Management & Financing of Working Capital Koray Erdoğan FIN603 Okan University 21.04.2012 What Is Working Capital ? • Working capital typically means the available current or shortterm assets of a firm such as cash, receivables, inventory and marketable securities that are used to finance its day-to-day operations. • These items are also referred to as «circulating capital». • Corporate executives devote a considerable amount of attention to the management of working capital. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. Working Capital Formula • Gross working capital = Current assets • Gross Working Capital (GWC) represents investment in current assets • (Net) working capital = Current assets – Current liabilities Example Company Balance Sheet December 31, 2010 ASSETS Current Assets Cash Petty Cash Temporary Investments Accounts Receivable - net Inventory Supplies Prepaid Insurance Total Current Assets Investments Property, Plant & Equipment Land Land Improvements Buildings Equipment Less: Accum Depreciation Prop, Plant & Equip - net Intangible Assets Goodwill Trade Names Total Intangible Assets Other Assets Total Assets $ 2,100 100 10,000 40,500 31,000 3,800 1,500 89,000 36,000 5,500 6,500 180,000 201,000 (56,000) 337,000 105,000 200,000 305,000 LIABILITIES Current Liabilities Notes Payable Accounts Payable Wages Payable Interest Payable Taxes Payable Warranty Liability Unearned Revenues Total Current Liabilities $ 5,000 35,900 8,500 2,900 6,100 1,100 1,500 61,000 Long-term Liabilities Notes Payable Bonds Payable Total Long-term Liabilities 20,000 400,000 420,000 Total Liabilities 481,000 STOCKHOLDERS' EQUITY Common Stock Retained Earnings Less: Treasury Stock Total Stockholders' Equity 110,000 229,000 (50,000) 289,000 Total Liab. & Stockholders' Equity $770,000 3,000 $770,000 The notes to the sample balance sheet have been omitted. Working Capital Management • Decisions relating to working capital and short term financing are referred to as working capital management. Short term financial management is concerned with decisions regarding to CA and CL. • Management of Working Capital refers to management of CA as well as CL. • If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. • These involve managing the relationship between a firm's shortterm assets and its short-term liabilities. Working Capital Management An increase in working capital indicates that the business has either increased current assets (that is received cash, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors. The fundamental principles of working capital management are reducing the capital employed and improving efficiency in the areas of receivables, inventories, and payables. Working Capital Management • The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. • Businesses face ever increasing pressure on costs and financing requirements as a result of intensified competition on globalized markets. When trying to attain greater efficiency, it is important not to focus exclusively on income and expense items, but to also take into account the capital structure, whose improvement can free up valuable financial resources Working Capital Management • Active working capital management is an extremely effective way to increase enterprise value. Optimising working capital results in a rapid release of liquid resources and contributes to an improvement in free cash flow and to a permanent reduction in inventory and capital costs, thereby increasing liquidity for strategic investment and debt reduction. Process optimisation then helps increase profitability. • Involves trade-offs between easier operation and cost of carrying short-term assets • Benefit of low working capital • Money otherwise tied up in current assets can be invested in activities that generate higher payoff • Reduces need for costly financing • Cost of low working capital • Risk of shortages in cash, inventory © 2006 by Nelson, a division of Thomson Canada Limited • To run firm efficiently with as little money as possible tied up in Working Capital 9 Objective of Working Capital Management Working Capital Trade-offs Inventory High Levels Benefit: • Happy customers • Few production delays (always have needed parts on hand) Cost: • Expensive • High storage costs • Risk of obsolescence Cash High Levels Benefit: • Reduces risk Cost: • Increases financing costs Low Levels Cost: • Shortages • Dissatisfied customers Benefit: • Low storage costs • Less risk of obsolescence Low Levels Benefit: • Reduces financing costs Cost: • Increases risk Working Capital Trade-offs Accounts Receivable High Levels (favorable credit terms) Benefit: • Happy customers • High sales Cost: • Expensive • High collection costs • Increases financing costs Low Levels (unfavorable terms) Cost: • Dissatisfied customers • Lower Sales Benefit: • Less expensive Accounts Payable and Accruals High Levels Benefit: • Reduces need for external finance--using a spontaneous financing source Cost: • Unhappy suppliers Low Levels Benefit: • Happy suppliers/employees Cost: • Not using a spontaneous financing source Need for Working Capital • As profits earned depend upon magnitude of sales and they do not convert into cash instantly, thus there is a need for working capital in the form of CA so as to deal with the problem arising from lack of immediate realization of cash against goods sold. • This is referred to as “Operating or Cash Cycle” . • It is defined as «The continuing flow from cash to suppliers, to inventory , to accounts receivable & back into cash». Need for Working Capital • Therefore needs for working capital arises from cash or operating cycle of a firm. • Which refers to length of time required to complete the sequence of events. • Thus operating cycle creates the need for working capital. Its length in terms of time span required to complete the cycle is the major determinant of the firm’s working capital needs. • Which then becomes product for sale • Eventually this will turn into cash again • Firm’s operating cycle is time from acquisition of inventory until cash is collected from product sales © 2006 by Nelson, a division of Thomson Canada Limited • Firm begins with cash which then becomes inventory and labour 14 The Cash Conversion Cycle (Operating Cycle) The Cash Conversion Cycle (Operating Cycle) Product is converted into cash, which is transformed into more product, creating the cash conversion cycle. Time Line Representation of the Cash Conversion Cycle Equity Capital vs Debt Capital DEBT CAPITAL EQUITY CAPITAL Equity Capital vs Debt Capital Operating cycle with borrowed money Cash is borrowed from banks Cash is used to buy raw materials Raw materials become products and services Products and services become trade receivables Receivables become cash again Raw Materials Banks Finished Goods Cash Accounts Receivable Time & Money Concepts in Operating Cycle • Each component of working capital (namely inventory, receivables and payables) has two dimensions ........TIME ......... and MONEY, when it comes to managing working capital. • You can get money to move faster around the cycle or reduce the amount of money tied up. Then, business will generate more cash or it will need to borrow less money to fund working capital. • As a consequence, you could reduce the cost of bank interest or you'll have additional free money available to support additional sales growth or investment. • Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit, you effectively create free finance to help fund future sales. If you Then ...... Collect receivables (debtors) faster You release cash from the cycle Collect receivables (debtors) slower Your receivables soak up cash Get better credit (in terms of duration or amount) from suppliers Shift inventory (stocks) faster You increase resources Move inventory slower You consume more cash (stocks) your You free up cash cash Working Capital Management means Cash Management While a company has usually a quite stable level of Fixed Assets (buildings, machines…) the level of Inventories, Receivables and Payables is volatile and has sometimes a typical seasonal pattern. Invested Capital Fixed Assets Financing Equity Provisions Working Capital levels shrink and expand. Working Capital The only way to flexibly finance the WC cycle is to adjust the Net Debt. Conclusion: Rising Working Capital sucks out cash from the company ! Lowering Working Capital frees up cash for the company ! Net Debt (Financial Position) Management Of Cash Importance of Cash When planning the short or long-term funding requirements of a business, it is more important to forecast the likely cash requirements than to project profitability etc. Bear in mind that more businesses fail for lack of cash than for want of profit. Cash vs Profit Sales and costs and, therefore, profits do not necessarily coincide with their associated cash inflows and outflows. The net result is that cash receipts often lag cash payments and while profits may be reported, the business may experience a short-term cash shortfall. For this reason it is essential to forecast cash flows as well as project likely profits. Calculating Cash Flows A projection should be made about whether to expect a cumulative positive net cash flow over several periods or, conversely, a cumulative negative cash flow. Cash flow planning entails forecasting and tabulating all significant cash inflows relating to sales, new loans, interest received etc., and then analyzing in detail the timing of expected payments relating to suppliers, wages, other expenses, capital expenditure, loan repayments, dividends, tax, interest payments etc. Income Statement: Month 1 Sales ($000) 75 Costs ($000) 65 Profit ($000) 10 CFs relating to Month 1: Amount in ($000) Month 1 Month 2 Month 3 Total Receipts from sales 20 35 20 75 Payments to suppliers etc. 40 20 5 65 Net cash flow (20) 15 15 10 (20) (5) 10 10 Cumulative net cash flow MANAGING CASH FLOWS After estimating cash flows, efforts should be made to adhere to the estimates of receipts and payments of cash. Cash Management will be successful only if cash collections are accelerated and cash payments (disbursements), as far as possible, are delayed. MANAGING CASH FLOWS Methods of ACCELERATING CASH INFLOWS • Prompt payment from customers (Debtors) • Quick conversion of payment into cash • Decentralized collections • Lock Box System (collecting centers at different locations) Methods of DECELERATING CASH OUTFLOWS • Paying on the last date • Payment through Cheques and Drafts • Adjusting Payroll Funds (Reducing frequency of payments) • Centralization of Payments • Inter-bank transfers • Making use of Float (Difference between balance in Bank Pass Book and Bank Column of Cash Book) FACTORS DETERMINING WORKING CAPITAL 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Nature of the Industry Demand of Industry Cash requirements Nature of the Business Manufacturing time Volume of Sales Terms of Purchase and Sales Inventory Turnover Business Turnover Business Cycle Current Assets requirements Production Cycle contd… Working Capital Determinants (Continued…) 13. 14. 15. 16. 17. 18. 19. 20. 21. Credit control Inflation or price level changes Profit planning and control Repayment ability Cash reserves Operation efficiency Changes in technology Firm’s finance and dividend policy Attitude towards risk Working Capital Needs of Different Firms Permanent and Temporary Working Capital • Working capital is permanent to the extent that it supports constant or minimum level of sales • There is always a minimum level of CA which is continuously required by a firm to carry on its business operations. • Therefore , the minimum level of investment in CA that is required to continue the business without interruption is referred as permanent working capital. Permanent and Temporary Working Capital • Temporary working capital supports seasonal peaks in business • This is the amount of investment required to take care of fluctuations in business activity or needed to meet fluctuations in demand consequent upon changes in production and sales as a result of seasonal changes. DISTINCTION • Permanent is stable over time whereas variable is fluctuating according to seasonal demands. • Investment in permanent portion can be predicted with some profitability but investment in variable can not be predicted easily. • While permanent reflects the need for a certain irreducible level of current assets on a continuous and uninterrupted basis, the temporary portion is needed to meet seasonal and other temporary requirements. • Also, permanent capital requirements should be financed from L-T sources, but, S-T funds should be used to finance temporary working capital needs of a firm. Financing Net Working Capital According to «maturity matching» principle; Maturity (due date) of financing should roughly match duration (life) of asset being financed • Then financing /asset combination becomes self-liquidating • Cash inflows from asset can be used to pay off loan Therefore; • Temporary (seasonal) should be financed with short-term borrowing • Permanent working capital should be financed with long-term sources, such as long-term debt and/or equity Working Capital Financing Policies Working Capital Financing Policies Short-Term vs. Long-Term Financing • The mix of short- or long-term working capital financing is a matter of policy • Use of long-term funds is a conservative policy • Use of short-term funds is an aggressive policy • Short-term financing • Cheap but risky • Cheap—short-term rates generally lower than long-term rates • Risky—because you are continually entering marketplace to borrow • Borrower will face changing conditions (ex; higher interest rates and tight money) Short-Term vs. Long-Term Financing • Long-term financing • Safe but expensive • Safe—you can secure the required capital • Expensive—long-term rates generally higher than short-term rates • Firm must set policy on following issues: • How much working capital is used • Extent to which working capital is supported by short- vs. longterm financing • How each component of working capital is managed • The nature/source of any short-term financing used Short-Term Financing • Spontaneous Financing • Negotiated Financing • Factoring Accounts Receivable • Composition of Short-Term Financing Spontaneous Financing • Accounts Payable (Trade Credit from Suppliers) • Accrued Expenses Trade Credit -- credit granted from one business to another Spontaneous Financing Examples of trade credit are: • Open Accounts: the seller ships goods to the buyer with an invoice specifying goods shipped, total amount due, and terms of the sale. • Notes Payable: the buyer signs a note that evidences a debt to the seller. • Trade Acceptances: the seller draws a draft on the buyer that orders the buyer to pay the draft at some future time period. S-t-r-e-t-c-h-i-n-g Accounts Payable Postponing payment beyond the end of the net (credit) period is known as “stretching accounts payable” or “leaning on the trade.” Possible costs of “stretching accounts payable • Cost of the cash discount (if any) forgone • Late payment penalties or interest • Deterioration in credit rating Who Bears the Cost of Funds for Trade Credit? Suppliers -- when trade costs cannot be passed on to buyers because of price competition and demand. • Buyers -- when costs can be fully passed on through higher prices to the buyer by the seller. • Both -- when costs can partially be passed on to buyers by sellers. • Accrued Expenses Accrued Expenses -- Amounts owed but not yet paid for wages, taxes, interest, and dividends. The accrued expenses account is a short-term liability. • Wages -- Benefits accrue via no direct cash costs, but costs can develop by reduced employee morale and efficiency. • Taxes -- Benefits accrue until the due date, but costs of penalties and interest beyond the due date reduce the benefits. Negotiated Financing Types of negotiated financing: • Money Market Credit • Commercial Paper • Bankers’ Acceptances • Unsecured Loans* • Line of Credit • Revolving Credit Agreement • Transaction Loan * Secured versions of these three loans also exist. “Stand-Alone” Commercial Paper Commercial Paper -- Short-term, unsecured promissory notes, generally issued by large corporations (unsecured corporate IOUs). • Commercial paper market is composed of the (1) dealer and (2) direct-placement markets. • Advantage: Cheaper than a short-term business loan from a commercial bank. • Dealers require a line of credit to ensure that the commercial paper is paid off. “Bank-Supported” Commercial Paper A bank provides a letter of credit, for a fee, guaranteeing the investor that the company’s obligation will be paid. • Letter of credit (L/C) -- A promise from a third party (usually a bank) for payment in the event that certain conditions are met. It is frequently used to guarantee payment of an obligation. • Best for lesser-known firms to access lower cost funds. Bankers’ Acceptances Bankers’ Acceptances -- Short-term promissory trade notes for which a bank (by having “accepted” them) promises to pay the holder the face amount at maturity. • Used to facilitate foreign trade or the shipment of certain marketable goods. • Liquid market provides rates similar to commercial paper rates. Short-Term Business Loans Unsecured Loans -- A form of debt for money borrowed that is not backed by the pledge of specific assets. Secured Loans -- A form of debt for money borrowed in which specific assets have been pledged to guarantee payment. Unsecured Loans Line of Credit (with a bank) -- An informal arrangement between a bank and its customer specifying the maximum amount of credit the bank will permit the firm to owe at any one time. • • • One-year limit that is reviewed prior to renewal to determine if conditions necessitate a change. Credit line is based on the bank’s assessment of the creditworthiness and credit needs of the firm. “Cleanup” provision requires the firm to owe the bank nothing for a period of time. Unsecured Loans Revolving Credit Agreement -- A formal, legal commitment to extend credit up to some maximum amount over a stated period of time. • Firm receives revolving credit by paying a commitment fee on any unused portion of the maximum amount of credit. • Commitment fee -- A fee charged by the lender for agreeing to hold credit available. • Agreements frequently extend beyond 1 year. Unsecured Loans Transaction Loan -- A loan agreement that meets the short-term funds needs of the firm for a single, specific purpose. • • Each request is handled as a separate transaction by the bank, and project loan determination is based on the cash-flow ability of the borrower. The loan is paid off at the completion of the project by the firm from resulting cash flows. Secured (or Asset-Based) Loans Security (collateral) -- Asset (s) pledged by a borrower to ensure repayment of a loan. If the borrower defaults, the lender may sell the security to pay off the loan. Collateral value depends on: • Marketability • Life • Riskiness Accounts-Receivable-Backed Loans One of the most liquid asset accounts. Loans by commercial banks or finance companies (banks offer lower interest rates). Loan evaluations are made on: • Quality: not all individual accounts have to be accepted (may reject on aging). • Size: small accounts may be rejected as being too costly (per dollar of loan) to handle by the institution. Accounts-Receivable-Backed Loans Types of receivable loan arrangements: Nonnotification -- firm customers are not notified that their accounts have been pledged to the lender. The firm forwards all payments from pledged accounts to the lender. Notification -- firm customers are notified that their accounts have been pledged to the lender and remittances are made directly to the lending institution. Inventory-Backed Loans Relatively liquid asset accounts Loan evaluations are made on: • Marketability • Perishability • Price stability • Difficulty and expense of selling for loan satisfaction • Cash-flow ability Types of Inventory-Backed Loans Floating Lien -- A general, or blanket, lien against a group of assets, such as inventory or receivables, without the assets being specifically identified. Chattel Mortgage -- A lien on specifically identified personal property (assets other than real estate) backing a loan. Types of Inventory-Backed Loans Trust Receipt -- A security device acknowledging that the borrower holds specifically identified inventory and proceeds from its sale in trust for the lender. Terminal Warehouse Receipt -- A receipt for the deposit of goods in a public warehouse that a lender holds as collateral for a loan. Types of Inventory-Backed Loans Field Warehouse Receipt -- A receipt for goods segregated and stored on the borrower’s premises (but under the control of an independent warehousing company) that a lender holds as collateral for a loan. Factoring Accounts Receivable Factoring -- The selling of receivables to a financial institution, the factor, usually “without recourse.” • Factor is often a subsidiary of a bank holding company. • Factor maintains a credit department and performs credit checks on accounts. • Allows firm to eliminate their credit department and the associated costs. • Contracts are usually for 1 year, but are renewable. Composition of Short-Term Financing The best mix of short-term financing depends on: • • • • • Cost of the financing method Availability of funds Timing Flexibility Degree to which the assets are encumbered Raising Long Term Finance • Initial Public Offering (IPO) • Secondary Public Offering • Rights Issue • Obtaining a Term Loan • Debentures • Private Placement • Leasing • Venture Capital or Private Equity transactions Term Loans • Provided by banks or financial institutions • Can be in domestic or foreign currency • Are typically secured against fixed assets or hypothecation of movable properties, prime security or collateral security • Carrying definite obligations on interest and principal repayment; interest is paid periodically; based on credit risk and also based on a floor rate • Have restrictive covenants for future financial and operational decisions of the company, its management, future fund raising and projects Term Loans • • • • • • Pros Interest on debt is tax deductible Does not result in dilution of control Do not partake in value created by the firm Issue costs of debt is lower Interest cost is normally fixed, protection against high unexpected inflation Has a disciplining effect on management • • • • Cons Entails fixed obligation for interest and principal, non payment can even lead to bankruptcy and legal action Debt contracts impose restrictions on firm’s financial and operational flexibility Increases financial leverage, excess raises cost of equity to the firm If inflation rate dips, cost of debt higher than expected Debentures • Like promissory notes, are instruments for raising Long Term debt • More flexible compared to term loans as they offer variety of choices with regards to maturity, interest rate, security, repayment and other special features • Interest rate can be fixed or floating • Warrants : Can have warrants attached, detachable or non detachable, detachable traded separately • Option : Can be with call or put option • Redemption: Bullet payment or redeemed in installments • Security: Secured or unsecured • Credit rating: Need to have a credit rating by a credit rating agency • Trustee: Need to appoint a trustee to ensure fulfillment of contractual obligations by company Leasing vs. Hire Purchase • • • • • • • Leasing Ownership not transferred to lessee Depreciation benefit to lessor Magnitude of funds are high for big volume items No margin money or down payment required Maintenance of asset by lessor in operating lease Tax benefits of depreciation taken by lessor; lessee gets tax shield on lease rentals Considered off balance sheet mode of financing, as no asset or liability figures in balance sheet • • • • • • • Hire-Purchase Ownership transferred to hirer on payment of all installments Depreciation shield available to hirer Maybe for smaller value capital goods Some down payment required Maintenance cost borne by hirer Hirer allowed depreciation claim and finance charge for taxation; seller may claim interest on amount borrowed to acquire asset Asset figures in balance sheet on complete of purchase Initial Public Offering • • • • • • Pros Access to larger amount of funds Further growth limited companies not using this route Listing: provides exit route to promoters; ensures marketability of existing shares Recognition in market Stock prices provide useful indicators to management Sometimes stipulated by private investors in the company • • • • • • Cons Pricing may have to be attractive to lure investors Loss of flexibility Higher accountability More disclosure requirements to be met Visibility in market Cost of making a public issue quite high Rights Issue • Issue of capital to existing shareholders • Offer made on a pro rata basis • Offer document called Letter of Offer • Option given to apply for additional shares • Rights renunciation: are tradable, may be sold off in the market • Comparison with Public issue: with familiar investors, hence likely to be more successful, less floatation costs since no underwriting but lower pricing to benefit shareholders Private Placement Sale of securities directly to wholesale investors like financial institutions, banks, private equity funds, etc. • • • • • Pros Less expensive mode Easier to market the issue to a few investors Entry of wholesale financially sophisticated investors in company’s profile May use this route until IPO decision taken Less administrative maintenance • • • • Cons Does not qualify for listing in an unlisted company Restrictive covenants may be imposed by the investors May call for management participation Issue pricing more tight Venture Capital & Private Equity • Reasonably long to medium term commitment • Hands on management approach, active participation in management • Considered value add investor • Exit route to be defined at the time of investment • Restrictive clauses on promoters’ holding sell off and other financial & operational issues • Detailed memorandum on company, its financials to be prepared • Shareholders agreement to be signed by both parties • Valuation of Company key issue • Leads to dilution of control by existing promoters Thank You For Listening!