BBC406 Fundamentals of

Finance
Week 9 Working Capital Management

Learning Objectives
At the end of this chapter, you should be
able to:
Explain working capital and the cash conversion
cycle
Describe motives for holding cash
Describe and analyse the different mechanisms for
managing the firms cash collection and
disbursement procedures
Identify and compute inventory management costs
Apply inventory management models to optimize
the firms inventory

Learning Objectives (cont.)

Explain the reasons for granting credit
Evaluate credit granting decisions
Describe important accounts
receivable management tools
Describe the mechanics of different
types of short-term borrowings and
evaluate their costs

Introduction
Working capital comprises of current assets minus
its current liabilities
Current assets comprise principally of inventories,
accounts receivables, cash and short-term
securities. These assets are termed current as
the assets concerned can be converted into cash
within one year (<12 months) or less.
Current liabilities comprise principally of accounts
payable, accruals, short-term borrowings and
taxes payable. These are obligations owed by the
firm that are expected to come due within one
year or less.

Introduction (cont.)
Net working capital is the difference
between the firms current assets and
current liabilities.
Working capital management involves
all aspects of the administration of
current assets and current liabilities.
Short term financing problems therefore
can arise in the management of a firms
investments in current assets and its use
of current liabilities

Introduction (cont.)
Working capital management hence, covers (but is not limited
to) several basic relationships:
Sales impactmust determine the appropriate levels of
receivables and inventories to maintain
Liquiditymust choose the levels of cash and marketable
securities to maintain
Relations with stakeholderscustomers are concerned with
price, availability, quality and service, goodwill and
reputation of a firm. On the opposite end, the firms would
also have similar concerns about its suppliers
Firms reputation depends on its ability to efficiently manage
its current assets and current liabilities

Guiding Principles about

Working Capital Finance
Risk return trade-off

Financing Working Capital

Three (3) approaches may be adopted:
i)

Maturity-matching approach

ii) Conservative approach

iii) Aggressive approach

Maturity-matching
Approach
Hedge risk by matching the maturities of
assets and liabilities.
Permanent current assets are financed with
long-term financing, while temporary current
assets are financed with short-term
financing.
There are no excess
funds.

Maturity-matching
Approach (contd)
Firm depends on short-term financing for its
temporary current assets. The firm assumes that
funds will always be available
Firms run the risk that the costs can rise dramatically,
especially during times of credit crunch.
Hedge risk by matching the maturities of assets and
liabilities.
Permanent current assets are financed with long-term
financing, while temporary current assets are
financed with short-term financing.
There are no excess funds.

Conservative Approach
Long-term funds are used to finance both
permanent as well as some temporary shortterm assets.
When there are
excess funds,
they are invested
in marketable
securities.

Aggressive Approach
Use less long-term and more short-term financing
than the conservative approach.
Higher expected returns and profitability comes at
the expense of the firms willingness to take on
greater risk

Cash Management Cycle

Overall measure of effectiveness in managing net working
capital.
Main objective is to minimize working capital subject to the
constraint that there should be adequate working capital to
support the firms operations

Cash Management Cycle

Cash Conversion Cycle

Cash Conversion Cycle (cont.)

Inventory conversion period is the average
time between purchasing stocks and selling
the goods:

Inventory
X 365 days
Cost of goods sold

Inventory conversion period=

Debtors collection period is the number of days for

debtors to pay from time of sale:
Debtors' collection period=

Receivables
Sales

X 365 days

Cash Conversion Cycle

Creditors credit period is the number of days
from the time of purchase of materials and
labour for goods and the time of payment:
Payables credit period =

Accounts payable
Cost of goods sold

X 365 days

Cash Budget
Detailed plan of a firms future cash flows
An estimation of the cash inflows and outflows for a firm for
a specific period of time in the future
Assess whether it has sufficient cash to fulfil its cash flow
requirements in the future and whether excess cash exists
3 main components necessary for creating a cash budget:
i) Time period
ii) Desired cash position
iii) Estimated sales and expenses

General Format of Cash

Budget

Reasons for Holding Cash

Transactionsthe need for cash make everyday payments
Precautionarythe need to have cash on hand to meet
unexpected needs or unforeseen expenses
Speculativebased on the desire to take advantage of
potential profit-making opportunities that require cash

Transaction Demand
Models
Baumol Model
The firm can predict its cash requirements with
certainty
Cash disbursements are spread uniformly over the
period
Interest rate or opportunity cost of funds (holding
cash) is fixed at all times, represented by K
Firm pays fixed transaction cost each time it
converts securities to cash, represented by F

Baumol Model

Baumol Model (cont.)

Optimal deposit size

Miller-Orr Cash Model

Optimal cash levels

The optimum amount of cash that ought to be held by a
firm depends on the following factors:
Forecasts of the future cash inflows and outflows of the
firm;
The efficiency with which the cash flows of the firm are
managed;
The availability of liquid assets to the firm and the
extent of liquidity risks it faces;
The borrowing capability and capacity of the firm;
The companys tolerance of risk

Investing surplus cash

Surplus cash should earn a return by being invested on a short-term basis.
There must be no risk of capital loss, since these funds are required to
support a companys continuing working capital needs.
The factors which should be considered when choosing an appropriate
investment method for short-term cash surpluses are:
a) The size of the surplus, as some investment methods require minimum
amounts;
b) The ease with which an investment can be realised;
c) When the investment is expected to mature;
d) The risk and yield of the investment;
e) Any penalties which may be incurred for early liquidation.

Short-term methods that can be useful in managing corporate liquidity

include fixed deposits, over-night deposits, certificates of deposits, Treasury
Bills, government securities, equities and so on.

Inventory Management
Inventory management ensures that firms have
sufficient inventory for production and for sale to
customers.
Manufacturing firms carry three types of inventories:
i) Raw materials
ii) Work in progress
iii) Finished goods

Economic Order Quantity

(EOQ)
Total inventory costs = Total
carrying costs + Total ordering costs
Average inventory = Q/2

Economic Order Quantity

(EOQ) (cont.)

Reorder Point
Reorder point = Expected lead time + Safety
stock

Debtors
Sales on credit terms to customers give rise to debtors
(accounts receivables)
Level of debtors is determined by the level of sales and credit
and collection policies of the firm

Credit Terms
Conditions as agreed in the contractual agreement between
the supplier and the customer pertaining to the credit granted
to customer
Interpretation of 3/10, net 30 => the supplier is granting a
total credit period of 30 days from the date of the invoice;
discount of 3% if paid within 10 days

Debtors (cont.)
Credit standards
The criteria to assess customers and determine the amount of credit and
extent of credit period to be granted to debtors
Firm needs to able to ascertain the NPV of a sale made to customer =>
depends on investment in the sale, required ROI and expected payment
period
Sources of credit information

Internal sources include:

Credit application, including referees
Customers past history, especially the payment history
Information and input from the firms sales and accounting department
staff

Debtors (cont.)
Sources of credit information
External sources of information include:
Recent years financial statements (typically the
last three most recent years)review of customers
profitability, financial standing, debt obligations
and liquidity
Reports from credit rating agencies e.g. Ratings
Agency Malaysia
Credit bureau reportsCentral Credit Reference
Information System (CCRIS)

Debtors (cont.)
Five Cs of credit
Characterthe commitment to meet credit obligations
Capacitythe ability to meet credit obligations with
current income
Capitalthe ability to meet credit obligations from
existing assets if necessary
Collateralrefers to the security that underlies assets if
necessary
Conditionsincludes consideration of general and
industry economic conditions

Credit-scoring Models
Credit-scoring models involve the numerical
evaluation of customers using scientific
approaches.
Score is a number that lenders use to determine
the credit risk.
Calculation is based on a mathematical equation
that evaluates information in the credit file and
compares it to the patterns in millions of other
credit files.

Credit-scoring Models
(cont.)
Multi-discriminant analysis (MDA)

Z-score 3.0: Firm is safe based on these

financial figures only
Z-score between 2.7 and 2.99: On alertshould
exercise caution

Credit-scoring Models
(cont.)
Z-score between 1.8 and 2.7: Good chance of the
company going bankrupt within 2 years of
operations from the date of financial figures given
Z-score below 1.80: Probability of bankruptcy is
very high

Credit-scoring Models
(cont.)
Other factors to consider
Order size and frequency
Market position
Profitability
Financial resources of the respective businesses
Industry norms
Business objectives

Other Credit Decisions

Delinquent credit accounts
Letter or statement
Telephone
Personal visits to customers premises
Collection agencies
Legal proceedings

Other Credit Decisions

Other Credit Decisions

(cont.)
Changing credit policy
Credit policy changes involves altering the
terms, standards or collection practices
Typical way to evaluate the net benefit of
changing a credit policy is via the use of the
incremental analysis

Other Credit Decisions

(cont.)
Using Accounts Receivable as Collateral
Accounts receivables (debtors) may be used
as collateral to raise short-term financing
The accounts receivable is pledged by the
firm as collateral to the lender.
The amount of the loan is a percentage of
the receivables pledged.

Other Credit Decisions

(cont.)
Factoring Accounts Receivable
Factoring is where a firm sells its debtors at a
discount
Involves raising funds against the security of the
firms trade debts
Basic services are offered:
a) Sales ledger accounting, involving invoicing and
collecting debts;
b) Credit insurance, which guarantees against bad
debts;
c) Provision of finance

Other Credit Decisions

(cont.)
Factoring Accounts Receivable (cont.)

2 types of factoring serviceNon-recourse factoring and

Recourse factoring

Non-recourse factoring is where the factoring company

purchases the debts without recourse to the firm selling its
accounts receivable.

Recourse factoring, on the other hand, is where the business

takes the bad debt risk.

Factoring also provides additional services such as:

a) Administration of a firms invoicing
b) Accounts maintenance
c) Debt collections service

Benefit of Factoring
Provides faster and more predictable cash flows
Firms can hence pay suppliers/creditors more promptly,
and so may be able to take advantage of any early
payment discounts that are available
Optimum inventory levels can be maintained, as the firm
will have funds to pay for inventories that it needs
Provision of finance, whereby the factor immediately
advances about 80% of the value of debts being
collected.
Finance provided is linked to sales, in contrast to
overdraft limits, which tend to be determined by
historical balance sheets.

Disadvantage of Factoring
By paying the factor directly, customers will lose some
contact with the supplier
Customers can obtain the perception that the firm is in need
of cash, and my be facing financial difficulties
When disputes over an invoice arise, having the factor in the
middle can lead to a confused three-way communication
system, which hinders the debt collection process
The interest charge usually costs more than other forms of
short-term credit financing
The administration fee can be quite high depending on the
number of debtors, the volume of business and the
complexity of the accounts.

Marketable Securities
Malaysian Government raises short-term
financing through the issue of marketable
debt instruments.
Forms of Government securities that are
available in Malaysia are:
a) Malaysian Government Securities (MGS)
b) Malaysian Treasury Bills (MTB)
c) Government Investment Issues (GII)
d) Malaysian Islamic Treasury Bills (MITB)

Marketable Securities
(cont.)
Repurchase Agreements
Banks sell market instruments to investors and buy
back those instruments later
Firms can invest in these securities for short periods,
ranging from one day to one year
Negotiable Certificate of Deposits
Receipts certifying that monies have been deposited
in a bank issuing the certificate
Represent high quality financial asset; fetches higher
yield than the comparable time deposit and treasury
bills

Marketable Securities
(cont.)
Bankers Acceptance
Short-term credit investments created by
other firms and guaranteed by a bank
Commercial Paper
Short-term unsecured debts issued by firms

Trade Creditors
Management of trade creditors involves:
Attempting to obtain satisfactory credit from
suppliers/creditors
Attempting to extend credit during periods of
cash shortage
Maintaining good relations with regular and
important suppliers

Trade Creditors (cont.)

Source of Short-term Finance
Represents another source of short-term finance as
firms make use of short-term trade credit offered
by supplier
Trade credit will have a cost
Firms may be offered discount for early payment
Finance managers therefore face whether to accept
the suppliers discount offer for early payment or to
forego the discount (and make use of the credit
period).

Trade Creditors (cont.)

Costs of foregoing early discount:
Estimated using annual percentage rate (APR) or annual
percentage yield (APY)

See Example 5.6 and 5.7 in textbook.

Trade Creditors (cont.)

Effective use of trade credit
Need to consider whether to take advantage of early
discounts offered by creditors.
Other considerations:
Trade credit is readily available
It is informal
Can gain additional credit simply by delaying its
payment until the end of the net period
More flexible than other types of short term finance.

Trade Creditors (cont.)

Other considerations (contd):
There may be instances where the consequences of
delaying payment to trade creditors to beyond the net
period may be less expensive than those that result
from late payments to banks on short term loans.

Trade credit may be valuable, especially to small firms

as small firms usually face difficulties in obtaining
credit, owing to a variety of reasons such as size
factor, lack of suitable collateral or business track
record.

Other Forms of Short-term

Financing
Bank Overdraft
Standby cash flow to cover a firms daily
working capital requirement
Provided by banks
Firms can withdraw funds from the Current
Account in excess of the credit balance up the
approved limit set by the bank
Interest Rate = Base Lending Rate (BLR)
+ Spread

Other Forms of Short-term

Financing (cont.)
Trust Receipts
Used by a firm (also know as buyer) to finance local
purchases and importation of goods
Document executed by a customer (pledger of goods or
documents of title)
Goods released to the firm by the bank, so that the firm
may sell the goods and pay the proceeds from the sale to
the bank
Upon receipt of the TR document, the bank will lend the
firm funds to pay the trade creditors/suppliers for the
goods purchased.

Other Forms of Short-term

Financing (cont.)
Bankers Acceptance
Issuance bill of exchange drawn by a firm to its
order, and accepted by the bank, and payable on
a specified date
Another form of short-term financing that allows
firms to take delivery of goods from the suppliers
faster to meet market demands
In the case of the firm that is a seller/exporter, it
can arrange for BA for its customers so that it can
have access to immediate funds for working
capital.

Other Forms of Short-term

Financing (cont.)
Letter of Credit
Undertaking by the bank, acting in accordance with
the instructions of the borrower, to pay a stipulated
amount of money stated in the letter of credit to a
named beneficiary against presentation of
stipulated documents and in full compliance of the
terms and conditions of the credit.
LC issued by bank to the suppliers acts as a form of
guaranteed payment. The supplier will be able to
collect the payment when all conditions of the LC
are met.

Other Forms of Short-term

Financing (cont.)
Letter of Credit
Types of LCs available include:
Irrevocable LCssuch LCs cannot be amended and not
cancelled without the agreement of all parties to the LC
Standby LCsfunded only if the buyer does not pay
the seller as agreed upon
Revolving LCsused for regular shipments of the same
commodity to the same customer (importer). This
means that a credit facility is set up with the LC
balances drawn down against the credit facility balance

Other Forms of Short-term

Financing (cont.)
Transferable LCsthe first beneficiary can
transfer all or part of the original LC to a third
party
Assignments of proceeds under an LCthe
original beneficiary assigns the proceeds to
the end supplier
Back-to-back LCsoriginal LC that has been
received by the firm from its customer, who
then uses that LC as security to establish
another LC, drawn on the firm in favour of its
creditors

Term Loans
Represent intermediate term debt
Duration ranging from 5 to 15 years
Usually carries fixed monthly repayments and interest is
pegged to BLR

Interest Rate = Base Lending Rate (BLR) +

Spread

Term Loans
Other Charges
Compensating balanceamount of money that a
bank may require the firm to maintain in a noninterest bearing account.
Deposit concerned may be used by the bank to off
set any unpaid loan owing by the firm to the bank

Interest Rate = Base Lending Rate (BLR) + Sprea

Has the effect of increasing the Effective Interest
Rate on the loan, measured by: Nominal interest
Proceeds

Overtrading
Overtrading (or undercapitalisation) occurs when a
firm experiences a situation where it is trying to
support a too large volume of trade with a too small
working capital base
It is the result of the supply of funds failing to meet the
demand for funds within the firm and it emphasises
the need for adequate working capital investment
Overtrading can be caused by rapid increase in
turnover; arise in the early years of a new business if it
starts off with insufficient capital; erosion of a firms
capital base and so on

Overtrading (contd)
Indications of overtrading
Rapid growth in sales over a relatively short period
Rapid growth in the amount of current assets, and fixed assets;
Deteriorating stock days and debtor days ratios;
Increasing use of trade credit to finance current asset growth
(increasing creditor days);
Declining liquidity, indicated perhaps by a falling quick ratio;
Declining profitability,
Decreasing amounts of cash and liquid investments, or a rapidly
increasing overdraft.

Overtrading (contd)
Strategies to deal with overtrading:
Introducing new capital
Improving working capital management
Reducing business activity