finquiz - smart summary_ study session 11_ reading 39

2015, Study Session # 11, Reading # 39

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WORKING CAPITAL MANAGEMENT

1. INTRODUCTION

Effective WCM adequate cash to fund

day to day necessary operations with

companys assets invested in most

productive way.

Insufficient access to cash:

Restructuring by selling of

assets.

Reorganization via bankruptcy

proceedings.

Final liquidation.

Excessive investment in cash, may

not be the optimum use of

company resources.

A careful balance is required in

WCM.

In effective WCM

Adequate cash levels are maintained.

Converting short-term assets into cash.

Controlling outgoing payments to vendors, employees and others.

It is done by investing in:

Short term funds.

Highly liquid securities.

Maintaining credit reserves in bank lines of credit.

Issuing money market instruments like commercial paper.

It requires reliable cash flow forecasts.

Internal Factors External Factors

Company size & growth

rates

Banking services

Organizational structure Interest rates

Sophistication of

working capital

management

New technologies & new

products

Borrowing & investing

position / activities /

capacities

The economy

Competitors

SCOPE OF WCM

Transaction Relation with trading partners Analysis of WCM activities Focus

Payment for trade,

financing and

investment.

To ensure smooth transactions. To formulate appropriate

strategies.

Global view

point.

Strong emphasis

on liquidity

WCM = Working Capital Management

LOC = Line Of Credit

STMI = Short Term Marketable Investments

CR = Current Ratio

CA = Current Assets

CL = Current Liabilities

A/R = Accounts Receivable

CGS = Cost of Goods Sold

SWCP = Short Term Working Capital Portfolios

BEY = Bond Equivalent Yield

DSO = Days Sales Outstanding

WADSO = Weighted Avg. Days of Sale Outstanding



2. MANAGING & MEASURING LIQUIDITY

2.1 Defining Liquidity Management

2.1.1 Primary Sources of Liquidity

2.1.2 Secondary Sources of Liquidity

2.1.3 Drags & Pulls on Liquidity

2.2 Measuring Liquidity Liquidity Companys ability to meet its short term

obligations.

An asset is liquid if it can be converted into cash, either

by sale or financing, quickly.

Companies with liquidity focus is on putting

abundant liquidity into most effective use.

In tight financial situation effective liquidity

management required ensures solvency.

If liquidity management is not done bankruptcy or

possible liquidation.

2.1 Defining Liquidity Management

Ability of management to generate cash when needed.

Usually it is associated with short-term assets and liabilities to provide

cash.

Long term assets & liabilities can be used to provide liquidity but can

reduce companys overall financial strength.

Liquidity management challenges developing, implementing and

maintaining liquidity policy.

Company must manage key resources which include primary sources and

secondary sources.

2.1.1 Primary Sources of Liquidity

Most readily available source can be held as cash or near-cash securities.

Ready cash balance: available at banks against payment collection,

investment income, liquidation of near cash securities (maturity < 90

days) & other cash flows.

Short- term funds: trade credit, bank lines of credit, shot term investment

portfolios.

Cash flow management: effectiveness of company in cash management,

system of cash collection, cash available to use.

These funds are readily accessible at lower costs.

2.1.2 Secondary Source of Liquidity

May affect companys normal operations and in some cases alter financial

and operating position.

Sources include:

Negotiating debt contracts: pressure of interest or principal

repayments.

Liquidating assets.

Filing for bankruptcy protection and re-organization.

Use of such sources may signal deteriorating financial health.

Bankruptcy protection may be considered a liquidity tool.

Under such protection, a company generating operating cash is liquid and

able to continue business operations until restructuring is approved.



2.1.3 Drags & Pulls on Liquidity

2.2 Measuring Liquidity

Liquidity ensures creditworthiness perceived ability of a borrower to make timely payments.

Creditworthiness chances to obtain credit at borrowing cost better trade credit terms profitable opportunities.

Liquidity chances of financial distress leads to insolvency & bankruptcy (extreme case).

Liquidity ratios check companys ability to meet short-term debt obligations.

=

=

Ratio chances to cover CL.

/ =

..

Measures how many times A/R created & collected on avg. in one fiscal period.

=

.

Measure how many times inventory created / acquired & sold during one fiscal period.

Activity ratios can also be re-arranged to estimate no. of days CA or CL are on hand.

. = /

.

/

/ !

. =

/ !

. = "

"/ !

Alternate name

No. of days payable Days payable outstanding Avg. days payable

No. of days inventory Avg. inventory period Inventory holding period

No. of days receivables Days sales outstanding Days in receivables

Turnover ratios tell how company is managing its liquid assets.

Ratio analysis must be done against some benchmark not in isolation.

Benchmark could be industry avg. or companys own track record (past performance) or with peer group.

= . +

Measure of time needed to convert raw material into cash from a sale.

Does not account for increased cash flow by deferring payment to suppliers.

= . + . .

Also called cash conversion cycle.

Cycles cash generating ability.

For many companies cash conversion cycle is a period that requires financing.

Drag when receipts lag Pull disbursements paid quickly

Major drags include

Uncollected receivables

outstanding, risk they wont be collected at all

Indicated by no. of days receivable and bad debts.

Obsolete inventory

Inventory stands than usual

Indication of no longer being usable

Indicated by slow inventory turnover ratios.

Tight credit

Economic condition not favorable

Short term debt cost.

Drags controlled by strict credit & collection practices.

Major pulls on payments include

Making payments early

Paying vendors before due date results in companies forgo use of funds.

Effective payment management means making payment when due, not early.

Reduced credit limit

History of late payments can lead to credit limit by suppliers.

Can squeeze companys liquidity.

Limits on short term lines of credit.

Liquidity squeeze occur when bank LOC.

LOC restrictions can be:

Government mandated, market-related & company specific.

Over-banking approach common in emerging as well as some developed

markets featuring unsound banking systems whereby companies establish lines

of credit in excess of their needs..

Low liquidity positions:

Such situation is faced by a company in a particular industry or with a weaker

financial position.

Secured borrowing is done by such companies.

Important for such companies to identify such assets for short term borrowings.

Critical to identify drags and pulls on time or before they have arisen.



3. MANAGING THE CASH POSITION

3.1 Forecasting Short-Term Cash Flows

3.1.1 Minimum Cash Balance

3.1.2 Identify Typical Cash Flows

3.1.3 Cash Forecasting System

3.2 Monitoring cash uses and levels Ensuring net cash positions not negative.

Negative balance is avoided b/c cost of borrowing is

and unacceptable.

Balance = inflows-outflows.

Managing short term portfolio opportunity cost is

considered acceptable.

To manage cash decisions are done on latest

information.

Companys treasury function uses optimum services

and techniques associated with companys payment

configuration to manage cash.

3.1 Forecasting Short Term Cash Flows

Necessary task.

Precision in forecasting effectiveness.

Forecast precise may not be accurate.

External uncertainty encourages companies to

maintain minimum level of cash as a buffer.

3.1.1 Minimum Cash Balance

Provides financial flexibility or protection.

An opportunity to take advantages from attractive

opportunities.

Size of this buffer depends upon:

Variation of cash inflows & outflows.

Access to liquid sources.

Ability to raise funds with lead time.

3.1.2 Identifying Typical Cash Flows

Cash mangers using cash flow history or organizational financial history must identify cash flow elements and collect data about them

regularly.

Real cash flows should be reflected.

Elements includes ;

Inflows Outflows

Receipts from operations, broken down by

operating unit, departments, etc.

Payables & payroll disbursements, broken down by

operating unit, departments, etc.

Funds transfers from subsidiaries, joint ventures,

third parties.

Funds transfer to subsidiaries.

Maturing investments Investments made

Debt proceeds (short and long term) Debt repayments.

Other income items (interest, etc.) Interest and dividend payments

Tax refunds. Tax payments.



3.1.3 Cash Forecasting System

Must be structured as a system to be effective.

Several aspects to be covered.

Importance of aspects varies in between forecast horizon.

Short Tem Medium Term Long Term

Data frequency Daily / weekly for 4-6 weeks Monthly for one year Annually for 3-5 years

Format Receipts & disbursements Receipts & disbursements Projected financial statements

Techniques Simple projections Projection models and averages Statistical models

Accuracy Very high Moderate Lowest

Reliability Very high Fairly high Not as high

Uses Daily cash management Planning financial transaction Long-range financial position

3.2 Monitoring Cash Uses and Levels

Financial manager in charge of managing cash position must know cash balance at real

time basis.

Monitoring cash flow key aspects of cash forecasting system.

It involves knowing of the transactions information in time to tackle with them.

Information should be gathered from principal users and providers of cash along with

cash projections.

Minimum cash level is estimated in advance and steps are taken to determine the target

balance for each bank.

Target balance is applied to one main account (the bank where companys transactions

are concentrated).

Large companies have more concentration banks making cash management more

complex.

Short term investments and borrowing assist in cash management.

Cyclical companies need to focus more on sources of cash in times when they produce

and stock inventory for peak seasons.

Companys cash needs are also influenced by long term investment and financial

activities.

Predicting cyclical and non-operating activity needs is critical in managing cash.

Setting aside too much cash can be costly while setting aside too little can cause penalty

to raise funds quickly either case would be costly; a reliable forecast is necessary.

4. INVESTING SHORT-TERM FUNDS

4.1 Short-Term Investment Instruments

4.1.1 Computing Yields On Short Term Investments

4.1.2 Investment Risks

4.2 Strategies 4.3 Evaluating Short Term Funds Management

4. Investing Short-Term Funds

Temporary store of funds not needed in daily transactions.

Extra working capital portfolio funds must be invested in long term portfolios.

SWCP include: highly liquid, less risky, and shorter maturity securities e.g. U.S

government securities & corporate obligation.

The portfolio changes as cash is needed or more cash is available for investment.



4.1 Short-Term Investment Instruments

Instruments Typical maturities Features Risks

U.S Treasury Bills (T-bills) 13, 26, and 52 weeks Obligation of U.S government (guaranteed), issued at a

discount.

Active secondary market.

Lowest rates for traded securities.

Virtually no risk

Federal agency securities 5-30 days Obligations of U.S federal agencies (e.g., Fannie Mae, Federal

Home Loan Board) issued as interest-bearing.

Slightly higher yields than T-bills.

Slight liquidity risk;

insignificant credit risk.

Bank certificates of

deposit (CDs)

14-365 days Bank obligations, issued interest-bearing in $100,000

increments.

Yankee CDs offer slightly higher yields.

Credit and liquidity risk

(depending on banks

credit).

Bankers acceptances

(BAs)

30-180 days Bank obligations for trade transactions (usually foreign), issued

at a discount.

Investor protected by underlying company and trade flow itself.

Small secondary market.


(depending on banks

credit).

Eurodollar time deposits 1-180 days Time deposit with bank off-shore (outside United States, such as

Bahamas)

Can be CDs or straight time deposit (TD).

Interest-bearing investment.

Small secondary market for CDs, but not TDs.

Credit risk (depending

on bank) very high

liquidity risk for TDs

Bank sweep services 1 day Service offered by banks that essentially provides interest on

checking account balance (usually over a minimum level).

Large numbers of sweeps are for overnight.


(depending on bank).

Repurchase agreement

(Repos)

1 day + Sale of securities with the agreement of the dealer (seller) to

buy them back at a future time.

Typically over-collateralized at 102 percent.

Often done for very short maturities (< 1 week).


(depending on dealer)

Commercial paper (CP) 1-270 days Unsecured obligations of corporations and financial institutions,

issued at discount.

Secondary market for large issuers

CP issuers obtain short-term credit ratings


(depending on credit

rating)

Mutual funds and money

market mutual funds

Varies Money market mutual funds commonly used by smaller

businesses.

Low yields but high liquidity for money market funds; mutual

fund liquidity dependent on underlying securities in fund.

Can be linked with bank sweep arrangement


(depending on fund

manager).

Tax-advantaged securities 7, 28, 35, 49, and 90

days

Preferred stock in many forms including adjustable rate

preferred stocks (ARPs), auction rate preferred stocks, (AURPs),

and convertible adjustable preferred stocks (CAPs).

Dutch auction often used to set rate.

Offer higher yields


(depending on issuers

credit).

Relative amounts to be invested in each type, depends upon the company.



4.1.1 Computing Yield on Short Term Investments

=

.

Investor pays less than face value but receives face value at maturity e.g. T-bill, bankers

acceptance.

Interest bearing securities investor pays face amount, receives back face amount +

interest.

Nominal rate rate based on securities face value.

Yield actual return if investment held till maturity.

=#$%%

%%

&

.''(

Annualized using 360 days.

! =#)$%%

""

!

.''(

Annualized using 365 days

also referred to as the investment yield basis.

U.S. T-bill may be quoted on discount basis or BEY.

=#)$%%

#)

&

*.'(

Though BEY is relevant for investment decisions but discount basis is often quoted.

4.1.2 Investment Risk

Type of Risk Key Attributes Safety Measures

Credit (or default) Issuer may default

Issuer could be adversely

affected by economy,

market

Little secondary market

Minimize amount

Keep maturities short

Watch for

questionable names

Emphasize government

securities

Market (or interest rate) Price or rate changes

may adversely affect

return.

There is no market to sell

the maturity to, or there

is only a small secondary

market

Keep maturities short

Keep portfolio diverse in

terms of maturity,

issuers.

Liquidity Security is difficult or

impossible to (re) sell.

Security must be held to

maturity and cannot be

liquidated until then.

Stick with government

securities.

Look for good secondary

market.

Keep maturities short.

Foreign exchange Adverse general market

movement against your

currency

Hedge regularly.

Keep most in your

currency and domestic

market (avoid foreign

exchange).



4.2 Strategies

Short-term investors do not want to take on substantial risk.

Strategies can be active or passive.

Passive: one or two decision rules for making daily investments.

Active: constant monitoring may involve matching, mismatching or laddering

strategies.

Company must have investment guideline policy

Passive Active

Top priority is safety & liquidity.

Less aggressive than active strategies.

Roll over is required

Must be monitored against some benchmark

More daily involvement & choice of

investments.

Active involvement with more flexible

investment policy and better forecasts.

Conservative & similar to passive strategies.

Matching is of timing of cash outflows with

investment maturities.

In b/w passive & matching

Schedules maturities so that investments are

distributed equally over the ladders term.

Helpful in managing long-term portfolios

Matching Strategy Ladder strategy Mismatching Strategy

Requires reliable cash forecast.

Riskier, requires liquid securities (T-bill) to

meet liquidity needs.

May also be accompanied by derivatives

posing additional risks.

4.3 Evaluating Short Term Funds Management

For portfolios which are not large or diversified use spread sheet models.

For diversified portfolios more expensive treasury workstations.

Investment returns must be expressed on BEY to allow comparability.

Overall portfolio return must be weighted according to the size of the

investment.

5. MANAGING ACCOUNTS RECEIVABLE

5.1 Key Elements of Trade Credit

Granting Process

5.2 Managing Customers Receipts 5.3 Evaluating Accounts Receivable

Management

5.3.2 The No. of Days of Receivables. 5.3.1 Account Receivable Aging

Schedule



5. Managing Accounts Receivable

Accounts receivable management granting credit and processing transaction,

monitoring credit balance, measuring performance of credit function.

Efficient processing and disbursement of information to concerned

departments and managers is required.

Ensuring account receivable accounts are current.

Co-ordination with treasury management function.

Preparation of regular performance measurement reports.

Captive finance subsidiary wholly owned subsidiary established to provide

financing of the sales of the parent company.

Some companies outsource accounts receivable function while some may invest

in credit insurance.

5.1 Key Elements of Trade Credit Granting Process

Effective credit management policy is required.

Basic guidelines of such policy sets boundaries for credit management function.

Credit scoring model is used to classify borrowers according to credit-

worthiness.

Such models can be used to predict late payers.

Based upon the quality of borrower the credit is granted.

5.2 Managing Customers Receipts

Avg. dailydeposit = totalamountofcheckdeposited

no. ofdays.

Cash collections systems are a function of types of customers and the methods

they use.

Nature of business nature of customers methods of paying.

Common electronic methods:

Direct debit

Electronic funds transfer

POS terminals

If payments do not transfer electronically, lock box system is used.

Lockbox: customer payments are mailed to a post office box and the banking

institution retrieves and deposits these payments several times a day.

Float factor measures time it takes for checks to clear does not measure time

it takes to receive, deposit and clear checks

= .'

."

Cash collection system must accelerate payments & information content

associated with those payments.

Cash concentration involves:

1) Consolidating deposits.

2) Moving funds (b/w company accounts or to outside points).

Best treatments for consolidating deposits & moving funds for cash

concentration may differ for.

For moving funds electronic methods are cost effective.

5.3 Evaluating Accounts Receivable Management

Accounts receivable management how efficiently receivable converted into

cash.

Such measures can be derived from 1) general financing reports and 2) Internal

financial records.



5.3.1 Accounts Receivable Aging Schedule

Key report used by accounts receivables managers.

It breaks down accounts into categories of days outstanding.

Can be converted into percentage for comparability.

5.3.2 The No. of Days Receivables.

Provides overall picture.

Can be compared with credit management policy to gauge

account collection performance.

Weighted average DSO gives better idea of how long it takes

to collect from customers irrespective of sales level and in

sales.

Aging schedule is used to calculate weighted avg. DSO.

Major drawback of WADSO requires more information

comparability across companies is difficult due to lack of

information.

6. MANAGING INVENTORY

6. Managing Inventory

Necessary for working capital management

Careful balance is required;

more inventories can lead to obsolete inventory and losses

on selling through discount liquidity squeeze.

Fewer inventories (shortage) can lead to lost sales &

companys inability to avoid price increase by suppliers.

Motive to hold inventory

a) Transaction motive need for inventory as a part of

routine.

b) Precautionary stocks amount maintained to avoid stock

out losses.

c) Speculative motive if costs to in future then benefit

can be achieved. Assumption storage cost < savings from

in price.

6.1 Approaches to Managing Levels of Inventory

Economic order quantity reorder point

Traditional method

Reliable short term forecast is necessary.

Based upon expected demand and predictability of demand.

Safety stock cushion beyond anticipated needs, helps when lead time.

Anticipation stock Inventory in excess to anticipated demand

It fluctuates with sales level.

Just-in-time method

System to minimize in-process inventory.

Materials ordered when reach re-order level.

Can reduce inventory level to optimum level if J.I.T method incorporated

with manufacturing resource planning method.

Careful planning is required.

6.1 Approaches to Managing Levels of Inventory 6.2 Inventory Costs 6.3 Evaluating Inventory Management



6.2 Inventory Costs

Several components represent both opportunity & real costs.

Ordering cost: depend on orders e.g. setup, labor, freight etc.

Carrying: financing & holding costs e.g. storage, cost of capital, insurance, taxes etc.

Stock-out: affected by level of inventory e.g. lost sales, back-order costs etc.

Policy: cost of gathering data can be soft cost e.g. data processing, overtime, training etc.

6.3 Evaluating Inventory Management

Inventory turnover ratio is used along with no. of days of

inventory.

Comparison can be drawn with other industries or past history.

Can be different due to product mixes.

Knowing the reason for or in inventory turnover is necessary.

7. MANAGING ACCOUNTS PAYABLE

7.1 The Economics of Taking a Trade Discount 7.2 Managing Cash Disbursements 7.3 Evaluating Account Payables Management

7. Managing Accounts Payable

Trade credit spontaneous form of credit in which purchaser finances its purchases by delaying payments.

Discount may be given by the supplier for early payment.

Usually a specific time is given in which discount can be earned.

Inefficient payable management could be costly in terms of real and opportunity cost.

Company must ensure payable practice is organized, consistent and cost-effective.

Factors need to be taken care off while devising guidelines for managing accounts payable include;

Organizations centralization / decentralization.

Number, size & location of vendors

Trade credit, cost of borrowing.

Controls of disbursement float (time for clearing a check).

Inventory management.

E-commerce and electronic data interchange (electronic supply chain management)

Stretching payables extending time to pay dues during grace period provided by suppliers.

Careful balance is required if paying too early is costly and delaying may deteriorate companys perceived

credit-worthiness.

7.1 The Economics of Taking a Trade Discount

Costoftradecredit = 1 + discount1 discount

. 1 2/10 net 30 2% discount in 10 days & net amount due on 30th day.

Cost of funds during discount period = 0% beneficial to pay near to discount periods end.

Customers short term investment rate < calculated rate discount offers a better return over companys short-term borrowing rate.

7.2 Managing Cash Disbursements

Companys delay funding bank accounts until the day checks clear.

Pay electronically when it is cost effective.



7.3 Evaluating Account Payables Management

. ="

.".

Comparison of no. of days payable with credit terms is necessary.

Paying early costly.

Paying later deteriorating relations with suppliers.

In some industries no. of days inventory & no. of days payable are

similar to one another.

8. MANAGING SHORT-TERM FINANCING

8.1 Source of Short-Term Financing 8.2 Short-Term Borrowing Approaches 8.3 Asset-Based Loans 8.4 Computing the Costs of Borrowing

8.1 Source of Short-Term Financing

Panel A: Bank Source

Sources / Type Users Rate Base Compensation Other

Uncommitted line Large corporations None Mainly in U.S; limited

reliability

Regular line All sizes Prime (U.S.) or base rate

(other countries), money

market, LIBOR+

Commitment fee Common everywhere

Overdraft line All sizes Commitment fee Mainly outside U.S.

Revolving credit

agreement

Larger corporations Commitment fee +extra

fees

Strongest form (primarily

in U.S.)

Collateralized loan Small, weak borrowers Base + Collateral Common everywhere

Discounted receivables Large companies Varies Extra fees More overseas, but some

in U.S.

Bankers acceptances International companies Spread over commercial

paper

None Small volume

Factoring Smaller Prime + + Service fees Special industries

Panel B: Nonbank Sources

Sources / Type Users Rate Base Compensation Other

Nonbank finance

companies

Small, weak borrowers Prime + + Service fees Weak credits

Commercial paper Largest corporations Money market sets rate Backup line of credit,

commissions +

Lowest rates for short-

term funds



8.2 Short-Term Borrowing Approaches

Effective strategy must ensure:

Sufficient capacity to handle peak cash needs.

Sufficient sources to fund ongoing cash needs.

Rates are cost effective.

Company should consider

Their size & credit-worthiness

Sufficient access

Flexibility of borrowing options

Both active and passive borrowing strategies exist. (Discussed earlier).

8.3 Asset-Based Loans

Companies with credit quality go for secured loans (asset-based

loans).

Often short term assets presents a challenge for the lender due to

uncertainty involved with such assets.

Lenders may have blanket lien right over assets if collateral does

not pay, even if its worth (in some cases).

Factorizing of accounts receivable can be used.

Inventory blanket lien lender can claim some or all inventory.

Requires company to certify that goods are segregated and sale

proceeds paid to the lender.

Warehouse receipt arrangement similar to above but third party

overlooks inventory.

Cost of asset-based loans depends upon length of time it takes to sell

the goods.

8.4 Computing the Costs of Borrowing

Cost = Interest + CommitmentFeeLoanAmount

Cost = InterestNetProceeds

= .

Cost = Interest + Dealerscommission + backupcost

Loanamount Interest

If amount borrowed includes interest cost e.g. bankers acceptance.

In case of dealers fee & backup costs e.g. commercial paper

Cost is usually annualized and compared.

finquiz - smart summary_ study session 11_ reading 39

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