Chapter 5

1. Chapter 5 Cash and Working Capital Management

2. Learning Objectives At the end of this chapter, you should be able to: • Explain working capital and the cash conversion cycle • Describe motives for holding cash • Describe and analyse the different mechanisms for managing the firm’s cash collection and disbursement procedures • Identify and compute inventory management costs • Apply inventory management models to optimize the firm’s inventory

3. Learning Objectives (cont.) • Explain the reasons for granting credit • Evaluate credit granting decisions • Describe important accounts receivable management tools • Describe the mechanics of different types of short-term borrowings and evaluate their costs

4. Introduction • Working capital comprises of current assets minus its current liabilities • Current assets comprise….. • Current liabilities…….. • WC=CA - CL

5. Introduction (cont.) • Working capital management involves all aspects of the administration of current assets and current liabilities. • Working capital management, hence, covers (but is not limited to) several basic relationships: • Sales impact—must determine the appropriate levels of receivables and inventories to maintain • Liquidity—must choose the levels of cash and marketable securities to maintain

6. Introduction (cont.) • Relations with stakeholders—customers are concerned with price, availability, quality and service, goodwill and reputation of a firm. On the opposite end, the firms would also have similar concerns about its suppliers • Firm’s reputation depends on its ability to efficiently manage its current assets and current liabilities

7. Guiding Principles about Working Capital Finance • Risk return trade-off

8. Financing Working Capital • Three (3) approaches may be adopted: i) Maturity-matching approach ii) Conservative approach iii) Aggressive approach

9. Maturity-matching Approach • Hedge risk by matching the maturities of assets and liabilities. • Permanent current assets are financed with long-term financing, while temporary current assets are financed with short-termfinancing. • There are no excessfunds.

10. Temporary current asset: A subset of a company's current assets that changes according to seasonal fluctuations. For example, a retail store's current inventory may include holiday decorations around Christmas. These decorations would be temporary assets with respect to the remainder of the store's inventory. • Permanent current asset: The current assets a firm needs in order to continue operations. Examples depreciatingassets such as computers. These assets are current because they do not remain assets for longer than a year, but they are permanent because they must be replaced with similar assets.

11. Conservative Approach • Long-term funds are used to finance both permanent as well as some temporary short-term assets. • When there areexcess funds,they are investedin marketablesecurities.

12. Aggressive Approach • Use less long-term and more short-term financing than the conservative approach.

13. Cash Management Cycle • Overall measure of effectiveness in managing net working capital. • Main objective is to minimize working capital subject to the constraint that there should be adequate working capital to support the firm’s operations

14. Cash Conversion Cycle

15. Inventory Inventory conversion period = X 365 days Cost of goods sold • Debtors’/ac receivables collection period is the number of days for debtors to pay from time of sale: Receivables Debtors' collection period = X 365 days Sales Cash Conversion Cycle (cont.) • Inventory conversion period is the average time between purchasing inventories and selling the goods:

16. Accounts payable Payables credit period = X 365 days Cost of goods sold Cash Conversion Cycle • Creditors’/ac payables credit period is the number of days from the time of purchase of materials and labour for goods and the time of payment: • Refer to Example 5.1 of textbook for illustration.

17. Cash Budget • Detailed plan of a firm’s future cash flows • An estimation of the cash inflows and outflows for a firm for a specific period of time in the future • Assess whether it has sufficient cash to fulfil its cash flow requirements in the future and whether excess cash exists • 3 main components necessary for creating a cash budget: i) Time period ii)Desired cash position iii)Estimated sales and expenses

18. General Format of Cash Budget

19. Reasons for Holding Cash • Transactions—the need for cash make everyday payments • Precautionary—the need to have cash on hand to meet unexpected needs or unforeseen expenses • Speculative—based on the desire to take advantage of potential profit-making opportunities that require cash

20. Transaction Demand Models Baumol Model • The firm can predict its cash requirements with certainty • Cash disbursements are spread uniformly over the period • Interest rate or opportunity cost of funds (holding cash) is fixed at all times, represented by ‘K’ • Firm pays fixed transaction cost each time it converts securities to cash, represented by ‘F’

21. Baumol Model

22. Baumol Model (cont.) • Optimal deposit size

23. Miller-Orr Cash Model

24. Inventory Management • Inventory management ensures that firms have sufficient inventory for production and for sale to customers. • Manufacturing firms carry three types of inventories: i) Raw materials ii) Work in progress iii) Finished goods

25. Economic Order Quantity (EOQ) • Total inventory costs = Total carrying costs + Total ordering costs • Average inventory = Q/2

26. Economic Order Quantity (EOQ) (cont.)

27. Reorder Point • Reorder point = Expected lead time + Safety stock

28. Debtors • Sales on credit terms to customers give rise to debtors (accounts receivables) • Level of debtors is determined by the level of sales and credit and collection policies of the firm Credit Terms • Conditions as agreed in the contractual agreement between the supplier and the customer pertaining to the credit granted to customer • Interpretation of ‘3/10, net 30’

29. Debtors (cont.) Credit standards • The criteria to assess customers and determine the amount of credit and extent of credit period to be granted to debtors Sources of credit information Internal sources include: • Credit application, including referees • Customer’s past history, especially the payment history • Information and input from the firm’s sales and accounting department staff

30. Debtors (cont.) Sources of credit information External sources of information include: • Recent years’ financial statements (typically the last three most recent years)—review of customer’s profitability, financial standing, debt obligations and liquidity • Reports from credit rating agencies e.g. Ratings Agency Malaysia • Credit bureau reports—Central Credit Reference Information System (CCRIS)

31. Debtors (cont.) Five C’s of credit • Character—the commitment to meet credit obligations • Capacity—the ability to meet credit obligations with current income • Capital—the ability to meet credit obligations from existing assets if necessary • Collateral—refers to the security that underlies assets if necessary • Conditions—includes consideration of general and industry economic conditions

32. Credit-scoring Models • Credit-scoring models involve the numerical evaluation of customers using scientific approaches. • Score is a number that lenders use to determine the credit risk. • Calculation is based on a mathematical equation that evaluates information in the credit file and compares it to the patterns in millions of other credit files.

33. Credit-scoring Models (cont.) • Multi-discriminant analysis (MDA) • Z-score ≥ 3.0: Firm is safe based on these financial figures only • Z-score between 2.7 and 2.99: On alert—should exercise caution

34. Credit-scoring Models (cont.) • Z-score between 1.8 and 2.7: Good chance of the company going bankrupt within 2 years of operations from the date of financial figures given • Z-score below 1.80: Probability of bankruptcy is very high

35. Other Credit Decisions Delinquent credit accounts • Letter or statement • Telephone • Personal visits to customers’ premises • Collection agencies • Legal proceedings

36. Other Credit Decisions (cont.) Changing credit policy • Credit policy changes involves altering the terms, standards or collection practices • Typical way to evaluate the net benefit of changing a credit policy is via the use of the incremental analysis • Refer to textbook—page 108 & 109

37. Other Credit Decisions (cont.) Using Accounts Receivable as Collateral • Accounts receivables (debtors) may be used as collateral to raise short-term financing • The accounts receivable is pledged by the firm as collateral to the lender. • The amount of the loan is a percentage of the receivables pledged.

38. Other Credit Decisions (cont.) Factoring Accounts Receivable • Factoring is where a firm sells its debtors at a discount • Involves raising funds against the security of the firm’s trade debts • Basic services are offered: • Sales ledger accounting, involving invoicing and collecting debts; • Credit insurance, which guarantees against bad debts; • Provision of finance

39. Other Credit Decisions (cont.) Factoring Accounts Receivable (cont.) • 2 types of factoring service—Non-recourse factoring and Recourse factoring • Non-recourse factoring is where the factoring company purchases the debts without recourse to the firm selling its accounts receivable. • Recourse factoring, on the other hand, is where the business takes the bad debt risk. • Factoring also provides additional services such as: • Administration of a firm’s invoicing • Accounts maintenance • Debt collections service

40. Marketable Securities • Malaysian Government raises short-term financing through the issue of marketable debt instruments. • Forms of Government securities that are available in Malaysia are: • Malaysian Government Securities (MGS) • Malaysian Treasury Bills (MTB) • Government Investment Issues (GII) • Malaysian Islamic Treasury Bills (MITB)

41. Marketable Securities (cont.) • Repurchase Agreements • Banks sell market instruments to investors and buy back those instruments later • Firms can invest in these securities for short periods, ranging from one day to one year • Negotiable Certificate of Deposits • Receipts certifying that monies have been deposited in a bank issuing the certificate • Represent high quality financial asset; fetches higher yield than the comparable time deposit and treasury bills

42. Marketable Securities (cont.) • Banker’s Acceptance • Short-term credit investments created by other firms and guaranteed by a bank • Commercial Paper • Short-term unsecured debts issued by firms

43. Trade Creditors Management of trade creditors involves: • Attempting to obtain satisfactory credit from suppliers/creditors • Attempting to extend credit during periods of cash shortage • Maintaining good relations with regular and important suppliers

44. Trade Creditors (cont.) Source of Short-term Finance • Represents another source of short-term finance as firms make use of short-term trade credit offered by supplier • Trade credit will have a cost • Firms may be offered discount for early payment • Finance managers therefore face whether to accept the suppliers’ discount offer for early payment or to forego the discount (and make use of the credit period).

45. Trade Creditors (cont.) Costs of foregoing early discount: • Estimated using annual percentage rate (APR) or annual percentage yield (APY) • See Example 5.5 in textbook.

46. Other Forms of Short-term Financing Bank Overdraft • Standby cash flow to cover a firm’s daily working capital requirement • Provided by banks • Firms can withdraw funds from the Current Account in excess of the credit balance up the approved limit set by the bank • Interest Rate = Base Lending Rate (BLR) + Spread

47. Other Forms of Short-term Financing (cont.) Trust Receipts • Used by a firm (also know as ‘buyer’) to finance local purchases and importation of goods • Document executed by a customer (pledger of goods or documents of title) • Goods released to the firm by the bank, so that the firm may sell the goods and pay the proceeds from the sale to the bank • Upon receipt of the TR document, the bank will lend the firm funds to pay the trade creditors/suppliers for the goods purchased.

48. Other Forms of Short-term Financing (cont.) Banker’s Acceptance • Issuance bill of exchange drawn by a firm to its order, and accepted by the bank, and payable on a specified date • Another form of short-term financing that allows firms to take delivery of goods from the suppliers faster to meet market demands • In the case of the firm that is a seller/exporter, it can arrange for BA for its customers so that it can have access to immediate funds for working capital.

49. Other Forms of Short-term Financing (cont.) Letter of Credit • Undertaking by the bank, acting in accordance with the instructions of the borrower, to pay a stipulated amount of money stated in the letter of credit to a named beneficiary against presentation of stipulated documents and in full compliance of the terms and conditions of the credit. • LC issued by bank to the suppliers acts as a form of guaranteed payment. The supplier will be able to collect the payment when all conditions of the LC are met.

50. Other Forms of Short-term Financing (cont.) Letter of Credit Types of LCs available include: • Irrevocable LCs—such LCs cannot be amended and not cancelled without the agreement of all parties to the LC • Standby LCs—funded only if the buyer does not pay the seller as agreed upon • Revolving LCs—used for regular shipments of the same commodity to the same customer (importer). This means that a credit facility is set up with the LC balances drawn down against the credit facility balance