Raising Entrepreneurial Capital
Chapter 10:
Internal Financial Management
Working capital per dollar sales,
WC/Sales
 Working Capital defined as Current Assets –
Current Liabilities.
 a company that generates sales with a
smaller investment in working capital is
managing its current assets and current
liabilities more efficiently.
 On average the Fortune 500 companies use
$0.20 in working capital to generate $1.00
in sales. Efficient companies use in the
$0.07 - $0.17 range.
Importance of Working Capital
Management
 Careful management of current
assets and liabilities should be a
priority in any business start up.
 Focus should be on cash flow not
profits
 Access to assets not ownership is
critical
Working capital management
in smaller firms
 Preserve cash by leasing fixed assets
 Relatively higher reliance on shortterm debt
 Small firm is much more likely to be
unable to withstand a cash flow crisis
than its larger, more established
counterpart
Tools
 Non-interest earning current asset balances
should be kept to a minimum.
 Accounts Receivable should be minimized
by expediting collections from customers.
 Inventories at all levels should be
minimized to reduce costs.
 On the liability side, Accounts Payable
should be managed so that payments to
suppliers take advantage of any free credit
provided.
Cash Conversion Cycle (CCC)
 calculates the time that money is tied
up in the normal business cycle of the
company.
 The CCC calculates the number of
day’s cash which is invested in
inventory and accounts receivable,
and the extent to which this cash
outflow is covered by the financing
provided by a firm’s creditors.
CCC calculation
CCC = ACP + ICP – DPO
 ACP, Average Collection Period =
Accounts Receivable/(Sales/365)
 ICP, Inventory Conversion Period =
Inventory/(Cost of Goods Sold/365)
 DPO, Days Payables Outstanding =
Accounts Payable/(Cost of Goods
Sold/365).
CCC usage
 Highlights the flow of dollars into current
assets and from current liabilities, used to
better manage those accounts to reduce the
firm’s need for external financing.
 Reduction in the CCC leads to:
 A one-time increase in cash as cash is
converted from current assets.
 An ongoing increase in efficiency as the firm
speeds up collections and inventory
conversion.
 The goal of working capital management is to
get the CCC to zero.
Trade credit
 Never pay early, except to get discount
 Example terms of 2/10 net 30 mean the
buyer may subtract 2% (the finance
charge) from the invoice amount if paying
by day 10, otherwise the full amount on the
invoice is due on day 30.
 Here is an opportunity to obtain vendor
financing for twenty days. What is the cost
of foregoing the discount and paying on
day 30? In this case a finance charge of 2%
is charged for 20 days of financing.
Effective cost of trade credit
 Periodic rate =
Discount Percentage/
(1-Discount Percentage)
 Effective rate =
(1+ periodic rate)n - 1
 Where n = the number of compounding
periods in a year and is calculated as
365/(payment date – discount date).
Cost of foregoing the discount
On terms of 2/10 net 30:
 Periodic Rate =
2%/(1.0-2%)
= 0.02/0.98 = .0204
 N = 365/ (30-10) =
18.25
 Effective Rate = (1 + .0204)
= 44.56%.
18.25
–1
Cash Budget
 The Cash Conversion Cycle indicates how
many days of financing are needed but
does not indicate the amount of external
financing needed.
 To predict the amount of external financing
needed, the financial manager must
prepare a Cash Budget.
 The Cash Budget is a forecast of cash
inflows and outflows, monthly over the next
year or daily over the next month.
Daily Budget
 A daily cash budget is critical because cash
inflows and outflows do not occur uniformly
throughout the month. While sales may
occur uniformly (or may not) expenses
almost certainly will be congregated on
certain days, throwing off the validity of the
monthly cash budget on certain days.
 The format of the daily cash budget is the
same as the monthly budget except that
cash flows are assigned to the actual days
on which they occur.
Financing Issues
How should external financing be split between
short-term and long-term sources of financing?
 “Finance current assets with short-term loans
and fixed assets with long-term sources of
funds”
 ignores the fact that all firms carry some
permanent levels of current assets. It is
unlikely that a firm will ever carry zero
receivables or zero inventory.
 permanent level of current assets may be more
efficiently financed with longer term sources of
funds, either equity or long-term debt.
Short-Term Alternatives




Lines of Credit
Asset Backed Loans
Factoring
Customers
Lines of Credit
 for cyclical current asset needs use a
revolving line of credit (LOC). A line of
credit is essentially a pre-approved loan,
available on demand in part or whole, up to
the preapproved limit.
 As cash deficits occur, a check can be
written against the line, drawing on it to a
predetermined maximum.
 should you end up not needing the funds
there is no charge. Also, unlike a term loan,
there are no scheduled repayments of
principal.
Asset Backed Loans
 In the early stages of a company’s life the
bank may not be willing to extend an
unsecured line of credit to the company and
a secured loan may be the only option for
obtaining financing.
 What assets are appropriate for securing a
short-term loan? Personal assets are
always an option. If the firm has a
marketable securities portfolio, it would be
good security for a loan. More likely assets
to use as collateral are the firm’s
inventories or accounts receivable.
Collateral
 To be acceptable collateral, inventory items
must be finished goods with a ready market for
liquidation. The key is, would the bank be able
to find a ready buyer for the asset in its
current state?
 Accounts Receivable may also be used as
collateral, but a bank is much more likely to
accept your receivables as collateral if your
customers are large corporate accounts. A
business selling to individual consumers would
not provide the type of receivables that a bank
would typically accept.
Factoring
 A firm can sell its accounts receivable to a third
party, the factor. The factor may be a bank or
a specialized factoring company.
 As with pledging, a factor will examine your
receivables and only accept quality, current
receivables. The difference is that you sell the
receivables to the factor, realizing cash from
the sale immediately and removing the
receivables from your balance sheet.
 The factor may only advance 70-95% of the
face value of receivables depending on their
quality.
Customers
 If your business provides a new or customized
product or service, it may be in the customer’s
best interest to help get your firm up to scale
through a direct investment; if there are no
good substitutes for what you offer, the chance
of direct investment by your customers rises
substantially.
 Another option for customer financing is to
demand full or partial payment in advance.
This strategy works best when the service is
ongoing (consulting) or the product takes some
time to develop or is highly customized.
Cash management techniques
 A basic goal of cash management is to get
access to incoming funds as quickly as
possible. Invoices should accompany goods out
the door.
 Discounts may provide enticement to
customers to pay sooner.
 All firms need a competent credit department.
Credit standards must be set and enforced
before credit is extended. Collections must be
timely and forceful to ensure payment.
Occasionally customers may need to be “fired”
for nonpayment and no further credit
extended.