CFA Exam Level I Corporate Finance Module Working Capital Management. Dr. C. Bulent Aybar. Professor of International Finance

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1 CFA Exam Level I Corporate Finance Module Working Capital Management Dr. C. Bulent Aybar Professor of International Finance

2 Net Working Capital Working Capital includes a firm s current assets, which consist of cash and marketable securities in addition to accounts receivable and inventories. It also consists of current liabilities, including accounts payable (trade credit), notes payable (bank loans), and accrued liabilities. Net Working Capital is defined as total current assets less total current liabilities.

3 The Tradeoff Between Profitability & Risk Positive Net Working Capital (low return, low risk) low return Current Assets Net Working Capital > 0 Current Liabilities Long-Term Debt low cost high cost high return Fixed Assets Equity highest cost

4 The Tradeoff Between Profitability & Risk Negative Net Working Capital (high h return and high h risk) low return Current Assets Current Liabilities Net Working Capital < 0 low cost high return Fixed Assets Long-Term Debt high cost Equity highest cost

5 Effects of Changing Ratios on Profits and Risk

6 The Cash Conversion Cycle Short-term financial management managing current assets and current liabilities is one of the financial manager s most important and time-consuming activities. The goal of short-term financial management is to manage each of the firms current assets and liabilities to achieve a balance between profitability and risk that contributes positively to overall firm value.

7 Effective Working Capital Management Ensures that the company has adequate ready access to the funds necessary to handle its day to day operations Makes sure that company assets are invested in the most productive way! Achieving these objectives require: Maintaining adequate levels of cash Converting short term assets into cash and Controlling outgoing payments to vendors, employees or others

8 Working Capital Management-Multifaceted Effective WCM requires multidimensional effectiveness in Managing Short Term Investments Granting credit to customers and managing Collections Managing Inventory Managing Payables Reliable cash flow forecasts Effective monitoring of transactions and bank balances Its scope ranges from transactions, to effective relationships with financial institutions, clients and suppliers (trading partners) to analysis to develop appropriate strategies.

9 Definition of Liquidity Liquidity is defined as the ability to meet short term obligations without disruption of business. Liquidity management refers to the ability of an organization to generate cash when and where it is needed. In general we associate liquidity with short term assets and short term liabilities. Effective liquidity management requires maintaining a productive balance between short term assets and liabilities, as well as efficient management of key sources of liquidity.

10 Drags and Pulls on Liquidity Uncollected Receivables Obsolete Inventory Tight Credit Making payments early Reduced credit limits imposed by suppliers Limits on short term lines of credit imposed by financial institutions Low liquidity positions

11 Measuring Liquidity Liquidity Ratios measure a company s ability to meet short term obligations to creditors. This measure of liquidity focuses on the relationships between current assets and current liabilities and relies on the rapidity with which h receivables and inventories can be converted in to cash Current Ratio (Current Assets/Total Current Liabilities) In most situations, inventory is the least liquid of the current assets, therefore exclusion of inventory yprovides more powerful measure of liquidity: Quick Ratio (Current Assets-Inventory/Total Current Liabilities)

12 A Word of Caution It is often said that the larger the current ratio, the more liquid the firm is. However, a firm s current ratio can be increased by: Having clients pay their bills as late as possible Maximizing ing inventories Paying the firm s suppliers in a hurry Although the quick ratio is an improvement over the current ratio, it still emphasizes a liquidation view of the firm Furthermore, a firm s inventories (which are excluded from the quick ratio on the assumption that they are less liquid than receivables) are often as liquid as the firm's receivables

13 Operating Cycle The Operating Cycle (OC) is the time between ordering materials and collecting cash from receivables. A long operating cycle is a drag on liquidity. If it takes too long to convert inventory to sales, and it takes too long to collect cash from sales on credit, company s ability to generate cash declines. These two potential drags can be measured by using several ratios such as Accounts Receivable Turnover and Inventory Turnover.

14 A Quick Review of Key Short Term Asset Management Ratios Accounts Receivable Ratios: Accounts Receivable Turnover =Credit Sales/Average Receivables Number of Days of Receivables =365/ART Number of Days of Receivables =Accounts Receivables/Average Daily Credit Sales Inventory Ratios: Inventory Turnover Ratio=Cost of Goods Sold/Average Inventory Number of Days in Inventory =365/Inventory Turnover Ratio Number of Days in Inventory =Average Inventory/Daily Cost of Goods Sold Accounts Payable Ratios: Number of Days of Payables: Average Accounts Payable/Daily Purchases

15 Operating Cycle OC=Number of Days in Inventory + Number of Days in Receivables Number of Days in Inventory=Average Age of Inventory Number of Days in Receivables=Average Collection Period OC=NDI+NDR OC=AAI+ACP As we indicated earlier the Operating Cycle (OC) is the time between ordering materials and collecting cash from receivables. The longer the OC, the longer the cash is tied up in operations. However, in order to accurately account for cash conversion we also need to incorporate payment cycle. This brings us to Net Operating Cycle.

16 Net Operating Cycle or Cash Conversion Cycle The Cash Conversion Cycle (CCC) is the time between when a firm pays it s suppliers (payables) for inventory and collecting cash from the sale of the finished product. CCC=Number of Days in Inventory-Number of Days in Receivables Number of days of Payables Average NOC=CCC+(NDI+NDR)-NDP NOC=CCC=OC-NDP

17 Example: Max s Cash Conversion Cycle MAX Company, a producer of paper dinnerware, has annual sales of $10 million, cost of goods sold of 75% of sales, and purchases that are 65% of cost of goods sold. MAX has an average age of inventory (AAI) of 60 days, an average collection period (ACP) of 40 days, and an average payment period (APP) of 35 days. U i th l f th i bl th ti l f MAX i Using the values for these variables, the operating cycle for MAX is =100 days. Cash Conversion or Net Operating Cycle is =65 days.

18 XYZ Inc. XYZ is a Southern California furniture manufacturer in a niche market. Company is in the process of reviewing its cash management practice. Treasurer gathers facts and identifies the following: Company purchases on open account, there are volume discounts (due to its order size), Suppliers also do not offer any cash discounts, currently company buys on net 30 terms. Its average payment period (APP) is 30 days. This is shorter than industry average of 39 days. Average days in inventory for the firm is 110 days. This is well above the industry average of 83 days. Company sales are on net 60 basis which is the industry standard. Average days in receivables is 75 days. If company used cash discounts (eg 3/10 net 60) ADR (or Average collection period) could be reduced by 40%. XYZ s operating cycle investment is currently $26.5m. This is the minimum i projected disbursement until 2010 and opportunity cost of this investment is about 15%.

19 Analyze the current operating cycle, cash conversion cycle and resource investment need. Assuming a constant rate of purchases calculate OC and NOC. If the company optimized its operations according to industry standards, what will be its operating cycle ( OC), cash conversion cycle ( CCC), and resource investment need? In terms of resource investment requirements, what is the cost of operational inefficiency?

20 Operating cycle (OC)= average age of inventory + average collection period = 110 days + 75 days = 185 days Cash conversion cycle(ccc)= OC - average payment period = 185 days - 30 days = 155 days Investment Tied-up= (Total Operating Cycle Outlays/365) x CCC = (26,500,000/365), x 155 = $11,253,425

21 OC, CCC and Resource Need at Industry Standards Industry OC= 83 days + 75 days = 158 days Industry CCC= 158 days - 39 days = 119 days Resources needed if CCC were at industry standard 119 days (26,500,000/365)x119= $8,639,726 Overinvestment in Operations=$11,253,425-8,639,726 = $2,613,699 Cost of inefficiency=$2,613,699 x 0.15 = $392,055

22 Offering 3/10 net 60 to Clients Reduction in collection period =75 days (1-0.4)=45 days OC = 110 days + 45 days = 155 days CCC =155 days - 39 days =116 days Resources needed = (26, /365)x116=$8,421,917 Additional savings =$ = $11,253,425 - $8,421,917 = =$2,831,507 =$2,831, = $424,126

23 Credit Policy Changes and Trade-offs Note that this savings occur at a cost. A more specific assessment of the credit policy changes require assessment of costs and benefits: The major cost is often the discount offered to the client, which reduces the revenues There are two typical benefits: A Reduction in investment in A/R A reduction in bad debt The adaptation of policy requires careful analysis of these costs and dbenefits.

24 Note The following slides (24-28) will not be covered in the review, and also are not covered in the preparation materials, however er it would be useful to put the preceding consideration into a perspective.

25 Discount and Reduction in Sales If the firms sales ( all on credit) are $ 40,000, and 45% of the customers are expected to take the cash discount, by how much will the firms annual revenues be reduced as a result of the discount? Reduction in sales: $40,000, = $540,000

26 ( 3) If the firms variable cost of the $ 40,000,000, in sales is 80%, determine the reduction in the average investment in accounts receivable and the annual savings that will result from this reduced investment, assuming that sales remain constant. Average investment in accounts receivable assuming cash discount: New average collection period = 45 days ($40,000, ) (365 45) = $3,945,205 Average investment in accounts receivable assuming no cash discount: (40,000, ) (365 75) = $6,575,342 Reduction in investment in accounts receivable: $6,575,342 - $3,945,205 = $2,630,137 Annual savings: $2,630, = $ 394,521

27 ( 4) If the firms bad- debts expenses decline from 2% to 1.5% of sales, what annual savings will result, assuming that sales remain constant? Reduction in bad debt expense: $40,000,000 ( )= $ 200,000 ( 5) Use your findings in parts ( 2) through ( 4) to assess whether offering the cash discount can be justified financially. Explain why or why not. Cost of offering cash discount ($ 540,000) Annual savings from reduction in investment in accounts receivable 394,521 Annual savings from reduction in bad debt expense: 200, Savings due to cash discount $ 54,521

28 End of Extra Material

29 Investing Short Term Funds Short term Working Capital Portfolios consist of highly liquid, less risky and shorter maturity securities. US Treasury Bills Federal Agency Securities (Fannie Mae, FHLB etc.) Bank CDs/Bank Sweep Services Banker s Acceptances (BA) Eurodollar Time Deposits Repos Commercial Papers Money Market Funds Adjustable Rate Preferred Stocks

30 Yield Calculations-A Quick Review Face Value-Purchase Price 360 Money Market Yield= Purchase Price Number of days to maturity Bond Equivalent Face Value-Purchase Price 365 Yield= Purchase Price Number of days to maturity Discount Basis Face Value-Purchase Price 360 Yield= Face Value Number of days to maturity

31 Example: Money Market and Bond Equivalent Yield A 91 day $100, US Treasury is sold at a discounted rate of 2.5%. Calculate the money market and bond equivalent Yield. Step-1: Calculate the Purchase Price 100,000-[0.025 x (91/360)x$100,000]=99, Step-2: Use MMY and BEY formulas MMY (100,000-99,368.06/99,368.06)x(360/91) =2.5159% BEY (100,000-99,368.06/99,368.06)x(365/91) =2.5508%

32 Managing Accounts Receivables The second component of the cash conversion cycle is the average collection period the average length of time from a sale on credit until the payment becomes usable funds to the firm. The collection period consists of two parts: the time period from the sale until the customer mails payment, and the time from when the payment is mailed until the firm collects funds in its bank account.

33 Average Collection Period Average Collection Period can be reduced by changing the credit terms and encouraging shorter pay periods through discounts. ACP can also reduced by increasing effectiveness of the collections by reducing collection float Collection float is the delay between the time when a payer deducts a payment from its checking account ledger and the time when the payee actually receives the funds in spendable form. There are three components of the collection float: Mail float is the delay between the time when a payer places payment in the mail and the time when it is received dby the payee. Processing float is the delay between the receipt of a check by the payee and the deposit of it in the firm s account. Clearing float is the delay between the deposit of a check kby the payee and the actual availability of the funds which results from the time required for a check to clear the banking system.

34 Float and Float Factor The Float is the amount of money in transit between payments made by customers and the funds usable by the company. Float Factor measures the time it takes for the deposited checks to clear, not the time it takes to receive the checks, deposit them and have them clear! Float Factor=Average Daily Float/Average Daily Deposits

35 Inventory Management Inventory is considered as an investment since managers must purchase the raw materials and make expenditures for the production of the product such as paying labor costs. Until cash is received through the sale of the finished goods, the cash expended for inventory, in any of its forms, is an investment by the firm. Classification of inventories: Raw materials: items purchased for use in the manufacture of a finished product Work-in-progress: all items that are currently in production Finished i goods: items that t have been produced d but not yet sold

36 Inventory Management: Differing Views About Inventory The different departments within a firm (finance, production, marketing, etc.) often have differing views about what is an appropriate level of inventory. Financial managers would like to keep inventory levels low to ensure that funds are wisely invested. Marketing managers would like to keep inventory levels high to ensure orders could be quickly filled. Manufacturing managers would like to keep raw materials levels high to avoid production delays and to make larger, more economical production runs.

37 Inventory Management Systems: Economic Order Quantity The EOQ looks at all of the various costs of inventory and determines what order size minimizes total inventory cost. The model analyzes the tradeoff between order cost and carrying cost and determines the order quantity that minimizes the total inventory cost. The model Parameters: S= Usage in units per period O=Order Cost per Order C=Carrying Cost per unit per period Q=Order Quantity per Period

38 Determination of optimal order size Invent tory costs s, dollars EOQ Optimal order size 2 SO C Total costs Carrying costs Total order costs Order size

39 Order Cost=Ox(S/Q) Carrying Cost=C x (Q/2) Economic Order Quantity TtlC Total Cost=Order tod Cost t+c Carrying Cost TC =[O x (S/Q)]+[ C x (Q/2)] Economic Order Quantity is the order quantity that minimizes the total cost. Minimum point for TC is the point where its slope is equal to zero. EOQ dtc/dq =0 EOQ 2SO C

40 Reorder Point Once a company has calculated its EOQ, it must determine when it should place its orders. More specifically, the reorder point must consider the lead time needed to place and receive orders If we assume that inventory is used at a constant rate throughout the year (no seasonality), the reorder point can be determined by using the following equation: Reorder point = lead time in days x daily usage Daily Usage=Annual Usage/360

41 Example: RLB Inc. EOQ and Cost of Inventory Assume that RLB, Inc., a manufacturer of electronic test equipment, uses S=1,600 units of an item annually. Its order cost is O=$50 per order, and the carrying cost is C=$1 per unit per year. EOQ={(2x50x1,600)/1} 1/2 =400 units Assuming that company orders 400 units at a time the total cost of inventory will be: TC=Order Cost +Carrying Cost ={50 x(1,600/400)}+ {$1 x (400/2)}=$400

42 RIB Reorder Point Using the RIB example above, if they know that it requires 10 days to place and receive an order, and the annual usage is 1,600 units per year, the reorder point can be determined as fll follows: Daily Usage=1600/360=4.444 Reorder Point=Lead Time x Daily Usage =10x =44.44 or 45 units Thus, when RIB s inventory level reaches 45 units, it should place an order for 400 units. However, if RIB wishes to maintain i safety stock kto protect tagainst stock outs, they would order before inventory reached 45 units.

43 Accounts Payable Management The longer the number of days of payables, the shorter the cash conversion cycle. Therefore firms have an incentive to delay payments. However, this effort should be managed carefully as it may result in deterioration ti of firm credibility and may have costly repercussions. While early payments should be avoided, and float factors should be carefully accounted for, systematic delays should be avoided and credit relationships should be carefully managed with suppliers. An important consideration in A/P management is the discount offers. Should the firm take discount offers and pay early? Or should the credit term be used fully?

44 Cash Discounts Taking the Cash Discount If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no cost associated with taking a cash discount Giving i Up the Cash Discount If a firm chooses to give up the cash discount, it should pay on the final day of the credit period. The cost of giving up a cash discount is the implied rate of interest paid to delay ypy payment of an account payable py for an additional number of days.

45 Example Zoom Industries, operator of a small chain of video stores, purchased $1,000 worth of merchandise on February 27 from a supplier extending terms of 2/10 net 30 EOM. If the firm takes the cash discount, it will have to pay $980 [$1,000 - (.02 x $1,000)] on March 10th saving $20. If Lawrence gives up the cash discount, payment can be made on March 30th. To keep its money for an extra 20 days, the firm must give up an opportunity to pay $980 for its $1,000 purchase, thus costing $20 for an extra $20 days.

46 Cost of Giving up Cash Discount 365/ N CD Annualized Cost of Giving up Discounts 1 1 (100% CD) 365/ 20 2% % (100% 2%) If the firm s short term financing cost Is lower than implied interest or cost of giving up cash discount, firm should take the discount

47 Cost of Giving Up Cash Discount Note that the cost of giving up cash discount increases with the credit period. The longer the credit period, or the longer the payment can be delayed, the lower the cost of cash discount. In the previous example, the payment can be delayed 20 more days. If the credit term was 2/10 net 70, payment could be delayed 60 more days. In that case the cost of giving up discount would be: 365/ 60 2% % (100% 2%)

48 Unsecured Sources of Short Term Loans The major type of loan made by banks to businesses is the short-term, self-liquidating loan which are intended to carry firms through seasonal peaks in financing needs. These loans are generally obtained as companies build up inventory and experience growth in accounts receivable. As receivables and inventories are converted into cash, the loans are then retired. These loans come in three basic forms: single-payment notes, lines of credit, and revolving credit agreements.

49 Interest on Short Term Loans Most banks loans are based on the prime rate of interest which is the lowest rate of interest charged by the nation s leading banks on loans to their most reliable business borrowers. Short term international bank loans are based on LIBOR Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate or LIBOR to adjust it for the borrowers riskiness. Interest rates may be fixed or floating: On a fixed-rate loan, the rate of interest is determined at a set increment above the prime rate or LIBOR and remains at that rate until maturity. On a floating-rate loan, the increment above the prime rate is initially established and is then allowed to float with prime or LIBOR until maturity

50 Method of Computing Interest Rates If interest is paid at maturity, the effective (true) rate of interest assuming the loan is outstanding for exactly one year may be computed as follows: Amount It Interestt Borrowed If the interest is paid in advance, it is deducted from the loan so that the borrower actually receives less money than requested. Loans of this type are called discount loans. The effective rate of interest on a discount loan assuming it is outstanding for exactly one year may be computed as follows: Interest Amount Borrowed Interest

51 Single Payment Notes ABC Inc. recently borrowed $100,000 from each of 2 banks AandB. and Loan A is a fixed rate note, and loan B is a floating rate note. Both loans were 90-day notes with interest due at the end of 90 days. The rates were set at 1.5% above prime for A and 1.0% above prime for B when prime was 6%. Based on this information, the total interest cost on loan A is: $1,849 [$100,000 x (6% +1.5%)x (90/365)]=$1,849 The effective cost is 1.85% or ($1,849/100,000) for 90 days. The effective annual rate may be calculated as follows: EAR = (1 + periodic rate) m - 1 = ( ) = 7.73%

52 Line of Credit A line of credit is an agreement between a commercial bank and a business specifying the amount of unsecured short-term borrowing the bank will make available to the firm over a given period of time. It is usually made for a period of 1 year and often places various constraints on borrowers. Although not guaranteed, the amount of a LOC is the maximum amount the firm can owe the bank at any point in time. The interest rate on a LOC is normally floating and pegged to prime. Both LOCs and revolving credit agreements often require the borrower to maintain compensating balances.a compensating balance is simply a certain ti checking account tbl balance equal lto a certain ti percentage of fthe amount borrowed (typically 10 to 20 percent). This requirement effectively increases the cost of the loan to the borrower.

53 Revolving Credit Agreement A RCA is nothing more than a guaranteed line of credit. Because the bank guarantees the funds will be available, they typically charge a commitment t fee which h applies to the unused portion of the borrowers credit line. A typical fee is around 0.5% of the average unused portion of the funds. Although more expensive than the LOC, the RCA is less risky ik from the borrowers perspective.

54 Example:RCA REH Company has a $2 million RCA. Its average borrowing under the agreement for the past year was $1.5 million. The bank charges a commitment fee of 0.5% As a result, they had to pay 0.5% on the unused balance of $500,000 or $2,500. In addition, REH paid $112,500 in interest on the $1.5 million it actually used. As a result, the effective annual cost of the RCA was 7.67% [($112,500 + $2500)/$1,500,000].

55 Commercial Paper Commercial paper is a short-term, unsecured promissory note issued by a firm with a high credit standing. Generally only large firms in excellent financial condition can issue commercial paper. Most commercial paper has maturities ranging from 3 to 270 days, is issued in multiples of $100,000 or more, and is sold at a discount form par value. Commercial paper is traded in the money market and is commonly held as a marketable security investment.

56 Cost of Commercial Paper XYZ Corporation has just issued $1 million worth of 90-day commercial paper at $990,000. At the end of 90 days, XYZ will pay the purchaser the full $1 million. The cost to XYZ is therefore 1.01% ($10,000/$990,000) for 90 days. The effective annual rate of interest can be calculated as follows: EAR = (1 + periodic rate) m - 1 = ( ) = 8.41%

57 Secured Loans-A/R and Inventory as Collaterals Although it may reduce the loss in the case of default, from the viewpoint of lenders, collateral does not reduce the riskiness of default on a loan. When collateral is used, lenders prefer to match the maturity of the collateral with the life of the loan. As a result, for short-term loans, lenders prefer to use accounts receivable and inventory as a source of collateral.

58 A/R as Collateral Pledging accounts receivable occurs when accounts receivable is used as collateral for a loan. After investigating the desirability and liquidity of the receivables, banks will normally lend between 50 and 90 percent of the face value of acceptable receivables. In addition, to protect its interests, the lender files a lien on the collateral and is made on a nonnotification basis (the customer is not notified).

59 Inventory as Collateral The most important characteristic of inventory as collateral is its marketability. Perishable items such as fruits or vegetables may be marketable, but since the cost of handling and storage is relatively high, they are generally not considered to be a good form of collateral. Specialized items with limited sources of buyers are also not desirable collateral. l A floating inventory lien is a lender s claim on the borrower s general inventory as collateral. This is most desirable when the level of inventory is stable and it consists of a diversified group of relatively inexpensive items. Because it is difficult to verify the presence of the inventory, lenders generally advance less than 50% of the book value of the average inventory and charge 3 to 5 percent above prime for such loans.

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