TKM CH 18

Copyright 2011 Pearson Prentice Hall. All rights reserved.
Working Capital
Management
Chapter 18
18-2
Slide Contents
Learning Objectives
Principles Used in This Chapter
1. Working Capital Management and the Risk-
Return Tradeoff
2. Working Capital Policy
3. Operating and Cash Conversion Cycle
4. Managing Current Liabilities
5. Managing the Firms Investment in Current
Assets
Key Terms

18-3
Learning Objectives
1. Describe the risk-return tradeoff involved
in managing a firms working capital.
2. Explain the principle of self-liquidating
debt as a tool for managing firm liquidity.
3. Use the cash conversion cycle to measure
the efficiency with which a firm manages
its working capital.
18-4
Learning Objectives (cont.)
4. Evaluate the cost of financing as a key
determinant of the management of a
firms use of current liabilities.
5. Understand the factors underlying a firms
investment in cash and marketable
securities, accounts receivable, and
inventory.
18-5
Principles Used in This Chapter
Principle 2:
There is a Risk-Return Tradeoff.
18.1 Working
Capital Management
and the Risk-Return
Tradeoff
18-7
Working Capital Management and
the Risk-Return Tradeoff
Working capital management encompasses
the day-to-day activities of managing the
firms current assets and current liabilities.
Examples of working capital decisions
include:
How much inventory should a firm carry?
Who should credit be extended to?
Should inventories be bought on credit or
cash?
If credit is used, when should payment be
made?
18-8
Measuring Firm Liquidity
The current ratio (current assets divided
by current liabilities) and net working
capital (current assets minus current
liabilities) are two popular measures of
liquidity.

Both measures of liquidity provide the
same information. However, current ratio
can be more easily used for comparing
firms.
18-9
Measuring Firm Liquidity (cont.)
Here the net working capital for two firms is very different
(due to differences in firm sizes) but the current ratio is
equal. Current ratio is a better measure of comparison of
liquidity among firms.

Firm A Firm B
Current Assets $100,000 $10,000
Current
Liabilities
$50,000 $5,000
Net Working
Capital
$50,000 $5,000
Current Ratio 2.0 2.0
18-10
Managing Firm Liquidity
Managing a firms liquidity requires
balancing the firms investments in current
assets in relation to its current liabilities.
This can be accomplished by minimizing the
use of current assets by efficiently managing
its inventories and accounts receivable and by
seeking out the most favorable accounts
payable terms and monitoring its use of short-
term borrowing.
18-11
Risk-Return Tradeoff
Working capital decisions will change the
firms liquidity.
For example, a firm can enhance its
profitability by reducing its cash and
marketable securities as they yield low rates of
return. However, the firm will be exposed to a
higher risk of default or not being able to pay
its bills on time if it does not have adequate
cash and marketable securities.
18-12
Checkpoint 18.1
Measuring Firm Liquidity Ford Motor Company (F) suffered
along with all the U.S. automakers with the onset of the
recession in 2007. The following information from the firms
financial statements for 2008 and 2006 provide the
information needed to assess the firms liquidity (Note: all
figures below are in $000):
18-13
Checkpoint 18.1
18-14
Checkpoint 18.1
18-15
Checkpoint 18.1
18-16
Checkpoint 18.1: Check Yourself
Consider the effect on Fords liquidity of
the firm having the opportunity to enter
into a long-term financing arrangement to
borrow $20 million, which could be used to
reduce the firms 2008 accounts payable.
What would be the effect of this event on
the firms liquidity measures?
18-17
Step 1: Picture the Problem
Liquidity refers to the firms ability to pay
its bills in a timely fashion.

We can determine the firms liquidity by
comparing firms current assets (assets
that can be converted to cash in the
coming year) and current liabilities (bills
the firm must pay within the year).
18-18
Step 1: Picture the Problem (cont.)
We are given the following information:

2008 2006
Total Current
Assets
$36,832,000 $49,244,000
Total Current
Liabilities
$58,158,000 $52,544,000
Note:
$20 million transferred
to long-term debt.
18-19
0
10000000
20000000
30000000
40000000
50000000
60000000
70000000
Current Assets and Current Liabilities
2008
Current
Assets
2008
Current
Liabilities
2006
Current
Assets
2006
Current
Liabilities
18-20
Step 2: Decide on a Solution
Strategy
Firms liquidity can be measured by
computing the following two measures:

1. Current Ratio = Current Assets Current
Liabilities

2. Working capital = Current Assets Current
Liabilities
18-21
Step 3: Solve
Current Ratio (2008)
= Current Assets Current Liabilities
= $36,832,000 $58,158,000
= 0.63
18-22
Step 3: Solve (cont.)
Working capital
= Current Assets Current Liabilities
= $36,832,000 - $58,158,000
= -$21,326,000

18-23
Step 4: Analyze
The long-term financing arrangement for
$20 million improves the liquidity
measures by increasing the current ratio
from 0.47 to 0.63. However, it is still
below the 2006 current ratio of 0.94.
18.2 Working
Capital Policy
18-25
Working Capital Policy
Managing the firms net working capital
involves deciding on an investment
strategy for financing the firms current
assets and liabilities.

Since each financing source comes with
advantages and disadvantages, the
financial manager has to decide on the
optimal source for the firm.
18-26
The Principle of Self-Liquidating
Debt
This principle states that the maturity of
the source of financing should be matched
with the length of time that the financing
is needed.

Thus a seasonal increase in inventories
prior to Christmas season must be
financed with short-term loan or current
liability.
18-27
Permanent and Temporary Asset
Investments
Temporary investments in assets
include current assets that will be
liquidated and not replaced within the
current year.

For example, cash and marketable securities,
accounts receivable, and seasonal fluctuation in
inventories.
18-28
Permanent and Temporary Asset
Investments (cont.)
Permanent investments are composed
of investments in assets that the firm
expects to hold for a period longer than
one year.

For example, the firms minimum level of
current assets such as accounts receivable and
inventories, as well as fixed assets.
18-29
Spontaneous, Temporary, and
Permanent Sources of Financing
Spontaneous sources of financing arise
spontaneously out of the day-to-day
operations of the business and consist of
trade credit and other forms of accounts
payable (such as wages and salaries
payable, tax payable, interest payable).
18-30
Spontaneous, Temporary, and Permanent
Sources of Financing (cont.)
Temporary sources of financing
typically consist of current liabilities the
firm incurs on a discretionary basis. The
firms management must make an overt
decision to use temporary sources of
financing.
For example, unsecured bank loans,
commercial paper, short-term loans secured by
the firms inventories or accounts receivables.
18-31
Permanent sources of financing are
called permanent since the financing is
available for a longer period of time than a
current liability.

For example, intermediate term loans, bonds,
preferred stock and common equity.
18-32
18-33
Figure 18-2 illustrates the use of principle
of self-liquidating debt to guide a firms
financing decision.
We observe that the firms temporary or short-
term debt rises and falls with the rise and fall
in the firms temporary investment in current
assets.
18.3 Operating
and Cash
Conversion Cycles
18-35
Operating and Cash Conversion
Cycles
Operating and cash conversion cycles
indicate how effectively a firm has
managed its working capital.

The shorter these two cycles are, the more
efficient is the firms working capital
management.
18-36
Measuring Working Capital
Efficiency
The operating cycle measures the time
period that elapses from the date that an
item of inventory is purchased until the
firm collects the cash from its sale. If an
item is sold on credit, this date is when the
accounts receivable is collected.

18-37
Efficiency (cont.)
When the firm is able to purchase items of
inventory on credit, cash is not tied up for
the full length of its operating cycle. This is
known as the accounts payable deferral
period.

18-38
Efficiency (cont.)
Cash conversion cycle is shorter than
the operating cycle as the firm does not
have to pay for the items in its inventory
for a period equal to the length of the
account payable deferral period.

18-39
Figure 18.3 (Cont.)
18-40
Calculating the Operating and Cash
Conversion Cycle
Figure 18-3 calculations are based on the
following information:
Annual credit sales = $15 million
Cost of goods sold = $12 million
Inventory = $3 million
Accounts receivable = $3.6 million
Accounts payable outstanding = $ 2million
18-41
Conversion Cycle (cont.)
To calculate the operating cycle, we need
to compute the inventory conversion
period and the accounts receivable
collection period.

18-42
The inventory conversion period measures
the number of days it takes the firm to
convert its inventory to credit sales (i.e.
accounts receivable).

The second half of the operating cycle is
the number of takes it takes to convert
accounts receivable to cash (or average
collection period).
18-43

To calculate the cash conversion cycle, we
need to calculate the accounts payable
deferral period.

18-44
We have now calculated the following:

Inventory conversion period = 91 days
Average collection period = 61 days
Accounts payable deferral period = 61 days
18-45

Cash conversion cycle = 176 days 61
days
= 116 days
18-46
Checkpoint 18.2
Analyzing the Cash Conversion Cycle
Financial information for the Dell Computer Corporation (DELL)
and Ford Motor Company (F) are found below:

Compute the operating cycle and cash conversion cycle for each
of these companies. You may assume for purposes of your
analysis that all of the firm sales are credit sales.
18-47
Checkpoint 18.2
18-48
Checkpoint 18.2
18-49
Checkpoint 18.2
18-50
If GM were to have an average collection
period of 18.89 days, an inventory
conversion period of 39.76 days and
accounts payable deferral period of 60.17
days, what would its operating and cash
conversion cycles be?

18-51
The operating and cash conversion cycle can be
visualized as shown below:

18-52
Strategy
The firms cash conversion cycle and
operating cycle are defined as follows:

18-53
Step 3: Solve
We are given the following for DELL:

Average collection period = 18.89 days
Inventory conversion period = 39.76 days
Accounts payable deferral period = 60.17 days
18-54

Operating Cycle = 39.76 days + 18.89 days
= 58.65 days

18-55

Cash conversion cycle
= 58.65 days 60.17 days
= -1.52 days
18-56
Step 4: Analyze
We observe that the operating cycle for Dell is
58.65 days which indicates that 58.65 days
elapse from the date an item of inventory is
purchased at Dell until the firm collects the cash
from its sale.

The cash conversion cycle is negative as Dell is
able to defer making payments on its account
payable for 60.17 days, which is longer than the
operating cycle.

18.4 Managing
Current Liabilities
18-58
Managing Current Liabilities
Current Liabilities
(debt obligations to be
repaid within one year)
Unsecured current
liabilities
(trade credit, unsecured
bank loans, commercial
paper)
Secured current
liabilities
(loans secured by specific
assts like inventories or
accounts receivable)
18-59
Calculating the Cost of Short-term
Financing
When evaluating alternative sources of
financing, it is critical to consider the cost.
The cost of short-term credit is given by:

Interest = principal rate time

59
18-60
Financing (cont.)
Example 18.1
What will be the interest payment on a 4-
month loan for $35,000 that carries an annual
interest rate of 12%?

Interest = principal rate time
= $35,000 .12 4/12
= $1,400
18-61
Financing (cont.)
The Annual Percentage Rate (APR) is
computed as follows:

18-62
Financing (cont.)
Example 18.2 Rio Corporation plans to borrow
$35,000 for a 120-day period and repay $35,000
principal amount plus $1,400 interest at maturity.
What is the APR?

APR = ($1400/$35000) (1/120/365)
= 12.167%
18-63
18-64
Evaluating the Cost of Credit
Trade credit is given by firms suppliers.
The credit terms generally include discount
for early payment.

For example, credit terms of 3/10, net 30
means that a 3% discount is offered for
payment within 10 days or the full amount
is due in 30 days. What is the cost of not
taking the 3% discount?

18-65
Evaluating the Cost of Credit (cont.)
The 3% cash discount is the interest cost
of extending the payment period an
additional 20 days. For a $100 invoice, the
cost is computed as follows:

APR = ($3/$97) (1/20/365)
= .5644 or 56.44%
18-66
Evaluating the Cost of Bank Loans
We can apply equation 18-8 (APR) to
estimate the cost of bank loans also.

However, firms generally borrow money
from bank by creating a line of credit.
18-67
Evaluating the Cost of Bank Loans
(cont.)
A line of credit entitles the firm to borrow
up to the stated amount. In exchange, the
firm is generally required to maintain a
minimum balance in the bank throughout
the loan period (known as compensating
balance).
The compensating balance increases the
annualized cost of loan to the borrower.

18-68
Checkpoint 18.3
Calculating the APR for a Line of Credit
M&M Beverage Company has a $300,000 line of credit that requires a
compensating balance equal to 10 percent of the loan amount. The
rate paid on the loan is 12 percent per annum, $200,000 is borrowed
for a six-month period, and the firm does not currently have a deposit
with the lending bank. The dollar cost of the loan includes the interest
expense as well as the opportunity cost of maintaining an idle cash
balance in the compensating balance (which is 10% of the loan). To
accommodate the cost of the compensating balance requirement,
assume that the added funds will have to be borrowed and simply left
idle in the firms checking account. What would the annualized rate on
this loan be if there was no compensating balance requirement? What
is the annual rate on this loan with the compensating balance
requirement?
18-69
Checkpoint 18.3
18-70
Checkpoint 18.3
18-71
Checkpoint 18.3
18-72
Assume that your firm has a $1,000,000 line of credit
that requires a compensating balance equal to 20
percent of the loan amount. The rate paid on the loan
is 12 percent per annum, $500,000 is borrowed for a
six-month period, and the firm does not currently have
a deposit with the lending bank. To accommodate the
cost of the compensating balances requirement,
assume that the added funds will have to be borrowed
and simply left idle in the firms checking account.
What would the annualized rate on this loan be with
the compensating balance requirement?
18-73
Since there is a compensating balance
requirement, the amount actually
borrowed (B) will be larger than the
$500,000 needed.
$500,000 will constitute 80% of the total
borrowed funds because of the 20 percent
compensating balance requirement.
Hence, .80B = $500,000
18-74
If .80B = $500,000
Amount borrowed (B) = $500,000/.80
= $625,000

Thus interest is paid on a $625,000 loan of
which only $500,000 is available for use by
the firm.
18-75
Strategy
We can solve for APR using Equation (18-
8),

18-76
Step 3: Solve
Here interest is paid on a loan of
$625,000.

Thus, interest for 6-months at 12%
= $625,000 .12
= $37,500

18-77

APR = ($37,500 $500,000) 2
= 0.15 or 15%

18-78
Step 4: Analyze
We observe that the presence of a
compensating balance requirement
increases the cost of credit from 12% to
15%.
This results from the fact that the firm
pays interest on $625,000 but it gets the
use of $37,500 less, or $500,000 -
$37,500 = $462,500.
18.5 Managing
the Firms
Investment in
Current Assets
18-80
Managing the Firms Investment in
Current Assets
The primary types of current assets that
most firms hold are:
Cash,
Marketable securities,
Accounts receivable, and
Inventories.
18-81
Cash and Marketable Securities
Cash and marketable securities are held to
pay the firms bills on a timely basis.
Holding too little cash and marketable
securities could lead to default.
However, holding excessive cash and
marketable securities is costly since they
earn little, or very low rates of return.
18-82
(cont.)
There are two fundamental problems of
cash management:
1. Keeping enough cash on hand to meet the
firms cash disbursal requirements on a timely
basis.

2. Managing the composition of the firms
marketable securities portfolio.
18-83
(cont.)
Problem #1: Maintaining a Sufficient
Balance

To maintain an adequate balance requires
an accurate forecast of firms cash receipts
and disbursements. This is accomplished
through a cash budget.
18-84
(cont.)
Once estimates of cash flows have been
made, firm may want to find ways to
reduces its need for cash.

For example, if the firm is able to
accelerate its cash collections or slow
down its cash disbursements, it will be
able to reduce its need for cash.
18-85
(cont.)
Problem #2: Managing the composition of
the firms marketable securities portfolio

Firms prefer to hold cash reserves in
money market securities as it can be
easily and quickly converted to cash at
little or no loss. These securities mature in
less than 1 year, have low or no default
probability, and are highly liquid.
18-86
18-87
Managing Accounts Receivable
Whenever a sale is made on credit, it
increases the firms account receivable
balance. Cash flow from sales cannot be
invested until accounts receivable are
collected.

Efficient collection policies and procedures
will improve firm profitability and liquidity.
18-88
Determinants of the Size of a Firms
Investment in Accounts Receivable
1. The level of credit sales as a percentage
of sales. This percentage will vary with
the type of business.
2. The level of sales. Higher the sales,
greater the accounts receivable.
3. The credit and collection policy.
18-89
18-90
Terms of Sale
Terms of sale identify the possible
discounts for early payment, the discount
period, and the total credit period.
It is generally stated in the form a/b, net
c. For example 1/10, net 30, means the
customer can deduct 1% if paid within 10
days, otherwise the account must be paid
within 30 days.

18-91
Terms of Sale (cont.)
What is the opportunity cost of passing up
this 1% discount in order to delay
payment for 20 days?

18-92
Terms of Sale (cont.)
Annualized opportunity cost

= 0.01/(1-.01) 365/(30-10)

= .1843 or 18.43%
18-93
Customer Quality
It is important to determine the type of
customer who should qualify for trade
credit. It is critical to understand the
customers short-run financial well being.

As the quality of customer declines, it
increases the costs of credit investigation,
default costs, and collection costs.
18-94
Customer Quality (cont.)
To determine customer quality, firm can
analyze the liquidity ratios, other
obligations, and overall profitability of the
firm.
The firm can also obtain information from
credit rating services such as Dun &
Bradstreet that provide information on the
financial status, operations, and payment
history for most firms.
18-95
Customer Quality (cont.)
Credit score is also a popular way to
evaluate the credit risk of individuals and
firms.

Credit score is a numerical evaluation of
each applicant based on the applicants
current debts and history of making
payments on a timely basis.
18-96
18-97
Collection Efforts
Control of accounts receivables focuses on
the control and elimination of past-due
receivables. This can be done by
analyzing various ratios such as average
collection period, the ratio of receivables to
assets, accounts receivable turnover ratio,
and the amount of bad debt relative to
sales over time.
18-98
Collection Efforts (cont.)
The manager can also perform aging of
accounts receivable to determine in
dollars and percentage the proportion of
receivables that are past due.
18-99
18-100
Managing Inventories
Inventory management involves the
control of assets that are produced to be
sold in the normal course of business. It
includes raw materials, work-in-process,
and finished goods inventory.
How much inventory a firm carries
depends upon the target level of sales,
and the importance of inventory.
18-101
Key Terms
Bank transaction loans
Cash conversion cycle
Commercial paper
Credit scoring
Factor
Float
Inventory conversion period
18-102
Key Terms (cont.)
Inventory management
Line of credit
Money market securities
Operating cycle
Permanent sources of financing
Permanent investments
Principle of self-liquidating debt
18-103
Key Terms (cont.)
Secured current liabilities
Spontaneous sources of financing
Temporary investments in assets
Temporary sources of financing
Terms of sale
Trade credit
Unsecured current liabilities

TKM CH 18

Caricato da

Informazioni sul documento

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

TKM CH 18

Caricato da

Copyright:

Formati disponibili

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Potrebbero piacerti anche