Working Capital Management: Current Assets and Current ...

Prepared byPrepared byKen HartviksenKen Hartviksen

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

Chapter 24 – Working Capital Chapter 24 – Working Capital Management: Current Assets and Current Management: Current Assets and Current LiabilitiesLiabilities

CHAPTER 24CHAPTER 24

Working Capital Management: Working Capital Management: Current Assets and Current Current Assets and Current

LiabilitiesLiabilities

CHAPTER 24 – Working Capital Management – Current Assets and Current Liabilities

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Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• Cash ManagementCash Management

– Reasons for Holding CashReasons for Holding Cash– Determining the Optimal Cash BalanceDetermining the Optimal Cash Balance– Cash Management TechniquesCash Management Techniques

• Accounts Receivable ManagementAccounts Receivable Management– The Credit DecisionThe Credit Decision– Credit PoliciesCredit Policies– The Collection ProcessThe Collection Process

• Inventory ManagementInventory Management– Inventory Management ApproachesInventory Management Approaches– Evaluating Inventory ManagementEvaluating Inventory Management

• Short-Term Financing ConsiderationsShort-Term Financing Considerations• Summary and ConclusionsSummary and Conclusions

– Concept Review QuestionsConcept Review Questions


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Learning ObjectivesLearning Objectives

You should understand the following:You should understand the following:• How to manage individual asset items, such as cash, How to manage individual asset items, such as cash,

receivables, and inventoryreceivables, and inventory• The nature of the major sources of short-term financing, The nature of the major sources of short-term financing,

such as trade credit, bank loans, factoring arrangements, such as trade credit, bank loans, factoring arrangements, and money market securitiesand money market securities

• The fact that in evaluating current asset and current The fact that in evaluating current asset and current liability decisions, the final decision rests on the standard liability decisions, the final decision rests on the standard problem of trading off expected benefits and potential problem of trading off expected benefits and potential costscosts


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Important Chapter TermsImportant Chapter Terms

• ABC approachABC approach• CapacityCapacity• CharacterCharacter• ConditionsConditions• Credit analysisCredit analysis• Credit enhancementsCredit enhancements• Economic Order QuantityEconomic Order Quantity• Factoring arrangementsFactoring arrangements• Finance motiveFinance motive• FloatFloat• Just-in-time inventory Just-in-time inventory

systemssystems

• Materials requirement Materials requirement planningplanning

• Open accountOpen account• Optimal cash balanceOptimal cash balance• Precautionary motivePrecautionary motive• PrepaymentsPrepayments• SecuritizationSecuritization• Special purpose vehiclesSpecial purpose vehicles• Speculative motiveSpeculative motive• Terms of creditTerms of credit• Transactions motiveTransactions motive

Cash and Marketable SecuritiesCash and Marketable Securities

Working Capital ManagementWorking Capital Management

Current Assets and Current LiabilitiesCurrent Assets and Current Liabilities


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Cash and Marketable SecuritiesCash and Marketable SecuritiesReasons for Holding CashReasons for Holding Cash

1.1. Transactions motiveTransactions motive

2.2. Precautionary motivePrecautionary motive

3.3. Finance motiveFinance motive

4.4. Speculative motiveSpeculative motive


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Cash and Marketable SecuritiesCash and Marketable SecuritiesDetermining the Optimal Cash BalanceDetermining the Optimal Cash Balance

• The optimal cash balance is the amount of The optimal cash balance is the amount of cash that balances the risks of illiquidity cash that balances the risks of illiquidity against the sacrifice in expected return that is against the sacrifice in expected return that is associated with maintaining cash.associated with maintaining cash.– Differs substantially across firmsDiffers substantially across firms

• Firms with predictable cash flows will have lower optimal Firms with predictable cash flows will have lower optimal cash balance requirementcash balance requirement

• Firms with excess borrowing capacity (unused line of credit Firms with excess borrowing capacity (unused line of credit for example) can hold less cash.for example) can hold less cash.


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Cash and Marketable SecuritiesCash and Marketable SecuritiesCash Management TechniquesCash Management Techniques

• Cash flow synchronization can free up cash (and lower Cash flow synchronization can free up cash (and lower the amount of capital a firm requires)the amount of capital a firm requires)

• This is done by:This is done by:– Speeding up cash inflows:Speeding up cash inflows:

• Bill clients earlier each monthBill clients earlier each month• Increase cash sales through incentivesIncrease cash sales through incentives• Encourage customers to pay using electronic payments systems Encourage customers to pay using electronic payments systems

such as direct deposit, automatic debit, debit card, rather than such as direct deposit, automatic debit, debit card, rather than cheque.cheque.

– Delaying outflows:Delaying outflows:• Arrange with suppliers for more liberal trade credit terms (net 40 Arrange with suppliers for more liberal trade credit terms (net 40

rather than net 30 for example)rather than net 30 for example)• Paying employees once a month rather than twice.Paying employees once a month rather than twice.


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Cash ManagementsCash ManagementsFloatFloat

• Float is the time that elapses between the time the Float is the time that elapses between the time the paying firm initiates payment, and the time the funds paying firm initiates payment, and the time the funds are available for use by the receiving firm.are available for use by the receiving firm.

• It has three major sources:It has three major sources:1.1. The time it takes the cheque to reach the firm after it is mailed by The time it takes the cheque to reach the firm after it is mailed by

the customer.the customer.2.2. The time it takes the receiving firm to process the cheque and The time it takes the receiving firm to process the cheque and

deposit in an account, anddeposit in an account, and3.3. The time it takes the cheque to clear through the banking system The time it takes the cheque to clear through the banking system

so that the funds are available to the firm.so that the funds are available to the firm.• Float has been reduced or eliminated through:Float has been reduced or eliminated through:

– Debit cardsDebit cards– Preauthorized paymentsPreauthorized payments– Electronic funds transfer (EFT) and electronic data interchange Electronic funds transfer (EFT) and electronic data interchange

(EDI) systems.(EDI) systems.

Accounts ReceivableAccounts Receivable




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Accounts ReceivableAccounts Receivable

1.1. The decision to extend credit to customers has The decision to extend credit to customers has significant cash flow and credit risk implications for significant cash flow and credit risk implications for the firm.the firm.

• Firms often don’t have a choice, if the availability of credit is an Firms often don’t have a choice, if the availability of credit is an important factor in the customer’s purchase decision process (if important factor in the customer’s purchase decision process (if competitors offer credit, then the firm must at least match those competitors offer credit, then the firm must at least match those credit terms, and then choose to compete on another basis.)credit terms, and then choose to compete on another basis.)

2.2. The second decision (once the firm has decided to The second decision (once the firm has decided to extend credit) is to determine which customers will extend credit) is to determine which customers will be granted credit.be granted credit.

3.3. The credit terms must be established.The credit terms must be established.

4.4. The collection process must be decided.The collection process must be decided.


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Accounts ReceivableAccounts ReceivableThe Credit DecisionThe Credit Decision

• The decision to extend credit is determined:The decision to extend credit is determined:– Nature of the product sold,Nature of the product sold,– The industryThe industry– Practices of competitors.Practices of competitors.


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Accounts ReceivableAccounts ReceivableCredit AnalysisCredit Analysis

• The process designed to assess the risk of non-The process designed to assess the risk of non-payment by potential customers, which involves payment by potential customers, which involves collecting information about potential customers with collecting information about potential customers with respect to their credit history, their ability to make respect to their credit history, their ability to make payments as reflected in their expected cash flows, payments as reflected in their expected cash flows, and their overall financial stability.and their overall financial stability.

• From the firm’s point of view:From the firm’s point of view:– Often willing to extend credit on terms better than a bank Often willing to extend credit on terms better than a bank

because:because:• The potential for the firm developing a good customer into the The potential for the firm developing a good customer into the

future, andfuture, and

• Losses are limited to production costs in the case of default.Losses are limited to production costs in the case of default.


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Accounts ReceivableAccounts ReceivableCredit AnalysisCredit Analysis

Variables that are weighed in the credit Variables that are weighed in the credit analysis process:analysis process:

– Capacity – the customer’s ability to payCapacity – the customer’s ability to pay– Character – the customer’s willingness to payCharacter – the customer’s willingness to pay– Collateral – the security that could be seized to satisfy Collateral – the security that could be seized to satisfy

paymentpayment– Conditions – the state of the economy.Conditions – the state of the economy.


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Accounts ReceivableAccounts ReceivableCredit PoliciesCredit Policies

• The firm must choose what terms of credit to The firm must choose what terms of credit to offer its customers.offer its customers.

• Terms of credit include:Terms of credit include:– The due dateThe due date– The discount amount (if any)The discount amount (if any)

• Options include:Options include:– Cash on delivery (COD)Cash on delivery (COD)– Cash before delivery (CBD)Cash before delivery (CBD)– Net 30, net 40 - no incentive for early paymentNet 30, net 40 - no incentive for early payment– 2/10 net 30 - a 2% discount for early payment2/10 net 30 - a 2% discount for early payment


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Accounts ReceivableAccounts ReceivableChange in Credit Policy AnalysisChange in Credit Policy Analysis

• When extending more lenient credit terms the firm hopes When extending more lenient credit terms the firm hopes to increase revenues through the sale of more units, and to increase revenues through the sale of more units, and perhaps even charge higher prices.perhaps even charge higher prices.

• These benefits are offset by financing costs and the These benefits are offset by financing costs and the increased risk of non-payment.increased risk of non-payment.

• Evaluation of these decisions can use an NPV framework:Evaluation of these decisions can use an NPV framework:

CF - CFs) PV(FutureNPV 0[ 24-1]


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Accounts ReceivableAccounts ReceivableThe Collection ProcessThe Collection Process

• The firm must monitor outstanding A/R by customer The firm must monitor outstanding A/R by customer and by category.and by category.

• The firm must then determine what action it will take The firm must then determine what action it will take when late payments occur.when late payments occur.– Charge interest on outstanding balancesCharge interest on outstanding balances– Notify customer of arrears (email, mail, telephone)Notify customer of arrears (email, mail, telephone)

• Actions on unpaid amounts:Actions on unpaid amounts:– Allow no further purchases on creditAllow no further purchases on credit– Choose from a number of additional options to collect:Choose from a number of additional options to collect:

1.1. Take legal actionTake legal action2.2. Sell receivable to a collection agencySell receivable to a collection agency3.3. Write off the debt as uncollectable.Write off the debt as uncollectable.


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Accounts ReceivableAccounts ReceivableFactoringFactoring

It may not be cost-effective for a firm to It may not be cost-effective for a firm to manage the collection process itself.manage the collection process itself.

Factoring arrangements are the sale of a Factoring arrangements are the sale of a firm’s receivables, at a discount, to a firm’s receivables, at a discount, to a financial company called a factor, which financial company called a factor, which specializes in collections, or the out-sourcing specializes in collections, or the out-sourcing of the collections to a factor.of the collections to a factor.


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Evaluating Receivables ManagementEvaluating Receivables Management

• Use of productivity ratios introduced in Use of productivity ratios introduced in Chapter 4 can give a tool for evaluating the Chapter 4 can give a tool for evaluating the firm’s ability to manage its accounts firm’s ability to manage its accounts receivable.receivable.


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Evaluating Receivables ManagementEvaluating Receivables ManagementReceivables TurnoverReceivables Turnover

• Measures the sales generated by every dollar Measures the sales generated by every dollar of receivables.of receivables.

Receivable Accounts

Sales

turnover sReceivable

RT

AR

S

[4- 16]


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Evaluating Receivables ManagementEvaluating Receivables ManagementAverage Collection PeriodAverage Collection Period

• Estimates the number of days it takes a firm to collect Estimates the number of days it takes a firm to collect on its accounts receivable.on its accounts receivable.

• If ACP is 40 days, and the firm’s credit policy is net 30, If ACP is 40 days, and the firm’s credit policy is net 30, clearly, customers are not paying in keeping with the clearly, customers are not paying in keeping with the firm’s policy, and there may be concerns about the firm’s policy, and there may be concerns about the quality of the firm’s customers, and what might happen quality of the firm’s customers, and what might happen if economic conditions deteriorate.if economic conditions deteriorate.

turnoversReceivable

AR

Turnover sReceivable

365 Period Collection Average

ACP

ADS

AR

[4- 17]

InventoryInventory




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InventoryInventory

• The level of inventory a firm holds is a trade off The level of inventory a firm holds is a trade off between benefits and costs:between benefits and costs:

Benefits of Holding Inventory:Benefits of Holding Inventory:• Take advantage of large-volume discountsTake advantage of large-volume discounts

• Reduce the probability of production disruptions because of lack of Reduce the probability of production disruptions because of lack of inventoryinventory

• Minimize lost sales because of stock-outsMinimize lost sales because of stock-outs

Costs of Holding Inventory:Costs of Holding Inventory:• Financing costs associated with inventory investmentFinancing costs associated with inventory investment

• Storage, handling, insurance, spoilage and obsolescence costs.Storage, handling, insurance, spoilage and obsolescence costs.


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InventoryInventoryInventory Management ApproachesInventory Management Approaches

• ABC ApproachABC Approach• Economic Order Quantity (EOQ) ModelEconomic Order Quantity (EOQ) Model• Materials Requirement Planning (MRP)Materials Requirement Planning (MRP)• Just-in-time (JIT) Inventory systems.Just-in-time (JIT) Inventory systems.


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InventoryInventoryEvaluating Inventory ManagementEvaluating Inventory Management

• Use of financial ratios can give some Use of financial ratios can give some indication of the effectiveness of a firm’s indication of the effectiveness of a firm’s inventory management.inventory management.

• Ratios, however, do not measure shortage Ratios, however, do not measure shortage costs, financing costs, etc.costs, financing costs, etc.

• These ratios include:These ratios include:– Inventory turnoverInventory turnover– Average day’s sales in inventory.Average day’s sales in inventory.


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Productivity RatiosProductivity RatiosInventory TurnoverInventory Turnover

• Estimates the number of times, ending inventory was Estimates the number of times, ending inventory was ‘turned over’ (sold) in the year.‘turned over’ (sold) in the year.

• A ratio that involves both ‘stock’ and ‘flow’ valuesA ratio that involves both ‘stock’ and ‘flow’ values• Is strongly a function of ending inventory value…Is strongly a function of ending inventory value…

managers often try to improve this ratio as they managers often try to improve this ratio as they approach year end through inventory reduction approach year end through inventory reduction strategies (cash and carry sales/inventory clearance, strategies (cash and carry sales/inventory clearance, etc.) etc.)

Turnover Inventory INV

CGS

[4- 18]


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Productivity RatiosProductivity RatiosInventory TurnoverInventory Turnover

• When Cost of Goods Sold is not available, it may be When Cost of Goods Sold is not available, it may be necessary to estimate inventory turnover using sales.necessary to estimate inventory turnover using sales.

• Use of the sales figure is less valid than Cost of Goods Use of the sales figure is less valid than Cost of Goods Sold because Cost of Goods Sold is based on Sold because Cost of Goods Sold is based on inventoried cost, but Sales includes a profit margin on inventoried cost, but Sales includes a profit margin on top of inventoried cost.top of inventoried cost.

Turnover Inventory INV

Sales

[4- 19]


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Productivity RatiosProductivity RatiosAverage Days Sales in Inventory (ADSI)Average Days Sales in Inventory (ADSI)

• Estimates the number of days of sales tied up Estimates the number of days of sales tied up in inventory (based on ending inventory in inventory (based on ending inventory values)values)

turnoverInventory

ADS

INV

365

(ADSI)inventory in sales days Average

[4- 20]

Short-Term Financing ConsiderationsShort-Term Financing Considerations




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• Investment in current assets tend to rise and Investment in current assets tend to rise and fall with the volume of activity.fall with the volume of activity.

• Accruals and accounts payable (trade credit) Accruals and accounts payable (trade credit) are ‘spontaneous’ liabilities.are ‘spontaneous’ liabilities.

• Other sources of financing must be Other sources of financing must be ‘negotiated’ and before using the firm must ‘negotiated’ and before using the firm must evaluate the cost effectiveness of alternative evaluate the cost effectiveness of alternative financing mechanisms.financing mechanisms.


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To estimate the annual effective rate of return or cost (k) of To estimate the annual effective rate of return or cost (k) of any financing alternative:any financing alternative:

1cos

1 365 - )ricePurchase p

tfinancing n-Day(k /n[ 24-2]


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Short-Term Financing ConsiderationsShort-Term Financing ConsiderationsTrade CreditTrade Credit

• Often a very important source of short-term financing.Often a very important source of short-term financing.• Offers a number of advantages:Offers a number of advantages:

– Readily availableReadily available– ConvenientConvenient– FlexibleFlexible– Usually does not entail any restrictive covenants or pledges of Usually does not entail any restrictive covenants or pledges of

security.security.

• There is no explicit cost associated with credit terms There is no explicit cost associated with credit terms such as:such as:– Net 30Net 30– Net 40Net 40


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Short-Term Financing ConsiderationsShort-Term Financing ConsiderationsTrade CreditTrade Credit

• There is usually a high implicit cost to a firm that forgoes There is usually a high implicit cost to a firm that forgoes discounts on early payment such as:discounts on early payment such as:– 2/10 Net 302/10 Net 30

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%

The firm is being charged 2% for the use of funds from day 10 to The firm is being charged 2% for the use of funds from day 10 to day 30 (20 days).day 30 (20 days).


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Short-Term Financing ConsiderationsShort-Term Financing ConsiderationsBank Loans and Factor ArrangementsBank Loans and Factor Arrangements

Options include:Options include:– Operating loans / lines of creditOperating loans / lines of credit

• Secured by accounts receivable and inventory to a maximum Secured by accounts receivable and inventory to a maximum percent of those assetspercent of those assets

• Interest only paymentsInterest only payments• Balance can be retired at the firm’s discretionBalance can be retired at the firm’s discretion

– Factor arrangementsFactor arrangements


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Short-Term Financing ConsiderationsShort-Term Financing ConsiderationsMoney Market InstrumentsMoney Market Instruments

• Large firms with high credit ratings may be able Large firms with high credit ratings may be able to by-pass financial institutions and borrow to by-pass financial institutions and borrow directly from the money market.directly from the money market.

• Two forms of money market instruments:Two forms of money market instruments:– Commercial paper Commercial paper – Bankers’ acceptancesBankers’ acceptances

• The firm pays a stamping fee, and is able to borrow based on their The firm pays a stamping fee, and is able to borrow based on their bank’s credit rating.bank’s credit rating.

• Money market securities:Money market securities:– Sold at a discount from face valueSold at a discount from face value– Maturities at time of issue of 30, 60, 90 daysMaturities at time of issue of 30, 60, 90 days– Face amounts of $100,000 or more.Face amounts of $100,000 or more.


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Short-Term Financing ConsiderationsShort-Term Financing ConsiderationsMoney Market InstrumentsMoney Market Instruments

• The annualized yield on a money market instrument:The annualized yield on a money market instrument:

365

yield annual eApproximatturityDays to mapriceMarket

Discount[ 24-3]


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Short-Term Financing ConsiderationsShort-Term Financing ConsiderationsSecuritizationsSecuritizations

• Special purpose vehicles (SPVs) are conduits for Special purpose vehicles (SPVs) are conduits for packaging portfolios of receivables and selling them to packaging portfolios of receivables and selling them to investors in the money market; a recent innovation in investors in the money market; a recent innovation in financing trade credit.financing trade credit.

• Credit enhancements are actions taken to reduce Credit enhancements are actions taken to reduce credit risk, such as requiring collateral, insurance or credit risk, such as requiring collateral, insurance or other agreements.other agreements.

• Asset-backed commercial paper (ABCP) is an example.Asset-backed commercial paper (ABCP) is an example.– The sub-prime mortgage problems in the U.S. has exposed the The sub-prime mortgage problems in the U.S. has exposed the

problems with ABCP where investors have become concerned problems with ABCP where investors have become concerned about the underlying asset values (packages of receivables) and about the underlying asset values (packages of receivables) and the market is actively repricing these money market instrumentsthe market is actively repricing these money market instruments

– In some cases the market has disappeared for some of these In some cases the market has disappeared for some of these money market instruments.money market instruments.


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Summary and ConclusionsSummary and Conclusions

In this chapter you have learned:In this chapter you have learned:– That the optimal level of investment in cash, That the optimal level of investment in cash,

receivables and inventory occurs when the receivables and inventory occurs when the benefits balance the costsbenefits balance the costs

– The advantages, the disadvantages and The advantages, the disadvantages and associated effective annual costs of the most associated effective annual costs of the most common short-term financing options available to common short-term financing options available to companies.companies.

Concept Review QuestionsConcept Review Questions

Working Capital Management – Working Capital Management – Current Assets and LiabilitiesCurrent Assets and Liabilities


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Concept Review Question 1Concept Review Question 1Motives for Holding CashMotives for Holding Cash

Why do firms hold cash?Why do firms hold cash?


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Concept Review Question 1Concept Review Question 1FloatFloat

What is float and why is it important to the What is float and why is it important to the firm?firm?


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Internet LinksInternet Links

• Securitization Net -Securitization Net - http://www.securitization.net/http://www.securitization.net/• Dun & Bradstreet Small Business solutions - Dun & Bradstreet Small Business solutions -

http://smallbusiness.dnb.com/credit-reports/browse-produhttp://smallbusiness.dnb.com/credit-reports/browse-products.aspcts.asp


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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.

Working Capital Management: Current Assets and Current ...

Documents

cash transactions

cash inflows

credit history

availability of credit

credit analysis process

expected cash flows

significant cash flow

predictable cash flows