9 working capital management compatibility mode

Topic Working capital management Introduction to Financial Management course By Dr Nguyen Thu Hien Modified from slides by Ross, Westerfield, Jordan, “Fundamentals of Corporate Finance”, 7th ed., McGraw-Hill Irwin Key Concepts and Skills



Understand the components of the cash cycle and why it is important Understand the pros and cons of the various short-term financing policies Be able to prepare a cash budget Understand the various options for short-term financing Sources and Uses of Cash
Review Balance sheet:




Sources


CA + FA = CL + Long-term Debt + Equity NWC + FA = LTD + E NWC = Cash + Other CA – CL Cash = LTD + E + CL – Other CA – FA Increasing long-term debt, equity or current liabilities Decreasing current assets other than cash or fixed assets Uses

Decreasing long-term debt, equity or current liabilities Increasing current assets other than cash or fixed assets The Operating Cycle



Operating cycle – time between purchasing the inventory and collecting the cash from selling the inventory Inventory period – time required to purchase and sell the inventory Accounts receivable period – time required to collect on credit sales Operating cycle = inventory period + accounts receivable period Figure 19.1 Cash Cycle
Cash cycle



Amount of time we finance our inventory Time from receiving cash from the sale and paying for the inventory Accounts payable period – time between purchase of inventory and payment for the inventory Cash cycle = Operating cycle – accounts payable period Example – Operating Cycle
Inventory:


Accounts Receivable:




Beginning = 160,000 Ending = 200,000 Accounts Payable:

Beginning = 200,000 Ending = 300,000 Beginning = 75,000 Ending = 100,000 Net sales = 1,150,000 Cost of Goods sold = 820,000 Example – Operating Cycle
Inventory period



Receivables period



Average inventory = (200,000+300,000)/2 = 250,000 Inventory turnover = 820,000 / 250,000 = 3.28 times Inventory period = 365 / 3.28 = 112 days Average receivables = (160,000+200,000)/2 = 180,000 Receivables turnover = 1,150,000 / 180,000 = 6.39 times Receivables period = 365 / 6.39 = 58 days Operating cycle = 112 + 58 = 170 days Example – Cash Cycle
Payables Period





Average payables = (75,000+100,000)/2 = 87,500 Payables turnover = 820,000 / 87,500 = 9.37 times Payables period = 365 / 9.37 = 39 days Cash Cycle = 170 – 39 = 131 days We have to finance our inventory for 131 days If we want to reduce our financing needs, we need to look carefully at our receivables and inventory periods – they both seem extensive Working capital management Short-Term Borrowing

Unsecured Loans
Line of credit
Committed vs noncommitted
Revolving credit arrangement
Letter of credit
Compensating balance Secured Loans
Accounts receivable financing


Inventory loans




Assigning Factoring Blanket inventory lien Trust receipt Field warehouse financing Commercial Paper Trade Credit 12 Example: Compensating Balance
We have a $500,000 line of credit with a 15% compensating balance requirement The quoted interest rate is 9% We need to borrow $150,000 for inventory for one year
How much we need to borrow?

150,000/(1-.15) = 176,471 What interest rate are we effectively paying?

Interest paid = 176,471(.09) = 15,882 Effective rate = 15,882/150,000 = 1059 or 10.59% 13 Example: Factoring
Last year your company had average accounts receivable of $2 million Credit sales were $24 million You factor receivables by discounting them 2% What is the effective rate of interest?


Receivables turnover = 24/2 = 12 times APR = 12(.02/.98) = 2449 or 24.49% EAR = (1+.02/.98)12 – = 2743 or 27.43% 14 Quick summary

How you compute the operating cycle and the cash cycle? What are the major forms of short-term borrowing? 15 Short-term lending


Credit policy and Receivables Terms of the Sale Credit Analysis 16 Credit Management: Key Issues

Granting credit increases sales Costs of granting credit


Chance that customers won’t pay Financing receivables Credit management examines the trade-off between increased sales and the costs of granting credit 17 Components of Credit Policy
Terms of sale Credit period
Cash discount and discount period
Type of credit instrument

Credit analysis – distinguishing between “good” customers that will pay and “bad” customers that will default
Collection policy – effort expended on collecting receivables 18 The Cash Flows from Granting Credit Credit Sale Check Mailed Check Deposited Cash Available Cash Collection Accounts Receivable 19 ... (75,000+100,000)/2 = 87,500 Payables turnover = 820,000 / 87,500 = 9. 37 times Payables period = 365 / 9. 37 = 39 days Cash Cycle = 170 – 39 = 131 days We have to finance our inventory for 131 days If... effective rate of interest?


Receivables turnover = 24/2 = 12 times APR = 12(.02/ .98 ) = 24 49 or 24. 49% EAR = (1+.02/ .98 )12 – = 2743 or 27.43% 14 Quick summary

How you compute the operating cycle... interest rate are we effectively paying?

Interest paid = 176,471(. 09) = 15,882 Effective rate = 15,882/150,000 = 10 59 or 10. 59% 13 Example: Factoring
Last year your company had average accounts