ACYMANS: Working Capital Management

Working Capital Management

Concerns on the determination of the optimal level, mix, and use of current assets and current liabilities. The objective is to minimize the cost of maintaining liquidity while guarding against the possibility of technical insolvency.

Management of Current Assets

Requires the determination of the appropriate mix of current assets (cash, marketable securities, accounts receivables, and inventories), considering safety, liquidity and profitability.

True

(True or False) Current assets rarely drop to zero. Companies maintain some permanent current assets which are assets needed at the low point of the business cycle. As the cycle moves on, sales increase during an upswing (seasonal), current assets are increased, and these extra current assets are what we call temporary current assets.

Moderate Approach (Maturity Matching) Financing Policy

A financing policy that matches financing with the corresponding maturity of each and every asset and liability.

Moderate Approach (Maturity Matching) Financing Policy

Fixed assets and permanent current assets are financed with long-term capital. (A machine expected to last for 5 years would be financed with a 5-year loan). Temporary current assets are financed with short-term debt (Inventory expected to be sold in 20 days would be financed with a 20-day bank loan).

Uncertainty about the Lives of the Assets

The first hurdle in using the maturity matching approach. It is difficult to ascertain the lives of every asset. E.g., inventories are expected to be sold in 20 days and financed with a 20-day bank loan. If sales are slow, the cash would not be forthcoming, and the firm might not be able to pay off the loan when it matures.

Common Equity has No Maturity

The second hurdle in using the maturity matching approach. The use of common equity would lead to a problem due to the fact that common equity, as a source of financing, does not have any maturity.

Aggressive Approach Financing Policy

A financing policy in which, some of the firm's permanent assets (current and fixed) are financed with short-term debt.

Aggressive Approach Financing Policy

In this approach, management keeps the investment in working capital at a minimum. Thus, a growing company would want to invest its funds in capital goods and not in idle assets.

Aggressive Approach Financing Policy

The financing policy in which there is a maximization on the return on investment, but at the price of the risk of minimal liquidity.

Aggressive Approach Financing Policy

A financing policy that has the following trade-offs:

a. Short-term rates are generally lower than long-term rates.

b. Financing long term assets with short-term debt is risky.

Conservative Approach Financing Policy

A financing policy in which long-term capital is used to finance all the permanent assets and to meet some of the seasonal needs (temporary current assets).

Conservative Approach Financing Policy

The firm uses a small amount of short-term credit to meet its peak requirements, but it also meets part of its seasonal needs by sorting liquidity in the form of marketable securities.

Conservative Approach Financing Policy

This policy minimizes the liquidity risk by increasing net working capital. The result is that the company forgoes the potentially higher returns available from using the additional working capital to acquire long-term assets.

Conservative Approach Financing Policy

Is characterized by a higher current ratio and acid test ratio. Thus, the company will increase current assets or decrease current liabilities.

Conservative Approach Financing Policy

This policy finances assets using long-term or permanent funds rather than short-term sources.

Cash and Marketable Securities Management

This involves the maintenance of the appropriate level of cash and investment in marketable securities to meet the firm's cash requirements and to maximize income on idle funds. The objective is to invest in cash for a return while retaining sufficient liquidity to satisfy future needs

Liquidity and Safety

Are the primary concerns of the treasurer when dealing with highly liquid assets.

Cash and Short-Term Investments

Are held because of their ability to facilitate routine operations of the company. These assets are not held for purposes of achieving investment returns.

Transaction Purposes

The first reason as to why a company must need to hold cash. Cash balances are needed to conduct the ordinary business transactions. Cash balances are needed to meet cash outflow requirements for operational or financial obligations.

Compensating Balance Requirements

The second reason as to why a company must need to hold cash. The amount left in the checking balance to be maintained at all times as part of a loan agreement. This amount compensates the bank for services rendered by providing it with deposits of funds.

Precautionary Reserves

The third reason as to why a company must need to hold cash. Cash is used to handle unexpected problems and contingencies due to the uncertain pattern of cash inflows and outflows.

Potential Investment Opportunities

The fourth reason as to why a company must need to hold cash. Cash is used to build up in anticipation of a future investment opportunity such as a major capital expenditure project.

Speculation

The fifth reason as to why a company must need to hold cash. There is a practice of delaying purchases and store up cash for use later to take advantage of possible changes in prices of materials, equipment and securities as well as changes in currency exchange rates.

Float

The difference between the bank's balance for a firm's account and the balance that the firm shows on its own books (Bank statement vs. Book Statement; relate to proper accounting for cash).

Two Aspects of Float

The aspects of float include:

a. The time it takes a company to process its checks internally.

b. The time consumed in clearing the check through the banking system.

Positive Float (Disbursement Float)

Occurs when the bank balance exceeds the book balance, such as when checks issued by the firm are already delivered to the supplier, but the same has not yet been cleared by the bank. This type of float should be increased.

Negative Float

Occurs when the book balance exceeds the bank balance. It shows that there is more cash tied up in the collection cycle. This type of float should be decreased or, if possible, eliminated.

Mail Float

Occurs when the payment has already been mailed by a customer but not yet received by the company.

Processing Float

Occurs when customers' payments have been received but not yet deposited.

Clearing Float

Occurs when customers' checks have been deposited but not yet cleared.

Accelerate Cash Collections

This is the first cash management strategy. This can be accomplished by:

a. Billing customers promptly

b. Offering cash discounts for prompt payment

c. Using of lockbox system

d. Establishing local collection office

e. Asking customers to make direct payments to the firm's depositary bank

f. Using of automatic fund transfer or electronic fund transfer.

Lockbox System

Is one strategy for expediting the receipt of funds. Customers submit their payments to a mailbox controlled by a bank rather than to the company's offices. Bank personnel remove the envelopes from the mailbox and deposit the checks to the company's account immediately. The remittance advices must then be transported to the company for entry into the accounts receivable system. The bank generally changes a flat monthly fee for this service.

Control or Slow Down Cash Disbursements

The second cash management strategy. This can be accomplished by:

a. Stretching payables

b. Maintaining zero-balance accounts

c. Playing with the float

d. Making less frequent payroll and scheduling issuance of checks to suppliers.

Zero-Balance Accounts (ZBA)

Are accounts with no minimum maintaining cash balance required. Funds are automatically transferred from a master account when a check is drawn.

Reduce the Need for Precautionary Cash Balance

The third cash management strategy. This can be accomplished by:

a. Having a more accurate cash budget.

b. Having ready lines of credit

c. Investing idle cash in highly liquid, short-term investments instead of holding idle precautionary cash balances

Cash Break-even Chart

This chart would show the amount of sales in pesos or the number of units to be sold so that the total cash inflows would equal total cash outflows.

Baumol Cash Management Model

It is an EOQ-type model which can be used to determine the optimal cash balance where the costs of maintaining and obtaining cash are at the minimum.

Cost of Securities and Opportunity Cost

These are the two types of costs related to holding cash.

Cost of Securities

The first type of cost related to holding cash. It pertains to the transactions or cost of obtaining a loan.

Opportunity Cost of Holding Cash

The second type of cost related to holding cash. It pertains to the return foregone by not investing in marketable securities or the cost of borrowing cash.

Optimal Cash Balance

√2TD/i

T = Transaction costs which is a fixed amount per transaction. It includes the cost of securities transactions or cost of obtaining a loan.

i = Interest rate on marketable securities or the cost of borrowing cash.

D = Total Demand for cash over a period of time.

Marketable Securities

Are those short-term money market instruments that can be easily converted into cash.

Marketable Securities

Securities that:

a. Serve as a substitute for cash balances.

b. Serve as a temporary investment that yield return while funds are idle.

c. Needed to meet known financial obligations.

Return on Marketable Securities

Considered as the opportunity cost of idle cash (i.e., the return that cash could be earning if it were invested at the market rate rather than held in a noninterest bearing account). This return is the denominator of the optimal cash balance formula provided in the Baumol cash management model.

Default Risk, Interest Rate Risk, and Inflation Risk

These are the risks that are involved in marketable securities.

Default Risk

Is the risk that the issuer may not be able to pay the interest or principal on time or at all.

Interest Rate Risk

The risk that the price of the securities that would fluctuate due to changes in the market interest rates.

Inflation Risk

Is the risk that inflation will reduce the real value of the investment.

Marketability

Measures how quickly a security can be sold before maturity without a significant price concession.

Receivables Management

Focuses on plans and policies related to sales on account and ensuring the maintenance of receivables at a predetermined level and their collectability as planned. The objective of which is to have the right amount of outstanding receivable balances and bad debts.

Things to Consider in Receivables Management

In deciding as to what the right amount of receivables the company should have, we consider:

a. The terms of the sale

b. The paying practices of customers

c. Collection policies and practices

d. Volume of credit sales

e. Credit extension policies and practices

f. Cost of Capital

Firm's Credit Policy

Is the primary determinant of accounts receivable. It is also the key determinant of sales, so sales and marketing executives are concerned with this policy.

Credit Period, Discounts, Credit Standards, and Collection Policy

These are the four primary determinant of accounts receivable.

Credit Period

It is the length of time buyers is given to pay for their purchases.

True

(True or False) Customers prefer longer credit periods, so lengthening the period will stimulate sales.

True

(True or False) Lengthening the credit period lengthens the cash conversion cycle (it ties up more capital in receivables, which is costly).

True

(True or False) The longer the receivables is outstanding, the higher the probability that the customer will default.

Discounts

Price reductions given for early payment. An increase in this, accompanied by declines in receivable balances and doubtful accounts all indicate that collections on the increased sales have been accelerated. Accordingly, the average collection period must have declined.

Benefits of Offering Discounts

a. The discount amounts to a price reduction, which stimulates sales.

b. Discounts encourage customers to pay earlier which shortens the cash conversion cycle.

Trade-Off of Offering Discounts

a. Offering discounts mean lower prices and lower revenues.

b. Quantity sold increases.

c. Balance: The increase in quantity may offset the reduction in price/revenue.

Credit Standards

The criteria that determine which customers will be granted credit and how much.

Strict Credit Standards

Credit standards that may tend to eliminate the risk of non-payment but may also decrease the potential sales due to rejected customers.

Liberal Credit Standards

Credit standards that may lead to higher sales, but also higher bad debt losses and collection costs.

Character, Capacity, Capital, and Conditions

These are the 4 C's of credit.

Character

The customer's willingness to pay.

Capacity

The customer's ability to generate cash flows.

Capital

The customer's financial sources such as collateral.

Conditions

The current economic or business conditions.

Collection Policy

The procedures used to collect past due accounts including the toughness or laxity used in the process.

Credit Terms

Is defined as the statement of a firm's credit period and discount policy.

Ways of Reducing Outstanding Receivables

Accelerated collection can be achieved by:

a. Shortening credit terms

b. Offer special discounts to customers who pay their accounts within a specified period (offer cash discounts)

c. Speeding up the mailing time of payments from customers to the firm.

d. Minimizing float, that is, reduce the time during which payments received by the firm remain uncollected funds.

Inventory Management

Management that focuses on plans and policies to efficiently and satisfactorily meet production and merchandising requirements and minimize costs relative to inventories. The objective is to get the right amount of inventory to best balance the estimate of actual savings, the cost of carrying additional inventory and the efficiency of inventory control.

Economic Order Quantity

Is a function of demand, carrying costs, and ordering costs. It is a deterministic model that calculates the ideal order (or production lot) quantity given specified demand, ordering or setup costs, and carrying costs. The model minimizes the sum of inventory carrying costs and either ordering or production setup costs.

Economic Order Quantity

Is the quantity to be ordered, which minimizes the sum of:

a. Ordering costs (which decrease with order size)

* Transportation (delivery costs)

* Administrative cost of purchasing and costs of receiving and inspecting goods.

b. Carrying costs (which increase with order size)

* Storage costs

* Interest costs

* Spoilage

* Insurance

EOQ for Inventories

√2aD/k

Where:

a = Cost of placing one order (or ordering cost)

D = Annual demand in units

k = Annual costs of carrying one unit in inventory for one year

Assumptions Under the EOQ Model

1. A fixed quantity is ordered every time there is an order.

2. Purchasing costs are unaffected by the quantity ordered.

3. Purchase order lead-time is known with certainty.

4. Adequate inventory is always maintained to avoid stockouts.

5. For each order, units are received in a single delivery and lead time does not vary.

6. The unit cost of the inventory is constant; hence, there can be no quantity discounts.

7. There is no limit as to the order size or the number of units that may be ordered.

Ordering Costs

Decreases when order size decreases. In computing this, we need the number (or frequency) of orders made during the year. The number of orders can be computed by dividing the annual demand in units by the order quantity and multiplying that amount to the cost of place one order.

No. of Orders

Annual Demand in Units / Order Quantity

Total Ordering Costs

No of Orders * Cost of Placing One Order (Ordering Cost)

Total Ordering Costs

Annual Demand in Units / Order Quantity * Cost of Placing One Order

Carrying Costs

Increases when order size increases. It is computed by multiplying average inventory and the annual costs of carrying one unit in inventory for one year.

Average Inventory

Order Quantity / 2

Total Carrying Costs

Average Inventory * k

Total Carrying Costs

Order Quantity/2 * Annual Costs of Carrying One Unit in Inventory for One Year

Reorder Point

The point in which units shall be ordered again. Having knowledge of this prevents stock-out problems. An entity should order at a point in time so as not to run out of stock before receiving the inventory ordered but not so early that an excessive quantity of safety stock is maintained.

Lead Time

The period between the time the order is placed and received.

Normal Lead Time Usage

Normal Lead Time * Average Usage

Safety Stock

(Maximum lead time - normal lead time) * Average Usage

Re-Order Point - No Safety Stock

Normal Lead Time Usage

Re-Order Point - With Safety Stock

Safety Stock + Normal Lead Time Usage or Maximum Lead Time * Average Usage

Primary Sources of Current Asset Financing

a. Bank loans

b. Credit from Suppliers (Accounts Payable)

c. Accrued Liabilities

d. Long-term Debt

e. Common Equity

Short-Term Financing

As to cost, it is generally lower. As to (interest cost) risk, interest expense may fluctuate widely, perhaps reaching levels that profits are extinguished. As to (bankruptcy) risk, a temporary recession may adversely affect the financial ratios and render the entity unable to repay this debt. As to negotiation, it is faster. In terms of flexibility, it has greater leeway. If a firm thinks that interest rates are abnormally high, it may prefer this financing to gain flexibility in changing the debt contract. As to provisions, it generally has fewer restrictions.

Long-Term Financing

As to cost, it is generally higher. As to (interest cost) risk, interest expense will be relatively stable over time. As to (bankruptcy) risk, a temporary recession will not adversely affect the entity's financial ratios. As to negotiation, it is slower, the entity needs to make a more thorough financial examination before extending long-term credit. In terms of flexibility, it has lesser leeway. A firm cannot just change or get out of a debt contract if provisions indicate long-term agreements or obligations. As to provisions, long-term loan contracts may contain provisions that constrain the firm's future actions in order to protect the lender.

Trade Credit (Accounts Payable)

A source of credit that is automatically obtained when a firm purchases goods or services on credit from a supplier. It arises spontaneously from ordinary business transactions. Because of its ease in use, it is the largest source of short-term financing for many firms both large and small.

Free Trade Credit

Credit received during the discount period.

Costly Trade Credit

Credit taken in excess of free trade credit, whose cost is equal to the discount lost.

Trade Credit - No Trade Discount

Cost of Financing: Difference between the selling prices (credit purchase vs. cash purchase)

Trade Credit - With Trade Discount

Cost of Financing: Trade Discount Forgone

Accruals (Accrued Expenses)

Represent liabilities for services that have been provided to the company but have not yet been paid for.