Working Capital Management
Chapter 10
Management of Cash and
Marketable Securities
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Firms hold cash balances in checking
accounts. Why?
1. Transaction motive: Firms maintain cash
balances to conduct normal business
transactions. For example,
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Payroll must be met
Supplies and inventory purchases must be paid
Trade discounts should be taken if financially
attractive
Other day-to-day expenses of being in business
must be met
Management of Cash and
Marketable Securities
2. Precautionary motive: Firms maintain
cash balances to meet precautionary
liquidity needs.
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Two major categories of liquidity needs:
1. To bridge the gaps between cash inflow and
cash outflow
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Recall Chapter 8: to predict these gaps, construct a
detailed cash budget
2. To meet unexpected emergencies
Management of Cash and
Marketable Securities
3. Speculative motive: Firms maintain
cash balances in order to “speculate” –
that is, to take advantage of
unanticipated business opportunities that
may come along from time to time.
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The nature of these opportunities may vary.
Management of Cash and
Marketable Securities
4. Firms using bank debt are required to
maintain a compensating balance with the
bank from which they have borrowed the
money.
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Compensating balance: when a bank makes a
loan to a firm, the bank requires this minimum
balance in a non-interest-earning checking account
equal to a specified percentage of the amount
borrowed
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Common arrangement is a compensating balance equal to
5-10% of amount of loan
Bankers maintain that existence of compensating balance
prevents firms from overextending cash flow position
because it forces them to maintain a reasonable minimum
cash balance.
Management of Cash and
Marketable Securities
• Compensating balance raises effective interest rate
on loan.
• Numerical example:
– Bank charges 14% interest on $250,000 loan but requires
$25,000 compensating balance.
– Loan amount available to borrowers is $225,000 ($250,000 $25,000), but interest is charged on $250,000.
– Monthly interest payment rate: 1.167% (14%/12 months)
– Monthly interest cost: $2,917.50 (0.01167 x $250,000)
– Effective monthly interest rate: 1.297% ($2,917.50/$225,000)
– Annual percentage rate: 15.56% (1.297 x 12 months)
Management of Cash and
Marketable Securities
• Marketable securities: short-term, high-quality
debt instruments that can be easily converted
into cash.
• In order of priority, three primary criteria for
selecting appropriate marketable securities to
meet firm’s anticipated short-term cash needs
(particularly those arising from precautionary
and speculative motives):
1. Safety
2. Liquidity
3. Yield
Management of Cash and
Marketable Securities
1. Safety
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Implies that there is negligible risk of default
of securities purchases
Implies that marketable securities will not be
subject to excessive market fluctuations due
to fluctuations in interest rates
Management of Cash and
Marketable Securities
2. Liquidity
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Requires that marketable securities can be sold
quickly and easily with no loss in principal value due
to inability to readily locate purchaser for securities
3. Yield
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Requires that the highest possible yield be earned
and is consistent with safety and liquidity criteria
Least important of three in structuring marketable
securities portfolio
Management of Cash and
Marketable Securities
• Safety, liquidity, and yield criteria severely restricts range
of securities acceptable as marketable securities.
• Most major corporations meet marketable securities
needs with U.S. Treasury bills or with corporate
commercial paper carrying highest credit rating.
– These securities are short-term, highly liquid, and have
reasonably high yields.
– Treasury bills are default-risk free.
– High-quality commercial paper carries miniscule default risk.
• Firms that have sought to achieve higher potential yields
via money market funds invested in asset-backed
securities have learned that those higher potential
yields carried higher risk.
Management of Cash and
Marketable Securities
Improving Cash Flow
• Actions firm may take to improve
cash flow pattern:
1. Attempt to synchronize cash inflows and
cash outflows
– Common among large corporations
– E.g. Firm bills customers on regular schedule
throughout month and also pays its own bills
according to a regular monthly schedule. This
enables firm to match cash receipts with cash
disbursements.
Management of Cash and
Marketable Securities
Improving Cash Flow
2. Expedite check-clearing process,
slow disbursements of cash, and
maximize use of “float” in corporate
checking accounts
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Three developments in financial services
industry have changed nature of cash
management process for corporate
treasurers
Management of Cash and
Marketable Securities
Improving Cash Flow
1. Impact of electronic funds transfer systems
(EFTS) and online banking
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Includes so-called “remote capture” technology for
quickly depositing checks without visiting a bank
branch
Radically reduced amount of time necessary to turn
customer’s check into available cash balance on
corporate books
Sharply reduced amount of float available, as
corporation’s own checks clear more rapidly
Management of Cash and
Marketable Securities
Improving Cash Flow
2. Expanded use of money market mutual
funds (as substitute for conventional checking
accounts)
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Funds sell shares at constant price of $1.00 per share
Proceeds of sales are invested in short-term money market
instruments
Interest earned is credited daily
Fluctuations in market values are credited/debited daily
Since large funds hold broadly diversified portfolio of shortterm securities, market-value fluctuations of overall portfolio
are normally small relative to interest earned
Checks written against money market funds continue to earn
interest until check clears fund. Available float is continually
earning interest for account.
Management of Cash and
Marketable Securities
Improving Cash Flow
3. Growth in cash management services
offered by commercial banks
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These systems efficiently handle firm’s cash
management needs at very competitive
price.
Accounts Receivable Management
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Accounts receivable management requires
balance between cost of extending credit
and benefit received from extending credit.
No universal optimization model to determine
credit policy for all firms since each firm has
unique operating characteristics that affect its
credit policy.
However, there are numerous general
techniques for credit management.
Accounts Receivable Management
• Industry conditions
– Manufacturing firms and wholesalers
generally extend credit terms
– Retailers commonly extend consumer credit,
either through store-sponsored charge plan or
acceptance of external credits cards
– Small retailers cannot afford cost of
maintaining credit department and thus do not
offer store-sponsored charge plans
Accounts Receivable Management
•
“Five Cs” of credit analysis” used to decide
whether or not to extend credit to particular customer:
1. Character: moral integrity of credit applicant and whether
borrower is likely to give his/her best efforts to honoring credit
obligation
2. Capacity: whether borrowing form has financial capacity to
meet required account payments
3. Capital: general financial condition of firm as judged by
analysis of financial statements
4. Collateral: existence of assets (i.e. inventory, accounts
receivable) that may be pledged by borrowing firm as security
for credit extended
5. Conditions: operating and financial condition of firm
Accounts Receivable Management
• Commercial credit services
– National credit services (e.g. Dun and
Bradstreet) provide credit reports on potential
new accounts that summarize firm’s financial
condition, past history, and other key
business information
– Local credit associations
Accounts Receivable Management
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Three types of cost:
1.
2.
3.
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Financing accounts receivable
Offering discounts
Bad-debt losses
Must analyze relationship of these costs to
profitability
– Marginal cost of credit must be compared to
expected marginal profit resulting from credit
terms
Accounts Receivable Management
Example
• Credit Policy A (see Exhibit 10.1)
– Credit terms: 2/10, net 60
– Average collection period: 50 days
– Expected sales: $75,000,000
– Income after tax: $8,700,000
– Return on sales: 11.6%
– Return on investment: 17.3%
– Return on equity: 34.4%
Accounts Receivable Management
Example (continued)
• Credit Policy B (see Exhibit 10.2) – preferable to
Policy A
– Tighter collection policy and shorter payment terms:
2/10, net 30
– Lower expected sales: $70,000,000
– Higher quality of accounts receivable and reduced
bad-debt losses
– Reduced interest expense since lower level of
financing for accounts receivable
– Reduced operating expenses: 15.7%  15.2%
– Increased return on sales: 11.9%
– Increased return on investment: 19.0%
– Increased return on equity: 37.3%
Accounts Receivable Management
• Supervising collection of accounts
receivable
– Requires close monitoring of average
collection period and aging schedule
– Aging schedule groups accounts by age and
then identified quantity of past due accounts
– Credit manager must develop some skills of
diplomacy: balance need to collect account
with need to maintain customer goodwill
(unless all efforts fail and account cannot pay)
Inventory Management
• Cost of maintaining inventory:
1. Carrying costs: all costs associated with carrying
inventory
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Storage, handling, loss in value due to obsolescence and
physical deterioration, taxes, insurance, financing
2. Ordering costs:
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Cost of placing orders for new inventory (fixed cost: same
dollar amount regardless of quantity ordered)
Cost of shipping and receiving new inventory (variable
cost: increase with increases in quantity ordered)
Inventory Management
• Total inventory maintenance costs
(carrying costs plus ordering costs) vary
inversely.
– Carrying costs increase with increases in average
inventory levels and therefore argue in favor of
low levels of inventory in order to hold these costs
down.
– Ordering costs decrease with increases in
average inventory levels and therefore firm wants
to carry high levels of inventory so that it does not
have to reorder inventory as often as it would if it
carried low levels of inventory.
Inventory Management
• Economic order quantity (EOQ) model:
mathematical model designed to
determine optimal level of average
inventory that firm should maintain to
minimize sum of carrying costs and
ordering costs (total cost inventory
maintenance cost)
– Explains inventory control problem
– EOQ = √2FS/CP
Inventory Management
• See Exhibit 10.3
• EOQ model determines equation of total
cost curve.
– Minimum point indicates optimal average
inventory.
– Optimal average inventory level dictates
how much inventory should be ordered on
each order to maintain average inventory
level.
Inventory Management
• Basic EOQ model assumes that inventory is used up
uniformly and that there are no delivery lags (inventory is
delivered instantaneously). Thus, two modifications:
1.
Establish reorder point that allows for delivery lead times.
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2.
Ex. If 2,700 units are ordered every 3 months and normal delivery
time is one month after order is placed, then EOQ should be
ordered when on-hand amount drops to 900 units.
Add quantity of safety stock to base average inventory
that allows for uncertainty of estimates used in model and
possibility of non-uniform usage.
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This added quantity is dependent on degree of uncertainty
of demand, cost of stockouts, level of carrying costs, and
probability of shipping delays
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Ex. Adequate level of safety stock is 500 units. Reorder
point would be increased to 1,400 units (900+500) and new
order would be placed each time on-hand quantity reached
1,400.
Inventory Management
Example: Widget Wholesalers, Inc.
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Widgets sold per year: 240,000
Cost price per widget: $2
Inventory carrying costs: 20% of average inventory level
Fixed cost of ordering: $30 per order
Solve EOQ = √(2FS/CP)
– EOQ = √(2)($30)(240,000)/(0.20)($2)
– Widget should order 6,000 units per order.
– If Widget allows ten-day supply as safety stock, then reorder
point would be at 6,575 units (10 days divided by 365 days times
240,000)
– At 6,000 units per order, Widget would place forty orders per
year (240,000/6,000)
Inventory Management
• EOQ model can be applied to current
asset management.
• EOQ can also be used to manage other
types of “inventories,” such as cash and
accounts receivable.
– Cost of maintaining these assets can be
divided into “ordering” and “carrying” costs,
and optimal assets levels can be determined.
Sources of Short-term
Financing
• Three major sources of short-term
financing:
1. Trade credit (accounts payable)
2. Commercial bank loans
3. Commercial paper
Sources of Short-term
Financing
1. Trade credit (“spontaneous financing”): form of “free”
financing in the sense that no explicit interest rate is
charged on outstanding accounts payable
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Accounts payable arise spontaneously during normal
course of business
Commercial firms buy inventory and supplies in open
account from their suppliers on whatever credit terms are
available rather than cash payments.
Two costs associated with trade credit:
1.
2.
Cost of missed discounts
Cost of financing outstanding accounts receivable (firm
offers trade credit) increases cost of doing business over
what it would be if firm sold on cash terms only.
Sources of Short-term
Financing
2. Commercial bank loans
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Employed to finance inventory and accounts
receivable
Used as source of funds to enable firm to take
discounts on accounts payable when cost of missed
discounts exceeds interest cost of bank debt
Sources of Short-term
Financing
2. Commercial bank loans (continued)
– Two possible structures:
1.
Note for a fixed period of time
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At end of note term (maturity date), face amount of note must be
repaid or note must be renewed (“rolled over”).
Bank and borrower may enter into formal/informal agreement to
renew note at maturity at specified rate, which is tied to prime
interest rate (rate charged to bank’s best corporate customers).
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Ex. Interest rate at prime plus some percentage over prime:
“prime plus 2%”
Size of premium above interest rate is determined by bank’s
assessment of risk involved in making loan
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Higher risk, higher premium
As prime rate changes, bank’s cost of obtaining funds changes, so
requiring firm to roll over its notes allows bank to change interest rate
on note.
Sources of Short-term
Financing
2. Commercial bank loans (continued)
– Two possible structures
2. Line of credit (“revolver”)
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Bank establishes upper limit on amount firm may
borrow and firm draws whatever money it needs
against credit line up to maximum.
Interest rate may be fixed or float with prime or LIBOR
rate.
Interest is charged only on amount actually borrowed,
not total amount available.
Sources of Short-term
Financing
2. Commercial bank loans (continued)
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Unsecured loan: “full faith and credit” obligation of
borrowing firm
– No specific assets are pledged as collateral for loan, but
bank has general claim against firm’s assets if firm
defaults on loan
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Secured loan: firm pledges specific asset as
collateral for loan (i.e. accounts receivable,
inventory)
– If firm defaults on loan, asset may be seized by bank and
liquidated to satisfy loan balance
– Any excess bank receives above amount of principal and
interest due on loan must be returned to borrower
Sources of Short-term
Financing
• 3. Commercial paper (recall Chapter 9):
short-term corporate IOU that is sold in
large dollar amounts through commercial
paper dealers
– Sold by large corporations
– Usually purchased by other corporations (as an outlet
for marketable securities) or by financial institutions
(i.e. banks, money market mutual funds)
– Not available means of financing for small business
organizations
Sources of Short-term
Financing
Financing Accounts Receivable
• Accounts receivable: used as collateral
for short-term loans
• Three methods of accounts receivable
financing:
1. Pledging
2. Assigning
3. Factoring
Sources of Short-term
Financing
Financing Accounts Receivable
1. Pledging
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Bank or other lender makes loan of some percentage of value of
receivables but does not take possession of them
Receivables merely serve as collateral in the event of default
If loan is not paid on time, bank has right to take possession of
receivables and collect amount necessary to satisfy loan principal and
interest due
Any excess money collected above amount owed must be returned to
borrower
Banks commonly loan 50-80% of face amount of receivables
Amount loaned depends mainly on credit reputation of borrower and
quality of receivables pledged
Quality of receivables is a function of credit rating of customer
accounts and age of receivables
Sources of Short-term
Financing
Financing Accounts Receivable
2. Assigning
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Borrowing firm signs over its right to collect account to lender
Lender advances money to borrower up to some
predetermined percentage of accounts receivable and then
collects directly from customer account
Payments received in excess of amount loaned are property of
borrower (treated as part of “circulating pot” of money from
which borrower may draw funds as needed)
Lenders commonly lend 75-90% of face value of receivables
assigned
Percentage loaned is a function of credit rating of borrower and
quality of accounts receivable
Sources of Short-term
Financing
Financing Accounts Receivable
• Pledging/Assigning (continued)
– Lender has recourse to borrower if account
fails to pay
– Lender only acts as supplier of funds so if
borrower defaults, borrower suffers bad-debt
loss, not lender
– Cost of pledging and assigning are about
equal
Sources of Short-term
Financing
Financing Accounts Receivable
3.Factoring
– Lender buys accounts receivable outright
from borrower at discount from face value
and assumes burden of collecting
receivables
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Burden includes assumption of bad-debt losses
If account does not pay, lender has no recourse
on borrowing firm
Sources of Short-term
Financing
Financing Accounts Receivable
3.Factoring (continued)
• Lenders provides three services
1. Provide financing of accounts receivable for
borrowing firms
2. Act as borrowing firm’s credit department
3. Assumes risk of bad-debt losses
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Transfers risk from borrowing firms to factor
Most expensive form of accounts receivable
financing
Sources of Short-term
Financing
Inventory Financing
• Commonly arranged through:
1. Blanket liens
2. Trust receipts
3. Field-warehousing arrangements
Sources of Short-term
Financing
Inventory Financing
1.Blanket lien
– Firm pledges its inventory as collateral for
short-term loan, but lender has no physical
control over inventory
– If borrower defaults, lender has right to seize
inventory and sell it to pay off loan principal
and interest; any funds realized in excess of
amount owed must be returned to borrower
Sources of Short-term
Financing
Inventory Financing
2.Trust receipt
– Legal document that creates lien on specific
item of inventory
– Commonly arranged for “big ticket” items (i.e.
inventory held by automobile dealers,
jewelers, or heavy equipment dealers
– When item is sold, amount loaned against
item must be remitted to lender
Sources of Short-term
Financing
Inventory Financing
3. Field-warehousing arrangement
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Inventory pledged as collateral is physically maintained
on premises of borrower but is under control of lender
Physical movement of inventory items into or out of
warehouse is supervised by independent third party
employed by lender
As inventory items are moved into warehouse, loans are
made to borrower
As items are released and sold, loans are paid off
Particularly appropriate for financing seasonal inventory
buildups