Working Capital and Liquidity Flashcards
Explain the different ways to finance working capital
Companies choose among their financing alternatives based on cost, risk, ease of access, flexibility, and current availability. Types of company financing are as follows:
Internal sources: operating cash flows, accounts payable, accounts receivable, inventory, and marketable securities.
Financial intermediaries: bank borrowing, asset-backed loans, loans from non-bank finance companies (more expensive), asset leasing.
Capital markets: long-term debt (highest priority claim to residual assets, more than equity), common equity (has a residual claim to firm cash flows and assets).
What is the difference between a uncommitted, committed and revolving line of credit?
Uncommitted line of credit. A bank extends an offer of credit for a certain amount but may refuse to lend if circumstances change, making this a less reliable source of funds.
Committed (regular) line of credit. A bank extends an offer of credit that it “commits to” for some period of time. The fact that the bank has committed to extend credit in amounts up to the credit line makes this a more reliable source of short-term funding than an uncommitted line of credit. Banks charge a fee for making such a commitment. Loans under the agreement are typically for periods of less than a year, and interest charges are stated in terms of a short-term reference rate, plus a margin to compensate for the credit risk of the loan. Outside the United States, similar arrangements are referred to as overdraft lines of credit.
Revolving line of credit. An even more reliable source of short-term financing than a committed line of credit, a revolving line of credit is typically for a longer term, sometimes years. With a revolving line of credit, companies may borrow and repay funds as their needs change over time. Along with committed lines of credit, revolving credit lines can be verified and can be listed in the footnotes of a firm’s financial statements as a source of liquidity.
Explain a conservative approach to working capital management
- High Current assets Financed with long term debt and equity
This provides more liquidity and less financial risk, but has HIGHER FINANCING COSTS
less risk less return
Explain an aggressive approach to working capital management
- Lower levels of current assets and financing with short term debt (vs conservative).
Increases RISK. decreases COSTS. Increases RETURNS.
more risk more return
Explain a company’s primary sources of liquidity
A company’s primary sources of liquidity are the sources of cash it uses in its normal day-to-day operations. The company’s cash balances result from selling goods and services, collecting receivables, and generating cash from other sources such as short-term investments. Typical sources of short-term funding include trade credit from vendors and lines of credit from banks. Effective cash flow management of a firm’s collections and payments can also be a source of liquidity for a company.
Explain a company’s secondary sources of liquidity
Secondary sources of liquidity include liquidating short-term or long-lived assets, renegotiating debt agreements, or filing for bankruptcy and reorganizing the company. While using its primary sources of liquidity is unlikely to change the company’s normal operations, resorting to secondary sources of liquidity such as these can change the company’s financial structure and operations significantly and may indicate that its financial position is deteriorating.
What are measures of a company’s short term liquidity
Current ratio = current assets / current liabilities.
Quick ratio = (cash + marketable securities + receivables) / current liabilities.
Measures of how well a company is managing its working capital include
Receivables turnover = credit sales / average receivables.
Number of days of receivables = 365 / receivables turnover.
Inventory turnover = cost of goods sold / average inventory.
Number of days of inventory = 365 / inventory turnover.
Payables turnover = purchases / average trade payables.
Number of days of payables = 365 / payables turnover.
Calculate operating cycle
Operating cycle = days of inventory + days of receivables.
Calculate cash conversion cycle
Cash conversion cycle = days of inventory + days of receivables – days of payables.
Evaluate short-term funding choices available to a company.
A company’s short-term funding plan should ensure that it maintains sufficient borrowing capacity to meet its ongoing needs, including seasonal or other times of peak requirements.
The primary consideration when choosing a strategy for short-term funding is cost. Companies should stay up-to-date on the costs of the various funding sources available to them.
Even companies that rely primarily or exclusively on one particular type of funding may find it advantageous to work with more than one lender.
Companies that rely on significant short-term financing should use more than one type of financing and multiple lenders for a given type of financing, because markets and lender circumstances can change over time, sometimes suddenly.
Maintaining excess funding for unforeseen events or to take advantage of business opportunities is also an important consideration. Ensuring access to funds may increase borrowing costs.
