Corporate Finance - Working Capital Management

2:45 pm

Working Capital Management
Reading 40 in CFAI Materials

Liquidity - extent to which a company can meet its short term obligations

• Focus on type of asset and speed at which it can be converted to cash, either by sale or financing
• Primary sources
• Cash
• Short term funds - trade credit, bank lines, short term investments
• Cash flow mgmt - more centralized/quicker is better
• Secondary sources
• Main difference is primary source not likely to interfere with normal operations
• Renegotiating debt contracts
• Liquidating assets
• Bankruptcy protection/reorgs
• Drag and Pull
• Drag - when receipts lag
• Long AR, obsolete inventory, and tight credit are all drags
• Pull - when expenditures are sped up
• Making pmts early, reduced credit limits, limits on short term lines of credit, and low liquidity positions

Measuring liquidity

• Company's cash flows ultimately determine solvency
• Liquidity should neither be too high nor too low - too much capital in non-earning assets is not a good thing
• Current Ratio
• Current ratio = current assets / current liabilities
• Quick Ratio
• Same as above but exclude inventory
• Must compare these to comps to see what is normal
• AR Turnover
• AR Turnover = credit sales / average receivables
• Days = AR / (credit sales / 365)
• Inventory Turnover
• Inv Turnover = COGS / Avg Inventory
• Days = Inventory / (COGS / 365)
• Days Payables
• Days = AP / (Purchases / 365)
• Operating cycle = days inventory + days receivables
• Net operating cycle = days inventory + days receivables - days payables

Managing the cash position is a complex task

Measuring yields on short term investments

• Money Mkt Yield = (Face value - purchase price) / purchase price * (360 / days to maturity)
• Bond equivalent - same as above but with 365

Risks

• Credit/default risk
• Market/interest rate risk
• Liquidity - security hard to sell
• Foreign exchange risk - adverse movements in currency

Strategies

• Passive - just use a few rules.  Less agressive
• Active
• Matching - match timing of cash outflows with investment maturities
• Mismatching - more aggressive - might use derivatives
• Laddering - somewhere in between - spread investments over the term of the ladder

Accounts Receivable Management

Cash Float Factor = average daily float / (total amount of checks deposited / number of days)

• Measures how long it takes checks to clear

AR Ageing Schedule - shows how much and for how long AR have been outstanding

• Can also calculate a wtd average days receivables

Managing inventory

• Transactions motive - need inventory as part of routine production cycle
• Precautionary stocks - keep these to avoid missing out on profit opportunities (stockout losses)
• Strategy 1: Economic Order Quantity
• Reorder at a certain quantity to meet expected demand based on how long it takes to replenish
• Must have a reliable short term forecast
• Probably use a safety stock as well
• Strategy 2: Just in Time Inventory
• Minimize in process inventory stocks
• Incorporate production planning into inventory management
• Can be used in conjunction with EOQ
• Inventory costs
• Ordering, carrying/storage, stockout (lost sales), policy (gathering data)

Managing AP

• Basically two countering forces - paying too early is costly unless company can take advantage of discounts, and paying late affects the company's perceived creditworthiness

Trade discounts

• Implicit rate of return:
• cost of trade credit = (1 + (discount / (1-discount)))^(365/number of days beyond discount) - 1
• Since cost of funds is 0, it is beneficial for customer to pay at the last moment
• Ex: terms are 1/10, net 30
• Paid on 20th day:
• (1 + (0.01/(1-0.01)))^(365/10) - 1 = 44.32%
• Paid on 30th day:
• (1 + (0.01/(1-0.01)))^(365/20) - 1 = 20.13%

Managing cash disbursements

• Delay funding bank accounts until checks clear
• Checkguards against fraud
• Pay electronically

Evaluating AP Management

• Days payable = AP / average day's purchases

Managing short term financing

• Sources
• Banks - secured/unsecured loans
• Committed lines of credit - prepayable without penalty, good for 364 days 
• Revolvers - good for multiple yrs, larger amounts usually
• Short term borrowing approaches
• Consider peak cash needs
• Maintain sources so you can fund ongoing needs
• Get a good rate
• Strategies can be active or passive, just like investing strategies

Asset based loans

• Shorter term ABLs can be secured by inventory and AR - challenge for the lender
• Lenders might have blanket lien on current and future assets of company
• AR can be collateralized (company still administers collections) or factored (shift off to a third party)
• Inventory can also be a source of liquidity
• Inventory blanket lien - company can still sell in ordinary course of business
• Trust receipt arrangement - company must certify goods are held in trust, proceeds of any sale remitted to lender immediately
• Warehouse receipt arrangement - similar to above but third party supervises the inventory

Computing costs of borrowing

• Divide total cost of borrowing by amount received
• Account for any commitment fees etc.

End

4:30 pm

1.75 hrs