Fundamentals
of Corporate
Finance
Third Canadian Edition
prepared by:
Sujata Madan
McGill University
Copyright © 2006 McGraw Hill Ryerson Limited
19-1
Chapter 19 Working Capital Management
and Short Term Planning
 Working Capital
 Links Between Long-Term and Short-Term
Financing
 Tracing Changes in Cash and Working Capital
 Cash Budgeting
 A Short-Term Financing Plan
 Sources of Short-Term Financing
 The Cost of Bank Loans
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19-2
Working Capital
 Terminology
 Net Working Capital: Current assets minus current
liabilities. Often called working capital.
 Cash Conversion Cycle: Period between firm’s
payment for materials and collection on its sales.
 Carrying Costs: Costs of maintaining current assets,
including opportunity cost of capital.
 Shortage Costs: Costs incurred from shortages in
current assets.
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19-3
Working Capital
 A Simple Cycle of Operations:
CASH
CASH
RECEIVABLES
RECEIVABLES
RAW MATERIALS
INVENTORY
FINISHED GOODS
INVENTORY
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Working Capital
 The Cash Conversion Cycle
Average Inventory
Inventory Period =
Annual Cost of Goods Sold/365
Accounts Receivable Period =
Accounts Payable Period =
Average A/R
Annual Sales/365
Average Accounts Payable
Annual Cost of Goods Sold/365
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19-5
Working Capital
 Example: Canadian non-financial enterprises
1. How long on average does it take Canadian non-financial
firms to produce and sell their product?
2. How long does it take to collect bills?
3. How long does it take to pay bills?
4. What is the cash conversion cycle?
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Working Capital
 Example: Canadian non-financial enterprises
Inventory Period =
=
=
Average Inventory
Annual Cost of Goods Sold/365
(218,896+222,513)/2
2,104,620/365
38.3 days
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19-7
Working Capital
 Example: Canadian non-financial enterprises
Receivables Period =
=
=
Average Accounts Receivable
Annual Sales/365
(264,622+264,733)/2
2,144,891/365
45.1 days
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19-8
Working Capital
 Example: Canadian non-financial enterprises
Payables Period =
=
=
Average Accounts Payable
Annual Cost of Goods Sold/365
(318,058+325,240)/2
2,104,620/365
55.8 days
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19-9
Working Capital
 Example: Canadian non-financial enterprises
Cash Conversion Cycle = Inventory Period
+ Receivables Period
- Accounts Payable Period
=
38.3 + 45.1 - 55.8
=
27.6 days
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19-10
Working Capital
The Working Capital Trade-Off
 Working capital can be managed.
 There are costs and benefits associated with the
firm’s investment in working capital.
 Carrying costs
 Shortage costs
 An important job of the financial manager is to
find the level of current assets that minimizes
the sum of carrying costs and shortage costs.
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19-11
Links Between Long-Term and
Short-Term Financing
 Total Capital Requirement Trend
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19-12
Tracing Changes in Cash and
Working Capital
 Example: Dynamic Mattress Company
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19-13
Tracing Changes in Cash and
Working Capital
 Example: Dynamic Mattress Company
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19-14
Cash Budgeting
Creating a Cash Budget
1. Forecast the sources of cash.
2. Forecast the uses of cash.
3. Calculate whether the firm is facing a cash
shortage or surplus.
 The financial plan then sets out a strategy for
investing a cash surplus or for financing a deficit.
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19-15
Cash Budgeting
 Example: Dynamic Mattress
 The managers have forecasted that quarterly
sales for 2002 will be:
Quarter
Sales ($ millions)
1st
2nd
3rd
4th
87.5
78.5
116
131
 Assume 20% of each quarter’s sales are collected
in the next quarter.
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19-16
Cash Budgeting
 Example: Dynamic Mattress
 DMC’s collections on its sales would be as
follows:
1st
2nd
3rd
4th
Sales ($ millions)
80% collected now:
87.5
70.0
78.5
62.8
116
92.8
131
104.8
20% in next period:
15.0
17.5
15.7
23.2
Quarter
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19-17
Cash Budgeting
 Example: Dynamic Mattress
 Dynamic Mattress’s collections on accounts
receivables:
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Cash Budgeting
 Example: Dynamic Mattress
 Dynamic Mattress’s forecast uses of cash:




Payment of accounts payable
Labor, administration, and other expenses
Capital expenditures
Taxes, interest, and dividend payments
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19-19
Cash Budgeting
 Example: Dynamic Mattress
 Dynamic Mattress’s cash budget:
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19-20
Cash Budgeting
 Example: Dynamic Mattress
 Dynamic Mattress’s short-term financing
requirement:
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19-21
A Short-Term Financing Plan
 Example: Dynamic Mattress
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19-22
A Short-Term Financing Plan
 Evaluating the Plan
 Short-term financial plans are developed by
trial and error.
 You lay out one plan, and iterate on it with
different assumptions about the financing
and investment alternatives.
 You continue until you can think of no
further improvements.
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19-23
Sources of Short-Term Financing
 Alternative Sources of Financing
 Bank Loans
 A bank loan is an unsecured loan.
 A line of credit is an agreement by a bank that a
company may borrow at any time up to an
established limit.
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19-24
Sources of Short-Term Financing
 Alternative Sources of Financing
 Commercial Paper
 Commercial paper is a short-term unsecured
note issued by a firm.
 Commercial paper is issued by large, wellknown companies which regularly need to
borrow large amounts of cash.
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19-25
Sources of Short-Term Financing
 Alternative Sources of Financing
 Banker’s Acceptance
 A banker’s acceptance is a firm’s time draft
that has been accepted by a bank.
 This means the bank guarantees payment of
the amount stated on the draft when it
matures.
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19-26
Sources of Short-Term Financing
Alternative Sources of Financing
 Secured Loans
 Sometimes a company will offer assets as
security.
A/R financing
Inventory financing
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The Cost of Bank Loans
 Comparing Rates
Simple Interest
Annual Interest Rate
= Amount of Loan x
Number of Periods in the Year
Effective Annual Rate
EAR =
(
Quoted Annual Interest Rate
1+
m
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m
) -1
19-28
Summary of Chapter 19
 Short-term financial planning is concerned with
the management of the firm’s short-term or
current assets.
 The difference between current assets and
current liabilities is called net working capital.
 The cash conversion cycle is the length of time
between the firm’s payment for materials and
the date it gets paid by its customers.
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19-29
Summary of Chapter 19
 A firm’s short-term financial planning is
determined by the amount of long-term capital it
raises.
 The starting point for short-term financial planning
is forecasting the sources and uses of cash.
 Most firms take a middle of the road approach,
investing cash surpluses during part of the year
and borrowing during the rest of the year.
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19-30