WORKING CAPITAL MANAGEMENT Flashcards
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.
CASH CYCLE
The length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory.
CASH CONVERSION CYCLE (CCC)
= Inventory Days + A/R Days - A/P Days
INVENTORY DAYS
= Inventory / Average Daily Cost of Goods Sold
ACCOUNTS RECEIVABLE DAYS
Accounts receivable / Average daily sales
ACCOUNTS PAYABLE DAYS
Accounts payable / Average daily cost of goods sold
How is firm value affected by working capital?
Any reduction in working capital requirements generates a positive free cash flow that the firm can distribute immediately to shareholders.
TRADE CREDIT
The difference between receivables and payables that is the net amount of a firm’s capital consumed as a result of those credit transactions.
The credit that a firm extends to its customers.
Example of trade credit terms:
2/10, Net 30
Cash Discount: a 2% cash discount is taken if paid during the discount period.
Discount period: in this example, 10 days.
Credit period:
The total length of time credit is extended to the buyer, in this example it is 30 days.
COST OF TRADE CREDIT
EAR = (1+2)^n - 1
What are the benefits of trade credit?
- It is simple and convenient to use, and it 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.
Why do firms offer trade credit?
- Providing financing at below-market rates is an indirect way to lower prices for certain customers.
- A supplier may have an ongoing business relationship with its customer, it may have more information about the credit quality of the customer than a traditional outside lender such as a bank would have.
- If the buyer defaults, the supplier may be able to seize the inventory as collateral.
MANAGING FLOAT
COLLECTION FLOAT
Mail float - customer mails check
Processing float - firm receives check
Availability float - firm deposits check
Finally, funds are credited to firm’s account.
DISBURSEMENT FLOAT
What three steps are involved in establishing a credit policy?
- Establishing credit standards.
- Establishing credit terms.
- Establishing a collection policy.
What are the 5 C’s of credit?
- Character
- Capacity
- Capital
- Collateral
- Conditions
ACCOUNTS RECEIVABLE DAYS
The average number of days that it takes a firm to collect its sales.
AGEING SCHEDULE
- Categorises accounts by the number of days they have been on a firm’s books.
- Can be prepared using either the number of accounts or the dollar amount of the accounts receivable outstanding.
PAYMENTS PATTERNS
Provides information on the percentage of monthly sales that the firm collects in each month after the sale.
How does a firm determine the accounts payable days outstanding?
Firms should monitor their accounts payable to ensure they are making their payments at an optimal time.
STRETCHING ACCOUNTS PAYABLE
When a firm ignores a payment due to period and pays later.
COD
Cash on delivery
CBD
Cash before delivery
What are the benefits of holding inventory?
- Inventory helps minimise the risk that the firm will not be able to obtain an input it needs for production and helps avoid stock outs.
- Factors such as seasonality and demand mean that customer purchases do not perfectly match the most efficient production cycle.
What are the costs of holding inventory?
- Acquisition costs
- Order costs
- Carrying costs
- “Just In Time” (JIT) Inventory management.
What is the motivation for holding cash?
- Transactions balance (to meet its day-to-day needs)
- Precautionary balance (to compensate for the uncertainty associated with its cash flows)
- Compensating Balance (To satisfy bank requirements)
What short term money market investments can a firm with excess cash invest in?
- Treasury bills
- Certificates of Deposit
- Repurchase Agreements
TREASURY BILLS
Short term debt of the US government.
MATURITY:
Four weeks, three months (91 days), six months (182 days), or 52 weeks when newly issued.
RISK:
Default risk free
LIQUIDITY:
Very liquid and marketable.
CERTIFICATE OF DEPOSIT (CDs)
Short term debt issued by banks.
Minimum denomination of $100,000.
MATURITY:
Varying maturities up to one year.
RISK:
If issuing bank is insured by the FDIC, any amount up to $250,000 is free of default risk because it is covered by the insurance. Any amount in excess of $250,000 is not insured and is subject to default risk.
LIQUIDITY:
Unlike CDs purchased by individuals, these CDs sell on the secondary market, but are less liquid than Treasury bills.
REPURCHASE AGREEMENTS
DESCRIPTION:
Essentially a loan agreement wherein a securities dealer is the “borrower” and the investor is the “lender”. The investor buys securities, such as U.S. Treasury bills, from the securities dealer, with an agreement to sell the securities back to the dealer at a later date for a specified higher price.
MATURITY:
Very short term, ranging from over night to approximately 3 months.
RISK:
The security serves as collateral for the loan, and therefore the investor is exposed to very little risk. However, the investor needs to consider the creditworthiness of the securities dealer when assessing the risk.
LIQUIDITY:
No secondary market for repurchase agreements.
BANKER’S ACCEPTANCES
Drafts written by the borrower and guaranteed by the bank on which the draft is drawn. Typically used in international trade transactions. The borrower is an importer who writes the draft in payment for goods.
MATURITY:
Typically 1-6 months.
RISK:
Because both the borrower and a bank have guaranteed the draft, there is very little risk.
LIQUIDITY:
When the exporter receives the draft, he may hold it until maturity and receive its full value or he may sell the draft at a discount prior to maturity.
COMMERCIAL PAPER
Short term, unsecured debt issued by large corporations. The minimum denomination is $25,000, but most commercial paper has a face value of $100,000 or more.
MATURITY:
Typically 1-6 months.
RISK:
Default risk depends on the creditworthiness of the issuing corporation.
LIQUIDITY:
No active secondary market, but issuer may repurchase commercial paper.
SHORT TERM TAX EXEMPTS
Short term debt of state and local governments. These instruments pay interest that is exempt from federal taxation, so their pretax yield is lower than that of a similar risk, fully taxable investment.
MATURITY:
Typically 1-6 months.
RISK:
Default risk depends on the creditworthiness of the issuing government.
LIQUIDITY:
Moderate secondary market.
AGGRESSIVE FINANCING POLICY
- Financing part or all of the permanent working capital with short-term debt.
- Funding risk
CONSERVATIVE FINANCING POLICY
- Financing short-term needs with long-term debt.
- Non-productive of cash
SHORT TERM FINANCING WITH BANK LOANS: Promissory note
-Single, end of period payment loan (benchmark rate, such as prime rate or LIBOR)
-Line of credit Uncommitted Committed Revolving Evergreen
-Bridge Loan
Often discount loan with fixed interest rate.
With a discount loan, borrower pays interest at the beginning of the loan period.
COMMON LOAN REQUIREMENTS
Commitment fees
Loan origination fee
Compensating balance requirements
DIRECT PAPER
Firm sells directly to investors
DEALER PAPER
Dealers sell to investors in exchange for a spread (or fee) for their services.
The spread decreases the proceeds that the issuing firm receives, increasing effective cost.
SECURED LOANS
Loans collateralised with short-term assets (account receivable/inventory)
Most common sources:
- Commercial banks
- Finance companies
- Factors - firms that purchase the receivables of other companies.
ACCOUNTS RECEIVABLE AS COLLATERAL
-Pledging of accounts receivable:
Lender reviews the invoices and decides which credit accounts it will accept as collateral, based on its own credit standards.
Factoring of accounts receivable:
- Firm sells receivables to the lender (i.e. the factor)
- Lender pays the firm the amount due from its customers at the end of the firm’s payment period less a factor’s fee.
INVENTORY AS COLLATERAL
-Floating lien, general lien, or blanket lien:
All of the inventory is used to secure the loan.
-Trust receipts loan or floor planning:
Distinguishable inventory items are held in a trust as security for the loan.
-Warehouse arrangement:
Inventory that serves as collateral is stored in a separated warehouse.
