20.FIM.

101
Financial Management
Working Capital
Management

S-1
Undergraduate Program Of
Management
Contents

 Background on Working Capital

 Current Assets Financing Policies

 The Cash Budget

 Inventories

 Account Receivables

 Account Payable
Objectives

• Explain how different amounts of current assets and current liabilities affect firms’
profitability and thus their stock prices.

• Explain how companies decide on the proper amount of each current asset— cash,
marketable securities, accounts receivable, and inventory.

• Discuss how companies set their credit policies and explain the effect of credit policy
on sales and profits.

• Describe how the costs of trade credit, bank loans, and commercial paper are
determined and how that information impacts decisions for financing working capital.

• Explain how companies use security to lower their costs of short-term credit
Background on Working
Capital
Background on Working Capital

 Working capital.
 Current assets are often called working capital because these
assets “turn over” (i.e., are used and then replaced all during the
year)
 Net working capital.
 When a firm buys inventory on credit, its suppliers in effect lend it
the money used to finance the inventory

NWC = Current Assets – Current Liabilities

Background on Working Capital

• This concept can be applied to modern businesses

• Net Operating Working Capital
• represent the working capital that is used for operating purposes.
• NOWC is an important component of the firm's free cash flow. NOWC differs from net
working capital because interest-bearing notes payable are deducted from current
liabilities in the calculation of NOWC.
• The reasons from this distinction is the most analysts view interest-bearing notes
payable as financing cost that is not part of the company's operating free cash flows.
• In contrast, the other current liabilities are treated as part of the company's
operations, and therefore are included as part of cash flows.
• NOWC = Current Assets – (Current Liabilities-Notes Payable)
Current Asset Financing
Policies
Current Asset Financing Policies

 Investments in current assets must be financed; and the primary sources of funds include bank loans, credit
from suppliers (accounts payable), accrued liabilities, long-term debt, and common equity

 To begin, note that most businesses experience seasonal and/or cyclical fluctuations

 For example
 construction firms tend to peak in the summer, retailers peak around Christmas, and the manufacturers
who supply both construction companies and retailers follow related patterns
 The sales of virtually all businesses increase when the economy is strong
 they build up current assets at those times but let inventories and receivables fall when the economy
weakens.
 that current assets rarely drop to zero—companies maintain some permanent current assets, which are the
current assets needed at the low point of the business cycle.
 Then as sales increase during an upswing, current assets are increased, and these extra current assets are
defined as temporary current assets as opposed to permanent current assets
Current Asset Financing Policies
• Maturity Matching, or “Self-Liquidating,” Approach
• A financing policy that matches asset and liability maturities. This is a moderate policy
• The maturity matching, or “self-liquidating,” approach calls for matching asset and liability
maturities
• shown in Panel a of Figure
• All of the fixed assets plus the permanent current
assets are financed with long-term capital, but
temporary current assets are financed with short-
term debt.
• Inventory expected to be sold in 30 days would be
financed with a 30-day bank loan, a machine
expected to last for 5 years would be financed with
a 5-year loan, a 20-year building would be financed
with a 20-year mortgage bond, and so forth
Current Asset Financing Policies

• Maturity Matching, or “Self-Liquidating,” Approach

• Two factors prevent an exact maturity matching
• There is uncertainty about the lives of assets.
• For example, a firm might finance inventories with a 30-day bank loan,
expecting to sell the inventories and use the cash to retire the loan. But if
sales are slow, the cash would not be forthcoming and the firm might not be
able to pay off the loan when it matures.

• Some common equity must be used, and common equity has no maturity.
• when a firm attempts to match asset and liability maturities, this is defined as
a moderate current asset financing policy.
Current Asset Financing Policies

• Aggressive Approach
• Aggressive firm that finances some of its permanent assets with short-term debt
• indicating that all of the current assets— both permanent and temporary—and
part of the fixed assets were financed with short-term credit
• This policy would be a highly aggressive, extremely non conservative position;
and the firm would be subject to dangers from loan renewal as well as problems
with rising interest rates
• The reason for adopting the aggressive policy is to take advantage of the fact
that the yield curve is generally upward-sloping; hence, short-term rates are
generally lower than long-term rates.
Current Asset Financing Policies

• Conservative Approach
• long-term capital is used to finance all the permanent assets
and to meet some of the seasonal needs
• the firm uses a small amount of short-term credit to meet its
peak requirements, but it also meets part of its seasonal
needs by “storing liquidity” in the form of marketable
securities
• This is a very safe, conservative financing policy.
The Cash Budget
The Cash Budget

• Firms need to forecast their cash flows

• If they are likely to need additional cash, they should line up funds well in
advance
• If they are likely to generate surplus cash, they should plan for its productive use

• The primary forecasting tool is the cash budget

• A table that shows cash receipts, disbursements, and balances over some period
• The monthly budget is good for annual planning, while the daily budget gives a
more precise picture of the actual cash flows and is good for scheduling actual
payments on a day-by-day basis
The Cash Budget

• Cash budget
• The monthly cash budget begins with a forecast of sales for each month and a
projection of when actual collections will occur.
• Then there is a forecast of materials purchases, followed by forecasted payments
for materials, labor, leases, new equipment, taxes, and other expenses.
• When the forecasted payments are subtracted from the forecasted collections,
the result is the expected net cash gain or loss for each month.
• This gain or loss is added to or subtracted from the beginning cash balance, and
the result is the amount of cash the firm would have on hand at the end of the
month if it neither borrowed nor invested.
The Cash Budget

• Cash Planning

• Cash planning is a technique to plan and control the use of cash.

• Cash Forecasting and Budgeting
• Cash budget is the most significant device to plan for and control cash
receipts and payments.
• Cash forecasts are needed to prepare cash budgets.
• Optimum Cash Balance
• Optimum Cash Balance under Certainty: Baumol’s Model
• Optimum Cash Balance under Uncertainty: The Miller–Orr Model
The Cash Budget

• Cash Planning
• Baumol’s Model–Assumptions:
• The firm is able to forecast its cash needs with certainty.
• The firm’s cash payments occur uniformly over a period of
time.
• The opportunity cost of holding cash is known and it does not
change over time.
• The firm will incur the same transaction cost whenever it
converts securities to cash.
 The Cash Budget
• Baumol’s Model:
• The firm incurs a holding cost for keeping the cash balance. It is an
opportunity cost; that is, the return foregone on the marketable
securities. If the opportunity cost is k, then the firm’s holding cost for
maintaining an average cash balance is as follows:
• Holding Cost = k(C/2)
• The firm incurs a transaction cost whenever it converts its
marketable securities to cash. Total number of transactions during
the year will be total funds requirement, T, divided by the cash
balance, C, i.e., T/C. The per transaction cost is assumed to be
constant. If per transaction cost is c, then the total transaction cost
will be:
• Transaction Cost = c(T/C)
• The total annual cost of the demand for cash will be:
• Total cost = k(C/2) + c(T/C)
• The optimum cash balance, C*, is obtained when the total2cT cost is minimum. The
*
formula for the optimum cash balance is as follows: C 
k
The Cash Budget

• Cash Planning
• The Miller–Orr Model
• The MO model provides for two control limits–the upper control limit
and the lower control limit as well as a return point.
• If the firm’s cash flows fluctuate randomly and hit the upper limit, then
it buys sufficient marketable securities to come back to a normal level
of cash balance (the return point).
• Similarly, when the firm’s cash flows wander and hit the lower limit, it
sells sufficient marketable securities to bring the cash balance back to
the normal level (the return point).
The Cash Budget
• Cash Planning
• The Miller–Orr Model
• The difference between the upper limit and the lower limit depends on the
following factors:
• The transaction cost (c)
• The interest rate, (i)
• The standard deviation (s) of net cash flows.
• The formula for determining the distance between upper and lower control
(Upper Limit
limits – Lower
(called Z)Limit) (3/ 4 × Transaction Cost × Cash Flow Variance / Interest Rate)1 / 3
is as=follows:
Upper Limit = Lower Limit + 3Z
Return Point = Lower Limit + Z
The net effect is that the firms hold the average the cash balance equal to:
Average Cash Balance = Lower Limit + 4/3Z
Inventories
Inventories

• Inventories, which can include Supplies, raw materials, work in process,

finished goods, are an essential part of virtually all business operations.

• Optimal inventory levels depend on sales, so sales must before casted

before target inventories can be established.

• Moreover, because errors in setting inventory levels lead to lost sales

or excessive carrying costs, inventory management is quite important.
• Therefore, firms must monitor their inventory holdings.
Inventories
• Inventory Management
• The objective for managing inventory, is to turn over inventory as quickly as possible without
losing sales from stock outs.
• Financial manager does provide input to the inventory management process
• Common techniques for managing inventory
• ABC System
• A firm using the ABC inventory system divides its inventory into three groups: A, B, and C.
• The A group includes those items with the largest dollar investment. Typically, this group
consists of 20 percent of the firm’s inventory items but 80 percent of its investment in
inventory.
• The B group consists of items that account for the next largest investment in inventory.
• The C group consists of a large number of items that require a relatively small investment.
Inventories

• Common techniques for managing inventory

• ABC System
• A firm using the ABC inventory system divides its inventory into three groups: A, B,
and C.
• The A group items receive the most intense monitoring because of the high dollar
investment.

• Typically, A group items are tracked on a perpetual inventory system that

allows daily verification of each item’s inventory level.

• B group items are frequently controlled through periodic, perhaps weekly,
checking of their levels.
• C group items are monitored with unsophisticated techniques
Inventories

• Common techniques for managing inventory

• Economic Order Quantity (EOQ) Model
• One of the most common techniques for determining the optimal order size for inventory items is the
economic order quantity (EOQ) model.
• Inventory management technique for determining an item’s optimal order size, which is the size that
minimizes the total of its order costs and carrying costs.
• EOQ assumes that the relevant costs of inventory can be divided into order costs and carrying costs
• Order costs include the fixed clerical costs of placing and receiving orders: the cost of writing a
purchase order, of processing the resulting paperwork, and of receiving an order and checking it
against the invoice
• Carrying costs are the variable costs per unit of holding an item of inventory for a specific period of
time.
• Carrying costs include storage costs, insurance costs, the costs of deterioration and obsolescence,
and the opportunity or financial cost of having funds invested in inventory
Inventories

• Common techniques for managing inventory

• Economic Order Quantity (EOQ) Model
• The EOQ model analyzes the tradeoff between order costs and carrying costs
to determine the order quantity that minimizes the total inventory cost.
• The resulting equation is

• S = usage in units per period

• O = order cost per order
• C = carrying cost per unit per period
• Q = order quantity in units
Inventories

• Common techniques for managing inventory

• Reorder point
• Once the firm has determined its economic order quantity, it must determine
when to place an order.
• The reorder point reflects the number of days of lead time the firm needs to
place and receive an order and the firm’s daily usage of the inventory item.
• Assuming that inventory is used at a constant rate, the formula for the
reorder point is
• Reorder point = Days of lead time x Daily usage
Accounts Receivable
Accounts Receivable

• The firm’s credit policy is the primary determinant of accounts

receivable, and it is under the administrative control
• A set of rules that includes the firm’s credit period, discounts, credit
standards, and collection procedures offered.

• Credit policy is a key determinant of sales

• Credit period is the length of time buyers are given to pay for their purchases
• Discounts are price reductions given for early payment.
• The discount specifies what the percentage reduction is and how rapidly
payment must be made to be eligible for the discount
Accounts Receivable

• Credit policy is a key determinant of sales

• Credit standards, which refer to the required financial strength of acceptable credit customers.
• With regard to credit standards, factors considered for business customers include ratios such as the
customer’s debt and interest coverage ratios, the customer’s credit history (has the customer paid
on time in the past or tended to be delinquent), and the like.
• For individual customers, their credit score as developed by credit rating agencies is the key item

• Collection policy refers to the procedures used to collect past due accounts, including the
toughness or laxity used in the process.
• At one extreme, the firm might write a series of polite letters after a fairly long delay
• at the other extreme, delinquent accounts may be turned over to a collection agency relatively
quickly
Accounts Payable
Accounts Payable

• Firms generally make purchases from other firms on credit and record the debt
as an account payable.
• Accounts payable, or trade credit, is the largest single category of short-term
debt, representing about 40% of the average corporation’s current liabilities.
• This credit is a spontaneous source of financing in the sense that it arises
spontaneously from ordinary business transactions

• For example
• If a firm makes a purchase of $1,000 on terms of net 30, it must pay for goods 30
days after the invoice date. This instantly and spontaneously provides $1,000 of
credit for 30 days
Accounts Payable

• Trade credit may be free, or it may be costly.

• If the seller does not offer discounts, the credit is free in the sense that there is no cost for using
it.

• If discounts are available, a complication arises

• Illustrated

• PCC Inc. buys 20 microchips each day with a list price of $100 per chip on terms of 2/10, net 30.

• the “true” price of the chips is 0.98($100)= $98

• because the chips can be purchased for only $98 by paying within 10 days

• If PCC decides to take the discount, it will pay at the end of Day 10 and show
Accounts Payable

• Illustrated

• If it decides to delay payment until the 30th day, its trade credit
will be

• By not taking discounts, PCC can obtain an additional $39,200 of

trade credit, but this $39,200 is costly credit because the firm
must give up the discounts to get it.
Question and Answer