Supply chains and Working capital
management
• Two basic questions: (1) what is the appropriate
amount of working capital, in both total and for
each specific account? (2) how should working
capital be financed?
1. Overview of working capital management
• Daily business operation involving production and
sales generates cash, A/R (accounts payable),
Inventory, A/P (accounts payable) and accruals
(unpaid wage or taxes).
• Net operating working capital = current asset –
A/P-accruals
• In addition to these accounts, there are short
term investment and short term debt (N/P, notes
payable).
• Difference between cash and short term
investment: cash is the short term financial asset
to support ongoing operation whereas short term
investment is for future purpose.
• Working capital (or gross working capital):
current assets used in operation.
• Net working capital= current asset – current
liabilities.
2. Using and financing operating current assets
• Operating current assets are used to support sale. Due
to seasonal or growing sales, many firms have various
operating current assets and related financing.
1) Efficient use of operating current assets
• Relaxed policy: a lot of cash, receivables and
inventories
• Restricted policy: minimum level of current assets
• Moderate policy: between relaxed and restricted
Optimal strategy: policy that will maximize the firm’s long
run free cash flow and stock’s intrinsic value.
2) Financing operating current assets.
• Primary financing source: bank loans, credit from
suppliers, accrued liabilities, long term debt and
common equity.
• Depending on seasonality or economic condition, firms
need to maintain varying levels of current assets to
support sales.
• Permanent operating current assets: the current
assets needed even at the low point of the business
cycle.
• Temporary operating current asset: extra current asset
due to increased sales.
3) Approaches
• Maturity matching or self liquidity approach: call for matching
assets and liabilities maturity. All of fixed assets plus
permanent current assets are financed with long term capital.
But temporary current assets are financed with short term
debt. For example inventory that will be sold in 30 days is
financed with a 30 day bank loan.
• Problem: not easy to exactly match.
• Aggressive approach: It takes advantage of low interests of
short term debts. In addition to temporary current assets,
permanent and part of fixed assets are financed with short
term credit.
• Problem: loan renewal as well as rising interest rate problem.
• Conservative approach: In addition to permanent and fixed
assets, part of temporary current asset is financed with long
term capital or marketable securities.
3. Short term financing
Advantages:
• Low interest rate
• Fast negotiating
• Flexibling – low/no prepayment penalty
• Fewer restriction (covenants)
Disadvantages:
• Renewal
• Unstable interest expense
• Bankruptcy
4. Cash conversion cycle (working capital cycle): firm
purchases or produces inventory, hold it for a time and
then sell it and receive cash. This process is known as
cash conversion cycle (CCC).
• CCC = Inventory conversion period + average collection
period – payable deferral period
= period in which a firm needs to pay interest if he or she
borrows to purchase materials.
• Inventory conversion = Inventory / (COGS/365)
• Average collection period = A/R / (Sales/365)
• Payable deferral period = A/P / (COGS/365)
1) Benefits of reducing CCC
• A firm tends to strengthen sales by providing
discount for early payment. Large amounts of
working capitals means large interest payment
because working capitals are financed with
debts.
• CCC reduction has several benefits- reduced
interest payment and improved free cash flow.
4. Cash budget (Figure 16-5): monthly cash in and out.
(1) Cash in:
- Sales forecast
- Credit policy: e.g) 2/10 net 60. It means a 2% discount is
given if payment is made within 10 days. Otherwise the
full amount is due in 60 days. E.g) net 30. It means no
discount but required to pay within 30 days.
(2) Cash out: Cost of purchasing raw materials, wages and
salaries, lease payments, other payments, etc.
(3) Cash balance (= net cash flow) = cash in – cash out.
(4) Cumulative cash net cash flow = cash balance in the
previous month + cash balance.
(5) Minimum balance: how much cash is needed to
maintain a minimum balance requirement.
1) Target cash balance
(1) Transaction balance: cash balance associated
with routine payments and collections.
(2) Precautionary balance: cash to meet random
and unforeseen fluctuations in inflows and
outflows.
• If the firm’s cash balances are less predictable
and the firm’s needs to take large trade discount,
cash balance should be large enough.
(3) Compensating balance: if a bank is providing
services to a customer, then it may require that
customer to leave a minimum balance on deposit to
help offset the cost of providing these services.
2) Cash management techniques
• Synchronization of cash flow: by timing cash
receipts to coincide when their cash outlays,
firms can hold their transaction balance to
minimum.
3) Speeding up the check-clearing process
• With the passage of a federal law in 2004
known as “Check 21,” banks can exchange
digital images of checks and most checks clear
in a single day.
4) Float: difference between the balance shown in a
firm’s check book and the balance on the bank’s
records. This difference happens due to the period
of check clearing.
• Disbursement float: when a firm write a check,
firm balance < bank balance.
• Collection float: when a firm receives a check,
firm balance > bank balance.
• Net float = disburse float – collection float.
• Collection float is bad but discount float is good.
And positive net float is even better.
Why float happens?
• Time for checks to travel through the mail, (2)
be processed by the receiving firm, and (3)
clear through the banking system.
• How to make a big and positive net float?
speeding up collection the firm receives and
slowing down collection on checks the firm
writes.
5) Speeding up collections: lock boxes and
electronic transfer.
• Lock boxes: incoming checks are sent to post
office boxes rather than to the firm’s
corporate head-quarters. A local bank with
the firm’s account will clear checks in
lockboxes. Compared to regular system, lock
box saves 2 to 5 days.
• Payment by wire or automatic transfer:
Eliminating the time of clearing checks.
5. Inventory management
• Financial management needs to raise capital
needed to carry inventory and for overseeing
the firm’s overall profitability.
• Twin goals of inventory management: (1)
ensuring that the inventories and (2) holding
the costs of ordering and carrying inventories
to the lowest possible level.
• Before computer age, Red line was used.
After computer age, Just in Time is used.
e.g) sales of $120 million and an inventory turnover
ratio of 3. How much inventory may be needed to
maintain current business?
• Inventory turnover ratio = sales / average
inventory.
• Thus an average inventory = sales / inventory
turnover = 120/3 =40. If the company can
improve its inventory turnover ratio to 4, the
inventory needed is 30 and free cash flow saved
is 10 (=40-30).
• However the low level of inventory may cause
other costs such as frequently ordering costs, lost
sale opportunities, etc.
6. Receivable management
• A/R (accounts receivable): A/Rs are caused by
sales on credit/accounts. They are indirect or
direct costs to firms. However sales on credit
improve sales volume.
1)Credit policy
• Sales are influenced by two factors:
• Exogenous: state of economy
• Endogenous (under the firm’s control): price,
product quality, adverting and credit policy, etc.
Credit policy consists of the four variables:
• Credit period: “net 30” which means that the
customer must pay within 30 days.
• Discount: “2/10, net 30” which means that
buyers may deduct 2% of the purchase price if
payment is made within 10 days. Otherwise the
full amount must be paid within 30 days.
• Credit standard: how much financial strength
must a customer show to qualify for credit?
Lower credit standard boost sales but they also
increase bad debts.
• Collection policy: how tough or lax is a company
in attempting to collect slow-paying accounts?
2) Accumulation of receivables
• The total amount of A/R outstanding is
determined by two factors.
• A/R = credit sales per day * length of collection
period
3) Monitoring the receivable position
• When a bank loan is approved, the agreement is
executed by signing a promissory note. The
promissory note specifies the amount borrowed,
the interest rate, the repayment schedule, any
collateral, any other terms and conditions.
Bankers and investors pay attention to A/Rs. Credit sales
reduces inventory by cost of goods sold, increase sales,
report as a profit the difference between sales and cost of
goods sold. But credit sales are not cash transaction…..
(1) Day sales outstanding (DSO) = receivables / sales per
day.
(e.g) Super set’s sales under 2/10, net 30
Assume that 70% of the customers take the discount and
pay on Day 10 and the other 30% pay on Day 30. Annual
sales = 200,000*198.
DSO = ACP (average collection period)
= 0.7*10 days + 0.3*30 days = 16 days
• ADS (average daily sales) = annual sale/365
= 200000*198/365 = 108493
A/R = 108493*16 =1735888.
DSO = (A/R) / ADS = (A/R) /(sales/365)
DSO is compared to an industry average or its
own credit terms.
(2) Aging schedules is a schedule table breaking
down receivables by age of account.
• A change in DSO or the aging scheduling
should be taken as a signal to investigate
further: it is not necessarily a sign that the
firm’s credit policy has weakened.
• 7. Accruals and A/P (trade credit)
Two major types of operating liabilities: accruals
and account payable.
1) Accruals: unpaid or accrued wages or taxes.
They are interest free and automatically increase
as a firm’s operations expand.
2) Account payable (trade credit): purchase on
credit. Typically, 40% of current liabilities for
nonfinancial corporations are A/P.
e.g) a firm has an average purchase of $2000 a day
on terms of net 30. It means that firm owes
30*2,000 = 60,000 to its suppliers. If credit terms
changes to net 40, the firm owes 40*2000 = 80,000.
(1) cost of trade credit
Under terms of 2/10, net 30
true price = net price = list price * (1-2%).
Or list price = true price/ (1-2%)
list price = true price + discount (2%)
discount = list price – true price
e.g) PPC buys $11,923,333 of memory ships from Microchip each
year at the net price. The amounts to $11,923,333/365
=32666.67 per day.
a) IF PPC decides to use 10 days, its payables will be
10*32666.67 =326667.
b) Now assume that PPC decides to take
additional 20 days credit. PPC will pay on the
30th day. Total payable will be
30*32666.67=980,000. Thus Microchip will
provide 653,333 (=980,000-326,667) of credit at
the true or net price.
• But the additional 20 days credit will cost to
PPC 243,333 [=11,923,333/(1-2%)11,923,333]. Here 11,823,333 is a true price.
c) Nominal annual cost =243333/653333 =37.2%
= Discount percentage /(100-discount percentage) * 365/(days
credit is outstanding – discount period)
= 2/(100-2) * 365 /(30-10) = 37.2%.
If PPC can borrow from its banks at an interest rate less than
37.2%, then it should use the bank loan. It means that PPC
should take 2% discount and forgo the additional trade credit.
If you consider a compounding schedule,
(1+discount rate/(100-discount rate))^(number of periods in a
year)-1 = (1+0.0204)^18.23-1 =44.6%.
• If PCC could get away with paying in 60 days
rather than the specified 30 days, then
number of periods per year changes from
18.25 to 7.3 (=365/50).
• In this example, trade credit could be
categorized into free trade credit (trade credit
in 10 days) and costly trade credit ( trade
credit in additional 20 days). Firm should use
free trade credit and use the costly trade
credit after analyzing the cost of costly trade
credit.
• 8. Management of short term investment: TBill, CP, Time deposit, etc.
• Three reasons companies hold short term
investments: (1) for liquidation just prior to
scheduled transaction, (2) unexpected
speculation or opportunities, (3) to reduce
company’s risk.
9. Short term financing
1) Advantages of short tern financing
- Obtained much faster than a long term loans
- less expensive in flotation costs and
prepayment penalty
- less restrictive in provisions or covenants
2) Disadvantages
- Fluctuating interest payment
- Possible financial distress if a firm heavily
relies on a short term loan
• 3) short term bank loan
• Banks provide funds/loans to firms and are very
important in running business.
• Loans from commercial banks generally appear on
balance sheets as notes payable.
• (1) maturity
• Bank loans to business are frequently written as 90
day notes.
• (2) Promissory notes
• When a bank loan is approved, the agreement
is executed by signing a promissory notes.
This promissory note specifies the amount
borrowed, the interest rate, the repayment
schedule, any collateral, any other terms and
conditions.
(3) Compensating balance
• An average demand deposit (checking amount)
balance required to maintain by borrowers.
• e.g) 20% compensation balance means if a loan
of $100,000 is issued, the 20% of 100000 must
stay in a checking account. A borrower will
receive only $80,000. If the stated annual rate is
8%, the effective cost is 10%
(=100000*0.08/(100000-20000)). Compensating
balance is less common now than earlier.
(4) Informal line of credit
• An informal agreement between a bank and a
borrower indicating the maximum credit the
bank will extend to the borrower.
• “taking down”: an action of using a portion of
line of credit.
• (e.g) financial manager signs a 90 day
promissory note for $15000. This would be
called “ taking down” $15000 of total line of
credit.
(5) Revolving credit agreement
• A formal line of credit often used by large firms.
• e.g) assume that Texas petroleum negotiated a
revolving credit agreement for $100 million with
a group of banks. The banks were formally
committed for 4 years to lend the firm up to $100
million if the funds were needed. Texas
Petroleum, in turn, paid an annual commitment
fee of 0.25% on unused balance of the
commitment to compensate the banks for
making commitment. A used portion of credit
will be charged at a different interest rate.
• The interest rate on revolvers is pegged to the
London Interbank Offered Rate (LIBOR), the T-bill
rate or some other market rate.
• Major difference between line of credit and
revolving credit: Revolving credit has a legal
obligation to honor a revolving credit agreement
and receive a commitment fee. But a legal
obligation or a fee do not exist under the informal
line of credit.
• Cleanup clause that requires the borrower to
reduce the loan balance to zero. In general, line
of credit will have a cleanup clause because it is
not a source of permanent capital.
(6) Costs of bank loans
• Interest rates are higher for riskier borrowers and
an smaller loans because of fixed costs involved
in making and servicing loans. They are scaled up
from the prime rate (which at one time was the
lowest rate bank charged) or LIBOR, depending
on size, or financial soundness.
• (e.g) The rate to smaller and riskier borrower is
generally stated something like “prime plus
1.0%”; The rate to larger borrower is stated like
LIBOR plus 1.5%.
•
a) Calculating bank’s interest charges: regular (or
simple) interest for typically for business loans.
• e.g) Borrowing $10,000 for 30 days at 3.25%
nominal rate (APR). Here one year is assumed to
have 360 days.
• Monthly interest = rate per day (= daily periodic
rate, DPR) * total loan amount * days used in a
month = 0.0325/360 * 10000*30 =27.08.
• EAR = (1+0.0325/12)12 – 1 = 3.2989%
b) Calculating bank’s interest charges: add-on interest. It is typically for
automobile and other types of installment loans (amortized loans). The
interest is calculated and then added to the amount borrowed to
determine the loan’s face value.
E.g) you borrow $10,000 on an add-on basis at a nominal rate of 7.25%
to buy a car with the loan to be repaid in 12 monthly installments.
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How to find APR?
Per month payment = (10000+725)/12 = 893.75
N = 12
PV = 10000
PMT = -893.75
FV=0, Then I/YR = 1.093585%
APR = 12* 1.093585 = 13.12%
EAR = (1+1.093585)12 – 1 = 13.94%
(7) Commercial paper
• Unsecured promissory note issued by large,
strong, firms and sold primarily to other
business firms such as insurance firms,
pension funds, money market mutual funds,
and other funds.
• Maturity : 1 day to 9 months
• Dealers prefer to handle the commercial
paper of firms whose net worth is $100
million or more and whose annual borrowing
exceeds $10 million.
8. Use of security in short term financing
• Most secured short term business borrowing
involves the use of A/R and inventories as
collateral.