CH 16 - 8e WRL PPT REVISED

Chapter Sixteen – Working Capital
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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
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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
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
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
Inventory
High Levels Low Levels
Benefit: Cost:
Happy customers – supplied quickly Shortages
Few production delays (parts always on hand) Dissatisfied customers –
Cost: product not available
High financing costs Benefit:
High storage costs Low financing and storage
Shrinkage (theft) costs
Risk of obsolescence Less risk of obsolescence
Cash
Benefit: Benefit:
Reduces risk of being unable to pay bills Reduces financing costs
Cost: Cost:
Increases financing costs Increases transaction risk
Objective of Working Capital Management
Accounts Receivable
Benefit: Cost:
Happy customers –can pay slowly Customers unhappy with
High credit sales payment terms
Cost: Lower Credit Sales
More bad debts Benefit:
High collection costs Less financing cost
Increased financing costs
Payables and Accruals

Benefit: Benefit:
Spontaneous financing reduces need to borrow Happy suppliers/employees
Cost: Cost:
Unhappy suppliers because paid slowly Not using spontaneous financing
Figure 16-1 Cash Conversion Cycle
Figure 16-2 Timeline Representation of Cash
Conversion Cycle
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otherwise on a password-
Permanent 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
Figure 16-3 Working Capital Needs of
Different Firms
Financing Net Working Capital
Short-term working capital should be
financed with short-term sources
Maturity Matching Principle – the

term of financing should match the
term or duration of the project or
item supported
Short-Term vs. Long-Term Financing in
Support of Working Capital
Long-term financing Short-term financing
Safe but expensive Cheap but risky

– Safe – funds are – Cheap - short-term
committed and interest rates are
can’t be withdrawn generally lower
– Expensive - long- – Risky - must
term rates are continually renew
generally higher borrowing
Alternative Financing Policies
The mix of short/long-term financing
supporting working capital
– Heavier use of longer term funds is
conservative
– Using more short-term funding is
aggressive
Figure 16-4a Working Capital
Financing Policies
Figure 16-4b Working Capital
Financing Policies
Working Capital Policy
A firm’s Working Capital Policy refers
to its handling the following issues:
– How much working capital is used
– Extent supported by short or long term
financing
– The nature and source of any short-term
financing used
– How each component is managed
Sources of Short-term Financing
Spontaneous financing
– payables and accruals
Unsecured bank loans
Commercial paper
Secured loans
Spontaneous Financing
Accruals Accounts Payable
– Interest–free loans – Effectively loans from
from whoever suppliers selling on
provides services credit
deferring payment – Credit Terms:
– Wage Accrual Specify details of
Money owed to payment
employees for E.g. 2/10, net 30
work performed 2% discount if pay
but not yet paid within 10 days,
otherwise entire amount
due in 30 days
Prompt Payment Discount
Passing up prompt payment

discounts is an expensive source of
financing
If terms are 2/10, net 30, and don’t pay by the 10th day,
essentially paying 2% for 20 days’ use of money
The implied annual rate is
(365 / 20) x 2% = 36.5%
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
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
Unsecured Bank Loans
Represent the primary source of
short-term financing for most
companies
Unsecured  Repayment is not
guaranteed by the pledge of a specific
asset
Promissory Note – Written promise
to repay amount borrowed plus
interest
Revolving Credit Agreement
Similar to a line of credit except bank
guarantees availability of funds up to
a maximum amount
– Borrower pays a commitment fee on the
unborrowed balance
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 0.25%.
What bank charges will Arcturus incur for the month of June?
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 × .000208 × [15/30]) = $ 624
($4,000,000 × .000208 × [15/30]) = $ 416
$1,040
So, total bank charges for June are $51,040
Compensating Balances
Minimum Balance Average Balance

Requirement Requirement
A percentage of the Average daily balance

loan amount must be over a month cannot
left in the borrower’s fall below a specified
account at all times level
and is not available Entire balance can be
for use used – but not all at
once
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
Commercial Paper
Notes issued by large, financially-
strong firms and sold to investors
– Basically a very short-term corporate
bond
Unsecured
Buyers are usually institutions
Maturity less than 270 days
Considered a very safe investment
Interest is discounted – no coupon
Rigid and formal - no flexibility in repayment
terms
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
Short-Term Credit Secured
by Current Assets
Receivables Financing
– Accounts receivable - money to be 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
Pledging Accounts Receivables
Kilraine’s $100,000 receivables balance of turns over

every 45 days. The firm pledges all receivables to a finance
company, which advances 75% of the total at prime plus 4%
plus a 1.5% administrative fee.
Prime is 8%, what interest rate is Kilraine effectively
paying for its receivables financing?
Pledging Accounts Receivables
Solution:
Traditional interest
8% + 4% = 12%
Administrative charge
Average loan balance
$100,000 × .75 = $75,000
Accounts offered to finance
company
$100,000 x 360/45 =
$800,000
The administrative fee at 1.5%
1.5% x $800,000 = $12,000
Fee as a percentage of loan
balance
$12,000  $75,000 = 16%
© 2017 Cengage Learning®. Total financing
May not be scanned, charges
copied or duplicated, or posted to a publicly accessible website, in whole
16% + with
or in part, except for use as permitted in a license distributed 12%a certain
= 28%. product or service or34otherwise on a password-
Factoring Receivables
Firm sells receivables at a discount to a
factor that takes control of accounts
– Accounts Receivable are paid directly to factor
– Factor accepts only creditworthy customer
accounts
– Factors offer a wide range of services all for fees
Perform credit checks on potential customers
Advance cash on accounts before collection or
remit cash after collection
Collect cash from problem customers
Assume bad-debt risk when customers don’t pay
– Factoring is usually very expensive financing
Inventory Financing
Inventory Financing
– Inventory is collateral for loans
– Repossessed items may be difficult for
lender to sell
– Inventory in borrower’s hands is hard for
lender to control
Blanket liens
Chattel mortgage agreements
Warehousing
– Field and public
Cash Management
Motivation for Holding Cash
– Transactions demand
– Precautionary demand
– Speculative demand
– Compensating balances
Objective of Cash Management
Business cash balances earn little or
no interest
– Firms generally borrow to support cash
balances
But it is easier to do business with
plenty of cash - Liquidity
Objective: Strike a balance
– Operate efficiently at a reasonable cost
Marketable Securities
Some assets are only slightly less
liquid than cash, and earn a return
– Treasury bills
– Other short term securities issued by
stable organizations
Held as a substitute for cash
Cash Transfers
Figure 16-5 The Check-Clearing
Process
Check Disbursement and
Collection Procedures
Float: money tied up in the check
clearing process
– Mail float
– Transit float
– Processing float
Use of Cash - Payers versus Payees
– Payers want to extend float periods
– Payees want to reduce float periods
“Check 21”
Traditional check processing shipped
paper checks around the country
Check Clearing for the 21st Century
Act – Known as “Check 21”
– Banks may now “truncate” checks
Replaced with electronic checks
Paper facsimiles available when needed
Has sped up clearing process
– Fed paper check processing locations
reduced from 45 to 1
Accelerating Cash Receipts
Lock-box systems
– Service provided by banks to accelerate
collections
Concentration Banking
– Sweep excess balances in distant
depository accounts into central
locations daily
Figure 16-6 A Lock Box System in the
Check-Clearing Process
Accelerating Cash Receipts
Wire Transfers Preauthorized Checks

– Transfers money – Customer gives the payee
electronically signed check-like documents
in advance
– Payee deposits it in its bank
account once product is
shipped
Managing Cash Outflow
Control Issues
– Centralized/decentralized
Zero Balance Accounts (ZBAs)
– Empty disbursement account at firm’s
concentration bank for its divisions
Remote Disbursing
– A way to extend mail float
Evaluating Lock-Box Systems
Kelso is located on the East Coast, but has
California customers that remit 5,000, $1,000
checks a year that take eight days to clear.
A California bank offers a lock box system for

$2,000 a year plus $0.20 per check, which will
reduce clearing time to six days. Is the proposal
a good deal if Kelso borrows at 12%?
Evaluating Lock-Box Systems
Solution:
Kelso’s float now
[(8 / 365) x $5,000,000] = $109,589
Float under proposed lockbox system
[(6 / 365) x $5,000,000] = $82,192
Interest on cash freed up
[$27,397 x 0.12] = $3,288
System cost
[$2,000 + ($0.20 x 5,000)] = $3,000,
Conclusion: Proposal is marginally worth doing.
Managing Accounts Receivable
Objectives and Policy
– Higher receivables means selling to
financially weaker customers and not
pressuring them to pay promptly
Higher sales but also more bad debts
Objective is to max profit, not revenue
Receivables Policy involves:
– Credit Policy
– Terms of Sale
– Collections Policy
Determinants of
Receivables Balance
Credit Policy
– Examine creditworthiness of potential
credit customers
– Tight credit policy = lower sales
– Loose credit policy = high bad debts
– Conflict between sales and credit
departments
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
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
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
Benefits and Costs of Carrying
Adequate Inventory
Benefits Costs
– Reduces – Interest on funds used to
stockouts and acquire inventory
backorders – Storage and security
– Makes operations – Insurance
run more – Taxes
smoothly – Shrinkage - theft
– Improves – Spoilage
customer relations – Breakage
– Increases sales – Obsolescence
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
Economic Order Quantity
(EOQ) Model
EOQ – An inventory cost minimization model
– Carrying Cost – Annual cost of holding a unit in
inventory
– Ordering Cost – Fixed cost of placing an order
and receiving the goods
– Objective: Find the order size that minimizes

the sum of Carrying and Ordering Costs
Figure 16-7 Inventory on Hand for a
Steadily Used Item
EOQ Variables and Formula
C = Annual Carrying Cost per Unit
F = Fixed Cost per Order
D = Annual Demand in Units
Q = Order Quantity
Carrying Cost = cost per unit × average units

= C × (Q / 2)
Ordering Cost = Cost per order × Orders per year
= F × (D / Q)
Total Cost = Carrying Cost + Ordering Cost
Q D
TC  C  F
2 Q
Figure 16-8 Inventory Costs and the
EOQ
Q D
Total Inventory Cost: TC  C  F
2 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
Solution is a basic maximization problem from calculus
1
 2FD  2
EOQ  
 C 
1
 2  Fixed Cost per Order  Annual Demand  2
EOQ =  
 Annual Carrying Cost per Unit 
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?
Economic Order Quantity (EOQ) Model
Solution: C = $5 × .20 = $1
F = $45
D = 1,000
1
 2  $45  1,000  2
EOQ =   = 300 units
 $1 
Annual number of orders = 1,000 / 300 = 3.33.
Carrying costs = $5 × .2 × (300/2) = $150 per year
Ordering costs = $45 x 3.333, = $150 per year
Total inventory cost = $150 + $150 = $300 per year
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
Figure 16-9 Pattern of Inventory
on Hand
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
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
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

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Chapter Sixteen – Working Capital

Gross Working Capital represents an

Payables and Accruals

Maturity Matching Principle – the

Long-term financing Short-term financing

Safe but expensive Cheap but risky

Passing up prompt payment

The implied annual rate is

(365 / 20) x 2% = 36.5%

Prior to June 1, it took down $4M that remained outstanding for

Prime is 9.5% and the bank’s commitment fee is 0.25%.

Minimum Balance Average Balance

A percentage of the Average daily balance

Kilraine’s $100,000 receivables balance of turns over

Wire Transfers Preauthorized Checks

A California bank offers a lock box system for

Collection policy: manner and aggressiveness with

Inventory: product held for sale

– Objective: Find the order size that minimizes

Carrying Cost = cost per unit × average units

How many orders will be placed each year if that

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