Working Capital Management

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1 Working Capital Management Gitman and Hennessey, Chapter 14 Spring Net Working Capital Fundamentals In 2002, current assets accounted for 31.7% of non-financial Canadian corporations total assets. Of this 31.7%, 46.1% were accounts receivable, 37.8% were inventories and 16.1% was cash. See Figure

2 14.1 Net Working Capital Fundamentals Short-term management managing current assets and liabilities is one of the financial manager s most important activities. Too large an investment in current assets can reduce profitability, whereas too little investment increases liquidity risk. Too little current liability financing can reduce profitability whereas too much increases liquidity risk Net Working Capital Fundamentals Current assets are often referred to as the firm s working capital. Current liabilities represent the firm s short-term financing. The conversion of current assets from inventory to receivables to cash provides the source of cash to pay the current liabilities. The timing of cash outlays for current liabilities is easily predictable but the inflows from current assets are not. This is a source of risk. 4

3 14.1 Net Working Capital Fundamentals A tradeoff exists between a firm s profitability and its risk. Profitability is the relationship between revenues and costs generated by using the firm s assets. Risk, in the context of short-term financial management, is the probability that the firm be unable to pay its bill when they come due Net Working Capital Fundamentals The greater the firm s net working capital, the lower the risk but the lower the firm s profitability. Current assets, however, includes assets that are not very productive (cash, for example). A firm s productive assets are its long-term assets. An increase in current liabilities, on the other hand, increases profitability but also increases risk. 6

4 14.2 The Cash Conversion Cycle Cash is not a productive asset but is needed to pay bills. What is a reasonable level of cash to keep on hand? How much should the firm borrow short-term? How much credit should be extended to customers? How much inventory should the firm carry? The Cash Conversion Cycle From the balance sheet identity we find Cash + non-cash CA + NFA = CL + LTD + E, Cash = CL + LTD + E non-cash CA NFA. Hence an increase in liabilities is a source of cash and an increase in assets is a use of cash. 8

5 14.2 The Cash Conversion Cycle Before selling goods, the firm needs to buy raw materials (inventory). Then it has to pay for the raw material (cash out). Then it sells the goods produced out of the raw material. Then it receives payment for the goods sold (cash in) The Cash Conversion Cycle How long does it take, on average, to recover the cash used to purchase raw material? Consider a firm with an average age of inventory (AAI, days sales in inventory) of 110 days, an average payment period (APP, days sales in payables) of 30 days and an average collection period (ACP, days sales in receivables) of 45 days. 10

6 14.2 The Cash Conversion Cycle The firm s operating cycle is the average length of time between the moment raw material is acquired and the moment customers pay for the goods they buy: Operating Cycle (OC) = AAI + ACP = = 155 days The Cash Conversion Cycle The firm s cash cycle is the average length of time between the moment raw material is paid for and the moment customers pay for the goods they buy: Cash Conversion Cycle (CCC) = OC APP = AAI + ACP APP = = 125 days. 12

7 14.2 The Cash Conversion Cycle The Cash Budget The cash budget is a primary tool of short-term financial planning. It allows managers to identify short-term financing needs. It helps identify when short-term borrowing will be needed. The cash budget basically records estimates of cash receipts and disbursements. 13 The Cash Budget The cash budget describes the firm s planned inflows and outflows of cash. This statements aims at determining when the firm will experience surpluses and shortages of cash. The cash budget covers a 6- to 12-month period divided into shorter intervals, usually months. The more seasonal or uncertain the firm s cash flows, the shorter these intervals (weeks or days). 14

8 The Cash Budget The Sales Forecast The starting point of financial planning, whether short- or long-term, is the firm s sales forecast. Sales forecast may come from past sales, economic conditions, sales expectations about new products, etc. These are usually provided by the marketing department. External forecasts come from key external economic indicators. Internal forecasts come from the firm s own channels. 15 The Cash Budget Using sales forecast, the firm can determine the fixed assets necessary to achieve these sales, variable costs can be evaluated, and cash inflows and outflows can be estimated. For example, some of the firm customers will pay immediately while others will pay after 30, 60 or 90 days. Some customers may not even pay at all. Cash inflows occur when customers pay, not when they buy. Similarly, some of the firm s cash outflows depend on its credit arrangements with suppliers. 16

9 The Cash Budget Suppose a firm expects to sell for $1,000 in January. Then, assuming that 20% of its customers pay cash at the time of the sale, 50% pay one month later, 28% pay two months later and 2% never pay, the cash inflows arising from January sales are expected to be $200 in January, $500 in February and $280 in March. Note that the missing $20 could be recovered at some point in time but it may be more conservative not to count on it. 17 The Cash Budget Cash Receipts Cash receipts include all of the firm s inflows of cash. These are mainly cash sales and collections of accounts receivable. Accounts receivable collected in a month come from sales that took place in preceding months. 18

10 Example Coulson Industries is developing its cash budget for October, November and December. Expected sales for these months are (in thousands of $) 400, 300 and 200, respectively. Sales in August and September were 100 and 200, respectively. Month August September October November December Sales (forecast) Example (continued) Coulton s sales are expected to convert to cash as follows: 20% of its customers pay at the time of sales, 50% pay one month later and 30% pay two months later (assume that every customer is expected to pay). On top of that, the firm expects to receive $30,000 from a subsidiary in December. The table below summarizes the cash inflows. 20

11 Coulton s Cash Receipts ($000) Month Aug. Sept. Oct. Nov. Dec. Forecast sales Cash sales (20%) Collections of A/R: Lagged one month (50%) Lagged two months (30%) Other cash receipts 30 Total cash receipts The Cash Budget Cash Disbursements The most common cash disbursements are Cash purchases Payments of accounts payable Rent (and lease) payments Wages and salaries Tax payments Fixed asset outlays Interest payments Cash dividend payments Principal payments (on loans) Repurchases of common shares 22

12 Example (continued) Purchases: Coulton s purchases are 70% of sales, 10% of which are paid in cash, 70% of which are paid one month later and 20% of which are paid two months later. That is, if Coulton sells for $S J in January, it will pay 10% 70% $S J =.07 S J in January, 70% 70% $S J =.49 S J in February, 20% 70% $S J =.14 S J in March. Note: This is not the case in this example, but very often some of the purchases will occur in months preceding the sales month. 23 Coulton Payments of A/P ($000) Month Aug. Sept. Oct. Nov. Dec. Sales (S) Purchases (.7 S) Cash purchases (10%) Payments of A/P: Lagged one month (70%) Lagged two months (20%)

13 Coulton s Other Cash Disbursements Rent payments: $5,000 each month. Wages and salaries: For Coulton, these are usually 10% of sales plus fixed salaries of $8,000 per month. Tax payments: $25,000 in December. Fixed asset outlays: New machinery costing $130,000 will be purchased in September and paid for in November. Interest payments: $10,000 in December. Cash dividends: $20,000 in October. Principal payments: $20,000 in December. Repurchases of shares: $0 for the rest of the year. 25 Coulton s Cash Disbursements ($000) Month Aug. Sept. Oct. Nov. Dec. Sales (S) Purchases (.7 S) Cash purchases (10%) Payments of A/P: Lagged one month (70%) Lagged two months (20%) Rent payments Wages and salaries Tax payments 25 Fixed asset outlays 130 Interest payments 10 Cash dividends 20 Principal payments 20 Total disbursements

14 The Cash Budget Net Cash Flow, Ending Cash and Excess Cash Net Cash Flow = Cash Receipts Cash Disbursements Ending Cash = Beginning Cash + Net Cash Flow Required Financing = Minimum Cash Balance Ending Cash Excess Cash = Ending Cash Minimum Cash Balance Suppose Coulton has $50,000 in cash at the beginning of October and suppose its minimum cash balance is $25, Coulton s Cash Budget ($000) Month Oct. Nov. Dec. Total cash receipts Less: Total cash disbursements Net cash flow (3) (98) 35 Add: Beginning cash (51) Ending cash 47 (51) (16) Less: Minimum cash balance Required financing Excess cash 22 28

15 The Cash Budget Evaluating the Cash Budget Using the information obtained so far, it is possible to determine, for each period, the balance in cash, in marketable securities and in notes payable. Note that a firm should liquidate its marketable securities before dipping into its line of credit. A firm may have both items at the same time but this should be temporary. 29 Coulton s End-of-Month Balances ($000) October November December Cash Marketable securities Line of credit Coulton s management must ensure that a line of credit of at least $76,000 is secured before November. 30

16 The Cash Budget Coping with Uncertainty in the Cash Budget Many items in the cash budget vary with sales. The cash budget thus depends on the level of sales expected. What financing will be needed if sales are 10% less than expected in each month? What financing will be needed if sales are 10% more than expected in each month? 31 The Cash Budget Coping with Uncertainty in the Cash Budget Cash flows are also affected by the time customers take to pay for their purchases. What would the cash budget look like if only 10% of the sales were paid cash, 50% paid after one month and 40% paid after two months? What if 5% of the sales are never paid? 32

17 Coping with Uncertainty in the Cash Budget Suppose, for example, that the time at which accounts are paid is not expected to change but sales could be Month Aug. Sept. Oct. Nov. Dec. Best case (10% higher) Worst case (10% lower) Scenario Analysis when only Sales Vary October November December Cash Most Likely Scenario Marketable securities Line of credit Best-Case Scenario Marketable securities Line of credit Worst-Case Scenario Marketable securities Line of credit

18 Coping with Uncertainty in the Cash Budget Suppose now that the best-case scenario is such that sales in the last three months of the year are 10% higher than the initial figures and, at the same time, 30% of sales are paid cash, 50% one month later and 20% two months later. The worst-case scenario, on the other hand, is such that sales are 10% lower than expected and cash sales are 10% of total sales, 50% of sales are paid one month later and 40% of sales are paid two months later. We will see that collection of receivables significantly affect the firm s cash flows. 35 Scenario Analysis when Sales and Collections of A/R Vary October November December Cash Expected Case Marketable securities Line of credit Best-Case Scenario Marketable securities Line of credit Worst-Case Scenario Marketable securities Line of credit

19 14.2 The Cash Conversion Cycle If a firm s sales are constant, its investment in operating assets will also be constant. This firm will only have permanent funding requirement. If a firm s sales vary over time, then its investment in operating assets will also vary over time. This firm will have seasonal funding requirements The Cash Conversion Cycle Funding Requirements of the Cash Conversion Cycle A firm may fund its seasonal needs with short-term debt and its permanent needs with long-term debt (aggressive funding strategy). A firm may fund all its needs, both seasonal and permanent with long-term debt (conservative funding strategy). 38

20 14.2 The Cash Conversion Cycle Funding Requirements: Example 1 Nicholson Company holds, on average, $50 in cash and marketable securities, $1,250 in inventory and $750 in accounts receivable. Nicholson s accounts payable of $425 are stable over time. Nicholson has a permanent investment in operating assets (net operating working capital) of , = $1, The Cash Conversion Cycle Funding Requirements: Example 2 Semper Pump Company, which produces bicycle pumps, has seasonal funding needs. It holds, at minimum, $25 in cash and marketable securities, $100 in inventory and $60 in accounts receivable. At peak times, inventory increases to $750 and accounts receivable increase to $400. Semper s accounts payable remain $50 throughout the year. 40

21 14.2 The Cash Conversion Cycle Funding Requirements: Example 2 Semper permanent funding requirement for its operating assets is = $135, and its maximum funding requirement is = $1,125. Hence Semper s seasonal funding requirement is 1, = $ The Cash Conversion Cycle Funding Strategies: Semper Semper s permanent funding requirement is $135 and its seasonal needs vary between $0 and $990, for an average of $ Semper can borrow short-term funds at 6.25% and long-term funds at 8%, and it can earn 5% on any surplus balance. 42

22 14.2 The Cash Conversion Cycle Funding Strategies: Semper If Semper follows an aggressive funding strategy, all its seasonal needs will be funded with short-term debt. There will not be any surplus to invest throughout the year. If it follows a conservative strategy, all its needs will be funded with long-term debt. In this case, there will be surpluses whenever funding requirements are below $1,125 and these surpluses will be invested at the rate of 5% The Cash Conversion Cycle Funding Strategies: Semper Suppose Semper follows an aggressive funding strategy. Then it uses long-term debt for its permanent funding requirement only, which costs 8% 135 = $10.8. Seasonal needs, which average $ will be funded with short-term debt, the cost being 6.25% = $

23 14.2 The Cash Conversion Cycle Funding Strategies: Semper The total cost of the aggressive funding strategy is then = $ The Cash Conversion Cycle Funding Strategies: Semper Suppose now that Semper follows a conservative funding strategy. Then long-term debt is used to finance all operating assets needed throughout the year, which means that $1,125 is borrowed at the rate of 8%. This implies a cost of 8% 1,125 = $90. 46

24 14.2 The Cash Conversion Cycle Funding Strategies: Semper The cash raised with long-term debt is not used all the time. More specifically, the average excess funding during the year is 1, = $888.75, which will be invested at the rate of 5%, creating a revenue of 5% = $ The Cash Conversion Cycle Funding Strategies: Semper The net cost of the conservative funding strategy is then = $ Note that the aggressive funding strategy is less expensive than the conservative strategy. The former, however, is more risky than the latter. 48

25 14.2 The Cash Conversion Cycle Strategies for Managing the Cash Conversion Cycle 1. Turn over inventory as quickly as possible without stockouts resulting in lost sales. 2. Collect account receivable as quickly as possible without losing sales from high-pressure collection techniques. 3. Pay accounts payable as slowly as possible without damaging the firm s credit rating Inventory Management The ABC System This concept suggests that 20 percent of the firm s products account for 80 percent of the firm s sales and thus 80 percent of the firm s inventory. The products within this 20 percent are classified as A items and are actively managed. The B group consists of items that account for the next largest investment in inventory. The C group consists of a large number of items that require a relatively small investment. 50

26 14.3 Inventory Management The Economic Order Quantity (EOQ) Model The EOQ is an appropriate model for the management of A and B items. Let S = usage in units per period, O = order cost per order, C = carrying cost per unit per period, Q = order quantity in units Inventory Management The Economic Order Quantity (EOQ) Model The number of orders per period is the number of units used, S, divided by the size of an order, Q, and thus total order cost per period is Order cost = O S Q. Inventory is assumed to deplete at a constant rate and thus the carrying cost of an order per period is Carrying cost = C Q 2. 52

27 14.3 Inventory Management The Economic Order Quantity (EOQ) Model The total cost of inventory is then the sum of the order cost and the carrying cost, which gives Total cost = O S Q + C Q 2 the quantity minimizing this cost, the economic order quantity (EOQ), is 2 S O EOQ =. C Inventory Management The Economic Order Quantity (EOQ) Model: Example MAX Company has an A group of inventory item that is vital for the production process. This item costs $1,500 and MAX uses 1,100 units of the item per year. The order cost per order of this item is $150 and the carrying cost per unit per year is $200. The optimal order strategy for this item is then EOQ = 2 1, = 41 units. 54

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