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CHAPTER 22

CHAPTER 22. Working Capital Management. Topics in Chapter. Alternative working capital policies Cash, inventory, and A/R management Accounts payable management Short-term financing policies Bank debt and commercial paper. Definitions. Working capital management:

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CHAPTER 22

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  1. CHAPTER 22 Working Capital Management

  2. Topics in Chapter • Alternative working capital policies • Cash, inventory, and A/R management • Accounts payable management • Short-term financing policies • Bank debt and commercial paper

  3. Definitions • Working capital management: Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable. • Working capital policy: • The level of each current asset. • How current assets are financed.

  4. Cash Conversion = Cycle Inventory Conversion + Period Receivables Collection - Period Payables Deferral . Period Cash Conversion Cycle The cash conversion cyclefocuses on the time between payments made for materials and labor and payments received from sales:

  5. CCC = + – CCC = + 45.6 – 30 CCC = 75.7 + 45.6 – 30 CCC = 91.3 days. Payables deferral period Days per year Inv. turnover Days sales outstanding 365 4.82 Cash Conversion Cycle (Cont.)

  6. Cash Management: Cash doesn’t earn interest, so why hold it? • Transactions: Must have some cash to pay current bills. • Precaution: “Safety stock.” But lessened by credit line and marketable securities. • Compensating balances: For loans and/or services provided. • Speculation: To take advantage of bargains, to take discounts, and so on. Reduced by credit line, marketable securities.

  7. What’s the goal of cash management? • To have sufficient cash on hand to meet the needs listed on the previous slide. • However, since cash is a non-earning asset, to have not one dollar more.

  8. Ways to Minimize Cash Holdings • Use lockboxes. • Insist on wire transfers from customers. • Synchronize inflows and outflows. • Use a remote disbursement account. (More…)

  9. Minimizing Cash (Continued) • Increase forecast accuracy to reduce the need for a cash “safety stock.” • Hold marketable securities instead of a cash “safety stock.” • Negotiate a line of credit (also reduces need for a “safety stock”).

  10. What are some other potential cash inflows besides collections? • Proceeds from fixed asset sales. • Proceeds from stock and bond sales. • Interest earned. • Court settlements.

  11. Inventory Management: Categories of Inventory Costs • Carrying Costs: Storage and handling costs, insurance, property taxes, depreciation, and obsolescence. • Ordering Costs: Cost of placing orders, shipping, and handling costs. • Costs of Running Short: Loss of sales, loss of customer goodwill, and the disruption of production schedules.

  12. Elements of Credit Policy • Cash Discounts: Lowers price. Attracts new customers and reduces DSO. • Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. (More…)

  13. Credit Policy (Continued) • Credit Standards: Tighter standards reduce bad debt losses, but may reduce sales. Fewer bad debts reduces DSO. • Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships.

  14. Is there a cost to accruals? Can firms control accruals? • Accruals are free in that no explicit interest is charged. • Firms have little control over the level of accruals. Levels are influenced more by industry custom, economic factors, and tax laws.

  15. 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. • Spontaneous, easy to get, but cost can be high.

  16. Working Capital Financing Policies • Moderate: Match the maturity of the assets with the maturity of the financing. • Aggressive: Use short-term financing to finance permanent assets. • Conservative: Use permanent capital for permanent assets and temporary assets.

  17. $ Temp. NOWC } S-T Loans L-T Fin: Stock & Bonds, Perm NOWC Fixed Assets Years Lower dashed line, more aggressive. Moderate Financing Policy

  18. $ Marketable Securities Zero S-T debt L-T Fin: Stock & Bonds Perm NOWC Fixed Assets Years Conservative Financing Policy

  19. What are the advantages of short-term debt vs. long-term debt? • Low cost-- yield curve usually slopes upward. • Can get funds relatively quickly. • Can repay without penalty.

  20. What are the disadvantages of short-term debt vs. long-term debt? • Higher risk. The required repayment comes quicker, and the company may have trouble rolling over loans.

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