L.35 Working Capital Management

Question 1

Learning outcomes

Answer 1

a. Describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position
b. Compare a company’s liquidity measures with those of peer companies
c. Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and compare the company’s effectiveness with that of peer companies
d. Describe how different types of cash flows affect a company’s net daily cash position
e. Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines
f. Evaluate a company’s management of accounts receivable, inventory, and accounts payable over time and compared to peer companies
g. Evaluate the choices of short-term funding available to a company and recommend a financing method

Question 2

Working capital management

Answer 2

• the management of short term assets and liabilities
• ensure that company has adequate ready access funds necessary for day to day operating expenses while at the same time making sure the company’s assets are invested in the most productive way

Question 3

Managing liquidity

Answer 3

Liquidity is the extent to which a company is able to meet its short term obligations using assets that can be readily transformed into cash

Question 4

Primary source of liquidity

Answer 4

Represent the most readily accessible resources available

• ready cash balances (cash in bank)
• short term funds such as trade credit
• cash flow management; the more decentralised, the more likely the company will be able to have cash tied up in system and not available for use

Question 5

Secondary source of liquidity

Answer 5

Main difference is that using primary sources will not likely to affect normal operations but secondary source will result in change in company’s financial and operating policies

• negotiating debt contracts
• liquidating assets
• filing for bankruptcy protection and reorganisation

Question 6

Drags and pulls on liquidity

Answer 6

Drag on liquidity - when receipts lag, creating pressure from decreased available funds

Pull on liquidity - when disbursements are paid too quickly, requiring companies to expend funds before they receive funds from sales

Question 7

Measuring liquidity

Answer 7

Credit worthiness - perceived ability of the borrower to pay what is owed on the borrowing in a timely manner and represents the ability of a company to withstand adverse impacts on cash flows

• allow company to obtain lower borrowing costs and better terms for trade credit and contributes to the company’s investment flexibility

1) Liquidity ratios
- measuring company’s ability to meet short term obligations to creditors as they mature

Current ratio = current assets/ current liabilities

2) Quick ratio aka acid test ratio

quick ratio = (cash + short terms marketable investments + receivables) / current liabilities

• the higher the quick ratio, the higher a company’s liquidity

3) Accounts receivable turnover
- measures how many times accounts receivables are created by credit sales and collected

ART = credit sales / average receivables

4) Inventory turnover
- measures how many times inventory is created or acquired and sold

Inventory turnover = COGS / average inventory

5) Number of days of receivables aka day’s sales outstanding aka days in receivables
- if no. of days is 35.5, means on average it takes 35.5 days to collect credit accounts

= average accounts receivables / (sales on credit/365)

6. Number of days of inventory
   = average inventory / ( COGS/ 365)
7. Operating cycle aka cash conversion cycle
   - measures time needed to convert raw materials into cash
   - the shorter the period, the greater a company able to generate cash

OC = no of days of inventory + no. of days of receivables

Question 8

Managing cash

Answer 8

1. Forecasting short term cash flow
2. min cash balances
   - cash buffer from unexpected cash needs
3. Identify typical cash flows
   a) Inflows
   - receipts from operations
   - funds transfer from subsidiaries
   - maturing investments
   - debts proceeds
   - tax refunds etc

b) outflows
- payables and payrolls
- funds transfers to subsidiaries
- investments made
- debt repayments

• do not be cheated by question that include non cash component to identify how cash is being managed

Question 9

Investing short term funds

Answer 9

Short term working capital portfolios consist of securities that are highly liquid, less risky and shorter in maturity than other types of investment portfolios

Types of short term investment instruments

• T bills
• Federal agency securities
• CDs
• Banker’s acceptances
• Eurodollar time deposits
• Bank sweep services
• Repurchase agreements
• Commercial paper
• Mutual funds and money market mutual funds
• Tax advantaged securities

Question 10

Computing yields on short term investments

Answer 10

Eg. T bills are issued at a discount 
- Face value = 1,000,000 
- 5% interest  
- 1 month remaining to maturity 
Purchase price = 1,000,000 - [(0.05)/ (1/12) * 1,000,000] = 995, 833.33 

Difference = 4,166,67 is the discount interest

Nominal rate = rate of interest based on security’s face value

Yield = actual return on the investment if held to maturity

Money market yield = pays interest on a 360 day basis
MMY = [(face value - purchase price) / purchase price] [(360/ number of days to maturity)]

Bond equivalent yield = pays interest on a 365 days basis

BEY = [(face value - purchase price) / purchase price] [(365/ number of days to maturity)]

Discount basis yield = [(face value - purchase price) / face value] [(360/ number of days to maturity)]

Question 11

Practice Qns

Answer 11

91day 100,000 US T bill sold at a discounted rate of 2.10%, calculate

1. Money market yield
2. Bond equivalent yield

To find MMY, use DBY
Discount basis yield = [(face value - purchase price) / face value] [(360/ number of days to maturity)]
so 2.1% =[ (100,000 - PV)/100,000] * (360/91)
PV = 99,469.17

Using MMY
[(face value - purchase price) / purchase price] [(360/ number of days to maturity)]

= [(100,000 - 99,469.17)/ 99,469.17] * 360/91
= 0.0211 = 2.11%

Use BEY
= [(face value - purchase price) / purchase price] [(365/ number of days to maturity)]
= [(100,000 - 99,469.17) / 99,469.17] * 365/91
= 0.0214 = 2.14%

Question 12

Types of risk and its safety measures

Answer 12

• Credit or default risks
  a) minimise amount
• Market or interest rate risks
  a) keep maturity short
• Liquidity
  a) stick with government securities
• Foreign exchange risks
  a) hedge regularly

Question 13

Short term investment strategies

Answer 13

2 types of strategies

1. Passive
   - one or 2 decision rules for making daily investments
2. Active
   - constant monitoring and may involve matching, mismatching or laddering strategies

a) matching strategy
- more conservative
- matching timing of cash outflows with investment maturities

b) mismatching
- riskier
- timing of cash outflows not matched with investment maturities

c) laddering
- entails scheduling maturities on a systematic basis within the investment portfolio such that investments are spread out equally over the term of the ladder

Question 14

Sample format of investment policy

Answer 14

1. Purpose
   - list and explain reasons that portfolio exists and describe attributes such as summary of strategy used and type of securities that are acceptable investments
2. Authorities
   - identify who oversee the portfolio
3. Limitations
   - describe type of investments considered, it should describe the general types of securities not specific, such as T bills or bank CDs
   - include the relative amount of each security is allowed in the overall portfolio
4. Quality
   - credit standards for potential investments
5. Other items
   - such as statements

Question 15

Managing accounts receivable

Answer 15

3 primary activities

1. granting credit and processing transactions
2. monitoring credit balances
3. measuring performance of the credit function

Companies can achieve scale economies by centralising the AR function by using a captive finance subsidiary = wholly owned subsidiary of the company that is established to provide financing of sales of the parent company

Float factor = estimate of the average # of days it takes deposited checks to clear

FF = average daily float / average daily deposit 
FF = average daily float / (total amount of checks deposited / # of days)

Question 16

Managing accounts payable

Answer 16

Disbursement float = amount of time between check issuance and a check’s clearing back against the company’s account

• 2 countering forces
  a) paying too early is costly (opportunity cost) unless company can take advantage of discounts
  b) paying late affects credit worthiness

Cost of trade credit
= ( 1 + (discount/1-discount) ^ (365/number of days beyond discount period) - 1

• cost of trade credit lower when company pays in net day than any day prior to net day

Question 17

Managing short term financing

Answer 17

Sources of short term financing

Bank sources

1. Uncommitted line
   - least reliable form of borrowing
   - as good as the bank’s desire to offer
2. Regular line
   - bank’s formal commitment and can be verified through acknowledgment letter
   - in effect for 364 days so can be classified as short term liabilities
   - borrowed at Libor plus a spread (london interbank offered rate)
   - spread depends on credit worthiness
3. Overdraft line
4. Revolving credit agreement
5. Collateralised loan
6. Discounted receivables
7. Banker’s acceptances
8. Factoring

Non bank sources

1. Finance companies
2. Commercial papers

Question 18

Inventory as collateral

Answer 18

1. Inventory blanket lien
   - lender has a claim on some or all of company’s inventory, but company can sell inventory
2. Trust receipt arrangement
   - lender requires company to certify that the goods are segregated and held in trust, proceeds of any sales remitted to lender immediately
3. Warehouse receipt arrangement
   - same as 2 but a third party supervises the inventory

Question 19

Computing cost of borrowing

Answer 19

Cost = (interest + commitment fee) / loan amount
or
Cost = interest / net proceeds = interest / (loan amount - interest)
or
Cost = (interest + dealer’s commission + backup costs) / (loan amount - interest)

Question 20

Practice qns for cost of borrowing

Answer 20

Which is the best choice 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.

Solution
1. Cost = [(interest + commitment fee) / loan amount ] x 12

= [(0.025×$5,000,000×1/12)+(0.005×$5,000,000×1/12) / $5,000,000 ] x 12
= 3%

2. Cost = [interest / net proceeds ] x 12
   = [0.0255×$5,000,000×1/12 / $5,000,000−(0.0255×$5,000,000×1/12)] ×12
   = 2.56%
3. Cost = (interest + dealer’s commission + backup costs) / (loan amount - interest) x 12

= (0.0215×$5,000,000×1/12)+(0.00125×$5,000,000×1/12)+(0.0025×$5,000,000×1/12) / $5,000,000−(0.0215×$5,000,000×1/12) ×12
= 2.53%