FINA351, Managerial Finance - Chapter 16 Notes WORKING CAPITAL. Involves current assets and liabilities in the operating cycle

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1 FINA351, Managerial Finance - Chapter 16 Notes WORKING CAPITAL Involves current assets and liabilities in the operating cycle Is important for every business major to understand because: (1) it is where new hires often start out in a business (2) it is cited as a major reason for business failure when not managed properly (3) it involves all functional areas of business (marketing, operations, accounting, finance) so just about everyone needs to know how it works. Net working capital equals current assets less current liabilities. Current ratio equals current assets divided by current liabilities. Operating cycle: The time period from when inventory is acquired to when cash is collected from sales. Consists of: (1) the inventory period (time it takes from acquisition to sale of inventory) (2) the accounts receivable period (time it takes from sale to cash collection). Cash cycle: The time period from when cash is paid out for inventory to when it is collected from sales. Is negative for some businesses (e.g. Dell, Wal-mart), which means that collections are made from customers before cash is paid out to suppliers. Wal-Mart

2 Operating Cycle = Inventory Period + Receivable Period Cash Cycle = Operating Cycle Payables Period S/T Credit S/T Investments Cash Cash Collect from Customer Purchase Inventory on Credit Make Sale Pay for Inventory Operating Cycle = Inventory Period + Receivable Period Cash Cycle = Operating Cycle Payables Period Inventory period - how long, on average, it sits on the shelf. Also called Days Sales in Inventory (see Ch. 3). Receivables period how long it takes to collect the receivables. Also called Days Sales in Receivables (see Ch. 3). Operating cycle time from when the invoice for inventory is received until the cash from the sale is collected. This equals the sum of the inventory period plus the receivables period. Shorter is better. Payables period how long it takes pay accounts payable. Cash cycle how long the firm is out cash (e.g. time from when it pays for its inventory until it collects from the sale). This equals the operating cycle minus the payables period. Shorter is better. Negative is great.

3 CURRENT ASSETS Too much current assets causes carrying costs. Examples: too much idle cash results in lost investment income & investment opportunities too much accounts receivable results in a non-income producing asset with an increasing chance of default and significant costs of monitoring and collecting. Also, there s the opportunity cost of what could have been done if the $$ was not tied up in A/R too much inventory results in a non-income producing asset that costs money to track, store and insure. Also, there s the opportunity cost of what could have been done if the $$ was not tied up in inventory. In addition, lots of inventory means more chance of spoilage, obsolescence or theft. Finally, too much inventory hides operating efficiencies. For these reasons, many firms have adopted JIT (Just in Time), which minimizes inventory and maximizes turnover. Too little CA causes shortage costs. Examples: too little cash results in deadly costs, insolvency and eventual bankruptcy. too little inventory results in stock outs, which lead to lost sales and lost customer goodwill. Also, unplanned reorder costs can be very expensive and be disruptive to operations. Just the right amount of CA (optimum point) is where the sum of carrying costs plus shortage costs is minimized. See chart. Current Assets in Practice Amount of CA varies among industries. Which industry would have more CA as a percent of total assets: A restaurant or a retailer? A flower shop or a jewelry store? Why? Overall, the amount of CA have been declining (from 50% of assets in the 1960s to about 40% today). This is due to efficiencies in communication, shipping, and information technology.

4 CURRENT LIABILITIES (S/T Financing) Unsecured: Secured: Trade credit: regular accounts with vendors, terms 2/10,n/30, etc. Line of credit: like a business credit card that you can write checks against Commercial paper: S/T notes payable by big, well-known corporations issued directly to investors (mutual funds, etc.) Compensating balance: balance in a bank account held to compensate if default occurs (i.e. bank would seize the money in the account if you failed to make your loan payment) A/R financing has two forms: assignment - borrow with receivables as collateral factoring - sell receivables to bank who collects money from your customers, which allows you to remove receivables off your balance sheet and replace them with cash; also, you don t have to deal with the time and effort to collect receivables. Conventional factoring is when the factor cannot come after you if your customers fail to pay (also called non-recourse financing). The biggest form of factoring is when businesses accept credit cards the businesses actually sell the receivable to VISA etc. and pay a factoring fee of 2-3% of sales to have VISA collect from the buyer. The bank behind the VISA card becomes the factor.) Would secured financing (e.g secured with receivables or inventory) likely have a higher or lower interest rate than unsecured financing?

5 Advantages to retailers of of selling receivables to credit card issuers (i.e. VISA)

6 Inventory financing has three forms: blanket lien - borrow with all inventory as collateral trust receipt - borrow with specific inventory as collateral field warehousing financing - independent warehouse supervises inventory for lender (e.g. consider Allied Crude Oil Vegetable Refining Co.) Pictured here is Tino De Angelis, CEO of Allied Crude Vegetable Refining Co., before he was sent to the slammer for inventory fraud. If his inventory, which was collateral for loans, had been stored in an independent field warehouse, he likely would not have been able to get away with the fraud. One of the biggest scams in modern finance was when Tino borrowed $200 million secured by large tanks of salad oil. But unbeknown to the foolish lenders, the company had significantly overstated its oil inventory using three methods: (1) 40-foot tanks were filled with 37 feet of seawater, which left 3-feet of oil floating on top for all the foolish lenders to admire. (2) Tino listed more tanks on the inventory records than actually existed. Then he had his men quickly repaint the numbers on the tanks after the lenders had examined them, thus causing the foolish bankers to count the same tanks twice. (3) Tino built underground pipes that could rapidly transfer oil from one tank to another, causing the same salad oil to be counted twice by the foolish lenders. In the end, the foolish lenders were left out in the cold looking for their $200 million and Tino was put in the slammer for 7 years. Current Liabilities in Practice Amount of current liabilities varies among industries. Generally, the more current assets there are, the more current liabilities there are. Overall, about 30% of total assets today are financed with current liabilities. This percentage has increased from 20% to 30% since 1960 as firms have relied more on S/T credit (restrictive policy.) WORKING CAPITAL POLICIES 1. Flexible - have a lot of current assets, little current liabilities. When needing funds, use cash and sell S/T investments. While considered a conservative "safe" approach, it can be inefficient and costly (carrying costs). Moreover, a high level of current assets hides inefficiencies such 2. Restrictive - have few current assets and instead rely on S/T financing for cash needs. An aggressive approach but comes with the risk of shortage costs. 3. Compromise - have the right amount of current assets and S/T financing. This balanced approach is the best.

7 Historically, firms have been moving towards a restrictive policy but with mechanisms to prevent shortage costs. Due primarily to technology, better communication, transportation, and payment options have allowed firms to reduce inventory (JIT), receivables, and other current assets.