Meaning and Overview of Working CapitalWorking Capital Management involves two fundamentalquestions• What is the appropriate amount and mix of current assets for the firm to hold ?• How should these current assets be financed.
Meaning and Overview of Working Capital• Firms must carry a certain amount of current assets to be able to operate smoothly. A company without sufficient cash on hand might not be able to pay any unexpected expense .• Without an inventory of raw materials, production might be subject to costly interruptions or shutdowns.• Without an inventory of finished goods, sales might be lost because a product is out of stock.
Meaning and Overview of Working Capital• Current assets are cash and other assets that the firm expects to convert into cash in a year or less. These assets are usually listed on balance sheet in order of their liquidities.• Current liabilities are obligations that the firm expects to repay in a year or less. They may be interest bearing such as short term notes and current maturity of long term debt. Also non interest bearing liabilities are accounts payable, accrued expenses or accrued taxes and wages.• For liquidity purpose onlyNet working capital = C.A. – C.L. (Net working capital determinesfirms’ liquidity and not Working capital requirement as cash and shortterm debt should be part of working capital requirement).
Meaning and Overview of Working Capital• Financing: Working capital management involves management of currents assets and their financing. The financial manager’s responsibilities include determining the optimum balance for each of the current asset accounts and deciding what mix of short term debt, long term debt and equity to use in financing working capital.• Conversion Cycle: Working capital efficiency is a term that refers to how efficiently working capital is used. It is most commonly measured by a firm’s cash conversion cycle, which reflects the time between the point at which raw materials are paid for and the point at which finished made from those materials are converted into cash. The shorter is conversion cycle , the more efficient is its use of working capital.
Levels of Working Capital ManagementThe size and nature of the firm’s investment in current assets is afunction of number of factors, including• The type of products manufactured• The length of operating cycle• Sales volume• Inventory policies
• Shortage costs (cost incurred because of lost production and sales).• Carrying costs (cost of having inventory).Shortage costs > carrying costs, flexible approachShortage costs < carrying costs, restrictive approach
Optimal Level of Working Capital InvestmentTo determine the optimal investment strategy for current assets, thefinancial manager must balance shortage costs against carrying costs.• If the cost running short of working capital (shortage costs) dominate the cost of carrying extra working capital (carrying costs), a firm will move towards a more flexible approach policy.• If carrying costs are greater than shortage costs, then firm will maximize value by adopting a more restrictive strategy.• Overall management will try to find the level of current assets that minimize the sum of carrying costs and shortage costs.
Working capital strategiesKey decision to be made by financial manager involves the fact:• How much money should be invested in current assets for a given level of sales.• Managers have limited control over extending Accounts payable days without risking of incurring high costs ( losing discounts or penalties).
Working capital strategiesTwo kind of working capital strategies:• Flexible current assets strategy• Restrictive current asset strategy
Working capital strategiesFlexible Current asset Investment strategy:• a firm that follows such strategy hold large balances of cash, marketable securities and inventory.• Such strategy generally followed by company’s that offer liberal credit terms to customers, which results in high levels of accounts payable.• Flexible strategy is generally perceived to be a low risk-low return course of action.• Holding large cash balances can help in credit crunch (recession) as with large cash in hand a company can survive the down turn in economy.
Working capital strategiesFlexible current asset investment strategy:• Downside of such strategy can include low returns on current assets, potentially high inventory carrying costs and the cost of financing liberal credit terms.• Return on cash and marketable securities is low.
Working capital strategies.Restrictive Current assets strategy:• This strategy follows the concept of keeping levels of current assets at a minimum.• The firm invests the minimum possible in cash, marketable securities and inventory• has strict terms of sale intended to limit credit sales and accounts receivables.• As discussed in points above it clearly reflects this strategy is High Risk –High Return.
Working capital strategy• In restrictive strategy company invests larger fraction of its money in higher yielding assets.• The high risk comes in the form of exposure to shortage costs, which can be either financial or operating costs.• Financial shortage costs arise mainly due to illiquidity (low level of cash and marketable securities).• Operating shortage costs result from lost production and sales. If the firm does not hold enough raw materials in inventory, precious hours may be wasted by a halt in production. If firms runs out of finished goods, sales may be lost.• Highly restrictive credit policies, such as low margin on credit sales (like only 50% of total sales volume will be on credit).
Profitability vs risk trade off for alternative financing strategiesWorking capital needs are of two types:• Short term• Long term (permanent in nature): the minimum level of working capital in the sense that it reflects a level that will always be on the firm’s books.The amount of working capital at a firm tends to fluctuate over timeas its sales rise and fall because of cyclicality.
Profitability vs risk trade off for alternative financing strategiesThere are three basic strategies that a firm can follow to finance itsworking capital and fixed assets needs.• Maturity matching strategy• Long term funding strategy• Short term funding strategy
Profitability vs risk trade off for alternative financing strategiesMaturity Matching strategy:• All seasonal working capital needs are financed by short term debt. As the level of sales varies seasonally, short-term borrowing fluctuates with short term borrowing.• All permanent working capital and fixed assets are funded with long-term financing.• The maturity of liability should match the maturity of assets that fund it.
Profitability vs risk trade off for alternative financing strategiesLong term funding strategy:• Long term debt and equity are used to finance fixed assets, permanent working capital and seasonal working capital.• When the need for working capital is at its peak, it is funded entirely by long term funds.• As the need for working capital diminishes over the seasonal cycle and cash becomes available, the excess cash is invested in short term money markets instruments to earn interest until the funds are needed again.• This strategy reduces the risk of funding current assets: there is less need to worry about refinancing assets, since all funding is long term.
Profitability vs risk trade off for alternative financing strategiesShort term funding strategies:• Whereby all seasonal working capital and a portion of the permanent working capital and fixed assets are funded with short- term debt.• The benefit of using this strategy is that it can take advantage of an upward-sloping yield curve and lower a firms’ overall cost of funding. The short term borrowing costs are typically less than the long term borrowing costs.• the biggest risk in this strategy is that a portion of firm’s long term assets must be periodically refinanced over their working lives, which can pose a significant risk.
Concept of Operating Cycle• The operating cycle starts with the receipt of raw materials and ends with the collection of cash from customers for the sale of finished goods made from those materials.• The operating cycle can described in terms of two components1. Days sales in inventory2. Days sales outstanding
Concept of Operating Cycle• Days sales in inventory (DSI): show on an average, how long a firm holds inventory before selling it.DSI = 365 / Inventory turnoverInventory turnover = COGS/InventoryCOGS: Cost of goods sold
Concept of Operating Cycle• Days sales outstanding (DSO) : indicates how long it takes, on average, for the firm to collect its outstanding accounts receivable. DSO = 365 / Accounts receivable turnoverAccounts receivable turn over = net sales / accounts receivable
Calculation of Working CapitalWorking capital = C.A. – C.L.There are two modifications that should be done to the above equation.The first modification is cash. It is inappropriate to consider cash as part ofworking capital for two reasons:• First cash is often held to cover day to day operations of the firm, it is also held for other reasons. Second cash is used for future investments or future buffer.• Second cash usually earns a market interest rate and has no opportunity cost. This makes it different from inventory and accounts receivable, where investments made have an opportunity cost. For same reasons marketable securities/short term investments should be removed from working capital calculation.
Calculation of Working CapitalThe second modification is that we should remove all interestbearing current liabilities from the working capital. The interestbearing liabilities include short –term debt (interest expense) andcurrent portion of long term debt (CPLTD).Non cash working capital = non cash current assets – non interestbearing current liabilities.
Meaning of Receivables• Accounts receivables are assets accounts representing amounts owed to the firm as a result of sale of goods and services.• On balance sheet these claims are under accounts receivables in current assets section.
Meaning of Receivables Management• Receivables management refers to the decisions a business makes regarding its overall credit and collection policies and the evaluation of individual credit applicants.• Receivables management has its merit and demerit where merit is because of the promise of future cash flows and demerit is because company needs financing while waiting for cash flows.
Determination of Appropriate Receivables PolicyAn appropriate receivables policy should include following factors:• Nature of business of firm: if the industry is cyclical in nature or seasonal in nature then line of credit should be extended or shortened accordingly.• The discounts should be offered for cash payment (higher discount) as well as payments (descent discount)before due date.• The penalties imposed should be of high value if the payment is not made on time.• The credit manager should interact with credit team of buyer in order to get timely payments.
Marginal Analysis• First step in margins analysis is identifying the price and quantity relationship.• Second we determine the cost and revenue as function of quantity (these relationships can be liner or non liner).• Third we take first order derivative of TR (total revenue ) and TC (total cost). The derivative of TR is called MR (marginal revenue) and of TC is called MC (marginal cost).• The price of product at certain quantity would make MR –MC = O and this is the price of product at which cost will be minimum.
Evaluation of Credit ProposalCredit proposal can be evaluation with the help of following:• Financial statements: balance sheet and income statement• Bank reference: bank of credit provider can help in credit check.• Trade checking: company can cross check with other suppliers in regard to credit facility provided and their experience with credit requiring company.• Credit bureaus: credit rating agencies can be contacted in regard to the rating of particular company. Credit bureaus have compiled reports on historical credit payment performance of given company.
Heuristic ApproachIn heuristic approach weights are given to eight factors thatinfluence the credit payments for credit scoring purpose and thesefactors are• Credit requirements (C) : how much of total requirement is bought from respective company by the applicant (C< 25%, wt. = 0 , 25%< C < 50%, wt. 5, C>50%, wt = 10).• Pay habits (P): It’s the measure of willingness as well as ability to pay.
Heuristic Approach• Years in business (Y): is a measure of company’s ability to pay.• Profit margin (M): this is operating margin and the it includes the operating expenses.• Current ratio (R): current ratio determines the liquidity of company and is considered as best when equal or greater than 2.• Total debt to assets ratio: lesser the debt ratio better is the ability to pay (even when company runs at optimal debt ratio it can get into trouble because of economic conditions.
Heuristic approach• Inventory turnover (I): Higher the turnover ratio better it is. A lower turnover ratio less efficiency.• Qualitative factor (Q): this is subjective evaluation of applicant in regard to general reputation and industry in which it operates.
Discriminant analysisThe discriminant analysis is a statistical approach of findingrelationship between variables to come up with statistical model.• First take data of independent variables.• Second take data of dependent variables for corresponding period.• Run the regression analysis to come with equation of relation.Equation is I = a0 + a1 X1 + a2 X2 + …………..+ an Xna1, a2……………an are the coefficients of respective variablesX1…….Xn.
Sequential Decision AnalysisIn sequential approach step by step approach of credit analysis isfollowed. This process helps in determining whether to go to nextstage or not. The three stages of sequential analysis are:Stage 1: consult company credit filesStage 2: examine agency credit ratingStage 3: request interchange bank report.
Meaning of Cash management• Cash management is a broad term that covers a number of functions that help individuals and businesses process receipts and payments in an organized and efficient manner.• The range of cash management services range from simple checkbook balancing to investing cash in bonds and other types of securities to automated software that allows easy cash collection.
Motives for Holding Cash• The first reason for holding cash is the transaction motive: that is, the cash is held to meet the needs that arise in the course of doing business.• The transactions demand for cash is also affected by any seasonal factors that may affect revenues and operations.• Firms also maintain cash as a precaution, that is, to meet contingencies and unforeseen needs. These unforeseen needs vary across firms operating in different industries.
Motives for Holding Cash• At times external financing can carry a high transaction cost and to cover this cost some firms hold more cash than others do.• Firms, need the services of banks, and in order to get these services, they are sometimes required to maintain a specified cash balance, which is called compensating balance (better liquidity ratios).
The cash balance that a firm has to maintain is determined largelyby the nature of its business. Some businesses are more cashintensive than others and require large operating cash balances.The factors that largely affect any given firms cash balances are :• Size of the firm• Sophistication of both banking technology and payment procedures Factors determining Cash• Availability of investments Balances
Factors determining Cash BalancesSize of the firm:• Larger firms maintain lower cash balances , relative to revenues, then smaller firms. This is because large firms enjoy economies of scale and greater bargaining power with their banks, suppliers and customers.
Factors determining cash balancesSophistication of both banking technology and paymentprocedures.• A firm that operates in sophisticated financial system, where suppliers and employees are paid with checks and customers pay with checks or credit cards, will find itself using cash less than a firm in a less sophisticated system.
Factors determining Cash BalancesAvailability of Investments• Investments that can be converted into cash at short notice, with little or no cost, affects operating cash balances.
Collection System• When a firm provides a buyer with its products, it transfers value through provision of goods and services.• There is opportunity cost incurred if value is not promptly received in return.• A primary objective of collection system is to receive value from the buyer as quickly as possible.• A second objective is to receive and process information associated with the payment.• A third objective is to take into consideration the relationship the firm has with those making payments.
Disbursement toolsThe commercial banks offer a number of tools and assist managers indesigning efficient disbursement systems.• Zero balance accounts: zero balance accounts are very common strategy, an account for disbursement is first established at the bank.• For zero balance account to be effective, the participating bank must be one on which most disbursements are made via the clearance system (not at bank).• As implied by the name, the disbursing firm does not keep any permanent stock of cash in the disbursing system. The participating banks agrees that when the morning disbursements for the firm are presented to it, the bank will advice the firm of the amount of cash required to cover these disbursements.
Disbursement tools• The money will then be wired transferred into the zero balance account and the cheques honored.Controlled Disbursing: if the bank doesn’t agree to provide companywith zero balance account, then the firm has to do controlleddisbursing.• QAB: Quarterly averaged balance is calculated at the end of the quarter and if the QAB is below the actual minimal QAB maintenance amount agreed upon by company and bank, then bank will put penalty charges according to mentioned in contract.
Investments in Marketable SecuritiesMarketable securities are near cash investments that earn a marketreturn, with little or no risk, and can be quickly converted into cash.• Firms can buy and sell treasury bills at little or no cost, treasury bills have no default risk, and as short term investments they don’t have large price changes, even when interest rate changes.• There are other near cash investments, and they all tend to be issued by entities with little or no default risk and to be short term. This is because long term investments, even if issued by entities with no default risk, can have a price risk (changes in interest rate).
Investments in Marketable securities• Treasury bills are short-term obligations issued by the US government. Since they backed by the full faith and credit of the government, they are perceived as riskless and carry no default risk. In general T-bills have maturity of less than one year.• Commercial Paper: is a short term note issued by corporations to raise funds. Although the original purpose of commercial paper was to raise short-term financing to cover working capital needs, firms have also issued commercial paper as a way of bridging the gap between funds needed now and long term funds that can be raised in the market. Generally the time to maturity of commercial paper is 30 days to 270 days.• Repurchase agreement: is the sale of security, with an agreement that the security will be bought back at a specified price at the end of the agreement period.
Determining Optimal level of CashOptimal Cash balance can be determined by two methods:• Baumol model optimal cash = ((2* annual cash usage rate* cost per sale ofsecurities)/annual interest rate))^(1/2)
Determining optimal level of cashMiller-Orr modelSpread between upper and lower cash balance limits= 3 ((3/4* (transaction cost * variance of cash flows)/interest rate))^(1/3).In miller-orr model you have to specify lower limit of cash balance.Upper limit = spread + lower limit of cash balance.
Four optimization models• Baumol model• Beranek model• Miller-Orr Model• Stone model
Determining Optimal Level of CashBaumol Model:In this model firm assumed to receive cash periodically but to pay cash continuously as steadyrate.• Let Y be the amount of cash a company holds at the beginning of the period.• If a company initially withdraws half of its income, Y / 2, spends it, then in the middle of the period goes back to the bank and withdraws the rest then it has made two withdrawals (N=2) and her average money holdings are equal to Y / 4.• If there are N number of withdrawals then average money holding equals Y/2N• So the company has lost interest income on the cash it has withheld with itself . This loss of interest income = Y*I /2N• Also there is cost associated with every transaction the company does. So for N transactions the cost will be NC, Where C is the cost of every transaction.
Determining Optimal Level of Cash• As seen from the previous slide the total cost to the company for holding cash for N periods and performing N transactions money management cost = NC + I*Y/2N• Next take the derivative of above equation to see the minimum value of N (number of withdrawals) and the condition of minimum is C – Y*I / 2N^2 = 0 N = (Y*I/2C)^(1/2)…..using this equations you can find the number of withdrawals a company should a make in given period
Determining Optimal Level of CashBeranek Model• In Beranek’s model cash inflows are steady, but the cash outflows are periodic.• Those companies which sells and bills uniformly throughout the month on net 30-days terms but writes cheques only a few times per month.• In this kind of scenario a company can keep collecting cash for few days and then invest that cash for certain days until the day it has to write a cheque.• The formula for calculating the number of transactions remain the same as of Baumol model.
Determining Optimal Level ofMiller and Orr Model: Cash• As per the Miller and Orr model of cash management the companies let their cash balance move within two limits - the upper limit and the lower limit.• The companies buy or sell the marketable securities only if the cash balance is equal to any one of these.• When the cash balances of a company touches the upper limit it purchases a certain number of saleable securities that helps them to come back to the desired level.
Determining Optimal Level of Cash•Ifthe cash balance of the company reaches the lower level thenthe company trades its saleable securities and gathers enoughcash to fix the problem.R = (3aV/4I)^(1/3)V is the daily variance of cash flows, I is the daily interest rate and a is thetransaction costReturn point is calculated by summing R + L (L is lower limit)Upper limit is calculated by summing 3R + L
Determining Optimal Level of CashStone Model:• Like Miller’s model takes a control limit approach.• Under stone model company does no analysis of its cash balance until it goes out of control limits.• If sum of the current cash balance and expected cash flows in coming few days fall outside the limit, investment is done.• If sum of the current cash balance and expected cash flows in coming few days fall short of lower limit, disinvestments are done.
Financial ForecastingFinancial forecasting is the estimation of the future value of afinancial variable often a cash flow, asset or debt. Financialforecasting can be done by following:• General liner model• Spot method• Proportion of another account• Compounded growth