Working capital introduction


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an introduction to working capital

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Working capital introduction

  1. 1. WORKING CAPITAL Short-Term Finance
  2. 2. What Is (Net) Working Capital? <ul><li>Current Assets – Current Liabilities </li></ul>2011 gbemiga adeosun
  3. 3. What Does It Mean to be Current? <ul><li>Convertible to cash with a year </li></ul>2011 gbemiga adeosun
  4. 4. What Are Current Assets? <ul><li>Cash </li></ul><ul><ul><li>Very liquid short-term securities - like T-bills, repurchase agreements, and commercial paper – are usually included here </li></ul></ul><ul><li>Marketable securities </li></ul><ul><ul><li>Less liquid and longer-term investments made out of current assets </li></ul></ul><ul><li>Inventory </li></ul><ul><li>Accounts receivable </li></ul>2011 gbemiga adeosun
  5. 5. What Are Current Liabilities? <ul><li>Accounts payable </li></ul><ul><li>Accruals of wages and salaries </li></ul><ul><li>All payments on long-term debt that are payable within a year </li></ul>2011 gbemiga adeosun
  6. 6. What Is Non-Cash Working Capital? <ul><li>Remove cash and marketable securities from current assets </li></ul><ul><ul><li>Cash and marketable securities are held for reasons beyond just working capita </li></ul></ul><ul><ul><li>They also pay interest, reducing their opportunity cost to something much closer to zero than can reasonably be expected from non-cash working capital </li></ul></ul><ul><li>Remove debt as well – it gets counted in cost of capital </li></ul><ul><li>Inventory+receivables-payables-accruals </li></ul>2011 gbemiga adeosun
  7. 7. What Is the Pitfall in Thinking About Non-Cash Working Capital? <ul><li>Increases in inventory and receivables bleed cash out of the firm </li></ul><ul><li>Increases in payables and accruals yield cash for the firm </li></ul>2011 gbemiga adeosun
  8. 8. What Are the Economics of Non-Cash Working Capital? <ul><li>Non-cash working capital is a derived demand </li></ul><ul><ul><li>You need it because of projects </li></ul></ul><ul><ul><li>You often need it before the project is generating cash flow </li></ul></ul><ul><li>It is subject to </li></ul><ul><ul><li>Economies of scale </li></ul></ul><ul><ul><li>Economies of scope </li></ul></ul>2011 gbemiga adeosun
  9. 9. What Is the Non-Cash Working Capital Tradeoff? <ul><li>Non-cash working capital is subtracted out of the present value of the project </li></ul><ul><li>Thus, present value and non-cash working capital are traded off </li></ul><ul><ul><li>The higher present value is traded off with the higher risk due to potential loss of customers, and higher default risk </li></ul></ul>2011 gbemiga adeosun
  10. 10. What Are the Cons of the Tradeoff Between Cash and Non-Cash Working Capital? <ul><li>Holding less cash: </li></ul><ul><ul><li>Is less of an issue if the firm has access to ready outside financing </li></ul></ul><ul><ul><li>Is harder if the economy tanks </li></ul></ul><ul><ul><li>Increases uncertainty about meeting debt obligations </li></ul></ul>2011 gbemiga adeosun
  11. 11. What Are the Pros of the Tradeoff Between Cash and Non-Cash Working Capital? <ul><li>Holding less cash: </li></ul><ul><ul><li>Makes it easier to satisfy the customer out of inventory </li></ul></ul><ul><ul><li>Makes it easier to entice the customer with easy credit </li></ul></ul>2011 gbemiga adeosun
  12. 12. Is There An Optimal Level of Non-Cash Working Capital? <ul><li>Probably, but there are a lot of difficulties getting the data to figure out the tradeoff </li></ul>2011 gbemiga adeosun
  13. 13. What Industries Use the Most and Least Non-Cash Working Capital? <ul><li>Most: </li></ul><ul><ul><li>Shoes, textiles, office equipment, homebuilding, auto manufacturing </li></ul></ul><ul><li>Least: </li></ul><ul><ul><li>Advertising, cable TV, restaurants, hotels/gaming, railroads </li></ul></ul>2011 gbemiga adeosun
  14. 14. What Are the Benefits of Holding Inventory? <ul><li>Raw materials </li></ul><ul><li>Works in progress </li></ul><ul><li>Finished items </li></ul><ul><ul><li>More if it takes time to fill an order </li></ul></ul><ul><ul><li>More if the product line is diverse </li></ul></ul><ul><ul><li>More if competitors are ready with substitutes </li></ul></ul>2011 gbemiga adeosun
  15. 15. What Are the Costs of Holding Inventory? <ul><li>Foregone interest </li></ul><ul><ul><li>Increases with the size of inventory </li></ul></ul><ul><ul><li>Increased with interest rates </li></ul></ul><ul><li>Carrying costs </li></ul><ul><ul><li>Storage </li></ul></ul><ul><ul><li>Tracking </li></ul></ul>2011 gbemiga adeosun
  16. 16. What Is EOQ (Economic Order Quantity)? <ul><li>A solution to a simple optimization problem for minimizing the costs of inventory </li></ul><ul><ul><li>EOQ = sqrt(2 x demand x ordering cost/carrying cost) </li></ul></ul><ul><ul><li>This yields a graph of inventory that looks like a series of “capital N’s” through time </li></ul></ul><ul><ul><li>A cushion can be added above zero inventory for safety </li></ul></ul><ul><li>Similar to the Baumol model for cash (presented later) </li></ul>2011 gbemiga adeosun
  17. 17. What Are the Weaknesses of Using EOQ? <ul><li>It assumes constant demand </li></ul><ul><li>It assumes that inventories can be replenished without a time delay </li></ul><ul><li>It assumes that ordering costs do not depend on the size of the order ( i.e. , there are no volume discounts) </li></ul>2011 gbemiga adeosun
  18. 18. How Can Optimal Inventories Be Determined? <ul><li>Ideally you want to measure the change in the value of the firm due to a marginal change in inventory </li></ul><ul><ul><li>This is difficult in practice </li></ul></ul><ul><li>Most firms look at similar firms for guidance </li></ul>2011 gbemiga adeosun
  19. 19. What Industries Hold the Most and Least Inventory? <ul><li>Most: </li></ul><ul><ul><li>Pharmacies, textiles, aerospace, apparel, homebuilding </li></ul></ul><ul><li>Least </li></ul><ul><ul><li>Healthcare information systems, medical services, telecommunications, hotels/gaming, restaurants </li></ul></ul>2011 gbemiga adeosun
  20. 20. How Does Trade Credit Relate to Non-Cash Working Capital? <ul><li>Leads to an accounts receivable </li></ul><ul><ul><li>Product is shipped, leading to a need to replenish inventory </li></ul></ul><ul><ul><li>Payment may not be made immediately </li></ul></ul><ul><ul><li>This can create cash flow problems </li></ul></ul>2011 gbemiga adeosun
  21. 21. What Are the Costs of Offering Trade Credit? <ul><li>Default risk </li></ul><ul><li>Interest foregone on the revenue </li></ul>2011 gbemiga adeosun
  22. 22. What Are the Benefits of Offering Trade Credit? <ul><li>Locks in a sale that the buyer can afford out of cash flows but not out of cash on hand </li></ul><ul><li>It’s also more of an additional general enticement to the buyer </li></ul><ul><ul><li>While trade credit is being “sold” to the prospective buyer you are keeping them on the line for the item you actually want to sell </li></ul></ul>2011 gbemiga adeosun
  23. 23. How Do You Decide Whether or Not to Offer Trade Credit? <ul><li>Present value analysis </li></ul>2011 gbemiga adeosun
  24. 24. How Do We Evaluate Trade Credit Policy? <ul><li>Similar to inventory policy? </li></ul><ul><ul><li>The problem is too murky to be solved directly. So we ask: </li></ul></ul><ul><ul><ul><li>Does it increase the value of the firm? </li></ul></ul></ul><ul><ul><ul><li>Is it consistent with what similar firms are offering? </li></ul></ul></ul>2011 gbemiga adeosun
  25. 25. How To Construct a Scoring System for Offering Trade Credit? <ul><li>Define characteristics associated with default </li></ul><ul><li>Obtain data legally </li></ul><ul><li>Weight the data in a way consistent with the default risk </li></ul><ul><li>Test fly the system </li></ul><ul><li>Put it into practice </li></ul>2011 gbemiga adeosun
  26. 26. How Are Terms of Trade Credit Expressed? <ul><li>a/b net c </li></ul><ul><ul><li>a% discount </li></ul></ul><ul><ul><li>Lasting for b days </li></ul></ul><ul><ul><li>The full undiscounted amount due within c days </li></ul></ul>2011 gbemiga adeosun
  27. 27. How Do You Figure Out the Rate You Are Offering? <ul><li>[1+discount/(1-discount)}^(365/discount length) = 1+effective rate </li></ul><ul><li>If the customer delays payment, they are effectively increasing the discount length – and reducing your interest rate </li></ul>2011 gbemiga adeosun
  28. 28. Who Has the Most and Least Accounts Receivable? <ul><li>Most </li></ul><ul><ul><li>Telecommunications, newspapers, energy, semiconductors, petroleum </li></ul></ul><ul><li>Least </li></ul><ul><ul><li>Restaurants, industrial services, healthcare information services, tobacco, trailers and RVs </li></ul></ul>2011 gbemiga adeosun
  29. 29. What About Accepting Trade Credit? <ul><li>This creates an accounts payable </li></ul><ul><li>It also tends to increase cash flows </li></ul><ul><li>The costs and benefits of this are the opposite of extending trade credit, but … </li></ul><ul><ul><li>Don’t forget that the interest you pay is deductible, while the interest you receive is not – so they are not quite mirror images of each other </li></ul></ul>2011 gbemiga adeosun
  30. 30. Who Accepts Trade Credit? <ul><li>Surprisingly, the same industries that extend lots of trade credit also tend to accept a lot of it </li></ul><ul><ul><li>Restaurants and tobacco firms use little of both </li></ul></ul><ul><ul><li>Defense and auto firms use a lot of both </li></ul></ul><ul><ul><li>The biggest exploiters of longer payables and shorter receivables are auto firms </li></ul></ul>2011 gbemiga adeosun
  31. 31. What About Cash? <ul><li>Cash </li></ul><ul><li>Money in accounts bearing rates lower than the risk-free rate </li></ul><ul><li>Short-term securities </li></ul>2011 gbemiga adeosun
  32. 32. Why Hold Operating Cash? <ul><li>Transactions motive </li></ul><ul><li>Precautionary motive </li></ul><ul><li>Compensating balances </li></ul><ul><ul><li>This is what you hold in the bank to get access to lines of credit and other services </li></ul></ul>2011 gbemiga adeosun
  33. 33. What Determines Cash Holdings? <ul><li>Size </li></ul><ul><li>Sophistication of the firm’s finances </li></ul><ul><li>Availability of investments </li></ul><ul><li>Most U.S. firms hold 1-2% of revenues as cash </li></ul>2011 gbemiga adeosun
  34. 34. What Is the Baumol Model? <ul><li>Similar to the EOQ for inventory </li></ul><ul><li>Optimal cash balances = sqrt[(2 x annual cash usage x cost per security sale)/(interest rate)] </li></ul>2011 gbemiga adeosun
  35. 35. What Is the Miller-Orr Model? <ul><li>Firm sets upper and lower limits on cash, and it only buys or sells securities when it reaches these thresholds. This requires us </li></ul><ul><ul><li>To assume a minimum balance </li></ul></ul><ul><ul><li>To know the variance of cash flows </li></ul></ul><ul><li>Spread = 3[(3/4)(transactions cost x variance/interest rate)]^(1/3) </li></ul>2011 gbemiga adeosun
  36. 36. How Does Holding Cash Affect the Firm’s Value? <ul><li>Holding operating cash is much like holding non-cash working capital </li></ul><ul><ul><li>It reduces the flow of cash that can be paid out to investors </li></ul></ul>2011 gbemiga adeosun
  37. 37. How Can Cash Be Reduced? <ul><li>Float managing </li></ul><ul><ul><li>Increase your disbursement float and decrease your processing float </li></ul></ul><ul><li>Better banking </li></ul><ul><ul><li>Lockboxes </li></ul></ul><ul><ul><li>Concentration banking </li></ul></ul><ul><ul><li>Have the bank control disbursements so they are made immediately after deposits </li></ul></ul>2011 gbemiga adeosun
  38. 38. What Near-Cash Investments Are Possible? <ul><li>In order of increasing risk and return (there is usually a less than 1% difference in this group) </li></ul><ul><ul><li>Treasury bills </li></ul></ul><ul><ul><li>Repurchase agreements </li></ul></ul><ul><ul><ul><li>On T-Bills </li></ul></ul></ul><ul><ul><ul><li>On non-mortgage securities </li></ul></ul></ul><ul><ul><ul><li>On mortgage-backed securities </li></ul></ul></ul><ul><ul><li>Commercial paper </li></ul></ul><ul><ul><ul><li>From financial institutions </li></ul></ul></ul><ul><ul><ul><li>From non-financial instititutions </li></ul></ul></ul>2011 gbemiga adeosun
  39. 39. How to Choose Between Cash and Near-Cash? <ul><li>Benefits of near-cash </li></ul><ul><ul><li>Earn interest </li></ul></ul><ul><li>Costs of near-cash </li></ul><ul><ul><li>Transactions costs </li></ul></ul><ul><ul><li>Default risk (admittedly, this is minimal) </li></ul></ul><ul><li>Choosing to park some cash in near-cash is an investment decision whose hurdle rate is the risk-free rate </li></ul><ul><ul><li>You need to be able to beat this after transactions costs and default risk </li></ul></ul>2011 gbemiga adeosun
  40. 40. When Can Investments In Cash and Near-Cash Reduce Firm Value? <ul><li>Not earning the market rate </li></ul><ul><ul><li>This is not much of a problem in the U.S. </li></ul></ul><ul><ul><li>This can be a big problem with overseas investments where local markets may be overregulated or too thin to offer reasonable risk-free rates </li></ul></ul><ul><li>Lousy management </li></ul><ul><ul><li>The value of cash will be discounted in the market if the firm has few viable projects </li></ul></ul><ul><li>Cash is a payment that has not been made to equity yet </li></ul><ul><ul><li>Thus, hording cash is the same as being underleveraged </li></ul></ul>2011 gbemiga adeosun
  41. 41. Are There Good Reasons to Hold Lots of Cash? <ul><li>High growth industries </li></ul><ul><li>High volatility industries </li></ul><ul><li>Industries in which viable projects appear unexpectedly </li></ul>2011 gbemiga adeosun
  42. 42. What About Riskier Investments In the Short-Term? <ul><li>Pros </li></ul><ul><ul><li>Higher returns </li></ul></ul><ul><ul><li>You can take advantage of undervalued securities issued by other firms </li></ul></ul><ul><ul><li>Strategic investment </li></ul></ul><ul><ul><ul><li>Push other firms decisions in your direction </li></ul></ul></ul><ul><ul><li>It’s the nature of some businesses </li></ul></ul><ul><li>Cons </li></ul><ul><ul><li>Higher risk </li></ul></ul><ul><ul><li>Higher transactions costs </li></ul></ul>2011 gbemiga adeosun
  43. 43. Who Holds Cash? <ul><li>Most </li></ul><ul><ul><li>Coal, copper, air transport, autos, steel </li></ul></ul><ul><li>Least </li></ul><ul><ul><li>Retail building supply, water utilities, pharmacies, groceries, retail </li></ul></ul><ul><li>Cash holdings are positively associated with revenue growth and negatively associated with revenue </li></ul>2011 gbemiga adeosun