19-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited
19-2
Chapter 19
Working Capital Management and
Short-Term Plannings
Chapter Outline
 Working Capital
 Links Between Long-Term and Short-Term
Financing
 Tracing Changes in Cash and Working
Capital
 Cash Budgeting
 A Short-Term Financing Plan
 Sources of Short-Term Financing
 The Cost of Bank Loans
copyright © 2003 McGraw Hill Ryerson Limited
19-3
Working Capital
• The

Components of Working Capital
Net Working Capital equals current assets
minus current liabilities.
 It
is often called working capital.
 Usually current assets exceed current liabilities
so firms have positive net working capital.

Firms need working capital as part of their
cycle of operations.
 Although
the amount of working capital is fixed,
the components of working capital constantly
change with the cycle of operations.
copyright © 2003 McGraw Hill Ryerson Limited
19-4
Working Capital
•A
Simple Cycle of Operations:
CASH
CASH
RECEIVABLES
RECEIVABLES
RAW MATERIALS
INVENTORY
FINISHED GOODS
INVENTORY



Firms go through a cycle in which cash is reduced to
purchase inventory.
Inventory is sold to become A/R.
Collection of A/R increases the firm’s cash holdings.
copyright © 2003 McGraw Hill Ryerson Limited
19-5
Working Capital
• The


Cash Conversion Cycle
The cash conversion cycle is the amount of
time between a firm’s payment for materials
and its collection on its sales.
In other words, it measures how much time
passes from the moment the firm lays out cash
on its inventories until it gets that cash back
through collection from its customers.
copyright © 2003 McGraw Hill Ryerson Limited
19-6
Working Capital
• The



Cash Conversion Cycle
If a firm paid cash for its inventories, then the
total time between the initial payment for the
raw materials and collection from the
customers would be the cash conversion
period.
However, most firms purchase their inventories
on account.
If the firm buys its materials on Accounts
Payable, then the net time the firm is out of
cash must be reduced by the time it takes the
firm to pay its own bills.
copyright © 2003 McGraw Hill Ryerson Limited
19-7
Working Capital
• The



Cash Conversion Cycle
If the firm starts the cycle by purchasing raw
materials, but it does not pay for them
immediately, the time between acquisition and
payment is called the accounts payable period.
The number of days between the initial
investment in inventory and its sale date is called
the inventory period.
The number of days between the date of sale
and the date at which the firm gets paid is called
the accounts receivable period.
copyright © 2003 McGraw Hill Ryerson Limited
19-8
Working Capital
• The

Cash Conversion Cycle
To summarize:
Inventory Period
+ Receivables Period
- Accounts Payable Period
= Cash Conversion Cycle

Key Question:
How is each of the periods measured?
copyright © 2003 McGraw Hill Ryerson Limited
19-9
Working Capital
• The

Cash Conversion Cycle
In Chapter 17, you learned:
Inventory Period =
Average Inventory
Annual Cost of Goods Sold/365
Accounts Receivable Period =
Accounts Payable Period =
Average A/R
Annual Sales/365
Average Accounts Payable
Annual Cost of Goods Sold/365
copyright © 2003 McGraw Hill Ryerson Limited
19-10
Working Capital
• The




Working Capital Trade-Off
Working capital can be managed, meaning that
the length of the cash conversion cycle can be
altered.
Note that there are costs and benefits
associated with the firm’s investment in
working capital.
Carrying costs are the costs of maintaining
current assets and includes the opportunity
cost of capital.
Shortage costs are costs incurred from
shortages in current assets.
copyright © 2003 McGraw Hill Ryerson Limited
19-11
Working Capital
• The

Working Capital Trade-Off
An important job of the financial manager
is to strike a balance between the costs
and benefits of current assets.
 That
is, to find the level of current assets
which minimizes the sum of carrying costs
and shortage costs.
copyright © 2003 McGraw Hill Ryerson Limited
19-12
Long-Term and Short-Term Financing
• Links
between Long-Term and ShortTerm Financing




Businesses must have assets in order to run
efficiently.
The total cost of these assets is called the
firm’s total capital requirement.
In a growing firm the amount of the total capital
requirement will grow over the long-term,
showing a steady up-trend.
The total capital requirement will also fluctuate
over the short-term, particularly if the firm is in
a seasonal business.
copyright © 2003 McGraw Hill Ryerson Limited
19-13
Long-Term and Short-Term Financing
• Links
between Long-Term and ShortTerm Financing

If you look at Figure 19.4 on page 578 of your
text, you will see this concept depicted
graphically:
 Note

the straight upward trending line.
This represents a growing firm’s steadily increasing
investment in assets over the long-term.
 Superimposed
on this is a wavy solid line which
shows the firm’s seasonal requirement for
assets.
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19-14
Long-Term and Short-Term Financing
• Links
between Long-Term and ShortTerm Financing

For example, if this were a retail firm, you would
expect the maximum quantity of assets to be
held at Christmas.
 The
firm would be carrying its cash, inventories and
accounts receivable at a seasonal high in December.
 Note that the dashed line for December 2001, shows
where the firm’s total capital requirement is at its
highest for the year.
 For the rest of the year, the firm’s need for capital
varies around this seasonal maximum.
 Note also that this pattern is repeated in 2000 and
2002.
copyright © 2003 McGraw Hill Ryerson Limited
19-15
Long-Term and Short-Term Financing
• Strategies
for Long-Term and Short-Term
Financing

This leads to the question of how to finance the
firm’s total capital requirement:
 Should
all the long-lived assets be funded with
long-term financing and all the seasonal assets
be funded with short-term?
 Or should all the assets be funded with long-term
financing?
 Or should all the assets be funded with shortterm financing?

Or, should some of the assets be funded long-term and
some short-term?
copyright © 2003 McGraw Hill Ryerson Limited
19-16
Long-Term and Short-Term Financing
• Strategies
for Long-Term and Short-Term
Financing

Figure 19.5 on page 579 shows three possible
strategies a financial manager could pursue:
 Panel
(a) shows all the assets funded with longterm financing.
 As a result, the firm is always sitting on
excess capital.
 That is, it has enough financing to cover all its
asset needs, even at the seasonal high.
 At other times of the year, the firm will have
fewer assets and hence, a surplus of cash.
copyright © 2003 McGraw Hill Ryerson Limited
19-17
Long-Term and Short-Term Financing
• Strategies
for Long-Term and ShortTerm Financing
 Panel
(c) shows the matching principal.
Long-term assets are funded using longterm financing, while short-term assets are
financed with short-term financing.
That is, the firm borrows short-term to meet
its short-term seasonal requirements.
 Its long-lived assets are funded using longterm financing.

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19-18
Long-Term and Short-Term Financing
• Strategies
for Long-Term and ShortTerm Financing
 Panel
(b) shows a policy in which some of
the assets (both long and short-term) are
financed with long-term funding.
 The remaining short-term assets are
funded using short-term financing.

Thus the firm is a borrower only during those
periods when its capital requirements are
relatively high.
copyright © 2003 McGraw Hill Ryerson Limited
19-19
Long-Term and Short-Term Financing
• Strategies
for Long-Term and Short-Term
Financing
Which strategy is the best financing alternative?
 It is hard to say.

 Panel
(a) shows a conservative, very relaxed
policy, in which the managers always have a
comfortable cushion of cash.
 Panel (c) is a more aggressive, restrictive policy
in which the firm’s financial managers must
always be prepared to arrange short-term
financing.
 Panel (b) is a middle of the road policy.
copyright © 2003 McGraw Hill Ryerson Limited
19-20
Cash and Working Capital
• Tracing
Changes in Cash and Working
Capital

If you look at Table 19.3 to 19.5 in your text,
you will see the financial statements for
Dynamic Mattress Company (DMC).
 Notice
that DMC’s cash balance increased from
$4 million to $5 million in 2001.
 What caused this increase? Did the extra cash
come from:
Additional borrowing?
 Reinvested earnings?
 A reduction in inventories?
 Extra credit from DMC’s suppliers?

copyright © 2003 McGraw Hill Ryerson Limited
19-21
Cash and Working Capital
• Tracing
Changes in Cash and Working
Capital


If you look at Table 19.5, you will see the firm’s
sources and uses of its cash.
The correct answer to the question of where
the additional cash came from is:
All of the above!
copyright © 2003 McGraw Hill Ryerson Limited
19-22
Cash Budgeting
• Forecasting

Sources and Uses of Cash
Forecasts of future sources and uses of cash
serve two essential purposes:
 They
alert the financial manager to future cash
needs.
 They provide a standard, or budget, against
which subsequent performance can be judged.

There are several methods of preparing a cash
budget, but no matter what method is chosen,
there are three common steps to preparing a
cash budget.
copyright © 2003 McGraw Hill Ryerson Limited
19-23
Cash Budgeting
•
Creating a Cash Budget
1. Forecast the sources of cash.
 The largest inflow comes from payments by
the firm’s customers.
2. Forecast the uses of cash.
3. Calculate whether the firm is facing a cash
shortage or surplus.
The financial plan then sets out a
strategy for investing a cash surplus
or for financing a deficit.
copyright © 2003 McGraw Hill Ryerson Limited
19-24
Cash Budgeting
• Forecasting


DMC’s cash inflows come from the sale of
mattresses.
The managers have forecasted that quarterly
sales for 2002 will be:
Quarter
Sales ($ millions)

Sources of Cash
1st
2nd
3rd
4th
87.5
78.5
116
131
Not all of these sales would be for cash:
 Assume
20% of each quarter’s sales are
collected in the next quarter.
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19-25
Cash Budgeting
• Forecasting

Sources of Cash
DMC’s collections on its sales would be as
follows:
1st
2nd
3rd
4th
Sales ($ millions)
80% collected now:
87.5
70.0
78.5
62.8
116
92.8
131
104.8
20% in next period:
15.0*
17.5
15.7
23.2
Quarter
* Sales collected from the 4th quarter of the previous year.
copyright © 2003 McGraw Hill Ryerson Limited
19-26
Cash Budgeting
• Forecasting

Sources of Cash
We can combine this information with DMC’s
receivables to calculate its period end A/R:
Quarter
1. A/R (start of period):
2. Sales ($ millions)
80% collected now:
20% in next period:
3. Total collections:
4. A/R (end of period):*
1st
2nd
30.0
87.5
70.0
15.0
85.0
32.5
32.5
78.5
62.8
17.5
80.3
30.7
3rd
30.7
116
92.8
15.7
108.5
38.2
4th
38.2
131
104.8
23.2
128.0
41.2
* 4 = 1 + 2 - 3 (Ending A/R = Beginning A/R + Sales – Collections)
copyright © 2003 McGraw Hill Ryerson Limited
19-27
Cash Budgeting
• Combining


Sources and Uses of Cash
DMC’s receivables are its primary source of
cash.
However, it is not the only one.
 If
you look at Table 19.7 on page 583, you will see
that DMC has other sources of cash.
 Assume that this other source of cash does not
represent an issue of debt or equity.

We can now combine our information about DMC’s
total sources of cash with its uses of cash to create
the firm’s forecasted cash budget.
copyright © 2003 McGraw Hill Ryerson Limited
19-28
Cash Budgeting
• Combining



Sources and Uses of Cash
If you look at the bottom line of Table 19.7, you
will see that DMC has a net cash outflow in the
first two quarters of the year.
This is followed by substantial cash inflows in
the final two quarters.
Cash outflows must always be financed.
 Now
that DMC’s financial managers have advance
warning of the negative cash flows, they can plan
how they will finance the expected deficit.
 A cash budget allows a financial manager to be
proactive with respect to the firm’s financing needs.
copyright © 2003 McGraw Hill Ryerson Limited
19-29
Cash Budgeting
• The Cash Balance
 Assume that DMC started the year with $5
million in cash.
 There is a $45 million cash outflow in the first
quarter, so DMC will have to find financing for
at least a $40 million deficit.
 However, this would leave the firm with a
forecast cash balance of zero at the start of the
second quarter.
What do you think of this
as a financial strategy?
copyright © 2003 McGraw Hill Ryerson Limited
19-30
Cash Budgeting
• The Cash Balance
 Most financial managers would see starting a
period with a cash balance of zero as a very
risky operating position!
 Generally, they establish a minimum operating
cash balance to cope with surprises.
 Assume that DMC’s minimum operating cash
balance is $5 million.
How much financing will DMC have to arrange
in the first and second quarter to maintain
this desired minimum cash balance?
copyright © 2003 McGraw Hill Ryerson Limited
19-31
Cash Budgeting
• The Cash Balance
 If it wants a minimum cash balance of $5
million in the 1st quarter, DMC will need $45
million of financing, not $40 million.
 In the second quarter, they will have to arrange
an additional $15 million of financing.
 In total, the firm will need $60 million of
financing for the first half of the year.
 This is the peak need.
 The cash inflows for the 2nd half of the year will
offset the cash outflows of the first half.

See Table 19.8 on page 584 for details.
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19-32
Cash Budgeting
• Options

for Short-Term Financing
Now that DMC’s financial managers have
estimated how much financing the firm
will need, they must decide on the best
route(s) for raising those funds.
 For
a healthy firm, multiple options will be
available for covering a temporary cash
short-fall.

The financial managers do a cost-benefit
analysis of the options and try to choose
the one(s) which are optimal.
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19-33
Cash Budgeting
• Options for Short-Term Financing
 If you look at Table 19.9 on page 567, you will
see the solution chosen by DMC’s financial
managers:
 In the 1st quarter, they will arrange a $40 million
loan and sell $5 million of securities.
 In the second quarter, they will stretch their
payables.
Stretching payables means delaying payment of
bills and allowing accounts payable to build up.
 In effect, DMC is taking a loan from its suppliers.

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19-34
Cash Budgeting
• Evaluating the Plan
 The plan in Table 19.9 is feasible, but
DMC’s financial managers can probably do
a lot better.
 The
most glaring weakness is the plan to rely
on stretching payables.
 This is an extremely expensive source of
financing!

However, the purpose of the first plan is to
get the managers thinking about options
and questions they should be addressing.
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19-35
Cash Budgeting
• Evaluating the Plan
 Short-term financial plans are developed by
trial and error.
 You lay out one plan, think about it, and
then try again with different assumptions
about the financing and investment
alternatives.
 You continue until you can think of no
further improvements.
copyright © 2003 McGraw Hill Ryerson Limited
19-36
Sources of Short-Term Financing
• Alternative

Sources of Financing
Bank Loans
 These
are the simplest and most common
source of short-term financing.
 A bank loan is an unsecured loan.
 A line of credit is an agreement by a bank that
a company may borrow at any time up to an
established limit.
 A revolving credit agreement is a long-term
commitment by the bank which allows the firm to
borrow up to the agreed limit.
copyright © 2003 McGraw Hill Ryerson Limited
19-37
Sources of Short-Term Financing
• Alternative

Sources of Financing
Bank Loans
 If
the bank commits to a multi-year agreement,
in return it will charge a commitment fee.
 This is a fee charged by the bank on the unused
portion of a line of credit.
 Most bank loans have a duration of a few
months and are designed to cover short-term
working capital needs such as a seasonal
increase in inventory.
 Banks also make term loans.
 These loans last for several years and may
involve very large sums of money.
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19-38
Sources of Short-Term Financing
• Alternative

Sources of Financing
Commercial Paper
 Commercial
paper is a short-term
unsecured note issued by a firm.
 Commercial paper is issued by large,
well-known companies which regularly
need to borrow large amounts of cash.
 Instead of a bank loan, they borrow
directly from investors at rate which is
less than what a bank would charge.
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19-39
Sources of Short-Term Financing
• Alternative

Sources of Financing
Banker’s Acceptance
A
banker’s acceptance is a firm’s time
draft that has been accepted by a bank.
 This means the bank guarantees payment
of the amount stated on the draft when it
matures.
 This guarantee means that the draft may
be sold to investors as a short-term note
issued by the firm.
copyright © 2003 McGraw Hill Ryerson Limited
19-40
Sources of Short-Term Financing
• Alternative

Sources of Financing
Secured Loans
 Many
short-term loans are unsecured, but
sometimes a company will offer assets as
security.
 Generally, they offer their A/R or their
inventory as security on the loan.
The former is known as A/R financing. Or it
may involve factoring, in which the firm sells
its A/R at a discount to get short-term
financing.
 The latter is called inventory financing.

copyright © 2003 McGraw Hill Ryerson Limited
19-41
The Cost of Bank Loans
• Comparing

Rates
Bank loans of less than a year almost
invariably have a stated rate which is
fixed for the term of the loan.
 However,
you must be careful when
comparing rates on short-term loans, for
rates may be calculated in different ways.
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19-42
The Cost of Bank Loans
• Comparing

Rates
The interest rate on bank loans is
frequently quoted as a simple interest
rate.
 You
would calculate such interest on a
loan as follows:
Amount of Loan x
Annual Interest Rate
Number of Periods in the Year
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19-43
The Cost of Bank Loans
• Comparing

Rates
The interest rate on bank loans may be
quoted as a compound interest rate.
 You
would calculate the effective annual
rate (EAR) on a loan as follows:
EAR =
(
Quoted Annual Interest Rate
1+
m
m
) -1
copyright © 2003 McGraw Hill Ryerson Limited
19-44
The Cost of Bank Loans
• Comparing

Rates
The interest rate on bank loans may be
quoted on a discount basis.
 You
would calculate such interest on a
loan as follows:
EAR =
(
1-
m
1
Quoted Annual Interest Rate
m
)
-1
copyright © 2003 McGraw Hill Ryerson Limited
19-45
The Cost of Bank Loans
• Comparing

Rates
A bank loan may be quoted with a
compensating balance.
 You
would calculate such interest on a
loan as follows:
EAR =
(
Actual Interest Paid
1+
Borrowed Funds Available
m
)- 1
copyright © 2003 McGraw Hill Ryerson Limited
19-46
Summary of Chapter 19


Short-term financial planning is concerned with
the management of the firm’s short-term or
current assets.
The difference between current assets and
current liabilities is called net working capital.
 Net
working capital arises because of lags
between the time a firm obtains raw materials
and the time it finally collects from customers.


The cash conversion cycle is the length of time
between the firm’s payment for materials and
the date it gets paid by its customers.
The cash conversion cycle is partly within the
control of management.
copyright © 2003 McGraw Hill Ryerson Limited
19-47
Summary of Chapter 19




The nature of a firm’s short-term financial
planning is determined by the amount of longterm capital it raises.
Issuing large amounts of long-term debt or
equity, or retaining earnings, may mean a firm
has permanent excess cash.
Other firms raise very little long-term financing
and end-up as permanent short-term debtors.
Most firms take a middle of the road approach,
investing cash surpluses during part of the year
and borrowing during the rest of the year.
copyright © 2003 McGraw Hill Ryerson Limited
19-48
Summary of Chapter 19

The starting point for short-term financial planning
is forecasting the sources and uses of cash.
 From
this the firm’s net financing requirement can
be estimated.

The search for the best method of financing a
temporary cash short-fall is a trial and error
process.
 The
financial manager explores assumptions about
the inputs to the process and the various kinds of
short-term financing which are available.
 These include: bank loans, banker’s acceptances,
secured loans, commercial paper, stretching
receivables, etc.
copyright © 2003 McGraw Hill Ryerson Limited