Working Capital Management PDF

BM2213 WORKING CAPITAL MANAGEMENT Overview of Working Capital Working capital, also known as net working capital (NWC), is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills), and inventories of raw m...

BM2213 WORKING CAPITAL MANAGEMENT Overview of Working Capital Working capital, also known as net working capital (NWC), is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills), and inventories of raw materials and finished goods and its current liabilities, such as accounts payable. Net operating working capital is a measure of a company's liquidity and refers to the difference between operating current assets and operating current liabilities. In many cases, these calculations are the same and are derived from company cash plus accounts receivable plus inventories, less accounts payable, and less accrued expenses (Kelton, 2019). 𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 Working capital originated with the old Yankee peddler, who would load up his wagon and go off to peddle his wares. The merchandise was called “working capital” because it was what he sold or “turned over” to produce his profits. The wagon and horse were his fixed assets. He generally owned the horse and wagon (so they were financed with “equity” capital), but he bought his merchandise on credit (that is, by borrowing from his supplier) or with money borrowed from a bank. Those loans were called working capital loans, which had to be repaid after each trip to demonstrate that the peddler was solvent and worthy of a new loan. Banks that followed this procedure were said to employ “sound banking practices.” The more trips the peddler took per year, the faster his working capital turned over and the greater his profits (Brigham & Houston, 2022). Current Assets Investment Policies If the probability is concerned, it is merely affected by the current assets held. The DuPont equation can be used to demonstrate how working capital management affects the Return on Equity (ROE): 𝑅𝑂𝐸 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 = × × 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 In terms of the size of current asset holdings, there are three (3) alternatives policies: Relaxed Investment Policy – The condition where relatively large amounts of cash, marketable securities, and inventories are carried, and a liberal credit policy results in a high level of receivables. The relaxed policy minimizes such operating problems but results in a low turnover, which in turn lowers ROE. The moderate policy falls between the two (2) extremes. The optimal strategy is the one that maximizes the firm’s long-run earnings and the stock’s intrinsic value. Restricted Investment Policy – The condition where cash holdings, marketable securities, inventories, and receivables are constrained. A restricted (lean-and-mean) policy indicates a low level of assets (hence, a high total asset turnover ratio), which results in a high ROE, other things held constant. However, this policy also exposes the firm to risks because shortages can lead to work stoppages, unhappy customers, and serious long-run problems. Moderate Investment Policy – The investment policy between relaxed and restricted policies. Note that changing technologies can lead to changes in the optimal policy. For example, when a new technology makes it possible for a manufacturer to produce a given product in five (5) rather than 10 days, work-in-progress inventories can be cut in half. Similarly, retailers typically have inventory management systems in which bar codes on all merchandise are read at the cash register. This information is transmitted electronically to a computer that records the remaining stock of each item, and the computer automatically places an order with 11 Handout 1 *Property of STI  [email protected] Page 1 of 6  BM2213 the supplier’s computer when the stock falls to a specified level. This process lowers the “safety stocks” that would otherwise be necessary to avoid running out of stock, which reduces inventories to profit-maximizing levels (Brigham & Houston, 2022). Current Assets Financing Policies Investments in current assets must be financed, and the primary sources of funds include bank loans, credit from suppliers (accounts payable), accrued liabilities, long-term debt, and common equity. Each source has advantages and disadvantages, so each firm must decide which sources are best for its situation (Brigham & Houston, 2022). Every business can experience seasonal and/or cyclical fluctuations like construction firms that tend to peak in the summer, retailers peak around Christmas, and the manufacturers who supply construction companies and retailers follow related patterns. Similarly, sales of all businesses increase when the economy is strong; hence, each build-up current assets at times but lets inventories and receivables fall when the economy weakens Though current assets rarely drop to zero, companies maintain some permanent current assets, which are the current assets needed at the low point of the business cycle. These are the current assets a firm must carry even at the trough of its cycles. Then as sales increase during an upswing, current assets are increased, and these extra current assets are defined as temporary current assets as opposed to permanent current assets. These are the current assets that fluctuate with seasonal or cyclical variations in sales. The way these types of current assets are financed is called the firm’s current assets financing policy. a. Maturity Matching, or “Self-Liquidating,” Approach The maturity matching or “self-liquidating” approach is a financing policy that matches the maturities of assets and liabilities. This is a moderate policy. All the fixed and permanent current assets are financed with long-term capital, but temporary current assets are financed with short-term debt. Inventory expected to be sold in 30 days would be financed with a 30-day bank loan; a machine expected to last for five (5) years would be financed with a 5-year loan; a 20-year building would be financed with a 20-year mortgage bond; and so forth (Brigham & Houston, 2022). Factors that prevent an exact maturity matching: 1. There is uncertainty about the lives of assets. 2. Some common equity must be used, and common equity has no maturity. Still, when a firm attempts to match asset and liability maturities, this is defined as moderate current assets financing policy. b. Aggressive Approach Aggressive financing policy relies more on short-term and long-term sources of finance. It is termed an aggressive policy because it is riskier as it involves the continuous renewal of the borrowing. In this policy, the firm finances its permanent current assets using short-term sources of finance (Borad, 2022). c. Conservative Approach An organization’s attempt to match assets with liabilities is not always possible. In such situations, the business uses a conservative financing policy. In this policy, the firm uses more long-term sources of finance and less short-term finance to purchase its assets. The business acquires permanent and current assets using long-term sources of finances. Only a part of short-term finance is used to finance its temporary current assets (Borad, 2022). 11 Handout 1 *Property of STI  [email protected] Page 2 of 6  BM2213 The Cash Conversion Cycle All firms follow a “working capital cycle” in which they purchase or produce inventory, hold it for a time, sell it and receive cash. This process is known as the cash conversion cycle (CCC). According to Hayes (2022), the cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales. Computing the Targeted CCC Assume that Great Fashions Inc. (GFI) is a start-up business that buys ladies’ golf outfits from a manufacturer in the Philippines and sells them through pro shops at high-end golf clubs in the United States, Canada, and Mexico. The company’s business plan calls for purchasing P5,500,000 in merchandise at the start of each month and having the merchandise sold within 60 days. The company will have 40 days to pay its suppliers and give its customers 60 days to pay for their purchases. GFI expects to break even during its first few years, so its monthly sales will be P5,500,000, the same as its purchases. Any funds required to support operations will be obtained from the bank, and those loans must be repaid as soon as cash is available. The following information can be used (Brigham & Houston, 2022): 1. Inventory conversion period. It is the average time required to convert raw materials into finished goods and sell them. For GFI, this is the 60 days it takes to sell the merchandise. 2. Average collection period (ACP). It is the average time required to convert the firm’s receivables into cash, that is, to collect cash following a sale. It can be described as the length of time given to customers to pay for goods following a sale. The ACP is also called the days' sales outstanding (DSO). GFI’s business plan calls for an ACP of 60 days, which is consistent with its 60-day credit terms. 3. Payables deferral period. It is the average time between the purchase of materials and labor and the payment of cash. For example, this is the time that suppliers give GFI to pay for its purchases (40 days in our example). On Day 1, GFI buys merchandise, expects to sell the goods, and thus converts them to accounts receivable in 60 days. It should take another 60 days to collect the receivables, totaling 120 days between receiving the merchandise and collecting cash. However, GFI can defer its payments for only 40 days. Combining these periods can result in the planned cash conversion cycle: Finish Goods and Sell Them Inventory Average Conversion Collection Period (60 days) Period (60 days) Payables Cash Deferral Conversion Period (40 days) Period (80 days) Receive Materials Pay cash for Days colllect cash for purchased materials Accounts Receivable Inventory Average Payables CASH Conversion + collection - deferral = CONVERSION period period period CYCLE 60 + 60 - 40 = 80 days 11 Handout 1 *Property of STI  [email protected] Page 3 of 6  BM2213 Although GFI must pay P5,500,000 to its suppliers after 40 days, it will not receive any cash until 120 days into the cycle. Therefore, GFI will have to borrow the P5,500,000 cost of the merchandise from its bank on Day 40, and it will not be able to repay the loan until it collects from customers on Day 120. Thus, for 80 days, CCC will owe the bank P5,500,000 and pay interest on this debt. The shorter the cash conversion cycle, the better because that will lower interest charges. If GFI could sell goods faster, collect receivables faster, or defer its payables longer without hurting sales or increasing operating costs, its CCC would decline, and its interest expense would be reduced. Its profits and stock price would be improved. Computing the CCC from Financial Statements In practice, CCC was calculated based on the firm’s financial statements. Moreover, the actual CCC would almost certainly differ from the theoretically forecasted value because of real-world complexities such as shipping delays, sales slowdowns, and customer delays in making payments (Brigham & Houston, 2022). To compute CCC in a real context, assume that GFI has been in business for several years and is now in a stable position, placing orders, generating sales, collecting cash receipts, and paying vendors regularly. The following data were taken from GFI’s latest financial statements: Annual Sales P 66,916,630 Cost of Goods Sold 55,763,895 Inventory 13,750,000 Accounts Receivable 16,500,000 Accounts Payable 8,250,000 First, compute the inventory conversion period: 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 13,750,000 13,750,000 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 = = = = 𝟗𝟎 𝒅𝒂𝒚𝒔 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝑝𝑒𝑟 𝐷𝑎𝑦 ( 55,763,895 152,777.79 ) 365 Thus, it takes GFI an average of 90 days to sell its merchandise, not the 60 days called for in its business plan. Note also that inventory is carried at cost, so the denominator of the equation is the cost of goods sold, not sales (Brigham & Houston, 2022). Next, the average collection period (or DSO) is calculated: 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 16,500,000 16,500,000.00 𝐴𝐶𝑃 (𝑜𝑟 𝐷𝑆𝑂) = = = = 𝟗𝟎 𝒅𝒂𝒚𝒔 𝑆𝑎𝑙𝑒𝑠 66,916,630 183,333.23 ( 365 ) ( 365 ) Note that it takes GFI 90 days after a sale to receive cash, not the 60 days called for in its business plan. Because receivables are recorded at the sales price, annual sales were used rather than the cost of goods sold in the denominator. The payables deferral period is found as follows, again using the cost of goods sold in the denominator because payables are recorded at a cost: 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 8,250,000 8,250,000 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝐷𝑒𝑓𝑒𝑟𝑟𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑 = = = = = 54 𝑑𝑎𝑦𝑠 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 ) (55,763,895) 152,777.79 365 365 GFI is supposed to pay its suppliers after 40 days, but it is a slow payer, delaying payment on average until Day 54. GFI’s actual cash conversion cycle (CCC) is computed as follows: 𝐶𝐶𝐶 = 90 𝑑𝑎𝑦𝑠 + 90 𝑑𝑎𝑦𝑠 − 54 𝑑𝑎𝑦𝑠 = 𝟏𝟐𝟔 𝒅𝒂𝒚𝒔 11 Handout 1 *Property of STI  [email protected] Page 4 of 6  BM2213 GFI’s actual 126-day CCC is quite different from the planned 80 days. It takes longer than planned to sell merchandise, customers don’t pay as quickly as they should, and GFI pays its suppliers slower than it should. The result is a CCC of 126 days versus the planned 80 days. Although the scheduled 80-day CCC is “reasonable,” the actual 126 days is too high. The CFO should push salespeople to speed up sales and the credit manager to accelerate collections. Also, the purchasing department should try to get longer payment terms. If GFI could take those steps without hurting its sales and operating costs, the firm would improve its profits and stock price (Brigham & Houston, 2022). The Cash Budget Firms forecast cash flows in case they need additional cash; funds must be lined up well in advance. On the other hand, if a company would like to generate surplus cash, it should plan its productive use. The primary forecasting tool is the cash budget, which is a table that shows cash receipts, disbursements, and balances over some period (Brigham & Houston, 2022). Cash budgets can be of any length, but firms typically develop a monthly cash budget for the coming year and a daily cash budget at the start of each month. The monthly budget is good for annual planning, while the daily budget gives a more precise picture of the actual cash flows and is good for actual scheduling payments daily. The cash budget begins with a monthly sales forecast and a projection of when actual collections will occur. Then there is a forecast of materials purchases, followed by forecasted payments for materials, labor, leases, new equipment, taxes, and other expenses. When the forecasted payments are subtracted from the forecasted collections, the result is the expected net cash gain or loss for each month. This gain or loss is added to or subtracted from the beginning cash balance, and the result is the amount of cash the firm would have on hand at the end of the month if it were neither borrowed nor invested (Brigham & Houston, 2022). To illustrate, Table 1 presents a company’s cash budget. The illustration shows semi-annual financial information. The company sells mainly to grocery chains, and its projected sales are 3,300,000,000. As Table 1 shows, sales increase during September and then decline during December. All sales are on terms of 2/10, net 30, meaning that a 2% discount is allowed if payment is made within 10 days. But if the discount is not taken, the full amount is due in 30 days. However, like most companies, some customers pay late. Experience shows that 20% of customers pay during the month of the sale - these are the discount customers. Another 70% pay during the month immediately following the sale, and 10% are late, paying in the second month after the sale. The information in Table 1 was used to forecast the monthly cash surpluses or shortfalls from July through December, along with the amount that the company will need to borrow or will have available to invest in keeping the end-of-month cash balance at the target level. Inputs used in the forecast are assumptions that may not be correct. References Borad, S. B. (2022, May 14). Financing policy. Retrieved from eFinance Management: https://efinancemanagement.com/financial-management/financing-policy Brigham, E. F., & Houston, J. F. (2022). Fundamentals of financial management. Cengage Learning, Inc. Hayes, A. (2022, June 15). Cash conversion cycle - CCC definition. Retrieved from Investopedia: https://www.investopedia.com/terms/c/cashconversioncycle.asp Kelton, W. (2019, September 19). Working Capital (NWC). Retrieved from Investopedia: https://www.investopedia.com/terms/w/workingcapital.asp 11 Handout 1 *Property of STI  [email protected] Page 5 of 6  Table 1. Cash Budget INPUT DATA Collections during month of sale 20% Assumed constant. Don't change 11 Handout 1 Collections during 1st month after sale 70% Assumed constant. Don't change Collections during 2nd month after sale 10% Equal to 100% - (20% + 70%) - Bad debt % Can Percent bad debts 0% change to see effects Discount on first month collections 2% Can change to see effects Purchases as a % of next month's sales 70% Can change to see effects Lease payments 15,000,000 Can change to see effects  [email protected] Construction cost for new plant (Oct) 100,000,000 Can change to see effects Target cash balance 10,000,000 Can change to see effects Sales adjustment factor (change from base) 0% % increase or decrease from base to see effects THE CASH BUDGET May June July Aug. Sept. Oct. Nov. Dec. Sales (Gross) 200,000,000 250,000,000 300,000,000 400,000,000 500,000,000 350,000,000 250,000,000 200,000,000 Collections During month of sale: 0.2(Sales)(0.98) 58,800,000 78,400,000 98,000,000 68,600,000 49,000,000 39,200,000 During 1st month after sales: 0.7(prior month's sales) 175,000,000 210,000,000 280,000,000 350,000,000 245,000,000 175,000,000 During 2nd month after sales: 0.1(sales 2 months ago) 20,000,000 25,000,000 30,000,000 40,000,000 50,000,000 35,000,000 Total Collections 253,800,000 313,400,000 408,000,000 458,600,000 344,000,000 249,200,000 Purchases: 70% of next months sales 210,000,000 280,000,000 350,000,000 245,000,000 175,000,000 140,000,000 Payments: Payment for materials: Last month's purchases 210,000,000 280,000,000 350,000,000 245,000,000 175,000,000 140,000,000 Wages and Salaries 30,000,000 40,000,000 50,000,000 40,000,000 30,000,000 30,000,000 Lease payments 15,000,000 15,000,000 15,000,000 15,000,000 15,000,000 15,000,000 Other expenses 10,000,000 15,000,000 20,000,000 15,000,000 10,000,000 10,000,000 Taxes 30,000,000 20,000,000 Payment for plant construction 100,000,000 Total Payments 265,000,000 350,000,000 465,000,000 415,000,000 230,000,000 215,000,000 Net Cash Flows: Net cash flow (NCF) for month: (Total Collections - Total Payments) (11,200,000) (36,600,000) (57,000,000) 43,600,000 114,000,000 34,200,000 Cumulative NCF: Prior month's cum. NCF plus this month;s NCF (11,200,000) (47,800,000) (104,800,000) (61,200,000) 52,800,000 87,000,000 Cash Surplus (or Loan Requirement) Target Cash Balance 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 Surplus cash (or loan needed): Cumulative NCF - Target cash balance (21,200,000) (57,800,000) (114,800,000) (71,200,000) 42,800,000 77,000,000 Maximum required loan (114,800,000) Maximum available for investment 77,000,000 *Property of STI Page 6 of 6 BM2213