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MANAGEMENT”
creation of firm value. To reach optimal working capital management firm manager
should control the trade off between profitability and liquidity accurately
Working capital refers to the firm’s investment in short-term assets (cash, marketable
securities, accounts receivable and inventories). Net working capital is the difference
between a firm’s 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. Generally, we want to match the firm’s financing with the lives of its assets. If
we consider a company that is growing over time, then its assets can be decomposed into
three categories – fixed assets, permanent current assets and fluctuating current assets.
Short-term
Fluctuating
Current Assets
Permanent
Current Assets Long-term
Fixed Assets
Fixed assets should be financed long-term, either equity or long-term debt, since the
assets are long-lived and need financing for a long period of time. The current assets can be
broken down into two portions, permanent current assets and fluctuating current assets. The
permanent current assets represent base levels of inventories, receivables, etc., that will
always be on hand. The fluctuating current assets represent the seasonal build-ups that
occur, such as inventories before Christmas and receivables after Christmas. The fluctuating
current asset levels should be financed short-term since we don’t want to pay financing
charges all year if we only need the money for a four-month period.
While the permanent current assets are, individually, short-lived assets, as a category
they are always there (hence, permanent) and will always need to be financed. Thus, the
permanent current assets should also be financed long-term, just like the fixed assets. While
it is possible to finance some of our permanent needs using short-term debt, it is risky to do
so. (Such financing is described as an “aggressive” working capital financing policy in your
text – aggressive being associated with risky.) The risk of financing permanent needs with
short-term financing is twofold: first, short-term interest rates fluctuate much more than long-
term interest rates. Rolling over short-term debt year after year will subject you to greater
fluctuation in your financing costs as a result. Probably a bigger risk is the inability to roll
over the short-term debt every year. You may have a bad year and find that lenders are
Of course, some companies take the opposite approach – they will finance some of
their seasonal needs of the fluctuating current assets with long-term financing. This is a
conservative approach, but the financing is there when it is needed – but it costs money
financing. For this reason, many banks will require that a company’s line of credit be
completely paid off for at least one month each year. This is to prevent the company from
using the bank for permanent financing. Of course, banks are essentially matching their
assets and liabilities as well. The 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. Since
a bank’s financing source is predominantly short-term deposits, it wants its loan portfolio to
Life insurance companies and pension funds, on the other hand, have liabilities that
are many years in the future. They would prefer to make longer term loans so that there isn’t
Cash
Cash is probably the least productive asset you can have. Not only does it not earn
hold cash? The three Keynsian motives for holding cash balances are
have the money available, you can take advantage of these opportunities.
While cash is necessary to cover the transactions motive, the precautionary and
speculative motives can be covered with the near money (or near cash) of marketable
securities.
In order to maximize your cash balances, you can do one of two things; either
accelerate the inflow of funds (ask for an advance on your salary) or delay the outflow of
funds (postpone paying the phone bill until next month). But why would we want to maximize
our cash holdings if it is the least productive asset? Because idle cash, either sitting in a
For example, suppose we have a client who owes us payment of Rs.1,000,000 that is
due. The opportunity cost of not collecting is the interest we could earn on the money.
In fact, for a large enough amount of money, someone will meet you at the bank on Sunday
This also illustrates the concept of “float”. Bank float is the period of time between
when a check is written to pay an obligation and when the funds are actually deducted from
your checking account. Within a city, it is common practice to have a local check clearing
system where banks meet each day to exchange checks written on one another’s accounts.
When the bank where a check is deposited is in a different city from the bank on which the
cheque is drawn, the deposited cheque first goes to the regional Federal Reserve Bank, and
is then forwarded to the issuing bank. This adds a day or two to the float period. If the check
is drawn on a bank account in another Federal Reserve District, then another day or so is
added as the local Fed must forward the check to the Fed in the issuing bank’s district which
then forwards the check to the bank. Exxon used to pay suppliers west of the Mississippi
river with checks written on a small bank in North Carolina, while suppliers east of the
Mississippi were paid with checks on a small bank in Arizona. One day’s worth of float to the
U.S. government is worth over $1 billion (which is one reason government employees now
get paid on the first of the following month rather than the last day of the month).
Most of us have probably played the float on at least one occasion (and probably
gotten caught!) It should be noted, however, that using float to cover up a deficit (i.e., hot
check) is illegal.
Another means of extending 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. This, again,
adds 2-3 days to the float period. Insurance companies are most noted for using drafts within
the U.S. The type of draft that insurance companies use are known as sight drafts since they
are paid upon presentation. Time drafts are those which are payable upon a specific future
date. Time drafts are an important financing instrument in international trade and will be
discussed later.
While bank float and drafts delay the outflow of funds, cash balances can also be
increased by speeding up the inflow of funds. The primary means of accomplishing this is
through the use of a lock-box system. A lock-box is a post office box in a local city where
payments from customers in the area are sent. The lock-box is cleared daily and the checks
are deposited in a local bank and then wired to the company’s main bank account. Referred
to as concentration banking, it cuts 2-3 days 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. The larger amount of funds that can be invested yields higher interest rates and
The local bank will offer the lock-box system if a local office is not available or does
not want to devote the personnel to tend to the system. Banks, however, charge for the
services that they provide through either a direct service charge, or by requiring that a
not pay any interest. The minimum balance can be either an absolute minimum or an
average minimum.
Marketable Securities
Marketable securities are a way of holding cash but with the attribute of earning
2. High marketability
• Treasury bills
Treasury bills are auctioned every Monday by the government. Most have
maturities of 91 or 181 days, although some 9-month (270 days) and 12-
month (360 days) bills are sold. The t-bills, generally with a face value of
$10,000 each, are sold at a discount to the highest bidders. The difference
between the amount paid and the face value at maturity represents the
• Anticipation notes
Anticipation notes are issued by municipalities and school districts. Since their
revenues come from tax sources, the notes are “in anticipation” of future tax
receipts.
• Commercial paper
the firms that issue commercial paper sell it directly to investors (insurance
than t-bills (currently about 4.3%) but significantly less than what banks would
• Banker’s Acceptances
bank. Since the draft is not payable until some future date (1-3 months,
typically) the company that receives it will often sell it to its local bank at a
discount. The local bank bundles the discounted drafts (banker’s
Accounts Receivable
Accounts receivable are generated when a firm offers credit to its customers. The
first thing that needs to be addressed when establishing a credit policy is to set the standards
by which a firm is judged in determining whether or not credit will be extended. There is
2. Capacity – the capability of the borrower to earn the money to repay the
obligation
capital; i.e., to make sure the owners of the firm have sufficient money at stake to
give them proper incentive to repay the loan and not let the company go bankrupt.
4. Collateral – assets to support the loan which can be liquidated if default occurs
5. Conditions – current and future anticipated conditions of the firm and the
industry.
Once the credit standards have been set, the terms of credit need to be established.
When must the customer pay? If they pay early, will they receive a discount? If they pay
profits, the expected increase in gross profits must be compared with the costs associated
• Collection costs
Competitors will respond very quickly to a change in price. How many times have we
seen the claims that “We will meet or beat any advertised price”? A change in credit policy,
on the other hand, is a more subtle means of competing for customers and one that the
competition will not necessarily respond to. In fact, many firms base their business on easy
credit. How many times have we seen the advertisements where they tell us “Good credit?
Bad credit? No credit? We don’t care!” Of course, these firms will have larger bad debt
expenses and larger financing costs, etc. Obviously, they will also need to have higher
Inventories
of most firm’s current assets, and for many, total assets. As such, the extent to which a firm
efficiently manages its inventories can have a large influence on its profitability. Thus,
keeping abreast of inventory policy is critical to the profitability (and value) of the firm.
Several factors influence the amount of inventory that a firm maintains. The most
• Level of sales – typically, the more sales a firm has, the more inventory it
holds
• Length of time and technical nature of the production process – The longer it
takes to produce finished goods inventories from raw materials, the larger the
amount of finished goods that a firm will typically hold (a safety stock). Also, if the
larger amounts of inventory will be produced with each production run in order to
fresh vegetables, a small amount will be held. Similarly, fashions of clothes and
car styles are “perishable” and will result in smaller inventories than durable goods
A. Ordering Costs
2. Warehousing costs
3. Insurance
4. Handling
C. Stock-out Costs
1. Lost sales
2. Loss of goodwill
Ideally, we want to balance these costs against each other so that our total costs are
minimized.
Short-term Financing
Trade Credit
The major source of short-term financing for firms is that of trade credit. While it is an
account payable on our balance sheet, it is an account receivable on the balance sheet of
our supplier.
3. Net amount with a discount if paid within a certain period of time, net amount
For example, 2/10 net 30 means that if you pay within the first ten days, you can
deduct 2% from the bill; otherwise the full amount of the bill is due within 30 days. Discounts
are offered by suppliers to keep their A/R balances down and minimize the funds that are
tied-up.
Not taking the discount can be a very expensive means of financing. For example,
suppose we do not pay within the first ten days. Then, if we pay on the thirtieth day, we have
paid 2% (approximately) for an additional twenty days’ use of the funds (the first ten days
were free anyway). Since there are 18 twenty-day periods in a year, this is approximately
2% * 18 = 36%
Actually, the cost is a little higher since we are paying 2% on top of the 98% we would
2 % 360days
* = 36. 7%
98% 20days
Of course, if you miss payment by day 10 for taking the discount, don’t pay the full amount of
2%*360 = 720%
Do banks charge 36% interest on loans? Not in Texas or most states. It is a violation of the
usury laws. Then why do many companies forego the discounts if the cost is so high? It is
the only source of funding that they can get. To reduce the effective cost, firms will often
stretch payment out past the due date. Of course, this subjects the firm to risk of its credit
being completely cut off by the supplier and possibly damages the credit reputation since
other suppliers will often request references before extending credit themselves.
Some firms will offer post-dated billing, typically in a seasonal industry. For example,
if a manufacturer’s primary sales are to retailers for the Christmas season they may
encourage retailers to order in June and July rather than waiting until September. The
encouragement is that if an order is placed in June or July, the manufacturer will not bill them
until September and even then regular credit terms will apply. The advantage here is that it
allows the manufacturer to smoothe out sale and thus production. The manufacturer can
then save on overtime with employees as well as not incur many of the carrying costs
associated with holding the inventories since the retailer takes possession and ownership
earlier.
Commercial Banks
The second major 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. In order
to get a credit line, you will want to show them your income statements, balance sheets,
financial ratios, etc. The bank will then allow a certain amount of credit with a set rate of
interest (usually prime plus). This can be renegotiated every year. In fact, commercial
banks’ bread and butter is their business accounts and they are very competitive with one
another in trying to attract corporate clients. The amount of the credit line is typically tied to
the amount of accounts receivable that the firm has and sometimes to the amount of
Another type 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. The firm will pay a normal rate of interest on the amounts of funds that it borrows
plus a commitment fee of one-half to one percent on any unborrowed funds. Unlike a regular
line of credit which can be changed, a revolving line of credit guarantees that the bank will
always make the amount available if needed. Additionally, a revolving line of credit will often
be extended jointly by several banks when the amounts used are larger than a single bank
Types of Loans
Loans come in a variety of shapes. A simple loan requires that the firm maintain a
non-interest-bearing account at the bank. While compensating balances are not used as
much as they have been in the past, they are still encountered frequently.
Suppose a bank offers a one-year loan for $100,000 at an 8% rate of interest with a
$100,000 loan
the other $80,000 (with the $20,000 in the compensating balance for a total of $100,000) is
the principal. Thus, the firm has effectively paid $8,000 interest on the use of $80,000 for an
Alternatively, the bank may offer a discounted loan where the interest is deducted up-
Rs.100,000 loan
At the end of the year, the firm repays the Rs.100,000 of principal (since the interest was paid
up-front). Effectively, the firm paid Rs.8,000 of interest for the use of Rs.92,000 of funds for a
Banker is there to help you and may express concern that the need to come up with
Rs.100,000 at the end of the year could be difficult. He/she may 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. Our example loan would then required that monthly payments of Rs.9,000 be
month).
Rs.100,000
Average
Owed
12 months
As an approximation, the amount of the loan that was outstanding during the year
was, on average, only Rs.50,000. The Rs. 8,000 of interest thus represents an
0 1 - - - - - - - - - - - - - - - - - 11 12
Of course, if you were the bank, the cash flows would be the same, only the signs
would be reversed. So as a bank officer, how would you determine the rate of interest that
The true cost of debt of any loan is the internal rate of return between what you
receive and what you have to pay back. Suppose we use our calculators and determine the
IRR of this interest add-on loan. We determine that the IRR is 1.2%. But remember that his
is 1.2% per month. Using simple interest, 1.2%*12 = 14.4% annual rate of interest.
Banks like some sort of collateral for loans to ensure repayment of the loan, at least in
part. The preferred collateral for bank loans is accounts receivable. The reason, of course,
is that collecting money is what banks do. Typically, a bank will loan up to 75-80% of the
receivables that are not over 60 days. There are two ways to obtain financing with
receivables:
Pledging of Accounts Receivable – This is the most common form. A lender will loan
up to 80% of the amount of the invoice. Upon payment, the borrower has “pledged” to use
the proceeds to reduce the amount of the loan. If the customer does not pay the invoice, the
Typically, this is used prior to making a sale on credit. The seller will go to a factor who will
run a credit check on the potential buyer. If the buyer has a good credit rating, the factor will
give the go-ahead to sell on credit and then buy the receivable (at a discount) from the seller.
The buyer is notified in writing to pay the factor directly for the receivable. Then, if the invoice
is not paid, it is up to the factor to collect from the buyer and the factor takes the risk of bad
debt. Sometimes, the factor may withhold 10% from the seller to make them share in the risk
of non-payment. Then, when payment is received, the 10% reserve will be refunded to the
seller.
The use of factoring is considerably more expensive than the pledging of accounts
receivable. This is due to the fact that, in addition to lending money for a period of 30-90
days, the factor also must run a credit check, incur the cost of collection, and undertake the
risk of nonpayment.
Banks 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 only loan 40-50% of
the cost of those goods. This is because, if default occurs, the lender will have to hire
someone to sell the inventories as well as substantially discounting them in order to liquidate
the inventories.
A warehouse receipts loan is where a third party holds the inventory as collateral for
the lender. A warehouse receipts loan is most commonly used in the canning industry or
where production of inventory is seasonal. For example, the cotton season runs from June to
October. Denim jeans, on the other hand, are purchased year-round. Thus, a denim
manufacturer might buy cotton in June and produce denim but not have enough for the
estimated annual demand. The producer could then go to a bank and borrow against the
bolts of denim that have been produced. These 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 notify the public warehousing company to release
X number of bolts of denim to the producer and the process reverses itself.
If the inventories are too bulky to transport to a public warehouse, a field warehouse
arrangement may be set up where the public warehousing company goes to the producer’s
place of business and physically segregates the inventories that are being held as collateral
for the lender. Only the public warehousing company would have access to the collateral
Securities Loans
notes payable) as collateral for a loan as well. Thus, if you hold a note payable from a
creditworthy firm, many lenders will loan money against it. (This is similar, in a sense, to