Chapter 17 Flashcards
Gross Working Capital
Total Current Assets
Net Working Capital
Current Assets minus non-interest bearing liabilities
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, A/R, short-term liability management
Why is it important to manage working capital?
Trade-off:
Working Capital=Current Assets that are necessary to conduct business. The greater the holding of current assets, the smaller the danger of running out. However, holding working capital is costly (opportunity cost, and non-returning assets with costs such as storage).
Management needs to keep a fine balance in keeping the right amount of working capital. There is pressure to hold the amount of working capital to the minimum consistent with running the business without interruption.
Moderate Policy
Match the maturity of assets to the maturity financing
Aggressive Policy
Use short-term financing to finance permanent assets
Conservative Policy
Use permanent capital to finance temporary and permanent assets
Permanent Current Assets
Current assets company must carry even at the trough of its cyces
Temporary Current Assets
Current assets that fluctuate with seasonal variations in sales i.e inventories, receivables
Cash Conversion Cycle
The length of time it takes to turn the cash investment into cash in the form of collections from the sale of inventory. High conversion cycle means a greater need for external financing.
Inventory Conversion Period
Average time required to convert raw materials into finished goods and then to sell them
Receivables Collection Period (DSO)
Average length of time to convert receivables into cah
Payables Deferral Period
Average length of time between purchase of resources and the payment of cash for them
Why hold cash?
Transactions - You must have some cash to operate
Reservations - “Safety stock”. Reduced by credit lines and marketable securities
Compensating for loans and services provided
Speculation to take advantage of bargains and discounts. Reduced by credit lines and marketable securities.
Goal of cash management
To meet the previous objectives and to have cash for transactions, yet not have excess cash.
To minimize transaction balances.
Minimize cash holdings
Use a lockbox (?) Insist on wire transfers from customers Synchronize inflow and outflows Use a remote disbursement account Reduce need for "safety stock" or cash -Line of Credit -Hold marketable securities -Increase forecast accuracy
Cash Budget
Forecasts inflows, outflows, ending cash balances
Used to plan loans needed or funds available to invest
How could bad debts be worked into cash budget?
Collections would be reduced. Lower collections would lead to higher borrowing requirements.
Should depreciation be included in cash budget?
No. Depreciation is a non-cash charge. Only cash payments and receipts appear on a cash budget.
Why would firms want to maintain a relatively high amount of cash?
If sales turn out to be considerable less than expected, the firm could face a cash shortfall. It may hold more cash if they do not have much faith in sales forecast, or is very conservative. Cash may be used to fund future investments.
Inventory Management
Heavily dependant on sales. Difficult to establish a target inventory level if a firm has unpredictable sales.
Inventory Cost - Carrying Cost
Storage and Handling Costs, Insurance, Property Taxes, Depreciation and Obsolescence
Inventory Cost - Ordering costs
Cost of placing orders, shipping & handling
Inventory Costs - Cost of running short
Loss of sales or customer goodwill, disruption of production schedules
Reducing Inventory Levels
Reduces carrying costs, increases ordering costs and increases cost of running short
Holding too much inventory reduces
ROE (Return on Equity) and EVA (economic value added)
Reducing Inventory causes
Short-Run: Cash will increase
Long-Run: Invest cash in more productive assets and increase EVA
Receivables Management
Firms would rather sell for cash than on credit, but competitive pressures force most firms to receive on credit. Carrying receivables has both direct and indirect costs, but it also has a benefit of increased sales.
Amount of Receivables depend on
Volume of credit sales
Length of time between sales and collections
Credit Policy
Tighten it to lower DSO or force customers to pay quicker
Elements of Credit Policy
Credit Period (shorter may reduce DSO but might discourage sales) Cash Discounts (increases sales) Credit Standards (reduces sales AND bad debt) Collection Policy (tough collection policy will reduce dso but damage customer relationships)
If reduce DSO without adversely affecting sales
Short Run: Cash will increase
Long Run- Invest cash in more productive assets and increase EVA
Short-term credit
Debt scheduled for repayment within a year
(accounts payables aka trade credit, bank loans, commercial loans, accruals) Riskier than L-T length as always required to pay.
Advantages of short-term financing
Speed, Flexibility, Lower Cost than Long term debt
Disadvantages of short-term financing
Fluctuating interest expense, default risk
Trade Credit
Credit furnished by a firm’s suppliers. Longest source of short-term credit. Spontaneous source of funds but cost can be high though easy to get.
Cost of Trade Credit
Credit is FREE during the discount period. If firm pays after discount expires, the cost of trade credit is the discount forgone.
Bank Loan - Simple Annual Interest
No discount/Add On
Bank Loan - Discount Interest
Discount = Deducted from loan amount
Bank Loan - Compensating Balance
A bank balance that a firm must maintain to compensate the bank for granting a loan. Effective cost is interest/amountneeded.
Bank Loan - Instalment Loan, add on
Add the interest from the loan
