chapter 15 - key concepts (working capital management) Flashcards
What are the three goals of working capital management?
Find the optimal levels of:
- Cash/marketable securities
- Inventory & Accounts receivable (sales/credit policy)
- Prepare Cash Budget
Know the pro/cons of having too much or too little inventory
Too much inventory: wasting capital/resources
Too little: losing sales because customers can’t find product
Revolution in inventory management due to real-time tracking technology (sold items automatically scanned) & databases
Know how to calculate net working capital and net operating working capital
Working capital simply means current assets! (Think products)
Net working capital = (CA – CL)
- Current assets minus current liabilities.
Net operating working capital
= (CA – CL - Excess Cash + Notes payable)
- Operating current assets – operating current liabilities
- Interest bearing notes are excluded from current liabilities b/c it’s a financing cost, not operating cost
What is the difference between relaxed versus restricted investment policy?
Relaxed: company holds large amounts of cash, inventories, and high level of receivables. LOW ROE
- Give the consumer plenty of time to play, generous credit
- Pro: easier to make sales
- Con: collect money slowly, may not receive payments
- iPhone: finance over 2 years or pay at once?
Restricted: low levels of cash, inventories, receivables HIGH ROE
- Demand customers pay quickly
- More common in high-turnover industries such as groceries (!)
What are the three components of working capital?
- Fixed Assets: long-lasting assets
- Permanent Level of Current Assets (CA): Inventory needed at the lowest
- Temporary current assets: Most businesses have sales seasonality
- Examples: Christmas for retailers, ice cream sales in summer
Where are the three approaches to financing working capital?
Moderate: match the maturity of the assets with the maturting of the financing
Aggressive: use short-term financing to finance permanent assets
Conservative: use permanent capital for permanent asset and temporary assets
Maturity matching (moderate risk) - one of the three approaches to financing working capital
Match the maturities of assets & liabilities
All fixed assets/ permanent current assets financed with long-term capital (bank loans or bonds)
Temporary current assets financed with short-term debt
Moderate level of risk b/c some short—term debt
Conservative (low risk) - one of the three approaches to financing working capital
All long-term assets AND some short-term assets are financed using long-term capital
Safest approach
Aggressive (high risk) - one of the three approaches to financing working capital
Finance permanent assets with short-term capital -Riskiest approach
- Rising interest rate risk
- Loan renewal risk (recession or liquidity crisis)
Benefit: often cheaper source of funding, save money
What are the pros and cons of using short-term capital to finance current assets?
It is tempting to use short-term capital to finance current assets because:
1. Cheaper (interest rates typically upward sloping);
2. Easier to arrange/get loan from bank
3. Few covenants
BUT IT IS RISKY!
1. Interest rates could rise
2. Rollover Risk
depends though: stable business and/or good economy, can use more short-term debt
What is the CCC (Cash Conversion Cycle?)
The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales.
how to calculate the CCC using the given formulas
CCC = Inventory conversion period + Average collection period - Payables deferral period
CCC = DIO - DPO + DSO
Do we want CCC to be higher or lower?
Know how changes in the different subcomponents (inventory turnover, avg collection
period, payable deferral period) impact the CCC
we want CCC to be low; sale items quicker, collect more quicker, pay suppliers later (up)
CCC = Inventory conversion period + Average collection period - Payables deferral period
What is a cash budget and its main functions?
- Forecasts cash inflows, outflows, and ending cash balances.
- Used to plan loans needed or funds available to invest.
- Can be daily, weekly, or monthly, forecasts.
—> Monthly for annual planning and daily for actual cash management
What are some strategies that firms use to minimize cash holdings?
Goal: Want to minimize cash holdings so we don’t have to borrow money
Strategies:
- Use wire transfers or credit cards (Get cash sooner)
- Synchronize cash inflows and outflows
- Reduce need for “safety stock” of cash –> Increase forecast accuracy and Negotiate a line of credit
What are four elements of credit policy?
Credit policy:
How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales
Cash discounts:
Lowers price, attracts more sales and reduces DSO
Credit standards:
more sales, potential losses
Tough standards → fewer sales, but fewer customers that can’t pay. Fewer bad debts reduce DSO.
Collection policy:
How tough? Aggressive collection policy will reduce DSO but may damage customer relationships.
if a company has a longer average collection period than the industry average,
what does this mean? Is this a good or bad thing?
Average collection period refers to the amount of time it takes for a business to receive payments owed by its clients in terms of accounts receivable (AR)
Companies prefer a longer average collection period over a shorter one as it indicates that a business can NOT efficiently collect its receivables.
What are the pros and cons of tightening a company’s credit policy?
Pro: fewer defaults, quicker payment
Con: discourage sales, some customers may go elsewhere if they are pressured to pay their bills sooner.
