Chapter 15 Working Capital Management WCM IMAS 1

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Chapter 15 Working Capital Management (WCM) IMAS 1

Chapter 15 Working Capital Management (WCM) IMAS 1

Working Capital Overview Working capital is a firm’s investment in short-term assets--cash, marketable securities,

Working Capital Overview Working capital is a firm’s investment in short-term assets--cash, marketable securities, inventory, and accounts receivable. Net working capital is current assets minus current liabilities. v. WC management is the management of all aspects of both current assets and current liabilities, to minimise the risk of insolvency while maximising the return on assets. Investing in WC has a cost which can either be expressed as: vthe cost of funding it, or vthe opportunity cost ** A company’s ideal situation is to have what they consider sufficient working capital IMAS 2

Objective of WC The main objective of working capital management is to get the

Objective of WC The main objective of working capital management is to get the balance of current assets and current liabilities right Liquidity Profitability Ensure sales with Low inventory high stocks High Payables Trade discounts allowed Low receivables Extend credit period IMAS 3

WC Goals v. Adequate cash flow for operations v. Most productive use of resources

WC Goals v. Adequate cash flow for operations v. Most productive use of resources Profitability Vs Liquidity IMAS 4

Managing and measuring Liquidity is the ability of the company to satisfy its short-term

Managing and measuring Liquidity is the ability of the company to satisfy its short-term obligations using assets that are readily converted into cash. Liquidity management is the ability of the company to generate cash when and where needed. Liquidity management requires addressing drags and pulls on liquidity. v. Drags on liquidity are forces that delay the collection of cash, such as slow payments by customers and obsolete inventory. v. Pulls on liquidity are decisions that result in paying cash too soon, such as paying trade credit early or a bank reducing a line of credit. IMAS 5

Sources of liquidity Primary sources of liquidity v. Ready cash balances (cash and cash

Sources of liquidity Primary sources of liquidity v. Ready cash balances (cash and cash equivalents) v. Short-term funds (short-term financing, such as trade credit and bank loans) v. Cash flow management (for example, getting customers’ payments deposited quickly) IMAS 6

Current assets and current liabilities components Current assets Current liabilities Inventory Payables Receivables Overdraft

Current assets and current liabilities components Current assets Current liabilities Inventory Payables Receivables Overdraft Marketable securities Cash IMAS 7

Examples of Marketable Securities Treasury Bills v. Short-term government notes issued at a discount

Examples of Marketable Securities Treasury Bills v. Short-term government notes issued at a discount with principal repaid at maturity Commercial Paper v. Short-term unsecured promissory notes issued by corporations with good credit Bankers’ Acceptances v. Short-term promissory notes issued by a firm and accepted (or guaranteed) by a bank IMAS 8

Liquidity Vs Profitability Discuss the advantages of keeping the following components of working capital

Liquidity Vs Profitability Discuss the advantages of keeping the following components of working capital high: v. Inventory v. Receivables v. Cash v. Current liabilities IMAS 9

Liquidity Vs Profitability Discuss the advantages of keeping the following components of working capital

Liquidity Vs Profitability Discuss the advantages of keeping the following components of working capital low: v. Inventory v. Receivables v. Cash v. Current liabilities IMAS 10

Operating cycle and the cash cycle Operating cycle v. Is the length of time

Operating cycle and the cash cycle Operating cycle v. Is the length of time it takes to acquire inventory, sell it, and collect the receivables resulting from the sale (describes how product moves through the current asset account) Inventory period + Accounts receivable period It describes how a product moves through the current asset accounts. It begins life as inventory, it is converted to receivables when it is sold, and it finally converted to cash when we collect the sale Cash Cycle v. Is the number of days that pass until we collect the cash from sale, measured from when we actually pay for the inventory IMAS Operating cycle – payables period 11

Cash conversion cycle The operating and cash conversion cycle can be visualized as shown

Cash conversion cycle The operating and cash conversion cycle can be visualized as shown below: IMAS 12

Factors affecting length of working capital v. Liquidity versus profitability v. Management efficiency v.

Factors affecting length of working capital v. Liquidity versus profitability v. Management efficiency v. Industry norms Activity/sales Length of cycle Funds needed increase in proportion to: increase Stays constant days in cycle Increase Stays constant sales **The optimum level of working capital is the amount that results in no idle cash or unused inventory, but does not put a strain on liquid resources IMAS 13

Level of working capital is affected by the following factors: v. Nature of business

Level of working capital is affected by the following factors: v. Nature of business (manufacturing VS service entities) v. Uncertainty in supplier delivery v. Overall activity v. Entity’s credit policy v. Length of working capital cycle v. Credit policy of suppliers IMAS 14

Working Capital Policy Firms must set policy on following issues: v. How much working

Working Capital Policy Firms must set policy on following issues: v. How much working capital is used v. Extent to which working capital is supported by short- vs. long-term financing v. How each component of working capital is managed v. The nature/source of any short-term financing used IMAS 15

Short-Term vs. Long-Term Financing Short-term financing v. Cheap but risk v. Cheap—short-term rates generally

Short-Term vs. Long-Term Financing Short-term financing v. Cheap but risk v. Cheap—short-term rates generally lower than long-term rates v. Risky—because you are continually entering marketplace to borrow v. Borrower will face changing conditions (ex; higher interest rates and tight money) Long-term financing v. Safe but expensive v. Safe—you can secure the required capital v. Expensive—long-term rates generally higher than short-term rates IMAS 16

Working Capital Needs of Different Firms IMAS 17

Working Capital Needs of Different Firms IMAS 17

Permanent and Temporary Working Capital v. Working capital is permanent to the extent that

Permanent and Temporary Working Capital v. Working capital is permanent to the extent that it supports constant or minimum level of sales v. Temporary working capital supports seasonal peaks in business Temporary investments in assets include current assets that will be liquidated and not replaced within the current year. IMAS 18

Maturity Matching Principle Maturity (due date) of financing should roughly match duration (life) of

Maturity Matching Principle Maturity (due date) of financing should roughly match duration (life) of asset being financed v. Then financing /asset combination becomes self-liquidating v Cash inflows from asset can be used to pay off loan IMAS 19

Financing Net Working Capital According to maturity matching principle v. Temporary (seasonal) should be

Financing Net Working Capital According to maturity matching principle v. Temporary (seasonal) should be financed with short-term borrowing v. Permanent working capital should be financed with long-term sources, such as long-term debt and/or equity In practice, firms may use more or less short-term funds to finance working capital IMAS 20

Working Capital Financing Policies IMAS 21

Working Capital Financing Policies IMAS 21

Working Capital Financing Policies IMAS 22

Working Capital Financing Policies IMAS 22

Overtrading – a company is growing its sales faster than it can finance them

Overtrading – a company is growing its sales faster than it can finance them ( transacting more than the firm’s working capital can normally sustain) Typical indicators v. Rapid increase in turnover v. Rapid increase in the volume of current assets v. Most of the increase in assets being financed by credit v. A dramatic drop in liquidity rations Potential solutions v. Raising more long term capital v. Slowing down growth to reduce increase in working capital v. Improving working capital IMAS 23

Ratios Liquidity Ratios Current ratio Quick ratio IMAS 24

Ratios Liquidity Ratios Current ratio Quick ratio IMAS 24

Efficiency ratios Inventory days material days Raw Receivables days WIP Payable days IMAS 25

Efficiency ratios Inventory days material days Raw Receivables days WIP Payable days IMAS 25

Turnover ratios Inventory turnover Discuss if the turnover ratios are useful? IMAS 26

Turnover ratios Inventory turnover Discuss if the turnover ratios are useful? IMAS 26

Operating cycle and firm’s organisation chart It is useful to understand people involved in

Operating cycle and firm’s organisation chart It is useful to understand people involved in managing working capital before we go into further detail. v. Always bear in mind the potential conflict if managers concentrate only on one part of the picture Cash manager Marketing manager Production manager Financial manager Credit manager Purchasing manager Payables manager IMAS 27