Chapter 24 - Working Capital Management - Current Assets and ...

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Nov 18, 2013 (4 years and 1 month ago)

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INTRODUCTION TO


CORPORATE FINANCE

Laurence Booth


W. Sean Cleary


Chapter 24


Working Capital
Management: Current Assets and Current
Liabilities

CHAPTER 24



Working Capital Management:
Current Assets and Current
Liabilities

CHAPTER 24


Working Capital Management


Current Assets
and Current Liabilities

24
-

3

Lecture Agenda


Learning Objectives


Important Terms


Cash Management


Reasons for Holding Cash


Determining the Optimal Cash Balance


Cash Management Techniques


Accounts Receivable Management


The Credit Decision


Credit Policies


The Collection Process


Inventory Management


Inventory Management Approaches


Evaluating Inventory Management


Short
-
Term Financing Considerations


Summary and Conclusions


Concept Review Questions

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Working Capital Management


Current Assets
and Current Liabilities

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Learning Objectives

You should understand the following:


How to manage individual asset items, such as cash,
receivables, and inventory


The nature of the major sources of short
-
term financing, such
as trade credit, bank loans, factoring arrangements, and
money market securities


The fact that in evaluating current asset and current liability
decisions, the final decision rests on the standard problem of
trading off expected benefits and potential costs


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Important Chapter Terms


ABC approach


Capacity


Character


Conditions


Credit analysis


Credit enhancements


Economic Order Quantity


Factoring arrangements


Finance motive


Float


Just
-
in
-
time inventory
systems


Materials requirement
planning


Open account


Optimal cash balance


Precautionary motive


Prepayments


Securitization


Special purpose vehicles


Speculative motive


Terms of credit


Transactions motive

Cash and Marketable Securities

Working Capital Management

Current Assets and Current Liabilities

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Cash and Marketable Securities

Reasons for Holding Cash

1.
Transactions motive

2.
Precautionary motive

3.
Finance motive

4.
Speculative motive


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Cash and Marketable Securities

Determining the Optimal Cash Balance


The optimal cash balance is the amount of cash
that balances the risks of illiquidity against the
sacrifice in expected return that is associated
with maintaining cash.


Differs substantially across firms


Firms with predictable cash flows will have lower optimal
cash balance requirement


Firms with excess borrowing capacity (unused line of credit
for example) can hold less cash.


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Cash and Marketable Securities

Cash Management Techniques


Cash flow synchronization can free up cash (and lower
the amount of capital a firm requires)


This is done by:


Speeding up cash inflows:


Bill clients earlier each month


Increase cash sales through incentives


Encourage customers to pay using electronic payments systems
such as direct deposit, automatic debit, debit card, rather than
cheque.


Delaying outflows:


Arrange with suppliers for more liberal trade credit terms (net 40
rather than net 30 for example)


Paying employees once a month rather than twice.


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Cash Managements

Float


Float is the time that elapses between the time the
paying firm initiates payment, and the time the funds
are available for use by the receiving firm.


It has three major sources:

1.
The time it takes the cheque to reach the firm after it is mailed by
the customer.

2.
The time it takes the receiving firm to process the cheque and
deposit in an account, and

3.
The time it takes the cheque to clear through the banking system
so that the funds are available to the firm.


Float has been reduced or eliminated through:


Debit cards


Preauthorized payments


Electronic funds transfer (EFT) and electronic data interchange
(EDI) systems.


Accounts Receivable

Working Capital Management

Current Assets and Current Liabilities


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Accounts Receivable

1.
The decision to extend credit to customers has
significant cash flow and credit risk implications for the
firm.


Firms often don’t have a choice, if the availability of credit is an
important factor in the customer’s purchase decision process (if
competitors offer credit, then the firm must at least match those
credit terms, and then choose to compete on another basis.)

2.
The second decision (once the firm has decided to
extend credit) is to determine which customers will be
granted credit.

3.
The credit terms must be established.

4.
The collection process must be decided.



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Accounts Receivable

The Credit Decision


The decision to extend credit is determined:


Nature of the product sold,


The industry


Practices of competitors.



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Accounts Receivable

Credit Analysis


The process designed to assess the risk of non
-
payment
by potential customers, which involves collecting
information about potential customers with respect to
their credit history, their ability to make payments as
reflected in their expected cash flows, and their overall
financial stability.


From the firm’s point of view:


Often willing to extend credit on terms better than a bank
because:


The potential for the firm developing a good customer into the
future, and


Losses are limited to production costs in the case of default.



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Accounts Receivable

Credit Analysis


Variables that are weighed in the credit analysis
process:



Capacity


the customer’s ability to pay


Character


the customer’s willingness to pay


Collateral


the security that could be seized to satisfy
payment


Conditions


the state of the economy.



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Accounts Receivable

Credit Policies


The firm must choose what terms of credit to
offer its customers.


Terms of credit include:


The due date


The discount amount (if any)


Options include:


Cash on delivery (COD)


Cash before delivery (CBD)


Net 30, net 40
-

no incentive for early payment


2/10 net 30
-

a 2% discount for early payment


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Accounts Receivable

Change in Credit Policy Analysis


When extending more lenient credit terms the firm hopes to
increase revenues through the sale of more units, and
perhaps even charge higher prices.


These benefits are offset by financing costs and the increased
risk of non
-
payment.


Evaluation of these decisions can use an NPV framework:



CF

-

CFs)

PV(Future
NPV
0

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Accounts Receivable

The Collection Process


The firm must monitor outstanding A/R by customer and
by category.


The firm must then determine what action it will take
when late payments occur.


Charge interest on outstanding balances


Notify customer of arrears (email, mail, telephone)


Actions on unpaid amounts:


Allow no further purchases on credit


Choose from a number of additional options to collect:

1.
Take legal action

2.
Sell receivable to a collection agency

3.
Write off the debt as uncollectable.


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Accounts Receivable

Factoring


It may not be cost
-
effective for a firm to
manage the collection process itself.



Factoring arrangements are the sale of a firm’s
receivables, at a discount, to a financial
company called a factor, which specializes in
collections, or the out
-
sourcing of the
collections to a factor.


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Evaluating Receivables Management


Use of productivity ratios introduced in Chapter
4 can give a tool for evaluating the firm’s ability
to manage its accounts receivable.

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Evaluating Receivables Management

Receivables Turnover


Measures the sales generated by every dollar of
receivables.


Receivable

Accounts
Sales


turnover
s
Receivable



RT
AR
S
[4
-

16]

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Evaluating Receivables Management

Average Collection Period


Estimates the number of days it takes a firm to collect on
its accounts receivable.









If ACP is 40 days, and the firm’s credit policy is net 30,
clearly, customers are not paying in keeping with the
firm’s policy, and there may be concerns about the
quality of the firm’s customers, and what might happen if
economic conditions deteriorate.


turnover
s
Receivable
AR

Turnover

s
Receivable
365


Period

Collection

Average




ACP
ADS
AR
[4
-

17]

Inventory

Working Capital Management

Current Assets and Current Liabilities


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Inventory


The level of inventory a firm holds is a trade off between
benefits and costs:


Benefits of Holding Inventory:


Take advantage of large
-
volume discounts


Reduce the probability of production disruptions because of lack of
inventory


Minimize lost sales because of stock
-
outs

Costs of Holding Inventory:


Financing costs associated with inventory investment


Storage, handling, insurance, spoilage and obsolescence costs.


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Inventory

Inventory Management Approaches


ABC Approach


Economic Order Quantity (EOQ) Model


Materials Requirement Planning (MRP)


Just
-
in
-
time (JIT) Inventory systems.


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Inventory

Evaluating Inventory Management


Use of financial ratios can give some indication
of the effectiveness of a firm’s inventory
management.


Ratios, however, do not measure shortage
costs, financing costs, etc.


These ratios include:


Inventory turnover


Average day’s sales in inventory.



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Productivity Ratios

Inventory Turnover


Estimates the number of times, ending inventory was
‘turned over’ (sold) in the year.








A ratio that involves both ‘stock’ and ‘flow’ values


Is strongly a function of ending inventory
value…managers often try to improve this ratio as they
approach year end through inventory reduction
strategies (cash and carry sales/inventory clearance,
etc.)



Turnover
Inventory

INV
CGS

[4
-

18]

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Productivity Ratios

Inventory Turnover


When Cost of Goods Sold is not available, it may be
necessary to estimate inventory turnover using sales.







Use of the sales figure is less valid than Cost of Goods
Sold because Cost of Goods Sold is based on inventoried
cost, but Sales includes a profit margin on top of
inventoried cost.



Turnover
Inventory

INV
Sales

[4
-

19]

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Productivity Ratios

Average Days Sales in Inventory (ADSI)


Estimates the number of days of sales tied up in
inventory (based on ending inventory values)

turnover
Inventory
ADS
INV
365



(ADSI)
inventory
in

sales

days

Average



[4
-

20]

Short
-
Term Financing Considerations

Working Capital Management

Current Assets and Current Liabilities


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Short
-
Term Financing Considerations


Investment in current assets tend to rise and
fall with the volume of activity.


Accruals and accounts payable (trade credit)
are ‘spontaneous’ liabilities.


Other sources of financing must be ‘negotiated’
and before using the firm must evaluate the
cost effectiveness of alternative financing
mechanisms.


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Short
-
Term Financing Considerations


To estimate the annual effective rate of return or cost (k) of
any financing alternative:



1
cos
1
365
-
)
rice
Purchase p
t
financing
n-Day
(
k
/n


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Short
-
Term Financing Considerations

Trade Credit


Often a very important source of short
-
term financing.


Offers a number of advantages:


Readily available


Convenient


Flexible


Usually does not entail any restrictive covenants or pledges of
security.


There is no explicit cost associated with credit terms
such as:


Net 30


Net 40



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Short
-
Term Financing Considerations

Trade Credit


There is usually a high implicit cost to a firm that forgoes
discounts on early payment such as:


2/10 Net 30


Example: assume (2/10 net 30)

Approximate percentage cost = (2/98)(365/20) = 37.2%




The firm is being charged 2% for the use of funds from day 10 to
day 30 (20 days).

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Short
-
Term Financing Considerations

Bank Loans and Factor Arrangements

Options include:


Operating loans / lines of credit


Secured by accounts receivable and inventory to a maximum
percent of those assets


Interest only payments


Balance can be retired at the firm’s discretion


Factor arrangements


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Short
-
Term Financing Considerations

Money Market Instruments


Large firms with high credit ratings may be able to
by
-
pass financial institutions and borrow directly
from the money market.


Two forms of money market instruments:


Commercial paper


Bankers’ acceptances


The firm pays a stamping fee, and is able to borrow based on their
bank’s credit rating.


Money market securities:


Sold at a discount from face value


Maturities at time of issue of 30, 60, 90 days


Face amounts of $100,000 or more.


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Short
-
Term Financing Considerations

Money Market Instruments


The annualized yield on a money market instrument:



365
yield

annual

e
Approximat
turity
Days to ma
price
Market
Discount


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Short
-
Term Financing Considerations

Securitizations


Special purpose vehicles (SPVs) are conduits for
packaging portfolios of receivables and selling them to
investors in the money market; a recent innovation in
financing trade credit.


Credit enhancements are actions taken to reduce credit
risk, such as requiring collateral, insurance or other
agreements.


Asset
-
backed commercial paper (ABCP) is an example.



The sub
-
prime mortgage problems in the U.S. has exposed the
problems with ABCP where investors have become concerned
about the underlying asset values (packages of receivables) and
the market is actively repricing these money market instruments


In some cases the market has disappeared for some of these
money market instruments.


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Summary and Conclusions

In this chapter you have learned:


That the optimal level of investment in cash,
receivables and inventory occurs when the
benefits balance the costs


The advantages, the disadvantages and
associated effective annual costs of the most
common short
-
term financing options available to
companies.

Concept Review Questions

Working Capital Management


Current Assets and Liabilities

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Concept Review Question 1

Motives for Holding Cash


Why do firms hold cash?


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Concept Review Question 1

Float


What is float and why is it important to the firm?


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Internet Links


Securitization Net
-

http://www.securitization.net/


Dun & Bradstreet Small Business solutions
-

http://smallbusiness.dnb.com/credit
-
reports/browse
-
products.asp





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Copyright

Copyright © 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this
work beyond that permitted by
Access Copyright (the Canadian
copyright licensing agency) is
unlawful. Requests for further
information should be addressed to
the Permissions Department, John
Wiley & Sons Canada, Ltd.

The
purchaser may make back
-
up copies
for his or her own use only and not for
distribution or resale.

The author and
the publisher assume no
responsibility for errors, omissions,
or damages caused by the use of
these files or programs or from the
use of the information contained
herein.