Corporate Issuers - Working Capital Management, CFA Level I

Level I - Corporate Finance Working Capital Management 1 Contents 1. 2. 3. 4. 5. 6. 7. 8. Introduction Managing and Measuring Liquidity Managing the Cash Position Investing Short-Term Funds Managing Accounts Receivable Managing Inventory Managing Accounts Payable Managing Short-Term Financing 2 1. Introduction • Working capital management involves managing the relationship between a firm's short term assets and its short term liabilities • The goal of effective working capital management is to ensure that a company has adequate ready access to the funds necessary for day to day operating expenses • Several factors impact working capital needs 3 Internal and External Factors That Affect Working Capital Needs Internal Factors External Factors Company size and growth rates Banking services Organizational structure Interest rates Sophistication of working capital management New technologies and new products Borrowing and investing positions, activities and capacities The economy Competitors 4 2. Managing and Measuring Liquidity Liquidity is the extent to which a company is able to meet its short term obligations using assets that can be readily transformed into cash. Liquidity management refers to the ability of an organization to generate cash when and where needed Secondary Sources of Liquidity Cash balance Negotiating debt contracts Trade credit Liquidating assets Short term investment portfolio Filing for bankruptcy protection ectio Bo o Primary Sources of Liquidity 5 Drags and Pulls on Liquidity Cash receipts and disbursements effect a company’s liquidity position Drag on liquidity: receipts lag Pull on liquidity: disbursements are paid too quickly or trade credit is limited Uncollected receivables Payments made early Obsolete inventory Reduced credit limits 6 Measuring Liquidity • Liquidity contributes to a company’s creditworthiness; creditworthiness is the perceived ability of the borrower to pay what is owed in a timely manner • High creditworthiness allows a company to ƒ obtain lower borrowing costs ƒ obtain better terms for trade credit ƒ have greater flexibility ƒ exploit profitable opportunities o ns • Liquidity ratios measure a company’s ability to meet short-term obligations 7 Liquidity Ratios: Current, Quick and RTO Ratio Numerator Denominator Current ratio Current assets Current liabilities Quick ratio Cash + short term marketable securities + receivables Current liabilities Receivable turnover Credit sales Average receivables Number of days of receivables 365 Receivable turnover 8 Liquidity Ratios: ITO and PTO Ratio Numerator Denominator Inventory turnover Cost of goods sold Average inventory Number of days of inventory 365 Inventory turnover Payables turnover ratio Purchases Average trade payables Number of days of payables 365 Payables turnover ratio Example 1: Liquidity improving but still below industry average 9 (Net) Operating Cycle Operating cycle = days of inventory + days of receivables Cash conversion cycle = Net operating cycle = average days of receivables + average days of inventor - average days of payables 10 3. Managing The Cash Position • Purpose of managing a firm’s daily cash position is to make sure there is sufficient cash (target balance) ƒ Do not want low or negative balances because it is expensive to borrow cash on short notice ƒ Do not want unnecessarily high case balances either • Companies should recognized the major sources of cash inflows and outflows in order to forecast and manage cash position Inflows: Receipts from operations Fund transfers from subsidiaries Maturing investments Other income Outflows: Payments to employees Payments to suppliers Other expenses Investments Debt payments 11 4. Investing Short-Term Funds • A temporary store of funds that are not necessarily needed in a company’s daily transactions • Short term working capital portfolios consist of securities that are highly liquid, less risky and shorter in maturity than other types of investment portfolios • Generally working capital portfolios consist of short term government securities, and short term bank and corporate obligations • Exhibit 7 – Examples of Short Term Investment Instruments 12 Yield on Short-Term Investment A 90-day $100,000 U.S. T-bill was purchased at a discount rate of 4%. Calculate the money market yield and bond equivalent yield. Yield Formula Discount basis yield (F – P) / F x (360/T) Money market yield (F – P) / P x (360/T) Bond equivalent yield (*) (F – P) / P x (365/T) (*) In Quant we studied that BEY = 2 x semi-annual yield 13 Strategies and Evaluation • Objective: Earn reasonable return while taking on limited credit and liquidity risk • Create investment policy statement. This should identify the purpose, authorities, limitations and/or restrictions, etc. ƒ Exhibit 9 and Example 3 • Short-term strategies can be passive or active nt e ƒ Passive strategies focus on rules; safety and liquidity are prioritized ƒ Active strategies are more aggressive and require constant monitoring; types of active strategies egies include matching, mismatching and laddering • Evaluate short-term funds management ak a 11 ƒ Compute weighted average of bond equivalent yields of all investments and compare comp pare with w short-term benchmark rate (Exhibit 10) 14 5. Managing Accounts Receivables • Three primary activities in accounts receivable management ƒ Establishing credit terms; granting credit and processing transactions ƒ Monitoring credit balances ƒ Measuring performance • Trade off between stricter credit terms and the ability to make sales • Managing customers’ receipts Bo 8 / ƒ Electronic funds transfer ƒ Lockbox: Customer payments mailed to post office box and bank collects ƒ Float factor is good measure for check deposits; float factor = Avg. daily float / Avg. vgg. daily daily deposit d de 15 Evaluating Receivables Management Many ways of measuring accounts receivable performance; most deal with how effectively outstanding receivables can be converted into cash. A simple measure is number of days of receivables but this does not consider the age distribution within the outstanding balance Days outstanding Jan Feb Mar Days outstanding Jan Feb Mar < 31 days 2000 2120 1950 < 31 days 40% 39% 40% 31 – 60 days 1500 1650 1400 31 – 60 days 30% 31% 28% 61 – 90 days 1000 900 920 61 – 90 days 20% 17% 19% > 90 days 500 700 660 > 90 days 10% 13% 13% Avg. collection days % weight Days x weight < 31 days 15 40% 6.0 31 – 60 days 45 30% 13.5 61 – 90 days 75 20% 15.0 > 90 days 120 10% 12.0 Weighted average collection llectio on period for Jan: 46.5 C Days outstanding 16 6. Inventory Management • Inventory represents a significant cost for many companies and needs to be managed • Inventory levels that are too low will result in loss of sales due to stock-outs; high inventory levels means excess capital is tied up in inventory. • Two broad approaches to managing inventory: ƒ Economic order quantity – reorder point ƒ Just in time inventory • Evaluating inventory management Example 5 a ƒ Inventory turnover and days of inventory ƒ Consider changes over time and relative to industry 17 7. Managing Accounts Payables A/P represents an important source of funds and should be managed well • Paying too early is costly unless the company can take advantage of discounts • Late payment impact a company’s perceived credit-worthiness • Evaluate A/P management using PTO and number of days of payables Example: Assume a firm purchases on credit and the terms are 2/10, Net 30. What is the cost of not taking the discount if the payment is made on the 30th day. Example 6 18 8. Managing Short-term financing Short-term financing strategy should focus on ensuring that a company maintains a sound liquidity position • Ensure sufficient capacity to handle peak cash needs • Maintain sufficient sources of credit (alternate sources) • Ensure rates are cost effective ak al 11 5 ok Short-term borrowing could be from banks or from non-bank sources • Bank sources include uncommitted lines of credit, committed lines of credit, revolving credit arrangements • Companies that do not have sufficient credit quality could borrow from other her financial institutions using asset-based loans • Commercial paper and bankers acceptance can also be used for short-term rt teerm ffinancing 19 Computing Cost of Borrowing You need to borrow $1 million for one month and have the three options shown below. Which one represents the lowest cost? 1. Drawing down on a line of credit at 5.5% with a 0.5% commitment fee on the full amount. Note: 1/12 of the commitment fee is allocated to the first month 2. A banker’s acceptance at 5.75%, an all inclusive rate 3. Commercial paper at 5.15% with a dealer’s commission of 0.125% and a backup line cost of 0.25%, both of which would be assessed on the $1 million commercial paper issued. Example 7 20 Summary • Managing and Measuring Liquidity • Managing the Cash Position • Investing Short-Term Funds • Managing Accounts Receivable • Managing Inventory • Managing Accounts Payable • Managing Short-Term Financing 21 Conclusion • Read summary • Review learning objectives • Examples are good • Practice problems: good but not enough • Practice questions from other sources 22