FIN303 - Chap 14
FIN303 - Chap 14
FIN303 - Chap 14
WORKING CAPITAL
MANAGEMENT
FIN303 – Advanced Corporate Finance
Instructor: Do T. Thanh Huyen
Lecturer, Faculty of Business
FPT University
LEARNING OBJECTIVES
CHAPTER 14: Working Capital Management
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14.1 WORKING CAPITAL
BASICS
FIN303 – CHAPTER 14
LEARNING OBJECTIVES
1. DEFINE NET WORKING CAPITAL, DISCUSS THE
IMPORTANCE OF WORKING CAPITAL MANAGEMENT, AND
COMPUTE A FIRM'S NET WORKING CAPITAL.
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14.1 WORKING CAPITAL BASICS
purchasing
Working capital and
paying for
refers to the short-term assets necessary to raw
run a business on a day-to-day basis. materials
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14.2 THE OPERATING AND
CASH CONVERSION CYCLES
FIN303 – CHAPTER 14
LEARNING OBJECTIVES
2. DEFINE THE OPERATING AND CASH CONVERSION
CYCLES, EXPLAIN HOW THEY ARE USED, AND COMPUTE
THEIR VALUES FOR A FIRM.
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OVERVIEW
1) The firm uses cash to pay for raw
materials and the cost of
converting them into finished
goods (conversion costs),
2) Finished goods are held in
finished goods inventory until they
are sold,
3) Finished goods are sold on credit
to the firm’s customers, and finally
4) Customers repay the credit the
firm has extended them and the
firm receives the cash.
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CASH CONVERSION CYCLE
Cash conversion cycle:
This is the length of time from the point at which a
company actually pays for raw materials until the point at
which it receives cash from the sale of finished goods
made from those materials.
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OPERATING CYCLE
Operating Cycle
is the length of time it takes a company’s investment in inventory to be collected in cash from customers,
starting with the receipt of raw materials and ends with the collection of cash from customers for the sale
of finished goods made from those materials.
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FORMULA
Operating cycle = DSI + DSO (14.1)
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THE OPERATING AND CASH CONVERSION CYCLES – EXAMPLE
EXHIBIT 14.3 Time Line for Operating and Cash Conversion Cycles for Apple Inc. in 2020
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MANAGING THE CASH CONVERSION CYCLE
Financial managers generally want to achieve several goals in
managing this cycle:
Delay paying accounts payable as long as possible without suffering any penalties.
Maintain the minimum level of raw material inventories necessary to support
production without causing manufacturing delays.
Use as little labor and other inputs to the production process as possible while
maintaining product quality.
Maintain the level of finished goods inventory that represents the best trade-off
between minimizing the amount of capital invested in finished goods inventory and
the desire to avoid lost sales.
Offer customers terms on trade credit that are sufficiently attractive to support
sales and yet minimize the cost of this credit, both the financing cost and the risk of
nonpayment.
Collect cash payments on accounts receivable as quickly as possible to close the
loop.
Managing the length of the cash conversion cycle is one aspect of managing working capital to
maximize the value of the firm
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14.3 WORKING CAPITAL
MANAGEMENT STRATEGIES
FIN303 – CHAPTER 14
LEARNING OBJECTIVES
3. DISCUSS THE RELATIVE ADVANTAGES AND
DISADVANTAGES OF PURSUING (1) FLEXIBLE AND (2)
RESTRICTIVE CURRENT ASSET MANAGEMENT STRATEGIES.
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WORKING CAPITAL MANAGEMENT STRATEGIES
Flexible Current Asset Management Strategy Restrictive Current Asset Management Strategy
What is it? Current asset management strategy that involves Current asset management strategy that involves
keeping high balances of current assets on hand keeping the level of current assets at a minimum.
The flexible strategy is perceived to be a low-risk and The restrictive strategy is a high-risk high-return
low-return course of action for management. alternative to the flexible strategy. A restrictive policy
has a low percent of current assets to sales.
Advantages the large working capital balances the firm’s ability to A restrictive strategy enables the firm to invest a larger
survive unforeseen threats. fraction of its money in higher yielding assets.
Downsides The strategy’s downside is the high carrying cost The high risk comes in the form of shortage costs which
associated with owning a high level of inventory and can be either financial or operating.
providing liberal credit terms to its customers. Whereas:
Whereas: Shortage costs is costs incurred because of lost
Inventory carrying costs expenses associated with production and sales or illiquidity
maintaining inventory, including interest forgone on Financial shortage costs arise mainly from illiquidity, shortage
money invested in inventory, storage costs, taxes, and of cash, and a lack of marketable securities to sell for cash.
insurance. Operating shortage costs result from lost production and sales.
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THE WORKING CAPITAL TRADE-OFF
The optimal current assets investment strategy will depend on the relative magnitudes of carrying costs
and shortage costs. This conflict is often referred to as the working capital trade-off.
Financial managers need to balance shortage costs against carrying costs to define an optimal strategy.
Overall, management will try to find the level of current assets that minimizes the sum of the
carrying costs and shortage costs.
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14.4 ACCOUNTS RECEIVABLE
FIN303 – CHAPTER 14
LEARNING OBJECTIVES
4. EXPLAIN HOW ACCOUNTS RECEIVABLE ARE CREATED
AND MANAGED, AND COMPUTE THE COST OF TRADE
CREDIT.
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TERMS OF SALE
Terms of sale
Whenever a firm sells a product, the seller spells out the
terms and conditions of the sale in a document called the
terms of sale
Term of sale
Cash on delivery • no credit is offered. Most firms would
(COD) prefer to get cash from all sales
immediately on delivery
Credit sale • the terms of sale spell out the credit How do firms determine their terms of sale?
agreement between the buyer and seller
Factors include:
Trade credit • which is short-term financing, is typically
made with a discount for early payment
i. the industry in which the firm operates
rather than an explicit interest charge. ii. the customer’s creditworthiness
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TRADE CREDIT
In this case, the seller is offering to lend the buyer money
for an additional 30 days. How expensive is it to the buyer
to take advantage of this financing?
To calculate the cost, we need to determine the interest
rate the buyer is paying.
To find the annual interest rate, we need to compute the
effective annual interest rate (EAR)
FIN303 – CHAPTER 14
LEARNING OBJECTIVES
5. EXPLAIN THE TRADE-OFF BETWEEN CARRYING COSTS
AND REORDER COSTS, AND COMPUTE THE ECONOMIC
ORDER QUANTITY FOR A FIRM'S INVENTORY ORDERS.
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MANAGING INVENTORY
• Objective of managing inventory:
To determine and maintain the level of inventory that is sufficient to meet demand, but not more than
necessary.
• Motives for holding inventory:
Transaction motive: To hold enough inventory for the ordinary production-to-sales cycle.
Precautionary motive: To avoid stock-out losses.
Speculative motive: To ensure availability and pricing of inventory.
• Approaches to managing levels of inventory:
Economic order quantity: Reorder point—the point when the company orders more inventory, minimizing the sum of
order costs and carrying costs.
Just in time (JIT): Order only when needed, when inventory falls below a specific level
Materials or manufacturing resource planning (MRP): Coordinates production planning and inventory management.
Bottom line: The appropriateness of an inventory management system depends on the costs and benefits of
holding inventory and the predictability of sales.
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ECONOMIC ORDER QUANTITY
ECONOMIC ORDER QUANTITY
Reorder point—the point when the company orders more inventory,
minimizing the sum of order costs and carrying costs.
Assumptions:
(1) that a firm’s sales are made at a constant rate over a period,
(2) that the cost of reordering inventory is a fixed cost, regardless of the
number of units ordered, and
(3) that inventory has carrying costs, which includes items such as the cost of
space, taxes, insurance, and losses due to spoilage and theft .
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ECONOMIC ORDER QUANTITY – EXAMPLE
Suppose that Best Buy sells Hewlett-Packard color printers at the rate of 2,200 units per year. The total cost of
placing an order is $750, and it costs $120 per year to carry a printer in inventory.
a) Using the EOQ formula, what is the optimal order size?
b) What is the average inventory? If Best Buy’s buffer stock should be
i. 0 printers.
ii. 15 printers.
ADVANTAGE: DOWNSIDE:
A firm using a just-in-time system has essentially no the firm is heavily dependent on its suppliers. If a
raw material inventory costs and no risk of supplier fails to make the needed deliveries, then
obsolescence or loss to theft. production shuts down.
• When such systems work, they can reduce working capital requirements dramatically.
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14.6 CASH MANAGEMENT
AND BUDGETING
FIN303 – CHAPTER 14
LEARNING OBJECTIVES
6. DEFINE CASH COLLECTION TIME, DISCUSS HOW A FIRM
CAN MINIMIZE THIS TIME, AND COMPUTE THE ECONOMIC
COSTS AND BENEFITS OF A LOCKBOX.
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REASONS FOR HOLDING CASH
There are three main reasons for holding cash.
(1) to facilitate transactions. (2) to ensure that the firm has (3) To meet banks’ requirement
• Operational activities usually require sufficient cash • banks often require firms to hold
cash. • to make it through unexpected crises or minimum cash balances as partial
• If a firm runs out of cash, it might have to take advantage of unexpected compensation for the loans and other
to sell some of its other investments or investment opportunities. services the banks provide. These are
borrow, either of which will result in the known as compensating balances.
firm incurring transaction costs.
Note: Firms may hold more cash than required by the transaction and precautionary motives. There are two common
explanations for why firms hold excess cash.
i. Cash holdings can be used by managers to pursue their own self-interest in conflict with their stockholders.
ii. Is attributable to differences in the tax rates applied to the earnings of multinational firms.
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CASH COLLECTION
COLLECTION TIME:
is the time between when a customer makes a payment and when the cash becomes available to the firm.
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CASH COLLECTION – FORMS OF PAYMENT
Cash payments Lockboxes or Concentration Electronic funds transfers
accounts.
• Cash payments made at the point • A lockbox system allows • Electronic payments reduce cash
of sale are the simplest, with a geographically dispersed collection time in every phase.
cash collection time of zero. customers to send their payments • First, mailing time is eliminated.
• If a firm takes checks or credit to a post office box close to • Second, processing time is
cards at the point of sale, then them. reduced or eliminated, since no
mailing time is eliminated, but • A concentration account system data entry is necessary.
processing and availability replaces the post office box with • Finally, there is little or no delay
delays will still exist. a local branch of the company. in funds availability.
• With either system, mailing time is • From the firm’s point of view,
reduced because the mailing has electronic funds transfers offer a
less distance to travel and perfect solution.
availability delay is often
reduced because the checks are
more frequently drawn on local
banks.
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14.7 FINANCING WORKING
CAPITAL
FIN303 – CHAPTER 14
LEARNING OBJECTIVES
7. DESCRIBE THREE CURRENT ASSET FINANCING
STRATEGIES AND DISCUSS THE MAIN SOURCES OF SHORT-
TERM FINANCING.
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LEVEL OF WORKING CAPITAL
In order to fully understand the strategies that might be used to finance working capital, it is important to
recognize that some working capital needs are short term in nature and that others are long term, or
permanent, in nature.
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WORKING CAPITAL FINANCING STRATEGIES
Three alternative strategies for financing working capital and fixed assets are
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SHORT-TERM BANK LOANS
An informal line of credit is a verbal agreement between the firm and the bank, allowing the firm to
borrow up to an agreed-upon upper limit. In exchange for providing the line of credit, a bank may
require that the firm holds a compensating balance with them.
Example 01: Suppose Virginia City Bank requires borrowers to hold a 10 percent compensating balance
in an account that pays no interest. If the Miller Corporation borrows $120,000 from Virginia City at a 9
percent stated rate, what is the effective interest rate on the loan?
Solution:
• Miller Corp. will have to maintain a compensating balance: 0.1 × $120,000 = $12,000.
• Because Miller cannot use this money, the effective amount borrowed is equal to only:
= $120,000 − $12,000 = $108,000
• The firm’s interest expense is 0.09 × $120,000 = $10,800
Effective rate on the loan is $10,800/$108,000 = 0.1, or 10% rather than 9%
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SHORT-TERM BANK LOANS
A formal line of credit is also known as “revolving credit.” Under this type of agreement, the bank
has a contractual obligation to lend to the firm an amount of money up to a preset limit. The firm pays a
yearly fee, in addition to the interest expense on the amount they borrow.
Example 02: Higgins Ltd. has a formal credit line of $20 million for five years with First Safety Bank. The
interest rate on the loan is 6 percent. Under the agreement, Higgins has to pay 75 basis points (0.75
percent) on the unused amount as the yearly fee. Suppose Higgins borrows $4 million the first day of the
agreement.
What is the effective interest rate on the loan for the first year?
Solution:
• If Higgins does not borrow at all, it will still have to pay First Safety 0.0075 × $20,000,000 =
$150,000 for each year of the agreement.
• Suppose Higgins borrows $4 million the first day of the agreement.
• Then the fee drops to 0.0075 × ($20,000,000 − $4,000,000) = $120,000.
• Annual interest expense of 0.06 × $4,000,000 = $240,000.
Effective rate on the loan for the first year is ($240,000 + $120,000)/$4,000,000 = 0.09, or 9%
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ACCOUNTS RECEIVABLE FINANCING
For medium-size and small businesses, accounts receivable financing is an important source of funds.
Accounts receivable can be financed in two ways.
(1) Pledging
• a company can secure a bank loan by pledging (assigning) the firm's accounts receivable as security. Then, if
the firm fails to pay the bank loan, the bank can collect the cash shortfall from the receivables as they come
due. If for some reason the assigned receivables fail to yield enough cash to pay off the bank loan, the firm is
still legally liable to pay the remaining bank loan.
• During the pledging process, the company retains ownership of the accounts receivable.
(2) Factoring
• a company can sell the receivables to a factor at a discount.
• A factor is an individual or a financial institution, such as a bank or a business finance company, that buys
accounts receivable without recourse. “Without recourse” means that once the receivables are sold, the factor
bears all of the risk of collecting the money due from the receivables.
• Factoring is just a specialized type of financing. The “discount” is the factor's compensation (in the trade, it is
called a “haircut”), which typically ranges from 2 to 5 percent of the face value of the receivable sold.
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ACCOUNTS RECEIVABLE FINANCING – EXAMPLE
Problem
Kirby Manufacturing sells $100,000 of its accounts receivable to a factor at a 5 percent discount. The firm's average
collection period is one month. What is the simple annual cost of the financing provided by the factor, and what is
the effective annual loan equivalent cost?
Solution
• The discount is 5 percent, and the average collection period is one month.
Therefore, in one month, the factor should be able to collect one dollar for every 95 cents paid today.
• The dollar cost to the company of receiving cash one month earlier is 5 cents ($1 × 0.05 = $0.05), and the
amount received is 95 cents ($1 × 0.95 = $0.95).
Thus, the monthly cost is $0.05/$0.95 = 0.0526, or 5.26 percent.
• Plugging the appropriate values into Equation 6.7 and solving for the EAR yields:
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SUMMARY
SUMMARY OF KEY EQUATIONS
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PRACTICE
THANK YOU FOR YOUR
ATTENTION
Instructor: Do T. Thanh Huyen
Lecturer, Faculty of Business
FPT University
Email: HuyenDTT24@fe.edu.vn