CHAPTER 14

Working Capital Management

 Alternative working capital policies
 Cash management
 Inventory management
 Accounts receivable management
 Working capital financing policies
 Trade credit
14-1
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.
14-2
 Selected ratios for SKI Inc.
SKI Ind. Avg.
Current 1.75x 2.25x
Debt/Assets 58.76% 50.00%
Turnover of cash & securities 16.67x 22.22x
DSO (days) 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%

14-3
How does SKI’s working capital
policy compare with its industry?
 SKI appears to have large amounts of
working capital given its level of sales.
 Working capital policy is reflected in
current ratio, turnover of cash and
securities, inventory turnover, and DSO.
 These ratios indicate SKI has large
amounts of working capital relative to its
level of sales. SKI is either very
conservative or inefficient.

14-4
Is SKI inefficient or just
conservative?
 A conservative (relaxed) policy may be
appropriate if it leads to greater
profitability.
 However, SKI is not as profitable as the
average firm in the industry. This
suggests the company has excessive
working capital.

14-5
 Working Capital Management
 Short-Term Investment
 Cash Management
 Account Receivable Management
 Inventory Management
 Short-Term Financing
 Trade Credit
 Bank Loans
 Commercial Paper
 Account Receivable and/or Inventory Financing

14-6
 Working Capital Management
Trade-off of Short-Term Investment

Cost 1 Cost 2
___________________________________________________________________________________
 Short-Term Assets
 Cash and Marketable Opportunity cost Illiquidity and solvency
Securities of funds costs

 Accounts receivable Cost of investment Opportunity cost of lost

in accounts sales due to overly
receivable and restrictive credit policy
bad debts and/or terms

 Inventory Carrying costs of Order and setup costs

 inventory, including associated with replenishment
financing, and production of finished
warehousing cost, goods
etc.

14-7
 Working Capital Management
Trade-off of Short-Term Financing
Cost 1 Cost 2
_________________________________________________________
 Short-Term Financing

 Accounts payable, Cost of reduced Financing costs resulting

 Accruals, and notes liquidity caused from the use of less
 Payable by increasing expensive short-term
current liabilities financing rather than
more expensive long-
term
debt and equity financing

14-8
 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

14-9
 Cash conversion cycle
Inventory Receivables Payables
CCC = conversion + collection – deferral
period period period
Payables
Days per year Days sales
CCC = Inv. turnover + outstanding – deferral
period
365
CCC = + 46 – 30
4.82
CCC = 76 + 46 – 30
CCC = 92 days.
14-10
Cash doesn’t earn a profit, so
why hold it?
1. Transactions – must have some cash to
operate.
2. Precaution – “safety stock”. Reduced by
line of credit and marketable securities.
3. Compensating balances – for loans and/or
services provided.
4. Speculation – to take advantage of
bargains and to take discounts. Reduced
by credit lines and marketable securities.

14-11
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.

14-12
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”).
14-13
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.

14-14
 Data Required for a Cash Budgeting

 1. Sales forecast.
 2. Information on collections delay.
 3. Forecast of purchases and
payment terms.
 4. Forecast of cash expenses, taxes,
etc.
 5. Initial cash on hand.
 6. Target cash balance.
14-15
SKI’s cash budget:
For January and February
Net Cash Inflows
Jan Feb
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
14-16
SKI’s cash budget
Net Cash Inflows
Jan Feb
Cash at start if
no borrowing $ 3,000.00 $16,857.64
Net CF 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

14-17
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.

14-18
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.

14-19
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.

14-20
Analyze SKI’s forecasted cash budget
 Cash holdings will exceed the target
balance for each month, except for
October and November.
 Cash budget indicates the company is
holding too much cash.
 SKI could improve its EVA by either
investing cash in more productive assets,
or by returning cash to its shareholders.

14-21
Why might SKI want to maintain a
relatively 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 used, in part, to fund future
investments.

14-22
Float

 Float refers t funds that have been sent by

the payer but are not yet usable funds to the
payee.
 Float increases both the firm’s average
collection period and its average payment
period.
 The primary role of a cash manager on the
collection side is to minimize this float
wherever possible and to maximize it.

14-23
Float

 Mail float: the time delay between when payment is

placed in the mail and when payment is received.
 Processing Float: the time between receipt of the
payment and its deposit into the firm’s account.
 Availability Float: the time between deposit of the
check and availability of the funds to the firm.
 Clearing Float: the time between deposit of the check
and presentation of the check back to the bank on
which it is drawn.

14-24
Types of Collection Systems
 Field-Banking system: collections are made either over the counter or
at a collection office. The main collection problem is moving the funds
from the local banks up to the main accounts at the company’s primary
bank.
 Mail-Based System: The process center will receive the mail payments,
open the envelopes, separate the check from the remittance
information, prepare the check for deposit, and send the remittance
information to the accounts receivable department application of
payment.
 Electronic System: In a electronic bill presentment and payment (EBPP)
system, customers are sent bills in an electronic format and then can
pay their bills via electronic means.
 Lockbox System: Customers mail payments to a post office box, which
is emptied regularly by the firm’s bank. The bank processes each
payment and deposits the payments in the firm’s account.

14-25
Lockbox System: An Example
 Firm Y believes that use of a lockbox system can
shorten its accounts receivable collection period by
four days. The firms’ annual sales, all on credit, are
$65 million, billed on a continuous basis. The firms
can earn 9% on its short-term investments. The cost
of the lockbox system is $57,500 per year. Assume a
365-day year.
 A. What amount of cash will be made available for
other uses under the lockbox system?
 B. What net benefit (or cost) will the firm receive if it
adopts the lockbox system? Should it adopt the
proposed lockbox system?

14-26
Lockbox System: An Example
 Solution:

 A. Cash available = ($65m/365) *4 = $712,329

 B. Interest Income from Reinvesting the cash

available = $712,329 *(9%/365) = $64,109.61

 Lockbox costs = $57,500

 Net Benefit = $64,109.61 - $57,500 = $6,609.61

14-27
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. 14-28
Is SKI holding too much
inventory?
 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 costs, which reduces its ROE.
Moreover, this additional working capital
must be financed, so EVA is also lowered.

14-29
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
increase its EVA.

14-30
Accounts Receivable Management

 ARs result from credit sales. The period

is the average length of time firm a sale
on credit until the payment becomes
usable funds for the firm.

14-31
Accounts Receivable Management

 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.

14-32
Elements of credit policy
1. 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.
14-33
Does SKI face any risk if it
tightens its credit policy?
 Yes, a tighter credit policy may
discourage sales. Some customers
may choose to go elsewhere if they
are pressured to pay their bills sooner.

14-34
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.

14-35
Receivable Management Example

 McDowell Industries sells on terms of 3/10, net 30.

Total sales for the year are $912,500. 40% percent
of the customers pay on the 10th day and take
discounts; the other 60% pay on average, 40 days
after their purchases.
 A. What is the days sales outstanding?
 B. What is the average amount of receivables?
 C. What would happen to average receivables if
McDowell toughed up on its collection policy with
the result that all nondiscount customers paid on
the 30th day?

14-36
Receivable Management Example

 Solution:

 a. 0.4(10) + 0.6(40) = 28 days.

 b. $912,500/365 = $2,500 sales per day.

$2,500(28) = $70,000 = Average receivables.

 c. 0.4(10) + 0.6(30) = 22 days.

 $912,500/365 = $2,500 sales per day.
 $2,500(22) = $55,000 = Average receivables.

 Sales may also decline as a result of the tighter credit.

This would further reduce receivables. Also, some
customers may now take discounts further reducing
receivables.

14-37
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.

14-38
Moderate financing policy
$ Temp. C.A.
S-T
Loans

Perm C.A. L-T Fin:

Stock,
Bonds,
Fixed Assets Spon. C.L.

Years
Lower dashed line would be more aggressive.
14-39
Conservative financing policy
Marketable
$ securities
Zero S-T
Debt

L-T Fin:
Perm C.A. Stock,
Bonds,
Spon. C.L.
Fixed Assets

Years
14-40
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.
14-41
What is trade credit?
 Trade credit is credit furnished by a firm’s
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.

14-42
The cost of trade credit
 A firm buys $506,985 net ($512,106 gross)
on terms of 1/10, net 30.
 The firm can forego discounts and pay on
Day 40, without penalty.

Net daily purchases = $506,985 / 365

= $1,389

14-43
Breaking down net and gross
expenditures
 Firm 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.

14-44
Breaking down trade credit
 Payables level, if the firm takes discounts
 Payables = $1,389 (10) = $13,890
 Payables level, if the firm takes no discounts
 Payables = $1,389 (40) = $55,560
 Credit breakdown
Total trade credit $55,560
Free trade credit - 13,890
Costly trade credit $ 41,670

14-45
Nominal cost of costly trade credit
 The firm loses 0.01($512,106)
= $5,121 of discounts to obtain
$41,670 in extra trade credit:

kNOM = $5,121 / $41,670

= 0.1229 = 12.29%
 The $5,121 is paid throughout the
year, so the effective cost of costly
trade credit is higher. 14-46
 Nominal trade credit cost formula
Discount % 365 days
k NOM = ×
1 - Discount % Days taken - Disc. period
1 365
= ×
99 40 - 10
= 0.1229
= 12.29%

14-47
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%

14-48
Bank Loans
 A firm is choosing among three alternative bank
loans. The firm wishes to minimize the
borrowing costs on a $200,000 borrowing.
Analyze the cost of each of these alternatives:
 1. An 18% rate of interest with interest paid at
year-end and no compensating balance
requirement.
 2. A 16% rate of interest but carrying a 20%
compensating balance requirement. This loan
also calls for interest to be paid at year-end.
 3. A 14% rate of interest that is discounted, plus
a 20% compensating balance requirement.

14-49
Bank Loans

 Solutions:
 1. Effective rate of interest = 18%.
 2. Effective rate of interest
 = $32,000/($200,000-$40,000) = 20%.
 3. Effective rate of interest
 = $28,000/($200,000-$40,000-
$28,000)
 = 21.21%

14-50
Commercial paper (CP)
 Short-term notes issued by large, strong
companies. B&B 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.

14-51
 Alternative Financing: Example
 Suncoast Boats Inc. estimates that because
of the seasonal nature of its business, it will
required an additional $2m of cash for the
month of July. Suncoast has the following 4
options available for raising the needed
funds:
 1. Establish a 1-year line of credit for $2m
with a bank. The commitment fee will be
0.5% per year on the unused portion, and
the interest charge on the used funds will be
11% per annum. Assume that the funds are
needed only in July, and that there are 30
days in July and 365 days in the year.
14-52
 Alternative Financing: Example
 2. Forgo the trade discount of 2/10, net 40, on $2m
of purchases during July.
 3. Issue $2m of 30-day commercial paper at a 9.5%
per annum interest rate. The total transactions fee,
including the cost of a backup credit line, on using
commercial paper is 0.5% of the amount of the
issue.
 4. Issue $2m of 60-day commercial paper at a 9%
per annum interest rate, plus a transaction cost of
0.5%. Since the funds are required for only 30
days, the excess funds ($2m) can be invested in
9.4% per annum marketable securities for the
month of August. The total transaction costs of
purchasing and selling the marketable securities is
0.4% of the amount of the issue.
14-53
 Alternative Financing: Example

 A. What is the dollar cost of each

financing arrangement?
 B. Is the source with the lowest
expected cost necessarily the one to
select? Why or why not?


14-54
 Alternative Financing: Example
 Solutions:
 a. 1. Line of credit:

 Commitment fee
 = (0.005)($2,000,000)(335/365)
 = $ 9,178

 Interest
 = (0.11)(30/365)($2,000,000)
 = 18,082

 Total = $27,260


14-55
 Alternative Financing: Example

 Solutions:
 2. Trade discount:
 a. = = 0.2483 = 24.83%.

 Total cost = 0.2483($2,000,000)(30/365)

= $40,816.

 b. Effective cost = (1 + 2/98)365/30 - 1
 = 0.2786 = 27.86%.

Total cost = 0.2786($2,000,000)(30/365)

= $45,804.

14-56
 Alternative Financing: Example

 Solutions:
 3.30-day commercial paper:

 Interest = (0.095)($2,000,000)(30/365)
= $15,616

Transaction fee = (0.005)($2,000,000)

= 10,000

Total = $25,616

14-57
 Alternative Financing: Example

 Solutions:
 4.60-day commercial paper:
 Interest = (0.09)($2,000,000)(60/365) = $29,589
 Transaction fee = (0.005)($2,000,000) = 10,000
 Total Costs = $39,589
 Marketable securities interest received
 = (0.094)($2,000,000)(30/365) = $15,452
 Transactions cost, marketable securities
 = (0.004)($2,000,000) = $8,000
 Total = $32,137


 The 30-day commercial paper has the lowest cost.

14-58