Chapter 22


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Chapter 22

  1. 1. Chapter 22 Working Capital Management in the MNE
  2. 2. Working Capital Management in the MNE <ul><li>Working capital management in a multinational enterprise requires managing current assets (cash balances, accounts receivable, and inventory) and current liabilities (accounts payable and short-term debt) when faced with political, foreign exchange, tax, and liquidity constraints. </li></ul><ul><li>The overall goal is to reduce funds tied up in working capital while simultaneously providing sufficient funding and liquidity for the conduct of global business. </li></ul><ul><li>Working capital management should enhance return on assets and return on equity and should also improve efficiency ratios and other performance measures. </li></ul>
  3. 3. Working Capital Management <ul><li>The operating cycle of a business generates funding needs, cash inflows and outflows (the cash conversion cycle ) and foreign exchange rate and credit risks. </li></ul><ul><li>The funding needs generated by the operating cycle of the firm constitute working capital . </li></ul><ul><li>The cash conversion cycle, a subcomponent of the operating cycle (working capital cycle), is that period of time extending between cash outflow for purchased inputs and materials and cash inflow from cash settlement. </li></ul>
  4. 4. Working Capital Management <ul><li>The operating and cash conversion cycles for Cascade Mexico is illustrated in the following exhibit. </li></ul><ul><li>This is decomposed into five different periods (each with business, accounting, and potential cash flow implications): </li></ul><ul><ul><li>Quotation period </li></ul></ul><ul><ul><li>Input sourcing period </li></ul></ul><ul><ul><li>Inventory period </li></ul></ul><ul><ul><li>Accounts payable period </li></ul></ul><ul><ul><li>Accounts receivable period </li></ul></ul>
  5. 5. Exhibit 22.1 Operating and Cash Cycles for Cascade Mexico time Operating Cycle Cash Conversion Cycle Price Quote Order Placed Order Shipped Payment Received Inputs Received Accounts Receivable Period Quotation Period Input Sourcing Period Accounts Payable Period t 0 t 1 t 2 t 3 t 4 t 5 Inventory Period Cash Payment for Inputs Cash Settlement Received Cascade Mexico Cash Outflow Cash Intflow
  6. 6. Working Capital Management <ul><li>If Cascade Mexico’s business continues to expand, it will continually add to inventories and accounts payable (A/P) in order to fill increased sales in the form of accounts receivable (A/R). </li></ul><ul><li>These components make up net working capital (NWC): </li></ul><ul><li>NWC = (A/R + inventory) – (A/P) </li></ul>
  7. 7. Exhibit 22.2 Cascade Mexico’s Net Working Capital Requirements Net Working Capital (NWC) is the net investment required of the firm to support on-going sales. NWC components typically grow as the firm buys inputs, produces product, and sells finished goods. Assets Liabilities & Net Worth Cash Accounts receivable (A/R) Inventory Current assets Accounts payable (A/P) Short-term debt Current liabilities NWC = ( A/R + Inventory ) - A/P Note that NWC is not the same as Current assets & Current liabilities. Cascade Mexico’s Balance Sheet
  8. 8. Working Capital Management <ul><li>The previous exhibit illustrates one of the key managerial decisions for any subsidiary: </li></ul><ul><ul><li>Should A/P be paid off early, taking discounts offered by suppliers? </li></ul></ul><ul><ul><li>The alternate form of financing for NWC balances is short-term debt </li></ul></ul><ul><li>In our example, Cascade Mexico’s CFO must decide which is the lower cost (short-term Mexican peso borrowings or the effective annual interest cost of supplier financing – cost of carry ). </li></ul><ul><li>Clearly, there are issues such as access to local currency debt, or various intra-company financing alternatives that complicate the decision. </li></ul>
  9. 9. Working Capital Management <ul><li>A common method of benchmarking financial management practice is to calculate the NWC of the firm on a “days sales” basis. </li></ul><ul><li>An analysis of this metric in a global context shows that US firms have a typical days sales of 29, while the European group has a days sales of 75. </li></ul><ul><li>Clearly, European-based (technology firms in this example) are carrying a significantly higher level of net working capital in their financial structures. </li></ul>
  10. 10. Working Capital Management <ul><li>The MNE itself poses some unique challenges in the management of working capital. </li></ul><ul><li>Many multinationals manufacture goods in a few specific countries and then ship the intermediate products to other facilities globally for completion and distribution. </li></ul><ul><li>The payables, receivables, and inventory levels of the various units are a combination of intra-firm and inter-firm. </li></ul><ul><li>The varying business practices observed globally regarding payment terms – both days and discounts – create severe mismatches in some cases. </li></ul>
  11. 11. Exhibit 22.4 Cascade’s Multinational Working Capital Sequence A/P A/R Inventory Cascade USA Balance Sheet A/P A/R Inventory Cascade Mexico Balance Sheet A/P Local-sourcing: 60 days Intra-firm: 30 days 30 days 60 days Cash inflows to Cascade Mexico arise from local market sales. These cash flows are used to repay both intra-firm payables (to Cascade USA) and local suppliers. Mexican Business Practices Payment terms in Mexico are longer than those typical of the United States. Cascade Mexico must offer 60-day terms to local customers to be competitive with other firms in the local market. United States Business Practices Payment terms used by Cascade USA are typical of the United States, 30 days. Cascade USA’s local customers will expect to be paid in 30 days. Cascade USA may consider extending longer terms to Mexico to reduce the squeeze . Result: Cascade Mexico is squeezed in terms of cash flow. It receives inflows in 60 days but must pay Cascade USA in 30 days.
  12. 12. Working Capital Management <ul><li>A firm’s operating cash inflow is derived primarily from the collection of accounts receivable. </li></ul><ul><li>Multinational accounts receivable are created by two separate types of transactions: </li></ul><ul><ul><li>Sales to related subsidiaries </li></ul></ul><ul><ul><li>Sales to independent or unrelated buyers </li></ul></ul><ul><li>Management of accounts receivable form independent customers requires two types of decisions: </li></ul><ul><ul><li>What currency should the transaction be denominated? </li></ul></ul><ul><ul><li>What should be the terms of payment? </li></ul></ul>
  13. 13. Working Capital Management <ul><li>Operations in inflationary, devaluation-prone economies sometimes force management to modify its normal approach to inventory management. </li></ul><ul><li>In some cases, management may choose to maintain inventory and reorder levels far in excess of what would be called for in an economic order-quantity model. </li></ul><ul><li>It is important to anticipate: </li></ul><ul><ul><li>Devaluation </li></ul></ul><ul><ul><li>Price freezes </li></ul></ul><ul><ul><li>The implications of various forms of free-trade zones </li></ul></ul>
  14. 14. International Cash Management <ul><li>International cash management is the set of activities determining the levels of cash balances held throughout the MNE ( cash management ) and the facilitation of its movement cross-border ( settlements and processing ). </li></ul><ul><li>These activities are typically handled by the international treasury of the MNE. </li></ul>
  15. 15. International Cash Management <ul><li>The level of cash maintained by an individual subsidiary is determined independent of the working capital management decisions we have discussed. </li></ul><ul><li>Cash balances, including marketable securities, are held partly to enable normal day-to-day cash disbursements and partly to protect against unanticipated variations from budgeted cash flows. </li></ul><ul><li>These two motives are called the transaction motive and the precautionary motive . </li></ul>
  16. 16. International Cash Management <ul><li>Cash disbursed for operations is replenished from two sources: </li></ul><ul><ul><li>Internal working capital turnover </li></ul></ul><ul><ul><li>External sourcing, traditionally short-term borrowing </li></ul></ul><ul><li>Efficient cash management aims to reduce cash tied up unnecessarily in the system, without diminishing profit or increasing risk, so as to increase the rate of return on invested assets. </li></ul>
  17. 17. International Cash Management <ul><li>All firms, both domestic and international, engage in some form of the following fundamental steps: </li></ul><ul><ul><li>Planning </li></ul></ul><ul><ul><li>Collection </li></ul></ul><ul><ul><li>Repositioning </li></ul></ul><ul><ul><li>Disbursement </li></ul></ul><ul><ul><li>Covering cash shortages </li></ul></ul><ul><ul><li>Investing surplus cash </li></ul></ul>
  18. 18. International Cash Management <ul><li>Multinational business increases the complexity of making payments and settling cash flows between related and unrelated firms. </li></ul><ul><li>Over time a number of techniques and services have evolved that simplify and reduce the costs of making these cross-border payments. </li></ul><ul><li>Four such techniques include: </li></ul><ul><ul><li>Wire transfers (exhibit 22.5) </li></ul></ul><ul><ul><li>Cash pooling </li></ul></ul><ul><ul><li>Payment netting (exhibit 22.7) </li></ul></ul><ul><ul><li>Electronic fund transfers </li></ul></ul>
  19. 19. Exhibit 22.5 Average Daily Dollar Amount Handled by CHIPS (billions of US dollars) Source: Clearing House Interbank Payment System, (April 2002).
  20. 20. Exhibit 22.7 Multilateral Matrix Before Netting (thousands of US dollars) Quad United Kingdom Quad Belgium Deutscheland Quad Quad de France $5,000 $4,000 $4,000 $3,000 $2,000 $1,000 $5,000 $3,000 $3,000 $2,000 $6,000 $5,000 The Four European Affiliates of Quad Corporation Prior to netting, the four sister affiliates of Quad Corporation have numerous intra-firm payments between them. Each payment results in transfer charges.
  21. 21. Financing Working Capital <ul><li>All firms need to finance working capital. </li></ul><ul><li>The normal sources of funds for financing short-term working capital are accounts payable to suppliers and loans against bank credit lines. </li></ul><ul><li>In some countries, such as the United States, borrowing is done by the firm issuing notes payable to banks and other creditors. </li></ul><ul><li>In many other countries, short term borrowing is done on an “overdraft” basis. </li></ul><ul><li>In all cases, permanent working capital requirements, as opposed to seasonal needs, are at least partially financed with long-term debt and equity. </li></ul>
  22. 22. Exhibit 22.9 Multilateral Matrix After Netting (thousands of US dollars) Quad United Kingdom Quad Belgium Deutscheland Quad Quad de France The Four European Subsidiaries of Quad Corporation After netting, the four sister subsidiaries of Quad Corporation have only three net payments to make among themselves to settle all intra-firm obligations Pays $1,000 Pays $3,000 Pays $1,000
  23. 23. Financing Working Capital <ul><li>Some MNEs have found that their financial resources and needs are either too large or too sophisticated for the financial services available in may locations where they operate. </li></ul><ul><li>One solution to this has been the establishment of an in-house or internal bank within the firm. </li></ul><ul><li>Such an in-house bank is not a separate corporation; rather, it is a set of functions performed by the existing treasury department. </li></ul><ul><li>The following exhibit, illustrates how the in-house bank of Cascade Pharmaceuticals, Inc., could work. </li></ul>
  24. 24. Financing Working Capital <ul><li>Cascade Mexico sells all its receivables to the in-house bank as they arise, reducing some of the domestic working capital needs. </li></ul><ul><li>Additional working capital needs are supplied by the in-house bank directly to Cascade Mexico. </li></ul><ul><li>Because the in-house bank is part of the same company, the interest rates it charges may be significantly lower than what Cascade Mexico could obtain on its own. </li></ul><ul><li>In addition to providing financing benefits, in-house banks allow for more effective currency risk management. </li></ul>
  25. 25. Exhibit 22.10 Cascade’s In-House Bank Cascade’s In-House Bank Cascade Europe Cascade Mexico Cash flow Cash flow Cascade Europe deposits excess cash balances with the in-house bank. Cascade Mexico sells its receivables to the in-house bank, receiving cash and receiving working capital financing. Cascade’s in-house bank reallocates cash and capital within the MNE network.
  26. 26. Financing Working Capital <ul><li>MNEs depend on their commercial banks to handle most of the trade financing needs, such as letters of credit, and to provide advice on government support, country risk assessment, introductions to foreign firms and banks, and general financing availability. </li></ul><ul><li>The main points of bank contacts are correspondent banks, representative offices, branch banks, subsidiaries, and affiliates. </li></ul>