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Working Capital Management Presented by John Lafare John.Lafare@SCORE114.org SCORE®

The ingredients of sound financial management

Why is working capital management critical? Businesses of any size experience working capital problems Small businesses struggle the most, especially during the start-up phase Working capital is yourlifeblood: You may have assets and be profitable But liquidity can be a serious problems if assets cannot converted into cash

What do we know about business failures? Findings from an SBA study: 1/3 of startups fail within 2 years Less than half make it to 4 years Dominant causes of failure: ,[object Object]

Poor cash flow managementThe good news (?): 90% of failures are due to poor decisions Understanding the causes of failure can help avoid repeating them

Workshop objectives Explore methods used to make optimal working capital decisions. Explain how current asset and liability accounts affect cash management. Learn to make working capital decisions based on forecasted financial data.

The dimensions of working capital management

Accounting 101: the one-minute balance sheet Current Assets Current Liabilities ,[object Object]

Taxes PayableFixed Assets Long-Term Financing ,[object Object]

What is net working capital? Total Current Assets: cash marketable securities accounts receivable inventories Less Total Current Liabilities: ,[object Object]

accrued liabilities,[object Object]

Managing accounts receivable Cost of carrying receivables Relaxing Credit Standards Changing Credit Terms Factoring Pledging of receivables

What is the cost of carrying receivables? Receivables represent credit sales that have trapped valuable cash They are an indirect free loan to clients Average investment in receivables: Variable cost of annual sales Turnover of receivables Variable costs are the relevant costs since we are concerned about out-of-pocket costs

Turnover of receivables Calculated as: 365 Average collection period Meaning of the ratio: A high ratioimplies you operate on a cash basis or that your extension of credit and collection of receivables is efficient A low ratiomay point to the need to re-assess credit policies to ensure timely collection

Relaxing credit standards Can have a significant influence on sales Lower the quality standard for accounts accepted as long as the profitability of additional sales exceeds the added costs Effects of Relaxing Credit Standards

Calculating the impact of relaxing credit standards

Step 1: profit contribution from increased sales

Step 2: cost of marginal investment in receivables

Step 3: cost of increased bad debts

Changing credit terms Credit terms are composed of: The cash discount The cash discount period The credit period Example: credit terms of 2/10 net 30 Discount = 2% Discount period = 10 days Credit period is 30 days Discount has to be meaningful to motivate early payment

Changing credit terms: costs vs. benefits Offering a cash discount means giving up a percentage of the invoice amount Potential benefits: You get cash sooner, reduce borrowing needs, more cash for investment Since the discount is a price reduction, sales may increase Inducing customers to pay early may reduce bad debt losses May encourage customers to pay cash, avoiding credit card processing fees

Changing credit terms: calculating the costs Example Average collection period is 40 days: 32 days until the customers mail payments 8 days to receive, process, and collect payments once they are mailed. Initiate a cash discount by changing credit terms from net 30 to 2/10 net 30 The change is expected to result in an average collection period of 25 days

Additional data Current production = 1,100 units. Product sells for $3,000, terms of net 30 Variable costs = $2,300 You estimate that: 80% of customers will take the 2% discount Sales will increase by 50 units The bad-debt percentage will be unchanged Opportunity cost of funds invested in accounts receivable = 14%

Changing credit terms: analysis 1. Additional profit contribution from sales: 50 units x ($3,000 - $2,300) = $35,000 2. Cost of marginal investment in receivables: Current: $2,300 x 1,100 units / (365 / 40) = $278,022 Proposed: $2,300 x 1,150 units / (365 / 25) = 181,164 Reduction in A/R investment: $ 96,858 3. Savings from reduced investment in receivables: Savings = 14% x $96,859 = $13,560 4. Cost of cash discount: 2% x 80% x 1150 x $3,000 = ($55,200) Net profit from proposed credit terms: ($ 6,540)

Factoring of receivables Outright sale of receivables at a discount to a factor Value assigned a function of the age of the receivables Anything older than 90 days typically not financed Factors may be either departments of banks or factoring companies Normally done on a notification basis where customers pay the factor directly

Pledging receivables Accounts receivable used as collateral Banks may fund between 50 - 90% of the face value of acceptable receivables In addition, to protect its interests, the lender files a lien on the collateral Receivables financing transfers the default riskto the financing company The focus shifts from trying to collect receivables to value-added business activities

Managing inventory Alternative Views About Inventory Consignment Inventory Just-In-Time (JIT) Economic Order Quantity

Alternative views about inventory

The system Divide inventory into three groups of descending order of importancebased on the dollar amount invested in each Typical system contains: Group A: 20% of the items worth 80% of the total dollar value Group B: the next largest investment And so on Control of the A items more intensive because of the high dollar investment

Consignment inventory Inventory in possession of the client, but still owned by the supplier Supplier: Places inventory in client’s possession Allows selling / consumption from stock Needs high degree of confidence in sales potential Client: Buys inventory only after sale/ consumption Does not have to tie up capital in inventory

Minimizes the inventory investment by having material inputs arrive exactly at the time they are needed for production Extensive coordination must exist between the business, its suppliers, and shipping companies to ensure that material inputs arrive on time In addition, the inputs must be of near perfect quality and consistency given the absence of safety stock Just-in-Time (JIT) system

Economic Order Quantity model (EOQ) EOQ = 2 x S x OC Used to determine what order size minimizes inventory costs Where: S = usage in units per period (year) O = order cost per order C = carrying costs per unit per period (year) Q = order quantity in units

EOQ calculation example Units used per year (S) = 1,600 Cost per order (O) = $50 Carrying Cost (C) = $1 per unit EOQ = (2 * 1,600 * $50) = 400 units $1

Key EOQ inputs Carrying Costs Of Inventory: rent, utilities, insurance, taxes, employee costs, and the opportunity cost of having your capital tied up in inventory Order Costs: For purchased items, thecost to create purchase orders, process receipts, conduct incoming inspections, process invoices & vendor payments, and shipping costs In manufacturing, the cost of the time to initiate the work order, time associated with picking & issuing components, production scheduling time, machine set up time, and inspection time.

Once a firm has calculated its EOQ, it must determine when to place orders. The reorder point must consider the lead time needed to place and receive orders. If we assume that inventory is used at a constant rate throughout the year (no seasonality), the reorder point can be determined as follows: Reorder point = lead time in days x daily usage where daily usage = annual usage / 360 EOQ: the reorder point

Daily usage = 1,600 / 360 = 4.44 units/day Reorder Point = 10*4.44 = 44.44 => 45 units Reorder point calculation example It takes 10 days to place and receive an order Annual usage = 1,600 units / year

Cash management Categories of float Managing float Float management techniques Zero-balance accounts

Categories of float (1 of 2) Collection float:delay between the time when a payer deducts a payment from its checking account ledger and the time when the payee actually receives the funds in spendable form Disbursement float:delay between the time when a payer deducts a payment from its checking account ledger and the time when the funds are actually withdrawn from the account

Mail float:delay between the time when a payer places payment in the mail and the time when it is received by the payee Processing float:delay between the receipt of a check by the payee and the deposit of it in the firm’s account Clearing float:delay between the deposit of a check by the payee and the actual availability of the funds due to the time required for a check to clear Categories of float (2 of 2)

Managing float The presence of float lengthens: The average collection period The average payment period The goal is to: Shorten the average collection period Lengthen the average payment period

Speeding up collections with lockboxes Payers send their payments to a nearby post office box Lockbox is serviced by the bank several times a day Lockboxes reduce collection float by: shortening the processing float shortening mail and clearing float

Slowing down payments with controlled disbursing Involves strategic use of mailing points and bank accounts to lengthen mail float and clearing float Should be used carefully, however, as longer payment periods may strain supplier relations

Cash concentration: direct sends & other techniques Wire transfers:removes funds from the payer’s bank and deposits them into the payees bank, reducing collections float. Automated clearinghouse (ACH) debits:pre-authorized electronic transfers from the payer’s account to the payee’s account via settlement among banks ACHs clear in one day, thereby reducing mail, processing, and clearing float

Zero-balance accounts Disbursement accounts that always have an end-of-day balance of zero The purpose is to eliminate non-earning cash balances in corporate checking accounts A ZBA works well as a disbursement account under a cash concentration system

Managing accounts payable Spontaneous liabilities Managing accounts payable Taking or not taking the cash discount Cost of giving up the cash discount Effect of stretching payables Using the cost of giving up the cah discount in decision making

Spontaneous liabilities Arise from the normal course of business Two major sources: accounts payable, accruals Accruals: Liabilities for services received for which payment has yet to be made Most common accruals: wages and taxes As sales increase, liabilities increase in response to increased purchases, wages, and taxes

Managing accounts payable Credit terms offered by suppliers allow for delays in payment for purchases Major source of unsecured short-term financing Pay as slowly as possible without damaging credit rating or relationships Suppliers may impute the cost of offering terms in the selling price Analyze terms to determine best credit strategy

Taking or not taking the cash discount Take the cash discount: Pay on the last day of the discount period No associated costs Can be a source of additional profitability Give up the cash discount: Pay on the final day of the credit period The cost is the implied rate of interestfordelaying payment an additional number of days

Cost of giving up a cash discount Annualized cost can be calculated as: CD x 365 100% - CD N Where CD = stated cash discount in percentage terms N = # of days payment can be delayed by giving up the cash discount Assuming terms of 2/10, net 30: Annualized Cost = 2% x 365 = 37.24% 100% - 2% 20

Effect of stretching payables Credit terms are 2/10 net 30 Assume payments can be stretched to 70 days without damaging the credit rating or raising issues with suppliers New cost of giving up the cash discount: Annualized Cost = 2% x 365 = 12.42% 100% - 2% 60 Stretching payables reduces the implicit cost of giving up the cash discount

Using the cost of giving up a cash discount in decision making You need short-term funds Short-term credit is available at 13% Borrow funds, take discounts from A/C/D Give up discount from B as opportunity cost is less than cost of borrowing

Funding with bank loans Unsecured short-term loans Loan interest rates Fixed and floating rate loans Payment of interest Computing the effecting rate of interest Single payment notes Lines of credit Revolving credit agreements

Unsecured short-term loans Short-term, self-liquidating loansfor seasonal peaks in financing needs Used during inventory build ups or when experiencing growth in receivables The loans are retired as receivables and inventories are converted into cash Three basic forms: Single-payment notes Lines of credit Revolving credit agreements

Loan Interest Rates Most banks loans are based on the prime rate of interest The lowest rate of interest charged by the nation’s leading banks on loans to their most reliable business borrowers Banks determine the rate to be charged by adding a premium to the prime rate to adjust for borrower “riskiness”

Fixed and Floating-Rate Loans Fixed-rate loan:rate determined at set increment above prime, remains at that rate until maturity Floating-rate loan: increment above the prime rate initially established and then allowed to float until maturity The increment above prime is generally lower on floating rate loans

Payment of Interest Interest can be paid at loan maturity or in advance If paid in advance, it is deducted from the loan so that the borrower actually receives less money than requested Loans of this type are called discount loans

Method of computing interest If paid at maturity, the effective (true) rate of interest for a one-year loan is: The effective rate of interest on a one-year discount loan is: Interest / Amount Borrowed Interest / (Amount Borrowed – Interest)

Computing interest example You need to borrow $10,000 at a stated rate of 10% for 1 year Interest paid at maturity, the effective interest rate is: Discount loan, the effective interest rate is: (10% X $10,000) / $10,000 = 10.0% (10% X $10,000) / ($10,000-$1,000) = 11.1%

Single payment notes Short-term, one-time loan payable as a single amount at its maturity The “note” states the terms of the loan, including the length of the loan and the interest rate Most have maturities of 30 days to 9 or more months Interest is usually tied to prime, may be fixed or floating

Computing interest on single payment notes: initial data You borrow $100,000 from each of 2 banks — A and B Loan A is a fixed rate note, loan B is a floating rate note Both loans are 90-day notes with interest due at the end of 90 days Prime is at 6% and the rates are: 1.5% above prime for A 1.0% above prime for B

Computing interest on loan A The total interest cost on loan A is: $100,000 x 7.5% x (90/365)] = $1,849 The effective cost is 1.85% for 90 days The effective annual rate is: EAR = (1 + periodic rate)m - 1 = (1+. 0185)4.06 - 1 = 7.73%

Computing Interest on Loan B Periodic rate = rate x (30/365) Total interest cost: $100,000 x (.575% + .616% + .596%) = $1,787 Effective cost = 1.787% for 90 days EAR = (1+.01787)4.06 - 1 = 7.46%

Lines of Credit (LOC) Agreement for a specific amount of unsecured short-term borrowing over a given period of time Usually made for a period of 1 year, with various operating restrictions on borrowers The interest rate on a LOC is normally floating and pegged to prime. Although not guaranteed, the amount of the LOC is the maximum you can owe the bank at any point in time

Lines of credit and compensating balances LOCs often require the borrower to maintain compensating balances A compensating balance is a certain checking account balance equal to a certain percentage of the amount borrowed (typically 10 to 20%). This requirement effectively increases the cost of the loan to the borrower

Line of credit: effective costs You get an LOC of $1 million, at 10%, compensating balance of 20% ($200K) You have access to only $800,000 and must pay $100, 000 as interest With the compensating balance, the effective cost of the loan is 12.5%($100,000/$800,000) That’s 2.5% more than the stated rate of interest

Revolving credit agreements Essentially a guaranteed line of credit, also sometimes called a “revolver” The bank guarantees the funds will be available and typically charge a commitment fee on the unused portion of the credit line A typical fee is around 0.5% of the average unused portion of the funds More expensive than the LOC, but less risky from the borrower’s perspective

Effective annual cost of revolving credit agreement You have a $2 million RCA Average borrowing for the past year = $1.5 million The bank charges: A commitment fee of 0.5% on the unused balance of $500,000 or $2,500 Interest of $112,500on the $1.5 million used Effective annual cost: [($112,500 + $2500)/$1,500,000] = 7.67%

Working capital requirements Estimating working capital requirements Alternative scenarios: 20% sales growth 0% sales growth 20% sales decline

Estimating working capital requirements Changes in working capital can be unstable Big increases in some years, followed by big decreases in following years Look at working capital per dollar of sales Then determine the approximate amount of working capital required to support sales

Working capital requirements Alternative Scenarios Working capital = $900,000 Total Sales = $4,500,000 Working Capital / Total Sales = 20% For every $1,000 of new sales, $200 required to support the sales increase

Working capital strategies Profitability and risk trade-offs Impact of working capital strategies Short-term financial management objectives The cash conversion cycle Financial forecasts

Profitability and risk trade-offs Profitability vs. risk trade-off Components of cash cycle: Average collection period Average age of inventory Average payment period Managing the cash conversion cycle

Positive Net Working Capital: Lower Return / Lower Risk Current Assets Net Working Capital > 0 Fixed Assets Current Liabilities Long-Term Debt Equity low cost low return high cost high return highest cost Lower return / lower risk profile

Negative Net Working Capital: Higher Return / Higher Risk Current Assets Fixed Assets Current Liabilities Net Working Capital < 0 Long-Term Debt Equity low return low cost high cost high return highest cost High return vs. high risk profile

Effect of working capital strategies on profits and risk

Short-Term financial management objectives Manage current assets and liabilities to balance profitability and risk Central to short-term financial management is an understanding of the cash conversion cycle

Average collection period Average length of time from a sale on credit until the collection of funds Consists of two parts: Time from a sale until the customer mails payment Time from mailing of payment until the collection of funds in the bank account Calculated as: Accounts Receivable Average Sales Per Day

Average age of inventory # of days an average inventory item takes to sell Calculated as : Example: average inventory is $47,500, and cost of goods sold is $500,000. $47,500 x 365 days = 34.7 days $500,000 Average Inventory x 365 days Cost of Goods Sold

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