Contemporary Financial Management
Chapter 15:
Working Capital Policy and Short
Term Financing
© 2004 by Nelson, a division of Thomson Canada Limited
Introduction
 This chapter deals with the management of
working capital, which involves decisions about
the optimal overall level of current assets and
the optimal mix of short-term funds used to
finance the company’s assets.
 It also deals with the financing of the current
assets that make up the working capital.
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© 2004 by Nelson, a division of Thomson Canada Limited
Working Capital
 Working capital is the firm’s total investment in
current assets
 Net working capital equals current assets minus
current liabilities
 Working capital represents assets that flow
through the firm
 Turned over at a rapid rate
 Usually recovered during the operating cycle when
inventory sells and receivables collected
 Working capital is needed because of the time lag
between cash disbursements and cash receipts
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Working Capital Policy
 Involves many decisions about a firm’s current
assets and current liabilities
 What they consist of
 How they are used
 How their mix affects the risk-return
characteristics of the company
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Operating Cycle
Sell
Finished Goods
on Credit
Purchase
Raw Materials
Pay for
Raw Materials
Operating Cycle
Inventory Conversion Period
Receivables Conversion Period
Payables Deferral Period
Cash Conversion Cycle
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© 2004 by Nelson, a division of Thomson Canada Limited
Collect
Receivables
Operating Cycle Analysis
Operating
=
Cycle
Inventory
Conversion
Period
Receivables
Conversion
Period
6
Inventory
Conversion
Period
=
=
+
Receivables
Conversion
Period
Average Inventory
Cost of Sales/ 365
Accounts Receivable
Annual Credit Sales/ 365
© 2004 by Nelson, a division of Thomson Canada Limited
Operating Cycle Analysis Continued
Payables
Deferral =
Period
Cash
Conversion
Cycle
7
Accounts
Payable
(
=
Salaries, Benefits
& Payroll Taxes
+
Payable
) /365
Cost of Selling, Gen,
–
Sales
Admin Exp
Operating
Cycle
© 2004 by Nelson, a division of Thomson Canada Limited
+
Payables
Deferral
Period
Size and Nature of Current Assets
 Depends on:
 Type of product manufactured or distributed
 Length of operating cycle
 Optimal amount of Inventory
 Optimal amount of safety stock
 Credit policies
 Efficiency of current asset management
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© 2004 by Nelson, a division of Thomson Canada Limited
Appropriate Level of Working Capital
 More conservative policies often result in lost
sales due to restrictive credit policies.
 Optimal level of working capital investment is
the level which is expected to maximize
shareholder wealth.
Conservative
Current Assets
Profitability
Risk
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More
Lower
Lower
© 2004 by Nelson, a division of Thomson Canada Limited
Aggressive
Less
Higher
Higher
Optimal Mix of ST and LT Debt
 Impact of term structure of interest rates
 Long rates usually higher than short rates
 Thus the interest cost of short-term debt
usually cheaper than long-term debt
 Borrower incurs higher risk with short term debt
 Must refinance frequently
 Short term interest rates are highly volatile
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© 2004 by Nelson, a division of Thomson Canada Limited
Profitability Versus Risk
 Need for financing equal to the sum of:
 Current assets
 Fixed assets
 Current assets may be:
 Permanent - Are not affected by seasonal or
cyclical demand
 Fluctuating - Are affected by seasonal or cyclical
demand
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Financing Strategies
 Matching
 Match the maturity of all assets & liabilities
 Reduces liquidity risk
 Hard to implement in practice
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Financing Strategies
 Conservative Approach
 High proportion of long term debt
 Less profitable, since LT debt usually more
expensive
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© 2004 by Nelson, a division of Thomson Canada Limited
Financing Strategies
 Aggressive Approach
 High proportion of short term debt
 More profitable (short term debt cheaper) but
also more risky
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An Optimal Financing Strategy?
 No one strategy is “right” for all firms
 The mix between ST and LT debt must also
consider:
 Industry norms
 Variability of sales
 Variability of cash flows
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© 2004 by Nelson, a division of Thomson Canada Limited
Cost of Short Term Credit
Simple interest
APR =
Interest + Fees
Usable funds

365
Maturity (Days)
Compound interest
EAR =
[1 +
Interest + fees
Usable funds
m
]
APR = Annual percentage rate
EAR = Equivalent annual return
m = number of compounding periods per year
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© 2004 by Nelson, a division of Thomson Canada Limited
–1
Sources of Short-Term Financing
 Trade credit
 Accrual expenses and deferred income
 Loans from commercial banks
 Commercial paper
 Borrowing against Account Receivables
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© 2004 by Nelson, a division of Thomson Canada Limited
Trade Credit
 Seller provides financing as part of the sales
inducement
 Spontaneous source of financing
 Cost of trade credit is captured in the purchase
price
 Trade credit is never free. The cost of foregoing
a cash discount is:
APR =
18
% discount
100% – % discount
© 2004 by Nelson, a division of Thomson Canada Limited

365
Credit – Disc period
Example: Cost of Foregoing a Discount
 A vendor offers a discount of 2% if payment is
made within ten days. If the discount is not
taken, full payment is due in 30 days. What is
the annual cost of not accepting the 2%
discount?
 Percentage Discount  

365
APR = 


 100 - %Discount   Credit Period - Discount Period 
2

  365 
= 


 100 - 2   30 - 10 
= 37.24%
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© 2004 by Nelson, a division of Thomson Canada Limited
Accrued Expenses & Deferred Income
 Any accrued but unpaid expense is a form of
short term financing
 Stretching payables extends the financing period
but can result in a poor credit rating
 Deferred income consists of payments received
for goods & services to be delivered in the future
 Are shown on the Balance Sheet as a liability
called Deferred Income
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© 2004 by Nelson, a division of Thomson Canada Limited
Short Term Bank Credit
 Single loans for specific financial needs
 Line of credit
 Agreement to borrow up to predetermined limit
at any time
 Revolving credit
 Legally commits the bank
 Usually secured
 Requires a commitment fee
Interest + Commitment
fee
costs
365
APR =

Maturity ( days )
Usable funds
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© 2004 by Nelson, a division of Thomson Canada Limited
Commercial Paper





Short-term unsecured promissory notes
Issued by large well-known corporations
Maturities from a few days to 9 months
Sold at a discount
Purchasers include corporations, banks,
insurance companies, pension funds, etc
Interest Placement
365
costs +
fee

APR =
Usable funds
Maturity ( days )
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Accounts Receivable Loans
 Receivables make excellent collateral:
 Fairly liquid
 Easy to recover in the event of default
 Problems with receivables includes:
 Subject to fraud
 High administrative costs
 Two common forms of receivables lending




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Pledging–Firm retains title
Factoring–Sale of A/R
With recourse
Without recourse
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Borrowing Against Inventory
 Inventory may make a good form of collateral,
depending on the following characteristics:




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Perishability
Identifiability
Marketability
Price stability
© 2004 by Nelson, a division of Thomson Canada Limited
Borrowing Against Inventory
 When lending against inventory, the lender must
decide who will hold the collateral (inventory)
 If borrower holds inventory, the lender may use:
 Floating lien: floating charge over all current
and future acquired inventory
 Trust receipt: inventory and sale proceeds are
held “in trust” for the lender
 A third party holds the inventory in a:
 Terminal warehouse: inventory is stored in a
bonded warehouse
 Field warehouse: secured inventory is
segregated on site and managed by a field
warehouse company
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Characteristics of Term Loans
 Granted by a bank or other lending institution
 Maturity – initial maturity of 1 to 10 years
 Less expensive than a public offering
 Repayment may include:
 Equal periodic payments of interest plus
principal (amortized)
 Equal principal payments plus interest on the
outstanding balance
 Periodic payments plus a large [balloon]
payment at the maturity date
 One large payment on the maturity date (bullet
payment)
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© 2004 by Nelson, a division of Thomson Canada Limited
Characteristics of Term Loans
 Interest rate varies, depending on:




General level of rates in the market
Size of the loan
Maturity of the loan
Borrower’s credit rating
 Interest may be charged as a:
 Fixed rate
 Variable rate (Prime plus ___%)
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© 2004 by Nelson, a division of Thomson Canada Limited
Characteristics of Term Loans
 Security Provisions
 Protect the lender in case of borrower default
 May include:
• Assignment of monies due under a contract
• Assignment of receivables or inventory
• Floating lien or debenture on firm assets
• Pledge of marketable securities
• Mortgage on fixed assets
• Assignment of the cash surrender value on a
life insurance policy
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© 2004 by Nelson, a division of Thomson Canada Limited
Characteristics of Term Loans
 Affirmative Covenants
 Things the borrower will do
• Provide periodic Financial statements
• Carry insurance
• Maintain minimum net working capital
 Negative Covenants
 Things the borrower will not do
• Not to pledge certain assets as security
• Not to merge or consolidate
• Not to make or guarantee loans to others
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© 2004 by Nelson, a division of Thomson Canada Limited
Sources of Term Loans





Banks
Insurance companies
Pension funds
Government agencies
Equipment suppliers
 Conditional sales contracts
 Chattel mortgages
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© 2004 by Nelson, a division of Thomson Canada Limited
Major Points
 Working capital consists of the current assets
carried on the Balance Sheet and the current
liabilities used to fund them.
 Current assets require an investment, similar to
that of a fixed asset.
 Current assets are low return; therefore the firm
wants to carry the minimum amount necessary.
 There are many forms of short-term funding
available, but each of them has a cost attached.
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© 2004 by Nelson, a division of Thomson Canada Limited