Asset & Liabilities Management Chapter 4

4
C
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The Management of
Working Capital
Slides Developed by:

Terry Fegarty
Seneca College

2006 by Nelson, a division of Thomson Canada Limited

2
Chapter 4 Outline (1)
Working Capital Basics
Working Capital and the Current Accounts
Working Capital and Funding Requirements
Objective of Working Capital Management
Working Capital Trade-offs
OperationsThe Cash Conversion Cycle
The Operating Cycle and the Cash Conversion Cycle


3
Permanent and Temporary Working Capital
Maturity Matching Principle
Financing Net working Capital
Short-Term vs. Long-Term Financing
Working Capital Policy


4
Cash Management
Objectives of Cash Management
Marketable Securities
Yield on a Discounted Money Market Security
Components of Float
Cheque Disbursement and the Cheque Clearing
process
Accelerating Cash Receipts
Electronic Funds Transfer
Managing Cash Outflow
Evaluating Cash Management Services


5
Managing Accounts Receivable
Tradeoffs in Managing Accounts Receivable
Credit Policy
Terms of Sale
Collections policy


6
Inventory Management
Benefits and Costs of Carrying Adequate Inventory
Inventory Ordering Costs
Inventory Control and Management
Economic Order Quantity Model
Safety Stocks, Reorder Points and Lead Times
Inventory on Hand Including Safety Stock
Tracking InventoriesThe ABC System
Just In Time (JIT) Inventory System


7
Working Capital Basics
Working Capital
Assets/liabilities required to operate
business on day-to-day basis
Cash
Accounts Receivable
Inventory
Accounts Payable
Accruals

Short-term in natureturn over regularly


8
Working Capital and the Current
Accounts

Gross working capital = Current assets
Gross Working Capital (GWC) represents
investment in current assets

(Net) working capital =
Current assets Current liabilities


9
Working Capital and Funding
Requirements

Working Capital Requires Funds
Maintaining working capital balance requires
permanent commitment of funds
Example: Firm will always have minimum level of
Inventory, Accounts Receivable, and Cashthis
requires funding


10
Requirements

Spontaneous Financing
Firm will also always have minimum level of
Accounts Payablein effect, money you have
borrowed
Accounts Payable (and Accruals) are generated
spontaneously
Arise automatically with inventory and expenses
Offset the funding required to support current assets


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Requirements

Net working capital is Gross Working
Capital Current Liabilities (including
spontaneous financing)

Reflects net amount of funds needed to
support routine operations


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Objective of Working Capital
Management
To run firm efficiently with as little money
as possible tied up in Working Capital
Involves trade-offs between easier operation
and cost of carrying short-term assets
Benefit of low working capital
Money otherwise tied up in current assets can be
invested in activities that generate higher payoff
Reduces need for costly financing

Cost of low working capital
Risk of shortages in cash, inventory


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Inventory
High Levels Low Levels
Benefit:
Happy customers
Few production delays (always have needed
parts on hand)
Cost:
Expensive
High storage costs
Risk of obsolescence
Cost:
Shortages
Dissatisfied customers
Benefit:
Low storage costs
Less risk of obsolescence

Cash
Benefit:
Reduces risk
Cost:
Increases financing costs
Benefit:
Reduces financing costs
Cost:
Increases risk


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Accounts Receivable
High Levels (favourable credit terms) Low Levels (unfavourable
terms)
Benefit:
Happy customers
High sales
Cost:
Expensive
High collection costs
Increases financing costs
Cost:
Dissatisfied customers
Lower Sales
Benefit:
Less expensive

Accounts Payable and Accruals
Benefit:
Reduces need for external finance--using a
spontaneous financing source
Cost:
Unhappy suppliers
Benefit:
Happy suppliers/employees
Cost:
Not using a spontaneous
financing source


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Current Assets High Level Low Level

Profitability Lower Higher
Risk Lower Higher


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OperationsThe Cash Conversion
Cycle

Firm begins with cash which then
becomes inventory and labour
Which then becomes product for sale
Eventually this will turn into cash again

Firms operating cycle is time from
acquisition of inventory until cash is
collected from product sales


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Figure 4.1: The Cash Conversion
Cycle
Product is
converted into
cash, which is
transformed into
more product,
creating the cash
conversion cycle.


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Figure 4.2: Time Line Representation
of the Cash Conversion
Cycle


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The Operating Cycle and the Cash
Conversion Cycle

Inventory conversion period
plus: Receivable collection period
equals: Operating cycle
minus: Payables deferral period
equals: Cash conversion cycle

Shortening cash conversion cycle frees up cash
to reinvest in business or to reduce debt and
interest


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Inventory
Conversion
Period
=
365
Inventory Turnover
Receivables
Collection
Period
=
Accounts Receivable 365
Annual Credit Sales
Cash Conversion Cycle Analysis
Payables
Deferral
Period
=
Accounts Payable 365
Cost of Goods Sold


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Cash Conversion Cycle
Purchase
Inventory
Pay for
Inventory

Sell Inventory
on Credit

Collect
Receivables
Operating Cycle
Inventory Conversion Period
Receivables Collection Period
Payables Deferral Period
Cash Conversion Cycle


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Figure 4.3: Working Capital
Needs of Different Firms


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Permanent and Temporary
Working Capital

Working capital is permanent to the
extent that it supports constant or
minimum level of sales

Temporary working capital supports
seasonal peaks in business


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Maturity Matching Principle

Maturity (due date) of financing should
roughly match duration (life) of asset
being financed
Then financing /asset combination becomes
self-liquidating
Cash inflows from asset can be used to pay off
loan


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Financing Net Working Capital
According to maturity matching principle
Temporary (seasonal) should be financed
with short-term borrowing
Permanent working capital should be
financed with long-term sources, such as
long-term debt and/or equity

In practice, firms may use more or less
short-term funds to finance working
capital


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Figure 4.4(a): Working Capital
Financing Policies


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Figure 4.4(b): Working Capital
Financing Policies


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Short-Term vs. Long-Term
Financing

The mix of short- or long-term working
capital financing is a matter of policy

Use of long-term funds is a conservative
policy
Use of short-term funds is an aggressive
policy


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Financing

Short-term financing
Cheap but risky
Cheapshort-term rates generally lower than
long-term rates

Riskybecause you are continually entering
marketplace to borrow
Borrower will face changing conditions (ex; higher
interest rates and tight money)


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Financing

Long-term financing
Safe but expensive

Safeyou can secure the required capital

Expensivelong-term rates generally higher
than short-term rates


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Working Capital Policy

Firm must set policy on following issues:
How much working capital is used
Extent to which working capital is supported
by short- vs. long-term financing
How each component of working capital is
managed
The nature/source of any short-term
financing used


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Cash Management

Cash managementdetermining:
Optimal size of firms liquid asset balance
Appropriate types and amounts of
short-term investments
Most efficient methods of controlling
collection and disbursement of cash


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Cash Management

Why have cash on hand?
Transactions demand: need money to pay bills
(employees, suppliers, utility/phone, etc.)

Precautionary demand: to handle emergencies
(unforeseen expenses)

Speculative demand: to take advantage of
unexpected opportunities (purchase of raw materials
that are on sale)


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Objectives of Cash Management
Cash doesnt earn a return
Want to maintain liquidity
Take cash discounts
Maintain firms credit rating
Minimize interest costs
Avoid insolvency
Good cash management implies maintaining
adequate liquidity with minimum cash in bank
Can place portion of cash balance into marketable
securities (AKA: near cash or cash equivalents)


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Marketable Securities

Liquid investments that can be held
instead of cash and earn a modest return

Examples include Treasury bills,
commercial paper, bankers acceptances

Many are bought and sold at a discount in
money market


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Examples of Marketable Securities
Treasury Bills
Short-term government notes issued at a
discount with principal repaid at maturity

Commercial Paper
Short-term unsecured promissory notes
issued by corporations with good credit

Bankers Acceptances
Short-term promissory notes issued by a firm
and accepted (or guaranteed) by a bank


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Yield on a Discounted Money Market
Security

Annualized yield
100 P 365
P d
where P = Discounted price as a
percentage of maturity value
d = Number of days to maturity
r = Annualized yield
r =


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Components of Float
Mail Float
delay between when cheque is sent to a payee and
is received by payee

Processing Float
time between receipt of payment by a payee and the
deposit of the payment in the payees account

Clearing Float
time between depositing a cheque and having
available spendable funds


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Cheque Disbursement and the
Cheque Clearing Process
When you pay a bill,
You write cheque and mail to payee (2-3
days of mail float)
Payee receives cheque and performs internal
processing (1 day of processing float)
Payee deposits cheque in its own bank (1 day
of processing float)
Payees bank sends cheque into interbank
clearing system which processes cheque (2
days of clearing float)


40
Figure 4.5: The Cheque-Clearing
Process


41
Lock-box systems
Post office box(es) located near customers in
order to shorten mail and processing float
Local bank empties the box, deposits payments
into firms account, and reports payments to firm

May involve significant fees

More cost-effective if small number of larger
deposits


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Figure 4.6: A Lock Box System in
the Cheque-Clearing Process


43
Concentration Banking
Customers send cheques sent to firms local
collection centres, where they are deposited

Local deposits are transferred electronically
into one central concentration account

Reduces mail float

Funds available for paying loans or investing
in marketable securities


44

Electronic funds transfer mechanisms
are reducing the importance of float
management techniques for many
companies


45
Wire Transfers
Transferring money electronically

Preauthorized Cheques
Customer gives payee signed cheque-like
documents in advance
When payee ships product, it deposits
preauthorized cheque in its bank account
Eliminates mail float
Payee must trust payer


46
Managing Cash Outflow
Zero balance accounts (ZBAs)
Decentralization of cash payments can lead to large
number of cash balances around the country

Divisions write cheques on ZBAsfunded from
central account only when cheques are cleared

Solves problem of idle cash in decentralized bank
accounts
Remote disbursing
Using bank in remote location for disbursement
chequing account
Increases mail float


47
Evaluating Cash Management
Services

Evaluation involves comparison of costs
versus benefits of faster collection


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Example 4.1: Evaluating Cash
Management Services
Q: Kelso Systems Inc. has customers in British Columbia that remit
about 500 cheques a year. The average cheque is for $10,000.
West coast cheques currently take an average of eight days
from the time they are mailed to clear into Kelsos east coast
account.
A British Columbia bank has offered Kelso a lock box system for
$1,000 a year plus $0.20 per cheque. The system can be
expected to reduce the clearing time to six days.
Is the banks proposal a good deal for Kelso if it borrows at 8%?

E
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Example 4.1: Evaluating Cash
Management Services
A: The cheques represent revenue of: 500 $10,000 =
$5,000,000 per year.
The average amount tied up in the cheque clearing process is:
8/365 x $5,000,000 = $109,589.
The proposed lockbox system will reduce this to: 6/365 x
$5,000,000 = $82,192, thus freeing up $27,397 of cash.
Kelso will be able to borrow $27,397 less, thus saving: $27,397
x 0.08 = $2,192 in interest
The system is expected to cost: $1,000 + ($0.20 x 500) =
$1,100.
The net saving is: $2,192 - $1,100 = $1,092
The banks proposal should be accepted
E
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50
Generally firms like as little money as possible
tied up in receivables
Reduces costs (firm has to borrow to support the
receivable level)
Minimizes bad debt exposure

But, having good relationships with customers
is important
Increases sales

Firm needs to strike a balance on these issues


51
Trade-offs in Receivable
Management
Liberal Management
More sales and gross
margin, but
More bad debts
Higher collection costs
More discount
expenses
Higher receivables
Longer collections
More interest expense

Strict Management
Less sales and gross
margin, but
Less bad debts
Lower collection costs
Less discount
expenses
Lower receivables
Shorter collections
Less interest expense

Trade-offs in Managing Accounts
Receivable


52
Policy Decisions Influencing Accounts
Receivable
Credit Policy
Criteria used to screen credit applications
Controls quality of accounts to which credit is extended
Terms of Sale
Terms and conditions under which credit extended must be
repaid
Collections Policy
Methods employed to collect payment on past due accounts


53
Credit Policy
Must examine creditworthiness of potential
credit customers
Credit report
Customers financial statements
Bank references
Customers reputation among other vendors

Conflicts often arise between sales and credit
departments
Sales departments job to generate sales
Credit department may refuse credit to high risk
accounts


54
Terms of Sale
Credit sales are made according to
specified terms of sale
Example: 2/10, net 30 means customer
receives 2% discount if payment is made
within 10 days, otherwise entire amount is
due by 30 days

Customers pay quickly to save money
Firms terms of sale generally follow
industry practice


55
Collections Policy
Firms collection policymanner and aggressiveness
with which firm pursues payment from delinquent
customers
Being overly aggressive can damage customer relations

Function of collections department to follow up on
overdue receivables (called dunning)
Mail polite letter
Follow up with additional dunning letters
Phone calls
Collection agency
Lawsuit


56
Inventory Management
Inventory management establishes a balance
between carrying enough inventory to meet
sales or production requirements while
minimizing inventory costs

Inventory usually managed by manufacturing
or operations
However, finance department has an oversight
responsibility
Monitor level of lost or obsolete inventory
Supervise periodic physical inventories


57
Benefits and Costs of Carrying
Adequate Inventory
Benefits
Reduces stockouts and backorders
Makes operations run more smoothly, improves customer
relations and increases sales

Carrying Costs
Interest on funds used to acquire inventory
Storage and security
Insurance
Taxes
Shrinkage
Spoilage
Breakage
Obsolescence


58
Inventory Ordering Costs
Inventory ordering costs
Expenses of placing orders with suppliers,
receiving shipments, and processing
materials into inventory
Excludes vendor charges

Relate to the number of orders placed
rather than to the amount of inventory held

Tend to vary inversely with carrying costs


59
Economic Order Quantity (EOQ)
Model

EOQ model recognizes trade-offs between
carrying costs and ordering costs
Carrying costs increase with amount of inventory
held ( from larger orders)
Ordering costs increase with the number of orders
placed (from more orders)

EOQ minimizes total of sum of ordering and
carrying costs


60
Inventory Costs and the EOQ
Q (Order Size)
Cost
($)
Total
Cost
EOQ
Carrying
Cost
Ordering
Cost


61
Model

EOQ model is:

where
Q= order size in units
D= annual quantity used in units
F= cost of placing one order
C= annual cost of carrying one unit in stock
denotes square root

| |
c
2FD
Q=


62
Figure 4.7: Inventory on Hand for a
Steadily Used Item


63
Model
Other Inventory Formulas

Average Inventory =

Total Carrying Cost: =

Number of Orders =

Total Ordering Cost = FN =

Total Ordering and Carrying Cost =

2
Q
| |
|
\ .
Q
c
2
| |
|
\ .
D
N=
Q
D
F
Q
| | | |
| |
\ . \ .
Q D
TC=c +F
2 Q


64
Example 4.3: Economic Order
Quantity
E
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p
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Q: The Galbraith Corp. buys a part that costs $5. The carrying
cost of inventory is approximately 20% of the parts dollar value
per year. It costs $50 to place, process and receive an order.
The firm uses 900 of the $5 parts per year.

What ordering quantity minimizes inventory costs?
How many orders will be placed each year if that order quantity
is used?
What inventory costs are incurred for the part with this ordering
quantity?


65
Example 4.3: Economic Order
Quantity
E
x
a
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A: Annual carrying cost per unit is 20% x $5 = $1

EOQ = 300 units
The annual number of reorders is 900 300 = 3
Ordering costs are $50 x 3 = $150 per year
Average inventory is 300 2 = 150 units
Carrying costs are 150 x $1 = $150 a year
Total inventory cost of the part is $300

( )( )
| |
1
900 50 2
Q =


66
Safety Stocks, Reorder Points and
Lead Times
Safety stock provides insurance against
unexpectedly rapid use or delayed
delivery
Additional supply of inventory that is carried
at all times to be used when normal working
stocks run out
Rarely advisable to carry so much safety
stock that stockouts never happen
Carrying costs would be excessive


67
Safety Stocks, Reorder Points and
Lead Times

Ordering lead timeadvance notice
needed so that an order placed will arrive
when required
Usually estimated by items supplier

Reorder pointlevel of inventory at
which order is placed


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Figure 4.9: Inventory on Hand
Including Safety Stock


69
Model
Other Inventory Formulas (with Safety
Stock)
Average Inventory =

Total Carrying Cost: =

Total Ordering and Carrying Cost =

Stock Safety
2
Q
+
| |
+
|
\ .
Q
c Safety Stock
2
| | | |
+
| |
\ . \ .
Q D
TC=c SafetyStock +F
2 Q


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Tracking InventoriesThe ABC
System
Some inventory items (A items) require great
deal of attention
Very expensive
Critical to firms processes or to those of customers

Some inventory items do not require great deal
of attention (C items)
Commonplace, easy to obtain

B items fall between items A & C

ABC system segregates items by value and
places tighter control on higher cost (value)
pieces


71
Just In Time (JIT) Inventory
System
Inventory supplied
At exactly the right time
In exactly the right quantities

Theoretically eliminates the need for factory inventory
Shortens operating cycle
Reduces costs
Eliminate wasteful procedures
But: late delivery can stop factorys entire production line

Works best with large manufacturers who are powerful
with respect to supplier
Supplier is willing to do almost anything to keep the
manufacturers business

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