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Week 05 Working Capital Management FINS2615 Intermediate Business Finance Dr. Ian Kwan i.kwan@unsw.edu.au See Berk (2018) Chapter 19: Working Capital Management 1How the Story of Corporate Finance will be explained: Cash Flows Discount rate (Risk & Return) Financial Mathematics Cash Flow Forecasting Working capital management Capital Asset Pricing Model Cost of capital Capital structure Week 01 Week 02 Weeks 03 and 04 Week 05 Week 07 Week 08 Week 09 Types of CF Debt Equity = =1 1 + 0 Important: As you take this course, clarify how to connect the different parts of the story! Week 10: Payout policy 2 Learning Objectives Overview of Working Capital Trade Credit Receivables Management Payable Management Inventory Management Cash Management Contents of lecture 3Learning objectives Following Berk Ch19, after this lecture, students should be able to Explain the Cash Conversion Cycle and why managing working capital is important Use trade credit to the firm’s advantage Make decisions on extending credit and adjusting credit terms Manage accounts payable Determine the costs and benefits of holding additional inventory Contrast the different instruments available to a financial manager for investing cash balances Overview of Working Capital 5Review: What is Net Working Capital Net Working Capital includes all the materials and services you need to run the daily operations of the firm. From Finance perspective, these include: Current Assets: Cash (excluding excess cash not needed in daily operations) Inventory, Accounts Receivable (A/Rec) Current Liabilities: Accounts Payable (A/Pay) NWC = Current Assets – Current Liabilities Increases in NWC Cash Outflow Decreases in NWC Cash Inflow Industry Inventory A/Rec A/Pay Retail supermarkets High Low High Pharmaceuticals High High High Airlines Low Low-Med High Consumer white goods High High High NWC composition depends on industry characteristics Affect firm valuation 6Operating Cycle vs. Cash Conversion Cycle = = = Components of Working Capital can be measured in DAYS: The number of days it takes to use up the inventory and turn it into sales The more days, the longer it takes to sell existing inventory Is the firm operating efficiently as it should be Can inventory be reduced The number of days it takes for customers to pay you cash for credit sales The more days, the longer it takes to receive customers’ cash payments Is the firm offering trade credit terms that are too generous Should it change The number of days for your firm to pay suppliers in cash The more days, the longer it takes you to pay suppliers Is the firm paying too early or too late Both can be bad! How do we know = 365 = 365 7Operating Cycle vs. Cash Conversion Cycle Cash Conversion Cycle = Inventory Days + Accounts receivable days – Accounts Payable Days = Average days from the time cash goes out to the time cash comes in Operating Cycle = Inventory Days + Accounts receivable days = Average days from purchasing inventory to receiving cash for goods/services With the Working Capital components measured in days, we define: From a finance perspective, investors need to fund the Cash Conversion Cycle! The longer the cycle, the more capital is tied up, the greater the funding cost. A Poll Question: Which is better from a finance perspective: A short CCC or long one Poll 8Berk Example 19.1 Calculating Cash Conversion Cycle Woolworths partial Income Statement & Balance Sheet: Using the following information, calculate the CCC for Woolworths Sales 58,276 Cost of Good Sold 42,677 Total Accounts Receivable 519 Total Inventory 4,559 Total Accounts Payable 6,266 = = 4559 116.9 = 39.0 days A/Rec days = = 519 159.7 = 3.2 days A/Pay days = = 6266 116.9 = 53.6 days = 365 = 42677 365 = 116.9 $/days = 365 = 58276 365 = 159.7 $/day Cash Conversion Cycle = Inventory Days + Accounts receivable days – Accounts Payable Days Woolworths’ CCC = 39 + 3.2 – 53.6 = -11.4 days Woolworths has a NEGATIVE CCC! It’s customers on average pay in cash 11 days BEFORE it pays its suppliers in cash! This accounts for its market dominance in offering low price guarantees 9Working capital needs depend on industry characteristics A/Rec A/Pay Invent. Airlines Qantas Customers pay up-front before starting trip Firm pays suppliers many days after trip is finished Very little. Only sufficient inventory for a trip (fuel, tray meals, drinks, movies!) Remark Main expense is depreciation of aircraft and labour costs White goods Harvey Norman To commit customers, firm offers interest-free purchases or financing Firm will get suppliers to help finance customers’ purchases, stretching out payments Hold inventory in showrooms for customers to give variety and choice Large holding costs Pharmaceuticals CSL Customers (pharmacies, labs, hospitals) pay on credit after receiving goods Firm pays suppliers later than it receives payment from customers, stretching paymt Batch manufacturing means holding large inventories that are sold seasonally Special handling and storage. Main cost is R&D expense. In the Team Assignment, analyse your Stock’s industry characteristics or norms to understand the effect on Working Capital Requirements. Compare with major competitors. For example, we compare and contrast the Working Capital Needs of three industries: 10 Firm value and managing working capital We know that Changes in NWC affect cash flows because: FCF = EBIT(1 – T) + Depr – Chg NWC – Capex Decrease in NWC increase in FCF increase in firm value BUT BY HOW MUCH VALUE Berk Example 19.2 Expected FCF Improvement Net Profit (earnings) 20 000 + Depreciation +5 000 – Capital Expenditure -5 000 – Incr in working capital -1 000 Reduce by 20% = FCF = 19 000 A firm next year expects the following FCF but wants to investigate the impact of improvements it can make to its need for more working capital. If the cost of capital is 12% and the working capital is projected to grow at 4% annually, what impact would a one-time 20% permanent reduction in its annual working capital requirement have to the stock’s valuation New FCF 20 000 +5 000 -5 000 -800 = 19 200 0 = 0 = 190000.12 0.04 = 237 500 000 0 = 192000.12 0.04 = 240 000 000 Current stock price: New price if WC reduced by one-time 20%: Conclusion: A one-time $200K permanent reduction in Working Capital does not affect earnings, but results in a $2.5 million increase in stock price! In $ thousands 11 Team Assignment: Questions for Reflection A firm that manages well its Work Capital requirements generates enormous value for customers! Especially permanent decreases in Working Capital requirements. Is working capital management a strategic advantage for firms in the same industry as your target company If so, how well does your Team’s company manage its Work Capital requirements compared with competitors As an investor in the company, can you suggest changes that it could make to increase its competitiveness in Working Capital Management We have seen that: Questions for Reflection in your Team Assignment Target Company: 12 Learning objectives Following Berk Ch19, after this lecture, students should be able to Explain the Cash Conversion Cycle and why managing working capital is important Use trade credit to the firm’s advantage Make decisions on extending credit and adjusting credit terms Manage accounts payable Determine the costs and benefits of holding additional inventory Contrast the different instruments available to a financial manager for investing cash balances Trade Credit 14 Berk 19.2 Trade Credit When a firm allows a customer to purchase on credit is said to “extend their customer trade credit”. The firm and customer respectively generate entries in accounts receivable and accounts payable. Note: a customer purchase on credit does NOT mean purchasing with their credit card or BNPL account! Why When a firm buys on credit from suppliers, each respectively generates accounts payable and receivable entries. The net difference between a firm’s a/rec and a/pay is the “capital required by trade credit”. To find optimal credit policies, financial managers analyze trade credit according to: 1. Trade credit terms 2. Trade credit market frictions 3. Float management Let’s look at this first Examples of Trade Credit Terms: Supplier offers customer “Net 30” Or maybe “2/10, Net 30” Means “Pay the full amount within 30 calendar days” Say “Two – ten, Net 30” Means “Get a 2% discount on the full amount if paid within 10 days, otherwise pay in full within 30 calendar days” 10 days is “discount period” 30 days is “credit period” Day 10 Day 30 $100 purchase Discount period Pay $98 for $100 purchase Net credit period Must pay $100 by Day 30 1. Trade credit terms 15 Berk 19.2 Trade Credit Day 10 Day 30 $100 purchase Discount period Net credit period 2. Trade Credit Market Frictions For example, “2/10, Net 30” If customer decides to take the 2% discount offer, what benefit interest rate is the customer getting Trade credit is essentially a loan from the supplier to customer. If like a loan, what is the trade credit interest rate Pay nothing now and repay $100 loan at end (day 30) Get $2 discount and pay $98 now (day 10) By taking the $2 discount, the customer is tying up $98 in funds that could be used elsewhere. This is an opportunity cost. $2 / $98 is the interest rate over 20 days Think: “A cost of $2 ties up $98 for 20 days” i.e., 2.040816% over 20 days What rate is this over 365 days i.e., what is the Effective Annual Rate 365/20 = 18.25 20-day periods in one year = 1 + 1= 1 + 2.040816% 36520 1= 44.59% By taking the discount, the customer is getting a benefit interest rate of 44.6%! This would be hard to get anywhere! What are the benefits of trade credit 1. Trade credit is simple and convenient to access. – Often standard terms, little paperwork involved – Few things to negotiate – Flexible arrangement 2. Lower cost of fund compared with alternative sources – For customer, lower than getting a bank loan – Collateral on trade credit are the goods provided – Often the only source of funding for the customer What market frictions does Trade Credit overcome 1. Provides cheaper prices to selected customers – Trade credit helps a firm discriminate between customers, providing favourable ones better terms 2. Provides a check on customer credit quality – Trade credit is built on trust and information sharing between a firm and its customer. This relationship is perhaps of better quality in gauging credit worthiness. 16 Berk 19.2 Trade Credit 3. Trade Credit Float Management A significant friction in trade credit is the management of collection float. Collection float is the amount of time it takes for a firm to be able to use the funds after a customer has paid for its goods or services. The longer the collection float, the greater is the need to invest in working capital. Collection float is determined by three factors: mail float, processing float, and availability float Because of financial technologies, direct customer bank transfers to supplier bank have significantly speeded up these processes and even eliminated them. 17 Learning objectives Following Berk Ch19, after this lecture, students should be able to Explain the Cash Conversion Cycle and why managing working capital is important Use trade credit to the firm’s advantage Make decisions on extending credit and adjusting credit terms Manage accounts payable Determine the costs and benefits of holding additional inventory Contrast the different instruments available to a financial manager for investing cash balances Receivables Management 19 Berk 19.3 Receivables Management When a firm allows a customer to purchase on credit, it generates accounts receivable. But before it does so, the firm should determine a credit policy by: Establishing credit standards Establishing credit terms Establishing a collection policy To whom will credit be extended Everyone Select customers Based on what – On credit worthiness Past volume of sales Potential sales Repeat customer – Potentially higher sales margin Establishing standards is about getting the right balance between High margin Receivables vs. High volume of Receivables How long to extend credit for E.g. Net 20 Net 30 Or Net 40 Offer a discount Over what discount period E.g., 1/15, Net 40 or 2/10, Net 20, etc Are your credit terms comparable with other companies in the same industry What do you do if the customer begins delaying payment – Do nothing (probably not) – Send a reminder – Start charging interest or a late fee – Threaten legal action – Sell delinquent receivables to a collection agency for $0.50 for each $1 of receivable As an analyst or consultant, you need to ask these questions to find out the appropriateness of the client’s credit policy 20 Berk 19.3 Receivables Management After generating accounts receivable, Accounts Receivable needs to be monitored using: Account Receivable Days Aging Schedule Accounts receivable days is the average days the firm takes to collect cash on its sales. = Annual accounts receivable / average daily sales Compare actual accounts receivable days vs. Credit Terms better / worse Compare actual accounts receivable days over past years following trend Careful! Accounts receivable days is an average that may hide seasonality in a year E.g., School holidays drives seasonality in movie theatre sales E.g., Summer season drives ice cream and sunscreen sales An aging schedule categorises accounts by days outstanding since the credit sale, by number of accounts and by amount. E.g. In the tables below, a firm has trade credit terms of 2/15, net 30. Average daily sales of $65 000. Accounts receivable days is 25 ( = 1 600 000 / 65 000). 28% by number of accounts are late; but 39% by amount in account are late Analysis of monthly payment patterns may provide better forecasting of late accounts, e.g., 10%, 40%, 25%, 20%, and 5% of prior sales were collected in the month of sales, 1 month, 2 months, 3 months, and 4 months after. Knowing these monthly patterns allows financial managers to plan working capital requirements Late 28% Late 38.8% Berk Table 19.2 21 Practice Berk Example 19.5: Ageing Schedules The Financial Training Centre bills its accounts on terms of 3/10, net 30. The average daily sales is $20 000. An Ageing Schedule has been partially prepared below. Complete the schedule. With the information given, what conclusions can you make about the firm’s accounts receivables Days outstanding Amt Outstanding ($) 1-10 100 000 11-30 300 000 31-40 100 000 41-50 20 000 51-60 10 000 60+ 2 000 532 000 % Outstanding 100.0% Soln = = Payables Management 23 Berk 19.4 Payables Management How can firms manage their accounts payable 1. Firms should choose to borrow using accounts payable if it is the cheapest source of funding. How do you know The higher the discount, the more attractive it is For the same discount, the shorter the term the more attractive it is 2. Firms should always pay on the lastest day possible E.g., Terms are 2/10, net 30. If discount is taken, pay on day 10 not earlier If discount is foregone, pay on day 30 not earlier Berk Example 19.6 Rowdy
Co has an average acc pay balance of $250 000. Its daily average COGS
is $14 000. The terms from its suppliers are 2/15, net 40. If it
chooses to forego the discount and pay at the end of 40 days, is it
managing its accounts payable well What should it do = =
25000014000 = 17.9 On average Rowdy is paying on Day 18, 3 days
after the 2% discount period. If it could pay 3 days earlier, it would
take advantage of the discount Also, it is paying on Day 18 means it is tying up cash that could have been used for 22 days more up to Day 40. CONCLUSION: Rowdy is not managing Acc Pay well. It either should pay 3 days earlier and take the discount or wait 22 days more and pay on Day 40. 24 Berk 19.4 Payables Management How else can firms manage their accounts payable 3. Firms should monitor their accounts payable days to ensure payment at the optimal time Like in previous example, making small adjustments can help make accounts payment reduce the burden on your Working Capital requirements 4. Firms should avoid stretching accounts payable Stretching accounts payable is deliberately paying late and risking penalties Stretching accounts payable can lead to suppliers imposing harsher terms, e.g., COD or CBD or discontinuing business. It is unethical business practice to systematically break the agreed terms with your supplier and may also affect your firm’s credit rating. Berk Example 19.7 If
a firm stretches its accounts payable to 60 days on credit terms of
1/15, net 40, what is the effective annual cost of its credit If the firm pays according to the credit terms, then by taking the $1 discount, the firm ties up $99 for 25 days (=40 – 15). 1/99 over 25 days 1.0101% over 25 days n = 365/25 = 14.6 25-day periods in 1 year = 1 + 1= 1 + 1.0101% 36525 1= 15.80% If the firm pays stretches accounts payable by taking the $1 discount, the firm ties up $99 for 45 days (=60 – 15). 1/99 over 45 days 1.0101% over 45 days n = 365/45 = 8.1111 45-day periods in 1 year = 1 + 1= 1 + 1.0101% 36545 1= 8.49% Conclusion: By stretching acc payable, the firm reduces its borrowing cost 7.31%, although it does so unethically. 25 Learning objectives Following Berk Ch19, after this lecture, students should be able to Explain the Cash Conversion Cycle and why managing working capital is important Use trade credit to the firm’s advantage Make decisions on extending credit and adjusting credit terms Manage accounts payable Determine the costs and benefits of holding additional inventory Contrast the different instruments available to a financial manager for investing cash balances Inventory Management 27 Berk 19.5 Inventory Management Inventory management aims to balance the costs and benefits of holding inventory. Excessive inventory is inefficient use of capital tied up for no benefit BUT, insufficient inventory can mean lost opportunities for sales Efficient use of inventory creates increased value for the firm. Benefits of holding inventory (Raw materials) Inventory minimizes the risk of not having production inputs when required. This situation is called a stock-out. Stock-outs may result in customers switching to a competitor and not coming back. (Finished goods) Inventory reduces the risk that demand seasonality does not match production cycles Costs of holding inventory Three direct costs of holding inventory: Acquisitions costs are the total costs of the inventory itself over the year Order costs are the total costs over the year of placing an order, getting it shipped, maybe expedited Carrying costs are the costs of storage, insurance, taxes, spoilage, obsolescence, and opportunity cost of keeping inventory ready for production or sale. An
extreme example of super-efficient inventory management is
“Just-in-time” (JIT). In JIT, inventory is reduced to (almost) zero.
Production is so well coordinated that just as one unit of input is
used up, the next one arrives in-time. There is no slack in the
production process. Timing is key. E.g. JIT inventory management of
local petrol production and distribution large predictable price
swings at the petrol bowser. 28 Learning objectives Following Berk Ch19, after this lecture, students should be able to Explain the Cash Conversion Cycle and why managing working capital is important Use trade credit to the firm’s advantage Make decisions on extending credit and adjusting credit terms Manage accounts payable Determine the costs and benefits of holding additional inventory Contrast the different instruments available to a financial manager for investing cash balances Cash Management 30 19.6 Cash Management Firms hold cash for three reasons 1. Transaction balance – to meet the day-to- day needs of the firm’s operations 2. Precautionary balance – to meet uncertain needs or opportunities that arise 3. Compensating balance – to satisfy the requirements of the firm’s bank Firms need to hold sufficient cash to pay their daily bills depending on the cash conversion cycle and the size of the average transaction. As the firm grows, this balance needs to grow in proportion. Uncertainties such as unexpected fire or property damage, competitor makes threatening move or wants to sell-out, a new technology arises that must be incorporated, a lawsuit that requires defense, etc. Having “reserve cash” allows firms the flexibility to respond to these uncertainties and not have to go through a lengthy process of seeking funding and approval. Start-up and growing firms, especially have cash reserves set aside for such opportunities. Banks provide firms financial services, such as over-draft facilities, letters of credit, capital expenditure lines of credit, etc. But to have these services, the bank requires a minimum amount of cash reserve as compensation, i.e., insurance for these services. Cash is the most liquid of assets. Excess liquidity, however, may result in below-market return rates. Holding too much cash is therefore inefficient use of this resource. Holding a sufficient cash balance depends on various reasons. 31 Practice: What is the end cash balance each month Month: 1 2 3 4 5 6 Beginning Invent. 200.0 Beginning Acc Rec 100.0 Beginning Acc Pay 50.0 Beginning Cash 100.0 New inventory 230.0 230.0 230.0 230.0 230.0 230.0 Sales 200.0 250.0 300.0 325.0 200.0 150.0 Cash collections Cash payments Net Cash Flow End Inventory End Acc Receiv. End Acc Payable End Cash Question parameters Credit terms: Net 20 Assume every month has 30 days Each sale reduces inventory by 1 Sales: 1/3 pay cash in the same month, 2/3 pay cash next month Inventory: 1/3 payable this month, 2/3 pay next month Q. Complete the spreadsheet Soln 32 Learning objectives Following Berk Ch19, after this lecture, students should be able to Explain the Cash Conversion Cycle and why managing working capital is important Use trade credit to the firm’s advantage Make decisions on extending credit and adjusting credit terms Manage accounts payable Determine the costs and benefits of holding additional inventory Contrast the different instruments available to a financial manager for investing cash balances 33 At what level is Working Capital Management Cash Flows Discount rate (Risk & Return) Project level CF = =1 1 + 0 Security level CF Project level discount rate Portfolio level discount rate CF that affect only a small part of the company E.g. replacing production machines in a manufacturing plant CF that affect a big part of the company E.g. introducing new product that changes the company strategy Rate depends on the risk of the project compared with the average risk of the company Rate depends on the risk of the company compared with other companies that have the same types of risks, i.e. portfolio view Important: As you take this course, be aware of which level of the story you are referring to! 34 Learning Objectives Overview of Working Capital Trade Credit Receivables Management Payable Management Inventory Management Cash Management What we covered Appendix: Solutions to Practice Problems 36 Practice Berk Example 19.5: Ageing Schedules SOLN The Financial Training Centre bills its accounts on terms of 3/10, net 30. The average daily sales is $20 000. An Ageing Schedule has been partially prepared below. Complete the schedule. With the information given, what conclusions can you make about the firm’s accounts receivables % Outstanding 18.8% 56.4% 18.8% 3.8% 1.9% 0.4% 100.0% Days outstanding Amt Outstanding ($) 1-10 100 000 11-30 300 000 31-40 100 000 41-50 20 000 51-60 10 000 60+ 2 000 532 000 = = 532 00020 000 = 26.6 days By amount of accounts, 18.8% + 56.4% = 75.2% of accounts pay according to the terms Hence, less than 25% are paying late Only 6.1% (=3.8% + 1.9% + 0.4%) are paying 40 days or later. Very small! On average, the accounts pay within 30 days: Conclusion: FTC’s Accounts Receivables are reasonably healthy Back 37 Practice: What is the end cash balance each month Soln Question paramaters Credit terms: Net 20 Assume every month has 30 days Each sale reduces inventory by 1 Sales: 1/3 pay cash in the same month, 2/3 pay cash next month Inventory: 1/3 payable this month, 2/3 pay next month Q. Complete the spreadsheet Month: 1 2 3 4 5 6 Beginning Invent. 200.0 230.0 210.0 140.0 45.0 75.0 Beginning Acc Rec 100.0 133.3 166.7 200.0 216.7 133.3 Beginning Acc Pay 50.0 153.3 153.3 153.3 153.3 153.3 Beginning Cash 100.0 140.0 126.7 163.3 241.7 295.0 New inventory 230.0 230.0 230.0 230.0 230.0 230.0 Sales 200.0 250.0 300.0 325.0 200.0 150.0 Cash collections 166.7 216.7 266.7 308.3 283.3 183.3 Cash payments 126.7 230.0 230.0 230.0 230.0 230.0 Net Cash Flow 40.0 -13.3 36.7 78.3 53.3 -46.7 End Inventory 230.0 210.0 140.0 45.0 75.0 155.0 End Acc Receiv. 133.3 166.7 200.0 216.7 133.3 100.0 End Acc Payable 153.3 153.3 153.3 153.3 153.3 153.3 End Cash 140.0 126.7 163.3 241.7 295.0 248.3 Back