c17 Brigham Fm3ce_ppt

ADAPTED FOR

ADAPTED FOR THE THE THIRD CTHIRD CANADIAN ANADIAN EDITIONEDITION BY:

BY:

THEORY & PRACTICE

THEORY & PRACTICE

 JIMMY

 JIMMY WWANGANG LAURENTIAN

LAURENTIAN

UNIVERSITY

UNIVERSITY

FINANCIAL

CHAPTER 17

CHAPTER 17

WORKING

WORKING CAPICAPITTALAL

MANAGEMENT AND SHORT MANAGEMENT AND SHORT--TERM FINANCING

CHAPTER 17

CHAPTER 17

WORKING

WORKING CAPICAPITTALAL

MANAGEMENT AND SHORT MANAGEMENT AND SHORT--TERM FINANCING

CHAPTER 17 OUTLINE

CHAPTER 17 OUTLINE

•

• 17-1 Overview of Working Capital17-1 Overview of Working Capital

Management Management

•

• 17-2 Using and Financing Operating Current17-2 Using and Financing Operating Current

Assets Assets

•

• 17-3 The Cash Conversion Cycle17-3 The Cash Conversion Cycle •

• 17-4 The Cash Budget17-4 The Cash Budget •

CHAPTER 17 OUTLINE

(cont’d)

• 17-6 Accruals and Accounts Payable (Trade Credit) • 17-7 Short-Term Bank Loans

• 17-8 Commercial Paper

• 17-9 Bankers’ Acceptances

• 17-10 Calculating Financing Costs

17-1 Overview of Working Capital

Management

• Two basic questions to answer:

1. What is the appropriate amount of working capital (both in total and for each account)?

2. How should working capital be financed?

• Improving the firm’s working capital position requires

the cooperation from all operating divisions of the firm, such as:

 ─ Experts in logistics

 ─ Operations management  ─ IT

The Role of Financial Managers

• Evaluate the effectiveness of the firm’s

operating departments, relative to other firms in its industry

• Evaluate the profitability of alternative

proposals for improving working capital management

• Decide how much cash the company should

keep on hand and how much short-term

financing should be used to finance working capital

Basic Definitions

• (Gross) working capital: Total current assets • Net working capital:

Current assets (CA) – Current liabilities (CL)

• Net operating working capital (NOWC):

Operating CA – Operating CL =

(Cash + A/R + Inv.) – (A/P + Accruals)

• Please note the difference between Operating CA

Definitions

(cont ’ d)

• Cash is defined as the total value of the

short-term financial assets held to support ongoing operations and is a part of NOWC.

• Short-term investments is defined as the total

value of short-term financial assets held for future purposes; thus it is not included in calculating NOWC.

Definitions

(cont ’ d)

• Working capital management:

 – Establishing working capital policy and then

the day-to-day control of cash, inventories, receivables, accruals, and accounts payable

• Working capital policy:

 – The level of each current asset  – How current assets are financed

Operating Working Capital

A simple cycle of operations:

CASH CASH RAW MATERIALS INVENTORY FINISHED GOODS INVENTORY RECEIVABLES RECEIVABLES

17-2 Using and Financing

Operating Current Assets

Two issues:

1. Efficient use of operating current assets 2. Financing operating current assets

(1) Alternative Net Operating

Working Capital Policies

• Relaxed

 – Current assets maximized while A/P and

accruals minimized

• Restricted

 – Current assets minimized while A/P and

accruals maximized; NOWC turned over more frequently

• Moderate

Comparison of Three Alternative

Policies

Policy Level Total Assets ROE Risk of CA Turnover

Relaxed high low low low Restricted low high high high Moderate all are moderate

The optimal strategy is the one that management

believes will maximize the firm’s long-term free

(2) Alternative Short-Term

Financing Policies

• Maturity matching (or “self-liquidating”):

Match the maturity of the assets with the maturity of the financing

• Aggressive: Use short-term financing to

finance permanent assets

• Conservative: Use permanent capital for

Maturity-Matching vs. Aggressive

Financing Policy

Lower dashed line, more aggressive.

}

L-T Fin: Stock & Bonds,

Conservative Financing Policy

Fixed Assets

 Years $

Perm NOWC L-T Fin:_{Stock &} Bonds Marketable Securities

Zero S-T debt

Choosing Among the Approaches

• In general, short-term debt has a lower cost

than long-term debt.

• But short-term debt is riskier for the

borrowing firm for two reasons:

1. Long-term debt maintains a relatively stable cost over time

Choosing Among the Approaches

(cont’d)

• Short-term loans’ advantages over long-term

loans:

1. Can be negotiated much faster 2. Offer greater flexibility

• The final decision depends on:

1. The firm’s specific conditions 2. Managers’ risk preferences

17-3 The Cash Conversion Cycle

The cash conversion cycle focuses on the time between payments made for materials and

labour and payments received from sales:

Cash Conversion = Cycle Inventory Conversion + Period Receivables Collection  _– Period Payables Deferral Period (17-4)

Inventory Conversion Period (ICP)

• Measures the average time required to

process materials into finished goods and then to sell them

• Can be calculated as

ICP = Inventory/Average daily COGS (17-1)

• Alternatively,

Receivables Collection Period

• Measures the average length of time required

to collect cash following a sale

• Also called the days sales outstanding (DSO) • Can be calculated as:

Receivables Collection Period = DSO = Receivables Sales/365 (17-2)

Payables Deferral Period (PDP)

• Measures the average length of time between

the purchase of materials and labour and the payment of cash for them

• Can be calculated as

PDP = Payables/Purchases per day

• Alternatively,

PDP = Payables

Cash Conversion Cycle (CCC)

• The cycle starts with cash paid out for

productive resources until cash is received from the sale of products.

• It represents the average length of time a

dollar is tied up.

• It measures management effectiveness. • The shorter, the better.

Shortening CCC

• CCC = ICP + DSO – PDP

1. Processing and selling goods more quickly 2. Speeding up A/R collections

3. Slowing down A/P payments 4. Any combination of the above

17-4 The Cash Budget

• Purpose: Uses forecasts of cash flows to

predict loan needs and funds available for temporary investment

• Timing: Daily, weekly, or monthly, depending

upon budget’s purpose. Monthly for annual planning, daily for actual cash management.

Data Required for Cash Budget

• Sales forecast

• Information on collections delay

• Forecast of purchases and payment terms • Forecast of cash expenses: wages, taxes,

utilities, and so on

• Initial cash on hand • Target cash balance

Cash Budget Issue: Depreciation

• Only cash payments and receipts appear in

the cash budget.

• As depreciation is a noncash charge, it is not

explicitly included in the cash budget.

• However, depreciation does affect taxes,

Cash Budget Issue: Other Potential

Cash Inflows in Addition to

Collections

• Proceeds from fixed asset sales

• Proceeds from stock and bond sales • Interest earned

Cash Budget Issue:

Interest Earned or Paid

• Interest earned: Add line in the collections

section

• Interest paid: Add line in the payments section • Found as interest rate×surplus/loan line of

cash budget for preceding month.

• Note: Interest on any other debt would need

Cash Budget Issue: Bad Debts

• Collections would be reduced by the amount

of bad debt losses.

• For example, if the firm had 3% bad debt

losses, collections would total only 97% of sales.

• Lower collections would lead to lower

MicroDrive Inc.: Cash Balance

• Cash budget indicates the company will incur

net cash loss in the first three months but

have net cash gain in the latter three months.

• To maintain a monthly target cash balance of

$10 million, MicroDrive will have to borrow in the first three months, and the total loan

requirement is expected to peak at the end of September.

MicroDrive Inc.: Cash Balance

(cont’d)

• As sales increase steadily in the first few months and

peak in September, increased payments for purchases, wages, and other items will exceed receipts from sales, leading to net cash outflow in the first few months.

• In the latter 3 months, sales, purchases, and payments

for past purchases will fall sharply, while collections will increase following strong sales in the previous months, resulting in net cash gain.

• The cash surplus can be used to pay off the loans taken

Cash Budgeting Applications

• Estimating short-term borrowing needs • Assessing minimum cash balance

requirements

• Planning for business expansion

• Don’t confuse a cash budget with an income

17-5 Short-Term Financing

• Spontaneous financing • Short-term bank loans

Short-Term Debt:

Advantages and Disadvantages

• Advantages:

 – Can be obtained much faster than long-term credit  – May not be appropriate for seasonal or cyclical

needs for funds

 – Normally carry lower interest rates • Disadvantages:

 – Interest rates fluctuate widely over time

17-6 Accruals and Accounts Payable

(Trade Credit)

Spontaneous financing:

• Arises automatically, or spontaneously, from a

firm’s operations

• Two types:  – Accruals

Cost of Trade Credit

• Trade credit is not free!

0 10 30

|---|---| pay $98 pay $100

|get to use $98 for 20 days at $2|

Cost of Not Taking Discounts

• Nominal annual cost of trade credit =

• Effective annual rate =

• (1 + 2.04%) 365/20 – 1 = 44.6% % 2 . 37 20 365 % 04 . 2 10 30 365 2 100 2  period Discount g outstandin is credit Days 365  percent Discount 100  percent Discount           (17-5)

17-7 Short-Term Bank Loans

17-7 Short-Term Bank Loans

(cont’d)

• Line of credit

• Commercial paper

Loan Application

• Historical financials • Pro forma financials • Income and EBITDA • Types of assets

Interest Rates

• Prime rate is the lowest interest rate that a

bank lends money at.

• Prime rate can swing very quickly in either

Collateral

• The short-term loan is secured by a specific

collateral item (asset).

• The item is registered under the Personal

Covenants

Covenants

•

• Designed to protect the lenderDesigned to protect the lender •

• Specific terms written into the loansSpecific terms written into the loans •

• Examples of covenants:Examples of covenants:  –

 – Better current ratioBetter current ratio  –

 – Minimum Minimum interest painterest payment coverageyment coverage  –

Line of Credit

Line of Credit

•

• One-year operating loanOne-year operating loan •

• Interest rate floats based on primeInterest rate floats based on prime •

17-8 Commercial Paper

17-8 Commercial Paper

•

• CP is short-term unsecured promissory notesCP is short-term unsecured promissory notes

issued by large, strong companies. issued by large, strong companies.

•

• CP trades in the market at rates just above theCP trades in the market at rates just above the

T-bill rate. T-bill rate.

•

• CP is bought with surplus cash by banks andCP is bought with surplus cash by banks and

other companies, then held as a marketable other companies, then held as a marketable security for liquidity purposes.

17-

9 Bankers’ Acceptances

• BAs are commonly used to finance goods with

long payment terms—typically exports and

imports.

• They are term drafts written by the purchasing

firm/importer and “accepted” by a major bank.

• The bank is the ultimate guarantor for payment. • BAs are bought and sold on the market before

17-10 Calculating Financing Costs

• Regular, or simple, interest  – Interest-only loan

 – Simple vs. effective interest rate • Discount interest

• Effects of compensating balances • Installment loans: Add-on interest

17-11 Secured Short-Term Financing

• Accounts receivable financing • Inventory financing

Accounts Receivable Financing

• Pledging A/R

 – A/R used as security for a loan

 – Lender not only has a claim against A/R but

also has recourse to the borrower

• Factoring or Selling A/R

 – Lender/buyer has no recourse to the

borrower/seller

 – Providing not only money but also a credit

Inventory Financing

Summary

• Working capital refers to current assets, and net

working capital (NWC) is defined as current assets minus current liabilities.

• Net operating working capital (NOWC) is defined

as operating current assets minus operating current liabilities.

• The cash conversion period is the average time

required to convert materials into finished goods and then to sell those goods.

Summary

(cont’d)

• The cash conversion cycle equals the length of time

between the firm’s actual cash expenditures to pay

for productive resources and its own cash receipts from the sale of products, i.e., the length of time between paying for labour and materials and

collecting on receivables.

• Under a relaxed working capital policy, a firm would

hold relatively large amounts of each type of current asset.

Summary

(cont’d)

• Under a restricted working capital policy, the firm

would hold minimal amounts of these items.

• The cash budget is a schedule showing projected

cash inflows and outflows over a period.

• The cash budget is used to predict cash surpluses

and deficits, and it is the primary cash management planning tool.

Summary

(cont’d)

• Permanent net operating working capital is the

NOWC that the firm holds even during slack

times, whereas temporary NOWC is the additional NOWC needed during seasonal or cyclical peaks.

• The methods used to finance permanent and

temporary NOWC define the firm’s short-term financing policy.

• There are three possible short-term financing

policy alternatives: moderate, aggressive, and conservative.

Summary

(cont’d)

• The advantages of short-term credit are (1) the

speed with which short-term loans can be

arranged, (2) increased flexibility, and (3) the fact that short-term interest rates are generally lower than long-term rates.

• The principal disadvantage of short-term credit

is the extra risk the borrower must bear because (1) the lender can demand payment on short

notice and (2) the cost of the loan will increase if interest rates rise.

Summary

(cont’d)

• Accounts payable, or trade credit, arises

spontaneously as a result of credit purchases.

• Firms should use all the free trade credit

available, but they should use costly trade credit only if it is less expensive than other forms of

short-term debt.

• A line of credit is an important short-term

operating loan designed to finance seasonal working capital requirements.

Summary

(cont’d)

• Commercial paper is a short-term promissory

note issued by large, strong firms with investment-grade credit ratings and sold primarily to large institutional investors.

• A bankers’ acceptance (BA) is a short-term note

of a borrower, unconditionally guaranteed by a major bank.