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CHAPTER 15 Working Capital Management

CHAPTER 15 Working Capital Management. Alternative working capital policies Cash management Inventory and A/R management Trade credit Bank loans. Working capital terminology. Gross working capital – total current assets Net working capital Current Assets

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CHAPTER 15 Working Capital Management

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  1. CHAPTER 15Working Capital Management Alternative working capital policies Cash management Inventory and A/R management Trade credit Bank loans

  2. Working capital terminology • Gross working capital – total current assets • Net working capital • Current Assets • Non-interest bearing current liabilities

  3. Working Capital terminology • Working Capital Policy • Level of each type of current asset to hold • How to finance current assets

  4. Working Capital terminology • Working capital management • Control • Cash • Inventories • Accounts Receivables • Short-term liability management.

  5. Examples

  6. $ Temp. C.A. S-T Loans Perm Current Assets L-T Fin: Stock, Bonds, Spon. C.L. Fixed Assets Years Lower dashed line would be more aggressive. Moderate financing policy

  7. Marketable securities $ Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L. Perm Current Assets Fixed Assets Years Conservative financing policy

  8. Cash Conversion Cycle • Page 522

  9. Inventory conversion period Receivables collection period Payables deferral period CCC = + – . Cash Conversion Cycle • Length of time between when a company makes payments to its creditors and when a company receives payments from its customers

  10. Inventory Conversion = Inventory Cost Goods Sold per day (Cost Goods Sold / 365)

  11. Average Collection = Receivables Sales on credit per day (Sales / 365)

  12. Payable Deferral Period = PayablesPurchases per day (Cost Goods Sold / 365)

  13. Cash doesn’t earn a profit, so why should the firm hold it? • Transactions – some cash necessary to operate • Precaution – “safety stock”. Reduced by line of credit and marketable securities • Compensating balances – for loans and/or services provided • Speculation – to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities

  14. Goal of cash management • Meet objectives • Cash for transactions • Yet not have excess cash • Minimize transactions balances in particular, and also needs for cash to meet other objectives

  15. Minimizing cash holdings • Use a lockbox • Insist on wire transfers from customers • Synchronize inflows and outflows • Use a remote disbursement account • Reduce need for “safety” cash • Increase forecast accuracy • Hold marketable securities • Negotiate a line of credit

  16. Cash Budget • Forecasts cash inflows, outflows, and ending cash balances • Plan loans needed or funds available to invest • Can be daily, weekly, or monthly, forecasts • Monthly for annual planning and daily for actual cash management

  17. Cash Budget:For January and February Net Cash Inflows Jan Feb Collections $67,652$62,755 Purchases 44,604 36,473 Wages 6,690 5,471 Rent 2,5002,500 Total payments $53,794$44,444 Net CF $13,858 $18,311

  18. SKI’s cash budget (con’t) Net Cash Inflows Jan Feb Cash at start if no borrowing $ 3,000 $16,857 Net CF 13,858 18,312 Cumulative cash 16,858 35,169 Less: target cash 1,500 1,500 Surplus $15,358 $33,669

  19. EXCEL MODEL • Page 526

  20. How could bad debts be worked into the cash budget? • Collections would be reduced by the amount of the 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 higher borrowing requirements

  21. Inventory Costs • Types of inventory costs • Carrying costs – storage and handling costs, insurance, property taxes, depreciation, and obsolescence • Ordering costs – cost of placing orders, shipping, and handling costs • Costs of running short – loss of sales or customer goodwill, and the disruption of production schedules • Reducing inventory levels generally reduces carrying costs, increases ordering costs, and may increase the costs of running short

  22. Is SKI holding too much inventory? • SKI’s inventory turnover (4.82x) is considerably lower than the industry average (7.00x) • Firm is carrying a lot of inventory per dollar of sales • Excessive inventory increases cost, reduces ROE • Additional working capital must be financed

  23. If SKI reduces its inventory, without adversely affecting sales, what effect will this have on the cash position? • Short run: Cash will increase as inventory purchases decline • Long run: Company is likely to take steps to reduce its cash holdings (and costs)

  24. Do SKI’s customers pay more or less promptly than those of its competitors? • SKI’s DSO (45.6 days) is well above the industry average (32 days) • SKI’s customers are paying less promptly • SKI should consider tightening its credit policy in order to reduce its DSO

  25. Elements of credit policy • Credit Period – How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales • Cash Discounts – Lowers price. Attracts new customers and reduces DSO • Credit Standards – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO • Collection Policy – How tough? Tougher policy will reduce DSO but damage customer relationships

  26. Does SKI face any risk if it tightens its credit policy? • Tighter credit policy may discourage sales • Some customers may choose to go elsewhere if they are pressured to pay their bills sooner • SKI must balance the benefits of fewer bad debts with the cost of possible lost sales

  27. Short-term credit • Debt scheduled for repayment within 1 year • Major sources of short-term credit • Accounts payable (trade credit) • Bank loans • Commercial loans • Accruals • From the firm’s perspective, S-T credit is riskier than L-T debt • Required payment around the corner • Possible trouble rolling over loans

  28. Advantages and disadvantages of using short-term financing • Advantages • Speed • Flexibility • Lower cost than long-term debt • Disadvantages • Fluctuating interest expense • Risk of default as a result of temporary economic conditions

  29. What is trade credit? • Trade credit is credit furnished by suppliers • Trade credit is often the largest source of short-term credit, especially for small firms • Spontaneous, easy to get, but cost can be high

  30. Terms of trade credit • A firm buys $2,970,000 net ($3,000,000 gross) on terms of 1/10, net 30. • The firm can forego discounts and pay on Day 40, without penalty. Net daily purchases = $3,000,000 / 365 = $8,137

  31. Breaking down trade credit • Payables level, if the firm takes discounts • Payables = $8,137 (10) = $81,370 • Payables level, if the firm takes no discounts • Payables = $8,137 (40) = $325,479 • Credit breakdown Total trade credit $325,497 Free trade credit - 81,370 Costly trade credit $244,127

  32. Nominal cost of trade credit • The firm loses 0.01($3,000,000) = $30,000 of discounts to obtain $ 244,127 in extra trade credit: rNOM = $30,000 / $244,127 = 0.1229 = 12.3% • $30,000 is paid throughout the year, so the effective cost of costly trade credit is higher

  33. Nominal cost of trade credit formula

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