20- 1 Fundamentals of Corporate Finance Chapter 20 Working Capital Management Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus Slides by Matthew Will McGraw McGraw Hill/Irwin Hill/Irwin Copyright ©Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved © 2009 by The McGraw-Hill Companies, Inc. All rights reserved 20- 2 Topics Covered Accounts Receivable and Credit Policy Inventory Management Cash Management Investing Idle Cash: The Money Market 20- 3 A/R and Credit Policy Credit Management Steps Establish terms of sale What form of IOU will you require? Perform a credit analysis Create a credit policy Develop a collection policy 20- 4 A/R and Credit Policy Trade Credit Bills awaiting payment from one company to another. Consumer Credit Bills awaiting payment from final customer to a company. Terms of Sale Credit, discount, and payment terms offered on a sale. 20- 5 Terms of Sale Example - 5/10 net 30 5 - percent discount for early payment 10 - number of days that the discount is available net 30 - number of days before payment is due 20- 6 Terms of Sale A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier. We can calculate the implicit cost of this loan Effective annual rate ( = 1 + ) discount discounted price 365 / extra days credit - 1 20- 7 Terms of Sale Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given? Effective annual rate 1+ 365/extra days credit discount discounted price 1 + 5 365/50 95 -1 - 1 = .454, or 45.4% 20- 8 Credit Agreements Terminology open account promissory note commercial draft sight draft time draft trade acceptance banker’s acceptance 20- 9 Credit Analysis Open Account - Agreement whereby sales are made with no formal debt contract. Credit Analysis - Procedure to determine the likelihood a customer will pay its bills. Credit agencies, such as Dun & Bradstreet provide reports on the credit worthiness of a potential customer. Financial ratios can be calculated to help determine a customer’s ability to pay its bills. 20- 10 Credit Analysis Numerical Credit Scoring categories The customer’s character The customer’s capacity to pay The customer’s capital The collateral provided by the customer The condition of the customer’s business 20- 11 Credit Analysis Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time. Altman Z Score formula Z = 3.3 EBIT sales market value of equity + 1.0 +.6 total assets total assets total book debt retained earnings working capital + 1.4 + 1.2 total assets total assets 20- 12 Credit Analysis Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client? EBIT .12 total assets retained earnings =.4 total assets sales 1.4 total assets working capital =.12 total assets market equity .9 book debt 20- 13 Credit Analysis Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client? Firm' s Z Score (3.3x.12) + (. 1 0x1.4) + (.6x.9) + (. 1 4 x.4) + (. 1 2 x.12) = 3.04 A score above 2.7 indicates good credit. 20- 14 Credit Analysis Credit analysis is only worth while if the expected savings exceed the cost. Don’t undertake a full credit analysis unless the order is big enough to justify it. Undertake a full credit analysis for the doubtful orders only. 20- 15 Return on Assets (%) Credit Analysis 10 5 0 Failing Firms -5 Non-failinf Firms -10 -15 -20 4 3 2 1 Years Before Bankruptcy 20- 16 Total Liabilities as a Percentage of Assets Credit Analysis 100 90 80 70 60 Failing firms 50 Non-failing firms 40 30 20 10 0 4 3 2 Years Before Bankruptcy 1 20- 17 EBITDA as a Percentage of Total Liabilities Credit Analysis 40 35 30 25 20 Failing Firms 15 Non-failinf Firms 10 5 0 -5 -10 4 3 2 Years Before Bankruptcy 1 20- 18 The Credit Decision Credit Policy - Standards set to determine the amount and nature of credit to extend to customers. Credit Scoring – What your lender won’t tell tell you. Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default. Denying credit guarantees neither profit or loss. 20- 19 The Credit Decision The credit decision and its probable payoffs Customer pays = p Payoff = Rev - Cost Offer credit Customer defaults = 1-p Refuse credit Payoff = 0 Payoff = - Cost 20- 20 The Credit Decision Based on the probability of payoffs, the expected profit can be expressed as: p x PV(Rev - Cost) - (1 - p) x (PV(cost) The break even probability of collection is: PV(Cost) p = PV(Rev) 20- 21 The Credit Decision Things to Remember in the Credit Decision 1. 2. 3. Maximize profit Concentrate on the dangerous accounts Look beyond the immediate order 20- 22 Collection Policy Collection Policy - Procedures to collect and monitor receivables. Aging Schedule - Classification of accounts receivable by time outstanding. 20- 23 Collection Policy Sample aging schedule for accounts receivable Customer' s Less than More than 1 - 2 months 2 - 3 months Total Owed Name 1 month 3 months A 10,000 0 0 0 10,000 B 8,000 3,000 0 0 11,000 * * * * * * * * * * * * * * * * * * Z 5,000 4,000 6,000 15,000 30,000 Total $200,000 $40,000 $15,000 $43,000 $298,000 20- 24 Inventory Management Components of Inventory Raw materials Work in process Finished goods Goal = Minimize amount of cash tied up in inventory Tools used to minimize inventory Just-in-time Lean manufacturing 20- 25 Inventories As the firm increases its order size, the number of orders falls and therefore the order costs decline. However, an increase in order size also increases the average amount in inventory, so that the carrying cost of inventory rises. The trick is to strike a balance between these two costs. 20- 26 Inventory, thousands of units Managing Inventories Inventory 60 Average Inventory 30 0 3 6 Weeks 9 12 20- 27 Inventories Determination of optimal order size Inventory costs, dollars Total costs Carrying costs Total order costs Optimal order size Order size 20- 28 Inventories Economic Order Quantity - Order size that minimizes total inventory costs. Economic Order Size Q = 2 x sales x cost per order carrying cost 20- 29 Cash Cash does not pay interest Move money from cash accounts into short term securities “Sweep programs” MMDAs Concentration banking Lock-box system 20- 30 Cash How purchases are paid. Percentage of total by payment type for 2005. 100% Direct debits Credit transfers Credit/debit cards Checks 80% 60% 40% 20% USA UK Switzerland Sweden Netherlands Italy Germany France Canada 0% 20- 31 Cash Electronic Funds Transfer (EFT) Automated Clearinghouse (ACH) Fedwire CHIPS (Clearing House Interbank Payments System) 2005 CHIPS / Fedwire transaction volume = $1,000 trillion International cash management Compensating balances 20- 32 Float Time exists between the moment a check is written and the moment the funds are deposited in the recipient’s account. This time spread is called Float. Payment Float - Checks written by a company that have not yet cleared. Availability Float - Checks already deposited that have not yet cleared. 20- 33 Concentration Banking Concentration Banking System whereby customers make payments to a regional collection center, which then transfers funds to a principal bank. Lock-box System System whereby customers send payments to a post office box, and a local bank collects and processes checks. 20- 34 Concentration Banking Lock-box example A lock box receives 150 payments per day, with an average size of $1,200. The daily interest rate if .02% and the lock box saves 1.2 days in mailing time and .8 days in processing time. 20- 35 Concentration Banking Lock-box example A lock box receives 150 payments per day, with an average size of $1,200. The daily interest rate if .02% and the lock box saves 1.2 days in mailing time and .8 days in processing time. Reduced collection float 150 $1,200 (1.2 .8) $360,000 Perpetuity value of extra float earnings $360,000 per day .0002 $72/day ($72/day) 365days $26,280 $26,280 $360,000 .073 20- 36 Managing Float Payers attempt to create delays in the check clearing process. Recipients attempt to remove delays in the check clearing process. Sources of delay Time it takes to mail check Time for recipient to process check Time for bank to clear check 20- 37 Managing Float Availability float Payment float Check mailed Mail float Check received Processing float Check clears Cash available to recipient Check deposited Check clears Check charged to payer’s account 20- 38 Cash Balances Money Market - market for short term financial assets. Treasury bills commercial paper certificates of deposit repurchase agreements LIBOR 20- 39 Web Resources