Effective Working Capital Management Strategies
"Learn about the components of working capital and how to manage cash, inventory, receivables, and payables effectively. Understand the cash cycle of a firm and calculate the cash conversion cycle. Explore trade credit and cash management techniques for optimal financial performance."
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Chapter 19 Working Capital Management
Chapter Outline 19.1 Overview of Working Capital 19.2 Trade Credit 19.3 Receivables Management 19.4 Payables Management 19.5 Inventory Management 19.6 Cash Management
Learning Objectives Understand the cash cycle of the firm and why managing working capital is important Use trade credit to the firm s advantage Make decisions on extending credit and adjusting credit terms
Learning Objectives (contd) Manage accounts payable Know the costs and benefits of holding additional inventory Contrast the different instruments available to a financial manager for investing cash balances
19.1 Overview of Working Capital Main Components of Net Working Capital Cash Inventory Receivables Payables
19.1 Overview of Working Capital Cash Cycle Operating Cycle The average length of time between when a firm originally purchases its inventory and when it receives the cash back from selling its product Cash Cycle The length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory
19.1 Overview of Working Capital Cash Cycle Cash Conversion Cycle (CCC) CCC = Inventory Days + A/R Days A/P Days (19.1) where: Inventory Inventory Days = Average Daily Cost of Goods Sold Accounts Receivable Accounts Receivable Days = Average Daily Sales Accounts Payable Accounts Payable Days = Average Daily Cost of Goods Sold
Figure 19.1 The Cash and Operating Cycle for a Firm
Example 19.1 Calculating the CCC Problem: The following information is from Dell s 2009 Income Statement and Balance Sheet (numbers are $ millions). Use it to compute Dell s cash conversion cycle. Sales Cost of Goods Sold 52,902 43,641 Accounts Receivable Inventory Accounts Payable 5,837 1,051 11,373
Example 19.1 Calculating the CCC Solution: Plan: The CCC is defined in Eq. 19.1 as Inventory Days + Accounts Receivable Days Accounts Payable Days. Thus, we need to compute each of the three ratios in the CCC. In order to do that, we need to convert Sales and COGS into their average daily amounts simply by dividing the total given for the year by 365 days in a year.
Example 19.1 Calculating the CCC Execute: Average Daily Sales = Sales/365 Days = 52,902/365 = 144.94 Average Daily COGS = COGS/365 Days = 43,641/365 = 119.56 Inventory 1051 119.56 = = = Inventory Days 8.79 Average Daily Cost of Goods Sold Accounts Receivable Average Daily Sales Accounts Payable Average Da ily Cost of Goods Sold 5837 144.94 = = = Accounts Receivable Days 40.27 11,373 119.56 = = = Accounts Payable Days 95.12 Dell s CCC = 8.79 + 40.27 95.12= 46.06
Example 19.1 Calculating the CCC Evaluate: Dell actually has a negative cash conversion cycle, meaning that it generally receives cash for its computers before it pays its suppliers for the parts in the computer. Dell is able to do this because it primarily sells directly to the consumer, so it charges your credit card as soon as you place the order. Dell s direct sales generate basically no receivables, so Dell s accounts receivables are due to sales to businesses, educational institutions and retail outlets. Once you place your order, Dell places orders for the parts for your computer with its suppliers. Because of Dell s size and bargaining power, its suppliers allow it to wait more than 95 days before paying them!
Example 19.1a Calculating the CCC Problem: Given the following information from Elite PC s 2010 income statement and balance sheet (numbers are in $ millions), calculate the company s cash conversion cycle (CCC) and use it to evaluate the company s efficiency: Sales Cost of Goods Sold Accounts Receivable Inventory Accounts payable 66,467 54,226 5,160 643 10,234
Example 19.1a Calculating the CCC Solution: Plan: The CCC is defined in Eq. 19.1 as Inventory Days + Accounts Receivable Days Accounts Payable Days. Thus, we need to compute each of the three ratios in the CCC. In order to do that, we need to convert Sales and COGS into their average daily amounts simply by dividing the total given for the year by 365 days in a year.
Example 19.1a Calculating the CCC Execute: Average Daily Sales = Sales/365 Days = 66,467/365 = 182.10 Average Daily COGS = COGS/365 Days = 54,226/365 = 148.56
Example 19.1a Calculating the CCC Execute (cont'd): Inventory Days = Inventory/Average Daily Cost of Goods Sold = 643/148.56= 4.33 Accounts Receivable Days = 5,160/182.10= 28.34 Accounts Payable Days = A/P/Average Daily Cost of Goods Sold = 10,234/148.56= 68.89 A/R/Average Daily Sales = So, Elite s CCC = 4.33+28.34 68.89 = -36.22!
Example 19.1a Calculating the CCC Evaluate: Elite PC actually has a negative cash conversion cycle, meaning that it generally receives cash for its computers before it pays its suppliers for the parts in the computer. Elite PC is able to do this because it sells directly to the consumer, so that it charges your credit card as soon as you place the order. Once you place your order, Elite PC places orders for the parts for your computer with its suppliers. Elite PC is paid by the credit card company about 28 days after you place your order. Because of Elite s size and bargaining power, its suppliers allow it to wait about 69 days before paying them.
Table 19.1 Working Capital in Various Industries (Fiscal Year End 2009)
19.1 Overview of Working Capital Firm Value and Working Capital Any reduction in working capital requirements generates a positive free cash flow that the firm can distribute immediately to shareholders
Example 19.2 The Value of Working Capital Management Problem: The projected net income and free cash flows next year for Emerald City Paints are given in the following table in $ thousands: Net Income 20,000 +Depreciation +5,000 -Capital Expenditures -5,000 - Increase in Working Capital -1,000 =Free Cash Flow 19,000
Example 19.2 The Value of Working Capital Management Problem (cont'd): Emerald City expects capital expenditures and depreciation to continue to offset each other and for both net income and increase in working capital to grow at 4% per year. Emerald City s cost of capital is 12%. If Emerald City were able reduce its annual increase in working capital by 20% by managing its working capital more efficiently without adversely affecting any other part of the business, what would be the effect on Emerald City s value?
Example 19.2 The Value of Working Capital Management Solution: Plan: A 20% decrease in required working capital increases would reduce the starting point from $1,000,000 per year to $800,000 per year. The working capital increases would still grow at 4% per year, but each increase would then be 20% smaller because of the 20% smaller starting point.
Example 19.2 The Value of Working Capital Management Plan (cont'd): We can value Emerald City using the formula for a growing perpetuity from Chapter 4 (Eq. 4.7): CF r = 1 g PV As shown in the table, we can get to Emerald City s free cash flow as: Net Income + Depreciation Capital Expenditures Increases in Working Capital.
Example 19.2 The Value of Working Capital Management Execute: Currently, Emerald City s value is: + 20,000,000 5,000,000 5,000,000 1,000,000 .12 .04 = 237,500,000 If they can manage their working capital more efficiently, the value will be: + 20,000,000 5,000,000 5,000,000 800,000 .12 .04 = 240,000,000
Example 19.2 The Value of Working Capital Management Evaluate: Although the change will not affect Emerald City s earnings (net income), it will increase the free cash flow available to shareholders, increasing the value of the firm by $2.5 million.
Example 19.2a The Value of Working Capital Management Problem: The projected net income and free cash flows next year for River City Games are given in the following table in $ thousands: Net Income 120,000 +Depreciation +80,000 -Capital Expenditures -95,000 - Increase in Working Capital -40,000 =Free Cash Flow 65,000
Example 19.2a The Value of Working Capital Management Problem (cont'd): River City expects capital expenditures and depreciation to continue to offset each other and for both net income and increase in working capital to grow at 6% per year. River City s cost of capital is 8%. If River City were able reduce its annual increase in working capital by 10% by managing its working capital more efficiently without adversely affecting any other part of the business, what would be the effect on River City s value?
Example 19.2a The Value of Working Capital Management Solution: Plan: A 10% decrease in required working capital increases would reduce the starting point from $40,000,000 per year to $36,000,000 per year. The working capital increases would still grow at 6% per year, but each increase would then be 10% smaller because of the 10% smaller starting point.
Example 19.2a The Value of Working Capital Management Plan (cont'd): We can value River City using the formula for a growing perpetuity from Chapter 4 (Eq. 4.7): CF r = 1 g PV As shown in the table, we can get to River City s free cash flow as: Net Income + Depreciation Capital Expenditures Increases in Working Capital.
Example 19.2a The Value of Working Capital Management Execute: Currently, River City s value is: + 120 000 , 000 , 80 000 , 000 , 95 000 , 000 , 40 000 , 000 , = , 3 250 000 , 000 , 08 . 06 . If they can manage their working capital more efficiently, the value will be: + 120 000 , 000 , 80 000 , 000 , 95 000 , 000 , 36 000 , 000 , = , 3 450 000 , 000 , 08 . 06 .
Example 19.2a The Value of Working Capital Management Evaluate: Although the change will not affect River City s earnings (net income), it will increase the free cash flow available to shareholders, increasing the value of the firm by $200 million.
19.2 Trade Credit Trade Credit The difference between receivables and payables that is the net amount of a firm s capital consumed as a result of those credit transactions The credit that a firm extends to its customers
19.2 Trade Credit Trade Credit Terms Example: 2/10, Net 30 Cash Discount In this example, a 2% cash discount is taken if paid by during the discount period Discount Period In this example, 10 days Credit Period The total length of time credit is extended to the buyer. In this example, 30 days
19.2 Trade Credit Trade Credit and Market Frictions Cost of Trade Credit EAR = (1 + r)n 1
Example 19.3 Estimating the Effective Cost of Trade Credit Problem: Your firm purchases goods from its supplier on terms of 1/15, net 40. What is the effective annual cost to your firm if it chooses not to take advantage of the trade discount offered?
Example 19.3 Estimating the Effective Cost of Trade Credit Solution: Plan: Using a $100 purchase as an example: 1/15, net 40 means that you get a 1% discount if you pay within 15 days, or you can pay the full amount within 40 days. 1% of $100 is a $1 discount, so you can either pay $99 in 15 days, or $100 in 40 days. The difference is 25 days, so you need to compute the interest rate over the 25 days and then compute the EAR associated with that 25-day interest rate.
Example 19.3 Estimating the Effective Cost of Trade Credit Execute: $1/$99 = 0.0101, or 1.01% interest for 25 days. There are 365/25 = 14.6 25- day periods in a year. Thus, your effective annual rate is (1.0101)14.6-1 = 0.158, or 15.8%
Example 19.3 Estimating the Effective Cost of Trade Credit Evaluate: If you really need to take the full 40 days to produce the cash to pay, you would be better off borrowing the $99 from the bank at a lower rate and taking advantage of the discount.
Example 19.3a Trade Credit Problem: Your corporation, Vitamin Soda, purchases goods from a supplier at 2/10 net 40. If your business requires the entire 40 days to pay back your supplier, would it be better to take a loan from the bank after the discount or just pay the EAR given by the trade credit?
Example 19.3a Trade Credit Solution: Plan: Using a $200 purchase as an example: 2/10, net 40 means that you get a 2% discount if you pay within 10 days, or you can pay the full amount within 40 days. 2% of $200 is a $4 discount, so you can either pay $196 in 10 days, or $200 in 40 days. The difference is 30 days, so you need to compute the interest rate over the 30 days and then compute the EAR associated with that 30-day interest rate.
Example 19.3a Trade Credit Execute: $4/$196 = 0.0204, or 2.04% interest for 30 days. There are 365/30 = 12.17 thirty-day periods in a year. Thus, your effective annual rate is (1.0204)12.17-1 =.2786, or 27.86%
Example 19.3a Trade Credit Evaluate: If you really need to take the full 40 days to produce the cash to pay, you would be better off borrowing the $196 from the bank at a lower rate and taking advantage of the discount.
Example 19.3b Estimating the Effective Cost of Trade Credit Problem: Your firm purchases goods from its supplier on terms of 2/10, net 45. What is the effective annual cost to your firm if it chooses not to take advantage of the trade discount offered?
Example 19.3b Estimating the Effective Cost of Trade Credit Solution: Plan: Using a $100 purchase as an example: 2/10, net 45 means that you get a 2% discount if you pay within 10 days, or you can pay the full amount within 45 days. 2% of $100 is a $2 discount, so you can either pay $98 in 10 days, or $100 in 45 days. The difference is 35 days, so you need to compute the interest rate over the 35 days and then compute the EAR associated with that 35-day interest rate.
Example 19.3b Estimating the Effective Cost of Trade Credit Execute: $2/$98 = 0.0204, or 2.04% interest for 35 days. There are 365/35 = 10.4 35- day periods in a year. Thus, your effective annual rate is (1.0204)10.4-1 = 0.234, or 23.4%
Example 19.3b Estimating the Effective Cost of Trade Credit Evaluate: If you really need to take the full 45 days to produce the cash to pay, you would be better off borrowing the $98 from the bank at a lower rate and taking advantage of the discount.
19.2 Trade Credit Trade Credit and Market Frictions Benefits of Trade Credit It is simple and convenient to use, and it has lower transaction costs than alternative sources of funds It is a flexible source of funds, and can be used as needed It is sometimes the only source of funding available to a firm
19.2 Trade Credit Trade Credit and Market Frictions Trade Credit Versus Standard Loans Firms offer trade credit because: Providing financing at below-market rates is an indirect way to lower prices for only certain customers A supplier may have an ongoing business relationship with its customer, it may have more information about the credit quality of the customer than a traditional outside lender such as a bank would have If the buyer defaults, the supplier may be able to seize the inventory as collateral
19.2 Trade Credit Managing Float Collection Float Mail Float Processing Float Availability Float Disbursement Float Electronic Check Processing Check Clearing for the 21st Century Act (Check 21)
