Working Capital Management Flashcards
Define working capital
A company’s current assets and liabilities
What do most projects require the firm to invest in?
Net working capital
What is net working capital?
Current assets - current liabilities
What are the main component s of working capital?
Cash
Inventory
Receivables
Payables
What is Europe’s average working capital ratio?
Around 20%
What is an operating cycle?
The average length of time between when a firm originally purchases its inventory and when it receives the cash back from selling its product
What is a cash cycle?
The length of time between when a firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory
What are the 4 key dates in the production cycle that influence the firm’s investment in working capital?
Raw material inventory
Finished goods inventory
Receivables
Cash
What is the cash conversion cycle?
The length of time between the firm’s payment for its raw materials and the collection of payment from the customer
What are all the periods of the cash conversion cycle?
Look at slides
In a formula, what is the cash conversion cycle?
CCC = operating cycle - accounts payable period = (inventory period + receivables period) - accounts payable period
What can reduce the amount of time between the cash investment and the receipt of that cash investment?
Buying inventory on credit
What does any reduction in working capital requirement generate?
A positive free cash flow that the firm can distribute immediately to shareholders
What can efficiently managing working capital increase?
The firms’s value
What does terms of sale concern?
Credit, discount, and payment terms offered on sale
Are terms of sale industry specific?
Yes
How is terms of sale quoted?
Example: 5/10 net 30
5 = 5% of discount of early payment
10 = number of days discount is available
net 30 = number of days company allows for payment
Assume a firm sells a product for £100 on terms of 2 /10, net 45. If the customer takes advantage of the discount and pays within the 10-day discount period, the customer pays only £98 for the product. the customer has the option to use the £98 for an additional 35 days (and repay the full price of £100)
What is the interest rate for the 35-day term loan?
2 / 98 = 2.04%
How do you calculate the implied EAR for trade credit?
Look at slides
What are the benefits of trade credit?
Trade credit is simple and convenient to use, and it therefore has lower transaction costs than alternative sources of funds.
It is a flexible source of funds, and can be used as needed.
It is sometimes the only source of funding available to a firm
Trade Credit Versus Standard Loans: why offer trade credit?
Providing financing at below-market rates is an indirect way to lower prices for only certain customers.
Relationship lending
If the buyer defaults, the supplier may be able to seize the inventory as collateral
What is credit analysis?
Procedure to determine likelihood customer will pay bills:
- Reports by credit agencies
- Financial ratios
What is credit policy?
Standards set to determine amount and nature of credit extended to customers:
- Credit standards
- Credit terms
What is credit scoring?
Procedure to determine eligibility of borrower:
- Extending credit
- Denying credit
How can a firm use accounts receivable days to monitor accounts?
A firm can compare the accounts receivable days to the credit terms- E.g. if the credit terms specify “net 30” and the accounts receivable days outstanding is 45 days: customers are paying 15 days late, on average.
A firm can look at the trend in accounts receivable days
What is an ageing schedule?
Categorizes a firm’s accounts by the number of days they have been on the firm’s books
When should a firm borrow using accounts payable?
only if trade credit is the least expensive source of funding.
What determines the cost of trade credit?
The higher the discount percentage offered, the greater the cost of forgoing the discount.
The shorter the loan period, the greater the cost of forgoing the discount.
What are the benefits of holding inventory?
Prevent stock-outs
Seasonality in demand
What are the costs of holding inventory?
Acquisition costs
Order costs
Carrying costs
Obsolete items
What are the motivations for holding cash?
Transaction balance
Precautionary balance
Compensating balance
What is the transactions balance?
The amount of cash a firm needs to be able to pay its bills
What is the precautionary balance?
The amount of cash a firm holds to counter the uncertainty surrounding its future cash needs
What is the compensating balance?
An amount a firm’s bank may require the firm to maintain in an account at the bank as compensation for services the bank may perform
