Lesson 13 - Working Capital Management

WORKING CAPITAL MANAGEMENT March 1, 2014

Riche Levin Lim [email protected] +63917 592 8990

THE MOST IMPOR IMP ORT TANT ASS ASSET ET MANAGING YOUR DAIL DAILY Y OPERATIONS

THE MOST IMPOR IMP ORT TANT ASS ASSET ET MANAGING YOUR DAIL DAILY Y OPERATIONS

Making a Transition from Medium Term to Short Term

WHAT CAPITAL BUDGETING ANSWERS COMPARISONS

• How much will this project cost? • Should I choose this project or this project? • Will I have enough to purchase these three machines? • Should I pursue this marketing strategy? • What is the impact of expanding to this region in the long run?

WHAT WHA T WCM ANSWERS COMPARISONS

• *Working Capital Management • Do I have enough cash to pay for this day’s expenses? What about this week? Month? • Do I have enough money in case there is an emergency? • How much of inventory should I be keeping stock? • How much credit should I extend my customers, to the extent that I still have enough cash? • Can I defer payment to my suppliers? What is the trade off? • How long does it take from selling an item to collecting money?

TERMINOLOGY

QUICK REVIEW BEFORE WE BEGIN

• Working capital – current assets. • Net working capital – current assets minus non-interest bearing current liabilities. – Net working capital = Current assets – (Payables + Accruals)

• Working capital policy – deciding the level of each type of current asset to hold, and how to finance current assets. • Working capital management – controlling cash, inventories, and A/R, plus short-term liability management.

CURRENT ASSET MANAGEMENT HOW IT AFFECTS PROFITABILITY

• Working capital policy, or the management of day-to-day activities, has important financial implications. • Recall DuPont Equation: Profit Margin x Total Assets Turnover x Leverage Factor = ROE • Working capital policy concerns itself with turnover. • Reflected in the current ratio, turnover of cash and securities, inventory turnover, and days sales outstanding. • If Operations Management manages the amount of inventory (EOQ), finance manages the method of financing these current assets

CURRENT ASSET MANAGEMENT ILLUSTRATION

SKI

Ind Avg

Current ratio

1.75x

2.25x

Debt/Assets

58.76%

50.00%

Turnover of cash & securities

16.67x

22.22x

Days sales outstanding

45.63

32.00

Inventory turnover

4.82x

7.00x

Fixed assets turnover

11.35x

12.00x

Total assets turnover

2.08x

3.00x

Profit margin

2.07%

3.50%

Return on equity

10.45%

21.00%

CURRENT ASSET FINANCING EXAMPLE

• A conservative (relaxed) policy may be appropriate if it leads to greater profitability. • However, SKI is not as profitable as the average firm in the industry. – This suggests the company has excessive working capital.

• Conservatism is based on your level of permanent and temporary current assets • Moderate – 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 permanent assets and temporary assets.

WORKING CAPITAL MANAGEMENT TOPICS

• Current Asset Financing • Cash Conversion Cycle • Cash Budgeting • Cash and Marketable Securities • Inventory • Accounts Receivables • Accounts Payable (Trade Credit) • Bank Loans • Accrued Liabilities • Secured / Collateralized Loans

AGGRESSIVE / MODERATE FINANCING EXAMPLE POLICY $

Temp. C.A. S-T Loans Perm C.A.

Fixed Assets

L-T Fin: Stock, Bonds, Spon. C.L. Years

Lower dashed line would be more aggressive.

CONSERVATIVE FINANCING POLICY EXAMPLE

$

Marketable securities

Perm C.A.

Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L.

Fixed Assets Years

CURRENT ASSET FINANCING EXAMPLE

• Current asset financing seeks to balance the following: – Riskiness of shorter term debts (since you have to pay them off faster) found in aggressive policies – More expensive interest rates for longer term borrowings found in conservative policies – Short-term debt however, is more flexible.

ELEMENTS OF CURRENT ASSET POLICY AND WORKING CAPITAL MANAGEMENT

WORKING CAPITAL MANAGEMENT OVERVIEW

• Two primary measures of working capital management are as follows: – Cash conversion cycle • How long does it take to turn my goods into cash? • How fast can my business create money? – Cash budget • Do I have enough cash to meet all my obligations? • Do I have to borrow to have enough for next period?

CASH CONVERSION CYCLE OVERVIEW

• The length of time between when a company makes payments to its creditors and when a company receives payments from its customers, less the time you can defer paying your own suppliers (delaying gives you more cash) • Purchase -> Selling -> Collecting -> Deferring Payments Inventory Receivables Payables CCC = conversion + collection ! deferral period period period CCC =

Days per year Inventory turnover

Payables Days sales + ! deferral outstanding period

365 CCC = + 46 ! 30 4.82 CCC = 76 + 46 ! 30 = 92 days

CASH CONVERSION CYCLE DEFINITION OF TERMS

• Begin with the income statement, then calculate three ratios: • Three Ratios: – Inventory Conversion Period / Days Inventory on Hand – how long It takes to sell an item – Receivables Conversion Period / Days Receivables on Hand – how long it takes to collect after making a sale (assuming not cash transaction) – Payables Deferral Period – how long you have before you have to pay your suppliers / creditors • Deferring payables reduces the cash conversion cycle because you can delay paying out money to purchase your inventory (via accounts payable). • Rule of thumb: Always compare a company’s ratios with industry averages to determine whether it is good or bad.

CASH CONVERSION CYCLE DEFINITION OF TERMS

CASH CONVERSION CYCLE OVERVIEW

Inventory Conversion Period ( 60 Days) Payables Deferral Period ( 40 Days) Receive Materials

Pay Cash for Purchased Materials

Finish Goods and Sell Them

Average Collection Period (60 Days)

Cash Conversion Period (80 days) Days Collect Cash for Accounts Receivable

CASH CONVERSION CYCLE EXAMPLE

• Primrose Corp has $15 million of sales, $2 million of inventories, $3 million of receivables, and $1 million of payables. Its cost of goods sold is 80% of sales, and it finances working capital with bank loans at an 8% rate. What is Primrose’s cash conversion cycle (CCC)? If Primrose could lower its inventories and receivables by 10% each and increase its payables by 10%, all without affecting sales or cost of goods sold, what would be the new CCC, how much cash would be freed up, and how would that affect pretax profits?

CASH CONVERSION CYCLE EXAMPLE

• Zocco Corporation has an inventory conversion period of 75 days, an average collection period of 38 days, and a payables deferral period of 30 days. – a. What is the length of the cash conversion cycle? – b. If Zocco’s annual sales are $3,421,875 and all sales are on credit, what is the investment in accounts receivable? – c. How many times per year does Zocco turn over its inventory?

CASH BUDGET OVERVIEW

• Table that shows cash receipts, disbursements, and balances over a period of time • Most basic form of accounting, forecasting inflows and outflows • Helps determine loans and additional funds needed • Makes sure that cash is sufficient for day-to-day working operations • Takes into account both cash-basis sales and accrual-basis sales (accounts receivables) • Developed on a daily, weekly, and monthly level. • Ensures that company will always meet its target cash balance (imagine reorder point but for cash)

CASH BUDGET STEP BY STEP

• Determine beginning cash balance • Forecast revenue and divide when you will collect these: – Cash sales can be collected now, but accounts receivables may be collected 1 to 3 months into the future. – Reduce collections by bad debt expenses. For example, if the firm had 3% bad debt losses, collections would total only 97% of sales.

• Forecast purchases of inventory, and when you will pay for them. Remember this is cash-basis, so you may be paying for previous month’s orders. • Tally all other payments and expenses. • Compute net cash flow (inflow – outflow) • Compute cumulative cash flow (beginning cash balance + net cash flow). Carry over to next period.


• Determine loan requirements. • Compare cumulative cash flow with target cash balance. • If CCF > target balance, no borrowing needed. • If CCF < target balance, determine the difference to find the amount of loans needed.


• There are two things the cash budget reveals: – Your total net cash inflow / outflow per period of time – Your loan level for that period provided you will borrow to meet your target cash level


SIMPLE CASH BUDGET ITEMS EXAMPLE

January

February

Collections

67,651.95

62,755,40

Purchases

44,603.75

36,472.65

Wages

6,690.56

5,470.90

Rents

2,500

2,500

Total Payments

53,794.31

44,443.55

Net Cash Flows

$13,857.64

18,311.85

SIMPLE CASH BUDGET (ACTUAL) EXAMPLE

January

February

Cash Budget, at Start Net Cash Flows

$3,000

16,857.64

13,857.64

18,311.85

Cumulative

16,857.64

35,169.49

1,500

1,500

15,357.64

33,669.48

Less: Target Cash Surplus

• If surplus was negative (shortfall), we would have to borrow money and cash budget at start would be target cash level.

CASH BUDGETING HARDER EXAMPLE

• I will teach this through an excel sheet. book.

! Problem

is 16-10 of your

• Helen Bowers, owner of Helen’s Fashion Designs, is planning to request a line of credit from her bank. She has estimated the following sales forecasts for the firm for parts of 2009 and 2010:


• Estimates regarding payments obtained from the credit department are as follows: collected within the month of sale, 10%; collected the month following the sale, 75%; collected the second month following the sale, 15%. Payments for labor and raw materials are made the month after these services were provided. Here are the estimated costs of labor plus raw materials:


• General and administrative salaries are approximately $27,000 a month. Lease payments under long-term leases are $9,000 a month. Depreciation charges are $36,000 a month. Miscellaneous expenses are $2,700 a month. Income tax payments of $63,000 are due in September and December. A progress payment of $180,000 on a new design studio must be paid in October. Cash on hand on July 1 will be $132,000, and a minimum cash balance of $90,000 should be maintained throughout the cash budget period. • Prepare a monthly cash budget for the last 6 months of 2009. • Prepare monthly estimates of the required financing or excess funds. • Now suppose receipts from sales come in uniformly during the month, but all outflows must be paid on the 5th. Will this affect the cash budget? That is, will the cash budget you prepared be valid under these assumptions? If not, what could be done to make a valid estimate of the peak financing requirements? • Bowers’ sales are seasonal; and her company produces on a seasonal basis, just ahead of sales. Without making any calculations, discuss how the company’s current and debt ratios would vary during the year if all financial requirements were met with short- term bank loans. Could changes in these ratios affect the firm’s ability to obtain bank credit? Explain.

A Question From a Finance Perspective

CASH BUDGET

INTERPRETING THE CASH BUDGET

• The previous example shows you will have a large surplus of cash every period. Is this a good thing? • Less Cash: – Unused cash is wasted cash, where there are good investment opportunities out there – Can be more productive spending on research, marketing • More Cash: – If sales turn out to be considerably less than expected, the company could face a cash shortfall. – May choose to hold large amounts of cash if it does not have much faith in its forecast, or if it is very conservative. – The cash may be used, in part, to fund future investments.

ELEMENTS OF WORKING CAPITAL ITEMS ON THE BALANCE SHEET

• Cash budget is tied to management of net working capital, which includes current assets and current liabilities. • Current assets – Cash and Marketable Securities – Inventory (affects CCC) – Accounts Receivables (affects CCC)

• Current Liabilities – Accounts Payable / Trade Credit (affects CCC) – Bank Loans – Accrued Liabilities – Secured / Collateralized Loans

CASH AND SECURITIES ELEMENTS OF WORKING CAPITAL

• Cash / Currency • Demand / Checking Deposits – Very important and composes majority of a company’s cash transactions. Firms try to optimize their demand deposits: • Hold marketable securities rather than deposits to earn interest • Borrow on short notice through credit line instead • Forecast payments and receipts better • Speed up payments / collections (get positive “float”) – Lockboxes • Credit cards, debit cards, wire transfers, direct deposits • Synchronize cash flows (both inflows and outflows)

• Marketable Securities – Highly liquid, very safe, and can be sold quickly at a predictable price (almost as good as cash). ***

INVENTORY

ELEMENTS OF WORKING CAPITAL

• In the example: SKI’s inventory turnover (4.82x) is considerably lower than the industry average (7.00x). – The firm is carrying a lot of inventory per dollar of sales.

• As per OPMAN: By holding excessive inventory, the firm is increasing its costs, which reduces its ROE. – Additional working capital also lowers EVA since it needs to be financed. – There has to be an optimal quantity to balance costs and risks of unavailability.

• Short run: Cash will free up and increase as inventory purchases decline. • Long run: Company is likely to take steps to reduce its cash holdings and increase its EVA.

INVENTORY


• Types of inventory costs – Carrying costs / holding costs – storage and handling costs, insurance, property taxes, depreciation, and obsolescence. – Ordering costs – cost of placing orders, shipping, and handling costs. – Costs of running short / shortage costs – loss of sales or customer goodwill, and the disruption of production schedules. – Reducing inventory levels generally reduces carrying costs, increases ordering costs, and may increase the costs of running short.

• Relevant Ratios – Inventory Turnover = Inventory / COGS – Days of Inventory = 365 / Inventory Turnover

ACCOUNTS RECEIVABLES ELEMENTS OF WORKING CAPITAL

• SKI’s DSO (45.6 days) is well above the industry average (32 days). • SKI’s customers are paying less promptly. • SKI should consider tightening its credit policy in order to reduce its DSO. • Relevant Ratios: – Accounts Receivables Turnover (Sales / AR) – Days of Sales Outstanding (365 / AR Turnover)

• The collection and management of receivables is called credit policy.


• Credit Period – How long to pay? – Shorter period reduces DSO and average A/R, but it may discourage sales. – Longer periods may increase tendencies of default (bad debt)

• Cash Discounts – Price reductions for early payments – Lowers price Attracts new customers and reduces DSO.

• Credit Standards – Financial strength customers must exhibit to extend credit – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO.

• Collection Policy – Toughness in collecting – Tougher policy will reduce DSO but may damage customer relationships.

• We always need to strike a balance. • Credit scores


• Policy Tightening – A tighter credit policy may discourage sales. – Some customers may choose to go elsewhere if they are pressured to pay their bills sooner. – SKI must balance the benefits of fewer bad debts with the cost of possible lost sales.

• Short run: If customers pay sooner, this increases cash holdings. • Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase EVA.

ACCOUNTS RECEIVABLES EXAMPLE

• Lamar Lumber Company has sales of $10 million per year, all on credit terms calling for payment within 30 days; and its accounts receivable are $2 million. What is Lamar’s DSO, what would it be if all customers paid on time, and how much capital would be released if Lamar could take action that led to on-time payments?

TRADE CREDIT / ACCOUNTS PAYABLE ELEMENTS OF WORKING CAPITAL

• Trade credit is credit furnished by a firm’s suppliers. – Trade credit is often the largest source of short-term credit, especially for small firms. – Spontaneous, easy to get, but cost can be high.

• Usually quoted in this format = (discount rate) / (days of discount), net (maximum days pay is required) • Deferring payment “frees” up cash • Types – Free trade credit – credit received during discount period – Costly trade credit – credit you get when you forego the discount and take longer to pay

TRADE CREDIT / ACCOUNTS PAYABLE EXAMPLE

• Suppose a firm buys $3,000,000 net ($3,030,303 gross) on terms of 1/10, net 40, annually. • The firm can forego discounts and pay on Day 40, without penalty. • First step is to get the net daily purchases. We need to do this to know the amount of accounts payable on hand, since they “cycle” every 10 to 40 days.

Net daily purchases

=

=

$3,000,000 /365 $8,219.18

TRADE CREDIT / ACCOUNTS PAYABLE EXAMPLE

• Payables level, if the firm takes discounts – Payables = $8,219.18(10) = $82,192

• Payables level, if the firm takes no discounts – Payables = $8,219.18(40) = $328,767

• This means that if you take up to 40 days to pay, your payables won’t go beyond $328,767 • Credit breakdown •

NOMINAL COST OF TRADE CREDIT EXAMPLE

• By not taking the discount though, the firm loses 0.01($3,030,303) = $30,303 of discounts to obtain $246,575 in extra trade credit: r NOM

= $30,303/$246,575 = 0.1229 = 12.29%

• The $30,303 is paid throughout the year, so the effective cost of costly trade credit is higher. This is a nominal annual measure.

NOMINAL COST OF TRADE CREDIT FORMULA

• An easy way to remember this is from its name. Nominal cost of trade credit. • Get the real discount rate (Discount Foregone / Net Price) • Multiply it by the number of “compounding” periods

rNOM

=

=

=

=

Discount % 365 days " 1 ! Discount % Days taken ! Disc. period 1 365 " 99 40 ! 10 0.1229 12.29%

EFFECTIVE COST OF TRADE CREDIT FORMULA

• Solve for the periodic rate = 0.01/0.99 = 1.01% • Periods/year = 365/(40 – 10) = 12.1667 • Effective cost of trade credit – Exactly the same as EAR formula

• Remember that EAR > nominal if compounding periods are more than once a year

EAR = (1 + Periodic rate)N ! 1 =

(1.0101)12.1667 ! 1 = 13.01%

NOMINAL COST OF TRADE CREDIT EXAMPLE

• Lamar Lumber buys $8 million of materials (net of discounts) on terms of 3/5, net 60; and it currently pays after 5 days and takes discounts. Lamar plans to expand, which will require additional financing. If Lamar decides to forgo discounts, how much additional credit could it get and what would be the nominal and effective cost of that credit? If the company could get the funds from a bank at a rate of 10%, interest paid monthly, based on a 365-day year, what would be the effective cost of the bank loan? Should Lamar use bank debt or additional trade credit? Explain.

WORKING CAPITAL MANAGEMENT EXAMPLE

• Prestopino Corporation produces motorcycle batteries. Prestopino turns out 1,500 batteries a day at a cost of $6 per battery for materials and labor. It takes the firm 22 days to convert raw materials into a battery. Prestopino allows its customers 40 days in which to pay for the batteries, and the firm generally pays its suppliers in 30 days. – What is the length of Prestopino’s cash conversion cycle? – At a steady state in which Prestopino produces 1,500 batteries a day, what amount of working capital must it finance? – By what amount could Prestopino reduce its working capital financing needs if it was able to stretch its payables deferral period to 35 days? – A new production process would allow Prestopino to decrease its inventory conversion period to 20 days and to increase its daily production to 1,800 batteries. However, the new process would cause the cost of materials and labor to increase to $7. Assuming the change does not affect the average collection period (40 days) or the payables deferral period (30 days), what will be the length of its cash conversion cycle and its working capital financing requirement if the new production process is implemented?

OTHER TYPES OF DEBT ELEMENTS OF WORKING CAPITAL

• Promissory Note • Line of Credit • Revolving Credit Agreement • Bank Loans – Simple Interest – Add-on Interest

• Commercial Paper • Collateralized Financing

BANK LOANS


• The firm can borrow $100,000 for 1 year at an 8% nominal rate. • Interest may be set / treated under one of the following scenarios: – Simple annual interest – Installment loan, add-on, 12 months

BANK LOANS

SIMPLE ANNUAL INTEREST

• Lenders can quote loans in two main ways: simple interest or add-ons. • Simple interest means no discount or add-on. – Interest = 0.08($100,000) = $8,000 – rNOM = EAR = $8,000/$100,000 = 8.0%

• For a 1-year simple interest loan, rNOM = EAR. • Similar to what we did for Bonds Valuation.

BANK LOANS

ADD-ON

• Add-on means the interest expense is added on top of the face amount. Example: – Interest = 0.08 ($100,000) = $8,000 – Face amount = $100,000 + $8,000 = $108,000

• Monthly payment = $108,000/12 = $9,000 • Avg loan outstanding = $100,000/2 = $50,000 • Approximate cost = $8,000/$50,000 = 16.0% • To find the appropriate effective rate, recognize that the firm receives $100,000 and must make monthly payments of $9,000 (like an annuity).

BANK LOANS

ADD-ON

• Let us say, solving for IRR we get .012043 per month (1.2043%). • Nominal Rate = 12 (0.012043) – = 0.1445 = 14.45%

• EAR = (1.012043)^12 – 1 = 15.45% • Notes: • Add-on interest is higher in actual terms than simple interest • Usually quoted at annual percentage rate(monthly rate x 12)

ACCRUED LIABILITIES ELEMENTS OF WORKING CAPITAL

• Spontaneous funds as a result of not paying your expenses. • Not really controllable but a source of “free” cash as well.

Lesson 13 - Working Capital Management

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