CHAPTER 16 Working Capital Management

1. CHAPTER 16Working Capital Management Working capital policies Cash management Inventory and A/R management Trade credit Exercises (16-1 – 16-7, page 545 – 546, Text Book)

2. Working capital terminology • Gross working capital – total current assets. • Net working capital – current assets minus current liabilities. • Working capital policy – deciding the level of each type of current asset to hold & how to finance current assets. • Working capital management – controlling cash, inventories, & A/R, plus short-term liability management.

3. 3 categories of business assets that affect a firm’s working capital policy 1) Temporary current assets - represent the lev. of inventory, cash & A/R that fluctuate seasonally. 2) Permanent current assets - represent the base level of inventory, cash & A/R, which tends to be maintained. 3) Fixed asset - represent land, building, equipments etc, would not normally be sold/otherwise disposed for a long period of time.

4. Current Assets (cash, A/R, Inventory) - do not earn the firm a very high return. - these assets are liquid, but holding them is not very profitable. • Noncurrent Assets (land, building, equipment etc) - can earn a substantial return, but they are ususally not very liquid)

5. BASIC POLICIES THAT A COMPANY CAN ADOPT: 1) Loose working capital policy - involves a relatively high level of current assets & minimizes risk - has the lowest expected return 2) Tight working capital policy - involves a relatively low level of current assets & maximizes risk. - has the highest expected return.

6. 3) Moderate working capital policy - involves a relatively moderate level of current assets between the lowest level & the highest level of working capital. - result in moderate risk & returns.

7. Working capital financing policies Aggressive approach • Use short-term financing to finance current assets. • Faces interest rates risk. • Low level of liquidity. • Low-cost financing offset the high risk.

8. Conservative approach • Use permanent capital for permanent assets and temporary assets. • Avoids s/term financing to avoid interest rate risk. • Exposed to high cost of l/term financing & high liquidity.

9. Moderate approach • Match the maturity of the assets with the maturity of the financing. • Balance risk & return tradeoff. • ‘Matching principle’ betw. aggressive & conservative.

10. Cash conversion cycle • focuses on the length of time • Between: - when a company makes payments to its creditors & - when a company receives payments from its customers.

11. Cash conversion cycle

12. Inventory Conversion Period FORMULA 1) Days per year Inventory Turnover 2) Inventory COGS per day

13. CASH • Provides margin of safety against technical insolvency, that is inability to pay debt on time. MARKETABLE SECURITIES • s/term instruments (2nd position after cash) • Can be liquidated easily • Ex: T-bills, T-notes, etc

14. Why should the firm hold cash? • Transactions - must have some cash to operate. - support day to day operation. - ex: buy raw material • Precaution – “safety stock”. - Cash inflows > cash outflows - If x, will use precautionary cash.

15. 3. Compensating balances - required by banks for loans and/or services provided. 4. Speculation – to take advantage of bargains & to take discounts. - take advantage of any good business offers that may arise.

16. The goal of cash management • To meet the above objectives, especially to have cash for transactions.

17. A/RECEIVABLES • Credit sales made by a firm. • Represent a large portion of a firm’s C/A. • Credit sales will increase the sales volume. • So, credit policy is important to determine the sles volume.

18. Average Collection Period (ACP) • To monitor firm’s receivables. • Measure the average duration of time between sales & customer payments for their credit purchases. • ACP = Receivables Average daily credit sales • Average daily credit sales = Sales 365

19. Cash budget • Forecasts cash inflows, outflows, & ending cash balances. • Used to plan loans needed or funds available to invest. • Can be daily, weekly, or monthly, forecasts. • Monthly for annual planning and daily for actual cash management.

20. Inventories 1) Raw Materials ex: crude palm oil 2) Work-in Progress ex: partially finished goods 3) Finished Goods ex: complete/ready for sales product

21. Inventory costs • Types of inventory costs 1) Carrying costs – storage and handling costs, insurance, property taxes, depreciation etc. 2) Ordering costs – cost of placing orders, shipping & handling costs.

22. 3) Costs of running short – loss of sales or customer goodwill & the disruption of production schedules. • Reducing inventory levels, generally: - reduces carrying costs, - increases ordering costs & - increase the costs of running short.

23. Elements of credit policy 1. Credit Period - How long to pay? - Shorter period reduces DSO & average A/R, but it may discourage sales. 2. Cash Discounts - Lowers price. - Attracts new customers and reduces DSO.

24. 3. Credit Standards - Tighter standards tend to reduce sales, but reduce bad debt expense. • Collection Policy - How tough? - Tougher policy will reduce DSO but may damage customer relationships.

25. Does a comp. face any risk if it tightens its credit policy? • Yes. • A tighter credit policy may discourage sales. • Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

26. Short-term credit • Debt scheduled for repayment within 1 year. • Major sources of short-term credit: • Accounts payable (trade credit) • Bank loans • Commercial loans • Accruals

27. Advantages and disadvantages of using short-term financing • Advantages • Speed • Flexibility • Lower cost than long-term debt • Disadvantages • Fluctuating interest expense • Firm may be at risk of default as a result of temporary economic conditions

28. What is trade credit? • Trade credit is credit furnished by a firm’s suppliers. • Trade credit is often the largest source of short-term credit, especially for small firms. • Easy to get, but cost can be high.

29. EXERCISES 1) Adam Corp. has RM 1,600,000 of sales, RM 200,000 of inventories, RM 150,000 of receivables & RM 100,000 of payables. Its cost of goods sold is 70% of sales. (Use a 365-day year) a) What is Adam’s cash conversion cycle (CCC)? b) If let say Adam produces 2,500 unit products per day at cost of RM 5 per unit product for materials & labour. What is the RM amount of working capital Adam must finance?

30. 2) Anaz Construction has annual sales of RM 730,000 & it has RM 100,000 of A/R. Based on a 365-day year, what is Anaz’s average collection period (DSO)?

31. 3) If Hamara Corp. borrows RM 500,000 on a 10% add-on basis, payable over 1 years in 12 equal end-of-month installments: i) how large would the monthly payments be? ii) what would the effective annual rate on this loan be?

32. 3) Dayah Trading Company is offered trade credit, terms of 2/15, net 60 to your company and your company did not have enough cash to take discount. (Use a 365-day year) i) What is the nominal and effective cost of trade credit if your company decides not to take discount?

33. SCORE A !!!!!! • Please do the exercises from your text book, Question 16-1 until 16-7.

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