B3: Working Capital Management

Front 1

Working Capital Policy and Working Capital MGMT:

Back 1

Involve managing cash so that a company can meet its short-term obligations, and include all aspects of the administration of CA and CL. The goal of WC MGMT is shareholder wealth maximization. The optimal mix of CA and CL depends on the nature of the business and the industry and requires offsetting the benefit of CA and CL against the probability of technical insolvency.

Front 2

Definition of Net Working Capital:

Back 2

New working capital is defined as the difference between CA and CL.

Front 3

Balancing Profitability and Risk:

Back 3

WC is expensive to carry b/c it must be financed either with long-term or short-term debt or with stockholders' equity. Adequate WC reserves mitigate risk, potentially reduce returns, and thereby increase profitability.

Aggressive WC MGMT = Low WC = Low Current ratio = High risk, High reward

Conservative WC MGMT = High WC = High Current ratio = Low risk, Low reward

Front 4

Current Ratio:

Back 4

Measures the number of times CA exceed CL and is a way of measuring short-term solvency. This ratio demonstrates a firm's ability to generate cash and meet its short-term obligations.

CR = CA / CL

The higher, the better (means less risk and higher WC)

Current ratio is the best single indicator of a company's ability to meet short-term obligations.

Limitations - unless short-term liquidity is a relevant issue, the CR is not necessarily the best measure of the health of a business. It could be misleading. Ratios need to be used together.

Front 5

Quick (Acid Test) Ratio:

Back 5

A more rigorous test of liquidity than the CR b/c inventory and prepaids are excluded from CA. Inventory is the least liquid of CA. The ability to meet current obligations without liquidating inventory is important.

Front 6

WC and Risk:

Back 6

1. Less working capital increases risk by exposing a company to the likelihood of a possible failure to meet current obligations

2. More working capital decreases risk b/c it may reduce a firm's ability to obtain additional short-term financing

Front 7

Management of Cash and Cash Equivalents:

Back 7

Too little = risk increases

Too much, ROA decreases

Front 8

Motives for Holding Cash:

Back 8

1. Transaction motive - a company may hold cash to meet payments arising from the ordinary course of business (pay your bills when they come due - avoid bankruptcy)

2. Speculative motive - cash may be needed to take advantage of temporary opportunities

3. Precautionary motive - concern of the treasurer (liquidity/safety). Safety cushion to meet unexpected needs

Front 9

Disadvantages of High Cash Levels:

Back 9

ROA decreases

1. The "negative arbitrage" effect (i.e., interest obligations exceed interest income from cash reserves - it's a better investment to take extra cash and buy back debt that is costing you 7% interest, than letting it sit in the bank so you earn 3% monthly interest)

2. Increased attractiveness as a takeover target

3. Investor dissatisfaction with allocation of assets (i.e., failure to pay dividends)

Front 10

Primary Methods of Increasing Cash Levels:

Back 10

(REDUCING the operating cycle) - sell and collect quickly

1. Speeding up cash inflows

-Customer screening and credit policy

-Prompt billing

-Payment discounts (***)

Give to customers = cost

Rec. from vendor and do not take advantage of = opportunity cost

-Expedite deposits (electronic funds transfer, lockbox systems)

Lockbox system - good if additional interest income > bank fees

-Concentration banking

-Factoring A/R

2. Slowing down cash outflows

-Defer payments

-Drafts (don't pay cash) (increases the payable float)

-Line of credit ("bank loan, safety, cushion"

-Zero-balance accounts

Front 11

Other Cash MGMT Techniques:

Back 11

1. Managing Float - more cash earning interest in bank longer

Bank bal. > Book bal.

2. Overdraft protection

Benefit > cost

Companies using float can provide some protections against overdrafts by arranging overdraft loans with the bank

3. Compensating balances

Protects lender/bank

Reduces fees. Does NOT increase cash

Front 12

Cash Conversion Cycle:

Back 12

Sometimes called the Net Operating Cycle. Is the length of time from the date of the initial expenditure for production to the date cash is collected from the customers and the vendors are paid for the initial expenditures.

Prime way to increase liquidity

Front 13

Management of A/R:

Back 13

A/R MGMT objectives include arriving at an appropriate balance between the A/R balance outstanding and the amount of bad debts and converting A/R into cash quickly enough to meet short-term obligations without angering customers.

1. Credit Policy (if strict -> # days to collect is low, but # days to sell is high. Goal - lower OC)

-Credit period

-Credit standards

-Collection policy

-Discounts

Front 14

Management of A/P:

Back 14

Defer without penalty.

Front 15

Management of Inventory:

Back 15

-Too little - lost sales = cost

-Too much - carrying costs increase, profit decreases

Inventories represent the most significant current noncash resource of an organization.

Front 16

Factors Influencing Inventory Levels:

Back 16

Inventory depends on the accuracy of sales forecasts. Lack of inventory can result in lost sales and excessive inventory can result in burdensome carrying costs, including:

-Storage costs

-Insurance costs

-Opportunity costs of inventory investment

-Lost inventory due to obsolescence or spoilage

The lower the carrying costs of inventory, the more inventory companies are willing to carry.

Front 17

Optimal Levels of Inventory:

Back 17

Numerous factors affect the optimal level of inventory, including the usage rate of inventory per period of time, cost per unit of inventory, cost of placing orders for inventory, and the time required to receive inventory.

Inventory models and systems used in the determination of the optimal level of inventory include:

-Inventory turnover

-Safety stock

-Reorder point

-Economic order quantity *

-Materials requirements planning

Front 18

Safety Stock:

Back 18

Used by companies to ensure that manufacturing or customer supply requirements are met. The determination of safety stock depends on the following factors:

-Reliability of sales forecasts *** (less reliable - more safety stock you need)

-Possibility of customer dissatisfaction resulting from back orders

-Cost of running out of inventory

-Lead time

-Seasonal demands of inventory

Front 19

Reorder Point:

Back 19

Is the inventory level at which a company should order or manufacture additional inventory to meet demand and to avert incurring stockout costs.

Front 20

Economic Order Quantity:

Back 20

"When I say two, you say "SOC" "

When managing inventory, there is a trade-off between carrying costs (the costs of holding inventory) and ordering costs (the costs of ordering additional inventory).

The EOQ model attempts to minimize both ordering and carrying costs.

Assumptions:

-Demand is known and is constant throughout the year

Front 21

Other Inventory MGMT Issues:

Back 21

1. Just-In-Time Inventory Model - Pull approach. Was developed to reduce the lag time between inventory arrival and inventory use. Reduces the need of manufacturers to carry large inventories, but requires considerable degree of coordination between manufacturer and supplier

2. Kanban Inventory Control

3. Computerized Inventory Control

4. Materials Requirement Planning

Front 22

Management of Marketable Securities:

Back 22

If highly liquid, risk is low, but return is low.

1. U.S. Treasury Bills (least risk)

2. Certificates of Deposit (CDs)

3. Banker's acceptances

4. Commercial paper (notes/drafts)

5. Equity securities of public companies (stocks) (most risk)

Front 23

Factors Influencing the Level of Marketable Securities:

Back 23

Liquidity and Credit Hedge.

Periods of low rates - cash holdings are preferable to marketable securities

Periods of high rates - marketable securities are advisable