Chapter 17

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Chapter 14
McGraw-Hill/Irwin
Working Capital
Management and Policies
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
1
Revisiting the Balance Sheet Model of
the Firm
• Current assets
– Most liquid
– Less profitable than fixed assets
– Represent net amount firm has to fund
14-2
Revisiting the
Balance Sheet Model
• Net working capital =
Current Assets – Current Liabilities
– Firm’s objective is to fund the least amount of net
working capital possible
14-3
Tracing Cash and
Net Working Capital
• Operating Cycle is the time needed to
– Acquire raw materials and turn into finished goods
– Sell and receive payment for them
14-4
Operating Cycle
14-5
Cash Cycle
• Portion of operating cycle firm must finance
• Time between payment for inventory and sales
receipts
14-6
Short Term Financial Policy
• Firms reduce net working capital needs
– Manage need for current assets
– Obtain current liabilities to fund current assets
14-7
Size of Current Assets Investment
Two categories of carrying costs:
1) Opportunity costs with capital tied up in current
assets
2) Explicit costs to maintain value of current assets
14-8
Financing Terms Consider Asset
Demand Peaks and Valleys
14-9
Alternative Financial Policies for
Current Assets
• Flexible financing policy
• Restrictive financing policy
• Compromise financing policy
14-10
Flexible Financing
Long-Term Debt for Peak Asset Demand
14-11
Restrictive Financing:
Long-Term Debt/Equity for Trough Asset Demand
14-12
Compromise Financing
Seasonal Average Asset Demand Financed with
Long-Term Debt/Equity
14-13
Short-Term Financial Plans
• Firms not using flexible financing will need to
seek short-term solutions
– Unsecured loans
– Secured loans
– Other short-term financing alternatives
14-14
Unsecured Loans
• Commercial loan from bank
– Usually a line of credit
– Fees can be explicit and implicit
14-15
Secured Loans
• Asset-based loans
– Lenders charge lower interest rates
– Real estate, accounts receivable, inventory used as
collateral
14-16
Other Financing Sources
• Commercial paper
• Banker’s acceptances
14-17
Cash Management
• Clarification on terminology cash flow vs. cash
account
– Cash flows are good
– Cash account is a current asset with high liquidity
and low profitability
14-18
Reasons for Holding Cash
• Transaction facilitation
• Compensating balances
• Investment opportunities
14-19
Baumol Model
• Strength: Minimizes sum of opportunity costs
and trading costs
• Weakness: Unrealistic assumptions
14-20
The Miller-Orr Model
• Assumes daily net cash flows normally
distributed
• Allows for cash inflows and outflows
14-21
Other Factors Influencing Target
Cash Balance
• Short-term borrowing for unexpected cash
demands
• Declining trading costs
• Firm requirement to maintain compensating
balances
14-22
Float Control: Collection and
Disbursement of Cash
Float – the period of time after check is written
but not yet cleared and deposited
14-23
Float Control
• Three types of collection float
– Mail
– In-house processing
– Availability
14-24
Delaying Disbursements
Legal ways to increase disbursement float
– Zero-balance account
– Drafts
14-25
Ethical and Legal Questions
Illegal practices
– Using collected cash before receiving it
– Continuing to use disbursed cash after check sent
– Check kiting is drawing money against account
with insufficient funds
14-26
Investing Idle Cash
• Most large firms invest in their own
marketable securities
• Smaller firms invest in money-market fund or
bank sweep account
14-27
Why Firms Have Excess Cash
• Seasonal fluctuations
• Preparation for a planned expenditure
14-28
What to Do with Surplus Cash
• Appropriate investments
–
–
–
–
–
–
Treasury bills
Federal Funds
Repurchase agreements
Commercial paper
Negotiable CDs
Banker’s acceptances
14-29
Credit Management
Trade-off between the opportunity cost of lost
sales, and the carrying costs of funding
Accounts Receivable (AR) plus the expected
costs of default on AR
14-30
Credit Policy: Terms of the Sale
Credit terms include
– Credit period
– Cash discount
– Description of the type of credit instrument
14-31
Credit Analysis
• Determination of the borrower’s ability and
willingness to pay
• 5 C’s of credit:
1.
2.
3.
4.
5.
Capacity
Character
Capital
Collateral
Conditions
14-32
Collection Policy
• Collecting past-due accounts from customers
• Typical procedure
– Send delinquency letters
– Initiate telephone calls
– Employ collection agency
– Legal action against the customer
14-33
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