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Practical financial managment 7e LASHER chapter 16

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Chapter 16 Working Capital


Working Capital Basics

Working Capital

– Assets and liabilities required to operate a business on a day-to-day
basis

Assets:

– Cash
– Accounts Receivable
– Inventory

Liabilities:

– Accounts Payable
– Accruals

2


Working Capital, Funding Requirements, and the Current Accounts

Gross Working Capital represents an investment in assets

– Capital – funds committed to support assets
– Working – short term, day-to-day operations
Working Capital Requires Funds



– Maintaining a working capital balance requires a permanent funds
commitment

3


The Short-Term Liabilities
Spontaneous Financing
Operating activities automatically create payables & accruals essentially debts

– These liabilities spontaneously offset the funding required to support
current assets

4


Working Capital and the Current Accounts

Net Working Capital – the difference between gross working
capital and spontaneous financing
Generally:

– Gross working capital = current assets
– Net working capital =
current assets – current liabilities
People often say working capital when they actually mean net working
capital

5



Objective of Working
Capital Management
To run the firm with as little money tied up in the current accounts
as possible
Working capital elements

– Inventory
– Receivables
– Cash
– Payables
– Accruals

6


Objective of Working Capital Management
Inventory
High Levels

Low Levels

Benefit:

Cost:

Happy customers – supplied quickly

Shortages


Few production delays (parts always on hand)

Dissatisfied customers – product not available

Cost:

Benefit:
High financing costs

Low financing and storage costs

High storage costs

Less risk of obsolescence

Shrinkage (theft)
Risk of obsolescence

Cash
High Levels
Benefit:
Reduces risk of being unable to pay bills
Cost:
Increases financing costs

Low Levels
Benefit:
Reduces financing costs
Cost:

Increases transaction risk

7


Objective of Working Capital Management

Accounts Receivable
High Levels

Low Levels

Benefit:

Cost:

Happy customers –can pay slowly

Customers unhappy with payment terms

High credit sales

Lower Credit Sales

Cost:

Benefit:
More bad debts

Less financing cost


High collection costs
Increased financing costs

Payables and Accruals
High Levels
Benefit:
Spontaneous financing reduces need to borrow
Cost:
Unhappy suppliers because paid slowly

Low Levels
Benefit:
Happy suppliers/employees
Cost:
Not using spontaneous financing

8


Figure 16-1 Cash Conversion Cycle

9


Figure 16-2 Timeline Representation of Cash Conversion Cycle

10



Permanent and Temporary
Working Capital
Need for working capital varies with sales level
Temporary working capital supports seasonal peaks in business
Working capital is permanent to the extent that it supports a
constant, minimum level of sales

11


Figure 16-3 Working Capital Needs of Different Firms

12


Financing Net Working Capital

Short-term working capital should be financed with short-term
sources

Maturity Matching Principle – the term of financing should match
the term or duration of the project or item supported

13


Short-Term vs. Long-Term Financing in Support of Working Capital

Long-term financing


Short-term financing

Safe but expensive



Safe – funds are committed and

Cheap but risky



can’t be withdrawn



Expensive - long-term rates are
generally higher

Cheap - short-term interest rates are
generally lower



Risky - must continually renew
borrowing

14



Alternative Financing Policies

The mix of short/long-term financing supporting working capital

– Heavier use of longer term funds is conservative
– Using more short-term funding is aggressive

15


Figure 16-4a Working Capital
Financing Policies

16


Figure 16-4b Working Capital
Financing Policies

17


Working Capital Policy

A firm’s Working Capital Policy refers to its handling the following
issues:

– How much working capital is used
– Extent supported by short or long term financing
– The nature and source of any short-term financing used

– How each component is managed

18


Sources of Short-term Financing

Spontaneous financing

– payables and accruals
Unsecured bank loans
Commercial paper
Secured loans

19


Spontaneous Financing

Accruals



Accounts Payable

Interest–free loans from



whoever provides services

deferring payment



Wage Accrual

Effectively loans from suppliers selling
on credit



Credit Terms:
Specify details of payment

Money owed to employees for

E.g. 2/10, net 30

work performed but not yet paid

2% discount if pay within 10 days,
otherwise entire amount due in 30 days

20


Prompt Payment Discount

Passing up prompt payment discounts is an expensive source of
financing


If terms are 2/10, net 30, and don’t pay by the 10th day,
essentially paying 2% for 20 days’ use of money

The implied annual rate is

(365 / 20) x 2% = 36.5%

21


Abuses of Trade Credit Terms
Trade credit, originally a service to customers, is now expected

– Paying beyond the due date is a common abuse of trade credit
Called “stretching” payables or “leaning on the trade”
Slow paying companies receive poor credit ratings



May lose the ability to buy on credit in future

22


Unsecured Bank Loans
Represent the primary source of short-term financing for most
companies
Unsecured  Repayment is not guaranteed by the pledge of a
specific asset

Promissory Note – Written promise to repay amount borrowed
plus interest

23


Unsecured Bank Loans

Line of credit

– Informal, non-binding agreement between a bank and a borrowing
firm specifying the maximum amount that can be borrowed during a
period

24


Revolving Credit Agreement

Similar to a line of credit except bank guarantees availability of
funds up to a maximum amount

– Borrower pays a commitment fee on the unborrowed balance

25


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