Session 24 25 Working Capital Management

Financial Management
Session 24 & 25
Working Capital Management
Corporate Finance
Management of long term assets
Capital Budgeting
Management of long term capital

Capital structure
Management of short term assets and liabilities

Working Capital Management
Cash, marketable securities, accounts receivables,
inventory, prepaid expenses etc.
Accounts payable, wages payables etc.
Simple Cycle of operations
Cash
Rawmaterials
inventory
Receivables
Finishedgoods
inventory
Simple Cycle of operations

Raw material
purchased
Finished goods sold
Cash
received
Order
Stock
Placed Arrives
Inventory period
Accounts receivable period
Time
Accounts payable period

Firm receives invoice
Cash paid for materials
Operating cycle
Cash cycle
4
Operating and Cash Conversion Cycle

Operating Cycle
= Inventory Period + Accounts Receivable Period
The delay between the initial investment in
inventories and the final sale date is called the
inventory period.
The delay between the time that goods are sold and
when the customers finally pay their bills is termed
the accounts receivable period.
5
Operating and Cash Conversion Cycle

Cash Cycle
= Inventory Period
+ Accounts Receivable Period
Accounts Payable Period
= Operating Cycle Accounts Payable Period
The interval between the firms payment for its raw
materials and the collection of payment from the
customer is know as the CCC.
Example:
Suppose, a company pays suppliers of inventory after
30 days, completes production and sells the finished
products to customers after 60 days of procuring the
inventory and receives cash from the customers after
30 days from sale.
Day
0
30
60
90
Activity
Procure inventory
Pay suppliers of inventory
Complete production and sell to customers
Collect cash from customers
Operating Cycle = 90 days

Cash Cycle = 60 days
7
Formulae
Inventory Period = Avg Inventory/ Daily COGS
Accounts Receivable Period = Avg Receivables /
Sales per day
Accounts Payable Period = Avg Payable/Daily COGS
Example:
Year
2011
2012
Inventory
9587
14544
16899
18149
5856
8161
Sales
42588
60138
COGS
28779
40831
Receivables
Payables
Calculate the Cash Conversion Cycle and Operating

Cycle
9
Cash Management
Why hold cash or other marketable securities
Low returns as compared to be generated by other assets
Cash for transactions
For the debt settlement
To pay suppliers
To hedge for unexpected needs

Seasonality, smoothening the cash flows
10
Money Market
Near cash, interest earning securities may be a good
substitute
Safety and liquidity with some return
Longer term bonds

Better expected return, may be liquid but may be risky
Term structure of interest rate effect
Stocks !
11
Money Market Instruments

T-Bills
G-securities with maturities 91, 182 and 364 days

Free of default risk
Small interest rate risk
Issued at discount and redeemed at par value
Extremely liquid and can be purchased in low
denominations
12
Money Market Instruments

Commercial Paper
Large denomination, unsecured debt
Usually with maturity of 30 days
Default risk is lessened as issuer obtain backup lines of
credit from commercial lines
Ratings are must
Certificates of Deposit
Bankers Acceptances
Repurchase Agreements
13
Cash Management
The goal of cash management is to make cash
available when needed and maximize interest income
on idle cash.
The principal tool for short-term cash planning is
the cash budget.
The cash budget records periodic estimates of cash
receipts and disbursements.
The period could be a day or a week or a month
depending on the need and convenience of the
company.
The cash budget provides an estimate of the
periodic cash surplus or deficit after adjusting cash
payments against receipts.
14
Cash Management: FloatContd

Time exists between the moment a cheque is written
and the moment the funds are deposited in the
recipients account.
This time spread is called Float.
Payment Float - cheques written by a company that
have not yet cleared.
Availability Float - cheques already deposited that have
not yet cleared.
15
Cash Management:FloatContd
Float = Firms bank cash Firms book cash
Total float = Mailing float

+ Processing float
+ Clearing float
16
Cash Management: Managing FloatContd

Payers attempt to create delays in the cheque
clearing process.
Recipients attempt to remove delays in the
cheque clearing process.
Sources of delay
Time it takes to mail cheque
Time for recipient to process cheque
Time for bank to clear cheque
17
Cash Management: Managing FloatContd

Lock-Box System - System whereby
customers send payments to a post office box
and a local bank collects and processes checks.
18
Inventory Management:
EOQ accounts for 3 types of costs:
Unit Cost: the cost of the units themselves,
assumed to be fixed, regardless of the number of
units ordered
Inventory-Holding Cost: the cost of holding units
in inventory
Fixed order cost: represents all the costs
associated with placing an order excluding the
cost of the units themselves (any administrative
costs of placing and/or receiving an order)
19
Inventories & Cash Balances

Total Cost = Purchase cost + Order cost + Holding
cost
Optimal inventory level involve a trade-off between
carrying costs and order costs.
Economic Order Quantity - Order size that
minimizes total inventory costs.
Economic Order Quantity =
2 x annual sales x cost per order

carrying cost
20

Determination of optimal order size
Inventorycosts,dollars
Totalcosts
Carryingcosts
Totalordercosts
Optimal
ordersize
Ordersize
21
Inventory Management: Example

Suppose the fixed order cost is 450 while the
annual carrying cost is 55 a ton. If the annual
sales of the company is 255,000 tons calculate
the EOQ.
22

The optimal amount of short term securities sold to
raise cash will be higher when annual cash outflows
are higher and when the cost per sale of securities is
higher. Conversely, the initial cash balance falls
when the interest is higher.
Initial cash balance =
2 x annual cash outflow s x cost per sale of securities

interest rate
23
Credit Management : Baumol Model

If you keep more cash in hand opportunity cost
is high
If you dont keep cash and sell securities for
every requirement transaction cost is high
Opportunity cost = (C/2) * R
Trading cost = (T/C)*F
T- total amount of new cash reqd in planning period
C Opportunity cost of holding cash
F- fixed cost of selling securities
24
Cash ManagementBaumol Model

Cash
balance ($000)
25
Average
12.5
Weeks
Value of bills sold = Q =

2 x annual cash disbursement x cost per sale
interest rate
2 x 1260 x 20
.08
= 25
25
Credit Management
How long are you going to give customers to
pay their bills?
Longer the account receivable period, risky and
less valuable
How do you determine which customers are

likely to pay their bills?
To get idea about the risk in receipts
How do you collect the money when it

becomes due?
Need some specialized agency
26
Terms of Sale
Terms of Sale - Credit, discount, and payment terms
offered on a sale.
Example - 2/10 net 30
2 - percent discount for early payment
10 - number of days that the discount is available
net 30 - number of days before payment is due
27
Terms of Sale
A firm that buys on credit is in effect borrowing
from its supplier. It saves cash today but will have
to pay later. This, of course, is an implicit loan from
the supplier.
We can calculate the implicit cost of this loan
Effective annual rate
= 1 +
365 / extra days credit
discount
discounted price
- 1
28
Credit Management
Usually five Cs are analyzed to assess credit
worthiness.
Character: Provides a clue to the customers willingness to
pay.
Capacity: Refers to the ability to pay out of revenue
surpluses.
Capital: Measures the financial assets of the customer that
can be used to pay the dues if revenue surplus is not
adequate
Collateral: Refers to assets, which can be taken as security
from the customer to cover defaults
Condition: Refers to the general economic conditions in the
customers business
29
Credit Management
Credit Analysis - Procedure to determine the likelihood
a customer will pay its bills.
Credit agencies provide reports on the credit
worthiness of a potential customer.
Financial ratios can be calculated to help determine a
customers ability to pay its bills.
30
Modelling credit risk: Credit Scoring Models...Contd

Altmans Z-Score Model
This uses a statistical technique, Multiple Discriminate Analysis (also
could use logit or probit analysis) to classify firms into those likely to
become bankrupt or non-bankrupt over a given future horizon
Past financial data on firm financial ratios and bankruptcies were used
to estimate the regression equation
Z 1.2X1 1.4X2 3.3X3 0.6X4 1.0X5

Z = 0 if firm becomes bankrupt and = 1 if firm does not.
X1=Working Capital / Total Assets
X2=Retained Earnings / Total Assets
X3=EBIT / Total Assets
X4=Market Value of Equity / Book Value Long-Term Debt
X5=Sales / Total Assets
Vivek Rajvanshi, <vivekr@iiml.ac.in>
31

Altmans Z-Score Model
For a given Type I error (classifying firm as not bankrupt
when it is) and a given Type II error (classifying a firm as
bankrupt when it is not), a critical value of Z could be used
to approve or deny a loan
Once z (critical value) is calculated, the credit risk is assessed as

follows:
z > 3.0
2.7 < z < 3.0
1.8 < z < 2.7
z < 1.8
means low probability of default

means an alert signal
means a good chance of default
means a high probability of default
(Safe zone)
(Grey zone)
(Grey zone)
(Distress zone)
32

If following information is available estimate
Altmans Z score and comment about the bankruptcy
Working Capital = $5,000,000
Retained Earnings = $1,000,000
Operating Income = $10,000,000
Market Value of Equity = $2,000,000
Book Value of Total Liabilities = $500,000
Sales = $15,000,000
Total Assets = $3,000,000
33

If following information is available estimate Altmans Z score
and comment about the bankruptcy
Working Capital / Total Assets = $5,000,000 / $3,000,000 = 1.67
Retained Earnings / Total Assets = $1,000,000 / $3,000,000 = .33
Operating Income / Total Assets = $10,000,000 / $3,000,000 = 3.33
Market Value of Equity / Book Value of Total Liabilities = $2,000,000 /
$500,000 = 4
Sales / Total Assets = $15,000,000 / $3,000,000 = 5
If Model A Z-Score = 1.2 X1 + 1.4 X2 + 3.3 X3 +0.6 X4 + X5 >= 3

Bankruptcy is very unlikely
34
The Credit Decision

The most important tool to monitor receivables is
Average collection period (ACP) of outstanding dues.
Credit analysis is only worth while if the expected
savings exceed the cost.
Extending credit gives you the probability of making
a profit, not the guarantee. There is still a chance of
default.
Denying credit guarantees neither profit or loss.
35
The Credit Decision

The credit decision and its probable payoffs
p probability that customer will pay
Customerpays=p
Payoff=Rev Cost
Offercredit
Customerdefaults=1p
Payoff= Cost
Refusecredit
Payoff=0
36
The Credit Decision

Based on the probability of payoffs, the expected
profit can be expressed as:
p x PV(Rev - Cost) - (1 - p) x (PV(cost)

The break even probability of collection is:
PV(Cost)
p =
PV(Rev)
37
The Credit Decision

Suppose you sign a deal with a company for a year.
As a part of deal you are expected to receive 1500
revenue while the COGS is 1000. Calculate the
breakeven probability of collection if the interest rate
is 10% per year.
We should also consider the probability of repeat
order and the chances of defaults simultaneously.
In repeat order chances of defaults may be less.
38
The Credit Decision

As a part of deal you are expected to receive 1500
revenue while the COGS is 1000. probability of
default in first year is 40%.
If this order executed the probability of receiving
second order is 90% and the probability of default
will reduce to .05%. From the second order (next
year) you are expected revenue of 2000 and COGS in
same proportion as it was in first time order.
Interest rate applicable are 10%.
39
Collection Policy
If credit is granted, then the procedures for collection
of dues have to be formalized.
These may include sending reminder letters to
customers, telephone calls and personal visits,
employing an outside agency or taking legal action if
default continues.
40
Credit Granting Decision

Credit to a customer should be granted only if the
return on investment in receivables is greater than the
cost of funds required to finance the receivables.
41

Suppose, a company sells its products at Rs.5000 per
unit with contribution of 40 %. Currently the annual
credit sale is Rs.120 million with average collection
period of one month.
If additional credit is allowed, by increasing the credit
period to two months, then sales will increase 25 %.
If the pre-tax cost of capital is 16 %, then should the
company allow additional credit?
42

Present level of sales = Rs.120 mn
Present level of accounts receivables = Rs.120 mn *1/12 = Rs.10 mn
Increased level of sales with additional credit = Rs.120 mn * 1.25 = Rs.150 mn
Increased level of accounts receivables = Rs.150 mn * 2/12 = Rs.25 mn
Incremental amount of receivables = Rs.(25 10) mn = Rs.15 mn
Contribution = 40 % of sales
Variable cost = 60 % of sales
The incremental investment in receivables will be equal to the variable cost.
43

Incremental investment in receivables
= Rs.15 mn * 0.6 = Rs. 9 mn
Cost of investment in incremental receivables
= Rs.9 mn * 0.16 = Rs.1.44 mn
Return from incremental sales
= Contribution from incremental sales
= Rs. (150 120) mn * 0.4 = Rs.12 mn
Hence, the return from incremental sales is greater than
the cost of investment in incremental accounts receivables.
So, credit should be allowed in this case.
44
Factoring
Factoring is a financial transaction whereby a business
sells its accounts receivable (i.e., invoices) to a third
party (called a factor) at a discount
The Factor apart from advancing money to the client
against invoices, also follows up customers, collects
money, helps in credit check of the customers and
maintains sales ledger accounts for the client.
45
Short-term Financing Policies

Short-term financing policy refers to the manner
in which the permanent and the fluctuating
current assets are financed. There can be three
approaches:
maturity matching
aggressive and
conservative.
46

In maturity matching approach, the maturities of
assets and liabilities are matched. This implies that
the permanent current assets and fixed assets should
be funded by long-term sources and the fluctuating
current assets by short-term sources.
47

If the company wants to play safe in financing of
assets, then it can adopt a conservative approach. In
this case, a part of the fluctuating current assets is
also funded by long-term sources. This will reduce
the risk of arranging short-term funds on a continuous
basis.
48

The company can alternatively follow an aggressive
approach. In this case, it will finance fixed assets and
part of the permanent current assets with long-term
funds and the balance current assets by short-term
funds.
This approach is aggressive because the finance
manager will be under continuous pressure to arrange
renewal of short-term loans.
49
Cash Flow/Maturity Matching for Multiple Liabilities

Cash Flow Matching:
A bond is selected with a maturity that matches the last liability
Amount invested in this bond is such that the principal plus final
coupon payment is equal to the last liability
The remaining elements of the liability stream are then reduced by the
coupon payments of this bond
Another bond is chosen for the next to last liability and this sequence
is continued until all liabilities have been matched by payments on
securities selected for the portfolio
50
Cash Flow Matching for Multiple Liabilities

1. For the last period, one would select a bond with a principal
(FT) and coupon (CT) that matches the amount of that final
liability (LT):
LT FT CT
LT FT (1 C R 0 )
where : C R 0 CT / FT
To meet this liability, one could buy

LT /(1+ CR0) of par value of bonds maturing in T periods.
51

2. To match the liability in period T-1, one would need to select
bonds with a principal of FT-1 and coupon CT-1 (or coupon rate
of CR1 = CT-1/ FT-1) that is equal to the projected liability in
period T-1 (LT-1) less the coupon amount of CT from the Tperiod bonds selected:
L T 1 C T FT 1 C T 1
L T 1 C T FT 1 (1 C R1 )
To meet this liability, one could buy (LT-1-CT)/(1+ CR1) of par

value of bonds maturing in T-1 periods.
52

3. To match the liability in period T-2, one would need to select
bonds with a principal of FT-2 and coupon CT-2 (or coupon rate
of CR2 = CT-2/ FT-2) that is equal to the projected liability in
period T-2 (LT-2) less the coupon amounts of CT and CT-1 from
the T-period and T-1-period bonds selected:
L T 2 C T C T 1 FT 2 C T 2
L T 2 C T C T 1 FT 2 (1 C R 2 )
To meet this liability, one could buy

(LT-2 CT - CT-1)/(1+ CR2) of par value of bonds maturing in T2 periods.
53
Cash Flow Matching for Multiple Liabilities: Example

Example: Suppose the liabilities structure is to pay $4M, $3M,
and $1M in years 3, 2, and 1 with 3-year, 2-year, and 1-year
bonds each paying 5% annual coupons and selling at par.
Year
Liability
$1M
$3M
$4M
54
Cash Flow Matching for Multiple Liabilities: Example

The $4M liability at the end of year 3 is matched by
buying $3,809,524 worth of three-year bonds:
$3,809,524 = $4,000,000/1.05.
buying $2,675,737 of 2-year bonds: $2,675,737 =
($3,000,000 (.05)($3,809,524))/1.05.
buying $643,559 of 1-year bonds: $643,559 =
($1,000,000 (.05)($3,809,524)
(.05)($2,675,737))/1.05
55
Control of Working Capital

The objective of working capital management is to
ensure liquidity with minimum sacrifice of
profitability.
So, it is necessary to check both these parameters
over time to analyze the trend of performance.
56
Measurement of Liquidity
(a) Current ratio
= Current Assets / Current Liabilities
(b) Quick or Acid test ratio
= (Current Assets Inventories) /
Current Liabilities
(c) Cash ratio
= Cash and equivalents / Current Liabilities
57
Measurement of Profitability
(a) Net Profit Margin
= Net Profit / Sales
(b) Return on assets
= Profit after tax / Total assets
(c) Return on equity
= Profit after tax / Total equity
58
Multiple Choice Question - 1

A company is negotiating with a bank for a one-year loan.
The bank has offered two options. The first option is to pay
interest at the rate of 12 percent per annum on quarterly
rest basis with repayment of principal at the end. The
second option is to pay 10 percent per annum interest upfront with repayment of principal at the end of one year.
Which option is better for the company?
(a) The first option
(b) The second option
(c) Both are same
(d) Do not know
59

Ans. (b)
Solution:
The cash flows for the two options are as follows:Time
First Option
Second Option
0 (Beginning)
100
100 10 = 90
End Quarter 1
(3)
nil
End Quarter 2
(3)
nil
End Quarter 3
(3)
nil
End Quarter 4
(103)
(100)
IRR
12 percent
10.68 percent
So, the second option is better.
60

Consider the following financial information of a company during a particular year.
Inventory Opening
Rs.2.0 million
Closing
Rs.2.4 million
Accounts Receivable - Opening Rs.4.0 million
Closing Rs.4.6 million
Accounts Payable Opening
Rs.1.8 million
Closing
Rs.2.0 million
Net Sales Rs.12 million
Cost of Goods Sold Rs. 8 million
The cash cycle of the company is
(a) 144.40 days
(b) 130.82 days
(c) 231.09 days
(d) 100.27 days
61

Ans. (a)
Solution:
Average Inventory
= (2.0 + 2.4)/2 = Rs.2.2 million
Average Accounts Receivable= (4.0 + 4.6)/2 = Rs.4.3 million
Average Accounts Payable
= (1.8 + 2.0)/2 = Rs.1.9 million
Inventory Turnover
= Rs. 8 mn / Rs. 2.2 mn = 3.64 times
Receivables Turnover= Rs. 12 mn / Rs. 4.3 mn = 2.79 times
Payables Turnover
= Rs. 8 mn / Rs. 1.9 mn = 4.21times
Inventory Period
= 365/3.64 = 100.27 days
Receivables Period
= 365/2.79 = 130.82 days
Payables Period
= 365/4.21 = 86.69 days
So, Cash Cycle
= 100.27 + 130.82 86.69
= 144.40 days
62

A supplier offers credit under terms of 2/20, net 60.
The implicit cost of credit is:
(a) 24.00 percent
(b) 18.62 percent
(c) 18.00 percent
(d) Do not know
63

Ans. (b)
Solution:
Assuming the price as 100,
Cash Discounted Price till 20 days
= 100 2 = 98
Price to be paid till 60 days = 100
So, implicit annualized cost of credit
=( 2/98)*(365/40) = 18.62 percent
64

A company has issued Rs.10 million worth of
commercial paper at an interest rate of 8 % for 3
months. It has to deposit 10 % of the issued
amount with a bank to maintain a line of credit with
the bank for the commercial papers. If the CP
placement cost is Rs.50,000, then the pre-tax cost
of funds from CP is:
(a) 8 percent
(b) 10 percent
(c) 8.23 percent
(d) 8.94 percent
65

Ans. (d)
Solution:
Money collected by issuing CP
= Rs.10 million 0.1 * Rs.10 million - Rs.50,000
= Rs.8.95 million
Interest paid after 3 months
= 0.08/4*10 mn
= Rs.0.2 million
So, Annualized Interest Cost = 0.2/8.95*12/3*100
= 8.94 percent
66
Thank You!
67

Session 24 25 Working Capital Management

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Session 24 25 Working Capital Management

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Financial Management

Management of long term capital

Management of short term assets and liabilities

Simple Cycle of operations

Simple Cycle of operations

Finished goods sold

Accounts receivable period

Accounts payable period

Cash paid for materials

Operating and Cash Conversion Cycle

Operating and Cash Conversion Cycle

Operating Cycle = 90 days

Calculate the Cash Conversion Cycle and Operating

To hedge for unexpected needs

Longer term bonds

Money Market Instruments

G-securities with maturities 91, 182 and 364 days

Money Market Instruments

Cash Management: FloatContd

Float = Firms bank cash Firms book cash

Total float = Mailing float

Cash Management: Managing FloatContd

Cash Management: Managing FloatContd

Inventories & Cash Balances

2 x annual sales x cost per order

Inventories & Cash Balances

Inventory Management: Example

Inventories & Cash Balances

Initial cash balance =

2 x annual cash outflow s x cost per sale of securities

Credit Management : Baumol Model

Cash ManagementBaumol Model

Value of bills sold = Q =

How do you determine which customers are

How do you collect the money when it

Effective annual rate

365 / extra days credit

Modelling credit risk: Credit Scoring Models...Contd

Z 1.2X1 1.4X2 3.3X3 0.6X4 1.0X5

Modelling credit risk: Credit Scoring Models...Contd

Once z (critical value) is calculated, the credit risk is assessed as

means low probability of default

Modelling credit risk: Credit Scoring Models...Contd

Vivek Rajvanshi, <vivekr@iiml.ac.in>

Modelling credit risk: Credit Scoring Models...Contd

If Model A Z-Score = 1.2 X1 + 1.4 X2 + 3.3 X3 +0.6 X4 + X5 >= 3

The Credit Decision

The Credit Decision

The Credit Decision

p x PV(Rev - Cost) - (1 - p) x (PV(cost)

The Credit Decision

The Credit Decision

Credit Granting Decision

Credit Granting Decision

Credit Granting Decision

Credit Granting Decision

Short-term Financing Policies

Short-term Financing Policies

Short-term Financing Policies

Short-term Financing Policies

Cash Flow/Maturity Matching for Multiple Liabilities

Cash Flow Matching for Multiple Liabilities

To meet this liability, one could buy

Cash Flow Matching for Multiple Liabilities