2015, Study Session # 11, Reading # 39 “WORKING CAPITAL MANAGEMENT” WCM LOC STMI CR CA CL = = = = = = Working Capital Management Line Of Credit Short Term Marketable Investments Current Ratio Current Assets Current Liabilities A/R CGS SWCP BEY DSO WADSO = = = = = = Accounts Receivable Cost of Goods Sold Short Term Working Capital Portfolios Bond Equivalent Yield Days Sales Outstanding Weighted Avg Days of Sale Outstanding INTRODUCTION Effective WCM ⇒ adequate cash to fund day to day necessary operations with company’s assets invested in most productive way Internal Factors External Factors Company size & growth rates Organizational structure Banking services Sophistication of working capital management Borrowing & investing position / activities / capacities New technologies & new products Interest rates The economy Competitors Insufficient access to cash: Restructuring by selling of assets Reorganization via bankruptcy proceedings Final liquidation Excessive investment in cash, may not be the optimum use of company resources A careful balance is required in WCM In effective WCM Adequate cash levels are maintained Converting short-term assets into cash Controlling outgoing payments to vendors, employees and others It is done by investing in: Short term funds Highly liquid securities Maintaining credit reserves in bank lines of credit Issuing money market instruments like commercial paper It requires reliable cash flow forecasts SCOPE OF WCM Transaction Payment for trade, financing and investment Relation with trading partners To ensure smooth transactions Analysis of WCM activities To formulate appropriate strategies Copyright © FinQuiz.com All rights reserved Focus Global view point Strong emphasis on liquidity 2015, Study Session # 11, Reading # 39 MANAGING & MEASURING LIQUIDITY 2.1 Defining Liquidity Management 2.1.1 Primary Sources of Liquidity 2.1.2 Secondary Sources of Liquidity 2.1.3 Drags & Pulls on Liquidity Liquidity ⇒ Company’s ability to meet its short term obligations An asset is liquid if it can be converted into cash, either by sale or financing, quickly Companies with liquidity ⇒ focus is on putting abundant liquidity into most effective use In tight financial situation ⇒ effective liquidity management required ⇒ ensures solvency If liquidity management is not done ⇒ bankruptcy or possible liquidation 2.2 Measuring Liquidity 2.1 Defining Liquidity Management Ability of management to generate cash when needed Usually it is associated with short-term assets and liabilities to provide cash Long term assets & liabilities can be used to provide liquidity but can reduce company’s overall financial strength Liquidity management challenges ⇒ developing, implementing and maintaining liquidity policy Company must manage key resources that include primary sources and secondary sources 2.1.1 Primary Sources of Liquidity Most readily available source can be held as cash or near-cash securities Ready cash balance: available at banks against payment collection, investment income, liquidation of near cash securities (maturity < 90 days) & other cash flows Short- term funds: trade credit, bank lines of credit, shot term investment portfolios Cash flow management: effectiveness of company in cash management, system of cash collection, cash available to use These funds are readily accessible at lower costs 2.1.2 Secondary Source of Liquidity May affect company’s normal operations and in some cases alter financial and operating position Sources include: Negotiating debt contracts: pressure of interest or principal repayments Liquidating assets Filing for bankruptcy protection and re-organization Use of such sources may signal deteriorating financial health Bankruptcy protection may be considered a liquidity tool Under such protection, a company generating operating cash is liquid and able to continue business operations until restructuring is approved Copyright © FinQuiz.com All rights reserved 2015, Study Session # 11, Reading # 39 2.1.3 Drags & Pulls on Liquidity Drag ⇒ when receipts lag Pull ⇒ disbursements paid quickly Major drags include Uncollected receivables → outstanding, risk they would not be collected at all → Indicated by no of days receivable and bad debts Obsolete inventory → Inventory stands than usual → Indication of no longer being usable → Indicated by slow inventory turnover ratios Tight credit → Economic condition not favorable → Short term debt cost Drags controlled by strict credit & collection practices Major pulls on payments include Making payments early → Paying vendors before due date results in companies forgo use of funds → Effective payment management means making payment when due, not early Reduced credit limit → History of late payments can lead to credit limit by suppliers → Can squeeze company’s liquidity Limits on short term lines of credit → Liquidity squeeze occur when bank LOC → LOC restrictions can be: Government mandated, market-related & company specific → Over-banking ⇒ approach common in emerging as well as some developed markets featuring unsound banking systems whereby companies establish lines of credit in excess of their needs Low liquidity positions: → Such situation is faced by a company in a particular industry or with a weaker financial position → Secured borrowing is done by such companies → Important for such companies to identify such assets for short term borrowings Critical to identify drags and pulls on time or before they have arisen 2.2 Measuring Liquidity Liquidity ensures creditworthiness ⇒ perceived ability of a borrower to make timely payments Creditworthiness chances to obtain credit at ↓ borrowing cost ⇒ better trade credit terms Liquidity chances of financial distress ⇒ leads to insolvency & bankruptcy (extreme case) Liquidity ratios ⇒ check company’s ability to meet short-term debt obligations Ratio = profitable opportunities = !" # $ % chances to cover CL &/ ( ) = * %+ # $ % → Measures how many times A/R created & collected on avg in one fiscal period - ) ) = /0 %+ % → Measure how many times inventory created / acquired & sold during one fiscal period Activity ratios can also be re-arranged to estimate no of days CA or CL are on hand 4 5 4 5 ) ) 78 = = 4 5 6 = 78 = %+ * 29 /# % $ * /0 /:;< $$1 > > $ /# / :;< $ * /:;< Alternate name No of days payable No of days inventory No of days receivables Days payable outstanding Avg inventory period Days sales outstanding Avg days payable Inventory holding period Days in receivables Turnover ratios tell how company is managing its liquid assets Ratio analysis must be done against some benchmark not in isolation Benchmark could be industry avg or company’s own track record (past performance) or with peer group ?= @ = 4 5 ) + B7 4 5 ) 78 Measure of time needed to convert raw material into cash from a sale Does not account for increased cash flow by deferring payment to suppliers = @ = 4 5 ) + 4 5 ) 78 6 – Also called cash conversion cycle Cycles cash generating ability For many companies cash conversion cycle is a period that requires financing 4 5 4 = 78 Copyright © FinQuiz.com All rights reserved 2015, Study Session # 11, Reading # 39 MANAGING THE CASH POSITION 3.1 Forecasting Short-Term Cash Flows Ensuring net cash positions not negative Negative balance is avoided as cost of borrowing is and unacceptable Balance = inflows-outflows Managing short term portfolio ⇒ opportunity cost is considered acceptable To manage cash decisions are done on latest information Company’s treasury function uses optimum services and techniques associated with company’s payment configuration to manage cash 3.1.1 Minimum Cash Balance 3.1.2 Identify Typical Cash Flows 3.1.3 Cash Forecasting System 3.2 Monitoring cash uses and levels 3.1 Forecasting Short Term Cash Flows Necessary task Precision in forecasting effectiveness Forecast ⇒ precise may not be accurate External uncertainty encourages companies to maintain minimum level of cash as a buffer 3.1.1 Minimum Cash Balance Provides financial flexibility or protection An opportunity to take advantages from attractive opportunities Size of this buffer depends upon: Variation of cash inflows & outflows Access to liquid sources Ability to raise funds with lead time 3.1.2 Identifying Typical Cash Flows Cash mangers using cash flow history or organizational financial history must identify cash flow elements and collect data about them regularly Real cash flows should be reflected Elements include ; Inflows Outflows Receipts from operations, broken down by operating unit, departments, etc Payables & payroll disbursements, broken down by operating unit, departments, etc Funds transfers from subsidiaries, joint ventures, third parties Funds transfer to subsidiaries Maturing investments Investments made Debt proceeds (short and long term) Debt repayments Other income items (interest, etc.) Interest and dividend payments Tax refunds Tax payments Copyright © FinQuiz.com All rights reserved 2015, Study Session # 11, Reading # 39 3.1.3 Cash Forecasting System Must be structured as a system to be effective Several aspects to be covered Importance of aspects varies in between forecast horizon Data frequency Format Techniques Accuracy Reliability Uses Short Tem Medium Term Long Term Daily / weekly for 4-6 weeks Receipts & disbursements Simple projections Very high Very high Daily cash management Monthly for one year Receipts & disbursements Projection models and averages Moderate Fairly high Planning financial transaction Annually for 3-5 years Projected financial statements Statistical models Lowest Not as high Long-range financial position 3.2 Monitoring Cash Uses and Levels Financial manager in charge of managing cash position must know cash balance at real time basis Monitoring cash flow ⇒ key aspects of cash forecasting system It involves knowing of the transactions information in time to tackle with them Information should be gathered from principal users and providers of cash along with cash projections Minimum cash level is estimated in advance and steps are taken to determine the target balance for each bank Target balance is applied to one main account (the bank where company’s transactions are concentrated) Large companies have more concentration banks making cash management more complex Short term investments and borrowing assist in cash management Cyclical companies need to focus more on sources of cash in times when they produce and stock inventory for peak seasons Company’s cash needs are also influenced by long term investment and financial activities Predicting cyclical and non-operating activity needs is critical in managing cash Setting aside too much cash can be costly while setting aside too little can cause penalty to raise funds quickly ⇒ either case would be costly; a reliable forecast is necessary INVESTING SHORT-TERM FUNDS 4.1 Short-Term Investment Instruments 4.2 Strategies 4.3 Evaluating Short Term Funds Management 4.1.1 Computing Yields On Short Term Investments 4.1.2 Investment Risks Investing Short-Term Funds Temporary store of funds not needed in daily transactions Extra working capital portfolio funds must be invested in long term portfolios SWCP include: highly liquid, less risky, and shorter maturity securities e.g U.S government securities & corporate obligation The portfolio changes as cash is needed or more cash is available for investment Copyright © FinQuiz.com All rights reserved 2015, Study Session # 11, Reading # 39 4.1 Short-Term Investment Instruments Instruments U.S Treasury Bills (T-bills) Typical maturities 13, 26, and 52 weeks Federal agency securities 5-30 days Bank certificates of deposit (CDs) 14-365 days Banker’s acceptances (BAs) 30-180 days Eurodollar time deposits 1-180 days Bank sweep services day Repurchase agreement (Repos) day + Commercial paper (CP) 1-270 days Mutual funds and money market mutual funds Varies Tax-advantaged securities 7, 28, 35, 49, and 90 days Features Obligation of U.S government (guaranteed), issued at a discount Active secondary market Lowest rates for traded securities Obligations of U.S federal agencies (e.g., Fannie Mae, Federal Home Loan Board) issued as interest-bearing Slightly higher yields than T-bills Bank obligations, issued interest-bearing in $100,000 increments “Yankee” CDs offer slightly higher yields Bank obligations for trade transactions (usually foreign), issued at a discount Investor protected by underlying company and trade flow itself Small secondary market Time deposit with bank off-shore (outside United States, such as Bahamas) Can be CDs or straight time deposit (TD) Interest-bearing investment Small secondary market for CDs, but not TDs Service offered by banks that essentially provides interest on checking account balance (usually over a minimum level) Large numbers of sweeps are for overnight Sale of securities with the agreement of the dealer (seller) to buy them back at a future time Typically over-collateralized at 102 percent Often done for very short maturities (< week) Unsecured obligations of corporations and financial institutions, issued at discount Secondary market for large issuers CP issuers obtain short-term credit ratings Money market mutual funds commonly used by smaller businesses Low yields but high liquidity for money market funds; mutual fund liquidity dependent on underlying securities in fund Can be linked with bank sweep arrangement Preferred stock in many forms including adjustable rate preferred stocks (ARPs), auction rate preferred stocks, (AURPs), and convertible adjustable preferred stocks (CAPs) Dutch auction often used to set rate Offer higher yields Relative amounts to be invested in each type, depends upon the company Copyright © FinQuiz.com All rights reserved Risks Virtually no risk Slight liquidity risk; insignificant credit risk Credit and liquidity risk (depending on bank’s credit) Credit and liquidity risk (depending on bank’s credit) Credit risk (depending on bank) very high liquidity risk for TDs Credit and liquidity risk (depending on bank) Credit and liquidity risk (depending on dealer) Credit and liquidity risk (depending on credit rating) Credit and liquidity risk (depending on fund manager) Credit and liquidity risk (depending on issuer’s credit) 2015, Study Session # 11, Reading # 39 4.1.1 Computing Yield on Short Term Investments D6 = ) – = ℎ = Investor pays less than face value but receives face value at maturity e.g T-bill, banker’s acceptance Interest bearing securities ⇒ investor pays face amount, receives back face amount + interest Nominal rate ⇒ rate based on securities face value Yield ⇒ actual return if investment held till maturity F B 85 = G $ % HI I $ ⇒ Annualized using 360 days N O ) 85 = G $ P > $ I $ HI I $ $ $ > $ :;K × I $ 1.1L * 1L M × :;< 1.1L * 1L M 2 ⇒Annualized using 365 days ⇒ also referred to as the investment yield basis U.S T-bill may be quoted on discount basis or BEY D6 N 6 85 = G $ P HI G $ P $ I $ × :;K Q1 1L * 1 M ⇒ Though BEY is relevant for investment decisions but discount basis is often quoted 4.1.2 Investment Risk Type of Risk Key Attributes Credit (or default) Issuer may default Issuer could be adversely affected by economy, market Little secondary market Market (or interest rate) Price or rate changes may adversely affect return There is no market to sell the maturity to, or there is only a small secondary market Security is difficult or impossible to (re) sell Security must be held to maturity and cannot be liquidated until then Adverse general market movement against your currency Liquidity Foreign exchange Safety Measures Minimize amount Keep maturities short Watch for “questionable” names Emphasize government securities Keep maturities short Keep portfolio diverse in terms of maturity, issuers Stick with government securities Look for good secondary market Keep maturities short Hedge regularly Keep most in your currency and domestic market (avoid foreign exchange) Copyright © FinQuiz.com All rights reserved 2015, Study Session # 11, Reading # 39 4.2 Strategies Short-term investors not want to take on substantial risk Strategies can be active or passive ⇒ Passive: one or two decision rules for making daily investments ⇒ Active: constant monitoring may involve matching, mismatching or laddering strategies Company must have investment guideline policy Passive Active Top priority is safety & liquidity Less aggressive than active strategies Roll over is required Must be monitored against some benchmark Matching Strategy More daily involvement & choice of investments Active involvement with more flexible investment policy and better forecasts Mismatching Strategy Conservative & similar to passive strategies Matching is of timing of cash outflows with investment maturities Ladder strategy Requires reliable cash forecast Riskier, requires liquid securities (T-bill) to meet liquidity needs May also be accompanied by derivatives posing additional risks In b/w passive & matching Schedules maturities so that investments are distributed equally over the ladder’s term Helpful in managing long-term portfolios 4.3 Evaluating Short Term Funds Management For portfolios that are not large or diversified ⇒ use spread sheet models For diversified portfolios ⇒ more expensive treasury workstations Investment returns must be expressed on BEY to allow comparability Overall portfolio return must be weighted according to the size of the investment MANAGING ACCOUNTS RECEIVABLE 5.1 Key Elements of Trade Credit Granting Process 5.2 Managing Customer’s Receipts 5.3.1 Account Receivable Aging Schedule 5.3 Evaluating Accounts Receivable Management 5.3.2 The No of Days of Receivables Copyright © FinQuiz.com All rights reserved 2015, Study Session # 11, Reading # 39 Managing Accounts Receivable Accounts receivable management ⇒ granting credit and processing transaction, monitoring credit balance, measuring performance of credit function Efficient processing and disbursement of information to concerned departments and managers is required Ensuring account receivable accounts are current Co-ordination with treasury management function Preparation of regular performance measurement reports Captive finance subsidiary ⇒ wholly owned subsidiary established to provide financing of the sales of the parent company Some companies outsource accounts receivable function while some may invest in credit insurance 5.1 Key Elements of Trade Credit Granting Process Effective credit management policy is required Basic guidelines of such policy set boundaries for credit management function Credit scoring model is used to classify borrowers according to creditworthiness Such models can be used to predict late payers Based upon the quality of borrower the credit is granted 5.2 Managing Customer’s Receipts Cash collection systems are function of types of customers and the methods they use Nature of business ⇒ nature of customers ⇒ methods of payment Common electronic methods: Direct debit Electronic funds transfer POS terminals If payments not transfer electronically, lock box system is used ⇒ Lockbox: customer payments are mailed to a post office box and the banking institution retrieves and deposits these payments several times a day Float factor measures time it takes for checks to clear ⇒ does not measure time it takes to receive, deposit and clear checks 48 = %+.* %+.* 2 L 2 * >1 total amount of check deposited no of days Cash collection system must accelerate payments & information content associated with those payments Cash concentration involves: 1) Consolidating deposits 2) Moving funds (b/w company accounts or to outside points) ⇒ Best treatments for consolidating deposits & moving funds for cash concentration may differ for ⇒ For moving funds electronic methods are cost effective Avg daily deposit = 5.3 Evaluating Accounts Receivable Management Accounts receivable management ⇒ how efficiently receivable converted into cash Such measures can be derived from 1) general financing reports and 2) Internal financial records Copyright © FinQuiz.com All rights reserved 2015, Study Session # 11, Reading # 39 5.3.1 Accounts Receivable Aging Schedule Key report used by accounts receivables managers It breaks down accounts into categories of days outstanding Can be converted into percentage for comparability 5.3.2 The No of Days Receivables Provides overall picture Can be compared with credit management policy to gauge account collection performance Weighted average DSO gives better idea of how long it takes to collect from customers irrespective of sales level and ∆ in sales Aging schedule is used to calculate weighted avg DSO Major drawback of WADSO ⇒ requires more information ⇒ comparability across companies is difficult due to lack of information MANAGING INVENTORY 6.1 Approaches to Managing Levels of Inventory 6.2 Inventory Costs 6.3 Evaluating Inventory Management Managing Inventory Necessary for working capital management Careful balance is required; ⇒ more inventories can lead to obsolete inventory and losses on selling through discount ⇒ liquidity squeeze ⇒ Fewer inventories (shortage) can lead to lost sales & company’s inability to avoid price increase by suppliers Motive to hold inventory a) Transaction motive ⇒ need for inventory as a part of routine b) Precautionary stocks ⇒ amount maintained to avoid stock out losses c) Speculative motive ⇒ if costs to in future then benefit can be achieved Assumption ⇒ storage cost < savings from in price 6.1 Approaches to Managing Levels of Inventory Economic order quantity – reorder point ⇒ Traditional method ⇒ Reliable short term forecast is necessary ⇒ Based upon expected demand and predictability of demand ⇒ Safety stock ⇒ cushion beyond anticipated needs, helps when lead time ⇒ Anticipation stock ⇒ Inventory in excess of anticipated demand It fluctuates with sales level Just-in-time method ⇒ System to minimize in-process inventory ⇒ Materials ordered when reach re-order level ⇒ Can reduce inventory level to optimum level if J.I.T method is incorporated with manufacturing resource planning method ⇒ Careful planning is required Copyright © FinQuiz.com All rights reserved 2015, Study Session # 11, Reading # 39 6.2 Inventory Costs Several components ⇒ represent both opportunity & real costs ⇒ Ordering cost: depend on orders e.g setup, labor, freight etc ⇒ Carrying: financing & holding costs e.g storage, cost of capital, insurance, taxes etc ⇒ Stock-out: affected by level of inventory e.g lost sales, back-order costs etc ⇒ Policy: cost of gathering data can be “soft” cost e.g data processing, overtime, training etc 6.3 Evaluating Inventory Management Inventory turnover ratio is used along with no of days of inventory Comparison can be drawn with other industries or past history Can be different due to product mixes Knowing the reason for or in inventory turnover is necessary MANAGING ACCOUNTS PAYABLE 7.1 The Economics of Taking a Trade Discount 7.2 Managing Cash Disbursements 7.3 Evaluating Account Payables Management Managing Accounts Payable Trade credit ⇒ spontaneous form of credit in which purchaser finances its purchases by delaying payments ⇒ Discount may be given by the supplier for early payment ⇒ Usually a specific time is given in which discount can be earned Inefficient payable management could be costly in terms of real and opportunity cost Company must ensure payable practice is organized, consistent and cost-effective Factors need to be taken care off while devising guidelines for managing accounts payable include; ⇒ Organization’s centralization / decentralization ⇒ Number, size & location of vendors ⇒ Trade credit, cost of borrowing ⇒ Controls of disbursement float (time for clearing a check) ⇒ Inventory management ⇒ E-commerce and electronic data interchange (electronic supply chain management) Stretching payables ⇒ extending time to pay dues during grace period provided by suppliers Careful balance is required if paying too early is costly and delaying may deteriorate company’s perceived credit-worthiness 7.1 The Economics of Taking a Trade Discount Cost of trade credit = h1 + :;< discount hlm.mn opqr stqmuo ovrwmxuy zt{vmok k − 1 − discount 2/10 net 30 ⇒ 2% discount in 10 days & net amount due on 30th day Cost of funds during discount period = 0% ⇒ beneficial to pay near to discount period’s end Customer’s short term investment rate < calculated rate ⇒ discount offers a better return over company’s short-term borrowing rate 7.2 Managing Cash Disbursements Company’s ability to delay funding bank accounts until the day checks clear Pay electronically when it is cost effective Copyright © FinQuiz.com All rights reserved 2015, Study Session # 11, Reading # 39 7.3 Evaluating Account Payables Management 4 5 6 = 78 = $$1 > %+.* 2’ > $ Comparison of no of day’s payable with credit terms is necessary Paying early ⇒ costly Paying later ⇒ deteriorating relations with suppliers In some industries no of days inventory & no of days payable are similar to one another MANAGING SHORT-TERM FINANCING 8.1 Source of Short-Term Financing 8.2 Short-Term Borrowing Approaches 8.3 Asset-Based Loans 8.4 Computing the Costs of Borrowing 8.1 Source of Short-Term Financing Panel A: Bank Source Sources / Type Users Uncommitted line Large corporations Regular line All sizes Overdraft line Rate Base Compensation Other None Mainly in U.S; limited reliability Commitment fee Common everywhere All sizes Commitment fee Mainly outside U.S Revolving credit agreement Larger corporations Commitment fee +extra fees Strongest form (primarily in U.S.) Collateralized loan Small, weak borrowers Base + Collateral Common everywhere Discounted receivables Large companies Varies Extra fees More overseas, but some in U.S Banker’s acceptances International companies Spread over commercial paper None Small volume Factoring Smaller Prime + + Service fees Special industries Prime (U.S.) or base rate (other countries), money market, LIBOR+ Panel B: Nonbank Sources Sources / Type Users Rate Base Compensation Other Nonbank finance companies Small, weak borrowers Prime + + Service fees Weak credits Commercial paper Largest corporations Money market sets rate Backup line of credit, commissions + Lowest rates for shortterm funds Copyright © FinQuiz.com All rights reserved 2015, Study Session # 11, Reading # 39 8.2 Short-Term Borrowing Approaches Effective strategy must ensure: ⇒ Sufficient capacity to handle peak cash needs ⇒ Sufficient sources to fund ongoing cash needs ⇒ Rates are cost effective Company should consider ⇒ Their size & credit-worthiness ⇒ Sufficient access ⇒ Flexibility of borrowing options Both active and passive borrowing strategies exist (Discussed earlier) 8.3 Asset-Based Loans Companies with credit quality go for secured loans (asset-based loans) Often short term assets presents a challenge for the lender due to uncertainty involved with such assets Lenders may have blanket lien ⇒ right over assets if collateral does not pay, even if it has worth (in some cases) Factorizing of accounts receivable can be used Inventory blanket lien ⇒lender can claim some or all inventory Requires company to certify that goods are segregated and sale proceeds paid to the lender Warehouse receipt arrangement ⇒ similar to above but third party overlooks inventory Cost of asset-based loans depends upon length of time it takes to sell the goods 8.4 Computing the Costs of Borrowing Cost = Interest + Commitment Fee Loan Amount If amount borrowed includes interest cost e.g bankers acceptance Cost = Interest Net Proceeds = 56 = B – In case of dealer’s fee & backup costs e.g commercial paper Cost = Interest + Dealer s commission + backup cost Loan amount − Interest Cost is usually annualized and compared Copyright © FinQuiz.com All rights reserved  ... liquidity management required ⇒ ensures solvency If liquidity management is not done ⇒ bankruptcy or possible liquidation 2.2 Measuring Liquidity 2.1 Defining Liquidity Management Ability of management. .. Levels of Inventory 6.2 Inventory Costs 6.3 Evaluating Inventory Management Managing Inventory Necessary for working capital management Careful balance is required; ⇒ more inventories can lead... Funds Management 4.1.1 Computing Yields On Short Term Investments 4.1.2 Investment Risks Investing Short-Term Funds Temporary store of funds not needed in daily transactions Extra working capital