chapter 26

Chapter 26: Working Capital Management

  • Components of Net Working Capital:
    • Cash
    • Inventory
    • Receivables
    • Payables
  • Significance of Working Capital:
    • Essential for daily operations of the firm.

Trade Credit

  • Definition:
    • A supplier offers its customers credit terms (e.g., "net 30").
    • Payment is due 30 days after the invoice date.
    • Variants of terms could include different day counts (net 40, net 15, etc.).
  • Discount Terms:
    • Example: "2/10, net 30" means:
    • 2% discount if paid within 10 days.
    • Full payment due in 30 days.
  • Effective Annual Cost:
    • If a firm chooses not to take the 1/15, net 40 offer, annual borrowing cost is 15.8%.

Receivables Management

  • Key Metric:
    • Accounts Receivable Days:
    • Formula: extAccountsReceivableDays=extAccountsReceivableextAverageDailySalesext{Accounts Receivable Days} = \frac{ ext{Accounts Receivable}}{ ext{Average Daily Sales}}
    • Example: If average daily sales are $65,000 and Accounts Receivable is $1,600,000, then days outstanding is 1,600,00065,000=25\frac{1,600,000}{65,000} = 25 days.
  • Aging Schedule:
    • Observes how long receivables have been outstanding.
    • A “bottom-heavy” aging schedule indicates issues with credit policy, especially if late payments rise.

Payables Management

  • Borrowing Choice:
    • Should only use accounts payable if trade credit is the cheapest funding source.
  • Cost Consideration:
    • Depends on offered credit terms.
    • Forgone discount costs grow with higher discount rates and shorter loan durations.
  • Trade Credit Decisions:
    • Always choose the least expensive supplier option when presented choices.

Inventory Management

  • Costs Associated with Inventory:
    • Acquisition Costs: Cost of inventory over a defined period (usually a year).
    • Order Costs: Costs related to placing orders throughout the year.
    • Carrying Costs: Includes storage, insurance, taxes, spoilage, and opportunity cost of tied-up funds.
  • Just in Time (JIT) Management:
    • Acquires inventory precisely when needed, minimizing carrying costs.
    • Requires excellent coordination with suppliers and reliable demand forecasting.

Cash Management

  • Rationale for Holding Cash:
    • To address day-to-day operational needs.
    • To buffer against cash flow uncertainty.
    • To comply with banking requirements.

Cost of Trade Credit Calculation

  • Formula for Cost of Trade Credit:
    • extCost=extDiscountAmountextAmountafterDiscount365extMaxDays−extDiscountDaysext{Cost} = \frac{ ext{Discount Amount}}{ ext{Amount after Discount}}^{\frac{365}{ ext{Max Days} - ext{Discount Days}}}
    • For an example, calculating a trade credit with terms 2/98 for 60 days results in an interest cost of 15.9%.

Final Recommendations in Trade vs. Cash Payments

  • Assess Payment Timing:
    • If borrowing rate is lower than trade credit cost (e.g., 13%), opt for borrowing to settle early discounts.
    • Otherwise, utilize trade credit until the due date.