Mpdule 2 Chapter 6: Working Capital Management

Inventory Conversion Period + Receivables Collection Period - Payables Deferral Period

Cash Conversion Cycle

(Days per year / Inventory turnover) + Day sales outstanding - Payables deferral period

CCC

(inventory / COGS per day) + (Receivables / Sales per day) - (Accounts Payable / COGS per day)

CCC per day

Collections - (Payments or Purchases + Wages + Rent)

Net Cash Flow Formula

Cash at Start, if no borrowing + Net Cash Flow = Cumulative Cash - Target Cash

Cash Surplus Formula

Float

length of time from when check is written until the actual recipient can use the “good funds”

Cash in Firm’s Books - Cash in its Bank’s Books or No. of Float Days × Float Amount per Day

Net Float Amount

Total Inventory Costs = Total Carrying Costs + Total Ordering Costs

Economic Order Quantity (EOQ)

(Q/2)C + (S/Q)O

Total Cost Formula

Q

Inventory order size in units

C

Carrying cost per unit

S

Total demand in units over a planning period

O

Ordering cost per order

Supplier’s Credit Terms

means you get a X% discount if you pay within A days, or pay the gross amount billed if paid after A days to B days. Penalty charge will be added to gross amount if you pay after B days.

(Gross Amount - Discount) / 365

Net Daily Purchase

Net Daily Purchase × Number of “No Penalty” Days

Total Trade Credit

Net Daily Purchase × Number of “Discount” Days

Free Trade Credit

Total Trade Credit - Free Trade Credit

Costly or Extra Trade Credit Formula

Discount Amount / Extra Trade Credit

kNOM Conceptual Formula

(Discount % / 1 - Discount %) × [365 Days / (Days Taken prior to penalty - Discount Period)]

kNOM Standard Formula

Periodic Rate × Periods per Year

kNOM Shortcut

(1 + Periodic Rate)^Periods per Year - 1

Effective Cost of Trade Credit (EAR)

Bank Loans

In comparing these with different interest schemes, compute for Annual Percentage Rate (APR) or Effective Rate of Interest (EAR) to determine the cheapest cost of bank loan to the firm

Effective Interest Rate 1-year

If you borrow $1000 from a bank for one year and have to pay $60 in interest for that year, your stated interest rate is 6%

Interest Amount / Principal

Effective Rate on a Simple Interest Loan

kNOM = EAR

Simple Annual Interest means no discount or no add-on interest. Your APR or EAR is the same as the stated rate in this example because there is no compound interest to consider.

Effective Interest Rate < 1 year

If you borrow $1000 from a bank for 120 days and the interest rate is 6%, what is the effective interest rate? $60 / $1000 X 360 / 120 = 18%. The effective rate of interest is 18% since you only have use of the funds for 120 days instead of 360 days.

(Interest Amount / Principal) × (Days in the Year (360) / Days Loan is Outstanding)

Effective Interest Rate on a Loan With a Term of Less Than one Year

Effective Rate on Discounted Loan

Some banks offer discounted loans. Discounted loans are loans that have the interest payment subtracted from the principal before the loan is disbursed. $60/$1,000 - $60 X 360 / 360 = 6.38%. The effective rate of interest is higher on a discounted loan than on a simple interest loan.

(Interest Amount / Principal) – [(Interest Amount × Days in the Year (360)) / Days Loan is Outstanding]

Effective Interest Rate on a Discounted Loan

Interest Rate × Gross (or Original) Loan Amount

Deductible Interest

Gross (or Original) Loan Amount – Deductible Interest

Usable Funds or Net Loan Amount

Amount of Funds Needed / (1 - Discount Loan Rate)

Amount Borrowed D

Effective Rate with compensating balance

Some banks require that the small business firm applying for a business bank loan hold a balance, called a compensating balance, with their bank before they will approve a discount loan. This requirement makes the effective rate of interest higher. 6% / (1 – 6% - 20%) = 8.11%, if c is a 20% compensating balance.

Interest Rate / (1 - Interest Rate - % Compensating Balance)

Effective Interest Rate of Discount Loans with Compensating Balances

Amount of Funds Needed / (1 - Discount Loan Rate - % Compensating Balance)

Amount Borrowed DC

(Discount Interest × Amount Borrowed DC) / Gross (or Original) Loan Amount

Another Computation for EAR

Effective Rate on Installment Loan

Installment loans are most often given by banks and Installment loan interest rates are generally the highest interest rates you will encounter. 2 × 12 × ($60/13 × $1,000) = 11.08%. The interest rate on this installment loan is 11.08% as compared to 8.11% on the discount loan with compensating balances.

(2 × Annual # of Payments) × [(Interest Amount / (Total No. of Payments + 1) × Principal]

Effective Interest Rate on Installment Loans

Interest Rate × Loan Amount

Interest Amount

Loan Amount + Interest Amount

Face Amount of the Loan

Face Amount of Loan / 12

Monthly Payment

Loan Amount / 2

Average Loan Outstanding

Interest Amount / Ave. Loan Outstanding

Approximate Cost

Annuity

To find the appropriate effective rate, recognize that the firm receives the loan amount and must make monthly payments based on face amount of loan / 12

Gross Working Capital

total current assets

Net Working Capital

current assets minus non-interest bearing current liabilities

Working Capital Policy

deciding the level of each type of current asset to hold, and how to finance current assets

Working Capital Management

controlling cash, inventories, and A/R, plus short-term liability management.

Cash Conversion Cycle

The cash conversion model focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.

Receive materials → Pay cash for purchased materials → Finish goods and sell them → Collect cash for accounts receivable

CCC Illustration

Transactions

must have some cash to operate

Precaution

“safety stock”. Reduced by line of credit and marketable securities.

Compensating Balances

for loans and/or services provided

Speculation

to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities.

Goal of cash management

◼ To meet above objectives, especially to have cash for transactions, yet not

have any excess cash.

◼ To minimize transactions balances in particular, and also needs for cash to

meet other objectives.

Cash inflows → Cash to purchase → Inventory to sales → Fixed Assets to support production → Cash outflows

Cash Generation & Disposition Process

Irregular cash inflows

Bond Sales, Other Debt Contracts, Preferred Stock Sales, Common Stock Sales

Cash

used to purchase fixed assets, labor & materials, inventory, and marketable securities

Inventory

turns into sales (cash or credit), creating receivables, which later become cash through collections

Fixed assets

support production and depreciate over time

Irregular cash outflows

Dividends, Interest, Principal on Debt, Share Repurchases, Taxes

Ways to minimize cash holdings

◼ Use a lockbox

◼ Insist on wire transfers from customers

◼ Synchronize inflows and outflows

◼ Use a remote disbursement account

◼ Increase forecast accuracy to reduce need for “safety stock” of cash

◼ Hold marketable securities (also reduces need for “safety stock”)

◼ Negotiate a line of credit (also reduces need for “safety stock”)

Float

the difference between cash as shown on the firm’s books and on its bank’s books.

Depreciation

a non-cash charge. Only cash payments and receipts appear on cash budget. does affect taxes, which appear in the cash budget.

Inflows aside from collections

◼ Proceeds from the Sale of Fixed Assets

◼ Proceeds from Stock and Bond Sales

◼ Interest Earned

◼ Court Settlements

Bad debts

◼ Collections would be reduced by the amount of the bad debt losses.

◼ For example, if the firm had 3% bad debt losses, collections would total only 97% of sales.

◼ Lower collections would lead to higher borrowing requirements.

When to improve EVA

◼ Cash holdings will exceed the target balance for each month

◼ Cash budget indicates the company is holding too much cash.

How to improve EVA

either investing cash in more productive assets, or by returning cash to its shareholders.

Cash shortfall

If sales turn out to be considerably less than expected

Conservative

A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast

fund future investments

other reasons why company wants to maintain high amount of cash

Types of inventory costs

Reducing the average amount of inventory generally reduces carrying costs, increases ordering costs, and may increase the costs of running short.

Carrying Costs

storage and handling costs, insurance, property taxes, depreciation, and obsolescence.

Ordering costs

cost of placing orders, shipping, and handling costs.

Cost of running short

loss of sales or customer goodwill, and the disruption of production schedules.

Inventory Management (EOQ Model)

attempts to determine the order size for an inventory item, given its usage, ordering costs, and carrying costs, that will minimize total inventory costs

ROE & EVA

By holding excessive inventory, the firm is increasing its costs, which reduces its ROE. Moreover, this additional working capital must be financed, so EVA is also lowered.

Short run reduction in inventory

Cash will increase as inventory purchases decline.

Long run reduction in inventory

Company is likely to take steps to reduce its cash holdings and increase its EVA.

High DSO

Customers are paying less promptly, and the company should consider tightening its credit policy in order to reduce DSO

Credit Period, Cash Discounts, Credit Standards, Collection Policy

Elements of Credit Policy

Credit Period

How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales.

Cash Discounts

Lowers price. Attracts new customers and reduces DSO.

Credit Standards

Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO.

Collection Policy

How tough? Tougher policy will reduce DSO but may damage customer relationships.

Determinants of investment in accounts receivable

Level of Sales, Percentage of Credit Sales to Total Sales, Actual Level of Credit Sales, Credit and Collection Policies, Length of Time Before Credit Sales are Collected

Tighter credit policy

may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

Short run reducing DSO

If customers pay sooner, this increases cash holdings

Long run reducing DSO

Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase EVA.

Moderate Approach

Match the maturity of the assets with the maturity of the financing.

Aggressive Approach

Use short-term financing to finance permanent assets.

Conservative Approach

Use permanent capital for permanent assets and temporary assets.

Short-Term Credit

Any debt scheduled for repayment within one year.

Major Sources of Short-Term Credit

◼ Accounts Payable (trade credit)

◼ Bank Loans

◼ Commercial Loans

◼ Accruals

Risk of S-T Credit

◼ Always a required payment around the corner.

◼ May have trouble rolling over loans.

Advantages of S-T Financing

◼ Speed

◼ Flexibility

◼ Lower cost than long-term debt

Disadvantages of S-T Financing

◼ Fluctuating interest expense

◼ Firm may be at risk of default as a result of temporary economic conditions

Accrued Liabilities

Continually recurring short-term liabilities, such as accrued wages or taxes.

They are free in the sense that no explicit interest is charged.

However, firms have little control over the level of accrued liabilities.

Trade Credit

credit furnished by a firm’s suppliers

often the largest source of short-term credit, especially for small firms.

Spontaneous, easy to get, but cost can be high.