CHAPTER 22

Working Capital Management

Working capital terminology

Gross working capital total current assets.

Net working capital current assets minus
non-interest bearing current liabilities.
Working capital policy deciding the level
of each type of current asset to hold, and
how to finance current assets.
Working capital management controlling
cash, inventories, and A/R, plus short-term
liability management.
22-2

Cash conversion cycle

The cash conversion model focuses on the

length of time between when a company
makes payments to its creditors and when a
company receives payments from its
customers.

Inventory
Receivables Payables
CCC = conversion + collection deferral .
period
period
period
22-3

Cash doesnt earn a profit, so

why hold it?
1.
2.
3.
4.

Transactions must have some cash 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.
22-4

What is the goal of cash

management?

To meet above objectives, especially

to have cash for transactions, yet not
have any excess cash.
To minimize transactions balances in
particular, and also needs for cash to
meet other objectives.

22-5

Ways to minimize cash holdings

Use a lockbox.
Insist on wire transfers from customers.
Synchronize inflows and outflows.
Use a remote disbursement account.
Increase forecast accuracy to reduce
need for safety stock of cash.
Hold marketable securities (also reduces
need for safety stock).
Negotiate a line of credit (also reduces
need for safety stock).
22-6

What is float, and how is it affected

by the firms cash manager?

Float is the difference between cash as

shown on the firms books and on its
banks books.
If a firm with 4 days of net float writes and
receives $1 million of checks per day, it
would be able to operate with $4 million
less capital than if it had zero net float.

22-7

Cash budget:
The primary cash management tool

Purpose: Forecasts cash inflows,

outflows, and ending cash balances.
Used to plan loans needed or funds
available to invest.
Timing: Daily, weekly, or monthly,
depending upon purpose of forecast.
Monthly for annual planning, daily for
actual cash management.
22-8

Should depreciation be explicitly

included in the cash budget?

No. Depreciation is a noncash

charge. Only cash payments and
receipts appear on cash budget.
However, depreciation does affect
taxes, which appear in the cash
budget.

22-9

What are some other potential

cash inflows besides collections?

Proceeds from the sale of fixed

assets.
Proceeds from stock and bond
sales.
Interest earned.
Court settlements.

22-10

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.
22-11

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 the average amount of inventory

generally reduces carrying costs, increases
ordering costs, and may increase the costs of
running short.
22-12

Elements of credit policy

Credit Period How long to pay? Shorter
period reduces DSO and average A/R, but it
may discourage sales.
2. Cash Discounts Lowers price. Attracts new
customers and reduces DSO.
3. Credit Standards Tighter standards tend to
reduce sales, but reduce bad debt expense.
Fewer bad debts reduce DSO.
4. Collection Policy How tough? Tougher
policy will reduce DSO but may damage
customer relationships.
1.

22-13

Working capital financing policies

Moderate Match the maturity of the

assets with the maturity of the
financing.
Aggressive Use short-term financing
to finance permanent assets.
Conservative Use permanent capital
for permanent assets and temporary
assets.
22-14

Moderate financing policy

$

Temp. C.A.
S-T
Loans
Perm C.A.

Fixed Assets

L-T Fin:
Stock,
Bonds,
Spon. C.L.
Years

Lower dashed line would be more aggressive.

22-15

Conservative financing policy

$

Marketable
securities

Perm C.A.

Zero S-T
Debt

L-T Fin:
Stock,
Bonds,
Spon. C.L.

Fixed Assets
Years
22-16

Short-term credit

Any debt scheduled for repayment within one

year.
Major sources of short-term credit

Accounts payable (trade credit)

Bank loans
Commercial loans
Accruals

From the firms perspective, S-T credit is

more risky than L-T debt.

Always a required payment around the corner.

May have trouble rolling over loans.
22-17

Advantages and disadvantages of

using short-term financing

Advantages

Speed
Flexibility
Lower cost than long-term debt

Disadvantages

Fluctuating interest expense

Firm may be at risk of default as a result of
temporary economic conditions
22-18

Accrued liabilities

Continually recurring short-term

liabilities, such as accrued wages or
taxes.
Is there a cost to accrued liabilities?

They are free in the sense that no

explicit interest is charged.
However, firms have little control over
the level of accrued liabilities.
22-19

What is trade credit?

Trade credit is credit furnished by a firms

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.

22-20

The cost of trade credit

A firm buys $3,000,000 net ($3,030,303

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
= $8,219.18

22-21

Breaking down net and gross

expenditures

Firm buys goods worth $3,000,000. Thats

the cash price.
They must pay $30,303 more if they dont
take discounts.
Think of the extra $30,303 as a financing
cost similar to the interest on a loan.
Want to compare that cost with the cost of
a bank loan.
22-22

Breaking down trade credit

Payables level, if the firm takes discounts

Payables level, if the firm takes no discounts

Payables = $8,219.18 (10) = $82,192

Payables = $8,219.18 (40) = $328,767

Credit breakdown
Total trade credit
Free trade credit
Costly trade credit

$328,767
- 82,192
$246,575
22-23

Nominal cost of costly trade credit

The firm loses 0.01($3,030,303)

= $30,303 of discounts to obtain
$246,575 in extra trade credit:
kNOM = $30,303 / $246,575
= 0.1229 = 12.29%

The $30,303 is paid throughout the

year, so the effective cost of costly
trade credit is higher.

22-24

Nominal trade credit cost formula

k NOM

Discount %
1 - Discount %
1
365
99 40 - 10
0.1229

365 days
Days taken - Disc. period

12.29%

22-25

Effective cost of trade credit

Periodic rate = 0.01 / 0.99 = 1.01%

Periods/year = 365 / (40-10) = 12.1667

Effective cost of trade credit

EAR

= (1 + periodic rate)n 1
= (1.0101)12.1667 1 = 13.01%

22-26

Commercial paper (CP)

Short-term notes issued by large, strong

companies. B&B couldnt issue CP--its
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.

22-27

Bank loans

The firm can borrow $100,000 for 1

year at an 8% nominal rate.
Interest may be set under one of the
following scenarios:

Simple annual interest

Discount interest
Discount interest with 10% compensating
balance
Installment loan, add-on, 12 months
22-28

Must use the appropriate EARs to

evaluate the alternative loan terms

Nominal (quoted) rate = 8% in all cases.

We want to compare loan cost rates and
choose lowest cost loan.
We must make comparison on EAR =
Equivalent (or Effective) Annual Rate basis.

22-29

Simple annual interest

Simple interest means no discount or

add-on.
Interest = 0.08($100,000) = $8,000
kNOM = EAR = $8,000 / $100,000 = 8.0%

For a 1-year simple interest loan, kNOM = EAR

22-30

Discount interest

Deductible interest = 0.08 ($100,000)

= $8,000
Usable funds = $100,000 - $8,000
= $92,000

INPUTS

1
N

OUTPUT

I/YR

92

-100

PV

PMT

FV

8.6957
22-31

Raising necessary funds with a

discount interest loan

Under the current scenario, $100,000 is

borrowed but $8,000 is forfeited
because it is a discount interest loan.
Only $92,000 is available to the firm.
If $100,000 of funds are required, then
the amount of the loan should be:
Amt borrowed = Amt needed / (1 discount)
= $100,000 / 0.92 = $108,696
22-32

Discount interest loan with a

10% compensating balance
Amount borrowed

Amount needed
1 - discount - comp. balance
$100,000
$121,951
1 - 0.08 - 0.1

Interest = 0.08 ($121,951) = $9,756

Effective cost = $9,756 / $100,000 = 9.756%

22-33

Add-on interest on a 12-month

installment loan

Interest = 0.08 ($100,000) = $8,000

Face amount = $100,000 + $8,000 = $108,000
Monthly payment = $108,000/12 = $9,000
Avg loan outstanding = $100,000/2 = $50,000
Approximate cost = $8,000/$50,000 = 16.0%
To find the appropriate effective rate, recognize
that the firm receives $100,000 and must make
monthly payments of $9,000. This constitutes an
annuity.
22-34

Installment loan
From the calculator output below, we have:
kNOM

= 12 (0.012043)
= 0.1445 = 14.45%

EAR

= (1.012043)12 1 = 15.45%

INPUTS

12
N

OUTPUT

I/YR

100

-9

PV

PMT

FV

1.2043
22-35

What is a secured loan?

In a secured loan, the borrower pledges

assets as collateral for the loan.
For short-term loans, the most commonly
pledged assets are receivables and
inventories.
Securities are great collateral, but
generally not available.

22-36