Working Capital Management Rev 4 0


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Overview of working capital concepts and introduction to working capital policies for business owners

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Working Capital Management Rev 4 0

  1. 1. Working Capital Management<br />Brought to You by<br />
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  11. 11. Working Capital Management<br />Presented by John Lafare<br /><br />SCORE®<br />
  12. 12. The ingredients of sound financial management<br />
  13. 13. Why is working capital management critical?<br />Businesses of any size experience working capital problems<br />Small businesses struggle the most, especially during the start-up phase<br />Working capital is yourlifeblood:<br />You may have assets and be profitable<br />But liquidity can be a serious problems if assets cannot converted into cash<br />
  14. 14. What do we know about business failures?<br />Findings from an SBA study:<br />1/3 of startups fail within 2 years<br />Less than half make it to 4 years<br />Dominant causes of failure:<br /><ul><li>Inadequate working capital
  15. 15. Poor cash flow management</li></ul>The good news (?):<br />90% of failures are due to poor decisions<br />Understanding the causes of failure can help avoid repeating them<br />
  16. 16. Workshop objectives<br />Explore methods used to make optimal working capital decisions.<br />Explain how current asset and liability accounts affect cash management.<br />Learn to make working capital decisions based on forecasted financial data.<br />
  17. 17. The dimensions of working capital management<br />
  18. 18. Accounting 101: the one-minute balance sheet<br />Current Assets<br />Current Liabilities<br /><ul><li>Cash
  19. 19. Marketable Securities
  20. 20. Accounts Receivable
  21. 21. Inventory
  22. 22. Accounts Payable
  23. 23. Accruals
  24. 24. Short-Term Debt
  25. 25. Taxes Payable</li></ul>Fixed Assets<br />Long-Term Financing<br /><ul><li>Investments
  26. 26. Plant & Machinery
  27. 27. Land & Buildings
  28. 28. Debt</li></ul>Equity<br />
  29. 29. What is net working capital?<br />Total Current Assets:<br />cash<br />marketable securities<br />accounts receivable<br />inventories<br />Less<br />Total Current Liabilities: <br /><ul><li>accounts payable (trade credit)
  30. 30. notes payable (bank loans)
  31. 31. accrued liabilities</li></li></ul><li>Working capital policies<br />Account receivables management<br />Inventory management<br />Cash management<br />Accounts payable management<br />Funding current assets<br />Working capital requirements<br />Working capital strategies<br />
  32. 32. Managing accounts receivable<br />Cost of carrying receivables<br />Relaxing Credit Standards<br />Changing Credit Terms<br />Factoring<br />Pledging of receivables<br />
  33. 33. What is the cost of carrying receivables?<br />Receivables represent credit sales that have trapped valuable cash<br />They are an indirect free loan to clients<br />Average investment in receivables:<br />Variable cost of annual sales<br />Turnover of receivables<br />Variable costs are the relevant costs since we are concerned about out-of-pocket costs<br />
  34. 34. Turnover of receivables<br />Calculated as: <br />365<br />Average collection period<br />Meaning of the ratio:<br />A high ratioimplies you operate on a cash basis or that your extension of credit and collection of receivables is efficient<br />A low ratiomay point to the need to re-assess credit policies to ensure timely collection<br />
  35. 35. Relaxing credit standards<br />Can have a significant influence on sales <br />Lower the quality standard for accounts accepted as long as the profitability of additional sales exceeds the added costs<br />Effects of Relaxing Credit Standards<br />
  36. 36. Calculating the impact of relaxing credit standards<br />
  37. 37. Step 1: profit contribution from increased sales<br />
  38. 38. Step 2: cost of marginal investment in receivables<br />
  39. 39. Step 3: cost of increased bad debts<br />
  40. 40. Step 4: making the decision<br />
  41. 41. Changing credit terms<br />Credit terms are composed of:<br />The cash discount<br />The cash discount period<br />The credit period<br />Example: credit terms of 2/10 net 30<br />Discount = 2%<br />Discount period = 10 days<br />Credit period is 30 days<br />Discount has to be meaningful to motivate early payment<br />
  42. 42. Changing credit terms: costs vs. benefits<br />Offering a cash discount means giving up a percentage of the invoice amount<br />Potential benefits:<br />You get cash sooner, reduce borrowing needs, more cash for investment<br />Since the discount is a price reduction, sales may increase<br />Inducing customers to pay early may reduce bad debt losses<br />May encourage customers to pay cash, avoiding credit card processing fees <br />
  43. 43. Changing credit terms: calculating the costs<br />Example<br />Average collection period is 40 days:<br />32 days until the customers mail payments<br />8 days to receive, process, and collect payments once they are mailed. <br />Initiate a cash discount by changing credit terms from net 30 to 2/10 net 30 <br />The change is expected to result in an average collection period of 25 days<br />
  44. 44. Additional data<br />Current production = 1,100 units. <br />Product sells for $3,000, terms of net 30 <br />Variable costs = $2,300<br />You estimate that:<br />80% of customers will take the 2% discount <br />Sales will increase by 50 units<br />The bad-debt percentage will be unchanged <br />Opportunity cost of funds invested in accounts receivable = 14% <br />
  45. 45. Changing credit terms: analysis<br />1. Additional profit contribution from sales:<br />50 units x ($3,000 - $2,300) = $35,000 <br />2. Cost of marginal investment in receivables:<br />Current: $2,300 x 1,100 units / (365 / 40) = $278,022<br />Proposed: $2,300 x 1,150 units / (365 / 25) = 181,164<br />Reduction in A/R investment: $ 96,858<br />3. Savings from reduced investment in receivables:<br />Savings = 14% x $96,859 = $13,560 <br />4. Cost of cash discount:<br />2% x 80% x 1150 x $3,000 = ($55,200)<br />Net profit from proposed credit terms: ($ 6,540)<br />
  46. 46. Factoring of receivables<br />Outright sale of receivables at a discount to a factor<br />Value assigned a function of the age of the receivables<br />Anything older than 90 days typically not financed<br />Factors may be either departments of banks or factoring companies<br />Normally done on a notification basis where customers pay the factor directly<br />
  47. 47. Pledging receivables<br />Accounts receivable used as collateral<br />Banks may fund between 50 - 90% of the face value of acceptable receivables<br />In addition, to protect its interests, the lender files a lien on the collateral<br />Receivables financing transfers the default riskto the financing company<br />The focus shifts from trying to collect receivables to value-added business activities<br />
  48. 48. Managing inventory<br />Alternative Views About Inventory<br />Consignment Inventory<br />Just-In-Time (JIT)<br />Economic Order Quantity<br />
  49. 49. Alternative views about inventory<br />
  50. 50. The system<br />Divide inventory into three groups of descending order of importancebased on the dollar amount invested in each<br />Typical system contains:<br />Group A: 20% of the items worth 80% of the total dollar value<br />Group B: the next largest investment<br />And so on<br />Control of the A items more intensive because of the high dollar investment<br />
  51. 51. Consignment inventory<br />Inventory in possession of the client, but still owned by the supplier<br />Supplier: <br />Places inventory in client’s possession<br />Allows selling / consumption from stock <br />Needs high degree of confidence in sales potential<br />Client: <br />Buys inventory only after sale/ consumption <br />Does not have to tie up capital in inventory<br />
  52. 52. Minimizes the inventory investment by having material inputs arrive exactly at the time they are needed for production<br />Extensive coordination must exist between the business, its suppliers, and shipping companies to ensure that material inputs arrive on time<br />In addition, the inputs must be of near perfect quality and consistency given the absence of safety stock<br />Just-in-Time (JIT) system<br />
  53. 53. Economic Order Quantity model (EOQ)<br />EOQ = 2 x S x OC<br />Used to determine what order size minimizes inventory costs<br />Where:<br />S = usage in units per period (year)<br />O = order cost per order<br />C = carrying costs per unit per period (year)<br />Q = order quantity in units<br />
  54. 54. EOQ calculation example<br />Units used per year (S) = 1,600<br />Cost per order (O) = $50<br />Carrying Cost (C) = $1 per unit<br />EOQ = (2 * 1,600 * $50) = 400 units<br />$1<br />
  55. 55. Key EOQ inputs<br />Carrying Costs Of Inventory: rent, utilities, insurance, taxes, employee costs, and the opportunity cost of having your capital tied up in inventory<br />Order Costs:<br />For purchased items, thecost to create purchase orders, process receipts, conduct incoming inspections, process invoices & vendor payments, and shipping costs<br />In manufacturing, the cost of the time to initiate the work order, time associated with picking & issuing components, production scheduling time, machine set up time, and inspection time.<br />
  56. 56. Once a firm has calculated its EOQ, it must determine when to place orders.<br />The reorder point must consider the lead time needed to place and receive orders.<br />If we assume that inventory is used at a constant rate throughout the year (no seasonality), the reorder point can be determined as follows:<br />Reorder point = lead time in days x daily usage<br />where daily usage = annual usage / 360<br />EOQ: the reorder point<br />
  57. 57. Daily usage = 1,600 / 360 = 4.44 units/day<br />Reorder Point = 10*4.44 = 44.44 => 45 units<br />Reorder point calculation example<br />It takes 10 days to place and receive an order<br />Annual usage = 1,600 units / year<br />
  58. 58. Cash management<br />Categories of float<br />Managing float<br />Float management techniques<br />Zero-balance accounts<br />
  59. 59. Categories of float (1 of 2)<br />Collection float:delay between the time when a payer deducts a payment from its checking account ledger and the time when the payee actually receives the funds in spendable form<br />Disbursement float:delay between the time when a payer deducts a payment from its checking account ledger and the time when the funds are actually withdrawn from the account<br />
  60. 60. Mail float:delay between the time when a payer places payment in the mail and the time when it is received by the payee<br />Processing float:delay between the receipt of a check by the payee and the deposit of it in the firm’s account<br />Clearing float:delay between the deposit of a check by the payee and the actual availability of the funds due to the time required for a check to clear<br />Categories of float (2 of 2)<br />
  61. 61. Managing float<br />The presence of float lengthens:<br />The average collection period <br />The average payment period<br />The goal is to:<br />Shorten the average collection period<br />Lengthen the average payment period<br />
  62. 62. Speeding up collections with lockboxes<br />Payers send their payments to a nearby post office box <br />Lockbox is serviced by the bank several times a day<br />Lockboxes reduce collection float by:<br />shortening the processing float<br />shortening mail and clearing float<br />
  63. 63. Slowing down payments with controlled disbursing<br />Involves strategic use of mailing points and bank accounts to lengthen mail float and clearing float<br />Should be used carefully, however, as longer payment periods may strain supplier relations<br />
  64. 64. Cash concentration: direct sends & other techniques<br />Wire transfers:removes funds from the payer’s bank and deposits them into the payees bank, reducing collections float.<br />Automated clearinghouse (ACH) debits:pre-authorized electronic transfers from the payer’s account to the payee’s account via settlement among banks<br />ACHs clear in one day, thereby reducing mail, processing, and clearing float<br />
  65. 65. Zero-balance accounts<br />Disbursement accounts that always have an end-of-day balance of zero<br />The purpose is to eliminate non-earning cash balances in corporate checking accounts<br />A ZBA works well as a disbursement account under a cash concentration system<br />
  66. 66. Managing accounts payable<br />Spontaneous liabilities<br />Managing accounts payable<br />Taking or not taking the cash discount<br />Cost of giving up the cash discount<br />Effect of stretching payables<br />Using the cost of giving up the cah discount in decision making<br />
  67. 67. Spontaneous liabilities<br />Arise from the normal course of business<br />Two major sources: accounts payable, accruals<br />Accruals: <br />Liabilities for services received for which payment has yet to be made <br />Most common accruals: wages and taxes<br />As sales increase, liabilities increase in response to increased purchases, wages, and taxes<br />
  68. 68. Managing accounts payable<br />Credit terms offered by suppliers allow for delays in payment for purchases<br />Major source of unsecured short-term financing<br />Pay as slowly as possible without damaging credit rating or relationships<br />Suppliers may impute the cost of offering terms in the selling price<br />Analyze terms to determine best credit strategy<br />
  69. 69. Taking or not taking the cash discount<br />Take the cash discount:<br />Pay on the last day of the discount period<br />No associated costs<br />Can be a source of additional profitability<br />Give up the cash discount:<br />Pay on the final day of the credit period <br />The cost is the implied rate of interestfordelaying payment an additional number of days<br />
  70. 70. Cost of giving up a cash discount<br />Annualized cost can be calculated as:<br /> CD x 365 <br /> 100% - CD N<br />Where<br />CD = stated cash discount in percentage terms<br /> N = # of days payment can be delayed by giving up the cash discount<br />Assuming terms of 2/10, net 30:<br />Annualized Cost = 2% x 365 = 37.24%<br /> 100% - 2% 20<br />
  71. 71. Effect of stretching payables<br />Credit terms are 2/10 net 30<br />Assume payments can be stretched to 70 days without damaging the credit rating or raising issues with suppliers<br />New cost of giving up the cash discount:<br />Annualized Cost = 2% x 365 = 12.42%<br /> 100% - 2% 60<br />Stretching payables reduces the implicit cost of giving up the cash discount<br />
  72. 72. Using the cost of giving up a cash discount in decision making<br />You need short-term funds<br />Short-term credit is available at 13%<br />Borrow funds, take discounts from A/C/D<br />Give up discount from B as opportunity cost is less than cost of borrowing <br />
  73. 73. Funding with bank loans<br />Unsecured short-term loans<br />Loan interest rates<br />Fixed and floating rate loans<br />Payment of interest<br />Computing the effecting rate of interest<br />Single payment notes<br />Lines of credit<br />Revolving credit agreements<br />
  74. 74. Unsecured short-term loans<br />Short-term, self-liquidating loansfor seasonal peaks in financing needs<br />Used during inventory build ups or when experiencing growth in receivables<br />The loans are retired as receivables and inventories are converted into cash<br />Three basic forms:<br />Single-payment notes<br />Lines of credit<br />Revolving credit agreements<br />
  75. 75. Loan Interest Rates<br />Most banks loans are based on the prime rate of interest<br />The lowest rate of interest charged by the nation’s leading banks on loans to their most reliable business borrowers<br />Banks determine the rate to be charged by adding a premium to the prime rate to adjust for borrower “riskiness”<br />
  76. 76. Fixed and Floating-Rate Loans<br />Fixed-rate loan:rate determined at set increment above prime, remains at that rate until maturity<br />Floating-rate loan: increment above the prime rate initially established and then allowed to float until maturity<br />The increment above prime is generally lower on floating rate loans<br />
  77. 77. Payment of Interest<br />Interest can be paid at loan maturity or in advance<br />If paid in advance, it is deducted from the loan so that the borrower actually receives less money than requested<br />Loans of this type are called discount loans<br />
  78. 78. Method of computing interest<br />If paid at maturity, the effective (true) rate of interest for a one-year loan is:<br />The effective rate of interest on a one-year discount loan is: <br />Interest / Amount Borrowed<br />Interest / (Amount Borrowed – Interest)<br />
  79. 79. Computing interest example<br />You need to borrow $10,000 at a stated rate of 10% for 1 year <br />Interest paid at maturity, the effective interest rate is: <br />Discount loan, the effective interest rate is:<br />(10% X $10,000) / $10,000 = 10.0%<br />(10% X $10,000) / ($10,000-$1,000) = 11.1%<br />
  80. 80. Single payment notes<br />Short-term, one-time loan payable as a single amount at its maturity<br />The “note” states the terms of the loan, including the length of the loan and the interest rate<br />Most have maturities of 30 days to 9 or more months<br />Interest is usually tied to prime, may be fixed or floating<br />
  81. 81. Computing interest on single payment notes: initial data<br />You borrow $100,000 from each of 2 banks — A and B <br />Loan A is a fixed rate note, loan B is a floating rate note <br />Both loans are 90-day notes with interest due at the end of 90 days <br />Prime is at 6% and the rates are:<br />1.5% above prime for A<br />1.0% above prime for B<br />
  82. 82. Computing interest on loan A<br />The total interest cost on loan A is: $100,000 x 7.5% x (90/365)] = $1,849 <br />The effective cost is 1.85% for 90 days <br />The effective annual rate is: <br />EAR = (1 + periodic rate)m - 1 <br /> = (1+. 0185)4.06 - 1 = 7.73%<br />
  83. 83. Computing Interest on Loan B<br />Periodic rate = rate x (30/365)<br />Total interest cost: <br />$100,000 x (.575% + .616% + .596%) = $1,787<br />Effective cost = 1.787% for 90 days <br />EAR = (1+.01787)4.06 - 1 = 7.46%<br />
  84. 84. Lines of Credit (LOC)<br />Agreement for a specific amount of unsecured short-term borrowing over a given period of time<br />Usually made for a period of 1 year, with various operating restrictions on borrowers<br />The interest rate on a LOC is normally floating and pegged to prime.<br />Although not guaranteed, the amount of the LOC is the maximum you can owe the bank at any point in time<br />
  85. 85. Lines of credit and compensating balances<br />LOCs often require the borrower to maintain compensating balances<br />A compensating balance is a certain checking account balance equal to a certain percentage of the amount borrowed (typically 10 to 20%).<br />This requirement effectively increases the cost of the loan to the borrower<br />
  86. 86. Line of credit: effective costs<br />You get an LOC of $1 million, at 10%, compensating balance of 20% ($200K) <br />You have access to only $800,000 and must pay $100, 000 as interest <br />With the compensating balance, the effective cost of the loan is 12.5%($100,000/$800,000)<br />That’s 2.5% more than the stated rate of interest<br />
  87. 87. Revolving credit agreements<br />Essentially a guaranteed line of credit, also sometimes called a “revolver”<br />The bank guarantees the funds will be available and typically charge a commitment fee on the unused portion of the credit line<br />A typical fee is around 0.5% of the average unused portion of the funds<br />More expensive than the LOC, but less risky from the borrower’s perspective<br />
  88. 88. Effective annual cost of revolving credit agreement<br />You have a $2 million RCA<br />Average borrowing for the past year = $1.5 million <br />The bank charges:<br />A commitment fee of 0.5% on the unused balance of $500,000 or $2,500 <br />Interest of $112,500on the $1.5 million used <br />Effective annual cost:<br />[($112,500 + $2500)/$1,500,000] = 7.67%<br />
  89. 89. Working capital requirements<br />Estimating working capital requirements<br />Alternative scenarios:<br />20% sales growth<br />0% sales growth<br />20% sales decline<br />
  90. 90. Estimating working capital requirements<br />Changes in working capital can be unstable<br />Big increases in some years, followed by big decreases in following years <br />Look at working capital per dollar of sales<br />Then determine the approximate amount of working capital required to support sales<br />
  91. 91. Working capital requirements Alternative Scenarios<br />Working capital = $900,000<br />Total Sales = $4,500,000<br />Working Capital / Total Sales = 20%<br />For every $1,000 of new sales, $200 required to support the sales increase<br />
  92. 92. Working capital strategies<br />Profitability and risk trade-offs<br />Impact of working capital strategies<br />Short-term financial management objectives<br />The cash conversion cycle<br />Financial forecasts<br />
  93. 93. Profitability and risk trade-offs<br />Profitability vs. risk trade-off<br />Components of cash cycle:<br />Average collection period<br />Average age of inventory<br />Average payment period<br />Managing the cash conversion cycle<br />
  94. 94. Positive Net Working Capital: <br />Lower Return / Lower Risk<br />Current Assets<br />Net Working<br />Capital > 0<br />Fixed <br />Assets<br />Current <br />Liabilities<br />Long-Term<br />Debt<br />Equity<br />low cost<br />low return<br />high cost<br />high return<br />highest cost<br />Lower return / lower risk profile<br />
  95. 95. Negative Net Working Capital: <br />Higher Return / Higher Risk<br />Current Assets<br />Fixed Assets<br />Current Liabilities<br />Net Working<br />Capital < 0<br />Long-Term<br />Debt<br />Equity<br />low return<br />low cost<br />high cost<br />high return<br />highest cost<br />High return vs. high risk profile<br />
  96. 96. Effect of working capital strategies on profits and risk<br />
  97. 97. Short-Term financial management objectives<br />Manage current assets and liabilities to balance profitability and risk<br />Central to short-term financial management is an understanding of the cash conversion cycle<br />
  98. 98. Average collection period<br />Average length of time from a sale on credit until the collection of funds<br />Consists of two parts:<br />Time from a sale until the customer mails payment<br />Time from mailing of payment until the collection of funds in the bank account<br />Calculated as:<br />Accounts Receivable<br /> Average Sales Per Day<br />
  99. 99. Average age of inventory<br /># of days an average inventory item takes to sell<br />Calculated as :<br />Example: average inventory is $47,500, and cost of goods sold is $500,000. <br />$47,500 <br /> x 365 days = 34.7 days <br /> $500,000 <br /> Average Inventory <br /> x 365 days <br /> Cost of Goods Sold<br />
  100. 100. Average payment period<br />The average payment period has two parts: <br />the time from purchase of goods on account until the firm mails its payment<br />the receipt, processing, and collection time required by the firm’s suppliers<br />Calculated as:<br />Accounts Payable <br />Average Purchases per Day<br />
  101. 101. Operating & cash conversion cycles<br />Operating Cycle:time between ordering materials & collections from receivables<br /> Average Age of Inventory<br /> + Average Collection Period <br />Cash Conversion Cycle:time between payments to suppliers and collection of cash from sales<br />= Operating Cycle – Average Payment Period<br />
  102. 102. Calculating the cash conversion cycle<br />Cash Conversion Cycle:<br />= 60 + 40 – 35 = 65 days<br />
  103. 103. Cash conversion cycle: graphic illustration<br />Time = 0<br />100 days<br />Operating Cycle<br />Purchase of Materials on Account<br />Sell Goods on Account<br />Collect <br />Receivables<br />Average Age of Inventory<br />60 days<br />Average Collection Period<br />40 days<br />Pay Accounts<br />Payable<br />Cash Inflow<br />Average Payment<br /> Period<br />35 days<br />Cash Conversion Cycle<br />65 days<br />Cash Outflow<br />
  104. 104. Resources invested in the cash conversion cycle<br />Reducing the cash conversion cycle reduces the amount of resources required to support operations<br />
  105. 105. Sales forecasts<br />Forecasting steps:<br />Project on the basis of historical growth<br />Assess the level of economic activity in the relevant marketing areas<br />Planning: market share targets, production and distribution capacity, competition, pricing strategies, inflation, impact of government policies, …<br />Factor in advertising campaigns, promotional discounts, credit terms, ….<br />Serious impacts when forecast is off<br />
  106. 106. Financial statement forecasting<br />Forecasted income statement<br />Assume that costs increase at the same rate as sales, or<br />Forecast specific costs separately<br />Forecast the balance sheet<br />If sales increase, assets must also grow<br />Liabilities and equity must also increase<br />Determine additional funds needed<br />Analyze the forecast<br />
  107. 107. Forecasting Additional Funds Needed (AFN Formula)<br />(3)<br />(2)<br />(1)<br />Additional <br />Funds <br />Needed<br />Required <br />increase<br />in assets<br />Spontaneous<br />increase in<br />liabilities<br />Increase in<br />retained<br />earnings<br />=<br />-<br />-<br />Pct of assets tied to sales / change in sales<br />Pct of liabilities that increase with sales / change in sales<br />Profit margin * sales (1- dividend payout)<br />
  108. 108. Using AFN<br />($2 mill. / 3 mill.) * $300K = $200K<br />[($60K+$140K) / $3 mill.] * $300K = $20K<br />($114K / $ 3 mill.) * [1 – ($58K/$114K)] = $62K<br />AFN = $200K - $20K - $62K = $118K<br />
  109. 109. Use of regression analysis in forecasting<br />Correlation 71%<br />Correlation 89%<br />
  110. 110. Application of regression analysis<br />Inventory Estimate = -35.7+0.186*Sales<br />Receivables Estimate = 62+0.097*Sales<br />
  111. 111. Visualizing the forecast<br />