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Chapter 14Chapter 14 Working Capital Management and Policies

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Revisiting the Balance Sheet Model of the Firm

• Current assets

– Most liquid

– Less profitable than fixed assets

– Represent net amount firm has to fund

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Revisiting the Balance Sheet Model

• Net working capital = Current Assets – Current Liabilities

– Firm’s objective is to fund the least amount of net working capital possible

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Tracing Cash and Net Working Capital

• Operating Cycle is the time needed to

– Acquire raw materials and turn into finished

goods

– Sell and receive payment for them

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Operating Cycle

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Cash Cycle

• Portion of operating cycle firm must finance• Time between payment for inventory and sales

receipts

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Short Term Financial Policy

• Firms reduce net working capital needs

– Manage need for current assets

– Obtain current liabilities to fund current assets

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Size of Current Assets InvestmentTwo categories of carrying costs:

1) Opportunity costs with capital tied up in current assets

2) Explicit costs to maintain value of current assets

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Financing Terms Consider Asset Demand Peaks and Valleys

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Alternative Financial Policies for Current Assets

• Flexible financing policy

• Restrictive financing policy

• Compromise financing policy

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Flexible Financing Long-Term Debt for Peak Asset Demand

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Restrictive Financing: Long-Term Debt/Equity for Trough Asset Demand

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Compromise FinancingSeasonal Average Asset Demand Financed withLong-Term Debt/Equity

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Short-Term Financial Plans• Firms not using flexible financing will need to

seek short-term solutions – Unsecured loans– Secured loans– Other short-term financing alternatives

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Unsecured Loans

• Commercial loan from bank

– Usually a line of credit

– Fees can be explicit and implicit

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Secured Loans

• Asset-based loans

– Lenders charge lower interest rates

– Real estate, accounts receivable, inventory used

as collateral

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Other Financing Sources

• Commercial paper

• Banker’s acceptances

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Cash Management• Clarification on terminology cash flow vs. cash

account– Cash flows are good– Cash account is a current asset with high liquidity

and low profitability

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Reasons for Holding Cash

• Transaction facilitation

• Compensating balances

• Investment opportunities

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Baumol Model• Strength: Minimizes sum of opportunity costs

and trading costs• Weakness: Unrealistic assumptions

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The Miller-Orr Model• Assumes daily net cash flows normally

distributed• Allows for cash inflows and outflows

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Other Factors Influencing Target Cash Balance

• Short-term borrowing for unexpected cash demands

• Declining trading costs• Firm requirement to maintain compensating

balances

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Float Control: Collection and Disbursement of Cash

Float – the period of time after check is written but not yet cleared and deposited

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Float Control• Three types of collection float

– Mail

– In-house processing

– Availability

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Delaying Disbursements

Legal ways to increase disbursement float

– Zero-balance account

– Drafts

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Ethical and Legal QuestionsIllegal practices

– Using collected cash before receiving it

– Continuing to use disbursed cash after check sent

– Check kiting is drawing money against account

with insufficient funds

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Investing Idle Cash• Most large firms invest in their own

marketable securities• Smaller firms invest in money-market fund or

bank sweep account

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Why Firms Have Excess Cash

• Seasonal fluctuations• Preparation for a planned expenditure

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What to Do with Surplus Cash• Appropriate investments– Treasury bills– Federal Funds– Repurchase agreements– Commercial paper– Negotiable CDs– Banker’s acceptances

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Credit ManagementTrade-off between the opportunity cost of lost

sales, and the carrying costs of funding Accounts Receivable (AR) plus the expected costs of default on AR

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Credit Policy: Terms of the SaleCredit terms include

– Credit period

– Cash discount

– Description of the type of credit instrument

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Credit Analysis• Determination of the borrower’s ability and

willingness to pay• 5 C’s of credit:

1. Capacity2. Character3. Capital4. Collateral5. Conditions

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Collection Policy• Collecting past-due accounts from customers• Typical procedure– Send delinquency letters– Initiate telephone calls– Employ collection agency– Legal action against the customer

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