Reading 35: Working Capital Management

Firm's liquidity

Liquidity sources

Primary source:

Secondary sources:

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=CurrentAssetCurrentLiability

Quick Ratio= \(\frac{Cash + MarketableSecurities+Receivables}{Current Liability}\)

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

Cash outflows

Purchases

Payroll

Cash transfer to subsidiaries

Interest & Principal paid on debt

Investment in securities

Taxes paid

Dividend paid

Short-term investment management

Measures

Money market yield =\( HPY \times \frac{360}{n}\)

Bond equivalent yield = \( HPY \times \frac{365}{n}\)

Discount basis yield =\(R_{BD}=\frac{Face.Value - Price}{Face.Value}\times \frac{360}{Days}\)

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)

Weighted-Average Collection Period

Available short-term funding choices
Decreasing degree of credit worthiness

Commercial paper

Bank lines of credit

Collateral borrowing

Non-bank financing: Weak credit

Factoring (selling account receivables for cash) : Small users, higher fees

Cash, cash equivalents, collections, and investment income

Trade credit, bank lines of credit, and short-term investment portfolios

ex: asset sales, debt re-negotiation, bankruptcy reorganization.

May significantly change among firm

Sources of cash used in normal operations.

Cash Ratio= \(\frac{Cash + MarketableSecurities}{Current Liability}\)

Operating receipts

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 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

%Discount = \(\frac{Face.Value-Price}{Face.Value} \)

Holding Period Yield (HPY) = \(\frac{Face.Value-Price}{Price} \)

Limitations

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

Evaluating performance

Receivables: Trade-off between credit terms and sales

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

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)

Bankers' acceptances

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 = \( (1+\frac{Discount\%}{1-Discount\%})^{\frac{360}{Fully.Allowed.Payment.Day-Discount.Day}}-1\)

Cost of credit = \( \frac{Interest + Commitment.Fee}{Net.Proceed}\)

(banks as intermediaries for trade) : In import/export world

Cost of credit = \( \frac{Interest}{Net.Proceed} \)

(like treasury bill): large, strong credit

Cost of credit = \( \frac{Interest + Commission + Backup.Cost}{Net Proceed}\)