Chapt r

The Management of Working Capital

Slides Developed by:

Terry Fegarty Seneca College

Chapter 4 Outline (1)

Working Capital Basics
Working Capital and the Current Accounts Working Capital and Funding Requirements Objective of Working Capital Management Working Capital Trade-offs OperationsThe Cash Conversion Cycle The Operating Cycle and the Cash Conversion Cycle

2006 by Nelson, a division of Thomson Canada Limited

Chapter 4 Outline (2)

Permanent and Temporary Working Capital Maturity Matching Principle Financing Net working Capital Short-Term vs. Long-Term Financing Working Capital Policy

2006 by Nelson, a division of Thomson Canada Limited

Chapter 4 Outline (3)

Cash Management
Objectives of Cash Management Marketable Securities Yield on a Discounted Money Market Security Components of Float Cheque Disbursement and the Cheque Clearing process Accelerating Cash Receipts Electronic Funds Transfer Managing Cash Outflow Evaluating Cash Management Services
2006 by Nelson, a division of Thomson Canada Limited

Chapter 4 Outline (4)

Managing Accounts Receivable
Tradeoffs in Managing Accounts Receivable Credit Policy Terms of Sale Collections policy

2006 by Nelson, a division of Thomson Canada Limited

Chapter 4 Outline (5)

Inventory Management
Benefits and Costs of Carrying Adequate Inventory Inventory Ordering Costs Inventory Control and Management Economic Order Quantity Model Safety Stocks, Reorder Points and Lead Times Inventory on Hand Including Safety Stock Tracking InventoriesThe ABC System Just In Time (JIT) Inventory System

2006 by Nelson, a division of Thomson Canada Limited

Working Capital Basics

Working Capital
Assets/liabilities required to operate business on day-to-day basis
Cash Accounts Receivable Inventory Accounts Payable Accruals

Short-term in natureturn over regularly

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Working Capital and the Current Accounts

Gross working capital = Current assets
Gross Working Capital (GWC) represents investment in current assets

(Net) working capital =

Current assets Current liabilities

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Working Capital and Funding Requirements

Working Capital Requires Funds
Maintaining working capital balance requires permanent commitment of funds
Example: Firm will always have minimum level of Inventory, Accounts Receivable, and Cashthis requires funding

2006 by Nelson, a division of Thomson Canada Limited

Working Capital and Funding Requirements

Spontaneous Financing
Firm will also always have minimum level of Accounts Payablein effect, money you have borrowed
Accounts Payable (and Accruals) are generated spontaneously
Arise automatically with inventory and expenses Offset the funding required to support current assets

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Working Capital and Funding Requirements

Net working capital is Gross Working Capital Current Liabilities (including spontaneous financing)
Reflects net amount of funds needed to support routine operations

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Objective of Working Capital Management

To run firm efficiently with as little money as possible tied up in Working Capital
Involves trade-offs between easier operation and cost of carrying short-term assets
Benefit of low working capital
Money otherwise tied up in current assets can be invested in activities that generate higher payoff Reduces need for costly financing

Cost of low working capital

Risk of shortages in cash, inventory
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Working Capital Trade-offs

Inventory
Benefit: Happy customers Few production delays (always have needed parts on hand) Cost: Expensive High storage costs Risk of obsolescence

High Levels

Cost: Shortages Dissatisfied customers Benefit: Low storage costs Less risk of obsolescence

Low Levels

Benefit: Reduces risk Cost: Increases financing costs

High Levels

Cash

Benefit: Reduces financing costs Cost: Increases risk

Low Levels

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Working Capital Trade-offs

Accounts Receivable
High Levels (favourable credit terms) Benefit: Happy customers High sales Cost: Expensive High collection costs Increases financing costs Low Levels (unfavourable terms) Cost: Dissatisfied customers Lower Sales Benefit: Less expensive

Accounts Payable and Accruals

High Levels Benefit: Reduces need for external finance--using a spontaneous financing source Cost: Unhappy suppliers 2006 by Nelson, a division of Thomson Canada Limited Low Levels Benefit: Happy suppliers/employees Cost: Not using a spontaneous financing source

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Working Capital Trade-offs

Current Assets Profitability Risk

High Level Lower Lower

Low Level Higher Higher

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OperationsThe Cash Conversion Cycle

Firm begins with cash which then becomes inventory and labour
Which then becomes product for sale Eventually this will turn into cash again

Firms operating cycle is time from acquisition of inventory until cash is collected from product sales
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Figure 4.1:

The Cash Conversion Cycle

Product is converted into cash, which is transformed into more product, creating the cash conversion cycle.

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Figure 4.2:

Cycle

Time Line Representation of the Cash Conversion

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The Operating Cycle and the Cash Conversion Cycle

plus: equals: minus: equals: Inventory conversion period Receivable collection period Operating cycle Payables deferral period Cash conversion cycle

Shortening cash conversion cycle frees up cash to reinvest in business or to reduce debt and interest
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Cash Conversion Cycle Analysis

Inventory Conversion Period Receivables Collection Period Payables Deferral Period 365 Inventory Turnover Accounts Receivable 365 Annual Credit Sales Accounts Payable 365 Cost of Goods Sold
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Cash Conversion Cycle

Purchase Inventory Sell Inventory on Credit

Pay for Inventory

Collect Receivables

Operating Cycle Inventory Conversion Period Receivables Collection Period Payables Deferral Period Cash Conversion Cycle
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Figure 4.3:

Working Capital Needs of Different Firms

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Permanent and Temporary Working Capital

Working capital is permanent to the extent that it supports constant or minimum level of sales Temporary working capital supports seasonal peaks in business

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Maturity Matching Principle

Maturity (due date) of financing should roughly match duration (life) of asset being financed
Then financing /asset combination becomes self-liquidating
Cash inflows from asset can be used to pay off loan

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Financing Net Working Capital

According to maturity matching principle
Temporary (seasonal) should be financed with short-term borrowing Permanent working capital should be financed with long-term sources, such as long-term debt and/or equity

In practice, firms may use more or less short-term funds to finance working capital
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Figure 4.4(a):

Working Capital Financing Policies

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Figure 4.4(b): Working

Capital Financing Policies

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Short-Term vs. Long-Term Financing

The mix of short- or long-term working capital financing is a matter of policy
Use of long-term funds is a conservative policy Use of short-term funds is an aggressive policy

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Short-Term vs. Long-Term Financing

Short-term financing
Cheap but risky
Cheapshort-term rates generally lower than long-term rates Riskybecause you are continually entering marketplace to borrow
Borrower will face changing conditions (ex; higher interest rates and tight money)

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Short-Term vs. Long-Term Financing

Long-term financing
Safe but expensive
Safeyou can secure the required capital Expensivelong-term rates generally higher than short-term rates

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Working Capital Policy

Firm must set policy on following issues:
How much working capital is used Extent to which working capital is supported by short- vs. long-term financing How each component of working capital is managed The nature/source of any short-term financing used
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Cash Management
Cash managementdetermining:
Optimal size of firms liquid asset balance Appropriate types and amounts of short-term investments Most efficient methods of controlling collection and disbursement of cash

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Cash Management
Why have cash on hand?
Transactions demand: need money to pay bills (employees, suppliers, utility/phone, etc.) Precautionary demand: to handle emergencies (unforeseen expenses) Speculative demand: to take advantage of unexpected opportunities (purchase of raw materials that are on sale)
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Objectives of Cash Management

Cash doesnt earn a return Want to maintain liquidity
Take cash discounts Maintain firms credit rating Minimize interest costs Avoid insolvency

Good cash management implies maintaining adequate liquidity with minimum cash in bank
Can place portion of cash balance into marketable securities (AKA: near cash or cash equivalents)
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Marketable Securities
Liquid investments that can be held instead of cash and earn a modest return
Examples include Treasury bills, commercial paper, bankers acceptances Many are bought and sold at a discount in money market
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Examples of Marketable Securities

Treasury Bills
Short-term government notes issued at a discount with principal repaid at maturity

Commercial Paper
Short-term unsecured promissory notes issued by corporations with good credit

Bankers Acceptances
Short-term promissory notes issued by a firm and accepted (or guaranteed) by a bank
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Yield on a Discounted Money Market Security

Annualized yield
r = 100 P P 365 d

where P = Discounted price as a percentage of maturity value d = Number of days to maturity r = Annualized yield
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Components of Float
Mail Float delay between when cheque is sent to a payee and is received by payee Processing Float time between receipt of payment by a payee and the deposit of the payment in the payees account Clearing Float time between depositing a cheque and having available spendable funds
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Cheque Disbursement and the Cheque Clearing Process

When you pay a bill,
You write cheque and mail to payee (2-3 days of mail float) Payee receives cheque and performs internal processing (1 day of processing float) Payee deposits cheque in its own bank (1 day of processing float) Payees bank sends cheque into interbank clearing system which processes cheque (2 days of clearing float)
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Figure 4.5:

The Cheque-Clearing Process

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Accelerating Cash Receipts

Lock-box systems
Post office box(es) located near customers in order to shorten mail and processing float
Local bank empties the box, deposits payments into firms account, and reports payments to firm

May involve significant fees More cost-effective if small number of larger deposits
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Figure 4.6:

A Lock Box System in the Cheque-Clearing Process

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Accelerating Cash Receipts

Concentration Banking
Customers send cheques sent to firms local collection centres, where they are deposited Local deposits are transferred electronically into one central concentration account Reduces mail float Funds available for paying loans or investing in marketable securities
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Electronic Funds Transfer

Electronic funds transfer mechanisms are reducing the importance of float management techniques for many companies

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Electronic Funds Transfer

Wire Transfers
Transferring money electronically

Preauthorized Cheques
Customer gives payee signed cheque-like documents in advance When payee ships product, it deposits preauthorized cheque in its bank account
Eliminates mail float Payee must trust payer
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Managing Cash Outflow

Zero balance accounts (ZBAs)
Decentralization of cash payments can lead to large number of cash balances around the country Divisions write cheques on ZBAsfunded from central account only when cheques are cleared Solves problem of idle cash in decentralized bank accounts Using bank in remote location for disbursement chequing account Increases mail float
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Remote disbursing

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Evaluating Cash Management Services

Evaluation involves comparison of costs versus benefits of faster collection

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Example 4.1:

Evaluating Cash Management Services

Q: Kelso Systems Inc. has customers in British Columbia that remit about 500 cheques a year. The average cheque is for $10,000. West coast cheques currently take an average of eight days from the time they are mailed to clear into Kelsos east coast account. A British Columbia bank has offered Kelso a lock box system for $1,000 a year plus $0.20 per cheque. The system can be expected to reduce the clearing time to six days. Is the banks proposal a good deal for Kelso if it borrows at 8%?

Example

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Example 4.1:

Evaluating Cash Management Services

A: The cheques represent revenue of: 500 $10,000 = $5,000,000 per year. The average amount tied up in the cheque clearing process is: 8/365 x $5,000,000 = $109,589. The proposed lockbox system will reduce this to: 6/365 x $5,000,000 = $82,192, thus freeing up $27,397 of cash. Kelso will be able to borrow $27,397 less, thus saving: $27,397 x 0.08 = $2,192 in interest The system is expected to cost: $1,000 + ($0.20 x 500) = $1,100. The net saving is: $2,192 - $1,100 = $1,092 The banks proposal should be accepted

Example

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Managing Accounts Receivable

Generally firms like as little money as possible tied up in receivables
Reduces costs (firm has to borrow to support the receivable level) Minimizes bad debt exposure

But, having good relationships with customers is important

Increases sales

Firm needs to strike a balance on these issues

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Trade-offs in Receivable Managing Accounts Trade-offs in Receivable Management

Strict Management Less sales and gross margin, but More sales and gross Less bad debts margin, but Lower collection costs More bad debts Less discount Higher collection costs expenses More discount Lower receivables expenses Shorter collections Higher receivables Less interest expense Longer collections More interest expense 51 Liberal Management
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Managing Accounts Receivable

Policy Decisions Influencing Accounts Receivable
Credit Policy
Criteria used to screen credit applications Controls quality of accounts to which credit is extended

Terms of Sale
Terms and conditions under which credit extended must be repaid

Collections Policy
Methods employed to collect payment on past due accounts

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Credit Policy
Must examine creditworthiness of potential credit customers
Credit report Customers financial statements Bank references Customers reputation among other vendors

Conflicts often arise between sales and credit departments

Sales departments job to generate sales Credit department may refuse credit to high risk accounts
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Terms of Sale
Credit sales are made according to specified terms of sale
Example: 2/10, net 30 means customer receives 2% discount if payment is made within 10 days, otherwise entire amount is due by 30 days Customers pay quickly to save money Firms terms of sale generally follow industry practice
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Collections Policy
Firms collection policymanner and aggressiveness with which firm pursues payment from delinquent customers
Being overly aggressive can damage customer relations

Function of collections department to follow up on overdue receivables (called dunning)

Mail polite letter Follow up with additional dunning letters Phone calls Collection agency Lawsuit

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Inventory Management
Inventory management establishes a balance between carrying enough inventory to meet sales or production requirements while minimizing inventory costs Inventory usually managed by manufacturing or operations
However, finance department has an oversight responsibility
Monitor level of lost or obsolete inventory Supervise periodic physical inventories
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Benefits and Costs of Carrying Adequate Inventory

Benefits
Reduces stockouts and backorders Makes operations run more smoothly, improves customer relations and increases sales

Carrying Costs
Interest on funds used to acquire inventory Storage and security Insurance Taxes Shrinkage Spoilage Breakage Obsolescence
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Inventory Ordering Costs

Inventory ordering costs
Expenses of placing orders with suppliers, receiving shipments, and processing materials into inventory
Excludes vendor charges

Relate to the number of orders placed rather than to the amount of inventory held Tend to vary inversely with carrying costs
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Economic Order Quantity (EOQ) Model

EOQ model recognizes trade-offs between carrying costs and ordering costs
Carrying costs increase with amount of inventory held ( from larger orders) Ordering costs increase with the number of orders placed (from more orders)

EOQ minimizes total of sum of ordering and carrying costs

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Inventory Costs and the EOQ

Cost ($)

Total Cost Carrying Cost

Ordering Cost

EOQ
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Q (Order Size)
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Economic Order Quantity (EOQ) Model

EOQ model is:
2FD Q= c

[ ]

where Q= order size in units D= annual quantity used in units F= cost of placing one order C= annual cost of carrying one unit in stock denotes square root
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Figure 4.7:

Inventory on Hand for a Steadily Used Item

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Economic Order Quantity (EOQ) Model

Other Inventory Formulas
Average Inventory = Total Carrying Cost: =

Q 2

Q c 2

D Number of Orders = N = Q

D Total Ordering Cost = FN = F Q

Q D Total Ordering and Carrying Cost = TC = c +F 2 Q

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Example 4.3:

Economic Order Quantity

Example

Q: The Galbraith Corp. buys a part that costs $5. The carrying cost of inventory is approximately 20% of the parts dollar value per year. It costs $50 to place, process and receive an order. The firm uses 900 of the $5 parts per year. What ordering quantity minimizes inventory costs? How many orders will be placed each year if that order quantity is used? What inventory costs are incurred for the part with this ordering quantity?

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Example 4.3:

Economic Order Quantity

A: Annual carrying cost per unit is 20% x $5 = $1

Q =
Example

2 ( 50 ) ( 900 ) 1

EOQ = 300 units The annual number of reorders is 900 300 = 3 Ordering costs are $50 x 3 = $150 per year Average inventory is 300 2 = 150 units Carrying costs are 150 x $1 = $150 a year Total inventory cost of the part is $300

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Safety Stocks, Reorder Points and Lead Times

Safety stock provides insurance against unexpectedly rapid use or delayed delivery
Additional supply of inventory that is carried at all times to be used when normal working stocks run out Rarely advisable to carry so much safety stock that stockouts never happen
Carrying costs would be excessive
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Safety Stocks, Reorder Points and Lead Times

Ordering lead timeadvance notice needed so that an order placed will arrive when required
Usually estimated by items supplier

Reorder pointlevel of inventory at which order is placed

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Figure 4.9:

Inventory on Hand Including Safety Stock

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Economic Order Quantity (EOQ) Model

Other Inventory Formulas (with Safety
Stock)
Average Inventory =

Q + Safety Stock 2
Q c + Safety Stock 2

Total Carrying Cost: =

Total Ordering and Carrying Cost =

Q D TC = c + SafetyStock +F 2 Q
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Tracking InventoriesThe ABC System

Some inventory items (A items) require great deal of attention

Very expensive Critical to firms processes or to those of customers

Some inventory items do not require great deal of attention (C items)

Commonplace, easy to obtain

B items fall between items A & C ABC system segregates items by value and places tighter control on higher cost (value) pieces 70
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Just In Time (JIT) Inventory System

Inventory supplied
At exactly the right time In exactly the right quantities

Theoretically eliminates the need for factory inventory

Shortens operating cycle Reduces costs Eliminate wasteful procedures But: late delivery can stop factorys entire production line

Works best with large manufacturers who are powerful with respect to supplier
Supplier is willing to do almost anything to keep the manufacturers business
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