INTRODUCTION TO

CORPORATE FINANCE
Laurence Booth W. Sean Cleary Chapter 24 Working Capital Management: Current Assets and Current Liabilities

Prepared by Ken Hartviksen

CHAPTER 24 Working Capital Management: Current Assets and Current Liabilities

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 ShortSummary and Conclusions

Concept Review Questions
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 3

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 shortas 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

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 4

Important Chapter Terms

ABC approach Capacity Character Conditions Credit analysis Credit enhancements Economic Order Quantity Factoring arrangements Finance motive Float Just-in-time inventory Just-insystems
Materials requirement planning Open account Optimal cash balance Precautionary motive Prepayments Securitization Special purpose vehicles Speculative motive Terms of credit Transactions motive

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 5

Cash and Marketable Securities

Working Capital Management Current Assets and Current Liabilities

Cash and Marketable Securities

Reasons for Holding Cash

1. 2. 3. 4.

Transactions motive Precautionary motive Finance motive Speculative motive

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 7

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.

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 8

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.
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 9

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.
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 10

Accounts Receivable
Working Capital Management Current Assets and Current Liabilities

Accounts Receivable
1. The decision to extend credit to customers has significant cash flow and credit risk implications for the firm.
Firms often dont have a choice, if the availability of credit is an important factor in the customers 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.
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 12

Accounts Receivable
The Credit Decision

The decision to extend credit is determined:

Nature of the product sold, The industry Practices of competitors.

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 13

Accounts Receivable
Credit Analysis

The process designed to assess the risk of non-payment nonby 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 firms 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.
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 14

Accounts Receivable
Credit Analysis

Variables that are weighed in the credit analysis process:

Capacity the customers ability to pay Character the customers willingness to pay Collateral the security that could be seized to satisfy payment Conditions the state of the economy.

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 15

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
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 16

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. non Evaluation of these decisions can use an NPV framework:

[ 24-1]

NPV ! PV(Future CFs) - CF0

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 17

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) 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.

Actions on unpaid amounts:

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 18

Accounts Receivable
Factoring

It may not be cost-effective for a firm to costmanage the collection process itself. Factoring arrangements are the sale of a firms receivables, at a discount, to a financial company called a factor, which specializes in collections, or the out-sourcing of the outcollections to a factor.

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 19

Evaluating Receivables Management

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

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 20

Evaluating Receivables Management

Receivables Turnover

Measures the sales generated by every dollar of receivables.

Receivables turnover ! RT !

S AR

[4- 16]

Sales Accounts Receivable

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 21

Evaluating Receivables Management

Average Collection Period
Estimates the number of days it takes a firm to collect on its accounts receivable.
AR 365 ! ADS Receivables Turnover

Average Collection Period ! AR ACP ! Receivables turnover

[4- 17]

If ACP is 40 days, and the firms credit policy is net 30, clearly, customers are not paying in keeping with the firms policy, and there may be concerns about the quality of the firms customers, and what might happen if economic conditions deteriorate.
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 22

Inventory
Working Capital Management Current Assets and Current Liabilities

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 large Reduce the probability of production disruptions because of lack of inventory Minimize lost sales because of stock-outs stock-

Costs of Holding Inventory:

Financing costs associated with inventory investment Storage, handling, insurance, spoilage and obsolescence costs.

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 24

Inventory
Inventory Management Approaches

ABC Approach Economic Order Quantity (EOQ) Model Materials Requirement Planning (MRP) Just-in-time (JIT) Inventory systems. Just-in-

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 25

Inventory
Evaluating Inventory Management

Use of financial ratios can give some indication of the effectiveness of a firms inventory management. Ratios, however, do not measure shortage costs, financing costs, etc. These ratios include:
Inventory turnover Average days sales in inventory.

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 26

Productivity Ratios
Inventory Turnover
Estimates the number of times, ending inventory was turned over (sold) in the year.
[4- 18]

CGS Inventory Turnover ! INV

A ratio that involves both stock and flow values Is strongly a function of ending inventory valuemanagers often try to improve this ratio as they approach year end through inventory reduction strategies (cash and carry sales/inventory clearance, etc.)
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 27

Productivity Ratios
Inventory Turnover
When Cost of Goods Sold is not available, it may be necessary to estimate inventory turnover using sales.
[4- 19]

Sales Inventory Turnover ! INV

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.
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 28

Productivity Ratios
Average Days Sales in Inventory (ADSI)

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

Average days sales in inventory (ADSI) ! ! 365 Inventory turnover

INV ADS

[4- 20]

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 29

ShortShort-Term Financing Considerations

Working Capital Management Current Assets and Current Liabilities

ShortShort-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.

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 31

ShortShort-Term Financing Considerations

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

[ 24-2]

k ! (1 

n-Day financing cos t 365 /n ) -1 Purchase price

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 32

ShortShort-Term Financing Considerations

Trade Credit
Often a very important source of short-term financing. short 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
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 33

ShortShort-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).

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 34

ShortShort-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 firms discretion

Factor arrangements

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 35

ShortShort-Term Financing Considerations

Money Market Instruments
Large firms with high credit ratings may be able to byby-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 banks 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.
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 36

ShortShort-Term Financing Considerations

Money Market Instruments
The annualized yield on a money market instrument:

[ 24-3]

Approximate annual yield !

Discount 365 v Market price Days to maturity

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 37

ShortShort-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. Asset The sub-prime mortgage problems in the U.S. has exposed the subproblems 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.
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 38

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 shortcompanies.

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 39

Concept Review Questions

Working Capital Management Current Assets and Liabilities

Concept Review Question 1

Motives for Holding Cash

Why do firms hold cash?

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 41

Concept Review Question 1

Float

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

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 42

Internet Links

Securitization Net - http://www.securitization.net/ Dun & Bradstreet Small Business solutions http://smallbusiness.dnb.com/credit-reports/browsehttp://smallbusiness.dnb.com/credit-reports/browseproducts.asp

CHAPTER 24 Working Capital Management Current Assets and Current Liabilities

24 - 43

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 backfor 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.
CHAPTER 24 Working Capital Management Current Assets and Current Liabilities 24 - 44