Chapter 18 - Working Capital Management

Overview of Working Capital
The main components of net working capital are cash, inventory, receivables, and payables. Working capital includes the cash that is needed to run the firm on an everyday basis but it does not include excess cash which is cash that is not required to run the business. This cash can be invested and is part of a company's capital structure. Working capital alters a firm's value by affecting its free cash flows

The Cash Cycle
The level of working capital reflects the length of time between when cash goes out of a firm at the beginning of the production process and when it comes back in. A firm's operating cycle is the average length of time between when the firm originally purchases its inventory and when it receives the cash back from selling its product. A firm's cash cycle is the length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory. A firm's cash conversion cycle (CCC):

CCC= Inventory Days + Accounts Receivable Days - Accounts Payable Days

Inventory Days = Inventory / Average Daily COGS

Accounts Receivable Days = Accounts Receivable / Average Daily Sales

Accounts Payable Days = Accounts Payable / Average Daily COGS

Working Capital Needs by Industry
The longer a firm's cash cycle, the more working capital it has, and the more cash it needs to carry to conduct its daily operations. When a company's cash conversion cycle is negative, it means that it receives cash from its customers before having to pay its suppliers.

Firm Value and Working Capital
Any reduction in working capital requirements generates a positive free cash flow that the firm can distribute immediately to shareholders. Since the value of any firm is determined by its free cash flows, it is important to manage working capital efficiently. By doing so, management will be able to increase the free cash flows of the company which will maximize the value of the firm.

Trade Credit
Accounts receivable represent the credit sales for which a firm has yet to receive payment for. The accounts payable represent the amount that a firm owes its suppliers for goods that it has received but has not yet paid for. The credit that the firm is extending to its customers is trade credit, the difference between receivables and payable is the net amount of a firm's capital consumed as a result of those credit transactions

Trade Credit Terms
Credit terms are often quoted "net X" with X being a certain number of days. For example, Net 30 means that payment is not due until 30 days from the date of the invoice. Sometimes, a discount will offered and stated as "2/10, net 30". This means that buying firm will receive a 2% discount if it pays by the 10th day or else they will pay the full amount in 30 days. The cash discount is the percentage discount offered if the buyer pays early. The discount period is the number of days the buyer has to take advantage of the cash discount. The credit period is the total length of time credit is extended to the buyer (the total amount of time the buyer has to pay). Firms offer discounts because if customers pay early, they will receive cash sooner. However, discounts also represent a cost to the seller since it will not receive the full selling price if the discount is taken.

Trade Credit and Market Frictions
Businesses can maximize their value by using trade credit options effectively. Trade credit is nothing more than a loan from the selling firm to its customers. The discount available represents the interest rate. Trade credit is simple and convenient to use and it has lower transaction costs than other sources of funding. No paperwork has to be filled out and it is flexible so that it can be used when needed. Providing financing at below market rates is an indirect way to lower prices for certain customers. Many suppliers have close businesses relationships with their customers and therefore know more about their customer's credit than a bank would. The supplier also has the power to cut off resources which can influence customers to pay on time.

Managing Float
A factor that contributes to the length of a firm's receivables and payables is the delay between the time a bill is paid and the cash is actually received. This delay impacts a firm's working capital.

The amount of time it takes for a firm to be able to use funds after a customer has paid for its goods is known as collection float. By reduction collection float, a firm can reduce their working capital needs. Collect float consists of three different components:

  1. Mail Float: how long it takes the firm to receive a payment check after the customer has mailed it
  2. Processing Float: how long it takes the firm to process a customer's payment check and deposit it in the bank
  3. Availability Float: how long it takes a bank to post the funds from customer payments the firm has deposited in the bank

The amount of time it takes before payments to suppliers actually result in a cash outflow for the firm if known as disbursement float. It is also a function of mail time, processing time, and check clearing time. The Check Clearing for the 21st Century Act (Check 21) eliminates the part of the disbursement float due to the check clearing process. This became effective on October 28, 2004. Banks can process check information electronically now and the funds are deducted from a firm's checking account on the same day that the firm's supplier deposits the check in its bank. However, the check recipient's account is not credited as quickly so the act does not reduce collection float.

Receivables Management

Determining the Credit Policy
There are 3 steps to undergo when developing a credit policy:
  1. Establish credit standards
  2. Establish credit terms
  3. Establish a collection policy

Management has to decide on credit standards. The decision of how much credit risk to assume plays a large role in determining how much money a firm ties up in its receivables. A restrictive policy will most likely result in lower sales but the firm will have a smaller investment in receivables. Less restrictive policies will generate higher sales as well as a higher receivables balance.

After establishing credit standards, the firm must decide on the length of the period before payment must be made and whether or not they will offer a discount for early payments. If a discount is offered, the amount of the discount must also be determined. The last step is to establish a collection policy. Collection policies vary widely among industries. Some companies do nothing when their customers don't pay. Others send out a reminder notifying customers that their payment is late. Yet still other companies may even take legal action at the first late payment.

Monitoring Accounts Receivable
After a firm establishes its credit policy, it must monitor its accounts receivable in order to determine whether its policy is working to the best advantage of the company. Accounts receivable days and an aging schedule are the most common monitor tools used.

The accounts receivable days is the average number of days that it takes a firm to collect on its sales. By comparing this number to the number in the credit policy, a business can determine whether its policy is effective or not. The accounts receivable days is important because investors utilize this measure to evaluate a firm's credit management policy. This method does have its weaknesses however. Seasonal sales patterns may cause accounts receivable days to change depending on when the calculation occurs. This goes to show that accounts receivable days can hide important information.

The other method commonly used is an aging schedule which categorizes accounts by the number of days they have been on the books. It can be constructed in one of two ways: using the number of accounts or using the dollar amount of the accounts receivable outstanding. If the percentages in the lower half of the schedule begin to increase, the firm needs to evaluate the effectiveness of its credit policy. Payment patterns provide information on the percentage of monthly sales that the firm collects in each month after the sale. The payment pattern can be used to forecast the working capital needs of the business.

The 5 C's of Credit
Character: Is the borrower trustworthy with a history of meeting its debt obligations?
Capacity: Will the borrower have enough cash flow to make its payments?
Capital: Does the borrower have enough capital to justify the loan?
Collateral: Does the borrower have any assets that can secure the loan?
Conditions: How are the borrower and the economy performing and how are they expected to perform?

Payables Management
Businesses should only utilize accounts payable if trade credit is the cheapest source of funding. This all depends on credit terms. The higher the discount percentage offered, the greater the cost of forgoing the discount. This cost of forgoing the discount also increases when the loan period is short. Firms should always take the least expensive trade credit if given a choice between multiple suppliers.

Accounts Payable Days Outstanding
Accounts payable days outstanding should be compared to credit terms to determine if the company is making its payments at the most optimal time. A business should always pay on the latest day allowed in order to keep its cash working as long as possible.

Stretching Accounts Payable
Some businesses choose to ignore payment due dates and pay their bills at a later date. This is known as stretching the accounts payable. By utilizing this method, a company can reduce the cost of trade credit because it increases the amount of time that the company has use of its money. However, companies have to be careful because paying late could result in damaged relationships with suppliers. As a result, suppliers may impose terms of cash on delivery or cash before delivery. Firms can also develop poor credit ratings making it difficult to obtain financing.

Inventory Management
The financial manager must arrange for the financing necessary to support the firm's inventory policy and is also responsible for ensuring the firm's profitability. The inventory manager has to balance the costs and benefits associated with inventory. Efficient management of inventory increase the value of the firm.

Benefits of Holding Inventory
Having large amounts of inventory in stock is costly for a business. There are three direct costs connected to inventory:
  1. Acquisition costs are the costs of the inventory itself over the period being analyzed
  2. Order costs are the total costs of placing an order over the period being analyzed
  3. Carrying costs include storage costs, insurance, taxes, spoilage, obsolescence, and the opportunity cost of the funds tied up in inventory

The lower the level of inventory a firm has on hand, the lower its carry costs but its order costs will increase because more orders will need to be placed throughout the year. Just in time (JIT) inventory management allows a firm to acquire inventory at the exact moment it is needed. With JIT, a firm's inventory balance is always zero.

Cash Management

Motivations for Holding Cash
There are three reasons why a firm holds cash:
  1. To meet its day to day needs
  2. To compensate for the uncertainty associated with its cash flows
  3. To satisfy bank requirements

The amount of cash a firm needs to be able to pay its bills is known as a transactions balance. The amount of cash a firm holds to counter the uncertainty surrounding its future cash needs is called a precautionary balance. The more uncertain future cash flows are, the harder it is for a firm to predict its needs so the larger the precautionary balance. A firm's bank might require a compensating balance in an account at the bank as compensation for services that the bank performs.

Alternative Investments
Treasury Bills
Short term debt of
the US government
Four weeks, three months
(91 days), or six months (182 days)
Default risk free
Very liquid and marketable
Certificates of
Deposit (CD)
Short term debt issued
by banks. Minimum denomination
of $100,000
Varying maturities up to one year
If the issuing bank is insured
by the FDIC, any amount up
to $100,000 is free of default
Sell on the secondary market, but
are less liquid than treasury bills.
Essentially a loan wherein a securities
dealer is the borrow and the investor is
the lender. The investor buys securities
from the dealer with an agreement to sell
the securities back to the dealer at a later
date for a specified higher price.
Very short term (overnight to 3 months)
The security serves as
collateral for the loan. The
investor is exposed to very little risk.
No secondary market
Drafts written by the borrower and
guaranteed by the bank on which the
draft is drawn.Typically used in international
trade transactions. The borrower is an
importer who writes the draft in payment for goods.
1 to 6 months
very little risk
When the exporter receives the
draft, he may hold it until maturity
and receive its full value or he may
sell the draft at a discount prior to maturity.
Short term, unsecured debt issued by large
corporations. The minimum denomination
is $25,000 but most has a face value of
$100,000 or more
1 to 6 months
Default risk depends on the
creditworthiness of the
issuing corporation
No secondary market but the issuer
may repurchase commercial paper
Short Term
Tax Exempts
Short term debt of state and local
governments. Pay interest that is exempt
from federal taxation so their pre-tax yield is
lower than that of a similar risk, fully taxable
1 to 6 months
Default risk depends on the
creditworthiness of the issuing
Moderate secondary market
A financial manager who wants to invest the firm's funds in the least risky security will chose to invest in treasury bills. If the financial manager wishes to earn a higher return on the firm's short term investments, they should invest the excess cash in a riskier alternative such as commercial paper. After all, the greater the risk, the higher the expected return on investments!