SOURCE: ©Greg Girard/Contact Press Images
CHAPTER
W o r k i n g C a p i t a l M a n a g e m e n t
15
Second, Dell uses information technology to collect data that enables it to better customize products for its customers. For example, a recent Fortune article described how Dell has been able to capture most of the Ford Motor Company’s PC business:
Look at what the company does for one big customer, Ford Motor. Dell creates a bunch of different configurations designed for Ford employees in different departments. When Dell receives an order via the Ford Intranet, it knows immediately what type of worker is ordering and what kind of computer he or she needs. The company assembles the proper hardware and even installs the right software, some of which consists of Ford-specific code that’s stored at Dell. Since Dell’s logistics software is so sophisticated, it can do the customization quickly and inexpensively.
Sound working capital management is necessary if a company wants to compete in the information age, and the lessons taught by Dell extend to other industries. Indeed, Michael Dell, founder and CEO of Dell Computer, recently discussed in an interview with The Wall Street Journal how traditional manufacturers, such as the automobile companies, can use the experience of Dell to improve their operations. The ramatic improvements in computer technology
and the growth in the Internet have dramatically transformed the computer industry. Some companies have succeeded while others have failed.
Despite some recent setbacks, Dell Computer has clearly been one that has succeeded: Its sales have grown from roughly $5 billion in 1995 to more than $30 billion in 2000.
There are a lot of reasons behind Dell’s remarkable success over the past decade. Perhaps the number one reason is the company’s impressive success in managing its working capital, which is the focus of this chapter.
The key to Dell’s success is its ability to build and deliver customized computers very quickly.
Traditionally, manufacturers of custom-design products had two choices. They could keep a large supply of inventory on hand to meet customer needs, or they could make their customers wait for weeks while the customized product was being built. Dell uses
information technology to revolutionize working capital management. First, it uses information technology to better coordinate with its suppliers. If a supplier wants to do business with Dell, it must be able to provide the necessary components quickly and cheaply. Suppliers that adapt and meet Dell’s demands are rewarded with increased business, and those that don’t lose their Dell business.
D E L L
R E V O L U T I O N I Z E S W O R K I N G C A P I TA L M A N A G E M E N T
DELL COMPUTER
$
D
About 60 percent of a typical financial manager’s time is devoted to working cap- ital management, and many students’ first jobs will involve working capital. This is particularly true in smaller businesses, where most new jobs in the United States are being created.
Working capital policy involves two basic questions: (1) What is the appropri- ate amount of current assets for the firm to carry, both in total and for each spe- cific account, and (2) how should current assets be financed? This chapter ad- dresses current asset holdings and their financing.
As you will see in this chapter, sound working capital management goes beyond finance. Indeed, most of the ideas for improving working capital management often stem from other disciplines. For example, experts in business logistics, operations management, and information technology often work with the marketing group to develop a better way to deliver the firm’s products. Where finance comes into play is in evaluating the profitability of alternative systems, which are generally costly to in- stall. For example, assume that a firm’s information technology and marketing groups decide that they want to (1) develop new software and (2) purchase computer ter- minals that will be installed in their customers’ premises. Customers will then keep track of their own inventories and automatically order new supplies when inventory information more easily, and in ways they never could before.
5. Think about what could be done with the capital that would be freed up by shedding excessive inventory and other redundant assets.■
SOURCES: J. William Gurley and Jane Hodges, “A Dell for Every Industry,” Fortune, October 12, 1998, 167–172; and Gary McWilliams and Joseph B. White, “Dell to Detroit: Get into Gear Online!” The Wall Street Journal, December 1, 1999, B1.
article included Michael Dell’s five points on how to build a better car:
1. Use the Internet to lower the costs of linking manufacturers with their suppliers and dealers.
2. Turn over to an outside specialist any operation that isn’t central to the business.
3. Accelerate the pace of change, and get employees conditioned to accept change.
4. Experiment with Internet businesses. Set up trials to see what happens when customers can access
levels hit specified targets. The system will improve inventory management for both the manufacturer and its customers and also help “lock in” good customers.
Significant costs will be incurred to develop and install the new system, but if it is adopted, the company can meet its customers’ needs better, and with smaller inventory, and also increase sales. In many respects, this scenario looks like a typ- ical capital budgeting project — it has an up-front cost followed by a series of pos- itive cash flows. The finance group can use the capital budgeting techniques de- scribed in Chapters 11 and 12 to evaluate whether the new system is worth the cost and also whether it should be developed in-house or purchased from an out- side source. As with other chapters in this text, the textbook’s CD-ROMcontains an Excel file, 15MODEL.xls, that will guide you through the chapter’s calculations. ■
W O R K I N G C A P I T A L T E R M I N O L O G Y
We begin our discussion of working capital policy by reviewing some basic definitions and concepts:
1. Working capital, sometimes called gross working capital, simply refers to current assets used in operations.
2. Net working capital is defined as current assets minus current liabilities.
3. Net operating working capital is defined as current assets minus non- interest-bearing current liabilities. More specifically, net operating work- ing capital is often expressed as cash and marketable securities, accounts receivable, and inventories, less accounts payable and accruals.1
4. The current ratio, which was discussed in Chapter 3, is calculated by di- viding current assets by current liabilities, and it is intended to measure liquidity. However, a high current ratio does not ensure that a firm will have the cash required to meet its needs. If inventories cannot be sold, or if receivables cannot be collected in a timely manner, then the apparent safety reflected in a high current ratio could be illusory.
5. The quick ratio, or acid test, also attempts to measure liquidity, and it is found by subtracting inventories from current assets and then dividing by current liabilities. The quick ratio removes inventories from current assets because they are the least liquid of current assets. Therefore, the quick ratio is an “acid test” of a company’s ability to meet its current obligations.
6. The best and most comprehensive picture of a firm’s liquidity position is shown by its cash budget. This statement, which forecasts cash inflows and Working Capital
A firm’s investment in short-term assets — cash, marketable securities, inventory, and accounts receivable.
Net Working Capital Current assets minus current liabilities.
Net Operating Working Capital Current assets minus non- interest-bearing current liabilities.
1This definition assumes that cash and marketable securities on the balance sheet are at their normal long-run target levels and that the company is not holding any excess cash. Excess holdings of cash and marketable securities are generally not included as part of net operating working capital.
outflows, focuses on what really counts, namely, the firm’s ability to gen- erate sufficient cash inflows to meet its required cash outflows. We will discuss cash budgeting in detail later in the chapter.
7. Working capital policy refers to the firm’s policies regarding (1) target levels for each category of current assets and (2) how current assets will be financed.
8. Working capital management involves both setting working capital policy and carrying out that policy in day-to-day operations.
The term working capital originated with the old Yankee peddler, who would load up his wagon with goods and then go off on his route to peddle his wares.
The merchandise was called working capital because it was what he actually sold, or “turned over,” to produce his profits. The wagon and horse were his fixed assets. He generally owned the horse and wagon, so they were financed with “equity” capital, but he borrowed the funds to buy the merchandise.
These borrowings were called working capital loans, and they had to be repaid after each trip to demonstrate to the bank that the credit was sound. If the ped- dler was able to repay the loan, then the bank would make another loan, and banks that followed this procedure were said to be employing “sound banking practices.”
S E L F - T E S T Q U E S T I O N S
Why is the quick ratio also called an acid test?
How did the term “working capital” originate?
Differentiate between net working capital and net operating working capital.
T H E C A S H C O N V E R S I O N C Y C L E
As we noted above, the concept of working capital management originated with the old Yankee peddler, who would borrow to buy inventory, sell the inventory to pay off the bank loan, and then repeat the cycle. That concept has been ap- plied to more complex businesses, where it is used to analyze the effectiveness of a firm’s working capital management.
Firms typically follow a cycle in which they purchase inventory, sell goods on credit, and then collect accounts receivable. This cycle is referred to as the cash conversion cycle, and it is discussed in detail in the next section. Sound work- ing capital policy is designed to minimize the time between cash expenditures on materials and the collection of cash on sales.
A
NI
L L U S T R AT I O NWe can illustrate the process with data from Real Time Computer Corporation (RTC), which in early 2001 introduced a new minicomputer that can perform one billion instructions per second and that will sell for $250,000. RTC expects Working Capital Policy
Basic policy decisions regarding (1) target levels for each category of current assets and (2) how current assets will be financed.
to sell 40 computers in its first year of production. The effects of this new prod- uct on RTC’s working capital position were analyzed in terms of the following five steps:
1. RTC will order and then receive the materials it needs to produce the 40 computers it expects to sell. Because RTC and most other firms purchase materials on credit, this transaction will create an account payable. How- ever, the purchase will have no immediate cash flow effect.
2. Labor will be used to convert the materials into finished computers.
However, wages will not be fully paid at the time the work is done, so, like accounts payable, accrued wages will also build up.
3. The finished computers will be sold, but on credit. Therefore, sales will create receivables, not immediate cash inflows.
4. At some point before cash comes in, RTC must pay off its accounts payable and accrued wages. This outflow must be financed.
5. The cycle will be completed when RTC’s receivables have been collected.
At that time, the company can pay off the credit that was used to finance production, and it can then repeat the cycle.
The cash conversion cycle model, which focuses on the length of time be- tween when the company makes payments and when it receives cash inflows, formalizes the steps outlined above.2 The following terms are used in the model:
1. Inventory conversion period, which is the average time required to convert materials into finished goods and then to sell those goods.
Note that the inventory conversion period is calculated by dividing in- ventory by sales per day. For example, if average inventories are $2 mil- lion and sales are $10 million, then the inventory conversion period is 73 days:
(15-1)
73 days.
Thus, it takes an average of 73 days to convert materials into finished goods and then to sell those goods.3
2. Receivables collection period, which is the average length of time re- quired to convert the firm’s receivables into cash, that is, to collect cash following a sale. The receivables collection period is also called the days
$2,000,000
$10,000,000/365 Inventory conversion period Inventory
Sales per day
2See Verlyn D. Richards and Eugene J. Laughlin, “A Cash Conversion Cycle Approach to Liq- uidity Analysis,” Financial Management, Spring 1980, 32–38.
3Some analysts define the inventory conversion period as inventory divided by daily cost of goods sold. However, most published sources use the formula we show in Equation 15-1. In addition, some analysts use a 360-day year; however, unless stated otherwise, we will base all our calculations on a 365-day year.
Cash Conversion Cycle Model Focuses on the length of time between when the company makes payments and when it receives cash inflows.
Inventory Conversion Period The average time required to convert materials into finished goods and then to sell those goods.
Receivables Collection Period The average length of time required to convert the firm’s receivables into cash, that is, to collect cash following a sale.
sales outstanding (DSO), and it is calculated by dividing accounts receivable by the average credit sales per day. If receivables are $657,534 and sales are $10 million, the receivables collection period is
(15-2)
Thus, it takes 24 days after a sale to convert the receivables into cash.
3. Payables deferral period, which is the average length of time between the purchase of materials and labor and the payment of cash for them.
For example, if the firm on average has 30 days to pay for labor and ma- terials, if its cost of goods sold are $8 million per year, and if its accounts payable average $657,534, then its payables deferral period can be calcu- lated as follows:
(15-3)
30 days.
The calculated figure is consistent with the stated 30-day payment period.4 4. Cash conversion cycle, which nets out the three periods just defined and which therefore equals the length of time between the firm’s actual cash expenditures to pay for productive resources (materials and labor) and its own cash receipts from the sale of products (that is, the length of time between paying for labor and materials and collecting on receiv- ables). The cash conversion cycle thus equals the average length of time a dollar is tied up in current assets.
We can now use these definitions to analyze the cash conversion cycle. First, the concept is diagrammed in Figure 15-1. Each component is given a number, and the cash conversion cycle can be expressed by this equation:
(1) (2) (3) (4)
(15-4) To illustrate, suppose it takes Real Time an average of 73 days to convert raw materials to computers and then to sell them, and another 24 days to collect on receivables. However, 30 days normally elapse between receipt of raw
Inventory conversion
period
Receivables collection
period
Payables deferral
period
Cash conversion
cycle .
$657,534
$8,000,000/365
Payables
Cost of goods sold/365 Payables
deferral period
Payables Purchases per day
$657,534
$10,000,000/365 24 days.
Receivables
collection period DSO Receivables Sales/365
4Some sources define the payables deferral period as payables divided by daily sales.
Payables Deferral Period The average length of time between the purchase of materials and labor and the payment of cash for them.
Cash Conversion Cycle The average length of time a dollar is tied up in current assets.
materials and payment for them. In this case, the cash conversion cycle would be 67 days:
Days in Cash Conversion Cycle 73 days 24 days 30 days 67 days.
To look at it another way,
Cash inflow delay Payment delay Net delay (73 days 24 days) 30 days 67 days.
S
H O R T E N I N G T H EC
A S HC
O N V E R S I O NC
Y C L EGiven these data, RTC knows when it starts producing a computer that it will have to finance the manufacturing costs for a 67-day period. The firm’s goal should be to shorten its cash conversion cycle as much as possible without hurt- ing operations. This would improve profits, because the longer the cash con- version cycle, the greater the need for external financing, and that financing has a cost.
The cash conversion cycle can be shortened (1) by reducing the inventory conversion period by processing and selling goods more quickly, (2) by reduc- ing the receivables collection period by speeding up collections, or (3) by lengthening the payables deferral period by slowing down the firm’s own pay- ments. To the extent that these actions can be taken without increasing costs or de- pressing sales, they should be carried out.
B
E N E F I T SWe can illustrate the benefits of shortening the cash conversion cycle by look- ing again at Real Time Computer Corporation. Suppose RTC must spend ap- proximately $197,250 on materials and labor to produce one computer, and it takes about nine days to produce a computer. Thus, it must invest $197,250/9
$21,917 for each day’s production. This investment must be financed for 67 days — the length of the cash conversion cycle — so the company’s working
F I G U R E 1 5 - 1 The Cash Conversion Cycle Model
Finish Goods and Sell Them
Receive Raw Materials
Pay Cash for Purchased
Materials
Collect Accounts Receivables
Days (1)
Inventory Conversion Period ( 73 Days)
(2) Receivables
Collection Period (24 Days) (3)
Payables Deferral Period ( 30 Days)
(4) Cash Conversion
Cycle
(73 24 30 67 Days)
capital financing needs will be 67 $21,917 $1,468,439. If RTC could reduce the cash conversion cycle to 57 days, say, by deferring payment of its accounts payable an additional 10 days, or by speeding up either the production process or the collection of its receivables, it could reduce its working capital financing requirements by $219,170.
Recall that free cash flow (FCF) is equal to NOPAT minus net investments in operating capital. Therefore, if working capital decreases, FCF increases by that same amount. RTC’s reduction in its cash conversion cycle would lead to an increase in FCF of $219,170. Notice also that reducing the cash conversion cycle reduces the ratio of net operating working capital to sales (NOWC/Sales). If sales stay at the same level, then the reduction in working capital is simply a one-time cash inflow. However, if sales are expected to grow, and if the NOWC/Sales ratio remains at its new level, then less working capi- tal will be required to support the additional sales, leading to an increase in projected FCF for each future year.
The combination of the one-time cash inflow and the long-term improve- ment in working capital can add substantial value to companies. Two profes- sors, Hyun-Han Shin and Luc Soenen, studied more then 2,900 companies during a recent 20-year period and found a strong relationship between a com- pany’s cash conversion cycle and its performance.5 In particular, their results show that for the average company a 10-day improvement in the cash conver- sion cycle was associated with an increase in pre-tax operating profit from 12.76 to 13.02 percent. They also demonstrated that companies with a cash conver- sion cycle 10 days shorter than average also had an annual stock return that was 1.7 percentage points higher than that of an average company, even after adjusting for differences in risk. Given results like these, it’s no wonder firms now place so much emphasis on working capital management!
5See Hyun-Han Shin and Luc Soenen, “Efficiency of Working Capital Management and Corpo- rate Profitability,” Financial Practice and Education, Fall/Winter 1998, 37–45.
S E L F - T E S T Q U E S T I O N S
Define the following terms: inventory conversion period, receivables collec- tion period, and payables deferral period. Give the equation for each term.
What is the cash conversion cycle? What is its equation?
What should the firm’s goal be regarding the cash conversion cycle? Explain your answer.
What are some actions the firm can take to shorten its cash conversion cycle?
A L T E R N A T I V E C U R R E N T
A S S E T I N V E S T M E N T P O L I C I E S
The cash conversion cycle highlights the strengths and weaknesses of the com- pany’s working capital policy, which depend critically on current asset manage-
ment and the financing of current assets. In the remaining part of this chapter, we consider each of these items in more detail. We begin by describing alter- native current asset investment policies, after which we consider a more de- tailed analysis of the various components of working capital. We conclude by discussing different strategies for financing current assets.
Figure 15-2 shows three alternative policies regarding the total amount of current assets carried. Essentially, these policies differ with regard to the amount of current assets carried to support any given level of sales, hence in the turnover of those assets. The line with the steepest slope represents a relaxed current asset investment (or “fat cat”) policy, where relatively large amounts of cash, marketable securities, and inventories are carried, and where sales are stimulated by the use of a credit policy that provides liberal financing to customers and a corresponding high level of receivables.
Relaxed Current Asset Investment Policy
A policy under which relatively large amounts of cash, marketable securities, and inventories are carried and under which sales are stimulated by a liberal credit policy, resulting in a high level of receivables.
F I G U R E 1 5 - 2 Alternative Current Asset Investment Policies (Millions of Dollars)
10 20 30 40
50 100 150 200
0 Current Assets
($)
Sales ($) Relaxed
Moderate
Restricted
CURRENT ASSETS TO SUPPORT TURNOVER OF CURRENT
POLICY SALES OF $100 ASSETS
Relaxed $30 3.3
Moderate 23 4.3
Restricted 16 6.3
NOTE: The sales/current assets relationship is shown here as being linear, but the relationship is often curvilinear.
Conversely, with the restricted current asset investment (or “lean-and- mean”) policy, the holdings of cash, securities, inventories, and receivables are minimized. Under the restricted policy, current assets are turned over more frequently, so each dollar of current assets is forced to “work harder.”
The moderate current asset investment policy is between the two ex- tremes.
Under conditions of certainty — when sales, costs, lead times, payment peri- ods, and so on, are known for sure — all firms would hold only minimal levels of current assets. Any larger amounts would increase the need for external funding without a corresponding increase in profits, while any smaller holdings would involve late payments to suppliers along with lost sales due to inventory shortages and an overly restrictive credit policy.
However, the picture changes when uncertainty is introduced. Here the firm requires some minimum amount of cash and inventories based on ex- pected payments, expected sales, expected order lead times, and so on, plus additional holdings, or safety stocks, which enable it to deal with departures from the expected values. Similarly, accounts receivable levels are determined by credit terms, and the tougher the credit terms, the lower the receivables for any given level of sales. With a restricted current asset investment policy, the firm would hold minimal safety stocks of cash and inventories, and it would have a tight credit policy even though this meant running the risk of losing sales. A restricted, lean-and-mean current asset investment policy gen- erally provides the highest expected return on this investment, but it entails the greatest risk, while the reverse is true under a relaxed policy. The mod- erate policy falls in between the two extremes in terms of expected risk and return.
Changing technology can lead to dramatic changes in the optimal current asset investment policy. For example, if new technology makes it possible for a manufacturer to speed up the production of a given product from 10 days to five days, then its work-in-progress inventory can be cut in half. Similarly, re- tailers such as Wal-Mart or Home Depot have installed systems under which bar codes on all merchandise are read at the cash register. The information on the sale is electronically transmitted to a computer that maintains a record of the inventory of each item, and the computer automatically transmits orders to suppliers’ computers when stocks fall to prescribed levels. With such a sys- tem, inventories will be held at optimal levels; orders will reflect exactly what styles, colors, and sizes consumers are buying; and the firm’s profits will be maximized.
M
A N A G I N G T H EC
O M P O N E N T S O FW
O R K I N GC
A P I TA LWorking capital consists of four main components: cash, marketable securities, inventory, and accounts receivable. The first part of this chapter will focus on the issues involved with managing each of these components, while the re- maining part will deal with their financing. As you will see, a common thread underlies all current asset management. For each type of asset, firms face a fun- damental trade-off: Current assets (that is, working capital) are necessary to conduct business, and the greater the holdings of current assets, the smaller the danger of running out, hence the lower the firm’s operating risk. However, holding working capital is costly — if inventories are too large, then the firm Restricted Current Asset
Investment Policy
A policy under which holdings of cash, securities, inventories, and receivables are minimized.
Moderate Current Asset Investment Policy A policy that is between the relaxed and restricted policies.
F R E E C A S H F L OW, E VA , A N D WO R K I N G C A P I TA L
R
ecall from Chapter 2 that a company’s value depends on its free cash flow (FCF), defined as follows:FCF Net operating profit after taxes Net investment in operating capital
NOPAT Net investment in operating capital
[EBIT (1 T)] [Capital this year Capital last year].
If a company can reduce its inventories, its cash holdings, or its receivables, then its net investment in operating capital will decline. If these actions don’t harm operating profit, then FCF will increase, which will lead to a higher stock price.
Economic Value Added (EVA) provides another useful way of thinking about working capital, particularly if a manager’s com- pensation is linked to EVA. Recall from Chapter 2 that EVA is defined as follows:
EVA NOPAT (WACC Total operating capital).
A reduction in working capital decreases total operating capital, which increases EVA. Many firms report that when division man- agers and other operating people begin to think in these terms, they often find ways to reduce working capital, especially if their compensation depends on their divisions’ EVAs.
We can also think of working capital management in terms of ROE and the Du Pont equation:
If working capital and hence total assets can be reduced with- out seriously affecting the profit margin, this will increase the total assets turnover and, consequently, ROE.
Net income/
Sales
Sales/
Total assets
Assets/
Equity. ROE Profit
margin Total assets
turnoverLeverage factor
S E L F - T E S T Q U E S T I O N S
Identify and explain three alternative current asset investment policies.
What are the principal components of working capital?
What are the reasons for not wanting to hold too little working capital? For not wanting to hold too much?
What is the fundamental trade-off that managers face when managing work- ing capital?
C A S H M A N A G E M E N T
Approximately 1.5 percent of the average industrial firm’s assets are held in the form of cash, which is defined as demand deposits plus currency. Cash is often called a “nonearning asset.” It is needed to pay for labor and raw materials, to will have assets that earn a zero or even negative return if storage and spoilage costs are high. And, of course, firms must acquire capital to buy assets such as inventory, this capital has a cost, and this increases the downward drag from ex- cessive inventories (or receivables or even cash). So, there is pressure to hold the amount of working capital to the minimum consistent with running the business without interruption.
buy fixed assets, to pay taxes, to service debt, to pay dividends, and so on. How- ever, cash itself (and also most commercial checking accounts) earns no inter- est. Thus, the goal of the cash manager is to minimize the amount of cash the firm must hold for use in conducting its normal business activities, yet, at the same time, to have sufficient cash (1) to take trade discounts, (2) to maintain its credit rating, and (3) to meet unexpected cash needs. We begin our analysis with a discussion of the reasons for holding cash.
R
E A S O N S F O RH
O L D I N GC
A S HFirms hold cash for two primary reasons:
1. Transactions. Cash balances are necessary in business operations. Pay- ments must be made in cash, and receipts are deposited in the cash ac- count. Cash balances associated with routine payments and collections are known as transactions balances.
2. Compensation to banks for providing loans and services. A bank makes money by lending out funds that have been deposited with it, so the larger its de- posits, the better the bank’s profit position. If a bank is providing services to a customer, it may require the customer to leave a minimum balance on deposit to help offset the costs of providing the services. Also, banks may require borrowers to hold deposits at the bank. Both types of de- posits are defined as compensating balances.6
Two other reasons for holding cash have been noted in the finance and eco- nomics literature: for precaution and for speculation. Cash inflows and outflows are unpredictable, with the degree of predictability varying among firms and in- dustries. Therefore, firms need to hold some cash in reserve for random, un- foreseen fluctuations in inflows and outflows. These “safety stocks” are called precautionary balances, and the less predictable the firm’s cash flows, the larger such balances should be. However, if the firm has easy access to borrowed funds — that is, if it can borrow on short notice — its need for precautionary bal- ances is reduced. Also, as we note later in this chapter, firms that would other- wise need large precautionary balances tend to hold highly liquid marketable se- curities rather than cash per se. Marketable securities serve many of the purposes of cash, but they provide greater interest income than bank deposits.
Some cash balances may be held to enable the firm to take advantage of bargain purchases that might arise; these funds are called speculative balances. How- ever, firms today are more likely to rely on reserve borrowing capacity and/or marketable securities portfolios than on cash per se for speculative purposes.
The cash accounts of most firms can be thought of as consisting of transac- tions, compensating, precautionary, and speculative balances. However, we can- not calculate the amount needed for each purpose, sum them, and produce a total desired cash balance, because the same money often serves more than one purpose. For instance, precautionary and speculative balances can also be used Transactions Balance
A cash balance associated with payments and collections; the balance necessary for day-to-day operations.
Compensating Balance A bank balance that a firm must maintain to compensate the bank for services rendered or for granting a loan.
Precautionary Balance A cash balance held in reserve for random, unforeseen fluctuations in cash inflows and outflows.
Speculative Balance A cash balance that is held to enable the firm to take advantage of any bargain purchases that might arise.
6In a 1979 survey, 84.7 percent of responding companies reported that they were required to main- tain compensating balances to help pay for bank services. Only 13.3 percent reported paying direct fees for bank services. By 1996 those findings were reversed: only 28 percent paid for bank services with compensating balances, while 83 percent paid direct fees. So, while use of compensating bal- ances to pay for services has declined, it is still a reason some companies hold so much cash.
to satisfy compensating balance requirements. Firms do, however, consider all four factors when establishing their target cash positions.
A
D VA N TA G E S O FH
O L D I N GA
D E Q U AT EC
A S H A N DN
E A R- C
A S HA
S S E T SIn addition to the four motives just discussed, sound working capital manage- ment requires that an ample supply of cash and near-cash assets be maintained for several specific reasons:
1. It is essential that the firm have sufficient cash and near-cash assets to take trade discounts. Suppliers frequently offer customers discounts for early payment of bills. As we will see later in this chapter, the cost of not taking discounts is very high, so firms should have enough cash to permit payment of bills in time to take discounts.
2. Adequate holdings of cash and near-cash assets can help the firm main- tain its credit rating by keeping its current and acid test ratios in line with those of other firms in its industry. A strong credit rating enables the firm both to purchase goods from suppliers on favorable terms and to main- tain an ample line of low-cost credit with its bank.
3. Cash and near-cash assets are useful for taking advantage of favorable business opportunities, such as special offers from suppliers or the chance to acquire another firm.
4. The firm should have sufficient cash and near-cash assets to meet such emergencies as strikes, fires, or competitors’ marketing campaigns, and to weather seasonal and cyclical downturns.
Trade Discount
A price reduction that suppliers offer customers for early payment of bills.
S E L F - T E S T Q U E S T I O N S
Why is cash management important?
What are the two primary motives for holding cash?
What are the two secondary motives for holding cash as noted in the finance and economics literature?
T H E C A S H B U D G E T
7The firm estimates its needs for cash as a part of its general budgeting, or fore- casting, process. First, it forecasts sales, its fixed asset and inventory require- ments, and the times when payments must be made. This information is com- bined with projections about when accounts receivable will be collected, tax
7 We used an Excel spreadsheet to generate the cash budget shown in Table 15-1. It would be worthwhile to go through the model, 15MODEL.xls, which is on the CD-ROM that accompanies this text. This will give you a good example of how spreadsheets can be applied to solve practical problems.
payment dates, dividend and interest payment dates, and so on. All of this in- formation is summarized in the cash budget, which shows the firm’s projected cash inflows and outflows over some specified period. Generally, firms use a monthly cash budget forecasted over the next year, plus a more detailed daily or weekly cash budget for the coming month. The monthly cash budgets are used for planning purposes, and the daily or weekly budgets for actual cash control.
The cash budget provides more detailed information concerning a firm’s fu- ture cash flows than do the forecasted financial statements. In Chapter 4, we developed Allied Food Products’ 2002 forecasted financial statements. Allied’s projected 2002 sales were $3,300 million, resulting in a net cash flow from op- erations of $162 million. When all expenditures and financing flows are con- sidered, Allied’s cash account is projected to increase by $1 million in 2002.
Does this mean that Allied will not have to worry about cash shortages during 2002? To answer this question, we must construct Allied’s cash budget for 2002.
To simplify the example, we will only consider Allied’s cash budget for the last half of 2002. Further, we will not list every cash flow but rather focus on the operating cash flows. Allied’s sales peak is in September, shortly after the majority of its raw food inputs have been harvested. All sales are made on terms of 2/10, net 40, meaning that a 2 percent discount is allowed if payment is made within 10 days, and, if the discount is not taken, the full amount is due in 40 days. However, like most companies, Allied finds that some of its customers delay payment up to 90 days. Experience has shown that payment on 20 per- cent of Allied’s dollar sales is made during the month in which the sale is made — these are the discount sales. On 70 percent of sales, payment is made during the month immediately following the month of sale, and on 10 percent of sales payment is made in the second month following the month of sale.
The costs to Allied of foodstuffs, spices, preservatives, and packaging mate- rials average 70 percent of the sales prices of the finished products. These purchases are generally made one month before the firm expects to sell the fin- ished products, but Allied’s purchase terms with its suppliers allow it to delay payments for 30 days. Accordingly, if July sales are forecasted at $300 million, then purchases during June will amount to $210 million, and this amount will actually be paid in July.
Such other cash expenditures as wages and lease payments are also built into the cash budget, and Allied must make estimated tax payments of $30 million on September 15 and $20 million on December 15. Also, a $100 million pay- ment for a new plant must be made in October. Assuming that Allied’s target cash balance is $10 million, and that it projects $15 million to be on hand on July 1, 2002, what will its monthly cash surpluses or shortfalls be for the period from July to December?
The monthly cash flows are shown in Table 15-1. Section I of the table pro- vides a worksheet for calculating both collections on sales and payments on pur- chases. Line 1gives the sales forecast for the period from May through Decem- ber. (May and June sales are necessary to determine collections for July and August.) Next, Lines 2 through 5 show cash collections. Line 2 shows that 20 percent of the sales during any given month are collected during that month.
Customers who pay in the first month, however, take the discount, so the cash collected in the month of sale is reduced by 2 percent; for example, collections during July for the $300 million of sales in that month will be 20 percent times sales times 1.0 minus the 2 percent discount (0.20)($300)(0.98) ⬇ $59 million.
Cash Budget
A table showing cash flows (receipts, disbursements, and cash balances) for a firm over a specified period.
Target Cash Balance
The desired cash balance that a firm plans to maintain in order to conduct business.
T A B L E 1 5 - 1
MAY JUN JUL AUG SEP OCT NOV DEC
I. COLLECTIONS ANDPURCHASESWORKSHEET
(1) Sales (gross)a $200 $250 $300 $400 $500 $350 $250 $200
Collections
(2) During month of sale:
(0.2)(0.98)(month’s sales) 59 78 98 69 49 39
(3) During first month after sale:
0.7(previous month’s sales) 175 210 280 350 245 175
(4) During second month after sale:
0.1(sales 2 months ago) 20 25 30 40 50 35
(5) Total collections (2 3 4) $254 $313 $408 $459 $344 $249
Purchases
(6) 0.7(next month’s sales) $210 $280 $350 $245 $175 $140
(7) Payments (prior month’s
purchases) $210 $280 $350 $245 $175 $140
II. CASHGAIN ORLOSSFORMONTH
(8) Collections (from Section I) $254 $313 $408 $459 $344 $249
(9) Payments for purchases (from
Section I) $210 $280 $350 $245 $175 $140
(10) Wages and salaries 30 40 50 40 30 30
(11) Lease payments 15 15 15 15 15 15
(12) Other expenses 10 15 20 15 10 10
(13) Taxes 30 20
(14) Payment for plant construction 100
(15) Total payments $265 $350 $465 $415 $230 $215
(16) Net cash gain (loss) during
month (Line 8 Line 15) ($ 11) ($ 37) ($ 57) $ 44 $114 $ 34
III. LOANREQUIREMENT ORCASHSURPLUS (17) Cash at start of month if no
borrowing is doneb $ 1 5 $ 4 ($ 33) ($ 90) ($ 46) $ 68
(18) Cumulative cash: cash at start if no borrowing
gain or loss (Line 16 Line 17) $ 4 ($ 33) ($ 90) ($ 46) $ 68 $102
(19) Target cash balance 10 10 10 10 10 10
(20) Cumulative surplus cash or loans outstanding to maintain $10 target
cash balance (Line 18 Line 19)c ($ 6) ($ 43) ($100) ($ 56) $ 58 $ 92
aAlthough the budget period is July through December, sales and purchases data for May and June are needed to determine collections and payments during July and August.
bThe amount shown on Line 17 for July, the $15 balance (in millions), is on hand initially. The values shown for each of the following months on Line 17 are equal to the cumulative cash as shown on Line 18 for the preceding month; for example, the $4 shown on Line 17 for August is taken from Line 18 in the July column.
cWhen the target cash balance of $10 (Line 19) is deducted from the cumulative cash balance (Line 18), a resulting negative figure on Line 20 (shown in parentheses) represents a required loan, whereas a positive figure represents surplus cash. Loans are required from July through October, and surpluses are expected during November and December. Note also that firms can borrow or pay off loans on a daily basis, so the $6 borrowed during July would be done on a daily basis, as needed, and during October the $100 loan that existed at the beginning of the month would be reduced daily to the $56 ending balance, which, in turn, would be completely paid off during November.
Allied Food Products: Cash Budget (Millions of Dollars)
Line 3 shows the collections on the previous month’s sales, or 70 percent of sales in the preceding month; for example, in July, 70 percent of the $250 million June sales, or $175 million, will be collected. Line 4 gives collections from sales two months earlier, or 10 percent of sales in that month; for example, the July col- lections for May sales are (0.10)($200) $20 million. The collections during each month are summed and shown on Line 5; thus, the July collections repre- sent 20 percent of July sales (minus the discount) plus 70 percent of June sales plus 10 percent of May sales, or $254 million in total.
Next, payments for purchases of raw materials are shown. July sales are fore- casted at $300 million, so Allied will purchase $210 million of materials in June (Line 6) and pay for these purchases in July (Line 7). Similarly, Allied will pur- chase $280 million of materials in July to meet August’s forecasted sales of $400 million.
With Section I completed, Section II can be constructed. Cash from collec- tions is shown on Line 8. Lines 9 through 14 list payments made during each month, and these payments are summed on Line 15. The difference between cash receipts and cash payments (Line 8 minus Line 15) is the net cash gain or loss during the month. For July there is a net cash loss of $11 million, as shown on Line 16.
In Section III, we first determine the cash balance Allied would have at the start of each month, assuming no borrowing is done. This is shown on Line 17.
Allied will have $15 million on hand on July 1. The beginning cash balance (Line 17) is then added to the net cash gain or loss during the month (Line 16) to obtain the cumulative cash that would be on hand if no financing were done (Line 18). At the end of July, Allied forecasts a cumulative cash balance of $4 million in the absence of borrowing.
The target cash balance, $10 million, is then subtracted from the cumulative cash balance to determine the firm’s borrowing requirements, shown in paren- theses, or its surplus cash. Because Allied expects to have cumulative cash, as shown on Line 18, of only $4 million in July, it will have to borrow $6 million to bring the cash account up to the target balance of $10 million. Assuming that this amount is indeed borrowed, loans outstanding will total $6 million at the end of July. (Allied did not have any loans outstanding on July 1.) The cash sur- plus or required loan balance is given on Line 20; a positive value indicates a cash surplus, whereas a negative value indicates a loan requirement. Note that the surplus cash or loan requirement shown on Line 20 is a cumulative amount.
Allied must borrow $6 million in July. Then, it has an additional cash shortfall during August of $37 million as reported on Line 16, so its total loan require- ment at the end of August is $6 $37 $43 million, as reported on Line 20.
Allied’s arrangement with the bank permits it to increase its outstanding loans on a daily basis, up to a prearranged maximum, just as you could increase the amount you owe on a credit card. Allied will use any surplus funds it generates to pay off its loans, and because the loan can be paid down at any time, on a daily basis, the firm will never have both a cash surplus and an outstanding loan balance.
This same procedure is used in the following months. Sales will peak in September, accompanied by increased payments for purchases, wages, and other items. Receipts from sales will also go up, but the firm will still be left with a $57 million net cash outflow during the month. The total loan re- quirement at the end of September will hit a peak of $100 million, the cumu- lative cash plus the target cash balance. The $100 million can also be found as
the $43 million needed at the end of August plus the $57 million cash deficit for September.
Sales, purchases, and payments for past purchases will fall sharply in Octo- ber, but collections will be the highest of any month because they will reflect the high September sales. As a result, Allied will enjoy a healthy $44 million net cash gain during October. This net gain can be used to pay off borrowings, so loans outstanding will decline by $44 million, to $56 million.
Allied will have an even larger cash surplus in November, which will permit it to pay off all of its loans. In fact, the company is expected to have $58 mil- lion in surplus cash by the month’s end, and another cash surplus in December will swell the excess cash to $92 million. With such a large amount of unneeded funds, Allied’s treasurer will certainly want to invest in interest-bearing securi- ties or to put the funds to use in some other way.
Here are some additional points about cash budgets:
1. For simplicity, our illustrative budget for Allied omitted many important cash flows that are anticipated for 2002, such as dividends and proceeds from stock and bond sales. Some of these are projected to occur in the first half of the year, but those that are projected for the July–December period could easily be added to the table. The final cash budget should contain all projected cash inflows and outflows, and it should be consis- tent with the forecasted financial statements.
2. Our cash budget does not reflect interest on loans or income from in- vesting surplus cash. This refinement could easily be added.
3. If cash inflows and outflows are not uniform during the month, we could seriously understate the firm’s peak financing requirements. The data in Table 15-1 show the situation expected on the last day of each month, but on any given day during the month, it could be quite different. For example, if all payments had to be made on the fifth of each month, but collections came in uniformly throughout the month, the firm would need to borrow much larger amounts than those shown in Table 15-1. In this case, we would prepare a cash budget that determined requirements on a daily basis.
4. Since depreciation is a noncash charge, it does not appear on the cash budget other than through its effect on taxable income, hence on taxes paid.
5. Since the cash budget represents a forecast, all the values in the table are expected values. If actual sales, purchases, and so on, are different from the forecasted levels, then the projected cash deficits and sur- pluses will also be incorrect. Thus, Allied might end up needing to bor- row larger amounts than are indicated on Line 20, so it should arrange a line of credit in excess of that amount. For example, if Allied’s monthly sales turn out to be only 80 percent of their forecasted levels, its maximum cumulative borrowing requirement will turn out to be
$126 million rather than $100 million, a 26 percent increase from the expected figure.
6. Spreadsheet programs are particularly well suited for constructing and analyzing cash budgets, especially with respect to the sensitivity of cash flows to changes in sales levels, collection periods, and the like. We
could change any assumption, say, the projected monthly sales or the lag before customers pay, and the cash budget would automatically and in- stantly be recalculated. This would show us exactly how the firm’s bor- rowing requirements would change if conditions changed. Also, with a spreadsheet model, it is easy to add features like interest paid on loans, interest earned on marketable securities, and so on. See 15MODEL.xls for the spreadsheet model we used to generate the cash budget for this chapter.
7. Finally, we should note that the target cash balance probably will be ad- justed over time, rising and falling with seasonal patterns and with long- term changes in the scale of the firm’s operations. Thus, Allied will prob- ably plan to maintain larger cash balances during August and September than at other times, and as the company grows, so will its required cash balance. Also, the firm might even set the target cash balance at zero — this could be done if it carried a portfolio of marketable securities that could be sold to replenish the cash account, or if it had an arrangement with its bank that permitted it to borrow any funds needed on a daily basis. In that event, the cash budget would simply stop with Line 18, and the amounts on that line would represent projected loans outstanding or surplus cash. Note, though, that most firms would find it difficult to op- erate with a zero-balance bank account, just as you would, and the costs of such an operation would in most instances offset the costs associated with maintaining a positive cash balance. Therefore, most firms do set a positive target cash balance.
T H E G R E AT D E BAT E : H OW M U C H C A S H I S E N O U G H ?
I
hate cash on hand,” says Fred Salerno, Bell Atlantic’s CFO.According to a recent survey, Salerno has backed up his talk with actions. When rated on the number of days of operating expenses held in cash (DOEHIC), Bell Atlantic leads its industry with a DOEHIC of 6 days versus an industry average of 27. Put another way, Bell Atlantic has cash holdings equal to only 0.90 percent of sales as compared with an industry median cash/sales ratio of 5.20 percent.
A great relationship with its banks is a key to keeping low cash levels. Jim Hopwood, treasurer of Wickes, says, “We have a credit revolver if we ever need it.” The same is true at Haverty Furniture, where CFO Dennis Fink says, “You don’t have to worry about predicting short-term fluctuations in cash flow,” if you have solid bank commitments.
Treasurer Wayne Smith of Avery Dennison says that their low cash holdings have reduced their net operating working capital to such an extent that their return on invested capital (ROIC)
is 3 percentage points higher than it would be if their cash holdings were at the industry average. He goes on to say that this adds a lot of economic value to their company.
Despite these and other comments about the advantages of low cash holdings, many companies still hold extremely large amounts of cash and marketable securities, including Procter &
Gamble ($2.6 billion, 32 days DOEHIC, 7.1 percent cash/sales) and Ford Motor Company ($24 billion, 76 DOEHIC). When asked about the appropriate level of cash holdings, Ford CFO Henry Wallace refused to be pinned down, saying, “There is no answer for a company this size.” However, it is interesting to note that Ford recently completed a huge stock repurchase, reducing its cash by about $10 billion.
SOURCE: S. L. Mintz, “Lean Green Machine,” CFO, July 2000, 76–94.
“
S E L F - T E S T Q U E S T I O N S
What is the purpose of a cash budget?
What are the three major sections of a cash budget?
Suppose a firm’s cash flows do not occur uniformly throughout the month.
What effect would this have on the accuracy of the forecasted borrowing re- quirements?
How could uncertainty be handled in a cash budget?
Does depreciation appear in a cash budget? Explain.
M A R K E T A B L E S E C U R I T I E S
Realistically, the management of cash and marketable securities cannot be sep- arated — management of one implies management of the other. In the first part of the chapter, we focused on cash management. Now, we turn to marketable securities.
Marketable securities typically provide much lower yields than operating as- sets. For example, recently DaimlerChrysler held approximately a $7 billion portfolio of short-term marketable securities that provided a much lower yield than its operating assets. Why would a company such as DaimlerChrysler have such large holdings of low-yielding assets?
In many cases, companies hold marketable securities for the same reasons they hold cash. Although these securities are not the same as cash, in most cases they can be converted to cash on very short notice (often just a few minutes) with a single telephone call. Moreover, while cash and most commercial check- ing accounts yield nothing, marketable securities provide at least a modest re- turn. For this reason, many firms hold at least some marketable securities in lieu of larger cash balances, liquidating part of the portfolio to increase the cash account when cash outflows exceed inflows. In such situations, the marketable securities could be used as a substitute for transactions balances, for precau- tionary balances, for speculative balances, or for all three. In most cases, the se- curities are held primarily for precautionary purposes — most firms prefer to rely on bank credit to make temporary transactions or to meet speculative needs, but they may still hold some liquid assets to guard against a possible shortage of bank credit.
A few years ago before its merger with Daimler-Benz, Chrysler had essen- tially no cash — it was incurring huge losses, and those losses had drained its cash account. Then a new management team took over, improved operations, and began generating positive cash flows. By 2000, DaimlerChrysler’s cash (and marketable securities) was up to about $7 billion. Management indicated, in various statements, that the cash hoard was necessary to enable the company to weather the next downturn in auto sales.
Although setting the target cash balance is, to a large extent, judgmental, an- alytical rules can be applied to help formulate better judgments. For example, years ago William Baumol recognized that the trade-off between cash and Marketable Securities
Securities that can be sold on short notice.
marketable securities is similar to the one firms face when setting the optimal level of inventory.8 Baumol applied the EOQ inventory model to determine the optimal level of cash balances.9He suggested that cash holdings should be higher if costs are high and the time to liquidate marketable securities is long, but that those cash holdings should be lower if interest rates are high. His logic was that if it is expensive and time consuming to convert securities to cash, and if securities do not earn much because interest rates are low, then it does not pay to hold securities as opposed to cash. It does pay to hold securi- ties if interest rates are high and the securities can be converted to cash quickly and cheaply.
To summarize, there are both benefits and costs associated with holding cash and marketable securities. The benefits are twofold: (1) the firm reduces trans- actions costs because it won’t have to issue securities or borrow as frequently to raise cash; and (2) it will have ready cash to take advantage of bargain purchases or growth opportunities. The primary disadvantage is that the after-tax return on cash and short-term securities is very low. Thus, firms face a trade-off be- tween benefits and costs.
Recent research supports this trade-off hypothesis as an explanation for firms’ cash holdings.10 Firms with high growth opportunities suffer the most if they don’t have ready cash to quickly take advantage of an opportunity, and the data show that these firms do hold relatively high levels of cash and mar- ketable securities. Firms with volatile cash flows are the ones most likely to run low on cash, so they are the ones that hold the highest levels of cash. In contrast, cash holdings are less important to large firms with high credit rat- ings, because they have quick and inexpensive access to capital markets. As ex- pected, such firms hold relatively low levels of cash. Of course, there will always be outliers such as Ford, which is large, strong, and cash-rich, but volatile firms with good growth opportunities are still the ones with the high- est cash balances, on average.
S E L F - T E S T Q U E S T I O N S
Why might a company hold low-yielding marketable securities when it could earn a much higher return on operating assets?
Why would a low interest rate environment lead to larger cash balances?
How might improvements in telecommunications technology affect the level of corporations’ cash balances?
8William J. Baumol, “The Transactions Demand for Cash: An Inventory Theoretic Approach,”
Quarterly Journal of Economics, November 1952, 545–556.
9A more complete description of the Economic Ordering Quantity (EOQ) model can be found in Eugene F. Brigham and Phillip R. Daves, Intermediate Financial Management, 7th ed. (Fort Worth, TX: Harcourt College Publishers, 2002), Chapter 22.
10See Tim Opler, Lee Pinkowitz, René Stulz, and Rohan Williamson, “The Determinants and Im- plications of Corporate Cash Holdings,” Journal of Financial Economics, Vol. 52, 1999, 3–46.
I N V E N T O R Y
Inventories, which may be classified as (1) supplies, (2) raw materials, (3) work-in- process, and (4) finished goods, are an essential part of virtually all business oper- ations. As is the case with accounts receivable, inventory levels depend heavily upon sales. However, whereas receivables build up after sales have been made, inventory must be acquired ahead of sales. This is a critical difference, and the necessity of forecasting sales before establishing target inventory levels makes inventory management a difficult task. Also, since errors in the establishment of inventory levels quickly lead either to lost sales or to excessive carrying costs, inventory management is as important as it is difficult.
Inventory management techniques are covered in depth in production management courses. Still, since financial managers have a responsibility both for raising the capital needed to carry inventory and for the firm’s over- all profitability, we need to cover the financial aspects of inventory manage- ment here.
Proper inventory management requires close coordination among the sales, purchasing, production, and finance departments. The sales/marketing depart- ment is generally the first to spot changes in demand. These changes must be worked into the company’s purchasing and manufacturing schedules, and the fi- nancial manager must arrange any financing needed to support the inventory buildup. Lack of coordination among departments, poor sales forecasts, or both, can lead to disaster.
S E L F - T E S T Q U E S T I O N S
Why is good inventory management essential to a firm’s success?
What departments should be involved in inventory decisions?
I N V E N T O R Y C O S T S
The twin goals of inventory management are (1) to ensure that the inventories needed to sustain operations are available, but (2) to hold the costs of ordering and carrying inventories to the lowest possible level. Table 15-2 gives a listing of the typical costs associated with inventory, divided into three categories: car- rying costs, ordering and receiving costs, and the costs that are incurred if the firm runs short of inventory.
Inventory is costly to store; therefore, there is always pressure to reduce in- ventory as part of firms’ overall cost-containment strategies. An article in For- tune highlights the fact that an increasing number of corporations are taking drastic steps to control inventory costs.11 For example, Trane Corporation, which makes air conditioners, recently adopted just-in-time inventory proce- dures.
11Shawn Tully, “Raiding a Company’s Hidden Cash,” Fortune, August 22, 1994, 82–87.
