Working Capital Management Current Assets

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary
Chapter 24 Working Capital

Management: Current Assets and Current
Liabilities
Prepared by
Ken Hartviksen
CHAPTER 24
Working Capital Management:
Current Assets and Current
Liabilities
Lecture Agenda
Learning Objectives
Important Terms
Cash Management
Reasons for Holding Cash

Determining the Optimal Cash Balance
Cash Management Techniques
Accounts Receivable Management

The Credit Decision
Credit Policies
The Collection Process
Inventory Management
Inventory Management Approaches

Evaluating Inventory Management
Short-Term Financing Considerations

Summary and Conclusions
Concept Review Questions
CHAPTER 24 Working Capital

Management Current Assets and Current
24 - 3
Learning Objectives
You should understand the following:
How to manage individual asset items, such as cash,

receivables, and inventory
The nature of the major sources of short-term financing,
such as trade credit, bank loans, factoring arrangements,
and money market securities
The fact that in evaluating current asset and current
liability decisions, the final decision rests on the standard
problem of trading off expected benefits and potential
costs

24 - 4
Important Chapter Terms
ABC approach
Capacity
Character
Conditions
Credit analysis
Credit enhancements
Economic Order Quantity
Factoring arrangements
Finance motive
Float
Just-in-time inventory
systems
Materials requirement
planning
Open account
Optimal cash balance
Precautionary motive
Prepayments
Securitization
Special purpose vehicles
Speculative motive
Terms of credit
Transactions motive

24 - 5
Cash and Marketable Securities

Working Capital Management
Current Assets and Current Liabilities

Reasons for Holding Cash
1.
2.
3.
4.
Transactions motive
Precautionary motive
Finance motive
Speculative motive

24 - 7

Determining the Optimal Cash Balance
The optimal cash balance is the amount of

cash that balances the risks of illiquidity
against the sacrifice in expected return that is
associated with maintaining cash.
Differs substantially across firms
Firms with predictable cash flows will have lower optimal
cash balance requirement
Firms with excess borrowing capacity (unused line of credit
for example) can hold less cash.

24 - 8

Cash Management Techniques
Cash flow synchronization can free up cash (and lower

the amount of capital a firm requires)
This is done by:
Speeding up cash inflows:
Bill clients earlier each month
Increase cash sales through incentives
Encourage customers to pay using electronic payments systems
such as direct deposit, automatic debit, debit card, rather than
cheque.
Delaying outflows:
Arrange with suppliers for more liberal trade credit terms (net 40
rather than net 30 for example)
Paying employees once a month rather than twice.
24 - 9
Cash Managements
Float
Float is the time that elapses between the time the

paying firm initiates payment, and the time the funds
are available for use by the receiving firm.
It has three major sources:
1. The time it takes the cheque to reach the firm after it is mailed by
the customer.
2. The time it takes the receiving firm to process the cheque and
deposit in an account, and
3. The time it takes the cheque to clear through the banking system
so that the funds are available to the firm.
Float has been reduced or eliminated through:
Debit cards
Preauthorized payments
Electronic funds transfer (EFT) and electronic data interchange
(EDI) systems.
24 - 10
Accounts Receivable
Accounts Receivable
1. The decision to extend credit to customers has
significant cash flow and credit risk implications for
the firm.
Firms often dont have a choice, if the availability of credit is an

important factor in the customers purchase decision process (if
competitors offer credit, then the firm must at least match those
credit terms, and then choose to compete on another basis.)
2. The second decision (once the firm has decided to

extend credit) is to determine which customers will
be granted credit.
3. The credit terms must be established.
4. The collection process must be decided.
24 - 12
Accounts Receivable
The Credit Decision
The decision to extend credit is determined:
Nature of the product sold,

The industry
Practices of competitors.

24 - 13
Accounts Receivable
Credit Analysis
The process designed to assess the risk of nonpayment by potential customers, which involves
collecting information about potential customers with
respect to their credit history, their ability to make
payments as reflected in their expected cash flows,
and their overall financial stability.
From the firms point of view:
Often willing to extend credit on terms better than a bank
because:
The potential for the firm developing a good customer into the
future, and
Losses are limited to production costs in the case of default.
24 - 14
Accounts Receivable
Credit Analysis
Variables that are weighed in the credit

analysis process:
Capacity the customers ability to pay

Character the customers willingness to pay
Collateral the security that could be seized to satisfy
payment
Conditions the state of the economy.

24 - 15
Accounts Receivable
Credit Policies
The firm must choose what terms of credit to

offer its customers.
Terms of credit include:
The due date
The discount amount (if any)
Options include:
Cash on delivery (COD)

Cash before delivery (CBD)
Net 30, net 40 - no incentive for early payment
2/10 net 30 - a 2% discount for early payment
24 - 16
Accounts Receivable
Change in Credit Policy Analysis
When extending more lenient credit terms the firm hopes to

increase revenues through the sale of more units, and
perhaps even charge higher prices.
These benefits are offset by financing costs and the
increased risk of non-payment.
Evaluation of these decisions can use an NPV framework:
[ 24-1]
NPV PV(Future CFs) - CF0

24 - 17
Accounts Receivable
The Collection Process
The firm must monitor outstanding A/R by customer

and by category.
The firm must then determine what action it will take
when late payments occur.
Charge interest on outstanding balances

Notify customer of arrears (email, mail, telephone)
Actions on unpaid amounts:
Allow no further purchases on credit

Choose from a number of additional options to collect:
1.
2.
3.
Take legal action

Sell receivable to a collection agency
Write off the debt as uncollectable.

24 - 18
Accounts Receivable
Factoring
It may not be cost-effective for a firm to

manage the collection process itself.
Factoring arrangements are the sale of a
firms receivables, at a discount, to a
financial company called a factor, which
specializes in collections, or the out-sourcing
of the collections to a factor.

24 - 19
Evaluating Receivables Management

Use of productivity ratios introduced in
Chapter 4 can give a tool for evaluating the
firms ability to manage its accounts
receivable.

24 - 20

Receivables Turnover
Measures the sales generated by every dollar

of receivables.
Receivables turnover
RT
S
AR
[4- 16]
Sales
Accounts Receivable

24 - 21

Average Collection Period
Estimates the number of days it takes a firm to collect on
its accounts receivable.
Average Collection Period
ACP
AR
365
ADS Receivables Turnover
AR
Receivables turnover
[4- 17]
If ACP is 40 days, and the firms credit policy is net 30,

clearly, customers are not paying in keeping with the firms
policy, and there may be concerns about the quality of the
firms customers, and what might happen if economic
conditions deteriorate.
24 - 22
Inventory
Inventory
The level of inventory a firm holds is a trade off
between benefits and costs:
Benefits of Holding Inventory:
Take advantage of large-volume discounts
Reduce the probability of production disruptions because of lack of
inventory
Minimize lost sales because of stock-outs
Costs of Holding Inventory:

Financing costs associated with inventory investment
Storage, handling, insurance, spoilage and obsolescence costs.

24 - 24
Inventory
Inventory Management Approaches
ABC Approach
Economic Order Quantity (EOQ) Model
Materials Requirement Planning (MRP)
Just-in-time (JIT) Inventory systems.

24 - 25
Inventory
Evaluating Inventory Management
Use of financial ratios can give some

indication of the effectiveness of a firms
inventory management.
Ratios, however, do not measure shortage
costs, financing costs, etc.
These ratios include:
Inventory turnover
Average days sales in inventory.

24 - 26
Productivity Ratios
Inventory Turnover
Estimates the number of times, ending inventory was
turned over (sold) in the year.
CGS
Inventory Turnover
INV
[4- 18]
A ratio that involves both stock and flow values

Is strongly a function of ending inventory value
managers often try to improve this ratio as they approach
year end through inventory reduction strategies (cash
and carry sales/inventory clearance, etc.)
24 - 27
Productivity Ratios
Inventory Turnover
When Cost of Goods Sold is not available, it may be
necessary to estimate inventory turnover using sales.
Sales
Inventory Turnover
INV
[4- 19]
Use of the sales figure is less valid than Cost of Goods

Sold because Cost of Goods Sold is based on
inventoried cost, but Sales includes a profit margin on
top of inventoried cost.
24 - 28
Productivity Ratios
Average Days Sales in Inventory (ADSI)
Estimates the number of days of sales tied up

in inventory (based on ending inventory
values)
Average days sales in inventory (ADSI)
INV
ADS
[4- 20]
365
Inventory turnover

24 - 29


Investment in current assets tend to rise and
fall with the volume of activity.
Accruals and accounts payable (trade credit)
are spontaneous liabilities.
Other sources of financing must be
negotiated and before using the firm must
evaluate the cost effectiveness of alternative
financing mechanisms.

24 - 31

To estimate the annual effective rate of return or cost (k) of
any financing alternative:
[ 24-2]
n-Day financing cos t 365 /n

k (1
)
-1
Purchase price

24 - 32

Trade Credit
Often a very important source of short-term financing.

Offers a number of advantages:
Readily available
Convenient
Flexible
Usually does not entail any restrictive covenants or pledges of
security.
There is no explicit cost associated with credit terms

such as:
Net 30
Net 40
24 - 33

Trade Credit
There is usually a high implicit cost to a firm that forgoes
discounts on early payment such as:
2/10 Net 30
Example: assume (2/10 net 30)

Approximate percentage cost = (2/98)(365/20) = 37.2%
The firm is being charged 2% for the use of funds from day 10 to
day 30 (20 days).

24 - 34

Bank Loans and Factor Arrangements
Options include:
Operating loans / lines of credit
Secured by accounts receivable and inventory to a maximum
percent of those assets
Interest only payments
Balance can be retired at the firms discretion
Factor arrangements

24 - 35

Money Market Instruments
Large firms with high credit ratings may be able
to by-pass financial institutions and borrow
directly from the money market.
Two forms of money market instruments:
Commercial paper
Bankers acceptances
The firm pays a stamping fee, and is able to borrow based on their
banks credit rating.
Money market securities:
Sold at a discount from face value

Maturities at time of issue of 30, 60, 90 days
Face amounts of $100,000 or more.
24 - 36

Money Market Instruments
The annualized yield on a money market instrument:
[ 24-3]
Approximate annual yield
Discount
365
Market price Days to maturity

24 - 37

Securitizations
Special purpose vehicles (SPVs) are conduits for
packaging portfolios of receivables and selling them to
investors in the money market; a recent innovation in
financing trade credit.
Credit enhancements are actions taken to reduce
credit risk, such as requiring collateral, insurance or
other agreements.
Asset-backed commercial paper (ABCP) is an example.
The sub-prime mortgage problems in the U.S. has exposed the
problems with ABCP where investors have become concerned
about the underlying asset values (packages of receivables) and
the market is actively repricing these money market instruments
In some cases the market has disappeared for some of these
money market instruments.
24 - 38
Summary and Conclusions

In this chapter you have learned:
That the optimal level of investment in cash,
receivables and inventory occurs when the
benefits balance the costs
The advantages, the disadvantages and
associated effective annual costs of the most
common short-term financing options available to
companies.

24 - 39
Concept Review Questions

Current Assets and Liabilities
Concept Review Question 1

Motives for Holding Cash
Why do firms hold cash?

24 - 41
Concept Review Question 1

Float
What is float and why is it important to the

firm?

24 - 42
Internet Links
Securitization Net - http://www.securitization.net/

Dun & Bradstreet Small Business solutions http://smallbusiness.dnb.com/credit-reports/browse-produc
ts.asp

24 - 43
Copyright
Copyright 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this
work beyond that permitted by
Access Copyright (the Canadian
copyright licensing agency) is
unlawful. Requests for further
information should be addressed to
the Permissions Department, John
Wiley & Sons Canada, Ltd. The
purchaser may make back-up copies
for his or her own use only and not
for distribution or resale. The author
and the publisher assume no
responsibility for errors, omissions,
or damages caused by the use of
these files or programs or from the
use of the information contained
herein.

24 - 44

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INTRODUCTION TO

Chapter 24 Working Capital

Reasons for Holding Cash

Accounts Receivable Management

Inventory Management Approaches

Short-Term Financing Considerations

CHAPTER 24 Working Capital

How to manage individual asset items, such as cash,

CHAPTER 24 Working Capital

Important Chapter Terms

CHAPTER 24 Working Capital

Cash and Marketable Securities

Cash and Marketable Securities

CHAPTER 24 Working Capital

Cash and Marketable Securities

The optimal cash balance is the amount of

CHAPTER 24 Working Capital

Cash and Marketable Securities

Cash flow synchronization can free up cash (and lower

Float is the time that elapses between the time the

Float has been reduced or eliminated through:

Firms often dont have a choice, if the availability of credit is an

2. The second decision (once the firm has decided to

The decision to extend credit is determined:

Nature of the product sold,

CHAPTER 24 Working Capital

Variables that are weighed in the credit

Capacity the customers ability to pay

CHAPTER 24 Working Capital

The firm must choose what terms of credit to

Cash on delivery (COD)

When extending more lenient credit terms the firm hopes to

NPV PV(Future CFs) - CF0

CHAPTER 24 Working Capital

The firm must monitor outstanding A/R by customer

Charge interest on outstanding balances

Actions on unpaid amounts:

Allow no further purchases on credit

Take legal action

CHAPTER 24 Working Capital

It may not be cost-effective for a firm to

CHAPTER 24 Working Capital

Evaluating Receivables Management

CHAPTER 24 Working Capital

Evaluating Receivables Management

Measures the sales generated by every dollar

CHAPTER 24 Working Capital

Evaluating Receivables Management

ADS Receivables Turnover

If ACP is 40 days, and the firms credit policy is net 30,

Costs of Holding Inventory:

CHAPTER 24 Working Capital

CHAPTER 24 Working Capital

Use of financial ratios can give some

CHAPTER 24 Working Capital

A ratio that involves both stock and flow values

Use of the sales figure is less valid than Cost of Goods

Estimates the number of days of sales tied up

Average days sales in inventory (ADSI)

CHAPTER 24 Working Capital