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CHAPTER 20 Working Capital Management. Working Capital Definitions and Policies Cash Management Inventory Management Credit Management Short-Term Financing Trade Credit Bank Debt and Commercial Paper Secured Loans. Basic Definitions. Gross working capital: Total current assets.

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Chapter 20 working capital management l.jpg
CHAPTER 20Working Capital Management

  • Working Capital Definitions and Policies

  • Cash Management

  • Inventory Management

  • Credit Management

  • Short-Term Financing

    • Trade Credit

    • Bank Debt and Commercial Paper

    • Secured Loans

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Basic Definitions

  • Gross working capital:

    Total current assets.

  • Net working capital:

    Current assets - Current liabilities.

  • Net operating working capital (NOWC):

    Operating CA – Operating CL =

    (Cash + Inv. + A/R) – (Accruals + A/P)

(More…)

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  • Working capital management:

    Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable.

  • Working capital policy:

    • The level of each current asset.

    • How current assets are financed

Please meet Danny the Banker.

Finance 402


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Selected Ratios for SKI

SKI Industry

Current 1.75x 2.25x

Quick 0.83x 1.20x

Debt/Assets 58.76% 50.00%

Turnover of cash 16.67x 22.22x

DSO (365-day basis) 45.63 32.00

Inv. turnover 4.82x 7.00x

F. A. turnover 11.35x 12.00x

T. A. turnover 2.08x 3.00x

Profit margin 2.07% 3.50%

ROE 10.45% 21.00%

Payables deferral 30.00 33.00

Finance 402


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How does SKI’s working capital policy compare with the industry?

  • Working capital policy is reflected in a firm’s current ratio, quick ratio, turnover of cash and securities, inventory turnover, and DSO.

  • These ratios indicate SKI has large amountsof working capital relative to its level of sales. Thus, SKI is following a relaxed policy.

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Alternative Current Asset industry?Investment Policies

Current Assets ($)

Relaxed

Moderate

Restricted

Sales ($)

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Is ski inefficient or just conservative l.jpg
Is SKI inefficient or just conservative? industry?

  • A relaxed policymay be appropriate if it reduces risk more than profitability.

  • However, SKI is much lessprofitable than the average firm in the industry. This suggests that the company probably has excessive working capital.

Finance 402


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Cash Conversion Cycle industry?

The cash conversion cyclefocuses on the time between payments made for materials and labor and payments received from sales:

Cash Inventory Receivables Payables

conversion = conversion + collection - deferral .

cycle period period period

What does the cash conversion cycle tell us about working capital management?

Finance 402


Cash conversion cycle cont l.jpg

Payables industry?

deferral

period

Days per year

Inv. turnover

Days sales

outstanding

365

4.82

Cash Conversion Cycle (Cont.)

CCC = + –

CCC = + 45.6 – 30

CCC = 75.7 + 45.6 – 30

CCC = 91.3 days.

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Shortening the Cash Conversion Cycle industry?

  • Reduce the Inventory Conversion Period by processing and selling goods more quickly

  • Reduce the Receivables Collection Period by speeding up collections

  • Lengthening the Payables Deferral Period by slowing down the firm’s own payments

Finance 402


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Cash Management: industry?Cash doesn’t earn interest,so why hold it?

  • Transactions:Must have some cash to pay current bills.

  • Precaution:“Safety stock.” But lessened by credit line and marketable securities.

  • Speculation:To take advantage of bargains, to take discounts, and so on. Reduced by credit line, marketable securities.

  • Compensating balances:For loans and/or services provided. But, Fee-Based Systems are rapidly replacing compensating balances.

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What is the goal of cash management? industry?

  • To reduce cash held to the minimum necessary to conduct business, yet maintain sufficient cash balances to:

    • Make timely payments,

    • Take trade discounts,

    • Maintain firm’s credit rating, and

    • Meet unexpected cash needs.

  • However, since cash is a non-earning asset, the goal is to have not one dollar more than necessary.

  • The Internet and telecommunications technology have dramatically affected cash management.

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What are “precautionary” and “speculative” balances? industry?

  • Precautionary balances:Cash reserves for unforeseen inflow/outflow fluctuations.

  • Speculative balances:Cash held for possible bargain purchases.

  • Both are better met with borrowing capacity and/or liquid securities.

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Two Internet Addresses for Cash Management Techniques industry?

  • Bank of America

    • http://www.bankofamerica.com/index.cfm?page=corp

  • Wachovia

    • http://www.wachovia.com/corp_inst

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Ways to Minimize Cash Holdings industry?

  • Use lockboxes.

  • Insist on wire transfersfrom customers.

  • Synchronizeinflows and outflows.

  • Use a remote disbursementaccount.

(More…)

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  • Increase industry?forecast accuracyto reduce the need for a cash “safety stock.”

  • Hold marketable securitiesinstead of a cash “safety stock.”

  • Negotiate a line of credit(also reduces need for a “safety stock”).

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How can a firm “synchronize” its cash flows and what good would this do?

  • Synchronize cash flows by arranging to bill customers and pay bills on regular “billing cycles” throughout the month.

  • Synchronized cash flows reduce the need for cash balances and required bank loans, thus lower interest expense and boost profits.

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Define disbursement float, collections float, and net float. good would this do?

  • Float: The difference between the balance shown in a firm’s checkbook and the balance on the bank’s books.

    • “Red Book” Balances

  • Disbursement float: Amount of funds tied up in checks the firm has written but which the bank has not yet deducted from its checking account balance. (More...)

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  • Collections float: good would this do?The time it takes a firm to deposit checks it has received and for the bank to process them and credit the firm’s account with “good” funds.

    • Ledger Balances vs. Available Balances

  • Net float = positive disbursement float (Good) – negative collections float (Bad)

Finance 402


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What is float and how can it be affected by cash management? good would this do?

  • Float is the difference between the balance shown on the firm’s books and the balance on its bank’s records.

  • If it takes SKI 1 dayto deposit checks it receives and it takes its bank another dayto clear those checks, SKI has 2 daysof collections float.

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  • If it takes 6 days for the checks that SKI writes to clear and be deducted from SKI’s account, SKI has6 days of disbursement float.

  • SKI’snet float is the difference between the disbursement float and the collections float:

    Net float = 6 days - 2 days = 4 days.

  • If SKI wrote and received $1 million of checks per day, it would be able to operate with $4 million less working capital than if it had zero net float.

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Components of Float and be deducted from SKI’s account, SKI has

  • Mail-Time Float

  • Processing Float

  • Clearing or Availability Float

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Techniques to Accelerate Inflows and be deducted from SKI’s account, SKI has

  • Lock Box System - Post Office Box

    • Retail - Large Number of Consumers

    • Wholesale - Typically Businesses

  • Automatic Debit - Automated Clearing House (ACH) Debits (Preauthorized)

    • e.g. Utilities debit users on a monthly basis

  • Payment by Wires

  • Field System

  • Concentration Banking

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Funds transfer tools between banks are used to accelerate inflows

  • Electronic (ACH) depository transfer. Uses data files to transfer funds. One Day Clearing.

  • Wires. The concentration bank instructs the field bank to initiate a wire transfer.

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Techniques to Manage Disbursements inflows

  • Payables Centralization

  • Internet Disbursement

  • Controlled Disbursement Accounts

    • Formerly Remote Disbursement

  • Zero-Balance Accounts

    • Money is moved from the Master Account to the Subsidiary Account to “zero” it out.

    • Breakdown by type of account and division

  • Payable Through Drafts

    • An order to pay, but not payable on demand

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Additional Disbursement Techniques inflows

  • Automated Clearing House (ACH) Credits

    • e. g. Direct Deposit of Payroll

    • GM automatically wires funds on 13th day to regular suppliers; no float but GM gets discounts (2/10, n/30).

  • With lower interest rates, emphasis has shifted to increased information benefits, ethical behavior, and decreased administrative costs.

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Account Analysis inflows

  • Bank Provides Monthly:

    • Summary of the Charges for Services Used

    • Analysis of the Balances Maintained

    • Credits “Earned” on the Balances

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Why would a firm hold low- yielding marketable securities inflows?

  • Substitute for cash balances

    • Reduces risk and transactions costs

    • Available for “bargain purchases”

  • Temporary investment resulting from:

    • Seasonal or cyclical operations.

    • Need to meet some unknown financial requirement.

    • Firm has just sold long-term assets.

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What factors should a firm consider when building its marketable securities portfolio?

  • Default risk (safety first)

  • Interest rate (price) risk

  • Purchasing power (inflation) risk

  • Liquidity and marketability risk

  • Returns on securities (yield)

  • Taxability

  • When it might need funds

  • Alternatively negotiate a line of credit

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Securities suitable to hold as liquid reserves: marketable securities portfolio?

  • U.S. Treasury bills

  • Commercial paper

  • Negotiable CDs

  • Money market mutual funds

  • Eurodollar market time deposits

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Securities not suitable to hold as liquid reserves: marketable securities portfolio?

  • Speculative derivatives

  • U.S. Treasury notes, bonds

  • Corporate bonds

  • State and local government bonds

  • Preferred stocks

  • Common stocks

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Cash Budget: The Primary Cash Management Tool marketable securities portfolio?

  • Purpose:Uses forecasts of cash inflows, outflows, and ending cash balances to predict loan needs and funds available for temporary investment.

  • Timing:Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management.

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Data Required for Cash Budget marketable securities portfolio?

  • 1. Sales forecast.

  • 2. Information on collections delay.

  • 3. Forecast of purchases and payment terms.

  • 4. Forecast of cash expenses: wages, taxes, utilities, and so on.

  • 5. Initial cash on hand.

  • Target cash balance.

  • Interest rate on outstanding loans

Finance 402


Ski s cash budget for january and february l.jpg
SKI’s Cash Budget for January and February marketable securities portfolio?

Net Cash Inflows

January February

Collections $67,651.95$62,755.40

Purchases 44,603.75 36,472.65

Wages 6,690.56 5,470.90

Rent 2,500.00 2,500.00

Total payments $53,794.31$44,443.55

Net CF $13,857.64 $18,311.85

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Cash Budget (Continued) marketable securities portfolio?

January February

Cash at start if no borrowing $ 3,000.00 $16,857.64

Net CF (slide 34) 13,857.64 18,311.85

Cumulative cash $16,857.64 $35,169.49

Less: target cash 1,500.00 1,500.00

Surplus $15,357.64 $33,669.49

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Should depreciation be explicitly included in the cash budget?

  • No.Depreciation is a noncash charge. Only cash payments and receipts appear in the cash budget.

  • However, depreciation does affect taxes, which do appear in the cash budget.

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What are some other potential cash inflows besides collections l.jpg
What are some other potential cash inflows besides collections?

  • Proceeds from fixed asset sales.

  • Proceeds from stock and bond sales.

  • Interest earned.

  • Court settlements.

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How can interest earned or paid on short-term securities or loans be incorporated in the cash budget?

  • Interest earned: Add line in the collections section.

  • Interest paid: Add line in the payments section.

  • Found as interest rate x surplus/loan line of cash budget for preceding month.

  • Note: Interest on any other debt would need to be incorporated as well.

  • Use Spreadsheet systems such as EXCEL.

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How could bad debts be worked into the cash budget? loans be incorporated in the cash budget?

  • Collections would be reduced by the amount of bad debt losses.

  • For example, if the firm had 3% bad debt losses, collections would total only 97% of sales.

  • Lower collections would lead to lower surpluses and higher borrowing requirements.

Finance 402


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SKI’s forecasted cash budget loans be incorporated in the cash budget?indicates that the company’s cash holdings will exceed the targetedcash balance every month, except for October and November.

  • Cash budget indicates the company probably might be holding too muchcash.

  • SKI could improve its EVA by either investing its excess cash in more productive assets or by paying it out to the firm’s shareholders.

Finance 402


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What reasons might SKI have for maintaining a relatively loans be incorporated in the cash budget?high amount of cash?

  • If sales turn out to be considerably less than expected, SKI could face a cash shortfall.

  • A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative.

  • The cash may be there, in part, to fund a planned fixed asset acquisition.

Finance 402


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Inventory Management: loans be incorporated in the cash budget?Categories of Inventory Costs

  • Carrying Costs: Cost of Capital tied up, storage and handling costs, insurance, property taxes, depreciation, and obsolescence.

  • Ordering Costs: Cost of placing orders, shipping, and handling costs. Supply Chain Management.

  • Costs of Running Short: Loss of sales (from stockouts), loss of customer goodwill, and the disruption of production schedules.

Finance 402


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Effect of Inventory Size on Costs loans be incorporated in the cash budget?

  • Reducing the average amount of inventory held generally:

  • Reduces carrying costs.

  • Increases ordering costs.

  • Increases probability of a stockout.

    • Air freight was stopped for a week or so after September 11, 2001

    • Effects of hurricanes

Finance 402


Is ski holding too much inventory l.jpg
Is SKI holding too much inventory? loans be incorporated in the cash budget?

  • SKI’s inventory turnover (4.82) is considerably lower than the industry average (7.00). The firm is carrying a lot of inventory per dollar of sales.

  • By holding excessive inventory, the firm is increasing its operating costs which reduces its NOPAT. Moreover, the excess inventory must be financed, so EVA is further lowered.

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If SKI reduces its inventory, without adversely affecting sales, what effect will this have on its cash position?

  • Short run: Cash will increase as inventory purchases decline.

  • Long run: Company is likely to then take steps to reduce its cash holdings.

Finance 402


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Inventory Control Systems sales, what effect will this have on its cash position?

  • Computerized Inventory Control Systems

  • Supply Chain Management

  • Just-In-Time (JIT) Systems

  • “Out-Sourcing”

  • Relationship between production scheduling and inventory levels

  • This topic will be discussed further in Chapter 22.

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Accounts Receivable Management: sales, what effect will this have on its cash position?Do SKI’s customers pay more or less promptly than those of its competitors?

  • SKI’s days’ sales outstanding (DSO)of 45.6 daysis well above the industry average (32 days).

  • SKI’s customers apparently are paying less promptly.

  • SKI should consider tightening its credit policy to reduce its DSO.

Finance 402


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Does SKI face any risk if it tightens its credit policy? sales, what effect will this have on its cash position?

YES!A tighter credit policy may

discourage sales. Some customers

may choose to go elsewhere if they

are pressured to pay their bills

sooner.

Finance 402


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If SKI succeeds in reducing DSO without adversely affecting sales, what effect would this have on its cash position?

  • Short run: if customers pay sooner, this increases cash holdings.

  • Long run: over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase EVA.

Finance 402


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Credit Management sales, what effect would this have on its cash position?

  • What terms of credit should the firm use?

  • To whom should the firm grant credit?

Finance 402


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Amount of Credit Outstanding sales, what effect would this have on its cash position?

  • The amount of Credit Outstanding at any given time is dependent on two factors:

    • The volume of credit sales

    • The average length of time between sales and collections

Finance 402


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Monitoring Accounts Receivable sales, what effect would this have on its cash position?

  • Days Sales Outstanding (DSO) or Average Collection Period (ACP)

  • Aging Schedules

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Monitoring A/R and Seasonal Fluctuations sales, what effect would this have on its cash position?

  • A seasonal increase in sales will increase the numerator more than the denominator, and will raise the DSO

    • Thus the DSO will look “worse,” but nothing has happened

  • A seasonal increase in sales will increase the amount of A/R that are less than 30 days outstanding

    • The Aging Schedule will look “better,” but nothing has happened

  • This topic will also be covered in Chapter 21.

Finance 402


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What five variables make up a firm’s credit policy? sales, what effect would this have on its cash position?

  • Cash discounts

  • Credit period

  • Credit standards

  • Collection policy

  • Size of credit line

Finance 402


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Elements of Credit Policy sales, what effect would this have on its cash position?

  • Cash Discounts: Lowers price. Attracts new customers and reduces DSO.

  • Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales.

(More…)

Finance 402


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  • Credit Standards sales, what effect would this have on its cash position?: Tighter standards reduce bad debt losses, but may reduce sales. Fewer bad debts reduces DSO.

  • Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships.

  • Credit Line: The firm determines the size of the line of credit extended to a particular customer.

Finance 402


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Credit Terms sales, what effect would this have on its cash position?

  • Discounts

    • For example, 2/10...

  • Credit Period

    • For example, n/30; or n/30 EOM

    • Seasonal Dating, for example n/30, July 1st

      • Promotes Sales

      • Reduces Inventory

      • Smoothes Production

      • Transfers Risk of Obsolescence

      • Might offer Anticipation Discount

      • Covered more fully in Chapter 21

Finance 402


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The six “Cs” of Credit Extension and Standards sales, what effect would this have on its cash position?

  • Character

  • Capital

  • Collateral

  • Capacity

  • Conditions

  • Country

Finance 402


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Credit Standards sales, what effect would this have on its cash position?

  • Might use Dun & Bradstreet ratings:

    • 1 = excellent

    • 2 = good

    • 3 = fair

    • 4 = limited

  • Credit Scoring Systems

    • Multiple Discriminant Analysis (MDA)

  • Judgmental Scoring Systems

Finance 402


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Sources of Credit Information sales, what effect would this have on its cash position?

  • The Seller’s Prior Experience

  • Credit Associations

    • Credit Interchange

  • Credit Rating Agencies

    • Dun & Bradstreet

    • Equifax

    • Experian

    • Trans Union

    • Fair Isaac

  • Analysis of Customer’s Financial Statements

  • Customer Visit

Finance 402


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Credit Investigation sales, what effect would this have on its cash position?

Proceed Sequentially in examining credit worthiness and making the credit decision.

Begin with the least costly and time consuming method. Then ask, is it worth it to continue further?

Use of computers in Relational Data Bases and Data Warehouses.

Finance 402


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Collection Policy sales, what effect would this have on its cash position?

  • Procedures the firm uses to collect past-due accounts

    • Charges for late payments

    • Letters

    • Phone calls

    • Legal action

Finance 402


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If a firm has no bad debts, does that mean that the credit manager is doing a good job?

  • No! The credit policy may be too restrictive, and the firm may be losing sales, profits and stockholder wealth.

Finance 402


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Size of Credit Line manager is doing a good job?

  • A key option is that the seller may grant a limited amount of credit, called a credit line or credit limit.

  • Possible reasons for this limit:

    • Limits are not as enforced as rejection

    • Increases in production costs

    • Funds Constraints

Finance 402


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Working Capital Financing Policies manager is doing a good job?

  • Moderate: matches the maturity of the assets with the maturity of the financing.

    • Self-liquidating approach

  • Aggressive: uses short-term (temporary) capital to finance some permanent assets.

  • Conservative: uses long-term (permanent) capital to finance some temporary assets.

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  • The choice of working capital financing policy is a classic risk/return tradeoff.

  • The aggressive policypromises the highest return but carries the greatest risk.

  • The conservative policyhas the least risk but also the lowest expected return.

  • The moderate (maturity matching) policyfalls between the two extremes.

Finance 402


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Moderate Financing Policy risk/return tradeoff.

$

Temp. NOWC

S-T

Debt

(Temporary)

L-T Fin:

Stock,

Bonds,

Spon. C.L.

(Permanent)

Perm NOWC

Fixed Assets

Years

What are “permanent” current assets?

Finance 402


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Relatively Aggressive Financing Policy risk/return tradeoff.

$

Temp. NOWC

S-T (temporary)

Debt

L-T Fin:

Stock,

Bonds,

Spon. C.L.

Perm NOWC

Fixed Assets

Years

More aggressive the lower the dashed line.

Finance 402


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Conservative Financing Policy risk/return tradeoff.

$

Marketable Securities

S-T Financing Requirements

L-T Fin:

Stock,

Bonds,

Spon. C.L.

Perm NOWC

Fixed Assets

Years

Finance 402


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What Is Short-term Credit? risk/return tradeoff.What Are the Major Sources?

  • Short-term credit: Debt requiring repayment within one year.

  • Major sources:

    • Accruals

    • Accounts payable (trade credit)

    • Commercial paper

    • Bank loans

      • Unsecured Loans

      • Secured Loans - Accounts Receivable

      • Secured Loans - Inventory

Finance 402


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Choosing a Source of Short Term Financing risk/return tradeoff.

  • Cost

    • Annual Percentage Rate

    • Effective Annual Rate (Compounded Rate)

  • Impact on credit rating

  • Reliability

  • Restrictions

    • Degree to which assets are encumbered

  • Flexibility

  • Availability

Finance 402


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What are the advantages of short-term debt vs. long-term debt?

  • Lower cost-- yield curve usually slopes upward.

  • Can get funds relatively quickly with lower flotation costs.

  • Repayment penalties can be expensive for long-term debt

  • Long-term debt typically contain more restrictive covenants.

Finance 402


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What are the disadvantages of short-term debt vs. long-term debt?

  • Short-term debt is riskier than long-term debt for the borrower.

    • The required repayment comes quicker.

    • May have trouble rolling debt over.

  • Short-term rates may rise

    • With long-term debt, interest rates will be relatively stable over time.

Finance 402


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Is There a Cost to Accruals, and Do Firms Have Much Control Over Them?

  • Accruals increase automaticallyas a firm’s operations expand.

  • Accruals are “free”in the sense that no explicit interest is charged.

  • A firm has little control over the level of accruals, They are influenced more by industry custom, economic factors, and tax laws than by managerial actions.

  • Spontaneous source of funds.

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What Is Trade Credit? Over Them?

  • Trade creditis credit furnished by a firm’s suppliers.

  • Trade credit is often the largest source of short-term credit for small firms.

  • Trade credit is spontaneousand relatively easy to get, but the cost can be high.

Finance 402


Advantages of trade credit l.jpg
Advantages of Trade Credit Over Them?

  • Flexible in amount

  • Informal - no restrictions placed on the user

  • Very convenient and easy to obtain

  • Easy for the small firm to obtain

Finance 402


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Disadvantages of Trade Credit Over Them?

  • Limited in amount

  • Not a direct source to pay other bills

  • Can affect credit rating

    • “Stretching” accounts payable

      • Pay beyond the due date -

Finance 402


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SKI buys $506,985 net, on terms of 1/10, net 30, and pays on Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

Net daily purchases = $506,985/365

= $1,389.

Annual gross purch. = $506,985/(1-0.01)

=$512,106

Finance 402


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Gross/Net Breakdown Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

  • Company buys goods worth $506,985. That’s the cash price.

  • They must pay $5,121 more if they don’t take discounts.

  • Think of the extra $5,121 as a financing cost similar to the interest on a loan.

  • Want to compare that cost with the cost of a bank loan.

Finance 402


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Payables level if Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?take discount:

Payables = $1,389(10) = $13,890.

Payables level if don’t take discount:

Payables = $1,389(40) = $55,560.

Credit Breakdown:

Total trade credit = $55,560

Free trade credit = 13,890

Costly trade credit = $41,670

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$5,121 Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

$41,670

rNom = = 0.1229 = 12.29%.

Nominal [Annual Percentage Rate (APR)] Cost of Costly Trade Credit

Firm loses 0.01($512,106) = $5,121 of discounts to obtain $41,670 in

extra trade credit, so

But the $5,121 is paid all during the year, not at year-end, so Effective Annual Rate (EAR) rate is higher.

Record purchases on books as net purchases and discounts lost as an interest expense.

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Nominal (APR) Cost Formula, 1/10, net 40 Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

Pays 1.01% 12.167 times per year.

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Effective Annual Rate (EAR), 1/10, net 40 Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

Periodic rate = 0.01/0.99 = 1.01%.

Periods/year = 365/(40 – 10) = 12.1667.

EAR = (1 + Periodic rate)n – 1.0

= (1.0101)12.1667 – 1.0 = 13.01%.

Normally, it is cheaper to borrow the money from the bank and take discounts.

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“Stretching” Accounts Payable Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

  • Effect on credit rating - reputation as a “slow payer”

  • Suppliers start requiring the firm to pay cash

  • Late payment penalties

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Choosing a Bank Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?(Negotiated Source of Funds)

  • Willingness to assume risks

  • Advise and counsel

  • Loyalty to customers

  • Maximum loan size

  • Specialization

  • Merchant Banking capabilities

  • Other Services

    • Technology and telecommunications

  • Discussed in Chapter 21

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Bank Short Term Credit Forms Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

  • A Line of Credit is a informal or formal understanding between the bank and the borrower indicating the maximum credit the bank will extend to the borrower.

    • One year or less

    • Can be tied to LIBOR, Prime, Fed Funds Rate

    • Often includes a “cleanup provision”

more

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Bank Short Term Credit Forms - continued Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

  • A Revolving Credit Agreement (“Revolver”) is a formal (legal) arrangement often used by large firms.

    • Can be more than one year , e. g. three years.

    • Usually calls for a commitment fee.

  • We will calculate the APR and EAR of bank loans in Chapter 21.

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Promissory Note Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

  • Negotiated source of funds

  • Amount borrowed

  • Percentage interest rate

  • Repayment schedule

    • Series of Installments

    • or Lump sum

  • Collateral specified as security

  • Other terms and conditions

    • Typically 90 days and renewable

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Commercial Paper Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

  • A type of unsecured (normally), discounted, large denomination, promissory note, typically issued by large, strong firms (Net Worth>$100 million)

    • Sold to other business firms, money market funds, pension funds, foundations, wealthy individuals, and insurance companies

    • Maturities vary from one to nine months

    • Can be asset-backed

  • Direct Placement vs. Dealer Placement

  • Rated by Moody’s, Standard & Poors, Fitch’s

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Advantages of Commercial Paper Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

  • Cheaper, as the effective interest rate is typically less than the prime rate

  • Size of market available is large

  • Medium-sized firms may use bank guarantees and enter the market

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Disadvantages of Commercial Paper Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

  • Impersonal market

  • Dealers prefer to handle the paper of firms where borrowings are $10 million or more

  • Can’t pay off prior to maturity

  • 270 day maximum maturity

  • 100% credit line needed to back up commercial paper in most cases

  • Amount of funds in market may be limited

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Commercial Paper (CP) Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

  • Short term notes issued by large, strong companies. SKI couldn’t issue CP--it’s too small.

  • CP trades in the market at rates just above T-bill rate.

  • CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes.

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What Is a Secured Loan? Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

  • In a secured loan, the borrower pledges assets as collateral for the loan.

  • For short-term loans, the most commonly pledged assets are receivables andinventories.

  • Securities are great collateral, but firms needing short-term loans generally do not have securities on hand.

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Important Legal Forms Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit?

  • UCC form-1: filed with Secretary of State to establish collateral claim. Prospective lenders will do a claims search, and won’t make the loan if a prior UCC-1 has been filed.

  • Security Agreement: standard form under the Uniform Commercial Code. Specifies when lender can claim collateral if default occurs.

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What Are the Differences Between Pledging and Factoring Receivables?

  • If receivables are pledged, the lender has recourse against both the original buyer of the goods and the borrower.

    • Normally non-notification for remittances

  • When receivables are factored, they are generally sold, and the lender has no recourse to the borrower.

    • Normally notification for remittances

    • Credit Cards are an example

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Aspects of Factoring Receivables?

  • Maturity Factoring

    • Continuous process

    • Funds are received at maturity

    • Factor performs:

      • Credit Checking and Investigation

      • Collections

      • Absorbs Bad Debt Expenses (Risk Bearing)

  • Discount Factoring

    • Additional function of lending is performed as firm receives the funds in advance

    • Flexible financing

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Drawbacks of Factoring Receivables?

  • Non-interest costs - e.g. 1 % to 3% of the amount of the invoice accepted by Factor

  • Constraints imposed on the seller

  • Administrative costs

  • Other creditors are placed at a disadvantage because A/R is used as collateral

  • Interest costs if Discount Factoring is used

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Shakespeare and Factoring Receivables?

  • King Henry IV

  • The Merchant of Venice

  • The Comedy of Errors

  • Othello

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What Are the Three Forms of Inventory Financing? Receivables?

Blanket lien:Gives the lender a lien against all of the borrower’s inventory.

Trust receipt:An instrument that acknowledges goods held in trust for the lender. A specific registration number is needed. Automobile dealer financing is a widely used example.

Warehouse receipt:Uses inventory as security.

Form used depends upon type of inventory and situation at hand. Provides flexible financing.

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Public Vs. Field Warehouse Receivables?

  • Public Warehouse is an independent third party engaged in the business of storing goods.

  • Field Warehouse may be established at the borrower’s place of business

    • Physical Control of inventory - e.g. canned peaches

    • Public notification

    • Supervision by custodian of Field Warehouse company

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Inventory Financing Costs Receivables?

  • Minimum of $5,000 plus 1 to 2 % of amount of credit extended

  • Interest charges typically set at 2% to 3% above prime

  • But, necessity for warehouse control may improve warehouse practices

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What Is “securitization” and Why Is It Used? Receivables?

  • Pension funds and mutual funds have money to lend, but they typically don’t make short term loans.

  • Companies like GM and Ford can bundle up their receivables, use them as security for a low-risk bond, and sell the bond to pension funds, etc.

  • This is “securitization,” and its purpose is to get funds at a low cost. However, the risk is substantial for the final investor.

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Sequential Method for Managing Current Debt Receivables?

  • List all the potential sources from the lowest effective rate to the highest

  • Start with the cheapest and proceed sequentially (typically) to the more expensive source

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Working Capital Management Receivables?

  • Working Capital Policies

  • Cash Management

    • Short-Term Investments

  • Inventory Management

  • Accounts Receivable Management

  • Short-Term Financing

    • Trade Credit

    • Bank Loans

    • Commercial Paper

    • Secured Loans

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