Liquidity

Management

22

Corporate Financial Management 3e

Emery Finnerty Stowe
Prentice Hall, 2004

Working Capital Management

Working capital
= current assets current liabilities
Working capital management refers to
choosing the levels and mix of:
cash, marketable securities, receivables and
inventories.
different types of short-term financing.

Considerations in Working
Capital Management
Sales impact
Liquidity
Relations with stakeholders
suppliers
customers

Short-term financing mix

profitability
risk considerations

Working Capital Management

Maturity matching approach
Conservative approach
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

$

Temporary Current Assets

ets
s
s
A
t
n
e
urr
C
t
n
e
n
Perma

Fixed Assets

Short Term
Financing

Long
Term
Financing

Time

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.

Conservative Approach
$

Temporary Current Assets

ets
s
s
A
t
ren
r
u
C
t
en
n
a
m
r
Pe
Marketable
securities

Fixed Assets

Short Term
Financing

Long
Term
Financing

Time

Aggressive Approach
Use less long-term and more short-term
financing than the conservative approach.

Aggressive Approach
$

Temporary Current Assets

Short Term
Financing

ets
s
s
A
t
n
rre
u
C
t
n
e
Perman
Fixed Assets

Long
Term
Financing
Time

Cost and Risk Considerations

Yield curve is usually upward sloping.
Short-term rates are more volatile than
long-term rates.
Firm's ability to obtain needed short-term
financing.

Cash Conversion Cycle

The cash conversion cycle is the length of time
between payment of accounts payable and the
receipt of cash from accounts receivable.

Cash Conversion Cycle

Purchase
Inventory

Sale on
Credit

Inventory Conversion Period

Collect Acct.
Receivable

Receivables Collection
Period
Time

Payables
Deferral Period

Payment of
Accts. Payable

Cash Conversion Cycle

Cash Conversion Cycle

Cash
Inventory Receivables Payables
conversion conversion collection deferral
cycle

period

period

period

Inventory Conversion Period

The inventory conversion period is the length of
time from the purchase of inventory to the time
the sales are made on credit.

Inventory
Inventory
365
conversion

Cost of Sales/365 Inventory turnover

period

Receivables Collection Period

The receivables collection period is the
average number of days it takes to collect
on accounts receivable.

Equal to days sales outstanding (DSO)

Receivables
Receivables
365
collection

Sales/365
Receivables turnover
period

Payables Deferral Period

The payables deferral period is the average
length of time between the purchase of materials
and labor and the payment of cash for the same.

Payables
deferral
period
Accounts payable Wages, benefits, payroll taxes payable
(Cost of sales Selling, general and administrative expenses)/365

Cash Conversion Cycle

Given the following information about Vision
Opticals, compute the firms cash conversion cycle.
Inventory
Accounts Receivable
Accounts Payable
Wages, Benefits, Payroll Taxes
Sales
Cost of Sales
Selling & Other Expenses

$19,000
$21,000
$5,600
$9,000
$227,000
$93,000
$22,000

Inventory Conversion Period

Inventory
conversion
period

Inventory
365

Cost of Sales/365 Inventory turnover

Inventory
conversion
period

$19,000
74.57 days
$93,000/365

Receivables Collection Period

Receivables
Receivables
365
collection

Sales/365
Receivables turnover
period
Receivables
$21,000
collection
33.77 days
$227,000/365
period

Payables Deferral Period

Payables
deferral
period
Accounts payable Wages, benefits, payroll taxes payable
(Cost of sales Selling, general and administrative expenses)/365
$5,600 $9,000

46.34 days
($93,000 $22,000) / 365

Cash Conversion Cycle

Cash
Inventory Receivables Payables
conversion conversion collection deferral
cycle

period

period

period

Cash
conversion 74.57 days 33.77 days 46.34 days
cycle
62 days

Cash Management
How much liquidity (cash plus marketable
securities) should the firm have?
What should be the relative proportions of
cash and marketable securities?

Demands for Cash

Transactions demand
Precautionary demand
Speculative demand
Compensating balances

Short-Term Investment
Alternatives
U.S. Treasury securities

T-bills, T-notes, and T-bonds

U.S. federal agency securities

Negotiable certificates of deposit
Short-term tax-exempt municipals
Bankers acceptances
Commercial paper
Preferred stock & money market preferred stock

Other Factors in Cash

Management
Compensating balance requirements
Optimal amount of marketable securities
transaction costs
maturity
risk
yield

Special tax situations

Float
Float is the difference between the available (or
collected) balance at the bank and the firms book
or ledger balance.
Disbursement float occurs when the firm writes a
check but the check has not yet cleared the
banking system.
Collection float occurs when a check has been
deposited but the funds are not yet credited to the
firms bank account.

Float Management Techniques

Wire transfers
Zero balance accounts (ZBAs)
Controlled disbursing
Centralized processing of payables
Lockboxes

Lockbox Systems
Discount Music Stores is evaluating a lockbox
system which will reduce float by 3 days. The
lockbox system costs $15,000 per year. The
firms daily collections average $150,000, and
its opportunity cost of funds is 6% per year.
Should the firm utilize this lockbox system?

Lockbox Systems
Funds freed up due to a reduction in float =
(3 days)($150,000 per day) or $450,000.
Annual value of float reduction =
$450,000(6%) = $27,000.
After deducting the $15,000 cost of the
lockbox system, the firm nets $12,000
before taxes.

Short-Term Financing
Trade Credit
Secured and Unsecured Bank Loans
Commercial Paper

Cost of Trade Credit

Discount Music Stores buys its inventory on 3/10,
net 30 terms. What is the cost of not taking the
discount?
Suppose DMS buys $1,000,000 worth of inventory; if they forgo
the 3% discount to pay on day 30 they are borrowing $970,000
for 20 days and paying $30,000 interest:

+$970,000

$1,000,000

10

30

Cost of Trade Credit: APY vs. APR

Discount %

APY 1

100% Discount %

Discount %

APR
100% Discount %

365
Total Period Discount Period

365

Total Period - Discount Period

Cost of Trade Credit: APR

+$970,000

$1,000,000

10

30

$30,000
APR

$
970
,
000

365
20 days

APR 56.44%

Cost of Trade Credit: APY

+$970,000

$1,000,000

10

30

$1,000,000
$970,000
(1 r ) 20 365

$1,000
r

$970

(1 r )
365
20

20 365

$1,000

$970

1 0.7435 74.35%

Effective Use of Trade Credit

Advantages:
Readily available
Informal
Flexible
Stretching payments

Disadvantages
High cost of discounts foregone
Stretching of payments can hurt reputation

Bank Loans
Short-term unsecured loans
Transaction loan
Line of credit
Revolving credit agreement

Term loans
Bullet maturity
Balloon payment

Cost of Bank Loans

Prime rate + spread
LIBOR + spread
Compensating balances

Compensating Balance
Requirements
Let

P = amount of loan
f = loan term
r = interest rate on loan
B = incremental cash balance as a result of
compensating balance requirements
y = interest earned (if any) on compensating balances

Interest charges = rPf

Interest received = yBf

Compensating Balance
Requirements

Interest charges - Interest received 1

APR
f
Loan
amount
compensati
ng
balance

rPf yBf

PB

1
f

Compensating Balance
Requirements
Custom Controls is considering a 1-year loan
of $150,000 at an interest rate of 14%. Due to
compensating balance requirements, Custom
Controls will have to maintain a deposit
balance of $20,000 which it would not have
otherwise maintained at the lending bank. The
deposit will earn 6% per year.
What is the APR of this loan?

Compensating Balance
Requirements
rPf yBf
APR
PB

1
f

0.14 $150,000 0.06 $20,000

APR

$
150
,
000

$
20
,
000

= 15.23%
Without the 6% yield on the compensating balance,
the APR = 16.15%

1
1

Discount Loans
The interest charge is deducted in advance for
discount loans.

Let
r = interest rate on the loan
f = the term of the loan
P = the principal amount
The APR of a discount loan is given by:

rPf 1
r
APR

P rPf f 1 fr

A Comparison of Single Payment

Loans
Ole Tools Inc. needs to borrow $5,000 for 6 months.
Four single payment loan alternatives are available as
shown below. In each case, the interest rate is 15% per
year. Compute the APR and APY of each alternative.
Loan

Interest Payment

Compensating
Balance

A
B
C
D

in arrears
in arrears
in advance
in advance

No
Yes (10%)
No
Yes (10%)

A Comparison of Single Payment

Loans
Interest charge on the loan is
$5,000 (.15) (0.5 years) or $375.
For loans A & B, this amount is added to the
repayment at loan maturity.
For discount loans (loans C & D), this amount is
deducted from the loan amount at loan initiation.

Compensating balances (for loans B & D), is

$5,0000.10 = $500.

A Comparison of Single Payment Loans

Loan
A
B
C
D

CF0
$5,000

CF1

APR

375
($5,375) APR

$
5
,
000

1
.5 15%

$4,500

375 1
16.67%
($4,875) APR

$4,500 .5

$4,625

$375
($5,000) APR $4,625

1
.5 16.22%

$4,125

$375
($4,500) APR $4,125

1
.5 18.18%

A Comparison of Single Payment Loans

Loan

CF0

CF1

$5,000

($5,375)

APR
15.00%

APY

$5,375
15.56% $5,000 1

$4,500

($4,875)

16.67%

$4,875
17.36%
1
$4,500
2

$4,625

($5,000)

16.22%

$5,000
16.87%
1
$4,625
2

$4,125

($4,500)

18.18%

$4,500
1
19.01%
$4,125

Discounted Installment Loans

Sheridan Systems borrows $12,000 for 3
months at 15%. The interest is paid in
advance, and Sheridan will pay the loan in 3
monthly installments of $3,000 at the end of
the first two months and $6,000 at the end of
the third month.
Compute the APY and APR of this loan.

Discounted Installment Loans

The interest cost of this loan is ($12,000)
(15%)(3/12 years) or $450.
Since the interest is deducted in advance,
Sheridan will get $12,000 - $450 or $11,550
at loan initiation.

Discounted Installment Loans

+$11,550

$3,000

$3,000

$6,000

$3,000 $3,000 $6,000

$11,550

2
1 r
(1 r ) (1 r ) 3

r 1.72% per month

APR 12 0.0172 20.6%
APY (1.0172)12 1 22.68%

Commercial Paper
Commercial paper is a negotiable business IOU
note.
It is sold by the largest, most creditworthy firms
on a discount basis.
Maturity is set to less than 270 days.

Registration with the SEC is not required.

40% of commercial paper is sold through dealers.

Commission of about 0.125% on an annualized basis.

Factors Affecting the Short-Term

Financing Mix
Cost of each source of funds / inclg options
Desired level of current assets
Seasonal component of current assets
Extent of maturity-matching
Flotation costs
Restricted access to long-term capital
Bankruptcy costs
Firm's choice of risk level