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!