INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth • W. Sean Cleary
Prepared by
Ken Hartviksen
CHAPTER 23
Working Capital
Management: General Issues
Lecture Agenda
• Learning Objectives
• Important Terms
• An integrated approach to working capital
management
• Analyzing cash inflows and outflows
• Working capital management
• Summary and Conclusions
– Concept Review Questions
CHAPTER 23 – Working Capital Management – General Issues
23 - 3
Learning Objectives
You should understand:
•
•
•
•
Why the management of net working capital is critical for the
survival of the firm
How managing receivables, inventory, and payables is related
in an integrated approach to net working capital management
How the financing and current asset investment decisions
interact to determine a company’s overall working capital
position
How some key financial ratios can be used to analyze a firm’s
net working capital policies
CHAPTER 23 – Working Capital Management – General Issues
23 - 4
Important Chapter Terms
•
•
•
•
•
Break-even sales growth
Cash budget
Cash conversion cycle
Credit policy
Inventory policy
•
•
•
•
•
Net working capital
Operating cycle
Payment policy
Trade credit
Working capital
management
CHAPTER 23 – Working Capital Management – General Issues
23 - 5
Working Capital Management
• The way in which a firm manages both its
current assets and its current liabilities.
CHAPTER 23 – Working Capital Management – General Issues
23 - 6
Good Working Capital Management
•
Characterized by:
1. The maintenance of optimal cash balances
2. The investment of any excess liquid funds in marketable
securities that provide the best return possible, considering any
liquidity or default-risk constraints
3. Proper management of accounts receivable
4. An efficient inventory management system
5. Maintaining an appropriate level of short-term financing, in the
least expensive and most flexible manner possible.
CHAPTER 23 – Working Capital Management – General Issues
23 - 7
Working Capital Management
Importance of Cash Flow Management
•
Management of the firm’s cash flow is one of
the greatest challenges facing the financial
manager:
– Exhaustion of liquid resources can leave the firm
unable to pay it’s maturing obligations as they come
due (a state of technical insolvency…an Act of
Bankruptcy)
CHAPTER 23 – Working Capital Management – General Issues
23 - 8
Working Capital Management
Exhaustion of Liquid Resources
•
Firms can ‘run out’ of liquid financial resources in a
number of ways:
–
Rapid growth in production and sales, can cause the firm to
use up all of its cash pursuing growth, leaving it invested in
illiquid assets such as inventories, accounts receivable and net
fixed assets.
•
–
–
The surprising thing about this state is that the firm may be highly
profitable in an accounting sense, but be on the verge of
bankruptcy as it pursues uncontrolled growth in sales.
Continuing to produce inventory in the face of falling sales
revenue.
Selling products/services for less than their variable cost to
produce.
CHAPTER 23 – Working Capital Management – General Issues
23 - 9
An Integrated Approach to Net Working Capital
Management
The Cash Budget
• The monthly cash budget is a management tool used to
forecast the timing, magnitude and duration of both cash
surpluses as well as deficits.
Table 23-2 ABC's Six-Month Cash Budget
$
1
2
3
4
5
6
Sales
1,000
1,500
2,000
2,500
3,000
3,500
Cash inflow
1,000
1,000
1,500
2,000
2,500
3,000
750
1,125
1,500
1,875
2,250
2,625
0
375
375
375
375
375
250
-500
-375
-250
-125
0
Start cash
1,000
1,250
750
375
125
0
End cash
1,250
750
375
125
0
0
Required cash
200
300
400
500
600
700
Surplus/deficit
1,050
450
-25
-375
-600
-700
Cash outflow
Current sales
Inventory
Operating cash
CHAPTER 23 – Working Capital Management – General Issues
23 - 10
An Integrated Approach to Net Working
Capital Management
• Knowledge of the cash flow cycle of a firm gives the
manager an awareness of the dynamics involved in
working capital management.
• The cash flow cycle helps the manager visualize the
impact of changes in variables on the cash account:
–
–
–
–
How increasing sales requires additional investment in inventory
How increasing accounts receivable reduces cash
How delaying payables preserves cash
How speeding collections on A/R improves the cash position
CHAPTER 23 – Working Capital Management – General Issues
23 - 11
Cash and Net Working Capital
•
The cash flow cycle – where cash comes from…how it is
used to finance the operations of the firm…and how it is
recovered and how it grows over time is a cruciallyimportant part of understanding how a business
functions.
CHAPTER 23 – Working Capital Management – General Issues
23 - 12
Cash and Net Working Capital
Activities that Increase Cash
•
•
•
•
•
Increasing long-term debt
Increasing equity
Increasing current liabilities
Decreasing current assets other than cash
Decreasing fixed assets
CHAPTER 23 – Working Capital Management – General Issues
23 - 13
Cash and Net Working Capital
Activities that Decrease Cash
•
•
•
•
•
•
Decreasing long-term debt
Decreasing equity
Decreasing current liabilities
Increasing current assets other than cash
Increasing fixed assets
Paying dividends
CHAPTER 23 – Working Capital Management – General Issues
23 - 14
Example of Exhaustion of the Liquid
Resources of a New Firm
A simple example of a $1.0 million equity
investment in a business levering additional
financial resources and the need to finance
the growth of the business leaving it
exhausted of cash resources.
7 steps to technical insolvency for an
otherwise profitable firm.
This Exercise
• This exercise reinforces the classic working
capital problem illustrated in the text.
• Demonstrates:
– How cash is utilized over time in the firm.
– How investment in assets such as accounts
receivable and inventory deplete cash resources.
– How the delays in receipt of cash from sales can
leave a firm without cash, despite overall profitability.
CHAPTER 23 – Working Capital Management – General Issues
23 - 16
The entrepreneur opens a
current account in the name of
the business.
Cash Flow Cycle
Step 1
Start
Cash Account
Balance = $0
CHAPTER 23 – Working Capital Management – General Issues
23 - 17
The entrepreneur invests
$1,000,000 in equity.
Cash Flow Cycle
Step 2
Initial Equity Investment
Cash Account
Balance = $1,000,000
Owner/Shareholders
invest and receive
common stock
Balance Sheet
Cash
= $1,000,000
$1m
Common Stock
$1 m
_____________________________________
T. Assets
CHAPTER 23 – Working Capital Management – General Issues
$1m
T. Claims
$1m
23 - 18
The firm purchases fixed
assets.
Cash Flow Cycle
Step 3
Purchase of $500,000 Fixed Assets
Fixed Assets
Cash Account
Balance = $500,000
Owner/Shareholders
invest and receive
common stock
= $1,000,000
Balance Sheet
Cash
$0.5
F. Assets
0.5
Common Stock $1 m
___________________________________
T. Assets $1m T. Claims
$1m
CHAPTER 23 – Working Capital Management – General Issues
23 - 19
The firm purchases
$300,000 inventory from
suppliers.
Cash Flow Cycle
Step 4
Buy $300,000 of inventory on trade credit
Fixed Assets
Cash Account
Inventory
Balance = $500,000
Owner/Shareholders
invest and receive
common stock
= $1,000,000
Balance Sheet
Cash
$0.5
A/P
$0.3
Inventory
0.3
F. Assets
0.5
Common Stock $1 m
_____________________________________
T. Assets $1.3m T. Claims
$1.3m
CHAPTER 23 – Working Capital Management – General Issues
23 - 20
Value is added to
inventory through labour
($300,000) and equipment
($100,000).
Further
Cash Flow Cycle
Step 5
Work-in-process plus finished goods
Work-in-process
inventory
Finished goods
inventory
Depreciation
Fixed Assets
Labour/utilities
Cash Account
Inventory
Balance = $500,000
Owner/Shareholders
invest and receive
common stock
= $1,000,000
Balance Sheet
Cash
$0.5
A/P
$0.3
Inventory
0.7
Accruals
0.3
F. Assets
0.4
Common Stock $1 m
_____________________________________
T. Assets $1.6m T. Claims
$1.6m
CHAPTER 23 – Working Capital Management – General Issues
23 - 21
Suppliers of initial inventory
are paid ($0.3m). Labour
costs ($0.2m in accruals)
are paid – resulting in a $0
cash balance.
Cash Flow Cycle
Step 6
Payment of initial A/P and Accruals
Work-in-process
inventory
Finished goods
inventory
Depreciation
Labour/utilities
Fixed Assets
$200,000 paid
Cash Account
Inventory
Balance = $0
Owner/Shareholders
invest and receive
common stock
= $1,000,000
$300,000 paid
Balance Sheet
Cash
$0.0
A/P
$0.0
Inventory
0.7
Accruals
0.1
F. Assets
0.4
Common Stock
$1 m
_____________________________________
T. Assets $1.0m T. Claims
$1.1m
CHAPTER 23 – Working Capital Management – General Issues
23 - 22
Sale of inventory occurs.
Accounts receivable created.
Cash = $0. There are 30
days till A/R collected.
Cash Flow Cycle
Step 7
Goods sold on A/R for a profit
Work-in-process
inventory
Finished goods
inventory
Depreciation
Fixed Assets
Sold $400,000 of
F.G. Inventory for
$500,000
Labour/utilities
Cash Account
Inventory
Balance = $0
Owner/Shareholders
invest and receive
common stock
= $1,000,000
Balance Sheet
Cash
A/R
Inventory
F. Assets
$0.0
0.5
0.3
0.4
A/P
$0.0
Accruals
0.1
Common Stock $1 m
R/E
0.1
____________________________________
T. Assets $1.2m T. Claims
$1.2m
CHAPTER 23 – Working Capital Management – General Issues
23 - 23
Summary of the Exercise
• This firm is left at the stage where it is waiting to
collect on accounts receivable, but should be
ordering more inventory and converting that
inventory into saleable products.
• The firm could move forward if it had additional
financing:
– Sale of additional shares to investors
– Borrow funds
– Delay payment of wages to employees until collection
of accounts receivable
– Collect on accounts receivable.
CHAPTER 23 – Working Capital Management – General Issues
23 - 24
The Cash Budget
Sample
Table 23-3 ABC's 12-Month Cash Budget
10
12
11
1
2
3
4
5
6
7
8
9
Sales
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
5,500
6,000
6,500
Cash inflow
1,000
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
5,500
6,000
750
1,125
1,500
1,875
2,250
2,625
3,000
3,375
3,750
4,125
4,500
4,875
0
375
375
375
375
375
375
375
375
375
375
375
250
-500
-375
-250
-125
0
0
250
375
500
625
750
Start cash
1,000
1,250
750
375
125
0
0
125
375
750
1,250
1,875
End cash
1,250
750
375
125
0
0
0
375
750
1,250
1,875
2,625
Required cash
200
300
400
500
600
700
700
900
1,000
1,100
1,200
1,300
Surplus/deficit
1,050
450
-25
-375
-600
-700
-700
-525
-250
150
675
1,325
$
Cash outflow
Current sales
Inventory
Operating cash
CHAPTER 23 – Working Capital Management – General Issues
23 - 25
The Cash Budget
Purpose
• The cash budget is a planning tool used to
forecast cash inflows and outflows (usually
each month) out into the future.
• The purpose of the cash budget is to forecast
the timing, magnitude and duration of cash flow
surpluses and deficits.
• The cumulative impact of the cash
inflows/outflows will be forecast through the
cash budget.
CHAPTER 23 – Working Capital Management – General Issues
23 - 26
Forecast Cash Balances
Timing
$ Cash
Predicting when forecast deficits start and end allow
the manager to communicate with the bank and
eventually becomes a control-mechanism for the bank
when monitoring the evolving financial condition of the
firm.
Jan Feb Mar Apr May Jun Jul Aug
CHAPTER 23 – Working Capital Management – General Issues
23 - 27
Forecast Cash Balances
Magnitude
$ Cash
How much the
firm is likely to
need to borrow
to cover a
projected
deficit.
Jan Feb Mar Apr May Jun Jul Aug
CHAPTER 23 – Working Capital Management – General Issues
23 - 28
Forecast Cash Balances
Duration
$ Cash
The length of time that the projected cash
deficit will last is useful in choosing the right
financing solution, but is also an important
control mechanism for monitoring after the
fact.
Jan Feb Mar Apr May Jun Jul Aug
CHAPTER 23 – Working Capital Management – General Issues
23 - 29
The Cash Budget
Use
• The Cash Budget:
– Allows management to change plans before they are
implemented to produce a more favourable cash
result
– Allows management to choose the most correct
investment option in the case of forecast surpluses
– Allows management to arrange the most appropriate
financing solution in the case of forecast deficits.
CHAPTER 23 – Working Capital Management – General Issues
23 - 30
Cash Budgets
Dealing with Forecast Surpluses
•
Knowing the timing, magnitude and duration of cash surpluses allows
management to choose the most appropriate management response:
– Small Amount of Surplus available for a short period of time (ie. less than
$100,000)
• Keep in current account
– Small Sum available for a long period time
• Consider dispersing as cash dividends
• Potentially retire debt
– Large Sum available for a short period of time 30 – 90 days (ie. greater than
$100,00)
• Invest in money market securities such as T-bills
– Large Sum available for a long period time
• Consider dispersing excess funds as cash dividends
• Alternatively invest in longer-time, higher yielding investments
CHAPTER 23 – Working Capital Management – General Issues
23 - 31
Cash Budgets
Dealing with Forecast Deficits
•
Knowing the timing, magnitude and duration of cash deficits allows
management to choose the most appropriate management response:
– Small deficit persisting for a short period of time (ie. less than $100,000)
• Delay purchases, speed collections and try to synchronize cash flows to eliminate
or minimize, or
• Negotiate an operating line of credit with the financial institution
– Small deficit available for a long period time
• Explore more permanent solutions to the under-funding
– Large deficit forecast to last a short period of time 30 – 90 days (ie. greater
than $100,00)
• Operating line of credit, or
• Seek longer term permanent capital solutions if large cash flow deficits are likely to
reoccur.
– Large Sum available for a long period time
• Seek permanent capital increases in the form of debt, equity or combination.
CHAPTER 23 – Working Capital Management – General Issues
23 - 32
Analyzing Cash Inflows and Outflows
Cash Changes and Sales Growth
• Analysis of the impact of sales growth on the firm’s cash
position can be done using Equation 23 -1:
[ 23-1]
Cash  St 1[1-b(1  2 g )]
The sensitivity of cash
to sales growth will be
strongly related to the
firm’s inventory and
accounts receivable
policies.
• Where:
g = monthly sales growth
b = the cash production cost and (1 – b ) = unit contribution margin, and
St-1 = Sales at time minus 1
• When this relationship is graphed we get a straight line.
CHAPTER 23 – Working Capital Management – General Issues
23 - 33
Analyzing Cash Inflows and Outflows
Credit, Inventory and Payables
• We can create a formula to explore the sensitivity of the
firm’s cash position with respect to the firms credit,
inventory and payables policies.
• Let:
α = the firm’s credit policy as the percentage of sales collected
this month
1 – α = the balance of sales collected in the month following sales
β = the proportion of this month’s production costs paid in this
month
1 - β= the proportion of production costs paid next month.
Γ = perecentage of the firm’s monthly sales tied up in inventory
CHAPTER 23 – Working Capital Management – General Issues
23 - 34
Analyzing Cash Inflows and Outflows
Credit, Inventory and Payables
• Equation 23 -2 shows that the change in cash each month depends
on:
– Credit policy – how much sales revenue is collected in the month of sale
– Inventory management practices
– Trade credit – how much of current production is paid this month versus
next month:
[ 23-2]
Cash  S1  (1   ) St 1-bβbt  b(1   ) St 1  bγ( St  St 1 )
CHAPTER 23 – Working Capital Management – General Issues
23 - 35
Analyzing Cash Inflows and Outflows
Credit, Inventory and Payables
• We can simplify Equation 23 -2 by including the sales growth rate
and removing the different sales levels:
[ 23-3]
Cash
 ( 1-b)  [-b(β  γ)]g
St 1
We can now graph the change in cash
against the sales growth rate:
CHAPTER 23 – Working Capital Management – General Issues
23 - 36
Analyzing Cash Inflows and Outflows
Change in Cash and Sales Growth
23 - 1 FIGURE
The slope of
this line is
determined by
the firm’s
credit,
inventory and
payables
policies and
practices.
Cash
Sb-1
(1-b)
(  b(    )) g
g
“Break-even” Sales Growth Rate
CHAPTER 23 – Working Capital Management – General Issues
23 - 37
Analyzing Cash Inflows and Outflows
Change in Cash and Sales Growth
23 - 1 FIGURE
A lower slope
for this line will
reduce the
firm’s cash
sensitivity to
changes in
sales.
Cash
Sb-1
(1-b)
(  b(    )) g
g
“Break-even” Sales Growth Rate
CHAPTER 23 – Working Capital Management – General Issues
23 - 38
Analyzing Cash Inflows and Outflows
Change in Cash and Sales Growth
23 - 1 FIGURE
Cash
Sb-1
(1-b)
(  b(    )) g
g
A lower slope can
be achieved
by:
• Collecting on
A/R more
quickly
• Delaying
payments on
A/P longer
• Increasing the
inventory
turnover rate.
“Break-even” Sales Growth Rate
CHAPTER 23 – Working Capital Management – General Issues
23 - 39
Analyzing Cash Inflows and Outflows
Credit, Inventory and Payables
•
We can solve for the monthly sales growth rate where the firm can grow
without needing or generating cash:
[ 23-4]
•
1 b
g
[b(    )   ]
The firm can grow faster if:
–
–
–
–
–
It has a higher gross margin (1 – b)
Lower production costs (b)
Collects is receivables more quickly (higher α)
Pays its bills more slowly (lower β)
Has less inventory (lower γ)
CHAPTER 23 – Working Capital Management – General Issues
23 - 40
Use of Ratios in Working Capital
Management
• Ratios are commonly used to assess or to
summarize a firm’s working capital
management.
• The focus of such an assessment is:
– Liquidity management
– The firm’s efficiency in asset utilization
– Current liability management
CHAPTER 23 – Working Capital Management – General Issues
23 - 41
Working Capital Management
Liquidity Ratios
•
Ratios used to assess the firm’s liquidity include the current and
quick ratios:
Current ratio 
[ 23-5]
[ 23-6]
•
Quick ratio 
Current assets (CA)
Current liabilitie s (CL)
Cash(C )  Marketable sec urities ( MS )  accounts receivable ( AR)
CL
Excessive liquidity will reduce ROI and ROE. It can also mean the
firm is too lenient in terms of credit policy, or may have excessive
inventories that may be subject to technological obsolescence.
CHAPTER 23 – Working Capital Management – General Issues
23 - 42
Working Capital Management
Working Capital Ratios
• Changes in these ratios can indicate growing problems with
credit policy and/or a need to improve collections efforts.
Receivable s turnover(R T) 
[ 23-7]
[ 23-8]
Average collection period(ACP ) 
Sales
AR
AR
365

Average daily sales ( ADS ) RT
• The shorter the collection period, the lower the cash
sensitivity to changes in sales.
CHAPTER 23 – Working Capital Management – General Issues
23 - 43
Working Capital Management
Working Capital Ratios
•
CGS is not likely to be comparable across different firms, so
alternative is to use Sales in the numerator as illustrated in Equation
23 - 10.
Inventory Turnover(I T) 
[ 23-9]
[ 23-10]
•
Costof goods sold (CGS )
Inventory
Inventory Turnover(I T) 
Sales
Inventory
The higher the inventory turnover, the lower the sensitivity of cash to
changes in sales.
CHAPTER 23 – Working Capital Management – General Issues
23 - 44
Working Capital Management
Working Capital Ratios
• Dividing 364 days by inventory turnover (IT) gives ADSI:
[ 23-10]
[ 23-11]
Inventory Turnover(I T) 
Sales
Inventory
Average days sales in inventory( ADSI) 
Inventory 365

ADS
IT
• The higher IT the lower ADSI showing more efficient inventory
management and a reduced sensitivity of cash to changes in
sales.
CHAPTER 23 – Working Capital Management – General Issues
23 - 45
Working Capital Management
Working Capital Ratios
•
On the liability side of the balance payable management ratios
include:
[ 23-12]
[ 23-13]
•
•
Payables turnover( PT) 
Sales
Accounts payable
Average days of sales in payables(A DSP) 
Accounts payable 365

ADS
PT
PT shows how many times a year a firm pays off its suppliers on
average.
ADSP showsCHAPTER
how long
a firm defers payments to its suppliers.
23 – Working Capital Management – General Issues
23 - 46
Operating Cycle (OC)
– Operating cycle is the time period
between the acquisition of inventory
and when cash is collected from
receivables.
CHAPTER 23 – Working Capital Management – General Issues
23 - 47
Working Capital Management
Operating and Cash Conversion Cycles
• Operating Cycle is defined by Equation 23 -14:
[ 23-14]
OC  ADSI  ACP
• Operating cycle is a function of average days sales in inventory and
the average collection period.
CHAPTER 23 – Working Capital Management – General Issues
23 - 48
Cash Conversion Cycle (CCC)
• Cash cycle is the time between cash
disbursement and cash collection.
• An estimate of the average time between
when a firm pays cash for its inventory
purchases and when it receives cash for
its sales; the average number of days of
sales that firm must finance outside the
use of trade credt.
CHAPTER 23 – Working Capital Management – General Issues
23 - 49
Working Capital Management
Operating and Cash Conversion Cycles
• The Cash Conversion Cycle is defined by Equation 23 – 15:
[ 23-15]
CCC  OC - ADSP
• The estimated time between when a firm pays cash for inventory
purchases and when it receives cash from sales.
CHAPTER 23 – Working Capital Management – General Issues
23 - 50
Cash Conversion Cycle (CCC)
Operating and Cash Conversion Cycles
Cash Conversion Cycle
= Inventory conversion period +
Receivables conversion period Payables deferral period
Management of the cash cycle can make an important difference
in the amount of financing required, assets employed to
generate a given level of sales...and therefore, can affect ROA
and ROE.
CHAPTER 23 – Working Capital Management – General Issues
23 - 51
Cash Flow Time Line
Operating and Cash Conversion Cycles
Cash
received
Inventory
sold
Inventory
purchased
Inventory period
Accounts receivable period
Time
Accounts payable period
Cash paid for
inventory
Operating cycle (OC)
Cash Conversion Cycle (CCC)
CHAPTER 23 – Working Capital Management – General Issues
23 - 52
Importance of Cash Flow
• Planning to have cash available to pay bills of the business as
they become due is a critical aspect of business survival…it is
a management skill.
• Understanding the cash flow cycle of a firm can help you
manage those elements that are critical to ensuring you can
pay your bills.
• Cash flow forecasting through a cash budget provides
important information to you and to your potential funding
partners about your operating financial needs and most
particularly, the timing and magnitude of any projected cash
deficits or surpluses.
CHAPTER 23 – Working Capital Management – General Issues
23 - 53
The Cash Budget
• The purpose of the cash budget is to forecast
the timing and magnitude of expected cash
deficits and surpluses so that, before the fact,
you (the manager) can arrange appropriate
financing or plan an appropriate investment
strategy.
CHAPTER 23 – Working Capital Management – General Issues
23 - 54
Short-term Credit
•
•
short-term loans can be secured much more quickly than long-term credit
short-term credit is generally more flexible
– low flotation costs
– generally no prepayment penalties
– fewer restrictive covenants
•
•
with an upward sloping yield curve - short-term credit is normally less
expensive than long-term debt
short-term credit may be more risky than long-term debt:
– interest rate risk exposure
– renegotiation risk
CHAPTER 23 – Working Capital Management – General Issues
23 - 55
Sources of Short-term Financing
• Accruals
– spontaneous source of financing
– no explicit cost to these sources
– examples:
• accrued wages
• accrued taxes
CHAPTER 23 – Working Capital Management – General Issues
23 - 56
Sources of Short-term Financing
• Accounts Payable / Trade Credit
– there may be no explicit cost (eg. Net 30)
– if there is a discount for early payment, then
there is an implicit cost for not taking the
discount.
– discounts lost - an expense on the income
statement can reduce net income more than
taking a loan in order to take the discount.
CHAPTER 23 – Working Capital Management – General Issues
23 - 57
Approximate Cost of A/P
Approximate percentage cost =
[Discount percentage/(100 - Discount percentage)]
[365/(Days credit is outstanding - Discount period)]
EAR = (1 + periodic interest rate)(number of times/year such an activity can occur) - 1
Example: assume (2/10 net 30)
Approximate percentage cost = (2/98)(365/20) = 37.2%
EAR = (1 + .0204082)18.25 - 1 = 1.4458539 - 1 = 44.6%
(This, of course, assumes that the company pays on the 30th day. The
costs will change if the firm pays later or earlier.)
CHAPTER 23 – Working Capital Management – General Issues
23 - 58
Sources of Short-term Financing
• Bank Loans
– types:
• operating loans
• line of credit
• revolving credit agreement
– costs:
Effective ratesimple = interest/amount received = $800/$10,000 = 8%
CHAPTER 23 – Working Capital Management – General Issues
23 - 59
Costs of Bank Loans
Discount Interest
Interest is deducted in advance, reducing the principal amount available to
to borrower.
Effective ratediscount = interest/amount received
= interest/(Face value - interest)
= $800/($10,000 - $800)
= 8.7%
or
Effective ratediscount = 8%/(1-.08) = 8%/(.92) = 8.7%
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Cost of Bank Loans
Compensating Balances
Reduce the the amount of the loan available to the borrower and effectively
increase the cost of the loan.
Effective ratesimple/CB = Nominal Rate(%)/ (1.0 - CB stated as a fraction)
= 8%/(1.0 - 0.10)
= 8%/.9
= 8.9%
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Commercial Paper
• short-term unsecured promissory note issued
only by the most credit-worthy of corporate
issuers
• by-passes banks and allows the firm direct
access to the money market
• is a negotiable security that does not carry a
stated rate of interest, rather, it trades at a
discount from par value.
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Banker’s Acceptances
• an alternative to commercial paper for smaller
firms that don’t have the credit-worthiness to
secure commercial paper financing.
• a money market instrument
• the bank “accepts” the promissory note by
stamping it “accepted”....the note therefore is
secured by the Bank’s promise to pay.
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Pledging of A/R
• lender has claims against the receivables as
well as recourse to the borrower.
• the risk of default on the receivable stays with
the borrower.
• the buyer of the goods does not know that the
receivables have been pledged as collateral for
a loan.
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Factoring (Selling) A/R
•
•
•
legally binding agreement between the seller of the goods and the financial
institution.
the factoring institution receives a credit approval slip...the institution does a credit
check...if approved, shipment is made and the buyer is instructed to make payment
directly to the factoring company.
the factor - credit check - lends - bears risk - in the process of performing these
•
functions, the firm that sells its receivables to a factor, eliminates the need for an
accounts receivable department and receives a net amount of cash immediately
following the sale...these funds are advanced by the factor.
the factor is compensated for its services and protects its interests by charging
•
interest, charging a commission and maintaining a hold-back(reserve) in the case
of disputes between buyer and seller over damaged goods, returns, etc.
once this arrangement is in place - the financing is spontaneous.
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Inventory Financing
•
•
•
Blanket Liens - gives the lending institution a lien against all of the
borrower’s inventories.
Trust Receipts - issued for specific items of inventory. The
lending institution sends someone to the borrower’s premises to
periodically check that the numbers are correctly listed.
Warehouse Receipts - either an independent third party
warehouses the goods, or the goods are secured in a separate
location on the borrower’s property. Warehouse financing
involves:
• public notification
• physical control of the inventory
• supervision by a custodian
- used to finance the seasonal buildup of inventory.
- ensures proper warehousing practices...and inventory control.
- because of the foregoing, inventory becomes more acceptable as collateral.
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Balance Sheet Accounts over time
120
100
80
Cash
Inventories
60
40
20
0
Ja Fe Ma Ap Ma Jn Ju Au Se Oc No De
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Selecting the Fiscal Year End
• tax considerations
– for smaller, owner/managed enterprises, there are greater tax-planning
opportunities if the corporate fiscal year end is set sometime after the calendar
year end
– the firm’s financial position
– firms will look most healthy if the fiscal year end is set sometime after
the seasonal sales peak....long enough afterward to see receivables
collected.
– auditors preferences
– auditors are busy around the calendar year end...with firms and
individuals that have selected Dec 31 as their year end.
– auditors are busy from February through May with income tax
CHAPTER 23 – Working Capital Management – General Issues
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Key Topics
•
•
•
•
•
•
•
Reasons for holding Cash
Advantages of holding Cash
Cash Budgets
Cash Management Techniques
Marketable Securities Management
Criteria for selecting marketable securities
Balancing Cash and Marketable Security Holdings
CHAPTER 23 – Working Capital Management – General Issues
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Reasons for Holding Cash
• transactions
• compensation to banks for providing services
and loans
• precautionary balances/speculative balances
vs. reserve borrowing capacity.
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Advantages of Holding Cash
• take advantage of trade discounts
• maintain adequate liquidity...and therefore a
strong credit rating
• take advantage of special offers and
unexpected opportunities
• have sufficient liquid resources in times of
emergency
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Marketable Securities
• holding M/S
–
–
–
–
conservative working capital management strategy
finance seasonal/cyclical needs
build funds for a major investment/acquisition/cash outflow
productive precautionary balance
• criteria used to select M/S
–
–
–
–
–
default risk
interest rate risk
purchasing power risk
liquidity or marketability risk
overall rate of return
CHAPTER 23 – Working Capital Management – General Issues
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In summary you have …
•
•
•
•
gained an understanding the management of short-term
finance
learned that short-term cash flow management involves
the minimizing of costs while ensuring there are adequate
liquid resources available to meet the anticipated needs
learned that in the real world, the firm must keep
additional working capital resources as a buffer against
unexpected needs and opportunities
learned how to prepare a cash budget and how to use it.
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Summary and Conclusions
In this chapter you have learned:
– The importance of effective working capital management
and the classic cash flow challenges faced by growing
firms.
– That an integrative approach to working capital
management reveals the relationships and
interdependency among working capital accounts
– How to generate and use cash budgets
– How to use some common ratios to assess a firm’s overall
approach to working capital management.
CHAPTER 23 – Working Capital Management – General Issues
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Copyright
Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
permitted by Access Copyright (the Canadian copyright licensing
agency) is unlawful. Requests for further information should be
addressed to the Permissions Department, John Wiley & Sons
Canada, Ltd. The purchaser may make back-up copies for his or her
own use only and not for distribution or resale. The author and the
publisher assume no responsibility for errors, omissions, or
damages caused by the use of these files or programs or from the
use of the information contained herein.
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