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Optimizing Working Capital Management for Financial Success

Explore working capital management, asset financing decisions, cash budgeting strategies, and cash flow analysis in this comprehensive guide. Learn how to maintain target cash balances, reduce interest costs, and improve cash flow for your business. Understand the importance of current assets, net working capital, cash conversion cycles, and effective credit management practices. Enhance your firm's financial health by mastering the art of working capital management.

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Optimizing Working Capital Management for Financial Success

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  1. Working Capital and the Financing Decision 6

  2. Chapter Outline • Working capital management • Current asset management • Asset financing • Long-term versus short-term financing • Risk and profitability vis-à-vis asset financing • Expected value analysis may sometimes be employed

  3. CASH BUDGET • Cash Budget: A schedule showing Cash Receipts, Cash Disbursements, and Cash Balance for a firm over a specified period of time. • Target Cash Balance: The minimum cash balance a firm desires to maintain in order to conduct business. • Receipts & Disbursements Method: The net cash flow is determined by estimating the Cash Receipts & Cash Disbursements expected to be generated each period.

  4. Cash Budget & Interest Costs • The cash budget determines your future ability to pay debts & expenses. • Preliminary budget estimates may reveal that your disbursements are lumped together and that, with more careful planning, you can spread your payments to creditors more evenly throughout the entire year. As a result, need less bank credit, and interest costs will be lower.

  5. CASH BUDGET Beginning cash balance $320,000 Add: Estimated cash sales 250,000     Estimated collections on A/R 750,000  $1,320,000 Deduct: Estimated payments on A/P $ 800,000     Estimated cash expenses 150,000     Contractual payments on long-term debt 150,000 $1,100,000 Estimated ending cash balance $ 220,000

  6. Cash Budget by month ($K) CASH FLOWJAN.FEB.MAR.APR.MAYJUNE CASH RECEIPTS860838835865895874 CASH DISBURSEMENTS859825894879873862 NET CASH FLOW1 13 (59)(14)22 12 Beginning CASH200 201 214 155 141 163 Ending CASH201 214 155 141 163 175 MINIMUM CASH BAL.175 175 175 175 175 175 EXCESS (deficit)26 39 (20)(34)(12)0

  7. Monthly Cash Budget CASH FLOWJAN.FEB.MAR.APR.MAYJUNE CASH INFLOWS CASH SALES230200204220240230 AR COLLECTIONS630638631645655644 TOTAL INFLOWS860838835865895 874 CASH OUTFLOWS WAGES/SALARIES200200210212215220 AP DISBURSEMENTS550510559552543537 INTEREST5 5 5 5 5 5 OTHER DISBURSEMENTS 104 110 120 110 110 100 TOATL OUTFLOWS 859 825 894 879 873 862   NET CASH FLOW1 13 (59)(14)22 12 BEGINNING CASH BALANCE200 201 214 155 141 163 ENDING CASH BALANCE 201 214 155 141 163 175

  8. Collection on Accts. Receivable

  9. Cash Outflows (Payments)

  10. Sales Forecasts, Cash Receipts, and Payments, and Cash Budget

  11. Working Capital • A firm’s investment in Current Assets: • Cash • Marketable Securities • Inventory • Accounts Receivable

  12. Net Working Capital • Net Working Capital • = Current Assets – Current Liabilities • = Amount of Current Assets financed by Long-term Liabilities

  13. Current Assets – Current Liabilities=

  14. Working Capital Policy • Target levels for each current asset account • How current assets will be financed

  15. Not Working Capital • Current maturities of long-term debt • Financing associated with a construction program that will be funded with the proceeds of a long-term security issue after the project is completed • Use of short-term debt to finance fixed assets

  16. The Cash Conversion Cycle • The length of time from the payment for purchases of raw materials, • to manufacture a product, • until the collection of accounts receivable associated with the saleof the product.

  17. Inventory Conversion Period • Length of time required to convert Materials into Finished Goods and then sell those goods. • The amount of time the product remains in Inventory in various stages of completion. • =Inventory/Daily Cost of Goods Sold

  18. Working Capital Management • The financing and management of the current assets of a firm • Crucial to achieving long-term objectives of the firm or its failure • Requires immediate action

  19. Receivables Collection Period • Average length of time required to convert the firm’s Receivables into Cash. • Days Sales Outstanding (DSO) • =Receivables/Daily Credit Sales

  20. Payables Deferral Period • Average length of time between the Purchase of Raw Materials and Labor and the payment of cash for them. • =Accounts Payable/Daily Credit Purchases

  21. Cash Conversion Cycle • Net the three periods • Average length of time a dollar is tied up in current assets. • Cash Conversion Cycle • =Inventory Conversion Period • +Receivable Collection Period • -Payables Deferral Period

  22. Credit Management • Credit Policy: A set of decisions that include a firm’s credit standards, credit terms, methods used to collect credit accounts, and credit monitoring procedures. • Credit Standards: Standards that indicate the minimum financial strength a customer must have to be granted credit.

  23. Credit Management • Terms of Credit: • The payment conditions offered to credit customers. • Length of credit period and any cash discounts offered. • Credit Period: • The length of time which credit is granted. • After that time, the credit account is considered delinquent.

  24. Credit Management • Cash Discount: A reduction in the invoice price of goods offered by the seller to encourage early payment. • Collection Policy: • The procedures followed by a firm to collect its Accounts Receivable

  25. Credit Management Receivables Monitoring • The process of evaluating the credit policy and payment patterns to determine if a shift in the customers' payment pattern occurs or if the credit policy needs modifications.

  26. Credit Management Analyzing Proposed Changes in Credit Policy • Marginal Costs & Benefits • Change in Sales • Change in Variable Operating Costs • Change in Average Collection Period • Change in Carrying Cost of Receivables

  27. Working Capital Management • Financial manager’s most time-consuming function. • Success in managing current assets in the short run is critical for the firm’s long-run. • Nature of Asset Growth • Seasonal & Permanent increases in Working Capital must be financed.

  28. The Nature of Asset Growth • Effective current assets management requires matching of the forecasted sales and production schedules • Differences in actual sales and forecasted sales can result in: • Unexpected buildup. • Reduction in inventory, affecting receivables and cash flow • Firm’s current assets could be: • Self-liquidating • ‘Permanent’ current assets.

  29. Controlling Assets – Matching Sales and Production • Fixed assets grow slowly with: • Increase in productive capacity • Replacement of old equipment • Current assets fluctuate in the short run, depending on: • Level of production versus the level of sales • When production is higher than sales the inventory rises • When sales are higher than production, inventory declines and receivables increase

  30. Controlling Assets – Matching Sales and Production (cont’d) • Cash budgeting process • Level production method • Smooth production schedules • Use of manpower and equipment efficiently to lower cost • Match sales and production as closely as possible in the short run • Allows current assets to increase or decrease with the level of sales • Eliminates the large seasonal bulges or sharp reductions in current assets

  31. Temporary Assets under Level Production – An Example • Yawakuzi Motorcycle Company • Sales fluctuations: High sales demand during early spring and summer; sales drop during October through March • Decision: Apply level production method - 12-month sales forecast is issued • Result: Level production and seasonal sales combine to produce fluctuating inventory

  32. Yawakuzi Sales Forecast (in units)

  33. Yawakuzi’s Production Schedule and Inventory

  34. Sales Forecasts, Cash Receipts, and Payments, and Cash Budget

  35. Sales Forecasts, Cash Receipts, and Payments, and Cash Budget (cont’d) • Table 6-3 is created to examine the buildup in accounts receivable and cash • Sales forecast: Based on assumptions taken earlier (table 6-1) • Cash receipts: 50% cash collected during the month of sale and 50% pertains to the prior month • Cash budget: a comparison of cash receipt and payment schedules to determine cash flow

  36. Total Current Assets, First Year ($millions)

  37. Yawakuzi’s Nature of Asset Growth

  38. Cash Budget and Assets for II Year With No Growth in Sales ($millions) • Graphic presentation of the current asset cycle.

  39. Patterns of Financing • Selection of external sources to fund financial assets is an important decision • The appropriate financing pattern: • Matching of asset buildup and • length of financing pattern

  40. Matching Long-Term and Short-Term Needs

  41. Alternative Plans • It is important to consider other alternatives • The challenge of constructing a financial plan is to prioritize the current assets into temporary and permanent • The exact timing of asset liquidation, even in the light of ascertaining dollar amounts is onerous • It is also difficult to judge the amount of short-term and long-term financing available

  42. Long-Term Financing • Firms can be assured of having adequate capital at all times: • Use long-term capital to cover part of the short-term needs • Long-term capital can be used to finance: • Fixed assets • Permanent current assets • Part of the temporary current assets

  43. Using Long-Term Financing for Part of Short-Term Needs

  44. Short- Term Financing • Small businesses do not have total access to long-term financing • They rely on short-term bank and trade credit • Advantage: interest rates are lower • Short-term finances are used finance: • Temporary current assets • Part of the permanent working capital needs

  45. Using Short-Term Financing for Part of Long-Term Needs

  46. Term Structure of Interest Rates • A yield curve – that shows the relative level of short-term and long-term interest rates • U.S. government securities are popular as they are free of default risks • Corporate debt securities entail a higher interest rate due to more financial risks • Yield curves for both securities change daily to reflect: • Current competitive conditions • Expected inflation • Changes in economic conditions

  47. Basic Theories - Yield Curve • Liquidity premium theory • Long-term rates should be higher than short-term rates • Market segmentation theory • Treasury securities are divided into market segments by the various financial institutions investing in the market • Expectations hypothesis • Yields on long-term securities is a function of short-term rates

  48. Long- and Short-Term Annual Interest Rates • Relative volatility and the historical level of short-term and long-term rates

  49. Alternative Financing Plans • A Decision Process: Comparing alternative financing plans for working capital

  50. Impact of Financing Plans on Earnings

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