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Reading 35: Working Capital Management (Available short-term funding…
Reading 35: Working Capital Management
Firm's liquidity
Liquidity sources
Primary source:
Cash, cash equivalents, collections, and investment income
Trade credit, bank lines of credit, and short-term investment portfolios
Sources of cash used in normal operations.
Secondary sources:
ex: asset sales, debt re-negotiation, bankruptcy reorganization.
May significantly change among firm
Factors affecting liquidity
Effectiveness of its cash flow management
Centralization of collections (decentralized account receivables are harder to collect)
Liquidity of short-term and long-term assets
Liquidity measures
Liquidity Ratios
Ability to meet short-term obligations
Current Ratio=\(\frac{Current Asset}{Current Liability}\)
Quick Ratio= \(\frac{Cash + MarketableSecurities+Receivables}{Current Liability}\)
Cash Ratio= \(\frac{Cash + MarketableSecurities}{Current Liability}\)
Working capital management
Receivable Turnover= \( \frac{Sales}{Receivables_{Avg}}\)
Days of Sales Outstanding = Days of receivables =\( \frac{365}{ReceivablesTurnover}\)
Inventory Turnover=\(\frac{CoGS}{Inventory_{Avg}}\)
Days of Inventory in hand=\( \frac{365}{InventoryTurnover}\)
Payables Turnover=\(\frac{Purchases}{TradePayables_{Avg}}\)
Payable Payment Period=\( \frac{365}{PayablesTurnover}\)
Based on operating and cash conversion
Operating cycle = Days of inventory+ Days of receivables
Net Operating Cycle = Cash Conversion Cycle = Days of inventory + Days of receivables - Days of Payables.
Operating and cash conversion cycles that are high relative to a company's peers suggest that the company has to much cash tied up
Managing Net Daily Cash
Cash flows type affecting WC
Cash inflows
Cash from subsidiaries
Cash received from security investment
Tax refunds
Borrowings
Operating receipts
Cash outflows
Purchases
Payroll
Cash transfer to subsidiaries
Interest & Principal paid on debt
Investment in securities
Taxes paid
Dividend paid
Goal: Keep enough cash for routine needs, but do not so forego interest income unnecessarily
Forecast cash inflows and outflows by type
Short-term horizon: Next few weeks
Medium-term horizon: Next 12 months
Long-term horizon: Multi-year
Short-term investment management
Measures
Money market yield =\( HPY \times \frac{360}{n}\)
Bond equivalent yield = \( HPY \times \frac{365}{n}\)
Discount basis yield =\(R_{BD}=\frac{Face.Value - Price}{Face.Value}\times \frac{360}{Days}\)
%Discount = \(\frac{Face.Value-Price}{Face.Value} \)
Holding Period Yield (HPY) = \(\frac{Face.Value-Price}{Price} \)
Objective
To earn a reasonable return while taking little credit-risk and liquidity-risk
Short-term investment policy statement should include
Purpose and objective of investment portfolio
Strategy guidelines
Types of securities
Individuals responsible for the portfolio
Corrective steps (in case of violation)
Limitations
Short-term securities
Treasury bills
Short-term federal agency securities
Bank certificates of deposit, banker's acceptances
Time deposits
Repurchase agreements
Commercial paper
Money market mutual fund
Adjustable-rate preferred stock
Weighted-Average Collection Period
Weighted-Average Collection Period
= \( \sum{Collection.Day_{Avg}\times W_{i}} \)
Average collection day: the average day to collect outstanding receivables
\( W_{i} \): The % compared to total receivables
Available short-term funding choices
Decreasing degree of credit worthiness
Commercial paper
(like treasury bill): large, strong credit
Cost of credit = \( \frac{Interest + Commission + Backup.Cost}{Net Proceed}\)
Bank lines of credit
Committed (bank have money set aside for you) : Require fee
Revolving (for large corporate): Fee, larger, strongest (U.S)
Uncommitted (like overdraft): Less reliable, no fee (U.S)
Cost of credit = \( \frac{Interest + Commitment.Fee}{Net.Proceed}\)
Collateral borrowing
Non-bank financing: Weak credit
Factoring (selling account receivables for cash) : Small users, higher fees
Bankers' acceptances
(banks as intermediaries for trade) : In import/export world
Cost of credit = \( \frac{Interest}{Net.Proceed} \)
Evaluating performance
Receivables: Trade-off between credit terms and sales
Credit term
Example: "1/10 Net 30" = If pay within 10 days, get 1% discount, else pay in full amount within 30 days
Cost of credit
= \( (1+\frac{Discount\%}{1-Discount\%})^{\frac{360}{Fully.Allowed.Payment.Day-Discount.Day}}-1\)
Inventories: Too low can lead to stock-outs, too high increases carrying costs
Payables: Early payment can take advantage of discounts but gives up potential interest costs, can damage supplier relationships