Chapter 16 Working Capital 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 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 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 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 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 Objective of Working Capital Management Inventory High Levels Low Levels Benefit: Happy customers – supplied quickly Few production delays (parts always on hand) Cost: High financing costs High storage costs Shrinkage (theft) Risk of obsolescence Cost: Shortages Dissatisfied customers – product not available Benefit: Low financing and storage costs Less risk of obsolescence Cash High Levels Benefit: Reduces risk of being unable to pay bills Cost: Increases financing costs Low Levels Benefit: Reduces financing costs Cost: Increases transaction risk Objective of Working Capital Management Accounts Receivable High Levels Benefit: Happy customers –can pay slowly High credit sales Cost: More bad debts High collection costs Increased financing costs Low Levels Cost: Customers unhappy with payment terms Lower Credit Sales Benefit: Less financing cost Payables and Accruals High Levels Benefit: Spontaneous financing reduces need to borrow Cost: Unhappy suppliers because paid slowly Low Levels Benefit: Happy suppliers/employees Cost: Not using spontaneous financing Figure 16-1 Cash Conversion Cycle Figure 16-2 Timeline Representation of Cash Conversion Cycle 10 Terms of Sale Credit sales are subject to specific payment terms – 2/10, net 30 - The most common terms 2% discount for paying within 10 days, otherwise entire amount due within 30 days – Prompt payment discounts are usually effective tools for managing receivables Customers pay quickly to save money May backfire if customers are very cash poor – Discount taken only by those who pay anyway 51 Collections Policy Collections Department - follows up on overdue receivables - called dunning – Mail polite letter – Follow up with additional increasingly aggressive dunning letters – Phone calls – Collection agency – Lawsuit Collection policy: manner and aggressiveness with which a firm pursues payment from delinquent customers 52 Inventory Management Inventory: product held for sale – Inventory mismanagement can ruin a company Finance department has only an oversight responsibility – Monitor level of lost or obsolete inventory – Supervise periodic physical inventories 53 Benefits and Costs of Carrying Adequate Inventory Costs Benefits – Reduces stockouts and backorders – Makes operations run more smoothly – Interest on funds used to acquire inventory – Storage and security – Insurance – Improves customer relations – Taxes – Increases sales – Spoilage – Shrinkage - theft – Breakage – Obsolescence 54 Inventory Control and Management Inventory Management - overall way a firm controls inventory and its cost – Define an acceptable level of operating efficiency with regard to inventory – Achieve that level with the minimum inventory cost EOQ – An inventory cost minimization model C = Annual Carrying Cost per Unit F = Fixed Cost per Order D = Annual Demand in Units Q = Order Quantity 55 Figure 16-7 Inventory on Hand for a Steadily Used Item 56 Figure 16-8 Inventory Costs and the EOQ Q D Total Inventory Cost: TC = C + F Q Economic Order Quantity (EOQ) Model EOQ minimizes the sum of ordering and carrying costs C = Annual Carrying Cost per Unit F = Fixed Cost per Order D = Annual Demand in Units  2FD  EOQ =   C   × Fixed Cost per Order × Annual Demand  EOQ =   Annual Carrying Cost per Unit   Concept Connection Example 16-9 Economic Order Quantity (EOQ) Model Galbraith buys a $5 part Its carrying cost is 20% of that value per year It costs $45 to place, process and receive an order 1,000 parts are used per year What order quantity minimizes inventory costs? How many orders will be placed each year if that order quantity is used? What annual inventory costs are incurred for the part with this ordering quantity? 59 Concept Connection Example 16-9 Economic Order Quantity (EOQ) Model Solution: C = $5 × 20 = $1 F = $45 D = 1,000  × $45 × 1,000  EOQ =  = 300 units  $1   Annual number of orders = 1,000 / 300 = 3.33 Carrying costs = $5 × × (300/2) = $150 per year Ordering costs = $45 x 3.333, = $150 per year Total inventory cost = $150 + $150 = $300 per year 60 Safety Stocks, Reorder Points and Lead Times Safety stock: Additional inventory, carried at all times, used when normal working stocks run out Quantity on hand diminishes until reorder point is reached Ordering lead time is the advance notice needed so an order will arrive on time 61 Figure 16-9 Pattern of Inventory on Hand 62 Safety Stock and the EOQ Inclusion of safety stocks does not change EOQ Cost trade-off: extra inventory increases carrying cost, but avoids losses from production delays and missed sales 63 Tracking Inventories The ABC System The ABC system segregates items by value and places tighter control on higher-cost pieces – “A” items – very expensive or critical – “B” items – moderate value – “C” items – cheap and plentiful Effort and spending on control diminishes from A to B to C 64 Just In Time (JIT) Inventory Systems JIT virtually eliminates manufacturing inventory by pushing it back on suppliers Suppliers deliver goods just in time for use in production Works best with large manufacturers Works poorly where firm has little control over distant suppliers 65 [...]... of money The implied annual rate is (365 / 20) x 2% = 36.5% 21 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 22 Unsecured Bank Loans Represent... companies Unsecured  Repayment is not guaranteed by the pledge of a specific asset Promissory Note – Written promise to repay amount borrowed plus interest 23 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 24 Revolving Credit Agreement Similar to a line of credit except bank... Maturity less than 270 days Considered a very safe investment Interest is discounted – no coupon Rigid and formal - no flexibility in repayment terms 30 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 31 Short-Term Credit Secured by Current Assets Receivables... specified level Entire balance can be used – but not all at once 28 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 29 Commercial Paper Notes issued by large, financially-strong firms and sold to investors – Basically a very short-term corporate bond Unsecured... used – Extent supported by short or long term financing – The nature and source of any short-term financing used – How each component is managed 18 Sources of Short-term Financing Spontaneous financing – payables and accruals Unsecured bank loans Commercial paper Secured loans 19 Spontaneous Financing Accruals Accounts Payable – Interest–free loans – Effectively loans from suppliers selling on credit... 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 32 Concept Connection Example 16-4 Pledging Accounts Receivables Kilraine’s $100,000 receivables balance of turns over every 45 days The firm pledges all... funds up to a maximum amount – Borrower pays a commitment fee on the unborrowed balance 25 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... 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 11 Figure 16-3 Working Capital Needs of Different Firms 12 Financing Net Working Capital Short-term working capital should be financed with short-term sources Maturity... Financing Accruals Accounts Payable – Interest–free loans – Effectively loans from suppliers selling on credit from whoever provides services – Credit Terms: deferring payment Specify details of payment – Wage Accrual Money owed to employees for work performed but not yet paid E.g 2/10, net 30 2% discount if pay within 10 days, otherwise entire amount due in 30 days 20 Prompt Payment Discount Passing... June? 26 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