WORKING CAPITAL MANAGEMENT Working capital refers to the firms investment in short-term assets (cash, marketable securities, accounts

receivable and inventories). Net working capital is the difference between a firms current assets and its current liabilities. Working capital management involves administering to both short-term assets and short-term liabilities. Assets and liabilities must be matched and coordinated in order to keep costs to a minimum and to control risks. enerall!, we want to match the firms financing with the lives of its assets. "f we consider a compan! that is growing over time, then its assets can be decomposed into three categories # fi$ed assets, permanent current assets and fluctuating current assets. %hort-term &luctuating 'urrent Assets

(ermanent 'urrent Assets &i$ed Assets

)ong-term

&i$ed assets should be financed long-term, either e*uit! or long-term debt, since the assets are long-lived and need financing for a long period of time. +he current assets can be broken down into two portions, permanent current assets and fluctuating current assets. +he permanent current assets represent base levels of inventories, receivables, etc., that will alwa!s be on hand. +he fluctuating current assets represent the seasonal build-ups that occur, such as inventories before 'hristmas and receivables after 'hristmas. +he fluctuating current asset levels should be financed short-term since we dont want to pa! financing charges all !ear if we onl! need the mone! for a fourmonth period. While the permanent current assets are, individuall!, short-lived assets, as a categor! the! are alwa!s there (hence, permanent) and will alwa!s need to be financed. +hus, the permanent current assets should also be financed long-term, ,ust like the fi$ed assets. While it is possible to finance some of our permanent needs using short-term debt, it is risk! to do so. (%uch financing is described as an -aggressive. working capital financing polic! in !our te$t # aggressive being associated with risk!.) +he risk of financing permanent needs with short-term financing is twofold/ first, short-term interest rates fluctuate much more than long-term interest rates. 0olling over short-term debt !ear after !ear will sub,ect !ou to greater fluctuation in !our financing costs as a result. (robabl! a bigger risk is the inabilit! to roll over the short-term debt ever! !ear. 1ou ma! have a bad !ear and find that lenders are unwilling to refund the debt (forcing !ou to default).

2f course, some companies take the opposite approach # the! will finance some of their seasonal needs of the fluctuating current assets with long-term financing. +his is a conservative approach, but the financing is there when it is needed # but it costs mone! during those times when it is not needed. 3anks generall! do not want companies to utili4e them as a source of permanent financing. &or this reason, man! banks will re*uire that a compan!s line of credit be completel! paid off for at least one month each !ear. +his is to prevent the compan! from using the bank for permanent financing. 2f course, banks are essentiall! matching their assets and liabilities as well. +he difference is that a banks assets are its loans which it matches to its sources of financing # while firms match their financing to their assets. %ince a banks financing source is predominantl! short-term deposits, it wants its loan portfolio to be predominantl! short-term as well. )ife insurance companies and pension funds, on the other hand, have liabilities that are man! !ears in the future. +he! would prefer to make longer term loans so that there isnt the need to reinvest the mone! ever! !ear. COMPONENTS OF WORKING CAPITAL Cash 'ash is probabl! the least productive asset !ou can have. Not onl! does it not earn an!thing, it actuall! loses purchasing power as a conse*uence of inflation. %o wh! do firms hold cash5 +he three 6e!nsian motives for holding cash balances are +ransactions motive # to conduct da!-to-da! business of pa!ing for purchases, labor, etc. (recautionar! motive # to cover une$pected e$penditures. "f the deliver! truck breaks down, it must be repaired or replaced if !ou want to sta! in business. %peculative motive # unusuall! good opportunities occasionall! arise. "f !ou have the mone! available, !ou can take advantage of these opportunities.

While cash is necessar! to cover the transactions motive, the precautionar! and speculative motives can be covered with the near mone! (or near cash) of marketable securities. "n order to ma$imi4e !our cash balances, !ou can do one of two things7 either accelerate the inflow of funds (ask for an advance on !our salar!) or dela! the outflow of funds (postpone pa!ing the phone bill until ne$t month). 3ut wh! would we want to ma$imi4e our cash holdings if it is the least productive asset5 3ecause idle cash, either sitting in a checking account or tied-up in accounts receivable is e$tremel! costl!. &or e$ample, suppose we have a client who owes us pa!ment of 89,:::,::: that is due. +he opportunit! cost of not collecting is the interest we could earn on the mone!. 89,:::,::: ;< 0eceivable due +reasur! bill rate

8 =::,::: Annual interest 8=::,:::>?@9 da!s A 8;BC per da! 'an !ou invest mone! for one da!5 Absolutel!. "n fact, for a large enough amount of mone!, someone will meet !ou at the bank on %unda! in order to accept !our deposit. +his also illustrates the concept of -float.. 3ank float is the period of time between when a check is written to pa! an obligation and when the funds are actuall! deducted from !our checking account. Within a cit!, it is common practice to have a local check clearing s!stem where banks meet each da! to e$change checks written on one anothers accounts. When the bank where a check is deposited is in a different cit! from the bank on which the check is drawn, the deposited check first goes to the regional &ederal 0eserve 3ank, (Dallas in the case of +e$as), and is then forwarded to the issuing bank. +his adds a da! or two to the float period. "f the check is drawn on a bank account in another &ederal 0eserve District, then another da! or so is added as the local &ed must forward the check to the &ed in the issuing banks district which then forwards the check to the bank. E$$on used to pa! suppliers west of the Fississippi river with checks written on a small bank in North 'arolina, while suppliers east of the Fississippi were paid with checks on a small bank in Ari4ona. 2ne da!s worth of float to the G.%. government is worth over 8= billion (which is one reason government emplo!ees now get paid on the first of the following month rather than the last da! of the month). Fost of us have probabl! pla!ed the float on at least one occasion (and probabl! gotten caughtH) "t should be noted, however, that using float to cover up a deficit (i.e., hot check) is illegal. Another means of e$tending the float is through the use of drafts. A draft is like a check, but must be returned to the issuer for verification prior being deposited. +his, again, adds ;-? da!s to the float period. "nsurance companies are most noted for using drafts within the G.%. +he t!pe of draft that insurance companies use are known as sight drafts since the! are paid upon presentation. Time drafts are those which are pa!able upon a specific future date. +ime drafts are an important financing instrument in international trade and will be discussed later. While bank float and drafts dela! the outflow of funds, cash balances can also be increased b! speeding up the inflow of funds. +he primar! means of accomplishing this is through the use of a lock-bo$ s!stem. A lock-bo$ is a post office bo$ in a local cit! where pa!ments from customers in the area are sent. +he lock-bo$ is cleared dail! and the checks are deposited in a local bank and then wired to the compan!s main bank account. 0eferred to as concentration banking, it cuts ;-? da!s off of the time it takes the checks to cross several states and allows funds to be concentrated in one bank for investment in short-term securities. +he larger amount of funds that can be invested !ields higher interest rates and lower transactions costs. +he local bank will offer the lock-bo$ s!stem if a local office is not available or does not want to devote the personnel to tend to the s!stem. 3anks, however, charge for the services that the! provide through either a direct service charge, or b! re*uiring that a minimum compensating balance be maintained. A compensating balance is one that does not pa! an! interest. +he minimum balance can be either an absolute minimum or an average minimum.

+he clearing of checks can also be accelerated through the use of the &ederal 0eserve 3anks Automated 'learing Iouse (A'I) s!stem which is governed b! the National Automated 'learing Iouse Association (NA'IA). 'ompanies can do this through the use of a check scanner which converts the paper check into an electronic check that can be processed from a computer. enerall! referred to as Electronic 'heck (rocessing, this is essentiall! the same as what occurs with direct deposit of pa!roll checks. Marketable Securities Farketable securities are a wa! of holding cash but with the attribute of earning interest. Farket securities have three characteristics/ =. %hort-term maturit! (less than one !ear, or -mone! market instruments. ;. Iigh marketabilit! ?. Jirtuall! no risk of default %everal t!pes of marketable securities e$ist, the ma,or ones being G.%. +reasur! bills +reasur! bills are auctioned ever! Fonda! b! the government. Fost have maturities of K= or =L= da!s, although some K-month (;B: da!s) and =;-month (?@: da!s) bills are sold. +he t-bills, generall! with a face value of 8=:,::: each, are sold at a discount to the highest bidders. +he difference between the amount paid and the face value at maturit! represents the interest that is earned. Anticipation notes Anticipation notes are issued b! municipalities and school districts. %ince their revenues come from ta$ sources, the notes are -in anticipation. of future ta$ receipts. 'ommercial paper 'ommercial paper is the promissor! notes of a ma,or national firms. Fost of the firms that issue commercial paper sell it directl! to investors (insurance companies, mone! market funds, pension funds) although sometimes it will be sold through investment bankers. 'ommercial paper is a substitute for bank debt, but at a rate of interest that is one-fourth to on-half of a percent higher than t-bills (currentl! about C.?<) but significantl! less than what banks would charge (prime is currentl! about L.9<). 3ankers Acceptances A bankers acceptance is a time draft that evolves from international e$port>import financing. An e$porter is paid b! a time draft issued b! a foreign bank. %ince the draft is not pa!able until some future date (=-? months, t!picall!) the compan! that receives it will often sell it to its local

bank at a discount. +he local bank bundles the discounted drafts (bankers acceptances) and then resells them in the mone! markets. Accounts Recei able Accounts receivable are generated when a firm offers credit to its customers. +he first thing that needs to be addressed when establishing a credit polic! is to set the standards b! which a firm is ,udged in determining whether or not credit will be e$tended. +here is whats known as the 9 's of credit/ =. 'haracter # the willingness of the borrower to repa! the obligation ;. 'apacit! # the capabilit! of the borrower to earn the mone! to repa! the obligation ?. 'apital # sufficient assets available to support operations (as opposed to a firm that is undercapitali4ed). %ometimes capital is interpreted to mean e*uit! capital7 i.e., to make sure the owners of the firm have sufficient mone! at stake to give them proper incentive to repa! the loan and not let the compan! go bankrupt. C. 'ollateral # assets to support the loan which can be li*uidated if default occurs 9. 'onditions # current and future anticipated conditions of the firm and the industr!. 2nce the credit standards have been set, the terms of credit need to be established. When must the customer pa!5 "f the! pa! earl!, will the! receive a discount5 "f the! pa! late, do the! get charged a penalt!5 While the whole purpose of e$tending credit is to increase sales and, thus, gross profits, the e$pected increase in gross profits must be compared with the costs associated with e$tending credit to customers. +hese costs include +he time value of mone! tied up in accounts receivable 3ad debts that occur 'redit checks (to minimi4e bad debts) 'ollection costs Discounts for earl! pa!ment (reduces revenues) 'lerical costs associated with maintaining a credit department

'ompetitors will respond ver! *uickl! to a change in price. Iow man! times have we seen the claims that -We will meet or beat an! advertised price.5 A change in credit polic!, on the other hand, is a more subtle means of competing for customers and one that the competition will not necessaril! respond to. "n fact, man! firms base their business on eas! credit. Iow man! times have we seen the advertisements where the! tell us - ood credit5 3ad credit5 No credit5 We dont careH. 2f course, these firms will have larger bad debt e$penses and larger financing costs, etc. 2bviousl!, the! will also need to have higher prices (higher gross profit margins) in order to cover these costs.

In entories "nventories (raw materials, work-in-process, finished goods) make up a large portion of most firms current assets, and for man!, total assets. As such, the e$tent to which a firm efficientl! manages its inventories can have a large influence on its profitabilit!. +hus, keeping abreast of inventor! polic! is critical to the profitabilit! (and value) of the firm. %everal factors influence the amount of inventor! that a firm maintains. +he most important of these include )evel of sales # t!picall!, the more sales a firm has, the more inventor! it holds )ength of time and technical nature of the production process # +he longer it takes to produce finished goods inventories from raw materials, the larger the amount of finished goods that a firm will t!picall! hold (a safet! stock). Also, if the production process is highl! technical, re*uiring that retooling be performed prior to each production run in order to assure that production is meeting specifications, larger amounts of inventor! will be produced with each production run in order to minimi4e the set-up costs associated with retooling. Durabilit! vs. (erishabilit! # "f an inventor! item is highl! perishable, such as fresh vegetables, a small amount will be held. %imilarl!, fashions of clothes and car st!les are -perishable. and will result in smaller inventories than durable goods such as tools and hardware. 'osts # 'ost of holding inventories as well as costs of obtaining inventories will influence inventor! si4es.

"nventor! costs can be broken down into three ma,or categories/ A. 2rdering 'osts =. &i$ed costs # stocking, clerical ;. %hipping costs # often fi$ed ?. Fissed *uantit! discounts # an opportunit! cost 'arr!ing 'osts =. +ime value of mone! tied-up in inventories ;. Warehousing costs ?. "nsurance C. Iandling 9. 2bsolescence, breakage, -shrinkage. %tock-out 'osts =. )ost sales ;. )oss of goodwill ?. %pecial shipping costs

3.

'.

"deall!, we want to balance these costs against each other so that our total costs are minimi4ed.

Short-term Sources of Financing Tra!e Cre!it +he ma,or source of short-term financing for firms is that of trade credit. While it is an account pa!able on our balance sheet, it is an account receivable on the balance sheet of our supplier. +he terms of credit can var! *uite a bit/ =. 'ash on Deliver! (i.e., no credit) ;. Net amount due within a certain period of time ?. Net amount with a discount if paid within a certain period of time, net amount within another period. &or e$ample, ;>=: net ?: means that if !ou pa! within the first ten da!s, !ou can deduct ;< from the bill7 otherwise the full amount of the bill is due within ?: da!s. Discounts are offered b! suppliers to keep their A>0 balances down and minimi4e the funds that are tied-up. Not taking the discount can be a ver! e$pensive means of financing. &or e$ample, suppose we do not pa! within the first ten da!s. +hen, if we pa! on the thirtieth da!, we have paid ;< (appro$imatel!) for an additional twent! da!s use of the funds (the first ten da!s were free an!wa!). %ince there are =L twent!-da! periods in a !ear, this is appro$imatel! ;< M =L A ?@< Actuall!, the cost is a little higher since we are pa!ing ;< on top of the KL< we would otherwise have to pa!/

2% 360days * = 36. 7% 98% 20days

2f course, if !ou miss pa!ment b! da! =: for taking the discount, dont pa! the full amount of da! == or !ou have paid ;<M?@: A B;:< Do banks charge ?@< interest on loans5 Not in +e$as or most states. "t is a violation of the usur! laws. +hen wh! do man! companies forego the discounts if the cost is so high5 "t is the onl! source of funding that the! can get. +o reduce the effective cost, firms will often stretch pa!ment out past the due date. 2f course, this sub,ects the firm to risk of its credit being completel! cut off b! the supplier and possibl! damages the credit reputation since other suppliers will often re*uest references before e$tending credit themselves.

%ome firms will offer post-dated billing, t!picall! in a seasonal industr!. &or e$ample, if a manufacturers primar! sales are to retailers for the 'hristmas season the! ma! encourage retailers to order in Nune and Nul! rather than waiting until %eptember. +he encouragement is that if an order is placed in Nune or Nul!, the manufacturer will not bill them until %eptember and even then regular credit terms will appl!. +he advantage here is that it allows the manufacturer to smoothe out sale and thus production. +he manufacturer can then save on overtime with emplo!ees as well as not incur man! of the carr!ing costs associated with holding the inventories since the retailer takes possession and ownership earlier. Co""ercial #anks +he second ma,or source of short-term financing for firms is commercial banks. A firm wants to establish a close relationship with its bank and obtain a line of credit. "n order to get a credit line, !ou will want to show them !our income statements, balance sheets, financial ratios, etc. +he bank will then allow a certain amount of credit with a set rate of interest (usuall! prime plus). +his can be renegotiated ever! !ear. "n fact, commercial banks bread and butter is their business accounts and the! are ver! competitive with one another in tr!ing to attract corporate clients. +he amount of the credit line is t!picall! tied to the amount of accounts receivable that the firm has and sometimes to the amount of inventories that it holds. Another t!pe of credit line is referred to as a revolving line of credit. With a revolving line of credit, the bank provides a written agreement guaranteeing loans up to a certain amount. +he firm will pa! a normal rate of interest on the amounts of funds that it borrows plus a commitment fee of one-half to one percent on an! unborrowed funds. Gnlike a regular line of credit which can be changed, a revolving line of credit guarantees that the bank will alwa!s make the amount available if needed. Additionall!, a revolving line of credit will often be e$tended ,ointl! b! several banks when the amounts used are larger than a single bank can (or wants to) handle alone. T$%es o& Loans )oans come in a variet! of shapes. A simple loan re*uires that the firm maintain a non-interest-bearing account at the bank. While compensating balances are not used as much as the! have been in the past, the! are still encountered fre*uentl!. %uppose a bank offers a one-!ear loan for 8=::,::: at an L< rate of interest with a compensating balance of ;:<. +hen, )ess/ 8=::,::: loan ;:,::: compensating balance 8 L:,::: net proceeds

At the end of one !ear, the firm repa!s the bank 8LL,:::. 8L,::: is interest on the loan and the other 8L:,::: (with the 8;:,::: in the compensating balance for a total of 8=::,:::) is the principal. +hus, the firm has effectivel! paid 8L,::: interest on the use of 8L:,::: for an annual rate of interest of =:<.

Alternativel!, the bank ma! offer a discounted loan where the interest is deducted up-front. Gsing our same e$ample, )ess/ 8=::,::: loan L,::: interest 8 K;,::: net proceeds

At the end of the !ear, the firm repa!s the 8=::,::: of principal (since the interest was paid up-front). Effectivel!, the firm paid 8L,::: of interest for the use of 8K;,::: of funds for a rate of interest of L.B< on the loan. 2f course, !our banker is there to help !ou and ma! e$press concern that the need to come up with 8=::,::: at the end of the !ear could be difficult. Ie>she ma! suggest, instead, an interest add-on loan where the amount of interest is added to the principal and then repaid in a series of installments. 2ur e$ample loan would then re*uired that monthl! pa!ments of 8K,::: be made (8=::,::: principal O 8L,::: interest A 8=:L,:::>=; months A 8K,::: per month). 8=::,::: Average 2wed

=; months As an appro$imation, the amount of the loan that was outstanding during the !ear was, on average, onl! 89:,:::. +he 8L,::: of interest thus represents an appro$imatel! =@< rate of interest on the average amount of the loan. Fore precisel!, this loan appears as : =::,::: = - - - - - - - - - - - - - - - - - == (K,:::) - - - - - - - - - - - - - - (K,:::) =; (K,:::)

2f course, if !ou were the bank, the cash flows would be the same, onl! the signs would be reversed. %o as a bank officer, how would !ou determine the rate of interest that !ou were earning on this investment5 +he true cost of debt of any loan is the internal rate of return between what !ou receive and what !ou have to pa! back. %uppose we use our calculators and determine the "00 of this interest add-on loan. We determine that the "00 is =.;<. 3ut remember that his is =.;< per month. Gsing simple interest, =.;<M=; A =C.C< annual rate of interest.

Securit$ &or #ank Loans 3anks like some sort of collateral for loans to ensure repa!ment of the loan, at least in part. +he preferred collateral for bank loans is accounts receivable. +he reason, of course, is that collecting mone! is what banks do. +!picall!, a bank will loan up to B9L:< of the receivables that are not over @: da!s. +here are two wa!s to obtain financing with receivables/ (ledging of Accounts 0eceivable # +his is the most common form. A lender will loan up to L:< of the amount of the invoice. Gpon pa!ment, the borrower has -pledged. to use the proceeds to reduce the amount of the loan. "f the customer does not pa! the invoice, the borrower is still obligated to repa! the loan. &actoring of Accounts 0eceivable # +he receivable is sold to a factoring institution. +!picall!, this is used prior to making a sale on credit. +he seller will go to a factor who will run a credit check on the potential bu!er. "f the bu!er has a good credit rating, the factor will give the go-ahead to sell on credit and then bu! the receivable (at a discount) from the seller. +he bu!er is notified in writing to pa! the factor directl! for the receivable. +hen, if the invoice is not paid, it is up to the factor to collect from the bu!er and the factor takes the risk of bad debt. %ometimes, the factor ma! withhold =:< from the seller to make them share in the risk of nonpa!ment. +hen, when pa!ment is received, the =:< reserve will be refunded to the seller. +he use of factoring is considerabl! more e$pensive than the pledging of accounts receivable. +his is due to the fact that, in addition to lending mone! for a period of ?:-K: da!s, the factor also must run a credit check, incur the cost of collection, and undertake the risk of nonpa!ment. 3anks will also use inventories as collateral for short-term loans. A blanket lien (or floating lien) is one that covers all inventories. Even then, the lender will onl! loan C:-9:< of the cost of those goods. +his is because, if default occurs, the lender will have to hire someone to sell the inventories as well as substantiall! discounting them in order to li*uidate the inventories. A warehouse receipts loan is where a third part! holds the inventor! as collateral for the lender. A warehouse receipts loan is most commonl! used in the canning industr! or where production of inventor! is seasonal. &or e$ample, the cotton season runs from Nune to 2ctober. Denim ,eans, on the other hand, are purchased !ear-round. +hus, a denim manufacturer might bu! cotton in Nune and produce denim but not have enough for the estimated annual demand. +he producer could then go to a bank and borrow against the bolts of denim that have been produced. +hese bolts of denim would then be stored in a public warehouse as collateral and funds would be made available for the producer to purchase more cotton and produce more denim. As inventories are sold, the loan could be paid down, in which case the lender would notif! the public warehousing compan! to release P number of bolts of denim to the producer and the process reverses itself.

"f the inventories are too bulk! to transport to a public warehouse, a field warehouse arrangement ma! be set up where the public warehousing compan! goes to the producers place of business and ph!sicall! segregates the inventories that are being held as collateral for the lender. 2nl! the public warehousing compan! would have access to the collateral and would onl! release it upon notification b! the lender. Securities Loans A borrower can pledge their inventories of securities of another compan! (bonds, notes pa!able) as collateral for a loan as well. +hus, if !ou hold a note pa!able from a creditworth! firm, man! lenders will loan mone! against it. (+his is similar, in a sense, to what happens with a margin purchase.) "n short, if a firm has assets of virtuall! an! kind, it can use them as collateral for short-term loans to meet its short-term cash needs.