next month:next month:

()1()1( 1111 )SSbγSb-bβbSSCash ttttt [ 23-2]



• We can simplify Equation 23 -2 by including the sales growth rate We can simplify Equation 23 -2 by including the sales growth rate and removing the different sales levels:and removing the different sales levels:

11

γ)]g-b(β[-b)(SCash

t

[ 23-3]

We can now graph the change in cash against the sales growth rate:


Analyzing Cash Inflows and OutflowsAnalyzing Cash Inflows and OutflowsChange in Cash and Sales GrowthChange in Cash and Sales Growth

23 - 1 FIGURE

g“Break-even” Sales Growth Rate

Cash Sb-1

(1-b) gb ))((

The slope of this line is

determined by the firm’s

credit, inventory and

payables policies and practices.



23 - 1 FIGURE


Cash Sb-1

(1-b) gb ))((

A lower slope for this line will

reduce the firm’s cash

sensitivity to changes in

sales.



A lower slope can be achieved

by:• Collecting on

A/R more quickly

• Delaying payments on A/P longer

• Increasing the inventory turnover rate.

23 - 1 FIGURE


Cash Sb-1

(1-b) gb ))((



• We can solve for the monthly sales growth rate where the firm can grow We can solve for the monthly sales growth rate where the firm can grow without needing or generating cash:without needing or generating cash:

• The firm can grow faster if:The firm can grow faster if:– It has a higher gross margin (It has a higher gross margin (1 – b1 – b))– Lower production costs (Lower production costs (bb))– Collects is receivables more quickly (higher Collects is receivables more quickly (higher αα))– Pays its bills more slowly (lower Pays its bills more slowly (lower ββ))– Has less inventory (lower Has less inventory (lower γγ))

])([

1

b

bg[ 23-4]

Useful Ratios in Working Capital Useful Ratios in Working Capital ManagementManagement



Use of Ratios in Working Capital Use of Ratios in Working Capital ManagementManagement

• Ratios are commonly used to assess or to Ratios are commonly used to assess or to summarize a firm’s working capital summarize a firm’s working capital management.management.

• The focus of such an assessment is:The focus of such an assessment is:– Liquidity managementLiquidity management– The firm’s efficiency in asset utilizationThe firm’s efficiency in asset utilization– Current liability managementCurrent liability management


Working Capital ManagementWorking Capital ManagementLiquidity RatiosLiquidity Ratios

• Ratios used to assess the firm’s liquidity include the current and Ratios used to assess the firm’s liquidity include the current and quick ratios:quick ratios:

• Excessive liquidity will reduce ROI and ROE. It can also mean the Excessive liquidity will reduce ROI and ROE. It can also mean the firm is too lenient in terms of credit policy, or may have excessive firm is too lenient in terms of credit policy, or may have excessive inventories that may be subject to technological obsolescence.inventories that may be subject to technological obsolescence.

)(

)(CLsliabilitieCurrentCAassetsCurrentratioCurrent [ 23-5]

)()(sec)(CL

ARreceivableaccountsMSuritiesMarketableCCashratioQuick [ 23-6]


Working Capital ManagementWorking Capital ManagementWorking Capital RatiosWorking Capital Ratios

• Changes in these ratios can indicate growing problems with Changes in these ratios can indicate growing problems with credit policy and/or a need to improve collections efforts.credit policy and/or a need to improve collections efforts.

• The shorter the collection period, the lower the cash sensitivity The shorter the collection period, the lower the cash sensitivity to changes in sales.to changes in sales.

[ 23-7] T)turnover(RsReceivable

ARSales

365)(

)period(ACP collectionAverageRTADSsalesdailyAverage

AR[ 23-8]



• CGS is not likely to be comparable across different firms, so CGS is not likely to be comparable across different firms, so alternative is to use Sales in the numerator as illustrated in alternative is to use Sales in the numerator as illustrated in Equation 23 - 10.Equation 23 - 10.

• The higher the inventory turnover, the lower the sensitivity of cash The higher the inventory turnover, the lower the sensitivity of cash to changes in sales.to changes in sales.

)(T)Turnover(IInventory Inventory

CGSsoldgoodsofCost[ 23-9]

T)Turnover(IInventory InventorySales

[ 23-10]



• Dividing 364 days by inventory turnover (IT) gives ADSI:Dividing 364 days by inventory turnover (IT) gives ADSI:

• The higher IT the lower ADSI showing more efficient inventory The higher IT the lower ADSI showing more efficient inventory management and a reduced sensitivity of cash to changes in management and a reduced sensitivity of cash to changes in sales.sales.

365ADSI)inventory(in sales days AverageITADS

Inventory[ 23-11]

T)Turnover(IInventory InventorySales

[ 23-10]



• On the liability side of the balance payable management ratios include:On the liability side of the balance payable management ratios include:

• PT shows how many times a year a firm pays off its suppliers on PT shows how many times a year a firm pays off its suppliers on average.average.

• ADSP shows how long a firm defers payments to its suppliers.ADSP shows how long a firm defers payments to its suppliers.

PT) turnover(PayablespayableAccounts

Sales[ 23-12]

365DSP)payables(Ain sales of days AveragePTADS

payableAccounts[ 23-13]

Operating and Cash Conversion CyclesOperating and Cash Conversion Cycles

Working Capital Management: Working Capital Management: General IssuesGeneral Issues


Operating Cycle (OC)Operating Cycle (OC)

– Operating cycle is the time period Operating cycle is the time period between the acquisition of inventory between the acquisition of inventory and when cash is collected from and when cash is collected from receivables.receivables.


Working Capital ManagementWorking Capital ManagementOperating and Cash Conversion CyclesOperating and Cash Conversion Cycles

• Operating Cycle is defined by Equation 23 -14:Operating Cycle is defined by Equation 23 -14:

• Operating cycle is a function of average days sales in inventory and Operating cycle is a function of average days sales in inventory and the average collection period.the average collection period.

ACPADSIOC [ 23-14]


Cash Conversion Cycle (CCC)Cash Conversion Cycle (CCC)

• Cash cycle is the time between cash Cash cycle is the time between cash disbursement and cash collection.disbursement and cash collection.

• An estimate of the average time An estimate of the average time between when a firm pays cash for its between when a firm pays cash for its inventory purchases and when it inventory purchases and when it receives cash for its sales; the average receives cash for its sales; the average number of days of sales that firm must number of days of sales that firm must finance outside the use of trade credt.finance outside the use of trade credt.


Working Capital ManagementWorking Capital ManagementOperating and Cash Conversion CyclesOperating and Cash Conversion Cycles

• The Cash Conversion Cycle is defined by Equation 23 – 15:The Cash Conversion Cycle is defined by Equation 23 – 15:

• The estimated time between when a firm pays cash for inventory The estimated time between when a firm pays cash for inventory purchases and when it receives cash from sales.purchases and when it receives cash from sales.

ADSP-OCCCC [ 23-15]


Cash Conversion Cycle (CCC)Cash Conversion Cycle (CCC) Operating and Cash Conversion CyclesOperating and Cash Conversion Cycles

Cash Conversion CycleCash Conversion Cycle == Inventory conversion period +Inventory conversion period +Receivables conversion period -Receivables conversion period -Payables deferral periodPayables deferral period

Management of the cash cycle can make an important Management of the cash cycle can make an important difference in the amount of financing required, assets difference in the amount of financing required, assets employed to generate a given level of sales...and therefore, employed to generate a given level of sales...and therefore, can affect ROA and ROE.can affect ROA and ROE.


Cash Flow Time LineCash Flow Time Line Operating and Cash Conversion CyclesOperating and Cash Conversion Cycles

Inventory period

Inventory sold

Cash received

Inventory purchased

Accounts receivable period

Operating cycle (OC)

Cash Conversion Cycle (CCC)

Cash paid for inventory

Accounts payable periodTime


Summary and ConclusionsSummary and Conclusions

In this chapter you have learned:In this chapter you have learned:– The importance of effective working capital management The importance of effective working capital management

and the classic cash flow challenges faced by growing and the classic cash flow challenges faced by growing firms.firms.

– That an integrative approach to working capital That an integrative approach to working capital management reveals the relationships and management reveals the relationships and interdependency among working capital accountsinterdependency among working capital accounts

– How to generate and use cash budgetsHow to generate and use cash budgets– How to use some common ratios to assess a firm’s overall How to use some common ratios to assess a firm’s overall

approach to working capital management.approach to working capital management.

Concept Review QuestionsConcept Review Questions

Working Capital Management: Working Capital Management: General IssuesGeneral Issues


Concept Review Question 1Concept Review Question 1Profit and Cash Flow from OperationsProfit and Cash Flow from Operations

What is the difference between profit and What is the difference between profit and cash flow from operations?cash flow from operations?


Internet LinksInternet Links

Treasury Management Association of Canada Canadian Tire Air Canada Dominion Bond Rating Service Standard and Poors

Web Links

http://www.tmac.ca/

http://www.canadiantire.ca/

http://www.aircanada.ca/

http://www.dbrs.com/

http://www.standardandpoors.com/


CopyrightCopyright

Copyright © 2007 John Wiley & Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights Sons Canada, Ltd. All rights reserved. Reproduction or reserved. Reproduction or translation of this work beyond that translation of this work beyond that permitted by Access Copyright (the permitted by Access Copyright (the Canadian copyright licensing Canadian copyright licensing agency) is unlawful. Requests for agency) is unlawful. Requests for further information should be further information should be addressed to the Permissions addressed to the Permissions Department, John Wiley & Sons Department, John Wiley & Sons Canada, Ltd.Canada, Ltd. The purchaser may The purchaser may make back-up copies for his or her make back-up copies for his or her own use only and not for distribution own use only and not for distribution or resale.or resale. The author and the The author and the publisher assume no responsibility publisher assume no responsibility for errors, omissions, or damages for errors, omissions, or damages caused by the use of these files or caused by the use of these files or programs or from the use of the programs or from the use of the information contained herein.information contained herein.


Importance of Cash FlowImportance of Cash Flow

• Planning to have cash available to pay bills of the business Planning to have cash available to pay bills of the business as they become due is a critical aspect of business as they become due is a critical aspect of business survival…it is a management skill.survival…it is a management skill.

• Understanding the cash flow cycle of a firm can help you Understanding the cash flow cycle of a firm can help you manage those elements that are critical to ensuring you manage those elements that are critical to ensuring you can pay your bills.can pay your bills.

• Cash flow forecasting through a cash budget provides Cash flow forecasting through a cash budget provides important information to you and to your potential funding important information to you and to your potential funding partners about your operating financial needs and most partners about your operating financial needs and most particularly, the particularly, the timingtiming and and magnitudemagnitude of any projected of any projected cash deficits or surpluses.cash deficits or surpluses.



• The purpose of the cash budget is to forecast The purpose of the cash budget is to forecast the timing and magnitude of expected cash the timing and magnitude of expected cash deficits and surpluses so that, before the fact, deficits and surpluses so that, before the fact, you (the manager) can arrange appropriate you (the manager) can arrange appropriate financing or plan an appropriate investment financing or plan an appropriate investment strategy.strategy.

Short-term BorrowingShort-term Borrowing


Short-term CreditShort-term Credit

• short-term loans can be secured much more quickly than long-term short-term loans can be secured much more quickly than long-term creditcredit

• short-term credit is generally more flexibleshort-term credit is generally more flexible– low flotation costslow flotation costs– generally no prepayment penaltiesgenerally no prepayment penalties– fewer restrictive covenantsfewer restrictive covenants

• with an upward sloping yield curve - short-term credit is normally less with an upward sloping yield curve - short-term credit is normally less expensive than long-term debtexpensive than long-term debt

• short-term credit may be more risky than long-term debt:short-term credit may be more risky than long-term debt:– interest rate risk exposureinterest rate risk exposure– renegotiation riskrenegotiation risk


Sources of Short-term FinancingSources of Short-term Financing• AccrualsAccruals

– spontaneous source of financingspontaneous source of financing– no explicit cost to these sourcesno explicit cost to these sources– examples:examples:

• accrued wagesaccrued wages• accrued taxesaccrued taxes


Sources of Short-term FinancingSources of Short-term Financing

• Accounts Payable / Trade CreditAccounts Payable / Trade Credit– there may be no explicit cost (eg. Net 30)there may be no explicit cost (eg. Net 30)– if there is a discount for early payment, then if there is a discount for early payment, then

there is an implicit cost for not taking the there is an implicit cost for not taking the discount.discount.

– discounts lost - an expense on the income discounts lost - an expense on the income statement can reduce net income more than statement can reduce net income more than taking a loan in order to take the discount.taking a loan in order to take the discount.


Approximate Cost of A/PApproximate Cost of A/P

Approximate percentage cost = Approximate percentage cost = [Discount percentage/(100 - Discount percentage)] [Discount percentage/(100 - Discount percentage)] [365/(Days credit is outstanding - Discount period)][365/(Days credit is outstanding - Discount period)]

EAR = (1 + periodic interest rate)EAR = (1 + periodic interest rate)(number of times/year such an activity can occur) (number of times/year such an activity can occur) - 1- 1

Example: assume (2/10 net 30)Example: assume (2/10 net 30)Approximate percentage cost = (2/98)(365/20) = 37.2%Approximate percentage cost = (2/98)(365/20) = 37.2%EAR = (1 + .0204082)EAR = (1 + .0204082)18.2518.25 - 1 = 1.4458539 - 1 = 44.6% - 1 = 1.4458539 - 1 = 44.6%

(This, of course, assumes that the company pays on the 30th day. The (This, of course, assumes that the company pays on the 30th day. The costs will change if the firm pays later or earlier.) costs will change if the firm pays later or earlier.)


Sources of Short-term FinancingSources of Short-term Financing• Bank LoansBank Loans

– types:types:• operating loans operating loans • line of creditline of credit• revolving credit agreementrevolving credit agreement

– costs:costs:

Effective rateEffective ratesimplesimple = interest/amount received = $800/$10,000 = 8% = interest/amount received = $800/$10,000 = 8%


Costs of Bank LoansCosts of Bank Loans

Discount InterestDiscount InterestInterest is deducted in advance, reducing the principal amount available Interest is deducted in advance, reducing the principal amount available

to to borrower.to to borrower.

Effective ratediscount = interest/amount received

= interest/(Face value - interest)= $800/($10,000 - $800) = 8.7%

or Effective ratediscount = 8%/(1-.08) = 8%/(.92) = 8.7%


Cost of Bank LoansCost of Bank Loans

Compensating BalancesCompensating BalancesReduce the the amount of the loan available to the borrower and Reduce the the amount of the loan available to the borrower and

effectively increase the cost of the loan.effectively increase the cost of the loan.

Effective rateEffective ratesimple/CBsimple/CB = Nominal Rate(%)/ (1.0 - CB stated as a fraction) = Nominal Rate(%)/ (1.0 - CB stated as a fraction)

= 8%/(1.0 - 0.10)= 8%/(1.0 - 0.10)= 8%/.9= 8%/.9= 8.9%= 8.9%


Commercial PaperCommercial Paper• short-term unsecured promissory note issued short-term unsecured promissory note issued

only by the most credit-worthy of corporate only by the most credit-worthy of corporate issuersissuers

• by-passes banks and allows the firm direct by-passes banks and allows the firm direct access to the money marketaccess to the money market

• is a negotiable security that does not carry a is a negotiable security that does not carry a stated rate of interest, rather, it trades at a stated rate of interest, rather, it trades at a discount from par value.discount from par value.


Banker’s AcceptancesBanker’s Acceptances• an alternative to commercial paper for an alternative to commercial paper for

smaller firms that don’t have the credit-smaller firms that don’t have the credit-worthiness to secure commercial paper worthiness to secure commercial paper financing.financing.

• a money market instrumenta money market instrument• the bank “accepts” the promissory note by the bank “accepts” the promissory note by

stamping it “accepted”....the note therefore is stamping it “accepted”....the note therefore is secured by the Bank’s promise to pay.secured by the Bank’s promise to pay.


Pledging of A/RPledging of A/R• lender has claims against the receivables as lender has claims against the receivables as

well as recourse to the borrower.well as recourse to the borrower.• the risk of default on the receivable stays the risk of default on the receivable stays

with the borrower.with the borrower.• the buyer of the goods does not know that the buyer of the goods does not know that

the receivables have been pledged as the receivables have been pledged as collateral for a loan.collateral for a loan.


Factoring (Selling) A/RFactoring (Selling) A/R• legally binding agreement between the seller of the goods and the financial legally binding agreement between the seller of the goods and the financial

institution.institution.• the factoring institution receives a credit approval slip...the institution does a the factoring institution receives a credit approval slip...the institution does a

credit check...if approved, shipment is made and the buyer is instructed to credit check...if approved, shipment is made and the buyer is instructed to make payment directly to the factoring company.make payment directly to the factoring company.

• the factor - the factor - credit check credit check - - lendslends - - bears risk bears risk - - in the process of performing these in the process of performing these functions, the firm that sells its receivables to a factor, eliminates the need for functions, the firm that sells its receivables to a factor, eliminates the need for an accounts receivable department and receives a net amount of cash an accounts receivable department and receives a net amount of cash immediately following the sale...these funds are advanced by the factor.immediately following the sale...these funds are advanced by the factor.

• the factor is compensated for its services and protects its interests by charging the factor is compensated for its services and protects its interests by charging interest, charging a commission and maintaining a hold-back(reserve) in the interest, charging a commission and maintaining a hold-back(reserve) in the case of disputes between buyer and seller over damaged goods, returns, etc.case of disputes between buyer and seller over damaged goods, returns, etc.

• once this arrangement is in place - the financing is once this arrangement is in place - the financing is spontaneous.spontaneous.


Inventory FinancingInventory Financing

• Blanket Liens Blanket Liens - gives the lending institution a lien against all of - gives the lending institution a lien against all of the borrower’s inventories.the borrower’s inventories.

• Trust Receipts Trust Receipts - issued for specific items of inventory. The - issued for specific items of inventory. The lending institution sends someone to the borrower’s premises lending institution sends someone to the borrower’s premises to periodically check that the numbers are correctly listed.to periodically check that the numbers are correctly listed.

• Warehouse ReceiptsWarehouse Receipts - either an independent third party - either an independent third party warehouses the goods, or the goods are secured in a separate warehouses the goods, or the goods are secured in a separate location on the borrower’s property. Warehouse financing location on the borrower’s property. Warehouse financing involves:involves:

• public notificationpublic notification• physical control of the inventoryphysical control of the inventory• supervision by a custodiansupervision by a custodian

- used to finance the seasonal buildup of inventory.- used to finance the seasonal buildup of inventory.- ensures proper warehousing practices...and inventory control.- ensures proper warehousing practices...and inventory control.- because of the foregoing, inventory becomes more acceptable as collateral.- because of the foregoing, inventory becomes more acceptable as collateral.

Financial Statement AnalysisFinancial Statement AnalysisUsing RatiosUsing Ratios


Balance Sheet Accounts over timeBalance Sheet Accounts over time

0

20

40

60

80

100

120

Ja Fe Ma Ap Ma Jn Ju Au Se Oc No De

CashInventories


Selecting the Fiscal Year EndSelecting the Fiscal Year End

• tax considerationstax considerations– for smaller, owner/managed enterprises, there are greater tax-planning for smaller, owner/managed enterprises, there are greater tax-planning

opportunities if the corporate fiscal year end is set sometime after the calendar opportunities if the corporate fiscal year end is set sometime after the calendar year endyear end

– the firm’s financial positionthe firm’s financial position– firms will look most healthy if the fiscal year end is set sometime after firms will look most healthy if the fiscal year end is set sometime after

the seasonal sales peak....long enough afterward to see receivables the seasonal sales peak....long enough afterward to see receivables collected.collected.

– auditors preferencesauditors preferences– auditors are busy around the calendar year end...with firms and auditors are busy around the calendar year end...with firms and

individuals that have selected Dec 31 as their year end.individuals that have selected Dec 31 as their year end.– auditors are busy from February through May with income taxauditors are busy from February through May with income tax

Cash and Marketable Securities Cash and Marketable Securities ManagementManagement

Business 2039Business 2039


Key TopicsKey Topics

• Reasons for holding CashReasons for holding Cash• Advantages of holding CashAdvantages of holding Cash• Cash BudgetsCash Budgets• Cash Management TechniquesCash Management Techniques• Marketable Securities ManagementMarketable Securities Management• Criteria for selecting marketable securitiesCriteria for selecting marketable securities• Balancing Cash and Marketable Security HoldingsBalancing Cash and Marketable Security Holdings


Reasons for Holding CashReasons for Holding Cash

• transactionstransactions• compensation to banks for providing services compensation to banks for providing services

and loansand loans• precautionary balances/speculative balances precautionary balances/speculative balances

vs. reserve borrowing capacity.vs. reserve borrowing capacity.


Advantages of Holding CashAdvantages of Holding Cash

• take advantage of trade discountstake advantage of trade discounts• maintain adequate liquidity...and therefore a maintain adequate liquidity...and therefore a

strong credit ratingstrong credit rating• take advantage of special offers and take advantage of special offers and

unexpected opportunitiesunexpected opportunities• have sufficient liquid resources in times of have sufficient liquid resources in times of

emergencyemergency


Marketable SecuritiesMarketable Securities

• holding M/Sholding M/S– conservative working capital management strategyconservative working capital management strategy– finance seasonal/cyclical needsfinance seasonal/cyclical needs– build funds for a major investment/acquisition/cash outflowbuild funds for a major investment/acquisition/cash outflow– productive precautionary balanceproductive precautionary balance

• criteria used to select M/Scriteria used to select M/S– default riskdefault risk– interest rate riskinterest rate risk– purchasing power riskpurchasing power risk– liquidity or marketability riskliquidity or marketability risk– overall rate of returnoverall rate of return


In summary you have …In summary you have …

• gained an understanding the management of short-term gained an understanding the management of short-term financefinance

• learned that short-term cash flow management involves learned that short-term cash flow management involves the minimizing of costs while ensuring there are adequate the minimizing of costs while ensuring there are adequate liquid resources available to meet the anticpated needsliquid resources available to meet the anticpated needs

• learned that in the real world, the firm must keep learned that in the real world, the firm must keep additional working capital resources as a buffer against additional working capital resources as a buffer against unexpected needs and opportunitiesunexpected needs and opportunities

• learned how to prepare a cash budget and how to use it.learned how to prepare a cash budget and how to use it.

Chapter 23 - Working Capital Management - General Issues

Documents

working capital

jun jul aug

net working

net working

analyzing

cash conversion

working capital

calendar year