Working Capital Langley

Question 1

What do we finance?

Answer 1

1. Mix of short-term and long-term assets
2. “Carry” working capital – accounts receivable, inventory
   -Average investment in accounts receivable
   -Inventory turnover:
   (CGS/average inventory)
   may differ significantly depending on the industry, product, specific company, etc.
3. Objective – match assets with appropriate mix of debt/equity

Question 2

The appeal of debt financing

Answer 2

1. Assume the after tax cost of debt is 5% and a company earns 12.5% after tax on its equity.
2. Then, the after tax return on book equity is:(12.5 % - 5.0%)(debt %) + (12.5%)(equity %)
   equity %

Question 3

Cash flow projections – key ingredients

Answer 3

1. operating earnings/cash flow (net income + non-cash expenses)
2. capital expenditures (CAPEX)
3. capital investments in subsidiaries (incl. foreign)
4. investment in working capital assets
5. principal repayments on long-term debt (assume short-term debt is rolled over)
6. dividends

Question 4

Which currency do we borrow?

Answer 4

1. Match assets and cash flows
   - “natural” hedge – doing something in the normal course of business
   - principal hedges assets
   - interest hedges cash flow/income statement
2. Accounting issues for public companies
   - ASC 830 (FAS 52) – foreign currency translation
   - ASC 815 (FAS 133) – accounting for derivatives and hedging activities

Question 5

Hedging vs. speculating

Answer 5

1. hedging – entering into transactions to preserve the value of other underlying transactions (receivables, payables, etc.)
2. speculating – entering into transactions solely for the purpose of making a profit – no underlying transactions exist

Question 6

Fixed or floating?

Answer 6

1. Establish policy – match asset base?
   short-term floating rates may be cheapest over time, but subject to volatility
   fixed rates may be higher, but with less volatile impact on the income statement (a “tradeoff” between rates and volatility)
2. Monitor policy vs. changing market conditions – be willing to change policy to take advantage of opportunities

Question 7

What maturity?

Answer 7

1. Match asset base
2. Maturity “ladders” (debt “skyline”)
3. Key – what’s available under current market conditions
4. Issue for small/medium-sized companies – “borrowing short to finance long” (violates matching principle)

Question 8

The financing “continuum”:

Answer 8

- Short-term, floating –rate financing
			↓
- Long-term, floating-rate financing
			↓
- Long-term, fixed-rate financing

Question 9

Two “risks” of debt, for the issuer

Answer 9

1. Liquidity risk
   
   • Long-term debt – lower
   • Short-term debt – higher
2. Repricing risk
   
   • Long-term fixed rate debt– higher
   • Short-term floating rate debt – lower

Question 10

Limitations imposed by debt

Answer 10

1. Lenders’ restrictions/covenants
2. Rating agency issues, especially if management has a targeted bond rating
3. Fear of liquidity constraints, violation of debt covenants, etc. may lead to conservative operating management decisions
4. Hidden “agency” costs of monitoring debt covenants, mortgages, performance guarantees, etc.

Question 11

Counterparty exposure

Answer 11

1. This exposure arises when we are, or could be, owed money by a counterparty
2. It is also an important issue when transactions are “marked-to-market” on an ongoing basis and we would be owed money (have a receivable) from that counterparty
3. Companies need to establish a policy for managing counterparty exposure on a portfolio basis
4. Guidelines should be developed for the amount of risk we’re willing to take at each credit rating level
5. This counterparty exposure policy is typically approved by the Board

Question 12

Financing decisions

Answer 12

1. Not made in a “vacuum” - decisions made on a cross functional team basis
2. Accounting policies, especially for public companies
3. Tax planning – on a global, consolidated basis
4. Legal issues – “WSJ test”/”headline risk”

Question 13

Internal “funding”

Answer 13

1. cash management – use of available technology and daily cash forecast
2. working capital management
   
   • accounts receivable (essentially “lending” to customers)
   • inventory
   • payables (essentially, “borrowing” from suppliers/vendors)
3. sale of underutilized assets

Question 14

DSO FORMULA

Answer 14

days accounts receivable = (average accts. receivable / annual sales) X 365

Question 15

DOH FORMULA

Answer 15

days inventory = (average inventory / annual cost of goods sold) X 365

Question 16

DPO FORMULA

Answer 16

# days payables  = (average accounts payable / annual cost of goods sold)
    X   365

Question 17

CCC FORMULA

Answer 17

“cash cycle” = # days receivables
+ # days inventory
- # days payables
# days in the cash cycle

Question 18

Trade financing

Answer 18

1. both domestic and international
2. types of payment
   
   • prepay – discount? – risk to importer (buyer)
   • open account – risk to exporter (seller)
   • letters of credit – bank credit at risk; assures exporter of payment
   • consignment – title doesn’t pass until product is sold

Question 19

Letters of credit – two basic types

Answer 19

1. trade – payment expected to be made
2. standby – payment not expected; “contingent”
   
   • performance – contracts;
     project finance; bid bonds
     
     • guarantee – leases; international loans (bank becomes credit intermediary)

Question 20

Countertrade

Answer 20

1. also known as “barter”
2. oldest known form of trade
3. no cash exchanged – instead, equivalent amounts of goods and/or services are exchanged, based on pre-agreed upon values