Working Capital

Management
Reading 35, GIIM 617 Corporate Finance
Fall 2020
Tarun Bansal
Topics
• Managing and Measuring Liquidity

• Management of Account Receivables

• Management of Inventory

• Management of Account Payables

• Short-Term Financing
Managing and Measuring
Liquidity
Introduction: Working Capital Management
• Working capital management is the management of the short-term investment and financing of a
company.

• Goals:
• Adequate cash flow for operations
• Most productive use of resources
Introduction: Liquidity
• Liquidity is the ability of the company to satisfy its short-term
obligations using assets that are readily converted into cash.

• Liquidity management is the ability of the company to generate cash

when and where needed.
Sources
• Primary sources of liquidity (for day-to-day operations)
• Selling goods and services
• Collecting receivables
• Short-term investments
• Trade credit from vendors
• Lines of credit from banks
• Effective cash flow management of collections and payments

• Secondary sources of liquidity

• Liquidate short-term or long-lived assets
• Negotiating debt agreements
• Filing for bankruptcy and reorganizing the company.
Factors
• Drags on liquidity: Delay or reduce cash inflows or increase in
borrowing costs.
• Uncollected receivables and bad debts
• Obsolete inventory
• Tight short-term credit

• Pulls on liquidity: Accelerate cash outflows

• Paying vendors sooner
• Changes in credit terms
• Limits on short-term lines of credit
• Low liquidity positions
Measures
• Current ratio (Best-known measure): higher ratio -> better liquidity

• Quick ratio or acid-test ratio (More stringent measure)

higher ratio -> better liquidity

• Receivables turnover ratio: better if close to industry norm

Measures
Number of days of receivables: Average number of days it takes for the company’s
customers to pay their bills.

Inventory Turnover: Measure of a firm’s efficiency

Number of days of inventory: better if close to industry norm

Measures
Payables Turnover: Measure of the use of trade credit 

Number of days of payables: Average amount of time it takes the company to pay its
bills
Working Capital effectiveness
Operating cycle: Average number of days that it takes to turn raw materials into cash
Collect
Acquire
Sellon Accounts
Inventory
forReceivable
for Cash
proceeds from sales. Inventory Credit

Operating cycle = days of inventory + days of receivables

Cash conversion cycle: Time it takes to turn the firm’s cash investment in inventory
back into cash, in the form of collections from the sales of that
inventory.
Acquire
Collect Pay
Inventory
Suppliers
SellonInventory
Accounts for
for Credit
Receivable
Credit

Cash Conversion cycle = (average days of receivables) + (average days of inventory) –

(average days of payables)
Example: Liquidity and Operating Cycles
Compare the liquidity and liquidity needs for
Company A and Company B for FY2:

Company A Company B
  FY2 FY1 FY2 FY1
Cash and cash equivalents €200 €110 €200 €300
Inventory €500 €450 €900 €900
Receivables €600 €625 €1,000 €1,100
Accounts payable €400 €350 €600 €825

Revenues €3,000 €950 €6,000 €6,000

Cost of goods sold €2,500 €750 €5,200 €5,050
Example
Managing the Cash Position
• Management of the cash position of a company has a goal
of maintaining positive cash balances throughout the day.
• Forecasting short-term cash flows is difficult because of
outside, unpredictable influences (e.g., the general
economy).
• Companies tend to maintain a minimum balance of cash (a
target cash balance) to protect against a negative cash
balance.
Managing the Cash Position
• Minimum Cash Balances
• Identifying Typical Cash Flows
Examples of Cash Inflows and Outflows
Inflows Outflows
 Receipts from operations, broken down by  Payables and payroll disbursements, broken
operating unit, departments, etc. down by operating unit, departments, etc.
 Fund transfers from subsidiaries, joint ventures,  Fund transfers to subsidiaries
third parties  Investments made
 Maturing investments  Debt repayments
 Debt proceeds (short and long term)  Interest and dividend payments
 Other income items (interest, etc.)  Tax payments
 Tax refunds

• Cash Forecasting Systems

Managing the Cash Position
• Monitoring Cash Uses and Levels

• keep track of cash balances and flows at different locations.

• Investment of cash in excess of day-to-day needs and
• Short-term sources of borrowing
• Other influences on cash flows:
• Capital expenditures
• Mergers and acquisitions
• Disposition of assets
Investing Short-term Funds
• Short-term investments are temporary stores of funds.

• Considerations:
• Liquidity
• Maturity
• Credit risk
• Yield
• Requirement of collateral
Short-term securities
• U.S. Treasury bills.
• Short-term federal agency securities.
• Bank certificates of deposit.
• Banker’s acceptances.
• Time deposits.
• Repurchase agreements.
• Commercial paper.
• Money market mutual funds.
• Adjustable-rate preferred stock.
 Yields on Short-Term Securities

• The nominal rate is the stated rate of interest, based on the face value
of the security.
• The yield is the actual return on the investment if held to maturity.
• There are different conventions for stating a yield:

Yield Formula
Money market yield
Bond equivalent yield
Bond equivalent yield
Discount-basis yield
Discount-basis yield

Note: Returns on the firm’s short-term securities investments should be stated as bond equivalent yields. The return on the
portfolio should be expressed as a weighted average of these yields.
Example: Yields on short-term investments
•Suppose
  a security has a face value of $100 million and a purchase price of $98 million and
matures in 180 days.

1. What is the money market yield on this security?

.0816%

2. What is the bond equivalent yield on this security?

3. What is the discount-basis yield on this security?

%
Investment Risks and Safety Measures
Short-term Investment Strategies

Matching Strategy

Active Mismatching Strategy

Short-Term
Investment Strategies
Passive Laddering Strategy
Short-term Investment policy
Purpose List and explain the reason the portfolio exists and describe general
attributes.

Authorities Describe the executives who oversee the portfolio managers (inside
and outside) and describe what happens if the policy is not followed.

Limitations or Describe the types of securities to be considered in the portfolio and

Restrictions any restrictions or constraints.

Quality List the credit standards for holdings (for example, refer to short-term
or long-term ratings).

Other Items Auditing and reporting may be included.

Management of Account
Receivables
Managing accounts Receivable
• Objectives in managing accounts receivable:
• Process and maintain records efficiently.
• Control accuracy and security of accounts receivable records.
• Collect on accounts and coordinate with treasury management.
• Coordinate and communicate with credit managers.
• Prepare performance measurement reports.

• Companies may use a captive finance subsidiary to centralize the

accounts receivable functions and provide financing for the
company’s sales.
Evaluating the Credit function
• Consider the terms of credit given to customers:
• Ordinary: Net days or, if a discount for paying within a period, discount/discount period,
net days (for example, 2/10, net 30).
• Cash before delivery (CBD): Payment before delivery is scheduled.
• Cash on delivery (COD): Payment made at the time of delivery.
• Bill-to-bill: Prior bill must be paid before next delivery.
• Monthly billing: Similar to ordinary, but the net days are the end of the month.

• Consider the method of credit evaluation that the company uses:

• Companies may use a credit-scoring model to make decisions of whether to extend
credit, based on characteristics of the customer and prior experience with extending
credit to the customer.
Managing Customers’ Receipts
• The most efficient method of managing the cash flow from customers depends on the type
of business.

• Methods of speeding the deposit of cash collected by customers:

• Using a lockbox system and concentrating deposits
• Encouraging customers to use electronic fund transfers
• Point of sale (POS) systems
• Direct debit program

• For check deposits, performance can be monitored using a float factor:

• "Float factor = " "Average daily float" /"Average daily deposit"
• The float is the amount of money in transit.
• The float factor measures how long it takes for checks to clear.
Evaluating Accounts Receivable
Management
 Calculate the average days of receivables

 Compare ratio to the firm’s historical performance or to the average ratios for a group of comparable
companies.

 Prepare aging schedule
Evaluating Accounts Receivable
Management
Evaluating Accounts Receivable
Management
Management of Inventory
Managing Inventory
• The objective of managing inventory is to determine and maintain the level of inventory that is sufficient to meet
demand, but not more than necessary.

• Motives for holding inventory:

• Transaction motive: To hold enough inventory for the ordinary production-to-sales cycle.
• Precautionary motive: To avoid stock-out losses.
• Speculative motive: To ensure availability and pricing of inventory.

• Approaches to managing levels of inventory:

• Economic order quantity: Reorder point—the point when the company orders more inventory, minimizing the sum of order costs
and carrying costs. (may involve safety stock and anticipation stock).
• Just in time (JIT): Order only when needed, when inventory falls below a specific level
• Materials or manufacturing resource planning (MRP): Coordinates production planning and inventory management.

• Bottom line: The appropriateness of an inventory management system depends on the costs and benefits of
holding inventory and the predictability of sales.
Inventory Costs
• Ordering: - Procurement or replenishment costs

• Carrying: - Financing and holding costs, which are opportunity or real costs.

• Stock-out: - Opportunity or real costs, which are affected by level of

inventory, item mix, processing time versus term of sale.

• Policy: - Costs of gathering data and general operating costs, which may be
real costs or “soft” costs.
Evaluating Inventory Management
If inventory levels too low -> Lost sales due to stock-outs

If inventory levels too large -> High carrying costs

If Increasing average days’ inventory or a decreasing inventory turnover ratio: Inventory level is too large

E.g. Company A (Inventory level = 100, Cost of goods sold = 200)

Company B (Inventory level = 50, Cost of goods sold = 200)

Different industries require different inventory levels.(E.g. Grocery business, Art gallery)
Management of Account
Payables
Managing Accounts Payable
• Accounts payable arise from trade credit and are a spontaneous form of credit.

• Credit terms may vary among industries and among companies, although these tend to be
similar within an industry because of competitive pressures.

• Factors to consider:
• Company’s centralization of the financial function
• Number, size, and location of vendors
• Trade credit and the cost of alternative forms of short-term financing
• Control of disbursement float (i.e., amount paid but not yet credited to the payer’s account)
• Inventory management system
• E-commerce and electronic data interchange (EDI), which is the customer-to-business payment
connection through the internet
Accounts Payable Management
 If pay its payables too quickly :- Unnecessary use of cash(Loss of interest)
 If pays its payables late :- May damage relationships with suppliers, restrictive credit terms, high
interest charges

Terms of “2/10 net 60" mean that if the invoice is paid within 10 days, the company gets a 2%
discount on the invoiced amount and that if the company does not take advantage of the discount,
the net amount is due 60 days from the date of the invoice.
Cost of Trade Credit
Calculate and interpret the annualized cost of trade credit for invoice terms of 2/10 net 60, when the invoice is paid
on the 40th, 50th, or 60th day.

Note: The annualized cost of trade credit decreases as the payment period increases. If the company does not take
the 2% discount within the first ten days, it should wait until the due date (day 60) to pay the invoice.
Evaluating Accounts Payable Management
Short-Term Financing
Managing Short-term Financing
• The objective of a short-term financing strategy is
to ensure that the company has sufficient funds,
but at a cost (including risk) that is appropriate.

Bank Sources Nonbank Sources

• Uncommitted line of credit • Asset-based loan
• Regular line of credit • Commercial paper
• Overdraft line of credit
• Revolving credit agreement
• Collateralized loan
• Discounted receivables
• Banker’s acceptances
• Factoring
Which Short-term Financing?
• Characteristics that determine the choice of financing:
• Size of borrower
• Creditworthiness of borrower
• Access to different forms of financing
• Flexibility of borrowing options (manage maturities)
• Asset-based loans are loans secured by an asset

Accounts Receivable Inventory

• Blanket lien • Inventory blanket lien
• Assignment of accounts • Trust receipt arrangement
receivable • Warehouse receipt
• Factoring arrangement
Costs of borrowing
•Cost
  of a loan without fees:

Cost of a loan with a commitment fee:

Cost of a loan with a dealer’s commission and bank-up costs:

If the interest is “all-inclusive,” it means that the loaned amount includes interest, so the denominator is
(Loan amount – Interest), which has the effect of increasing the cost of the loan.
Example: Cost of Borrowing
• You are asked to select one of the following choices as the best offer
for borrowing $5,000,000 for one month:
1. Drawing down on a line of credit at 2.5 percent with a 1/2 percent
commitment fee on the full amount. Note: One-twelfth of the cost
of the commitment fee (which gives an option to borrow any time
during the year) is allocated to the first month.
2. A banker’s acceptance at 2.55 percent, an all-inclusive rate.
3. Commercial paper at 2.15 percent with a dealer’s commission of
1/8 percent and a backup line cost of 1/4 percent, both of which
would be assessed on the $5 million of commercial paper issued.