Working Capital Management: Current Assets and Current ...


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Working Capital Management: Current Assets and Current ...

  1. 1. Prepared by Ken Hartviksen INTRODUCTION TO CORPORATE FINANCE Laurence Booth • W. Sean Cleary Chapter 24 – Working Capital Management: Current Assets and Current Liabilities
  2. 2. CHAPTER 24 Working Capital Management: Current Assets and Current Liabilities
  3. 3. Lecture Agenda <ul><li>Learning Objectives </li></ul><ul><li>Important Terms </li></ul><ul><li>Cash Management </li></ul><ul><ul><li>Reasons for Holding Cash </li></ul></ul><ul><ul><li>Determining the Optimal Cash Balance </li></ul></ul><ul><ul><li>Cash Management Techniques </li></ul></ul><ul><li>Accounts Receivable Management </li></ul><ul><ul><li>The Credit Decision </li></ul></ul><ul><ul><li>Credit Policies </li></ul></ul><ul><ul><li>The Collection Process </li></ul></ul><ul><li>Inventory Management </li></ul><ul><ul><li>Inventory Management Approaches </li></ul></ul><ul><ul><li>Evaluating Inventory Management </li></ul></ul><ul><li>Short-Term Financing Considerations </li></ul><ul><li>Summary and Conclusions </li></ul><ul><ul><li>Concept Review Questions </li></ul></ul>
  4. 4. Learning Objectives <ul><li>You should understand the following: </li></ul><ul><li>How to manage individual asset items, such as cash, receivables, and inventory </li></ul><ul><li>The nature of the major sources of short-term financing, such as trade credit, bank loans, factoring arrangements, and money market securities </li></ul><ul><li>The fact that in evaluating current asset and current liability decisions, the final decision rests on the standard problem of trading off expected benefits and potential costs </li></ul>
  5. 5. Important Chapter Terms <ul><li>ABC approach </li></ul><ul><li>Capacity </li></ul><ul><li>Character </li></ul><ul><li>Conditions </li></ul><ul><li>Credit analysis </li></ul><ul><li>Credit enhancements </li></ul><ul><li>Economic Order Quantity </li></ul><ul><li>Factoring arrangements </li></ul><ul><li>Finance motive </li></ul><ul><li>Float </li></ul><ul><li>Just-in-time inventory systems </li></ul><ul><li>Materials requirement planning </li></ul><ul><li>Open account </li></ul><ul><li>Optimal cash balance </li></ul><ul><li>Precautionary motive </li></ul><ul><li>Prepayments </li></ul><ul><li>Securitization </li></ul><ul><li>Special purpose vehicles </li></ul><ul><li>Speculative motive </li></ul><ul><li>Terms of credit </li></ul><ul><li>Transactions motive </li></ul>
  6. 6. Cash and Marketable Securities Working Capital Management Current Assets and Current Liabilities
  7. 7. Cash and Marketable Securities Reasons for Holding Cash <ul><li>Transactions motive </li></ul><ul><li>Precautionary motive </li></ul><ul><li>Finance motive </li></ul><ul><li>Speculative motive </li></ul>
  8. 8. Cash and Marketable Securities Determining the Optimal Cash Balance <ul><li>The optimal cash balance is the amount of cash that balances the risks of illiquidity against the sacrifice in expected return that is associated with maintaining cash. </li></ul><ul><ul><li>Differs substantially across firms </li></ul></ul><ul><ul><ul><li>Firms with predictable cash flows will have lower optimal cash balance requirement </li></ul></ul></ul><ul><ul><ul><li>Firms with excess borrowing capacity (unused line of credit for example) can hold less cash. </li></ul></ul></ul>
  9. 9. Cash and Marketable Securities Cash Management Techniques <ul><li>Cash flow synchronization can free up cash (and lower the amount of capital a firm requires) </li></ul><ul><li>This is done by: </li></ul><ul><ul><li>Speeding up cash inflows: </li></ul></ul><ul><ul><ul><li>Bill clients earlier each month </li></ul></ul></ul><ul><ul><ul><li>Increase cash sales through incentives </li></ul></ul></ul><ul><ul><ul><li>Encourage customers to pay using electronic payments systems such as direct deposit, automatic debit, debit card, rather than cheque. </li></ul></ul></ul><ul><ul><li>Delaying outflows: </li></ul></ul><ul><ul><ul><li>Arrange with suppliers for more liberal trade credit terms (net 40 rather than net 30 for example) </li></ul></ul></ul><ul><ul><ul><li>Paying employees once a month rather than twice. </li></ul></ul></ul>
  10. 10. Cash Managements Float <ul><li>Float is the time that elapses between the time the paying firm initiates payment, and the time the funds are available for use by the receiving firm. </li></ul><ul><li>It has three major sources: </li></ul><ul><ul><ul><li>The time it takes the cheque to reach the firm after it is mailed by the customer. </li></ul></ul></ul><ul><ul><ul><li>The time it takes the receiving firm to process the cheque and deposit in an account, and </li></ul></ul></ul><ul><ul><ul><li>The time it takes the cheque to clear through the banking system so that the funds are available to the firm. </li></ul></ul></ul><ul><li>Float has been reduced or eliminated through: </li></ul><ul><ul><li>Debit cards </li></ul></ul><ul><ul><li>Preauthorized payments </li></ul></ul><ul><ul><li>Electronic funds transfer (EFT) and electronic data interchange (EDI) systems. </li></ul></ul>
  11. 11. Accounts Receivable Working Capital Management Current Assets and Current Liabilities
  12. 12. Accounts Receivable <ul><li>The decision to extend credit to customers has significant cash flow and credit risk implications for the firm. </li></ul><ul><ul><ul><li>Firms often don’t have a choice, if the availability of credit is an important factor in the customer’s purchase decision process (if competitors offer credit, then the firm must at least match those credit terms, and then choose to compete on another basis.) </li></ul></ul></ul><ul><li>The second decision (once the firm has decided to extend credit) is to determine which customers will be granted credit. </li></ul><ul><li>The credit terms must be established. </li></ul><ul><li>The collection process must be decided. </li></ul>
  13. 13. Accounts Receivable The Credit Decision <ul><li>The decision to extend credit is determined: </li></ul><ul><ul><li>Nature of the product sold, </li></ul></ul><ul><ul><li>The industry </li></ul></ul><ul><ul><li>Practices of competitors. </li></ul></ul>
  14. 14. Accounts Receivable Credit Analysis <ul><li>The process designed to assess the risk of non-payment by potential customers, which involves collecting information about potential customers with respect to their credit history, their ability to make payments as reflected in their expected cash flows, and their overall financial stability. </li></ul><ul><li>From the firm’s point of view: </li></ul><ul><ul><li>Often willing to extend credit on terms better than a bank because: </li></ul></ul><ul><ul><ul><li>The potential for the firm developing a good customer into the future, and </li></ul></ul></ul><ul><ul><ul><li>Losses are limited to production costs in the case of default. </li></ul></ul></ul>
  15. 15. Accounts Receivable Credit Analysis <ul><li>Variables that are weighed in the credit analysis process: </li></ul><ul><ul><li>Capacity – the customer’s ability to pay </li></ul></ul><ul><ul><li>Character – the customer’s willingness to pay </li></ul></ul><ul><ul><li>Collateral – the security that could be seized to satisfy payment </li></ul></ul><ul><ul><li>Conditions – the state of the economy. </li></ul></ul>
  16. 16. Accounts Receivable Credit Policies <ul><li>The firm must choose what terms of credit to offer its customers. </li></ul><ul><li>Terms of credit include: </li></ul><ul><ul><li>The due date </li></ul></ul><ul><ul><li>The discount amount (if any) </li></ul></ul><ul><li>Options include: </li></ul><ul><ul><li>Cash on delivery (COD) </li></ul></ul><ul><ul><li>Cash before delivery (CBD) </li></ul></ul><ul><ul><li>Net 30, net 40 - no incentive for early payment </li></ul></ul><ul><ul><li>2/10 net 30 - a 2% discount for early payment </li></ul></ul>
  17. 17. Accounts Receivable Change in Credit Policy Analysis <ul><li>When extending more lenient credit terms the firm hopes to increase revenues through the sale of more units, and perhaps even charge higher prices. </li></ul><ul><li>These benefits are offset by financing costs and the increased risk of non-payment. </li></ul><ul><li>Evaluation of these decisions can use an NPV framework: </li></ul>[ 24-1]
  18. 18. Accounts Receivable The Collection Process <ul><li>The firm must monitor outstanding A/R by customer and by category. </li></ul><ul><li>The firm must then determine what action it will take when late payments occur. </li></ul><ul><ul><li>Charge interest on outstanding balances </li></ul></ul><ul><ul><li>Notify customer of arrears (email, mail, telephone) </li></ul></ul><ul><li>Actions on unpaid amounts: </li></ul><ul><ul><li>Allow no further purchases on credit </li></ul></ul><ul><ul><li>Choose from a number of additional options to collect: </li></ul></ul><ul><ul><ul><li>Take legal action </li></ul></ul></ul><ul><ul><ul><li>Sell receivable to a collection agency </li></ul></ul></ul><ul><ul><ul><li>Write off the debt as uncollectable. </li></ul></ul></ul>
  19. 19. Accounts Receivable Factoring <ul><li>It may not be cost-effective for a firm to manage the collection process itself. </li></ul><ul><li>Factoring arrangements are the sale of a firm’s receivables, at a discount, to a financial company called a factor, which specializes in collections, or the out-sourcing of the collections to a factor. </li></ul>
  20. 20. Evaluating Receivables Management <ul><li>Use of productivity ratios introduced in Chapter 4 can give a tool for evaluating the firm’s ability to manage its accounts receivable. </li></ul>
  21. 21. Evaluating Receivables Management Receivables Turnover <ul><li>Measures the sales generated by every dollar of receivables. </li></ul>[4- 16]
  22. 22. Evaluating Receivables Management Average Collection Period <ul><li>Estimates the number of days it takes a firm to collect on its accounts receivable. </li></ul><ul><li>If ACP is 40 days, and the firm’s credit policy is net 30, clearly, customers are not paying in keeping with the firm’s policy, and there may be concerns about the quality of the firm’s customers, and what might happen if economic conditions deteriorate. </li></ul>[4- 17]
  23. 23. Inventory Working Capital Management Current Assets and Current Liabilities
  24. 24. Inventory <ul><li>The level of inventory a firm holds is a trade off between benefits and costs: </li></ul><ul><ul><li>Benefits of Holding Inventory: </li></ul></ul><ul><ul><ul><li>Take advantage of large-volume discounts </li></ul></ul></ul><ul><ul><ul><li>Reduce the probability of production disruptions because of lack of inventory </li></ul></ul></ul><ul><ul><ul><li>Minimize lost sales because of stock-outs </li></ul></ul></ul><ul><ul><li>Costs of Holding Inventory: </li></ul></ul><ul><ul><ul><li>Financing costs associated with inventory investment </li></ul></ul></ul><ul><ul><ul><li>Storage, handling, insurance, spoilage and obsolescence costs. </li></ul></ul></ul>
  25. 25. Inventory Inventory Management Approaches <ul><li>ABC Approach </li></ul><ul><li>Economic Order Quantity (EOQ) Model </li></ul><ul><li>Materials Requirement Planning (MRP) </li></ul><ul><li>Just-in-time (JIT) Inventory systems. </li></ul>
  26. 26. Inventory Evaluating Inventory Management <ul><li>Use of financial ratios can give some indication of the effectiveness of a firm’s inventory management. </li></ul><ul><li>Ratios, however, do not measure shortage costs, financing costs, etc. </li></ul><ul><li>These ratios include: </li></ul><ul><ul><li>Inventory turnover </li></ul></ul><ul><ul><li>Average day’s sales in inventory. </li></ul></ul>
  27. 27. Productivity Ratios Inventory Turnover <ul><li>Estimates the number of times, ending inventory was ‘turned over’ (sold) in the year. </li></ul><ul><li>A ratio that involves both ‘stock’ and ‘flow’ values </li></ul><ul><li>Is strongly a function of ending inventory value…managers often try to improve this ratio as they approach year end through inventory reduction strategies (cash and carry sales/inventory clearance, etc.) </li></ul>[4- 18]
  28. 28. Productivity Ratios Inventory Turnover <ul><li>When Cost of Goods Sold is not available, it may be necessary to estimate inventory turnover using sales. </li></ul><ul><li>Use of the sales figure is less valid than Cost of Goods Sold because Cost of Goods Sold is based on inventoried cost, but Sales includes a profit margin on top of inventoried cost. </li></ul>[4- 19]
  29. 29. Productivity Ratios Average Days Sales in Inventory (ADSI) <ul><li>Estimates the number of days of sales tied up in inventory (based on ending inventory values) </li></ul>[4- 20]
  30. 30. Short-Term Financing Considerations Working Capital Management Current Assets and Current Liabilities
  31. 31. Short-Term Financing Considerations <ul><li>Investment in current assets tend to rise and fall with the volume of activity. </li></ul><ul><li>Accruals and accounts payable (trade credit) are ‘spontaneous’ liabilities. </li></ul><ul><li>Other sources of financing must be ‘negotiated’ and before using the firm must evaluate the cost effectiveness of alternative financing mechanisms. </li></ul>
  32. 32. Short-Term Financing Considerations <ul><li>To estimate the annual effective rate of return or cost (k) of any financing alternative: </li></ul>[ 24-2]
  33. 33. Short-Term Financing Considerations Trade Credit <ul><li>Often a very important source of short-term financing. </li></ul><ul><li>Offers a number of advantages: </li></ul><ul><ul><li>Readily available </li></ul></ul><ul><ul><li>Convenient </li></ul></ul><ul><ul><li>Flexible </li></ul></ul><ul><ul><li>Usually does not entail any restrictive covenants or pledges of security. </li></ul></ul><ul><li>There is no explicit cost associated with credit terms such as: </li></ul><ul><ul><li>Net 30 </li></ul></ul><ul><ul><li>Net 40 </li></ul></ul>
  34. 34. Short-Term Financing Considerations Trade Credit <ul><li>There is usually a high implicit cost to a firm that forgoes discounts on early payment such as: </li></ul><ul><ul><li>2/10 Net 30 </li></ul></ul><ul><ul><li>Example: assume (2/10 net 30) </li></ul></ul><ul><ul><ul><li>Approximate percentage cost = (2/98)(365/20) = 37.2% </li></ul></ul></ul><ul><ul><li>The firm is being charged 2% for the use of funds from day 10 to day 30 (20 days). </li></ul></ul>
  35. 35. Short-Term Financing Considerations Bank Loans and Factor Arrangements <ul><li>Options include: </li></ul><ul><ul><li>Operating loans / lines of credit </li></ul></ul><ul><ul><ul><li>Secured by accounts receivable and inventory to a maximum percent of those assets </li></ul></ul></ul><ul><ul><ul><li>Interest only payments </li></ul></ul></ul><ul><ul><ul><li>Balance can be retired at the firm’s discretion </li></ul></ul></ul><ul><ul><li>Factor arrangements </li></ul></ul>
  36. 36. Short-Term Financing Considerations Money Market Instruments <ul><li>Large firms with high credit ratings may be able to by-pass financial institutions and borrow directly from the money market. </li></ul><ul><li>Two forms of money market instruments: </li></ul><ul><ul><li>Commercial paper </li></ul></ul><ul><ul><li>Bankers’ acceptances </li></ul></ul><ul><ul><ul><li>The firm pays a stamping fee, and is able to borrow based on their bank’s credit rating. </li></ul></ul></ul><ul><li>Money market securities: </li></ul><ul><ul><li>Sold at a discount from face value </li></ul></ul><ul><ul><li>Maturities at time of issue of 30, 60, 90 days </li></ul></ul><ul><ul><li>Face amounts of $100,000 or more. </li></ul></ul>
  37. 37. Short-Term Financing Considerations Money Market Instruments <ul><li>The annualized yield on a money market instrument: </li></ul>[ 24-3]
  38. 38. Short-Term Financing Considerations Securitizations <ul><li>Special purpose vehicles (SPVs) are conduits for packaging portfolios of receivables and selling them to investors in the money market; a recent innovation in financing trade credit. </li></ul><ul><li>Credit enhancements are actions taken to reduce credit risk, such as requiring collateral, insurance or other agreements. </li></ul><ul><li>Asset-backed commercial paper (ABCP) is an example. </li></ul><ul><ul><li>The sub-prime mortgage problems in the U.S. has exposed the problems with ABCP where investors have become concerned about the underlying asset values (packages of receivables) and the market is actively repricing these money market instruments </li></ul></ul><ul><ul><li>In some cases the market has disappeared for some of these money market instruments. </li></ul></ul>
  39. 39. Summary and Conclusions <ul><li>In this chapter you have learned: </li></ul><ul><ul><li>That the optimal level of investment in cash, receivables and inventory occurs when the benefits balance the costs </li></ul></ul><ul><ul><li>The advantages, the disadvantages and associated effective annual costs of the most common short-term financing options available to companies. </li></ul></ul>
  40. 40. Concept Review Questions Working Capital Management – Current Assets and Liabilities
  41. 41. Concept Review Question 1 Motives for Holding Cash <ul><li>Why do firms hold cash? </li></ul>
  42. 42. Concept Review Question 1 Float <ul><li>What is float and why is it important to the firm? </li></ul>
  43. 43. Internet Links <ul><li>Securitization Net - </li></ul><ul><li>Dun & Bradstreet Small Business solutions - </li></ul>
  44. 44. Copyright <ul><li>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. </li></ul>