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Working Capital Management: Analysis, Investment, and Policy Evaluation
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WORKING CAPITAL The undergraduate learning material covered in ManAcc 278 and ManAcc 378 is considered assumed knowledge for MAF 771 and is fully examinable. Financial distress → Business rescue Revision 1 Impact on SFP: ∆ Acc Rec ∆ Acc Pay ∆ Bank Impact on SFP: ∆ Acc rec ∆ Finished goods Impact on SFP: ∆ Raw materials ∆ WIP ∆ Finished goods Payments for nonoperating activities Impact on SFP: ∆ Acc pay ∆ Raw materials Inventory Accounts receivable Accounts payable Sales Cost of sales Raw materials days = RM/Purchases x 365 Work in progress days = WIP/COS x 365 Finished goods days = FG/COS x 365 Opening Closing Average 2 000 1 600 750 3 000 2 000 1 000 2 500 1 800 875 11 500 8 200 4 Use C/B if no info given for O/B Purchases = COS + CI – OI = 8 200 + 3 000 – 2 000 = 9 200 Inventory days = Inventory/CoS x 365 = 2 500/8 200 x 365 = 111.3 days Debtors’ days = Debtors/credit sales x 365 = 1 800/11 500 x 365 = 57.1 days Creditors’ days = Creditors/Purchases x 365 = 875/9 200 x 365 = 34.7 days Working capital cycle (or Operating cycle) = 111.3 + 57.1 = 168.4 days NWC cycle (or Cash cycle) = 111.3 + 57.1 - 34.7 = 168.4 – 34.7 = 133.7 days WORKING CAPITAL MANAGEMENT Inventory days 60 Debtors days 15 Operating cycle = 60 + 15 = 75 Days Creditors days 60 Net WC cycle (75-60 = 15) Financing required / Bridging finance WORKING CAPITAL MANAGEMENT To optimiseTopolicy decisions onworking current asset & its financing, decrease the net capitalinvestment (cash cycle), so that risk exposure is balanced by returns Less NWC Optimal NWC Risk of stock-out & lost sales The NWC cycle could be static year-to-year, disguising wild fluctuations in its underlying components. Always analyse debtors’ days, inventory days and creditors’ days separately. More NWC Cash flow risk WORKING CAPITAL MANAGEMENT When a business tries to do too much, too fast with too little financing Usually profitable, but negative cash from operations Rapid increase in turnover Equity funding, rights-issue or large loans incurred Rapid increase in current assets (inventory and debtors) Increase in proportion of assets funded by debt, trade creditors and overdrafts % Increase in debtors and inventory is larger than % increase in sales Decrease in proportion of assets funded by equity 8 WORKING CAPITAL INVESTMENT Determining the investment policy Find the level of working capital where return and risk are balanced ❑ The lower the current assets, the higher the ROA ❑ If working capital is too low, the risk of the enterprise increases Accounts receivable Collection policy too strict? Loss of sales; Increase in bad debts and outstanding amounts Inventory Stock-out situations? Loss of sales; Increase in inventory holding costs Cash Too little cash held on hand? Liquidity problem to meet obligations; Opportunity cost of foregoing investment opportunities WORKING CAPITAL INVESTMENT Determining the investment policy Conservative policy SOCI Sales Profit SFP Current assets Non-current assets Moderate policy Agressive policy 80 9 80 9 80 9 55 40 95 (20) 45 40 85 (20) 35 40 75 (20) Return on assets = 9 / 95 9.5% = 9 / 85 10.6% = 9 / 75 12.0% Current ratio = 55/20 2.75 = 45/20 2.25 =35/20 = 1.75 Current liabilities RISK WORKING CAPITAL INVESTMENT Accounts receivable preferences Why would a business prefer low ... Why would a business tolerate high ... • Cash sales to match perishable / non-returnable nature of product • To entice or retain customers • To stay competitive with others • Customer base known for nonpayment • To stay competitive with others • Cyclicality of sales, or expectation of upcoming higher demand • Lack of cash reserves • Cyclicality of sales, or expectation of upcoming lower demand • Sufficient cash reserves • Customer base is timeous with payments WORKING CAPITAL INVESTMENT Inventory preferences Why would a business prefer low ... Why would a business prefer high ... • Fear of obsolescence or perishability • Fear of running out of stock • Able to re-stock quickly • Production time is very fast (for business or suppliers) • Cyclicality of sales, or expectation of low upcoming demand • Expensive storage costs • Re-stock might take too long • Production time is very long • Cyclicality of sales, or expectation of high upcoming demand • Disruption in supply due to industrial action • Taking advantage of bulk discounts CHANGES IN WORKING CAPITAL INVESTMENT Evaluating a ΔWC investment Less NWC Current NWC Examples Generate cash (SFP) … but at what cost (SCI)? More NWC Generate return (SCI) ... but requires cash investment (SFP) • Introducing a JIT inventory system – less holding and storage costs, but a greater risk of a stock-out situation. • Stocking more inventory – higher sales volumes are possible, but cash is tied up in supplier payments and unsold inventory for longer • Imposing tighter credit terms – earlier and better debtor collection, but at a loss of customers who can’t pay according to the stricter terms • No longer offering early settlement discounts – no discounts to expense, but payment is received from customers much later. CHANGES IN WORKING CAPITAL INVESTMENT Evaluating a ΔWC investment How does one normally evaluate business actions or projects? 1• If evaluating a single proposal, based on the effect on profits Profit/loss 2• If comparing multiple proposal, by ranking the effect on profits per Return% Rand of resources Cost% 3• If evaluating a single proposal, based on the effect on company value NPV CHANGES IN WORKING CAPITAL INVESTMENT Evaluating a ΔWC investment Less NWC Current NWC Generate cash (SFP) … but at what cost (SCI)? 1• More NWC Generate return (SCI) ... but requires cash investment (SFP) If evaluating a single proposal, based on the effect on profits Profit/loss Cash generated x Return Opportunity elsewhere cost% Income Income Return on increase in NWC - Costs of reduction in NWC Costs utilised x Return Opportunity cost% - Cash elsewhere = Profit/loss on change = Profit/loss on change CHANGES IN WORKING CAPITAL INVESTMENT Evaluating a ΔWC investment Less NWC Current NWC Generate cash (SFP) … but at what cost (SCI)? 2• More NWC Generate return (SCI) ... but requires cash investment (SFP) If comparing multiple proposals, by ranking the effect on profits per Rand of resources Return% Cost% Costs of reduction in NWC Resources generated Cash generated % Returns on increase in NWC Resources Cash utilisedutilised % CHANGES IN WORKING CAPITAL INVESTMENT Evaluating a ΔWC investment •3 If evaluating a single proposal, based on the effect on company value NPV T=0 Return/costs on ΔNWC PV of costs/returns ΔNWCgenerated/utilised Cash xxx xxx xxx T=1 xx T=2 xx T=3 xx … xx xxx xxx xxx … NPV @ Opportunity cost% Discount perpetuity to present value using PV = CFperp r CHANGES IN WORKING CAPITAL INVESTMENT Evaluating a ΔWC investment Less NWC Current NWC Generate cash (SFP) … but at what cost (SCI)? More NWC Generate return (SCI) ... but requires cash investment (SFP) •3 If evaluating a single proposal, based on the effect on company value NPV PV of costs of decr in NWC Cash generated NPV @ Opportunity cost% T=0 (xxx) xxx xxx PV of returns on incr in NWC Cash invested T=0 xxx (xxx) Xxx NPV @ Opportunity cost% The more positive the NPV, the more attractive the proposed ΔNWC CHANGES IN WORKING CAPITAL INVESTMENT Evaluating a Δ credit policy ∆ GGross profit This calculation shows the profit effect of the change for only one year. However, a - ∆B Bad debts change in credit policy will impact profits - ∆D Settlement discounts for the foreseeable future (i.e. ΔNPV). - ∆ IOpportunity cost of carrying debtors ∆ PNet profit Incremental method Correia vs Gross method 10/30 net 60 More intuitive Allowed 60 days to settle, with 10% discount if settled within 30 days Evaluating Δ credit policy CHANGES IN WORKING CAPITAL INVESTMENT Example Current NWC More NWC Sales ? Bad debt ? Discount ? Total sales of R320m Gross profit margin of 20% WACC of 12% 5/15 net 30 Ignore tax 76% of sales are on credit 4% of total sales end in bad debts Collection takes approx. 25 days 60% of debtors settle early Generate return (SCI) ... but requires cash investment (SFP) Total sales of R350m Gross profit margin of 20% WACC of 12% 8/15 net 40 Ignore tax 85% of sales are on credit 2% of credit sales end in bad debts Collection takes approx. 22 days 75% of debtors settle early 20 ∆P = ∆G - ∆B - ∆D - ∆I Example ∆G = NEW – OLD = [20% x R350m] – [20% x R320m] = R70m – R64m = +R6 000 000 Gross profit incr, so profits incr ∆B = NEW - OLD = [R350m x 85% x 2%] – [R320m x 4%] = R5 950 000 – R12 800 000 = +R6 850 000 Bad debts decr, so profits incr ∆D = NEW – OLD = [R350m x 85% x 75% x 8%] – [R320m x 76% x 60% x 5%] = R17 850 000 – R7 296 000 = -R10 554 000 Discounts incr, so profits decr + R2 296 000 ∆I = Example Gross method: First angle ΔI = = R152 877 R1R3273 272973 877 X 12% R1 998 904 Incrincrease in debtors Net in debtors due to incr sales DecrIncreases in debtors opp due to timecosts effect Increase in debtors from new sales: = 22/365 x (change in sales) = 22/365 x (297.5m - 243,2m) = R3 272 877 Credit sales R297,5m More sales, more debtors Could’ve been invested for 22 days – increase in opportunity costs R243,2m Time effect: Existing debtors need to be carried for shorter 22 days Decrease in debtors from earlier payment: = (existing debtors) x (change in days) = 243,2m x (3)/365 = R1 998 904 25 Debtors days days Money from existing debtors can now be invested for 3 days – decrease in opportunity costs Example Gross method: Second angle ΔI = Incrincrease in debtors Net in debtors due to incr sales ΔI = Credit sales = R152 877 R1R3273 272973 877 X 12% R1 998 904 DecrIncreases in debtors opp due to timecosts effect ΔDebtors x Opportunity cost% R1 273 973 X 12% = R152 877 R297,5m More sales, more debtors NEW Debtors – OLD Debtors R243,2m Time effect: Existing debtors need to be carried for shorter 22 days NEW credit sales x NEW debtors’ days / 365 R350m x 85% x 22/365 = R17 931 507 OLD credit sales x OLD debtors’ days / 365 25 Debtors days days R320m x 76% x 25/365 = R16 657 534 Example Incremental method ΔI = = R74 R619 397301 X 12% R1 R2 618 998 328 904 Incrincrease in debtors Net in debtors due to incr sales DecrIncreases in debtors opp due to timecosts effect Increase in debtors from new sales: Credit sales = 22/365 x (change in sales) x CP of inv = 22/365 x (297.5m - 243,2m) X 80% R297,5m R243,2m More sales, requiring more inventory = R2 618 301 Cost price of extra inventory Time effect: Existing debtors need to be carried for shorter 22 days Decrease in debtors from earlier payment: = (existing debtors) x (change in days) = 243,2m x (3)/365 = (R1 998 904) 25 Debtors days days Decrease in debtors due to time effect 24 Refer to slide 19 - 21 (Gross method) ∆P = ∆G - ∆B - ∆D - ∆I ∆G = NEW – OLD = R70m – R64m = +R6 000 000 Example ∆B = NEW - OLD = R5 950 000 – R12 800 000 = +R6 850 000 ∆D = NEW – OLD = R17 850 000 – R7 296 000 = -R10 554 000 +R2 296 000 ∆I = -R152 877 ∆P = Gross method +R2 143 123 Opportunity costs increase, so profits decrease CHANGES IN WORKING CAPITAL INVESTMENT Evaluating a Δcredit policy Current NWC More NWC Example Generate return (SCI) ... but requires cash investment (SFP) 1• If evaluating a single proposal, based on the effect on profits Profit/loss Return Incomeon increase in NWC ∆G - ∆B - ∆D Opportunity cost% - -Cash elsewhere Costsutilised x Return - ∆Debtors x Opportunity cost% ∆I ==Profit/loss Profit/lossononchange change = ∆P + R2 296 000 - R152 877 = +R2 143 123 Slide 19 – 21 Gross method CHANGES IN WORKING CAPITAL INVESTMENT Evaluating a Δcredit policy Current NWC More NWC Example Generate return (SCI) ... but requires cash investment (SFP) 2• If comparing multiple proposals, by ranking the effect on profits per Return% Rand of resources Cost% Returns on increase in NWC Resources Cash utilisedutilised The higher the return% or lower the cost%, the better! % ∆G - ∆B - ∆D ∆Debtors % + R2 296 000 = 180,22 % + R1 273 973 Slide 19 – 21 Gross method CHANGES IN WORKING CAPITAL INVESTMENT Evaluating a Δcredit policy Current NWC More NWC Example Generate return (SCI) ... but requires cash investment (SFP) 3• If evaluating a single proposal, based on the effect on company value NPV T=0 Return/costs PV of returnson ΔNWC ΔNWCutilised Cash xxx xxx T=0 R19 133 333 (R1 273 973) R17 859 360 PV = CFperp r PV = R2 296 000 12% xxx NPV @ Opportunity cost% Slide 19 – 21 Gross method WHAT ABOUT TAX ?? ∆P = ∆G - ∆B - ∆D - ∆I Example ∆G = +R6 000 000 Additional sales – taxable? ∆B = +R6 850 000 Additional bad debts – tax deductible? ∆D = -R10 554 000 Less discount – effect on taxable income? +R2 296 000 ∆I = -R152 877 ∆P = +R2 143 123 Increase in taxable income – after tax (x 73% = 1 676 080) Opportunity cost – effect on taxable income? Rate used? 1) WACC – after tax rate 2) WC opportunity cost – assume after tax 3) Specific interest rate on bank account - ?? After tax profit = 1 676 080 – 152 877 (after tax: 12% WACC) = 1 523 203 28 WORKING CAPITAL FINANCING • Although all enterprises have a minimal level of working capital needed for daily operations (permanent current assets), actual levels may be higher by a ever-changing amount of fluctuating current assets. • Entities with seasonal/cyclical sales experience higher but fewer fluctuations. • Matching of financing terms to permanent/fluctuating current assets determines whether a financing policy is conservative, moderate or aggressive Why does the choice of short-term vs long-term financing even matter? term structure of assets and liabilities correspond ASSETS S-T financing Fluctuating current assets Permanent current assets L-T financing Fixed assets TIME portion of permanent current assets are funded with short-term financing ASSETS S-T financing Fluctuating current assets Permanent current assets L-T financing Fixed assets TIME portion of fluctuating current assets are funded with long-term financing ASSETS S-T financing Fluctuating current assets L-T financing Permanent current assets Fixed assets TIME WORKING CAPITAL Non-current FINANCINGassets ASSETS 20x1 20x2 20x3 150 xxx 190 Current assets 50 30 70 Equity 110 xxx 125 Non-current liabs 90 xxx 110 Current liabs - xxx 25 A portion of fluctuating current assets are funded by long-term financing – therefore it is a conservative financing policy 260 S-T financing 235 200 180 Fluctuating current assets Permanent current assets 220 L-T financing 190 150 Non-current assets 20x1 TIME 20x3 CASH MANAGEMENT Risk of holding too much cash Risk of holding too little cash • Has lower return than other growth investments – lowers company ROA • Lagging creditors, forfeiting early settlement discounts • Transaction costs from needing to liquidate investments • Urgent S-T borrowings carry higher interest rates Held as a precaution – against unpredictability Held for speculation – flexibility to act quickly Held for compliance – with laws and contracts Held to conduct transactions – operational needs 35 Why not keep too much cash? Low return = ROA is low What must be done with a surplus cash? Growth opportunities Invest short-term Back to shareholders Increase dividends Special dividend Share buy-back MANAGEMENT OF CASH SURPLUS • • • • Temporary in nature - term of maturity must be less than one year Liquidity/marketability – must be easy to convert back to cash Low default risk of counterparty Profitability – maximise returns within acceptable level of risk Negotiable certificates of deposit Commercial paper Treasury bill Government treasury bonds Fixed deposits / Money market deposits • Redeemable, tradeable government instruments issued at a discount every week for a 91/182/273/365 day term • Redeemable, tradeable bank deposits with pre-determined interest rate and term • Equivalent fixed deposits give better returns as non-redeemable and non-tradeable Formulae for S-T instruments Nominal rate Profits lost Profits gained or Cash inflow generated Cash outflow invested Cost% per period Effective rate Return% per period Profits lost or gained 1 + Cash generated or invested Cost or return per period 365 X Term of instrument Converts to equivalent annualised cost/return% 365 Term of instrument -1 Converts to effective annual cost/return Our business has some cash to temporarily invest for ± 3 months in T-bills, which are currently issued at a 6% discount to nominal Nominal rate Effective rate Profits lost Profits gained or Cash inflow generated Cash outflow invested X Term of instrument For every R94 spent today, we will get R100 back after 91 days = Profits lost or gained 365 R6 X 91 R94 1 + Cash generated or invested Our bank offers an effective rate of 40% on 30day fixed deposits - much better than the T-bills! 365 25,6021% p.a. 365 Term of instrument 1 + R6 R94 -1 365 91 -1 = 28,1693% p.a. MANAGEMENT OF CASH SHORTAGE Manage working capital (debtors, inventory & creditors) Improve other areas of business (cost-savings or incr revenue) Sell or saleandleaseback non-core assets Issue shares Decrease dividends Limit operational expansion Delay capital expenditure & replacements Defer loan payments Borrow from bank Use bank overdraft SHORT-TERM FINANCING • • • • • All types on p.12-25 to 12-33 Creditor financing Invoice discounting Factoring of debtors Bankers acceptance Letters of credit 40 Our supplier offers credit terms of 2/10 net 30. Either we grab the early settlement discount on Day 10, or we hang onto our cash as long as possible till Day 30 – it wouldn’t be wise to settle anytime in between! Nominal rate Profits lost Profits gained or Cash inflow generated Cash outflow invested The supplier is actually offering us 20 days’ financing at the cost of a forfeited discount Effective rate Profits lost or gained 1 + Cash generated or invested Our bank overdraft only costs an effective rate of only 22% per annum – much cheaper! 365 X Term of instrument 365 R2 X 20 R98 = 37,2449% p.a. 365 Term of instrument 1 + R2 R98 -1 365 20 -1 = 44,5853% p.a. 42 MANAGEMENT OF CASH SHORTAGE • Company sells individual invoices to a third-party buyer at a discount • Company receives cash upfront (although a lower amount), but is still responsible for debt collection • Invoices are usually sold with recourse, so the company retains the risk of bad debt and is liable to pay the buyer if the customer defaults Factoring is similar, but involves the entire debtors’ book (not individual invoices) MANAGEMENT OF CASH SHORTAGE • Factoring houses buy a selling company’s outstanding debtors’ book, usually at a discount (known as the retention%) and then handles debtor collection for their own benefit afterwards • If sold with recourse, the factoring house can claim bad debts back from the selling company • The selling company receives cash in advance and it may be charged a service fee (based on total sales) and/or interest (based on the cash advanced). Why would a company bother with factoring its debtors – it doesn’t seem cheap? MANAGEMENT OF CASH SHORTAGE 10% RETENTION INTEREST & FEES R1m Admin costs Settlement discounts Bad debt R1m R1m R1m R1m R4m R4,5m MANAGEMENT OF CASH SHORTAGE ∆ Fee expenses Because factoring reduces the investment in debtors, the thought ∆ Financing costs process of this calculation is very similar ∆ GAdmin costs to other changes in working capital - ∆ Bad B debts investment (e.g. changes in credit policy). - ∆ Settlement D discounts - ∆ Opportunity I cost of carrying debtors However, the impact of this change in working capital investment will only ∆ PNet cost of factoring persist for as long as the factoring contract is in effect. MANAGEMENT OF CASH SHORTAGE Evaluating factoring contracts Example Less NWC Generate cash (SFP) … but at what cost (SCI)? Current NWC Factoring costs 20% retention Factoring without recourse 75% of sales are on credit Usually 2/10 net 60 Service fee of 6,5% of turnover Cost savings of R80 000 Interest at 2,5% on cash advance 1,5% of credit sales are settled early 4% of credit sales end as bad debt Total expected sales of R40m Average collection period is 40 days WACC of 12% Example MANAGEMENT OF CASH SHORTAGE Evaluating factoring contracts Fee expenses Financing costs Admin cost saving Saving on bad debts Saving on discounts R2 600 000 R40m x 6,5% R65 753 R2 630 137 x 2,5% (R80 000) given (R1 200 000) R40m x 75% x 4% (R9 000) R40m x 75% x 1.5% x 2% Gross cost of factoring R1 376 753 Opp benefit of cash advance (R315 616) R2 630 137 x 12% Net cost of factoring R1 061 137 Cash advance R2 630 137 (R40m x 75% x 40/365) x 80% MANAGEMENT OF CASH SHORTAGE Evaluating factoring contracts Example Less NWC Current NWC Decreasing NWC frees up cash, but at the cost of factoring expenses •1 If evaluating a single proposal, based on the effect on profits Profit/loss Cash generated Opportunity elsewhere cost% Income x Return Cash advance x Opportunity cost% Costs - Costs- of reduction in NWC - Gross cost of factoring = Profit/loss on change = Profit/loss on change = ∆P R2 630 137 x 12% - R1 376 753 = -R1 061 137 MANAGEMENT OF CASH SHORTAGE Evaluating factoring contracts Example Less NWC Current NWC Decreasing NWC frees up cash, but at the cost of factoring expenses 2• If comparing multiple proposals, by ranking the effect on profits per Return% Rand of resources Cost% Costs of reduction in NWC Resources generated Cash generated Wow, this is much more expensive than my bank overdraft of 22%! % = = Gross cost of factoring Cash advance R1 376 753 R2 630 137 = 52,35% % MANAGEMENT OF CASH SHORTAGE A short-term credit facility offered by banks to borrowers for 90/180 days, which is financed by tradeable short-term instruments issued by the same banks to investors, at a discount to nominal value. Discounted Discounted Borrower Nominal Issuing bank Nominal Investor 51 Bankers’ acceptances (C12-29) • Borrower endorse BA at nominal amount, which implies ‘acceptance’ of debt obligations to repay nominal amount at maturity. • The repayment term is usually 90 or 180 days. • Lending bank accepts BA and pays nominal amount less discount (i.e. required amount of funding) to the borrower. • Cost of the BA = the discount (i.e. “cost price” less nominal amount) • BA’s are tradable in the money market. Bank approves credit facility for company. Company issues BA to bank at nominal amount. Bank signs acceptance and pays discounted amount to company Bank sells BA in secondary market at discounted amount Co Company uses money to purchase inventory Company pays nominal amount to bank at maturity Bank Bank pays nominal amount to investor at maturity Investor A major credit customer has asked my business for a payment extension. We agreed to maintain goodwill in the relationship, but now we’re struggling for cash. Our bank can offer us a 180 days BA at a 13.4% discount though. Nominal rate Profits lost Profits gained or Cash inflow generated Cash outflow invested Our bank is actually offering us 180 days’ financing at a cost of the discount forfeited Effective rate 365 R13,40 X 180 R86,60 Profits lost or gained 1 + Cash generated or invested Our bank overdraft only costs an effective rate of only 22% per annum – much cheaper! 365 X Term of instrument = 31,3767% p.a. 365 Term of instrument 1 + R13,40 R86,60 -1 365 180 -1 = 33,8751% p.a. MANAGEMENT OF CASH SHORTAGE A guarantee from the issuing bank that a buyer’s payment to a seller will be made on time and for the correct amount, when certain conditions are met Buyer’s bank (issuer) Seller’s bank (advising) Buyer Seller
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