Studied by 9 people
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Working Capital (WC)
other names for it are Net Working Capital (NWC) or net current assets
Methods of calculating Working Capital
capital and asset approach
capital approach
asset approach
Level and structure of WC
part of current assets that remain in the entity after settlement of current liabilities; or part of current assets, which is not financed by current liabilities but with fixed capital
Working Capital can appear as -
posivite, zero and negative
The size of WC, and in particular its increase in absolute and relative quantities, indicates the strengthening of the comapny's [BLANK]
financial position
WC is necessary to [BLANK] arising from the financing of working assets
limit the risk
too much WC, however, indicates [BLANK]
excessive current assets
need for WC depends on the length of the [BLANK] and the [BLANK] of current assets
operating cycle; rapidity of operation
WC may be higher in entities which can not easily [BLANK]
take out current loans
Functions of Working Capital
liquidity reserve for payment of liabilities; economic reserve generating profits
Internal Factors of WC
borrowing and investing positions/activities/capacities; company size and growth rates; organizational structure; sophistication of WC management
External Factors of WC
banking services; competitors; interest rates; new technologies and products; the economy
Measuring and managing LIQUIDITY
the extent to which a company can meet its short-term obligations using assets that can be readily transformed into cash
Dimensions of an asset’s liquidity
Type of assets and speed at which the asset can be converted to cash
Sources of liquidity
Primary and secondary
Primary sources of liquidity
Represent the most readily accessible resources available; Using these sources is not likely to affect the normal operations of the company; They may be held as cash or near-cash securities; These sources represent liquidity that is typical for most companies; These sources represent funds that are readily accessible at relatively low cost
Secondary sources of liquidity
Using these sources may result in a change in the company's financial and operating positions; Using these sources may signal a company’s deteriorating financial health and provide liquidity at a high price (the cost of giving up a company asset to produce emergency cash)
Example of PRIMARY liquidity sources
short-term fuds, which may include trade credit, and short-term investment portfolio; ready cash balances, which has cash available in bank accounts, resulting from payment collection (investment income, liquidation or near-cash security), and other cash flows; negotiating debt contracts, relieving pressures from high interest payments or principal repayments
Example of SECONDARY liquidity sources
liquidating assets, which depend on the degree to which short-term and (or) long-term assets can be liquidated and coverted into cash without substantial loss in value; filling for bankruptcy protection and reorganization
DRAG on liquidity
when receipts occur infrequently, especially after payments are made; a [BLANK] on liquidity occurs due to the decreased availability of funds
PULL on liquidity
when disbursements are paid too early; an [BLANK] on liquidity occurs because companies will be forced to spend money prior to recieving funds from sales which cover their obligations
A measure of Liquidity - liquidity contributes to a company’s [BLANK]
creditwhorthiness
Creditworthiness allows the company to:
obtain lower borrowing costs; obtain better terms for trade credit; have greater investment flexibility; exploit profitable opportunities
Immediate sources of funds for paying bills
cash on hand; proceeds from the sale of marketable securities; collection of accounts receivables
Additional liquidity
sales of inventory directly converted into cash; sales of inventory indirectly converted into cash credit sales
Liquidity Ratio
measures of company’s ability to meet short-term obligations to creditors as they mature or come due
CURRENT RATIO
an ideal ratio is 1.0; less than 1.5 means the firm may not have enough CA to pay bills within 12 months; much higher than 2.0 means the firm may have to many recourses tied up and not used effectively
QUICK RATIO
an ideal ration is 1.0; less than 1.0 means the firm may not have enough QA to pay bills within about 3 months; much higher than 1.0 means the firm may have too many liquid assets in relation to CL
Turnover Ratio
measure how well key current assets are managed over time
the ratio indicates how many, on average, accounts receivable are created by credit sales and collected during the fiscal policy
the ratio indicates how much, on average, inventory is created or acquired and sold during the fiscal policy
the ratio indicates how many days, on average, it takes to collect on the credit accounts
the ratio indicates the average length of time that the inventory remains within the company during the fiscal period
the ratio is a measure of how long on average, it takes the company to pay its suppliers
Managing the CASH POSITIONS
the amount of cash that a company holds on its books at any point in time; in addition to cash, it also takes highly liquid assets as marketable securities; certificate of deposit and other cash equivalents
Interest-bearing securities
the investor pays the face value amount and receives back that same amount plus the interest on the security
yield on short-term investments
The factor that is used to annualized the yield depend on
type of security, the traditions for quoting yield
money market yield; annualizing ratio of 360 to the number of days to maturity
bound equivalent yield; annualizing ratio of 365 to the number of days to maturity
discount basis yield; face value basis and annualizing ratio of 360 to the number of days to maturity
Types of INVESTMENT RISKS
credit (default); market (interest rate); foreign exchange; liquidity
Attributes of CREDIT RISK
issuer may default; issues could be adversely affected by economy or market; little secondary market
Attributes of MARKET RISK
price or rate changes may adversely affect return; there is no market to sell the maturity to, or there is only a small secondary amrket
Attributes of LIQUIDITY RISK
security is difficult or impossible to (re) sell; security must be held to maturity and cannot be liquidated until then
Attributes of FOREIGN EXCHANGE RISK
adverse general market movement against our currency
Safety measures of CREDIT RISK
minimize amount; keep maturities short; watch for “questionable” anmes; emphasize government securities
Safety measures of MARKET RISK
keep maturities short; keep portfolio diverse in terms of maturity and issuer
Safety measures of LIQUIDITY RISK
stick with government securities; look for good secondary market; keep maturities short
Safety measures of FOREIGN EXCHANGE RISK
hedge regularly; keep most in our currency and domestic market to avoid foreign exchange
Securities issued at a discount
the investors invests less than the face value (FV) of the security and received the FV back at maturity
What are the active strategies for short-term investments?
matching, mismatching, laddering
Matching Strategy
the strategy can use T-bills as an investment type; it’s more conservative and allows for the instrument to be encashed, should market condition turn adverse
Mismatching Strategy
the strategy is riskier and more likely to use investment tools like derivatives, which can prove dangerous if the company has little or no experience in dealing with them
Laddering Strategy
a more balanced strategy, which has characteristics of passive and matching strategy; in this strategy the maturity of the investments are scheduled at systematic intervals
Primary activities in accounts receivable management
Granting credit and processing transactions, measuring the performance of the credit function, monitoring credit balances
Granting credit and processing transactions
Requires posting customers' payments to the account receivables account by applying the payment against the customer's outstanding balance; Requires recording credit sales
Monitoring
Requires a regular reposting of outstanding receivable balances and notifing the collection managers of past due situations
Measuring the performance of the credit function
This entails preparing and disturbing key performance measurement reports, including an account receivable agein schedule; Involves the day’s sales outstanding reports
Efficient processing and maintaining accurate, up-to-date records that are available to [BLANK]
Credit managers and other interested parties as soon as possible after payments have been received
Control of accounts receivable and assuring that accounts receivable records are current and that [BLANK]
No unauthorized entry into the accounts receivable file has occured
Collection of accounts and coordination with [BLANK]
The treasury management function
Preparation of regular [BLANK]
Performance measurements reports
Companies may achieve scale economics by centralizing the accounts receivables function by using a
Captive financial subsidiary
Captive Financial Subsidiary
A wholly owned subsidiary of the company that is established to provide financing for the sales of the parent company
Challengers in accounts receivable management
Monitoring receivables, collecting on accounts
Many companies resorted to outsourcing the accounts receivables function to
Increase the account collection; credit evaluation provide service; apply the most recent technologies
Major types of credit accounts
Open book, documentary (with or without lines of credit), instalment credit, revolving credit
Open book
A form of trade credit in which sellers ship merchandise on faith that payment will be forthcoming; the most common
Documentary (with or without lines of credit)
A credit arrangement, in which a bank undertakes to pay for a shipment, provided the exported submits the required documentation within a specified period
Instalment credit
A line of credit where the customer pays a commitment fee and is then allowed to use the funds when they are needed
Revolving credit
A loan for a fixed amount of money; the borrower agrees to make a set number of monthly payments at a specific amount
The types of credit terms offered vary depending on
Type of customer; Relative financial strength of customer; Type of credit terms the competition is offering
Credit Scoring Models
statistical models used to classify borrowers according to their credit-worthiness or predict late payers; offer an opportunity for a company to make fast decisions on the basis of simple data
Appreciate Credit Scoring Model
Organization type, with corporations, rated higher than sole-proprietorships or partnerships; Ready cash (e.g. high checking account balances; Being current in supplier payments, as indicated by financial services;
Panelised Credit Scoring Model
Previous personal bankruptcy or tax lines (carries over from person to company); High-risk categories: food service, hospitality industries; Heavy use of personal credit cards (no reserves or reduced reserves available); Proper late payment behaviour or defaults (payment patterns are habitual);
Motives for Holding Inventory
transaction, precautionary, speculative motive
Transaction Motive
Reflects the need for inventory as part of the routine production-sales cycle; inventory need is equal to the planned manufacturing activity
Precautionary Motive
Related to the desire to avoid stock-out losses, which are profits lost from not having sufficient inventory on hand to satisfy demand
Speculative Motive
Related to the reasons such as ensuring the availability and pricing of inventory; aimed at benefiting from out-of-ordinary purchases
Approaches to Managing Inventory
minimising inventory levels and maintaining high inventory level
Minimising Inventory Levels
Requires accurate forecasting of market supply and demand; Storing only the supplies necessary for current operations; Minimises inventory maintenance costs; Increases the risk of losing sales
Maintaining a High Inventory Level
Prevents shortages that lead to a decrease in the current and future turnover; Increases the level of customer service; Desirable because companies operate in uncertain conditions and are not able to make error-free predictions
Inventory consists of:
Materials used for production and used for own needs; Semi-finished product and work in progress; Finished products; Goods intended for resale
AIM of Managing Inventory
Optimizing inventory level by balancing benefits related to keeping inventories with costs of maintaining them (achieved by order frequency control and the volume of delivery)
ABC Method
approach involving the division of stocks into 3 groups: A, B, C (or more)
Group A includes
inventories of this group are subject to more detailed monitoring and they are kept at a relatively low level
Group B includes
a group of stocks between A and C
Group C includes
stocks in this group - due to their key importance, and at the same time low cost - are ordered and maintained in large amount
SIMPLE methods of inventory management
red-line and two-bin method
Economic Order Quantity
model of inventory management, in which the optimal volume of delivery is determined, guaranteeing the minimisation of total inventory costs
FAVOURABLE CONDITIONS for JIT
Mass production; Multi-phase production process (product complexity); Stable market; Well-developed transport network; Efficient communication system in the company; Qualified employees
UNFAVOURABLE CONDITIONS for JIT
Unitary production; Simple production process (low complexity of product); Unstable market; Poorly functioning transport; Disruptions in the communication process; Lack of qualified employees
ADVANTAGES of JIT
Reduction of inventory-related costs; Release of some working capital used for financing inventory; Increase in work efficiency; Increasing the quality of products
DISADVANTAGES of JIT
Risk of losses caused by production stoppage due to lack of materials; Risk of losing sales, and even losing clients as a result of the lack of goods or products
Stretching Payables
pushing on payables when it stretch beyond the due date and taking advantage of vendor grace periods
Credit Risk Analysis
the procedure of determining the contractor’s default probability
Receivables Collection Policy
the procedure to deal with the situation, when the receivables are not paid on time
Note
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