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1. Foundations. 2. Financial Background: A Review of Accounting, Financial Statements, and Taxes. 3. Cash Flows and Financial Analysis. 4. Financial Planning. 5. The Financial System, Corporate Governance, and Interest. Part II: DISCOUNTED CASH FLOW AND THE VALUE OF SECURITIES. 6. Time Value of Money. 7. The Valuation and Characteristics of Bonds. 8. The Valuation and Characteristics of Stock. 9. Risk and Return. Part III: BUSINESS INVESTMENT DECISIONS--CAPITAL BUDGETING. 10. Capital Budgeting. 11. Cash Flow Estimation. 12. Risk Topics and Real Options in Capital Budgeting. 13. Cost of Capital. Part IV: LONG-TERM FINANCING ISSUES. 14. Capital Structure and Leverage. 15. Dividends. Part V: OPERATIONS ISSUES--WORKING CAPITAL MANAGEMENT AND PLANNING. 16. The Management of Working Capital. 17. Corporate Restructuring. 18. International Finance.
Chapter 16 Working Capital Working Capital Basics Working Capital – Assets and liabilities required to operate a business on a day-to-day basis Assets: – Cash – Accounts Receivable – Inventory Liabilities: – Accounts Payable – Accruals Working Capital, Funding Requirements, and the Current Accounts Gross Working Capital represents an investment in assets – Capital – funds committed to support assets – Working – short term, day-to-day operations Working Capital Requires Funds – Maintaining a working capital balance requires a permanent funds commitment The Short-Term Liabilities Spontaneous Financing Operating activities automatically create payables & accruals essentially debts – These liabilities spontaneously offset the funding required to support current assets Working Capital and the Current Accounts Net Working Capital – the difference between gross working capital and spontaneous financing Generally: – Gross working capital = current assets – Net working capital = current assets – current liabilities People often say working capital when they actually mean net working capital Objective of Working Capital Management To run the firm with as little money tied up in the current accounts as possible Working capital elements – Inventory – Receivables – Cash – Payables – Accruals Objective of Working Capital Management Inventory High Levels Low Levels Benefit: Cost: Happy customers – supplied quickly Shortages Few production delays (parts always on hand) Dissatisfied customers – product not available Cost: Benefit: High financing costs Low financing and storage costs High storage costs Less risk of obsolescence Shrinkage (theft) Risk of obsolescence Cash High Levels Benefit: Reduces risk of being unable to pay bills Cost: Increases financing costs Low Levels Benefit: Reduces financing costs Cost: Increases transaction risk Objective of Working Capital Management Accounts Receivable High Levels Low Levels Benefit: Cost: Happy customers –can pay slowly Customers unhappy with payment terms High credit sales Lower Credit Sales Cost: Benefit: More bad debts Less financing cost High collection costs Increased financing costs Payables and Accruals High Levels Benefit: Spontaneous financing reduces need to borrow Cost: Unhappy suppliers because paid slowly Low Levels Benefit: Happy suppliers/employees Cost: Not using spontaneous financing Figure 16-1 Cash Conversion Cycle Figure 16-2 Timeline Representation of Cash Conversion Cycle 10 Terms of Sale Credit sales are subject to specific payment terms – 2/10, net 30 - The most common terms 2% discount for paying within 10 days, otherwise entire amount due within 30 days – Prompt payment discounts are usually effective tools for managing receivables Customers pay quickly to save money May backfire if customers are very cash poor – Discount taken only by those who pay anyway 51 Collections Policy Collections Department - follows up on overdue receivables - called dunning – Mail polite letter – Follow up with additional increasingly aggressive dunning letters – Phone calls – Collection agency – Lawsuit Collection policy: manner and aggressiveness with which a firm pursues payment from delinquent customers 52 Inventory Management Inventory: product held for sale – Inventory mismanagement can ruin a company Finance department has only an oversight responsibility – Monitor level of lost or obsolete inventory – Supervise periodic physical inventories 53 Benefits and Costs of Carrying Adequate Inventory – – – – Benefits Reduces stockouts and backorders Makes operations run more smoothly Improves customer relations Increases sales – – – – – – – – Costs Interest on funds used to acquire inventory Storage and security Insurance Taxes Shrinkage - theft Spoilage Breakage Obsolescence 54 Inventory Control and Management Inventory Management - overall way a firm controls inventory and its cost – – Define an acceptable level of operating efficiency with regard to inventory Achieve that level with the minimum inventory cost EOQ – An inventory cost minimization model C = Annual Carrying Cost per Unit F = Fixed Cost per Order D = Annual Demand in Units Q = Order Quantity 55 Figure 16-7 Inventory on Hand for a Steadily Used Item 56 Figure 16-8 Inventory Costs and the EOQ Total Inventory Cost: Q D TC = C + F Q Economic Order Quantity (EOQ) Model EOQ minimizes the sum of ordering and carrying costs C = Annual Carrying Cost per Unit F = Fixed Cost per Order D = Annual Demand in Units 2FD EOQ = C × Fixed Cost per Order × Annual Demand EOQ = Annual Carrying Cost per Unit Concept Connection Example 16-9 Economic Order Quantity (EOQ) Model Galbraith buys a $5 part Its carrying cost is 20% of that value per year It costs $45 to place, process and receive an order 1,000 parts are used per year What order quantity minimizes inventory costs? How many orders will be placed each year if that order quantity is used? What annual inventory costs are incurred for the part with this ordering quantity? 59 Concept Connection Example 16-9 Economic Order Quantity (EOQ) Model Solution: C = $5 × 20 = $1 F = $45 D = 1,000 × $45 × 1,000 EOQ = $1 = 300 units Annual number of orders = 1,000 / 300 = 3.33 Carrying costs = $5 × × (300/2) = $150 per year Ordering costs = $45 x 3.333, = $150 per year Total inventory cost = $150 + $150 = $300 per year 60 Safety Stocks, Reorder Points and Lead Times Safety stock: Additional inventory, carried at all times, used when normal working stocks run out Quantity on hand diminishes until reorder point is reached Ordering lead time is the advance notice needed so an order will arrive on time 61 Figure 16-9 Pattern of Inventory on Hand 62 Safety Stock and the EOQ Inclusion of safety stocks does not change EOQ Cost trade-off: extra inventory increases carrying cost, but avoids losses from production delays and missed sales 63 Tracking Inventories The ABC System The ABC system segregates items by value and places tighter control on higher-cost pieces – “A” items – very expensive or critical – “B” items – moderate value – “C” items – cheap and plentiful Effort and spending on control diminishes from A to B to C 64 Just In Time (JIT) Inventory Systems JIT virtually eliminates manufacturing inventory by pushing it back on suppliers Suppliers deliver goods just in time for use in production Works best with large manufacturers Works poorly where firm has little control over distant suppliers 65 [...]... Policies The mix of short/long-term financing supporting working capital – Heavier use of longer term funds is conservative – Using more short-term funding is aggressive 15 Figure 16- 4a Working Capital Financing Policies 16 Figure 16- 4b Working Capital Financing Policies 17 Working Capital Policy A firm’s Working Capital Policy refers to its handling the following issues: – How much working capital is used... Connection Example 16- 2 Revolving Credit Agreements Arcturus has a $10M “revolver” at prime plus 2.5% Prior to June 1, it took down $4M that remained outstanding for the month On June 15, it took down another $2M which remained outstanding through June 30 Prime is 9.5% and the bank’s commitment fee is 0.25% What bank charges will Arcturus incur for the month of June? 26 Concept Connection Example 16- 2 Revolving... to be collected in the near future – Banks are willing to lend on A/R if the borrowing firm’s customers have good financial ratings Pledging AR: using A/R as collateral for loan Factoring AR: selling receivables at a discount directly to a financing source 32 Concept Connection Example 16- 4 Pledging Accounts Receivables Kilraine’s $100,000 receivables balance of turns over every 45 days The firm pledges... Connection Example 16- 4 Pledging Accounts Receivables Solution: Traditional interest 8% + 4% = 12% Administ rat ive charge Average loan balance $100,000 × 75 = $75,000 Accounts offered to finance company $100,000 x 360/45 = $800,000 The administrative fee at 1.5% 1.5% x $800,000 = $12,000 Fe e a s a pe rc e nta ge of loa n ba la nc e $ 12 ,0 00 ÷ $ 75 ,0 00 = 1 6% Total f inancing charges 16% + 12% = 28%... required to be out of short-term debt for a period once a year – Usually 30-45 days – Prevents funding long-term needs and projects with short-term borrowing 29 Commercial Paper Notes issued by large, financially-strong firms and sold to investors – Basically a very short-term corporate bond Unsecured Buyers are usually institutions Maturity less than 270 days Considered a very safe investment Interest... working capital varies with sales level Temporary working capital supports seasonal peaks in business Working capital is permanent to the extent that it supports a constant, minimum level of sales 11 Figure 16- 3 Working Capital Needs of Different Firms 12 Financing Net Working Capital Short-term working capital should be financed with short-term sources Maturity Matching Principle – the term of financing... charges are: ($4,000,000 × 01) + ($2,000,000 × [15/30] × 01) = $50,000 The unused balance was $6M for 15 days and $4M for 15 days ($6,000,000 × 000208 × [15/30]) = $ 624 ($4,000,000 × 000208 × [15/30]) = $ 416 $1,040 So, total bank charges for June are $51,040 27 Compensating Balances Minimum Balance Requirement Average Balance Requirement A percentage of the loan amount Average daily balance over a month ... is conservative – Using more short-term funding is aggressive 15 Figure 16- 4a Working Capital Financing Policies 16 Figure 16- 4b Working Capital Financing Policies 17 Working Capital Policy A firm’s... Benefit: Happy suppliers/employees Cost: Not using spontaneous financing Figure 16- 1 Cash Conversion Cycle Figure 16- 2 Timeline Representation of Cash Conversion Cycle 10 Permanent and Temporary... capital is permanent to the extent that it supports a constant, minimum level of sales 11 Figure 16- 3 Working Capital Needs of Different Firms 12 Financing Net Working Capital Short-term working