Session 24 25 Working Capital Management

Financial Management

Session 24 & 25

Working Capital Management

Corporate Finance

Management of long term assets Capital Budgeting

Management of long term capital Capital structure

Management of short term assets and liabilities Working Capital Management Cash, marketable securities, accounts receivables,

inventory, prepaid expenses etc. Accounts payable, wages payables etc.

2

Simple Cycle of operations

3

Cash

Finishedgoodsinventory

ReceivablesRawmaterialsinventory

Simple Cycle of operations

4

TimeAccounts payable period

Cash cycle

Operating cycle

Cash received

Accounts receivable periodInventory period

Finished goods sold

Firm receives invoice Cash paid for materials

Order Placed

Stock Arrives

Raw material purchased

Operating and Cash Conversion Cycle

Operating Cycle= Inventory Period + Accounts Receivable Period

The delay between the initial investment in inventories and the final sale date is called the inventory period.

The delay between the time that goods are sold and when the customers finally pay their bills is termed the accounts receivable period.

5

Operating and Cash Conversion Cycle

Cash Cycle= Inventory Period + Accounts Receivable Period Accounts Payable Period= Operating Cycle Accounts Payable Period

The interval between the firms payment for its raw materials and the collection of payment from the customer is know as the CCC.

6

Example: Suppose, a company pays suppliers of inventory after

30 days, completes production and sells the finished products to customers after 60 days of procuring the inventory and receives cash from the customers after 30 days from sale.

Day Activity0 Procure inventory30 Pay suppliers of inventory60 Complete production and sell to customers90 Collect cash from customers

Operating Cycle = 90 daysCash Cycle = 60 days

7

Formulae

Inventory Period = Avg Inventory/ Daily COGS

Accounts Receivable Period = Avg Receivables / Sales per day

Accounts Payable Period = Avg Payable/Daily COGS

8

Example:

Calculate the Cash Conversion Cycle and Operating Cycle

9

Year 2011 2012Inventory 9587 14544Receivables 16899 18149Payables 5856 8161Sales 42588 60138

COGS 28779 40831

Cash Management

Why hold cash or other marketable securities Low returns as compared to be generated by other assets Cash for transactions

For the debt settlement To pay suppliers

To hedge for unexpected needs Seasonality, smoothening the cash flows

10

Money Market

Near cash, interest earning securities may be a good substitute Safety and liquidity with some return

Longer term bonds Better expected return, may be liquid but may be risky

Term structure of interest rate effect

Stocks !

11

Money Market Instruments

T-Bills G-securities with maturities 91, 182 and 364 days Free of default risk Small interest rate risk Issued at discount and redeemed at par value Extremely liquid and can be purchased in low

denominations

12

Money Market Instruments

Commercial Paper Large denomination, unsecured debt Usually with maturity of 30 days Default risk is lessened as issuer obtain backup lines of

credit from commercial lines Ratings are must

Certificates of Deposit Bankers Acceptances Repurchase Agreements

13

Cash Management The goal of cash management is to make cash

available when needed and maximize interest income on idle cash.

The principal tool for short-term cash planning is the cash budget.

The cash budget records periodic estimates of cash receipts and disbursements.

The period could be a day or a week or a month depending on the need and convenience of the company.

The cash budget provides an estimate of the periodic cash surplus or deficit after adjusting cash payments against receipts.

14

Cash Management: FloatContd

Time exists between the moment a cheque is written and the moment the funds are deposited in the recipients account.

This time spread is called Float.

Payment Float - cheques written by a company that have not yet cleared.

Availability Float - cheques already deposited that have not yet cleared.

15

Cash Management:FloatContd

Float = Firms bank cash Firms book cash

Total float = Mailing float + Processing float

+ Clearing float

16

Cash Management: Managing FloatContd

Payers attempt to create delays in the chequeclearing process.

Recipients attempt to remove delays in the cheque clearing process.

Sources of delay Time it takes to mail cheque Time for recipient to process cheque Time for bank to clear cheque

17

Cash Management: Managing FloatContd

Lock-Box System - System whereby customers send payments to a post office box and a local bank collects and processes checks.

18

Inventory Management:

EOQ accounts for 3 types of costs: Unit Cost: the cost of the units themselves,

assumed to be fixed, regardless of the number of units ordered

Inventory-Holding Cost: the cost of holding units in inventory

Fixed order cost: represents all the costs associated with placing an order excluding the cost of the units themselves (any administrative costs of placing and/or receiving an order)

19

Inventories & Cash Balances

20

Total Cost = Purchase cost + Order cost + Holding cost

Optimal inventory level involve a trade-off between carrying costs and order costs.

Economic Order Quantity - Order size that minimizes total inventory costs.

Economic Order Quantity =2 x annual sales x cost per order

carrying cost


21

Determination of optimal order size

Inventorycosts,

dollars

Ordersize

TotalcostsCarryingcosts

Totalordercosts

Optimalordersize

Inventory Management: Example

Suppose the fixed order cost is 450 while the annual carrying cost is 55 a ton. If the annual sales of the company is 255,000 tons calculate the EOQ.

22


23

The optimal amount of short term securities sold to raise cash will be higher when annual cash outflows are higher and when the cost per sale of securities is higher. Conversely, the initial cash balance falls when the interest is higher.

Initial cash balance =2 x annual cash outflow s x cost per sale of securities

interest rate

Credit Management : Baumol Model

If you keep more cash in hand opportunity cost is high

If you dont keep cash and sell securities for every requirement transaction cost is high

Opportunity cost = (C/2) * R Trading cost = (T/C)*F T- total amount of new cash reqd in planning period C Opportunity cost of holding cash F- fixed cost of selling securities

24

Cash ManagementBaumol Model

25

Value of bills sold = Q =

2 x annual cash disbursement x cost per saleinterest rate

2 x 1260 x 20.08

Weeks0

25

12.5

balance ($000)Cash

Average

=

= 25

1 2 3 4 5

Credit Management

How long are you going to give customers to pay their bills? Longer the account receivable period, risky and

less valuable How do you determine which customers are

likely to pay their bills? To get idea about the risk in receipts

How do you collect the money when it becomes due? Need some specialized agency

26

Terms of Sale

Terms of Sale - Credit, discount, and payment terms offered on a sale.

Example - 2/10 net 30

2 - percent discount for early payment10 - number of days that the discount is availablenet 30 - number of days before payment is due

27

Terms of Sale

28

A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier.

We can calculate the implicit cost of this loan

( )Effective annual rate

1 + - 1discountdiscounted price365 / extra days credit

=

Credit Management Usually five Cs are analyzed to assess credit

worthiness. Character: Provides a clue to the customers willingness to

pay. Capacity: Refers to the ability to pay out of revenue

surpluses. Capital: Measures the financial assets of the customer that

can be used to pay the dues if revenue surplus is not adequate

Collateral: Refers to assets, which can be taken as security from the customer to cover defaults

Condition: Refers to the general economic conditions in the customers business

29

Credit Management

Credit Analysis - Procedure to determine the likelihood a customer will pay its bills.

Credit agencies provide reports on the credit worthiness of a potential customer.

Financial ratios can be calculated to help determine a customers ability to pay its bills.

30

Modelling credit risk: Credit Scoring Models...Contd

Altmans Z-Score Model This uses a statistical technique, Multiple Discriminate Analysis (also

could use logit or probit analysis) to classify firms into those likely to become bankrupt or non-bankrupt over a given future horizon

Past financial data on firm financial ratios and bankruptcies were used to estimate the regression equation

Z = 0 if firm becomes bankrupt and = 1 if firm does not.X1=Working Capital / Total AssetsX2=Retained Earnings / Total AssetsX3=EBIT / Total AssetsX4=Market Value of Equity / Book Value Long-Term DebtX5=Sales / Total Assets

31Vivek Rajvanshi,

1 2 3 4 51.2 1.4 3.3 0.6 1.0Z X X X X X


Altmans Z-Score Model For a given Type I error (classifying firm as not bankrupt

when it is) and a given Type II error (classifying a firm as bankrupt when it is not), a critical value of Z could be used to approve or deny a loan

Once z (critical value) is calculated, the credit risk is assessed as follows:

z > 3.0 means low probability of default (Safe zone)2.7 < z < 3.0 means an alert signal (Grey zone)1.8 < z < 2.7 means a good chance of default (Grey zone)z < 1.8 means a high probability of default (Distress zone)

32Vivek Rajvanshi,


If following information is available estimate Altmans Z score and comment about the bankruptcy Working Capital = $5,000,000

Retained Earnings = $1,000,000Operating Income = $10,000,000Market Value of Equity = $2,000,000Book Value of Total Liabilities = $500,000Sales = $15,000,000Total Assets = $3,000,000

33Vivek Rajvanshi,


If following information is available estimate Altmans Z score and comment about the bankruptcy

Working Capital / Total Assets = $5,000,000 / $3,000,000 = 1.67

Retained Earnings / Total Assets = $1,000,000 / $3,000,000 = .33

Operating Income / Total Assets = $10,000,000 / $3,000,000 = 3.33

Market Value of Equity / Book Value of Total Liabilities = $2,000,000 / $500,000 = 4

Sales / Total Assets = $15,000,000 / $3,000,000 = 5

If Model A Z-Score = 1.2 X1 + 1.4 X2 + 3.3 X3 +0.6 X4 + X5 >= 3

Bankruptcy is very unlikely

34Vivek Rajvanshi,

The Credit Decision

The most important tool to monitor receivables is Average collection period (ACP) of outstanding dues.

Credit analysis is only worth while if the expected savings exceed the cost.

Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default.

Denying credit guarantees neither profit or loss.

35

The Credit Decision

The credit decision and its probable payoffs p probability that customer will pay

36

Refusecredit

Offercredit

Payoff=Rev Cost

Payoff= Cost

Customerpays=p

Customerdefaults=1p

Payoff=0

The Credit Decision

37

Based on the probability of payoffs, the expected profit can be expressed as:

The break even probability of collection is:

p x PV(Rev - Cost) - (1 - p) x (PV(cost)

p =PV(Cost)PV(Rev)

The Credit Decision

Suppose you sign a deal with a company for a year. As a part of deal you are expected to receive 1500 revenue while the COGS is 1000. Calculate the breakeven probability of collection if the interest rate is 10% per year.

We should also consider the probability of repeat order and the chances of defaults simultaneously.

In repeat order chances of defaults may be less.

38

The Credit Decision

As a part of deal you are expected to receive 1500 revenue while the COGS is 1000. probability of default in first year is 40%.

If this order executed the probability of receiving second order is 90% and the probability of default will reduce to .05%. From the second order (next year) you are expected revenue of 2000 and COGS in same proportion as it was in first time order.

Interest rate applicable are 10%.

39

Collection Policy

If credit is granted, then the procedures for collection of dues have to be formalized.

These may include sending reminder letters to customers, telephone calls and personal visits, employing an outside agency or taking legal action if default continues.

40

Credit Granting Decision

Credit to a customer should be granted only if the return on investment in receivables is greater than the cost of funds required to finance the receivables.

41

Credit Granting Decision

Suppose, a company sells its products at Rs.5000 per unit with contribution of 40 %. Currently the annual credit sale is Rs.120 million with average collection period of one month.

If additional credit is allowed, by increasing the credit period to two months, then sales will increase 25 %.

If the pre-tax cost of capital is 16 %, then should the company allow additional credit?

42

Credit Granting DecisionPresent level of sales = Rs.120 mnPresent level of accounts receivables = Rs.120 mn *1/12 = Rs.10 mn

Increased level of sales with additional credit = Rs.120 mn * 1.25 = Rs.150 mnIncreased level of accounts receivables = Rs.150 mn * 2/12 = Rs.25 mn

Incremental amount of receivables = Rs.(25 10) mn = Rs.15 mnContribution = 40 % of salesVariable cost = 60 % of salesThe incremental investment in receivables will be equal to the variable cost.

43

Credit Granting DecisionIncremental investment in receivables = Rs.15 mn * 0.6 = Rs. 9 mn

Cost of investment in incremental receivables = Rs.9 mn * 0.16 = Rs.1.44 mn

Return from incremental sales = Contribution from incremental sales= Rs. (150 120) mn * 0.4 = Rs.12 mn

Hence, the return from incremental sales is greater than the cost of investment in incremental accounts receivables.So, credit should be allowed in this case.

44

Factoring

Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount

The Factor apart from advancing money to the client against invoices, also follows up customers, collects money, helps in credit check of the customers and maintains sales ledger accounts for the client.

45

Short-term Financing Policies

Short-term financing policy refers to the manner in which the permanent and the fluctuating current assets are financed. There can be threeapproaches: maturity matching aggressive and conservative.

46


In maturity matching approach, the maturities of assets and liabilities are matched. This implies that the permanent current assets and fixed assets should be funded by long-term sources and the fluctuating current assets by short-term sources.

47


If the company wants to play safe in financing of assets, then it can adopt a conservative approach. In this case, a part of the fluctuating current assets is also funded by long-term sources. This will reduce the risk of arranging short-term funds on a continuous basis.

48


The company can alternatively follow an aggressive approach. In this case, it will finance fixed assets and part of the permanent current assets with long-term funds and the balance current assets by short-term funds.

This approach is aggressive because the finance manager will be under continuous pressure to arrange renewal of short-term loans.

49

Cash Flow/Maturity Matching for Multiple Liabilities

Cash Flow Matching: A bond is selected with a maturity that matches the last liability Amount invested in this bond is such that the principal plus final

coupon payment is equal to the last liability The remaining elements of the liability stream are then reduced by the

coupon payments of this bond Another bond is chosen for the next to last liability and this sequence

is continued until all liabilities have been matched by payments on securities selected for the portfolio

50

Cash Flow Matching for Multiple Liabilities

1. For the last period, one would select a bond with a principal (FT) and coupon (CT) that matches the amount of that final liability (LT):

To meet this liability, one could buy LT /(1+ CR0) of par value of bonds maturing in T periods.

51

TTR

RTT

TTT

FCCwhere

CFL

CFL

/:

)1(0

0


2. To match the liability in period T-1, one would need to select bonds with a principal of FT-1 and coupon CT-1 (or coupon rate of CR1 = CT-1/ FT-1) that is equal to the projected liability in period T-1 (LT-1) less the coupon amount of CT from the T-period bonds selected:

To meet this liability, one could buy (LT-1-CT)/(1+ CR1) of par value of bonds maturing in T-1 periods.

52

)C1(FCL

CFCL1R

1TT1T

1T1TT1T


3. To match the liability in period T-2, one would need to select bonds with a principal of FT-2 and coupon CT-2 (or coupon rate of CR2 = CT-2/ FT-2) that is equal to the projected liability in period T-2 (LT-2) less the coupon amounts of CT and CT-1 from the T-period and T-1-period bonds selected:

To meet this liability, one could buy (LT-2 CT - CT-1)/(1+ CR2) of par value of bonds maturing in T-2 periods.

53

)C1(FCCL

CFCCL2R

2T1TT2T

2T2T1TT2T

Cash Flow Matching for Multiple Liabilities: Example

Example: Suppose the liabilities structure is to pay $4M, $3M, and $1M in years 3, 2, and 1 with 3-year, 2-year, and 1-year bonds each paying 5% annual coupons and selling at par.

54

Year 1 2 3

Liability $1M $3M $4M

Cash Flow Matching for Multiple Liabilities: Example

The $4M liability at the end of year 3 is matched by buying $3,809,524 worth of three-year bonds: $3,809,524 = $4,000,000/1.05.

The $3M liability at the end of year 2 is matched by buying $2,675,737 of 2-year bonds: $2,675,737 = ($3,000,000 (.05)($3,809,524))/1.05.

The $1M liability at the end of year 1 is matched by buying $643,559 of 1-year bonds: $643,559 = ($1,000,000 (.05)($3,809,524) (.05)($2,675,737))/1.05

55

Control of Working Capital

The objective of working capital management is to ensure liquidity with minimum sacrifice of profitability.

So, it is necessary to check both these parameters over time to analyze the trend of performance.

56

Measurement of Liquidity

(a) Current ratio = Current Assets / Current Liabilities

(b) Quick or Acid test ratio= (Current Assets Inventories) /

Current Liabilities

(c) Cash ratio = Cash and equivalents / Current Liabilities

57

Measurement of Profitability

(a) Net Profit Margin = Net Profit / Sales

(b) Return on assets = Profit after tax / Total assets

(c) Return on equity= Profit after tax / Total equity

58

59

Multiple Choice Question - 1A company is negotiating with a bank for a one-year loan. The bank has offered two options. The first option is to payinterest at the rate of 12 percent per annum on quarterlyrest basis with repayment of principal at the end. Thesecond option is to pay 10 percent per annum interest up-front with repayment of principal at the end of one year.Which option is better for the company?(a) The first option(b) The second option(c) Both are same(d) Do not know

60

Multiple Choice Question - 1Ans. (b)

Solution: The cash flows for the two options are as follows:-

Time First Option Second Option0 (Beginning) 100 100 10 = 90End Quarter 1 (3) nilEnd Quarter 2 (3) nilEnd Quarter 3 (3) nilEnd Quarter 4 (103) (100)IRR 12 percent 10.68 percentSo, the second option is better.

61

Multiple Choice Question - 2Consider the following financial information of a company during a particular year.Inventory Opening Rs.2.0 million

Closing Rs.2.4 millionAccounts Receivable - Opening Rs.4.0 million

Closing Rs.4.6 millionAccounts Payable Opening Rs.1.8 million

Closing Rs.2.0 millionNet Sales - Rs.12 millionCost of Goods Sold - Rs. 8 millionThe cash cycle of the company is(a) 144.40 days(b) 130.82 days(c) 231.09 days(d) 100.27 days

62

Multiple Choice Question - 2Ans. (a)Solution:

Average Inventory = (2.0 + 2.4)/2 = Rs.2.2 millionAverage Accounts Receivable= (4.0 + 4.6)/2 = Rs.4.3 millionAverage Accounts Payable = (1.8 + 2.0)/2 = Rs.1.9 millionInventory Turnover = Rs. 8 mn / Rs. 2.2 mn = 3.64 times

Receivables Turnover= Rs. 12 mn / Rs. 4.3 mn = 2.79 times Payables Turnover = Rs. 8 mn / Rs. 1.9 mn = 4.21times Inventory Period = 365/3.64 = 100.27 daysReceivables Period = 365/2.79 = 130.82 daysPayables Period = 365/4.21 = 86.69 daysSo, Cash Cycle = 100.27 + 130.82 86.69

= 144.40 days

63

Multiple Choice Question - 3A supplier offers credit under terms of 2/20, net 60. The implicit cost of credit is:

(a) 24.00 percent(b) 18.62 percent(c) 18.00 percent(d) Do not know

64

Multiple Choice Question - 3Ans. (b)

Solution: Assuming the price as 100, Cash Discounted Price till 20 days = 100 2 = 98Price to be paid till 60 days = 100So, implicit annualized cost of credit =( 2/98)*(365/40) = 18.62 percent

65

Multiple Choice Question - 4A company has issued Rs.10 million worth of commercial paper at an interest rate of 8 % for 3 months. It has to deposit 10 % of the issuedamount with a bank to maintain a line of credit withthe bank for the commercial papers. If the CP placement cost is Rs.50,000, then the pre-tax costof funds from CP is:(a) 8 percent(b) 10 percent(c) 8.23 percent(d) 8.94 percent

66

Multiple Choice Question - 4Ans. (d)Solution: Money collected by issuing CP= Rs.10 million 0.1 * Rs.10 million - Rs.50,000= Rs.8.95 millionInterest paid after 3 months = 0.08/4*10 mn

= Rs.0.2 millionSo, Annualized Interest Cost = 0.2/8.95*12/3*100

= 8.94 percent

Thank You!

67

Documents

Session 24 25 Working Capital Management