Lesson 13 - Working Capital Management

135 1 Riche Levin Lim

WORKING CAPITAL MANAGEMENT March 1, 2014

Riche Levin Lim [email protected] +63917 592 8990


THE MOST IMPORTANT ASSET MANAGING YOUR DAILY OPERATIONS


CAPITAL BUDGETING -> WORKING CAPITAL

Making a Transition from Medium Term to Short Term


WHAT CAPITAL BUDGETING ANSWERS

How much will this project cost? Should I choose this project or this project? Will I have enough to purchase these three machines? Should I pursue this marketing strategy? What is the impact of expanding to this region in the long

run?

COMPARISONS


WHAT WCM ANSWERS

*Working Capital Management Do I have enough cash to pay for this days expenses?

What about this week? Month? Do I have enough money in case there is an emergency? How much of inventory should I be keeping stock? How much credit should I extend my customers, to the

extent that I still have enough cash? Can I defer payment to my suppliers? What is the trade off? How long does it take from selling an item to collecting

money?

COMPARISONS


TERMINOLOGY

Working capital current assets. Net working capital current assets minus non-interest

bearing current liabilities. Net working capital = Current assets (Payables + Accruals)

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.

QUICK REVIEW BEFORE WE BEGIN


CURRENT ASSET MANAGEMENT

Working capital policy, or the management of day-to-day activities, has important financial implications.

Recall DuPont Equation: Profit Margin x Total Assets Turnover x Leverage Factor = ROE

Working capital policy concerns itself with turnover. Reflected in the current ratio, turnover of cash and

securities, inventory turnover, and days sales outstanding. If Operations Management manages the amount of

inventory (EOQ), finance manages the method of financing these current assets

HOW IT AFFECTS PROFITABILITY


CURRENT ASSET MANAGEMENT ILLUSTRATION

SKI Ind Avg

Current ratio 1.75x 2.25x

Debt/Assets 58.76% 50.00%

Turnover of cash & securities

16.67x 22.22x

Days sales outstanding 45.63 32.00

Inventory turnover 4.82x 7.00x

Fixed assets turnover 11.35x 12.00x

Total assets turnover 2.08x 3.00x

Profit margin 2.07% 3.50%

Return on equity 10.45% 21.00%


CURRENT ASSET FINANCING

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.

Conservatism is based on your level of permanent and temporary current assets

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.

EXAMPLE


WORKING CAPITAL MANAGEMENT

Current Asset Financing Cash Conversion Cycle Cash Budgeting Cash and Marketable Securities Inventory Accounts Receivables Accounts Payable (Trade Credit) Bank Loans Accrued Liabilities Secured / Collateralized Loans

TOPICS


AGGRESSIVE / MODERATE FINANCING POLICY EXAMPLE

Years

Lower dashed line would be more aggressive.

$

Perm C.A.

Fixed Assets

Temp. C.A. S-T Loans

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


CONSERVATIVE FINANCING POLICY EXAMPLE

$

Years

Perm C.A.

Fixed Assets

Marketable securities Zero S-T

Debt

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


CURRENT ASSET FINANCING

Current asset financing seeks to balance the following: Riskiness of shorter term debts (since you have to pay

them off faster) found in aggressive policies More expensive interest rates for longer term borrowings

found in conservative policies Short-term debt however, is more flexible.

EXAMPLE


ELEMENTS OF CURRENT ASSET POLICY AND WORKING CAPITAL MANAGEMENT



Two primary measures of working capital management are as follows: Cash conversion cycle

How long does it take to turn my goods into cash? How fast can my business create money?

Cash budget Do I have enough cash to meet all my obligations? Do I have to borrow to have enough for next period?

OVERVIEW


CASH CONVERSION CYCLE

The length of time between when a company makes payments to its creditors and when a company receives payments from its customers, less the time you can defer paying your own suppliers (delaying gives you more cash)

Purchase -> Selling -> Collecting -> Deferring Payments

OVERVIEW

days 92 30 46 76 CCC

30 46 4.82365

CCC

perioddeferralPayables goutstandin

sales Days turnoverInventory

per year Days CCC

perioddeferralPayables

periodcollection

sReceivable

periodconversionInventory

CCC

=+=

+=

+=

+=



Begin with the income statement, then calculate three ratios: Three Ratios:

Inventory Conversion Period / Days Inventory on Hand how long It takes to sell an item

Receivables Conversion Period / Days Receivables on Hand how long it takes to collect after making a sale (assuming not cash transaction)

Payables Deferral Period how long you have before you have to pay your suppliers / creditors

Deferring payables reduces the cash conversion cycle because you can delay paying out money to purchase your inventory (via accounts payable).

Rule of thumb: Always compare a companys ratios with industry averages to determine whether it is good or bad.

DEFINITION OF TERMS


CASH CONVERSION CYCLE DEFINITION OF TERMS


CASH CONVERSION CYCLE OVERVIEW

would decline, its interest charges would be reduced, and its profits and stockprice would be improved.

16-4b Calculating the CCC from Financial StatementsThe preceding section illustrates the CCC in theory; but in practice, we wouldcalculate the CCC based on the firms financial statements. Moreover, the actualCCC would almost certainly differ from the theoretically forecasted value becauseof real-world complexities such as shipping delays, sales slowdowns, and cus-tomer delays in making payments. Moreover, a firm such as GFI would start anew cycle before the earlier one ended, and this too would muddy the waters.

To see how the CCC is calculated in practice, assume that GFI has been inbusiness for several years and is now in a stable positionplacing orders, makingsales, obtaining collections, and making payments on a recurring basis. The fol-lowing data were taken from its latest financial statements:

Annual sales $1,216,666Cost of goods sold 1,013,889Inventory 250,000Accounts receivable 300,000Accounts payable 150,000

We begin with the inventory conversion period:

Inventory conversion period InventoryCost of goods sold per day

$250,000$1,013,889=365

90 days

16-2

Thus, it takes GFI an average of 90 days to sell its merchandise, not the 60 dayscalled for in the business plan. Note also that inventory is carried at cost; so thedenominator of the equation should be the cost of goods sold, not sales.

The average collection period (or days sales outstanding) is calculated next:

Average collection period ReceivablesSales=365

$300,000$1,216,666=365

90 days

16-3

So it takes GFI 90 days after a sale to receive cash, not the 60 days called for in thebusiness plan. Because receivables are recorded at the sales price, we use salesrather than cost of goods sold in the denominator.

The Cash Conversion CycleFIGURE 16-3

Finish Goodsand Sell Them

Receive Materials

Pay Cash forPurchasedMaterials

Collect Cash for Accounts

Receivable

Days

InventoryConversion

Period (60 Days)

AverageCollection

Period (60 Days)

PayablesDeferral

Period (40 Days)

CashConversion

Period (80 days)

496 Part 6 Working Capital Management and Financial Forecasting



Primrose Corp has $15 million of sales, $2 million of inventories, $3 million of receivables, and $1 million of payables. Its cost of goods sold is 80% of sales, and it finances working capital with bank loans at an 8% rate. What is Primroses cash conversion cycle (CCC)? If Primrose could lower its inventories and receivables by 10% each and increase its payables by 10%, all without affecting sales or cost of goods sold, what would be the new CCC, how much cash would be freed up, and how would that affect pretax profits?

EXAMPLE



Zocco Corporation has an inventory conversion period of 75 days, an average collection period of 38 days, and a payables deferral period of 30 days. a. What is the length of the cash conversion cycle? b. If Zoccos annual sales are $3,421,875 and all sales are on

credit, what is the investment in accounts receivable?

c. How many times per year does Zocco turn over its inventory?

EXAMPLE


CASH BUDGET

Table that shows cash receipts, disbursements, and balances over a period of time

Most basic form of accounting, forecasting inflows and outflows

Helps determine loans and additional funds needed Makes sure that cash is sufficient for day-to-day working

operations Takes into account both cash-basis sales and accrual-basis

sales (accounts receivables) Developed on a daily, weekly, and monthly level. Ensures that company will always meet its target cash

balance (imagine reorder point but for cash)

OVERVIEW


CASH BUDGET

Determine beginning cash balance Forecast revenue and divide when you will collect these:

Cash sales can be collected now, but accounts receivables may be collected 1 to 3 months into the future.

Reduce collections by bad debt expenses. For example, if the firm had 3% bad debt losses, collections would total only 97% of sales.

Forecast purchases of inventory, and when you will pay for them. Remember this is cash-basis, so you may be paying for previous months orders.

Tally all other payments and expenses. Compute net cash flow (inflow outflow) Compute cumulative cash flow (beginning cash balance +

net cash flow). Carry over to next period.

STEP BY STEP


CASH BUDGET

Determine loan requirements. Compare cumulative cash flow with target cash balance. If CCF > target balance, no borrowing needed. If CCF < target balance, determine the difference to find the

amount of loans needed.

STEP BY STEP


CASH BUDGET

There are two things the cash budget reveals: Your total net cash inflow / outflow per period of time Your loan level for that period provided you will borrow to meet

your target cash level

STEP BY STEP


CASH BUDGET STEP BY STEP


SIMPLE CASH BUDGET ITEMS EXAMPLE

January February

Collections 67,651.95 62,755,40

Purchases 44,603.75 36,472.65

Wages 6,690.56 5,470.90

Rents 2,500 2,500

Total Payments 53,794.31 44,443.55

Net Cash Flows $13,857.64 18,311.85


SIMPLE CASH BUDGET (ACTUAL) EXAMPLE

January February

Cash Budget, at Start

$3,000 16,857.64

Net Cash Flows 13,857.64 18,311.85

Cumulative 16,857.64 35,169.49

Less: Target Cash 1,500 1,500

Surplus 15,357.64 33,669.48

If surplus was negative (shortfall), we would have to borrow money and cash budget at start would be target cash level.


CASH BUDGETING

I will teach this through an excel sheet. J Problem is 16-10 of your book.

Helen Bowers, owner of Helens Fashion Designs, is planning to request a line of credit from her bank. She has estimated the following sales forecasts for the firm for parts of 2009 and 2010:

HARDER EXAMPLE


CASH BUDGETING

Estimates regarding payments obtained from the credit department are as follows: collected within the month of sale, 10%; collected the month following the sale, 75%; collected the second month following the sale, 15%. Payments for labor and raw materials are made the month after these services were provided. Here are the estimated costs of labor plus raw materials:

HARDER EXAMPLE


CASH BUDGETING

General and administrative salaries are approximately $27,000 a month. Lease payments under long-term leases are $9,000 a month. Depreciation charges are $36,000 a month. Miscellaneous expenses are $2,700 a month. Income tax payments of $63,000 are due in September and December. A progress payment of $180,000 on a new design studio must be paid in October. Cash on hand on July 1 will be $132,000, and a minimum cash balance of $90,000 should be maintained throughout the cash budget period.

Prepare a monthly cash budget for the last 6 months of 2009. Prepare monthly estimates of the required financing or excess funds. Now suppose receipts from sales come in uniformly during the month,

but all outflows must be paid on the 5th. Will this affect the cash budget? That is, will the cash budget you prepared be valid under these assumptions? If not, what could be done to make a valid estimate of the peak financing requirements?

Bowers sales are seasonal; and her company produces on a seasonal basis, just ahead of sales. Without making any calculations, discuss how the companys current and debt ratios would vary during the year if all financial requirements were met with short- term bank loans. Could changes in these ratios affect the firms ability to obtain bank credit? Explain.

HARDER EXAMPLE


IS IT GOOD TO HAVE MORE OR LESS EXCESS CASH?

A Question From a Finance Perspective


CASH BUDGET

The previous example shows you will have a large surplus of cash every period. Is this a good thing?

Less Cash: Unused cash is wasted cash, where there are good

investment opportunities out there Can be more productive spending on research, marketing

More Cash: If sales turn out to be considerably less than expected, the

company could face a cash shortfall. May choose to hold large amounts of cash if it does not

have much faith in its forecast, or if it is very conservative. The cash may be used, in part, to fund future investments.

INTERPRETING THE CASH BUDGET


ELEMENTS OF WORKING CAPITAL

Cash budget is tied to management of net working capital, which includes current assets and current liabilities.

Current assets Cash and Marketable Securities Inventory (affects CCC) Accounts Receivables (affects CCC)

Current Liabilities Accounts Payable / Trade Credit (affects CCC) Bank Loans Accrued Liabilities Secured / Collateralized Loans

ITEMS ON THE BALANCE SHEET


CASH AND SECURITIES

Cash / Currency Demand / Checking Deposits

Very important and composes majority of a companys cash transactions. Firms try to optimize their demand deposits: Hold marketable securities rather than deposits to earn interest Borrow on short notice through credit line instead Forecast payments and receipts better Speed up payments / collections (get positive float)

Lockboxes Credit cards, debit cards, wire transfers, direct deposits Synchronize cash flows (both inflows and outflows)

Marketable Securities Highly liquid, very safe, and can be sold quickly at a predictable price

(almost as good as cash). ***



INVENTORY

In the example: SKIs inventory turnover (4.82x) is considerably lower than the industry average (7.00x). The firm is carrying a lot of inventory per dollar of sales.

As per OPMAN: By holding excessive inventory, the firm is increasing its costs, which reduces its ROE. Additional working capital also lowers EVA since it needs to be

financed.

There has to be an optimal quantity to balance costs and risks of unavailability.

Short run: Cash will free up and increase as inventory purchases decline.

Long run: Company is likely to take steps to reduce its cash holdings and increase its EVA.



INVENTORY

Types of inventory costs Carrying costs / holding 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 / shortage costs 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.

Relevant Ratios Inventory Turnover = Inventory / COGS Days of Inventory = 365 / Inventory Turnover



ACCOUNTS RECEIVABLES

SKIs DSO (45.6 days) is well above the industry average (32 days).

SKIs customers are paying less promptly. SKI should consider tightening its credit policy in order to

reduce its DSO. Relevant Ratios:

Accounts Receivables Turnover (Sales / AR) Days of Sales Outstanding (365 / AR Turnover)

The collection and management of receivables is called credit policy.




Credit Period How long to pay? Shorter period reduces DSO and average A/R, but it may discourage

sales. Longer periods may increase tendencies of default (bad debt)

Cash Discounts Price reductions for early payments Lowers price Attracts new customers and reduces DSO.

Credit Standards Financial strength customers must exhibit to extend credit Tighter standards tend to reduce sales, but reduce bad debt expense.

Fewer bad debts reduce DSO.

Collection Policy Toughness in collecting Tougher policy will reduce DSO but may damage customer relationships.

We always need to strike a balance. Credit scores




Policy Tightening A 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.

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.




Lamar Lumber Company has sales of $10 million per year, all on credit terms calling for payment within 30 days; and its accounts receivable are $2 million. What is Lamars DSO, what would it be if all customers paid on time, and how much capital would be released if Lamar could take action that led to on-time payments?

EXAMPLE


TRADE CREDIT / ACCOUNTS PAYABLE

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. Usually quoted in this format = (discount rate) / (days of

discount), net (maximum days pay is required) Deferring payment frees up cash Types

Free trade credit credit received during discount period Costly trade credit credit you get when you forego the discount

and take longer to pay




Suppose a firm buys $3,000,000 net ($3,030,303 gross) on terms of 1/10, net 40, annually.

The firm can forego discounts and pay on Day 40, without penalty.

First step is to get the net daily purchases. We need to do this to know the amount of accounts payable on hand, since they cycle every 10 to 40 days.

EXAMPLE

18.219,8$365/000,000,3$ purchasesdaily Net

=

=



Payables level, if the firm takes discounts Payables = $8,219.18(10) = $82,192

Payables level, if the firm takes no discounts Payables = $8,219.18(40) = $328,767

This means that if you take up to 40 days to pay, your payables wont go beyond $328,767

Credit breakdown

EXAMPLE


NOMINAL COST OF TRADE CREDIT

By not taking the discount though, the firm loses 0.01($3,030,303) = $30,303 of discounts to obtain $246,575 in extra trade credit: rNOM = $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. This is a nominal annual measure.

EXAMPLE



An easy way to remember this is from its name. Nominal cost of trade credit.

Get the real discount rate (Discount Foregone / Net Price) Multiply it by the number of compounding periods

FORMULA

12.29% 0.1229

10 40

365

991

period Disc. taken Daysdays 365

%Discount 1

%Discount rNOM

=

=

=

=


EFFECTIVE COST OF TRADE CREDIT

Solve for the periodic rate = 0.01/0.99 = 1.01% Periods/year = 365/(40 10) = 12.1667 Effective cost of trade credit

Exactly the same as EAR formula Remember that EAR > nominal if compounding periods are

more than once a year

FORMULA

%01.131)0101.1(

1rate) Periodic (1 EAR1667.12

N

==

+=



Lamar Lumber buys $8 million of materials (net of discounts) on terms of 3/5, net 60; and it currently pays after 5 days and takes discounts. Lamar plans to expand, which will require additional financing. If Lamar decides to forgo discounts, how much additional credit could it get and what would be the nominal and effective cost of that credit? If the company could get the funds from a bank at a rate of 10%, interest paid monthly, based on a 365-day year, what would be the effective cost of the bank loan? Should Lamar use bank debt or additional trade credit? Explain.

EXAMPLE



Prestopino Corporation produces motorcycle batteries. Prestopino turns out 1,500 batteries a day at a cost of $6 per battery for materials and labor. It takes the firm 22 days to convert raw materials into a battery. Prestopino allows its customers 40 days in which to pay for the batteries, and the firm generally pays its suppliers in 30 days. What is the length of Prestopinos cash conversion cycle? At a steady state in which Prestopino produces 1,500 batteries a day,

what amount of working capital must it finance? By what amount could Prestopino reduce its working capital financing

needs if it was able to stretch its payables deferral period to 35 days? A new production process would allow Prestopino to decrease its

inventory conversion period to 20 days and to increase its daily production to 1,800 batteries. However, the new process would cause the cost of materials and labor to increase to $7. Assuming the change does not affect the average collection period (40 days) or the payables deferral period (30 days), what will be the length of its cash conversion cycle and its working capital financing requirement if the new production process is implemented?

EXAMPLE


OTHER TYPES OF DEBT

Promissory Note Line of Credit Revolving Credit Agreement Bank Loans

Simple Interest Add-on Interest

Commercial Paper Collateralized Financing



BANK LOANS

The firm can borrow $100,000 for 1 year at an 8% nominal rate.

Interest may be set / treated under one of the following scenarios: Simple annual interest Installment loan, add-on, 12 months



BANK LOANS

Lenders can quote loans in two main ways: simple interest or add-ons.

Simple interest means no discount or add-on. Interest = 0.08($100,000) = $8,000 rNOM = EAR = $8,000/$100,000 = 8.0%

For a 1-year simple interest loan, rNOM = EAR. Similar to what we did for Bonds Valuation.

SIMPLE ANNUAL INTEREST


BANK LOANS

Add-on means the interest expense is added on top of the face amount. Example: 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 (like an annuity).

ADD-ON


BANK LOANS

Let us say, solving for IRR we get .012043 per month (1.2043%).

Nominal Rate = 12 (0.012043) = 0.1445 = 14.45%

EAR = (1.012043)^12 1 = 15.45%

Notes: Add-on interest is higher in actual terms than simple interest Usually quoted at annual percentage rate(monthly rate x 12)

ADD-ON


ACCRUED LIABILITIES

Spontaneous funds as a result of not paying your expenses. Not really controllable but a source of free cash as well.



CONCLUSIONS

Main point of the lesson is to manage current assets and liabilities or working capital management.

Two main goals are the following: Optimizing your cash conversion cycle Ensuring you have enough to meet your daily cash needs (cash

budget, target cash balance)

These two goals are affected by the following: Cash and Securities Inventory Accounts Receivables Accounts Payables Other Loans and Accruals

TO SUMMARIZE THE LESSON

Documents

Lesson 13 - Working Capital Management