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Copyright 2011 Pearson Prentice Hall. All rights reserved.

Working CapitalManagement

Chapter 18

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Copyright 2011 Pearson Prentice Hall. All rights reserved.18-2

Slide Contents

Learning Objectives

Principles Used in This Chapter

1. Working Capital Management and the Risk-

Return Tradeoff2. Working Capital Policy

3. Operating and Cash Conversion Cycle

4. Managing Current Liabilities

5. Managing the Firms Investment in CurrentAssets

Key Terms

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Learning Objectives

1. Describe the risk-return tradeoff involvedin managing a firms working capital.

2. Explain the principle of self-liquidating

debt as a tool for managing firm liquidity.3. Use the cash conversion cycle to measure

the efficiency with which a firm managesits working capital.

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Copyright 2011 Pearson Prentice Hall. All rights reserved. 18-4

Learning Objectives (cont.)

4. Evaluate the cost of financing as a keydeterminant of the management of afirms use of current liabilities.

5. Understand the factors underlying a firmsinvestment in cash and marketablesecurities, accounts receivable, andinventory.

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Principles Used in This Chapter

Principle 2:

There is a Risk-Return Tradeoff.

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18.1 WorkingCapital Managementand the Risk-ReturnTradeoff

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Working Capital Management andthe Risk-Return Tradeoff

Working capital management encompassesthe day-to-day activities of managing thefirms current assets and current liabilities.

Examples of working capital decisionsinclude:

How much inventory should a firm carry?

Who should credit be extended to?

Should inventories be bought on credit orcash?

If credit is used, when should payment bemade?

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Measuring Firm Liquidity

The current ratio (current assets dividedby current liabilities) and net workingcapital (current assets minus current

liabilities) are two popular measures ofliquidity.

Both measures of liquidity provide thesame information. However, current ratiocan be more easily used for comparingfirms.

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Measuring Firm Liquidity (cont.)

Here the net working capital for two firms is very different(due to differences in firm sizes) but the current ratio isequal. Current ratio is a better measure of comparison ofliquidity among firms.

Firm A Firm B

Current Assets $100,000 $10,000

Current

Liabilities

$50,000 $5,000

Net WorkingCapital

$50,000 $5,000

Current Ratio 2.0 2.0

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Managing Firm Liquidity

Managing a firms liquidity requiresbalancing the firms investments in currentassets in relation to its current liabilities.

This can be accomplished by minimizing theuse of current assets by efficiently managingits inventories and accounts receivable and byseeking out the most favorable accountspayable terms and monitoring its use of short-term borrowing.

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Risk-Return Tradeoff

Working capital decisions will change thefirms liquidity.

For example, a firm can enhance its

profitability by reducing its cash andmarketable securities as they yield low rates ofreturn. However, the firm will be exposed to ahigher risk of default or not being able to payits bills on time if it does not have adequatecash and marketable securities.

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Checkpoint 18.1

Measuring Firm Liquidity Ford Motor Company (F) sufferedalong with all the U.S. automakers with the onset of therecession in 2007. The following information from the firmsfinancial statements for 2008 and 2006 provide theinformation needed to assess the firms liquidity (Note: all

figures below are in $000):

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Checkpoint 18.1

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Checkpoint 18.1

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Checkpoint 18.1

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Step 1: Picture the Problem

Liquidity refers to the firms ability to payits bills in a timely fashion.

We can determine the firms liquidity bycomparing firms current assets (assetsthat can be converted to cash in thecoming year) and current liabilities (billsthe firm must pay within the year).

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Step 1: Picture the Problem (cont.)

We are given the following information:

2008 2006

Total CurrentAssets

$36,832,000 $49,244,000

Total CurrentLiabilities

$58,158,000 $52,544,000

Note:$20 million transferredto long-term debt.

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0

10000000

20000000

30000000

40000000

50000000

60000000

70000000

Current Assets and Current Liabilities

2008Current

Assets

2008CurrentLiabilities

2006Current

Assets

2006CurrentLiabilities

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Step 2: Decide on a SolutionStrategy

Firms liquidity can be measured bycomputing the following two measures:

1.Current Ratio = Current Assets CurrentLiabilities

2.Working capital = Current Assets Current

Liabilities

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Step 3: Solve

Current Ratio (2008)

= Current Assets Current Liabilities

= $36,832,000 $58,158,000

= 0.63

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Step 3: Solve (cont.)

Working capital

= Current Assets Current Liabilities

= $36,832,000 - $58,158,000

= -$21,326,000

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Step 4: Analyze

The long-term financing arrangement for$20 million improves the liquiditymeasures by increasing the current ratio

from 0.47 to 0.63. However, it is stillbelow the 2006 current ratio of 0.94.

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18.2 Working

Capital Policy

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Working Capital Policy

Managing the firms net working capitalinvolves deciding on an investmentstrategy for financing the firms current

assets and liabilities.

Since each financing source comes withadvantages and disadvantages, thefinancial manager has to decide on theoptimal source for the firm.

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The Principle of Self-LiquidatingDebt

This principle states that the maturity ofthe source of financing should be matchedwith the length of time that the financing

is needed.

Thus a seasonal increase in inventoriesprior to Christmas season must befinanced with short-term loan or currentliability.

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Permanent and Temporary AssetInvestments

Temporary investments in assetsinclude current assets that will beliquidated and not replaced within the

current year.

For example, cash and marketable securities,accounts receivable, and seasonal fluctuation in

inventories.

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Permanent and Temporary AssetInvestments (cont.)

Permanent investments are composedof investments in assets that the firmexpects to hold for a period longer than

one year.

For example, the firms minimum level ofcurrent assets such as accounts receivable and

inventories, as well as fixed assets.

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Spontaneous, Temporary, andPermanent Sources of Financing

Spontaneous sources of financing arisespontaneously out of the day-to-dayoperations of the business and consist of

trade credit and other forms of accountspayable (such as wages and salariespayable, tax payable, interest payable).

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Spontaneous, Temporary, and PermanentSources of Financing (cont.)

Temporary sources of financingtypically consist of current liabilities thefirm incurs on a discretionary basis. The

firms management must make an overtdecision to use temporary sources offinancing.

For example, unsecured bank loans,

commercial paper, short-term loans secured bythe firms inventories or accounts receivables.

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Permanent sources of financingarecalled permanent since the financing isavailable for a longer period of time than a

current liability.

For example, intermediate term loans, bonds,preferred stock and common equity.

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Figure 18-2 illustrates the use of principleof self-liquidating debt to guide a firmsfinancing decision.

We observe that the firms temporary or short-term debt rises and falls with the rise and fallin the firms temporary investment in currentassets.

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18.3 Operatingand Cash

Conversion Cycles

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Operating and Cash ConversionCycles

Operating and cash conversion cyclesindicate how effectively a firm hasmanaged its working capital.

The shorter these two cycles are, the moreefficient is the firms working capitalmanagement.

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Measuring Working CapitalEfficiency

The operating cycle measures the timeperiod that elapses from the date that anitem of inventory is purchased until the

firm collects the cash from its sale. If anitem is sold on credit, this date is when theaccounts receivable is collected.

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Measuring Working CapitalEfficiency (cont.)

When the firm is able to purchase items ofinventory on credit, cash is not tied up forthe full length of its operating cycle. This is

known as the accounts payable deferralperiod.

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Figure 18.3(Cont.)

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Calculating the Operating and CashConversion Cycle

Figure 18-3 calculations are based on thefollowing information:

Annual credit sales = $15 million

Cost of goods sold = $12 million Inventory = $3 million

Accounts receivable = $3.6 million

Accounts payable outstanding = $ 2million

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Calculating the Operating and CashConversion Cycle (cont.)

To calculate the operating cycle, we needto compute the inventory conversionperiod and the accounts receivable

collection period.

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The inventory conversion period measuresthe number of days it takes the firm toconvert its inventory to credit sales (i.e.

accounts receivable).

The second half of the operating cycle isthe number of takes it takes to convert

accounts receivable to cash (or averagecollection period).

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To calculate the cash conversion cycle, we

need to calculate the accounts payabledeferral period.

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We have now calculated the following:

Inventory conversion period = 91 days

Average collection period = 61 days Accounts payable deferral period = 61 days

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Cash conversion cycle = 176 days 61days

= 116 days

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Checkpoint 18.2

Analyzing the Cash Conversion CycleFinancial information for the Dell Computer Corporation (DELL)and Ford Motor Company (F) are found below:

Compute the operating cycle and cash conversion cycle for eachof these companies. You may assume for purposes of youranalysis that all of the firm sales are credit sales.

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Checkpoint 18.2

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Checkpoint 18.2

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Checkpoint 18.2:Check Yourself

If GM were to have an average collectionperiod of 18.89 days, an inventoryconversion period of 39.76 days and

accounts payable deferral period of 60.17days, what would its operating and cashconversion cycles be?

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The operating and cash conversion cycle can bevisualized as shown below:

St 2 D id S l ti

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The firms cash conversion cycle andoperating cycle are defined as follows:

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Step 3: Solve

We are given the following for DELL:

Average collection period = 18.89 days

Inventory conversion period = 39.76 days Accounts payable deferral period = 60.17 days

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Operating Cycle = 39.76 days + 18.89 days

= 58.65 days

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Cash conversion cycle

= 58.65 days 60.17 days

= -1.52 days

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Step 4: Analyze

We observe that the operating cycle for Dell is58.65 days which indicates that 58.65 dayselapse from the date an item of inventory ispurchased at Dell until the firm collects the cash

from its sale.

The cash conversion cycle is negative as Dell isable to defer making payments on its account

payable for 60.17 days, which is longer than theoperating cycle.

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18.4 ManagingCurrent Liabilities

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Managing Current Liabilities

Current Liabilities

(debt obligations to be

repaid within one year)

Unsecured currentliabilities

(trade credit, unsecuredbank loans, commercial

paper)

Secured currentliabilities

(loans secured by specificassts like inventories or

accounts receivable)

Calculating the Cost of Short term

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Calculating the Cost of Short-termFinancing

When evaluating alternative sources offinancing, it is critical to consider the cost.The cost of short-term credit is given by:

Interest = principal rate time

59


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Calculating the Cost of Short-termFinancing (cont.)

Example 18.1

What will be the interest payment on a 4-month loan for $35,000 that carries an annualinterest rate of 12%?

Interest = principal rate time

= $35,000 .12 4/12

= $1,400


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The Annual Percentage Rate (APR) iscomputed as follows:


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Example 18.2 Rio Corporation plans to borrow$35,000 for a 120-day period and repay $35,000principal amount plus $1,400 interest at maturity.What is the APR?

APR = ($1400/$35000) (1/120/365)

= 12.167%

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Evaluating the Cost of Credit

Trade credit is given by firms suppliers.The credit terms generally include discountfor early payment.

For example, credit terms of 3/10, net 30means that a 3% discount is offered forpayment within 10 days or the full amount

is due in 30 days. What is the cost of nottaking the 3% discount?

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Evaluating the Cost of Credit (cont.)

The 3% cash discount is the interest costof extending the payment period anadditional 20 days. For a $100 invoice, the

cost is computed as follows:

APR = ($3/$97) (1/20/365)

= .5644 or 56.44%

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Evaluating the Cost of Bank Loans

We can apply equation 18-8 (APR) toestimate the cost of bank loans also.

However, firms generally borrow moneyfrom bank by creating a line of credit.

Evaluating the Cost of Bank Loans

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Evaluating the Cost of Bank Loans(cont.)

A line of credit entitles the firm to borrowup to the stated amount. In exchange, thefirm is generally required to maintain a

minimum balance in the bank throughoutthe loan period (known as compensatingbalance).

The compensating balance increases the

annualized cost of loan to the borrower.

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Checkpoint 18.3

Calculating the APR for a Line of Credit

M&M Beverage Company has a $300,000 line of credit that requires a

compensating balance equal to 10 percent of the loan amount. The

rate paid on the loan is 12 percent per annum, $200,000 is borrowed

for a six-month period, and the firm does not currently have a deposit

with the lending bank. The dollar cost of the loan includes the interest

expense as well as the opportunity cost of maintaining an idle cash

balance in the compensating balance (which is 10% of the loan). To

accommodate the cost of the compensating balance requirement,

assume that the added funds will have to be borrowed and simply left

idle in the firms checking account. What would the annualized rate on

this loan be if there was no compensating balance requirement? What

is the annual rate on this loan with the compensating balance

requirement?

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Checkpoint 18.3

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Checkpoint 18.3

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Checkpoint 18.3

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Checkpoint 18.3:Check Yourself

Assume that your firm has a $1,000,000 line of creditthat requires a compensating balance equal to 20percent of the loan amount. The rate paid on the loanis 12 percent per annum, $500,000 is borrowed for asix-month period, and the firm does not currently havea deposit with the lending bank. To accommodate thecost of the compensating balances requirement,assume that the added funds will have to be borrowedand simply left idle in the firms checking account.

What would the annualized rate on this loan be withthe compensating balance requirement?

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Since there is a compensating balancerequirement, the amount actuallyborrowed (B) will be larger than the$500,000 needed.

$500,000 will constitute 80% of the totalborrowed funds because of the 20 percentcompensating balance requirement.

Hence, .80B = $500,000

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If .80B = $500,000

Amount borrowed (B) = $500,000/.80

= $625,000

Thus interest is paid on a $625,000 loan ofwhich only $500,000 is available for use by

the firm.

Step 2: Decide on a Solution

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We can solve for APR using Equation (18-8),

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Step 3: Solve

Here interest is paid on a loan of$625,000.

Thus, interest for 6-months at 12%= $625,000 .12

= $37,500

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APR =($37,500 $500,000) 2

= 0.15 or 15%

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Step 4: Analyze

We observe that the presence of acompensating balance requirementincreases the cost of credit from 12% to15%.

This results from the fact that the firmpays interest on $625,000 but it gets theuse of $37,500 less, or $500,000 -

$37,500 = $462,500.

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18.5 Managingthe Firms

Investment inCurrent Assets

Managing the Firms Investment in

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Managing the Firm s Investment inCurrent Assets

The primary types of current assets thatmost firms hold are:

Cash,

Marketable securities, Accounts receivable, and

Inventories.

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Cash and Marketable Securities

Cash and marketable securities are held topay the firms bills on a timely basis.

Holding too little cash and marketable

securities could lead to default. However, holding excessive cash and

marketable securities is costly since theyearn little, or very low rates of return.


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(cont.)

There are two fundamental problems ofcash management:

1. Keeping enough cash on hand to meet thefirms cash disbursal requirements on a timelybasis.

2. Managing the composition of the firmsmarketable securities portfolio.


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(cont.)

Problem #1: Maintaining a SufficientBalance

To maintain an adequate balance requiresan accurate forecast of firms cash receiptsand disbursements. This is accomplishedthrough a cash budget.


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(cont.)

Once estimates of cash flows have beenmade, firm may want to find ways toreduces its need for cash.

For example, if the firm is able toaccelerate its cash collections or slowdown its cash disbursements, it will be

able to reduce its need for cash.


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(cont.)

Problem #2: Managing the composition ofthe firms marketable securities portfolio

Firms prefer to hold cash reserves inmoney market securities as it can beeasily and quickly converted to cash atlittle or no loss. These securities mature in

less than 1 year, have low or no defaultprobability, and are highly liquid.

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Managing Accounts Receivable

Whenever a sale is made on credit, itincreases the firms account receivablebalance. Cash flow from sales cannot beinvested until accounts receivable arecollected.

Efficient collection policies and procedures

will improve firm profitability and liquidity.

Determinants of the Size of a Firms

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Investment in Accounts Receivable

1. The level of credit sales as a percentageof sales. This percentage will vary withthe type of business.

2. The level of sales. Higher the sales,greater the accounts receivable.

3. The credit and collection policy.

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Terms of Sale

Terms of sale identify the possiblediscounts for early payment, the discountperiod, and the total credit period.

It is generally stated in the form a/b, netc. For example 1/10, net 30, means thecustomer can deduct 1% if paid within 10days, otherwise the account must be paid

within 30 days.

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18-91

Terms of Sale (cont.)

What is the opportunity cost of passing upthis 1% discount in order to delaypayment for 20 days?

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18-92

Terms of Sale (cont.)

Annualized opportunity cost

= 0.01/(1-.01) 365/(30-10)

= .1843 or 18.43%

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18-93

Customer Quality

It is important to determine the type ofcustomer who should qualify for tradecredit. It is critical to understand thecustomers short-run financial well being.

As the quality of customer declines, itincreases the costs of credit investigation,

default costs, and collection costs.

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18-94

Customer Quality (cont.)

To determine customer quality, firm cananalyze the liquidity ratios, otherobligations, and overall profitability of thefirm.

The firm can also obtain information fromcredit rating services such as Dun &Bradstreet that provide information on the

financial status, operations, and paymenthistory for most firms.

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18-95

Customer Quality (cont.)

Credit score is also a popular way toevaluate the credit risk of individuals andfirms.

Credit score is a numerical evaluation ofeach applicant based on the applicantscurrent debts and history of making

payments on a timely basis.

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18-96

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18-98

Collection Efforts (cont.)

The manager can also perform aging ofaccounts receivable to determine indollars and percentage the proportion ofreceivables that are past due.

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18-99

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18-100

Managing Inventories

Inventory management involves thecontrol of assets that are produced to besold in the normal course of business. Itincludes raw materials, work-in-process,and finished goods inventory.

How much inventory a firm carriesdepends upon the target level of sales,

and the importance of inventory.

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18-101

Key Terms

Bank transaction loans

Cash conversion cycle

Commercial paper

Credit scoring Factor

Float

Inventory conversion period

( )

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18-102

Key Terms (cont.)

Inventory management

Line of credit

Money market securities

Operating cycle Permanent sources of financing

Permanent investments

Principle of self-liquidating debt

( )

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Key Terms (cont.)

Secured current liabilities Spontaneous sources of financing

Temporary investments in assets

Temporary sources of financing Terms of sale

Trade credit

Unsecured current liabilities

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