Working-Capital

Management

Chapter 15
 Learning Objectives
1. Describe the risk-return tradeoff involved in
managing a firm’s working capital.
2. Explain the determinants of net working capital.
3. Calculate the firm’s cash conversion cycle and
interpret its determinants.
4. Calculate the effective cost of short-term credit.
5. List and describe the basic sources of short-term
credit.
6. Describe the special problems encountered by
multinational firms in managing working capital.

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Slide Contents
1. Principles Used in this Chapter
2. Working Capital
3. The Appropriate Level of Working Capital
4. Cash Conversion Cycle
5. Cost of Short-term Credit
6. Multinational Working Capital Management

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1. Principles Used in this Chapter
Principles Used in this Chapter

 Principle 1:
 The Risk-Return Trade-Off – We Won’t
Take On Additional Risk Unless We Expect
to Be Compensated with Additional Return.

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2. Working Capital
Working Capital
 Working capital – The firm’s total investment
in current assets.

 Net working capital – The difference between

the firm’s current assets and its current
liabilities.

 This chapter focuses on net working capital.

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 Managing Net Working Capital
 Managing net working capital is
concerned with managing the firm’s
liquidity. This entails managing two
related aspects of the firm’s
operations:
1. Investment in current assets
2. Use of short-term or current liabilities

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Short-Term Sources of Financing
 Includes current liabilities i.e. all forms of
financing that have maturities of 1 year or
less.
 Two issues to consider:
 How much short-term financing should the firm
use?
 What specific sources of short-term financing
should the firm select?
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How Much Short-Term Financing
Should a Firm Use?

 This question is addressed by hedging

the principle of working-capital
management.

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 What Specific Sources of Short-Term
Financing Should the Firm Select?
 Three basic factors influence the decision:
 The effective cost of credit
 The availability of credit in the amount needed
and for the period that financing is required
 The influence of a particular credit source on
the cost and availability of other sources of
financing

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Current Assets
 A firm’s current assets are assets that are
expected to be converted to cash within a
period of a year or less, such as cash and
marketable securities, accounts receivable,
inventories.

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Risk-Return Trade-off
 Holding more current assets will reduce the risk of
illiquidity.
 However, liquid assets like cash and marketable
securities earn relatively less compared to other
assets. Thus larger amount liquid investments will
reduce overall rate of return
 The Trade-off: Increased liquidity must be traded-off
against the firm’s reduction in return on investment.

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Use of Current versus
Long-term Debt
 Other things remaining the same, the greater the
firm’s reliance on short-term debt or current liabilities
in financing its assets, the greater the risk of
illiquidity.
 Trade-off: A firm can reduce its risk of illiquidity
through the use of long-term debt at the expense of
a reduction in its return on invested funds. Trade-off
involves an increased risk of illiquidity versus
increased profitability.

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Advantages of Current Liabilities:
Return

 Flexibility
 Current liabilities can be used to match the timing
of a firm’s needs for short-term financing.
Example: Obtaining seasonal financing versus
long-term financing for short-term needs.
 Interest Cost
 Interest rates on short-term debt are lower than
on long-term debt.

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Disadvantages of Current
Liabilities: Risk

 Risk of illiquidity increases due to:

 Short-term debt must be repaid or rolled over
more often
 Uncertainty of interest costs from year to year

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3. The Appropriate Level of
Working Capital
Appropriate Level of
Working Capital
 Managing working capital involves
interrelated decisions regarding
investments in current assets and use of
current liabilities.
 Hedging Principle or Principle of Self-
Liquidating Debt provides a guide to the
maintenance of appropriate level of
liquidity.

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Hedging Principle
 Involves matching the cash flow generating
characteristics of an asset with the maturity of the
source of financing used to finance its acquisition.
 Thus a seasonal need for inventories should be
financed with a short-term loan or current liability.
 On the other hand, investment in equipment
expected to last for a long time should be financed
with long-term debt.

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Permanent and Temporary Assets
 Permanent investments
 Investments that the firm expects to hold
for a period longer than one year
 Temporary Investments
 Current assets that will be liquidated and
not replaced within the current year

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Sources of Financing
 Total assets will equal the sum of
temporary, permanent and spontaneous
sources of financing.

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Temporary & Permanent Source
 Temporary sources of financing consist of
current liabilities such as short-term secured
and unsecured notes payable.
 Permanent sources of financing include:
intermediate-term loans, long-term debt,
preferred stock common equity

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 Spontaneous Sources of
Financing
 Spontaneous sources of financing arise
spontaneously in the firm’s day-to-day
operations.
 Trade credit is often made available spontaneously or
on demand from the firm’s supplies when the firm
orders its supplies or more inventory of products to
sell.
 Trade credit appears on a balance sheet as accounts
payable.
 Wages and salaries payable, accrued interest and accrued
taxes also provide valuable sources of spontaneous financing.
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Also see table 15-1

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Hedging Principle Summary
 Asset needs of the firm not financed by
spontaneous sources should be financed
in accordance with this rule:
 Permanent-asset investments are financed
with permanent sources, and temporary
investments are financed with temporary
sources.

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4. Cash Conversion Cycle
 Cash Conversion Cycle
 A firm can minimize its working capital by
speeding up collection on sales, increasing
inventory turns, and slowing down the
disbursement of cash.
 Cash Conversion cycle (CCC) captures the
above.
 CCC = days of sales outstanding + days of
sales in inventory – days of payables
outstanding.
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Cash Conversion Cycle
 Figure 15-2 shows that both Dell and Apple
have been effective in reducing their CCC.
 CCC is below zero due to effective
management of inventories and being able to
receive favorable credit terms.
 See table 15-2 for Dell’s CCC.

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5. Cost of Short-term Credit
Cost of Short-term Credit
 Interest = principal x rate x time
 Cost of short-term financing = APR or
annual percentage rate
 APR = (interest / principal) * (1 / time)

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APR example
 A company plans to borrow $1,000 for 180
days. At maturity, the company will repay
the $1,000 principal amount plus $40
interest. What is the APR?

APR = ($40/$1,000) X [1/(180/360)]

= .04 X (180/90)
= .08 or 8%

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Annual Percentage Yield (APY)
 APR does not consider compound interest. To
account for the influence of compounding, must
calculate APY or annual percentage yield.
 APY = (1 + i/m)m – 1
 Where:
 i is the nominal rate of interest per year;
 m is number of compounding period within a year.

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APY example
 In the previous example,
 # of compounding periods 360/180 = 2
 Rate = 8%

 APY = (1 + .08/2)2 –1

= .0816 or 8.16%

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APR or APY?
 Because the differences between APR
and APY are usually small, we can use
the simple interest values of APR to
compute the cost of short-term credit.

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5. Sources of Short-term Credit
Sources of Short-term Credit
 Short-term credit sources can be
classified into two basic groups:
 Unsecured
 Secured

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Unsecured Loans
 Unsecured loans include all of those sources
that have as their security only the lender’s
faith in the ability of the borrower to repay the
funds when due.
 Major sources:
 Accrued wages and taxes, trade credit, unsecured
bank loans, and commercial paper

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Secured Loans
 Involve the pledge of specific assets as
collateral in the event that the borrower
defaults in payment of principal or interest.

 Primary Suppliers:
 Commercial banks, finance companies, and factors

 Principal sources of collateral:

 Accounts receivable and inventories
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Unsecured Source:
Accrued wages and taxes
 Since employees are paid periodically
(biweekly or monthly), firms accrue a wage
payable account that is, in essence, a loan
from their employees.
 Similarly, if taxes are deferred or paid
periodically, the firm has the use of the tax
money.

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Unsecured Source:
Trade Credit
 Trade credit arises spontaneously with the
firm’s purchases. Often, the credit terms
offered with trade credit involve a cash
discount for early payment.
 Terms such as 2/10 net 30 means a 2%
discount is offered for payment within 10
days, or the full amount is due in 30 days
 A 2% penalty is involved for not paying within
10 days.
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Effective Cost of Passing Up a
Discount
Terms 2/10 net 30
The equivalent APR of this discount is:
APR = $.02/$.98 X [1/(20/360)]
= .3673 or 36.73%

The effective cost of delaying payment for 20

days is 36.73%

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Unsecured Source:
Bank Credit
 Commercial banks provide unsecured
short-term credit in two forms:
 Lines of credit
 Transaction loans (notes payable)

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Line of Credit
 Informal agreement between a borrower and a
bank about the maximum amount of credit the
bank will provide the borrower at any one time.
 There is no legal commitment on the part of the
bank to provide the stated credit.
 Usually requires that the borrower maintain a
minimum balance in the bank throughout the loan
period, called a compensating balance.
 Interest rate on line of credit tends to be floating.
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Revolving Credit

 Revolving credit is a variant of the line of

credit form of financing.
 A legal obligation is involved.

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Transaction Loans
 Transaction loan is made for a specific
purpose. This is the type of loan that most
individuals associate with bank credit and is
obtained by signing a promissory note.

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Commercial Paper
 The largest and most credit worthy companies are
able to use commercial paper – a short-term promise
to pay that is sold in the market for short-term debt
securities.
 Maturity: Usually 6 months or less.
 Interest Rate: Slightly lower ( ½ to 1%) than the
prime rate on commercial loans.
 New issues of commercial paper are placed directly or
dealer placed.
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 Commercial Paper: Advantages
 Interest rates
 Rates are generally lower than rates on bank loans.
 Compensating-balance requirement
 No minimum balance requirements are associated with
commercial paper.
 Amount of credit
 Offers the firm with very large credit needs a single source for all
its short-term financing.
 Prestige
 Signifies credit status.
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 Secured Sources of Loans
 Secured loans have assets of firm pledged as
collateral. If there is a default, the lender has first
claim to the pledged assets. Because of its liquidity,
accounts receivable is regarded as the prime source
for collateral.
 Accounts Receivable loans
 Pledging Accounts Receivable
 Factoring Accounts Receivable
 Inventory loans

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Pledging Accounts Receivable
 Borrower pledges accounts receivable as collateral for a loan
obtained from either a commercial bank or a finance company.
 The amount of the loan is stated as a percentage of the face value
of the receivables pledged.
 If the firm pledges a general line, then all of the accounts are
pledged as security. (Simple and inexpensive)

 If the firm pledges specific invoices each invoice must be evaluated

for creditworthiness. (more expensive)
 Credit Terms: Interest rate is 2-5% higher than the bank’s
prime rate. In addition, handling fee of 1-2% of the face
value of receivables is charged.

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Factoring Accounts Receivable
 Factoring accounts receivable involves the
outright sale of a firm’s accounts to a
financial institution called a factor.
 A factor is a firm (such as commercial
financing firm or a commercial bank) that
acquires the receivables of other firms. The
factor bears the risk of collection in exchange
for a fee of 1-3 % of the value of all
receivables factored.
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 Inventory Loans
 These are loans secured by inventories
 The amount of the loan that can be obtained depends
on the marketability and perishability of the inventory
 Types:
 Floating lien agreement
 Chattel Mortgage agreement
 Field warehouse-financing agreement
 Terminal warehouse agreement

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Types of Inventory Loans
 Floating Lien Agreement
 The borrower gives the lender a lien
against all its inventories.
 Chattel Mortgage Agreement
 The inventory is identified and the borrower
retains title to the inventory but cannot sell
the items without the lender’s consent
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Types of Inventory Loans
 Field warehouse-financing
agreement
 Inventories used as collateral are physically
separated from the firm’s other inventories
and are placed under the control of a third-
party field-warehousing firm

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Types of Inventory Loans
 Terminal warehouse agreement
 Inventories pledged as collateral are
transported to a public warehouse that is
physically removed from the borrower’s
premises.

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6. Multinational Working-
Capital Management
Multinational Working-Capital
Management
 The basic principle is the same for both
domestic and multinational corporations.
However, since multinationals spend and
receive money in different countries, it is
exposed to exchange rate risk.
 Exposed position (exposed assets-exposed
liabilities) is of interest to the firm.

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