Chapter 16 Working Capital

1. Chapter 16 Working Capital

2. Working Capital Basics • Working Capital • Assets and liabilities required to operate a business on a day-to-day basis • Assets: • Cash • Accounts Receivable • Inventory • Liabilities: • Accounts Payable • Accruals

3. Working Capital, Funding Requirements, and the Current Accounts • Gross Working Capital represents an investment in assets • Capital – funds committed to support assets • Working – short term, day-to-day operations • Working Capital Requires Funds • Maintaining a working capital balance requires a permanent funds commitment

4. The Short-Term Liabilities Spontaneous Financing • Operating activities automatically create payables & accruals - essentially debts • These liabilities spontaneously offset the funding required to support current assets

5. Working Capital and the Current Accounts • Net Working Capital – the difference between gross working capital and spontaneous financing Generally: • Gross working capital = current assets • Net working capital = current assets – current liabilities People often say working capital when they actually mean net working capital

6. Objective of Working Capital Management • To run the firm with as little money tied up in the current accounts as possible • Working capital elements • Inventory • Receivables • Cash • Payables • Accruals

7. Objective of Working Capital Management

8. Objective of Working Capital Management

9. Figure 16-1 Cash Conversion Cycle

10. Figure 16-2 Timeline Representation of Cash Conversion Cycle

11. Permanent and Temporary Working Capital • Need for working capital varies with sales level • Temporary working capital supports seasonal peaks in business • Working capital is permanent to the extent that it supports a constant, minimum level of sales

12. Figure 16-3 Working Capital Needs of Different Firms

13. Financing Net Working Capital • Short-term working capital should be financed with short-term sources • Maturity Matching Principle – the term of financing should match the term or duration of the project or item supported

14. Short-Term vs. Long-Term Financing in Support of Working Capital Long-term financing • Safe but expensive • Safe – funds are committed and can’t be withdrawn • Expensive - long-term rates are generally higher Short-term financing • Cheap but risky • Cheap - short-term interest rates are generally lower • Risky - must continually renew borrowing

15. Alternative Financing Policies • The mix of short/long-term financing supporting working capital • Heavier use of longer term funds is conservative • Using more short-term funding is aggressive

16. Figure 16-4a Working Capital Financing Policies

17. Figure 16-4b Working Capital Financing Policies

18. Working Capital Policy • A firm’s Working Capital Policy refers to its handling the following issues: • How much working capital is used • Extent supported by short or long term financing • The nature and source of any short-term financing used • How each component is managed

19. Sources of Short-term Financing • Spontaneous financing • payables and accruals • Unsecured bank loans • Commercial paper • Secured loans

20. Spontaneous Financing Accruals • Interest–free loans from whoever provides services deferring payment • Wage Accrual • Money owed to employees for work performed but not yet paid Accounts Payable • Effectively loans from suppliers selling on credit • Credit Terms: • Specify details of payment • E.g. 2/10, net 30 • 2% discount if pay within 10 days, otherwise entire amount due in 30 days

21. Prompt Payment Discount • Passing up prompt payment discounts is an expensive source of financing If terms are 2/10, net 30, and don’t pay by the 10th day, essentially paying 2% for 20 days’ use of money The implied annual rate is (365 / 20) x 2% = 36.5%

22. Abuses of Trade Credit Terms • Trade credit, originally a service to customers, is now expected • Paying beyond the due date is a common abuse of trade credit • Called “stretching” payables or “leaning on the trade” • Slow paying companies receive poor credit ratings • May lose the ability to buy on credit in future

23. Unsecured Bank Loans • Represent the primary source of short-term financing for most companies • Unsecured  Repayment is not guaranteed by the pledge of a specific asset • Promissory Note – Written promise to repay amount borrowed plus interest

24. Unsecured Bank Loans • Line of credit • Informal, non-binding agreement between a bank and a borrowing firm specifying the maximum amount that can be borrowed during a period

25. Revolving Credit Agreement • Similar to a line of credit except bank guarantees availability of funds up to a maximum amount • Borrower pays a commitment fee on the unborrowed balance

26. Concept Connection Example 16-2 Revolving Credit Agreements Arcturus has a $10M “revolver” at prime plus 2.5%. Prior to June 1, it took down $4M that remained outstanding for the month. On June 15, it took down another $2M which remained outstanding through June 30. Prime is 9.5% and the bank’s commitment fee is 0.25%. What bank charges will Arcturus incur for the month of June?

27. Concept Connection Example 16-2 Revolving Credit Agreements • Monthly interest rate: (Prime + 2.5%)  12 = 1% • Monthly commitment fee: 0.25%  12 = 0.0208% • $4M was outstanding for the entire month of June and $2M was outstanding for 15 days, so the total interest charges are: • ($4,000,000 × .01) + ($2,000,000 × [15/30] × .01) = $50,000 • The unused balance was $6M for 15 days and $4M for 15 days • ($6,000,000 × .000208 × [15/30]) = $ 624 • ($4,000,000 × .000208 × [15/30]) = $ 416 • $1,040 • So, total bank charges for June are $51,040

28. Compensating Balances Minimum Balance Requirement • A percentage of the loan amount must be left in the borrower’s account at all times and is not available for use Average Balance Requirement • Average daily balance over a month cannot fall below a specified level • Entire balance can be used – but not all at once

29. Clean-Up Requirements • Borrowers are required to be out of short-term debt for a period once a year • Usually 30-45 days • Prevents funding long-term needs and projects with short-term borrowing

30. Commercial Paper • Notes issued by large, financially-strong firms and sold to investors • Basically a very short-term corporate bond • Unsecured • Buyers are usually institutions • Maturity less than 270 days • Considered a very safe investment • Interest is discounted – no coupon • Rigid and formal - no flexibility in repayment terms

31. Short-Term Credit Secured by Current Assets • Debt is secured by the current asset being financed • Accounts receivable • Inventory • Self liquidating nature of current assets makes loans very safe

32. Short-Term Credit Secured by Current Assets • Receivables Financing • Accounts receivable - money to be collected in the near future • Banks are willing to lend on A/R if the borrowing firm’s customers have good financial ratings • Pledging AR: using A/R as collateral for loan • Factoring AR: selling receivables at a discount directly to a financing source

33. Concept Connection Example 16-4 Pledging Accounts Receivables Kilraine’s $100,000 receivables balance of turns over every 45 days. The firm pledges all receivables to a finance company, which advances 75% of the total at prime plus 4% plus a 1.5% administrative fee. Prime is 8%, what interest rate is Kilraine effectively paying for its receivables financing?

34. Concept Connection Example 16-4 Pledging Accounts Receivables Solution: Traditional interest 8% + 4% = 12% Administrative charge Average loan balance $100,000 × .75 = $75,000 Accounts offered to finance company $100,000 x 360/45 = $800,000 The administrative fee at 1.5% 1.5% x $800,000 = $12,000 Fee as a percentage of loan balance $12,000  $75,000 = 16% Total financing charges 16% + 12% = 28%.

35. Factoring Receivables Firm sells receivables at a discount to a factor that takes control of accounts • Accounts Receivable are paid directly to factor • Factor accepts only creditworthy customer accounts • Factors offer a wide range of services all for fees • Perform credit checks on potential customers • Advance cash on accounts before collection or remit cash after collection • Collect cash from problem customers • Assume bad-debt risk when customers don’t pay • Factoring is usually very expensive financing

36. Inventory Financing • Inventory Financing • Inventory is collateral for loans • Repossessed items may be difficult for lender to sell • Inventory in borrower’s hands is hard for lender to control • Blanket liens • Chattel mortgage agreements • Warehousing • Fieldand public

37. Cash Management • Motivation for Holding Cash • Transactions demand • Precautionary demand • Speculative demand • Compensating balances

38. Objective of Cash Management • Business cash balances earn little or no interest • Firms generally borrow to support cash balances • But it is easier to do business with plenty of cash - Liquidity • Objective: Strike a balance • Operate efficiently at a reasonable cost

39. Marketable Securities • Some assets are only slightly less liquid than cash, and earn a return • Treasury bills • Other short term securities issued by stable organizations • Held as a substitute for cash

40. Figure 16-5 The Check-Clearing Process

41. Check Disbursement and Collection Procedures • Float: money tied up in the check clearing process • Mail float • Transit float • Processing float • Use of Cash - Payers versus Payees • Payers want to extend float periods • Payees want to reduce float periods

42. “Check 21” • Traditional check processing shipped paper checks around the country • Check Clearing for the 21st Century Act – Known as “Check 21” • Banks may now “truncate” checks • Replaced with electronic checks • Paper facsimiles available when needed • Has sped up clearing process • Fed paper check processing locations reduced from 45 to 1

43. Accelerating Cash Receipts • Lock-box systems • Service provided by banks to accelerate collections • Concentration Banking • Sweep excess balances in distant depository accounts into central locations daily

44. Figure 16-6 A Lock Box System in the Check-Clearing Process

45. Accelerating Cash Receipts Wire Transfers • Transfers money electronically Preauthorized Checks • Customer gives the payee signed check-like documents in advance • Payee deposits it in its bank account once product is shipped

46. Managing Cash Outflow • Control Issues • Centralized/decentralized • Zero Balance Accounts (ZBAs) • Empty disbursement account at firm’s concentration bank for its divisions • Remote Disbursing • A way to extend mail float

47. Concept Connection Example 16-7 Evaluating Lock-Box Systems Kelso is located on the East Coast, but has California customers that remit 5,000, $1,000 checks a year that take eight days to clear. A California bank offers a lock box system for $2,000 a year plus $0.20 per check, which will reduce clearing time to six days. Is the proposal a good deal if Kelso borrows at 12%?

48. Concept Connection Example 16-7 Evaluating Lock-Box Systems Solution: Kelso’s float now [(8 / 365) x $5,000,000] = $109,589 Float under proposed lockbox system [(6 / 365) x $5,000,000] = $82,192 Interest on cash freed up [$27,397 x 0.12] = $3,288 System cost [$2,000 + ($0.20 x 5,000)] = $3,000, Conclusion: Proposal is marginally worth doing.

49. Managing Accounts Receivable • Objectives and Policy • Higher receivables means selling to financially weaker customers and not pressuring them to pay promptly • Higher sales but also more bad debts • Objective is to max profit, not revenue • Receivables Policy involves: • Credit Policy • Terms of Sale • Collections Policy

50. Determinants of Receivables Balance • Credit Policy • Examine creditworthiness of potential credit customers • Tight credit policy = lower sales • Loose credit policy = high bad debts • Conflict between sales and credit departments