week 9

Slide 1

Introduction

Welcome to Financial Management. In this lesson we will discuss working capital management.

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Slide 2

Topics

The following topics will be covered in this lesson:

Current asset holdings;

Current asset financing policies;

The cash conversion cycle;

The cash budget;

Cash management and the target cash balance;

Cash management techniques;

Inventory management;

Receivables management;

Accruals and accounts payable (Trade Credit);

Short-term marketable securities;

Short-term financing;

Short-term bank loans;

Commercial paper; and

Use of security in short-term financing.

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Slide 3

Current asset holdings

The level of working capital required by the firm answers two questions:

First, what is the correct amount of both total working capital and for each specific account?

Second, how should working capital be financed?

Gross working capital refers to current assets used in operations. Networking capital is given by current assets minus current liabilities. Net operating working capital or NOWC is given by current operating assets minus current operating liabilities. Usually, NOWC consists of cash required in operations, accounts receivable, and inventories minus accounts payable and accruals.

When deciding upon the amount of working capital the firm focuses on operating current assets which consist of cash plus marketable securities, inventories, and accounts receivable. The level of operating current assets is a policy decision on the part of the firm and impacts profitability. Depending on its level of current operating assets the firm may run a relaxed, moderate or restrictive level of operating current assets. The optimal strategy is the one that management believes will maximize the stock’s intrinsic value.

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Slide 4

Current asset financing policies

Any investment in operating current assets must be financed and the primary sources of funding are bank loans, accounts payable, accrued liabilities, long-term debt, and common equity. Since current assets rarely dropped to zero, companies usually have some level of permanent current operating assets which the firm needs even at the lowest point of the business cycle.

Additionally, the firm has temporary operating assets which increase as sales increase during a cyclical upswing. The difference between permanent and temporary current operating assets and how they are financed is referred to as the current operating assets financing policy.

The firm has three policies it may use to address this issue:

First, a maturity-matching policy requires that the maturities of assets and liabilities match.

Second, an aggressive policy permits the use of short-term financing for some permanent assets.

And third, a conservative policy uses long-term financing for all permanent operating assets and for some of the temporary current assets.

Ultimately the financing method used depends on the manager’s personal preference and subjective judgments.

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Slide 5

The cash conversion cycle

The cash conversion cycle, CCC, is the length of time the firm has funds tied up in current assets and nets out the following three time periods. The inventory conversion period, ICP, is the time it takes to sell the equipment. Next, the average collection period, ACP, or days sales outstanding, DSO, is enough time it takes to collect accounts receivable. Last, the payables deferral, PDP, is the length of time the firm’s suppliers give it to pay for its purchases.

Then CCC equals ICP plus ACP minus PDP;

Where ICP equals inventory divided by cost of goods sold per day;

ACP equals receivables divided by the quantity sales divided by three hundred sixty-five.

The CCC is calculated from information contained in the first financial statements. It is advantageous for the firm to have a shorter rather than longer CCC relative to the average firm in the industry because there is a strong relationship between the CCC and the rate of return on the first stock. A shorter CCC usually results in a higher the rate of return.

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Slide 6

The cash budget

The main purpose of the cash budget is to forecast the firm’s liquidity. While the cash budget can be prepared for any time period, firms usually use a monthly cash budget but prepare it for a twelve month period. The firm also prepares a daily cash budget that it uses to schedule payments on a daily basis and it uses the monthly budget for longer – range planning.

Cash budgets are based on forecasts so the actual amount of cash the firm needs each month can vary from the expected amount required. Each month the firm forecasts total payments and collections.

When the total forecasted payments are subtracted from the total forecasted collections this yields the expected net cash gain or loss for each month. This amount when added or subtracted from the excess cash on hand at the beginning of the forecast period the result is the cumulative net cash flow. This is the amount of cash the firm has on hand if it didn’t borrow or invest funds. If the amount is negative the firm must borrow money but if the amount is positive the firm has surplus cash for investment or other uses.

It is important to understand that while the cash budget, income statement, and the FCF are related, they’re different concepts. The cash budget reflects actual cash inflows and outflows. The income statement reflects the firm’s profitability. FCF reflects the after – tax operating income and the investment required to maintain future operations.

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Slide 7

Cash management and the target cash balance

The firm holds cash for several reasons.

First, cash is held for transactions purposes. The firm requires cash to make routine payments and collections. We say that cash held for these purposes is referred to as transactions purposes.

The firm also holds cash for precautionary balances because cash inflows and outflows can be unpredictable.

Sometimes the firm holds compensating balances. These are funds maintained on deposit in a bank for providing loans and bank services.

Finally, the firm holds cash so we can take trade discounts because suppliers may offer discounts for the early payment of bills.

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Slide 8

Cash management techniques

Since most business is transacted by large firms that operate nationally or globally and have funds deposited in various banks, they must have a system to transfer funds where needed, to arrange loans, and to invest net surpluses. There are number of techniques the firm can use.

First, the firm may synchronize cash flows in which it times their cash receipts to coincide with their cash outlays.

Next, with the passage of check twenty-one banks clear most checks within one day. This speeds up the check clearing process.

Another technique used is to manage float where flow is defined as the difference between the balance in the firm’s checkbook and the balance on the banks records.

If the firm uses a lockbox its incoming checks are sent to post office boxes. The bank obtains the checks from the lockbox and deposits them into the firm’s account.

Finally, the firm can use wire transfers or electronic debits.

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Slide 9

Inventory management

The goal of inventory management is to ensure there is sufficient inventory to sustain operations and keep the cost of ordering and carrying inventory at a minimum. If inventories are too high, the costs associated with storage and handling, insurance, property taxes, spoilage, and obsolescence are high. Many firms use a just- in-time method system to reduce the carrying costs. Carrying too little inventories can be costly as well since the firm must order to frequently and this increases costs. Most firms use supply chain management and closely monitor the system.

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Slide 10

Receivables management

Managing the firm’s accounts receivable begins with the firm’s credit policy and consists of the credit period, discounts, credit standards, and the firm’s collection process. At any point time the firm’s total accounts receivable is determined by the credit sales per day and the average collection time of accounts receivable.

The firm monitors its accounts receivable by tracking its days sales outstanding and its average daily sales. The firm can also use an aging schedule which breaks down accounts receivable as to how long they have been outstanding. Using an aging schedule shows trends so the firm can say how their collection process compares with the average firm in the industry.

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Slide 11

Accruals and accounts payable (Trade Credit)

Accruals and accounts payable are the two major types of operating liabilities. Accruals are short-term, interest –free loans from employees, and the taxing authorities. As the firm’s operations grow accruals automatically increase and the firm has very little control over them.

Accounts payable or trade credit is the largest current liability. Since trade credit results from ordinary business transactions it also increases as the firm grows.

When the firm develops its credit policy it includes its terms of credit which consists of two components, free trade credit which results from the firm offering a discount and costly trade credit which involves credit in excess of free trade credit.

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Slide 12

Short-term marketable securities

Firms hold short – term marketable securities for two reasons: as a substitute for cash and in the form of non-operating investment.

Usually the firm combines its marketable securities with currency and bank deposits and refers to it as cash and cash equivalents. These are the current assets the firm needs to function on a daily basis. The firm chooses to hold marketable securities because it reduces risk and transactions costs and the firm will have cash to take advantage of growth opportunities or bargain purchases.

The primary disadvantage to holding short-term securities is that the after-tax return is very low. Empirical research supports the idea that firms with high growth opportunities tend levels of marketable securities.

In contrast, firms with high credit ratings tend to hold lower levels of cash and marketable securities.

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Slide 13

Short-term financing

There are several advantages to using short – term credit.

First, it’s easier for the firm to obtain than long – term financing because in the case of long-term financing lenders require a detailed examination of the firm’s financial records.

Second, the firm may not want to obligate itself to long – term debt.

Finally, short – term interest rates are usually lower than long – term rates. Therefore, the interest rate paid on short – term financing is usually lower.

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Slide 14

Short-term bank loans

Bank loans made to the firm include several key features. Most of the loans made by banks or short – term in nature and mature in one year or less. Once the loan is approved the borrower signs a promissory note. It specifies the amount borrowed, the interest rate, the repayment schedule, any collateral required, and any other agree upon terms. Sometimes the bank requires a compensating balance for bank services rendered. A compensating balance is a minimum checking account balance the firm maintains and is usually ten to percent of the outstanding loan.

A line of credit with the bank which is an informal agreement between the firm and the bank and specifies the maximum credit the bank will extend. A revolving credit agreement is a formal, committed line of credit and is used by large firms. It is similar to an informal line of credit except the bank has a legal obligation to honor the credit agreement and it receives a commitment fee. The cost of bank loans varies for different types of borrowers. Riskier borrowers are charged higher interest rates. If the firm is very credit worthy it can borrow at the prime rate. Banks charge simple interest rates on business loans and add-on interest rates for automobile and other types of installment loans.

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Slide 15

Commercial paper

Commercial paper is an unsecured promissory note issued primarily by financial institutions to other businesses, insurance companies, pension plans, money market mutual funds, and banks.

Maturities on commercial paper range from one day to nine months. Because of their short – term the rate paid is very low.

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Slide 16

Use of security in short-term financing

Commercial paper is always unsecured. While it’s better for the firm to borrow on an unsecured basis, sometimes the firm has no choice but to use security.

Types of security the firm can use as collateral are marketable stocks and bonds, land, buildings, equipment, inventoried, and accounts receivable. Land and buildings and equipment are usually used as collateral for long – term financing while accounts receivable and inventories are used as collateral for short – term financing.

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Slide 17

Check your understanding

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Slide 18

Summary

We have now reached the end of this lesson. Let’s review what we’ve covered.

First, we determined two questions concerning current asset holdings: What is the correct amount of both total working capital and for each specific account? And, how should working capital be financed? The level of working capital required by the firm answers these questions.

Next, we identified the difference between permanent and temporary current operating assets and how they are financed is referred to as the current operating assets financing policy.

Then, we defined the cash conversion cycle as the length of time the firm has funds tied up in current assets and nets out in three time periods: Inventory conversion period, average collection period and days sales outstanding.

Also, we determined the main purpose of the cahs budget is to forecast the firm’s liquidity. While the cash budget can be prepared for any time period, firms usually use a monthly cash budget.

Then, we introduced the concepts of target cash balance and cash management techniques. Firms hold cash for numerous reasons. One reason included holding cash for precautionary balances because cash inflows and outflows can be unpredictable. Also, since most business is transacted by large firms operating nationally or globally, they have a system to transfer fund where needed to arrange loans and to invest net surpluses.

Also, we discussed inventory and receivables management. The goal of inventory management is to ensure there is sufficient inventory to sustain operations and keep the cost of ordering and carrying inventory at a minimum. Receivables management begins with the firm’s credit policy and consists of the credit period, discounts, credit standards, and the firm’s collection process.

Next, we identified accruals and accounts payable as the two major types of operating liabilities.

Then, we discussed short-term marketable securities, financing, and bank loans Short-term marketable securities are held for two reasons: as a substitute for cash and in the form of non-operating investment. Short-term financing has several advantages including ease at which a firm can obtain short-term credit versus long-term credit. And short-term bank loans made to a firm include some key features such as maturing in one year or less.

Also, we defined commercial paper as an unsecured promissory note issued primarily by financial institution to other businesses, insurance companies, pension plans, money market mutual funds, and banks.

Finally, we learned that commercial paper is always unsecured. While it’s better for the firm to borrow on an unsecured basis, sometimes the firm has no choice but to use security.

This concludes this lesson.