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Caer) “>. €3 a ee Strathclyde MSc Finance — Finance 4 Working Capital Management Issues for this unit • The working capital cycle • Current assets • Stocks / inventories • Cash management • Debtors / accounts receivable • Current liabilities • Creditors / accounts payable as a source of finance Working capital cycle Cash Finished goods inventory Receivables Raw materials inventory Creditors Wages Simple cycle of operations Management of working capital • Have sufficient short-term assets in place to pay short-term liabilities as they arise • Liquidity is vital to continued operations of business • Overtrading • Trading at a level where insufficient funds are in place to cover current liabilities • Company may be profitable but has insufficient cash • Firm must reduce trading to recoup cash University of Strathclyde Business School Cash and operating cycles Raw material Finished goods sold Cash received purchased Order Stock placed —_ arrives |< Inventory period ——->/«—— Accounts receivable period ——| Time '<- Accounts payable period > Y Firm receives Cash paid invoice for materials Operating cycle Cash cycle Debtor and creditor days • Accounts payable days • = (average creditors / daily credit purchases) x 360 • = (2,000 / 9,000) x 360 = 80 days • Accounts receivable days • = (average debtors / daily credit sales) x 360 • = (6,000 / 60,000) x 360 = 36 days Working capital cycle • Operating cycle • = inventory period + accounts receivable period • = (140 + 54 + 48) + 36 = 278 days • Period from arrival of stock until receipt of cash • Working capital cycle • = inventory period + accounts receivable period – accounts payable period • (140 + 54 + 48) + 36 – 80 = 198 days • Period from payment of cash for materials until receipt of cash from sale of goods Liquidity • Why is it important to companies? • High transaction costs of raising cash quickly • Problems of raising cash if company is perceived to be in financial difficulty • Some liquidity stored in current assets • Securities, stocks and debtors can be liquidated for cash • Cash, securities and lines of credit provide liquidity but carry explicit cots • Debtors and stocks carry less obvious costs Working capital and financing strategies (3) • Intermediate financing strategy (F3) • Finance fixed assets and some of permanent current assets from long-term sources • Use current liabilities to finance all temporary requirements plus some proportion of permanent current assets • Risky / aggressive financing strategy (F4) • Only use long-term finance for fixed assets • Finance all current assets from current liabilities Trade-off considerations in working capital management •Aggressive Policy • Low current assets • High current liabilities •Advantages • Low interest charges •Disadvantages • Possible loss of sales through stock-outs and less generous credit terms • Potentially high cost / low quality suppliers if offering generous credit terms • Risk of insolvency •Conservative policy • High current assets • Low current liabilities •Advantages • Stock and credit policies may increase sales • Able to manage short-term setbacks more comfortably •Disadvantages • High interest charges Why hold stocks / inventory? • Acts as a buffer against uncertain and fluctuating demand • Difficulties in predicting • Sales demand • Production requirements • Productivity • Problems with • Suppliers • Labour force Factors determining optimal stock of raw materials • Level of production • Variability of production over time • Reliability of sources of supply • Efficiency of scheduling purchases and production • Holding costs of materials • Ordering costs of stock Economic order quantity (EOQ) model • Determines the optimal order to replenish the stocks of an item • Indirectly the optimal average level of stocks • Appropriate where the demand for an item is stable • Optimal order size determined by trading off • Holding costs • Ordering costs EOQ Assumptions • Demand is known with certainty and is uniform over time • The order level (Q) is constant • The order cost is fixed • Is unrelated to the order size • Total annual cost falls as the number of order falls • Shortages, leading to stock-outs, do not occur • The lead time for orders is zero in the basic model Economic order quantity (EOQ) model • Determined as average level of stock multiplied by annual holding cost per unit of stock • Total demand divided by order size (giving number of orders) multiplied by cost per order HQCCostHoldingAnnual 2 1 = 0CQ DCostOrderingAnnual = 02 1 C Q DQCCostAnnualTotal H += EOQ model – deriving optimal order size and period Take the derivative and set equal to zero to solve for the level of Q that minimises total cost, Q* 02 1 C Q DQCCostAnnualTotal H += HC DCQ 0* 2= 365 D Q DemandDaily Average EOQPeriodOrder Optimal * == EOQ model Cost Av.total cost Annual ordering cost Annual holding cost Order quantity Formal proof of EOQ for Baron wines Average holdings = Q/2 = 1,249 cases 62.45 orders per annum (156,000 / 2498) Total ordering costs = £4,996 Total holding costs = £4,996 orderpercases2,498 4 8052)(3,0002Q* =×××= days 5.84 365 156,000 2498 365 D QPeriodOrder Optimal * === EOQ and Safety Stock Inventory time Average Inventory 0 Safety stock EOQ and Safety Stock Inventory time Average Inventory 0 Safety stock Re-order level Another example – Dyfed Furniture The Dyfed Furniture Company sells kitchen units from stock. It is anticipated that next year it will sell 1200 units and a decision must be made on how many units to hold in stock. It has been estimated that each order will cost £60 to process (i.e. administrative costs, transportation, and handling costs) and inventory carrying costs are estimated to £40 per unit per annum. What are the economic order quantity and optimal order period? Annual holding, ordering and total costs for Dyfed Furniture Ordering Quantity Holding Cost Annual Ordering Cost Total Cost of Stock 10 £200 £7,200 £7,400 20 £400 £3,600 £4,000 30 £600 £2,400 £3,000 40 £800 £1,800 £2,600 50 £1,000 £1,440 £2,440 60 £1,200 £1,200 £2,400 70 £1,400 £1,029 £2,429 80 £1,600 £900 £2,500 90 £1,800 £800 £2,600 100 £2,000 £720 £2,720 Formal proof of EOQ for Dyfed Furniture Average holdings = Q/2 = 30 kitchen units 20 orders per annum (1200 / 60) Total ordering costs = £1,200 Total holding costs = £1,200 orderper units 60 40 60)1200(2* =××=Q days 18.25 365 1200 60 365 PeriodOrder Optimal * === D Q Stock-outs and profitability Level of stock Stock-out possibility Stock-out cost Probability Expected value of stock-out cost Holding cost of stock Total cost 180 0 0 0 0 360 360 160 20 200 0.15 30 320 350 140 40 400 0.15 60 20 200 0.20 40 100 280 380 120 60 600 0.15 90 40 400 0.20 80 20 200 0.30 60 230 240 470 100 80 800 0.15 120 60 600 0.20 120 40 400 0.30 120 20 200 0.20 40 400 200 600 A final note on inventory management • Reducing costs of stockholdings in practice • Seek out reliable suppliers able to fulfil company’s orders at short notice • Dispose of potentially obsolete stocks by lowering prices immediately when problems become apparent • Select production methods to lower inventory needs Cash management • Why hold cash? • Strictly speaking we talk about cash and cash equivalents (i.e. t-bills) • Transaction motive • Normal disbursement and collection activities • Security • Common for banks to require ‘compensating balances’ for banking services • General aim is to minimise cash balance University of Strathclyde School Cash management and the Baumol model 0.5C Cash management and the inventory model (2) • Identical to the economic order quantity • The optimal cash balance is increasing with • The lower the interest rate (r) • The higher the transaction cost of raising cash (TC) • The higher the annual cash requirement (ACR) ( )( ) r TCACRC 2* = University of Strathclyde Business Optimal cash balance under Baumol” Total costs of holding cash Opportunity costs Cost of holding cash Trading costs Size of cash Optimal size balance (C) of cash balance Limitations of the Baumol model • Assumes no cash receipts during the projected time period • Assumes the firm has a constant disbursement rate for cash • No safety level of cash is assumed University of Strathclyde School Amore realistic alternative — the Miller- Orr model U is the upper control limit. L is the lower control limit. Z The target cash balance is Z. As long as cash is between L L and U, no transaction is made. Cash The Miller-Orr model in words • The firm sets a minimum lower limit cash balance (L) • Allows the financial manager to solve for: • The target cash balance held by the firm (Z) • The upper limit (U) on the firm’s cash balance • Model inputs are similar in spirit to Baumol • Opportunity cost given as the daily interest rate – (r) • Transaction cost of raising cash – (TC) • Variance of daily net cash flows – VAR(CF) Solving for Z*, U and Average cash balance 08.946,30£000,10 000261.04 8000503 2 3 * =+= x xxZ 23.838,72£000,10208.946,30323 ** =−=−= xxLZU 10.928,37£ 3 000,1008.946,304 3 4 * = − = − = xLZACB Implications of the Miller-Orr model • Best return point, Z* is • Increasing with transaction costs of raising cash • Negatively related to opportunity costs of holding cash • Consistent with Baumol’s trade-off model predictions • Best return point and average cash balance are increasing with variability of cash flows • Firms with more uncertain cash flows should hold more cash Other factors influencing cash balances • Borrowing • Alternative to selling marketable securities • Higher interest cost than selling marketable securities • Depends on manager’s desire to hold low cash balances • Compensating balances • Previously discussed security provided for banking facilities • Forecasting • Predictability in future cash flows and their variability University of . . Strathclyde Investing idle cash Sih S Bank 3 Marketable loans Short-term financing > securities = 5 & Long-term financing: re} Equity plus long-term debt 2 ! i | 0 1 2 3 Time Time 1: A surplus cash flow exists. Seasonal demand for investing is low. The surplus cash flow is invested in short-term marketable securities. Time 2: A deficit cash flow exists. Seasonal demand for investing is high. The financial deficit is financed by selling marketable securities, and by bank borrowing. Investment in debtors • Issues to be considered • Terms of sale • The credit decision • Credit analysis • Debtor collection policy • Legalities and offering trade credit Terms of sale • Terms of sale • Credit, discount and payment terms offered on a sale • For example • 5/10, net 30 • 5% discount for early payment • 10 number of days that the discount is available • 30 number of days before payment is due and expected Valuing the cash discount • Value of discount can be calculated with reference to loan alternative to credit • May also be other costs if financing through credit reduces credit rating 1 365 −⎟⎟ ⎠ ⎞ ⎜⎜ ⎝ ⎛ = reditextradaysc pricediscounted cesellingpriEAR An example – early payment discount XYZ plc has recently won a very large order to supply a retail chain, called TT Ltd, with items over the next two years. The size of any order may vary considerably and XYZ are obliged to deliver within 2 days of an order being placed. This will mean that XYZ will have to invest much more heavily in stocks. TT Ltd also usually requires 90 days credit from any of its suppliers and this will mean that XYZ will need a considerable additional investment in debtors. The bank charges 12 per cent per annum for a loan. XYZ are considering either a debt factoring, loan financing or offering TT Ltd a 3 per cent discount to settle within 10 days instead of 90 days. Calculate whether it is better for XYZ to offer the discount to get payment in 10 days or to finance via a loan. Solution to early payment example %9.14149.01 97 100 1 price discounted price selling 80 365 credit days extra 365 ==−⎟ ⎠ ⎞ ⎜ ⎝ ⎛= −⎟⎟ ⎠ ⎞ ⎜⎜ ⎝ ⎛ = EAR EAR Credit analysis (2) • Multiple discriminant analysis • Method of determining a quantitative measure of a company’s solvency • Altman’s Z-scores • Able to successfully identify companies that went bankrupt in 95% of cases Decision to offer credit and discriminant analysis • Seek to identify companies less likely to pay • There are differences in the characteristics of companies that are likely to pay their accounts and those likely to default • Such characteristics are identifiable and measurable • Allows credit applicants to be classified on a probabilistic basis Discriminant analysis • Can be applied to any problem requiring differentiation between two groups • Likelihood of receiving a takeover bid • Likelihood of a manager being removed • Likelihood of a company going bankrupt • Credit risk • Size, ROCE, Debt-to-assets • Example using quick ratio and net assets-to-assets Successful implementation of multiple discriminant analysis • Successful application requires that • MDA function must draw from a sample that is similar to the potential customer being analysed • Applicants in the gray area around the cut-off point should be evaluated in more depth • The validity and effectiveness of the function will fall over time • Relevant variables change • Parameter estimates change Multiple discriminant analysis (MDA) • Altman’s Z-score formula • If Z > 2.7 the firm is determined as healthy and could be provided with credit • Firms with Z > 2.7 were highly unlikely to be bankrupt within 2 years assets total capital working1.2+ assets total earnings retained1.4+ debtbook total equity of uemarket val.6+ assets total sales1.0+ assets total EBIT3.3=Z MDA – an example • The Altman Z-score for identifying a credit- worthy business is 2.7 • Would we accept the following client? 9. debtbook equitymarket 4.1 assets total sales 12.0 assets total EBIT = = = 12. assets total capital working 4. assets total earnings retained = = 04.3)12.2.1()4.4.1()9.6(.)4.10.1()12.3.3( Score Z =++++= xxxxx The credit decision: possible repeat payoffs The credit decision and its probable payoffs Customer defaults = 1-p Customer pays = p Customer pays = p (H) Customer defaults = 1-p (L) Payoff = 2(Rev - Cost) Payoff = - Cost Payoff = - Cost + Rev - Cost The Credit Decision The credit decision and its probable payoffs Refuse credit Offer credit Customer pays = p Customer defaults = 1-p Payoff = 0 Offer further credit Refuse further credit An example – expected profitability of a new customer with default possibility It is estimated that the probability of a potential customer defaulting on his account is 40 per cent. If credit is granted and the customer meets his obligations the estimated default on the second order is far less than the first. The probability of default on a repeat order, is estimated 10 per cent. The price of the product is £150 and the incremental cost of production per unit is £100. Accounts receivable collection policy • Average collection period and ageing schedule • Classification of accounts receivable by time to collect and time outstanding • Collection policy • Procedures to collect and monitor debtors • Collection effort – self explanatory • Factoring • Using accounts receivable to raise additional funds Average debtor collection period – debtor days A company sells 500,000 widgets each year at £1 per widget. All sales are for credit with terms of 3/30, net 90. Assume that 70% of the firm’s customers take the discount, with the remaining 30% paying within the required 90 days. Average collection period (ACP) • Measures time taken to collect accounts receivable • Problematic where customers don’t pay on two specific dates • Determine accounts receivable today (assumed in example below) and divide by daily sales days 48days 90 x 0.3 days 30 x 0.7ACP =+= days 48 days 365 500,000x£1 £65,753.42 salesdaily Average receivable AccountsACP === Ageing schedule for balance of debtors Age of Account (Days) Percent of Debtors Outstanding (April 30) Percent of Debtors Outstanding (May 31) 0-30 45.7 37.1 30-60 35.7 33.6 60-90 12.9 20.7 90-120 5.7 8.6 Total 100% 100% Pattern of the balance of debtors • Allows us to measure how long our debtors are taking to pay based on each month’s revenues Month of Sale April May Same month 30% 30.7% One month earlier 25% 24.4% Two months earlier 15% 16.0% 3 months earlier 5% 11.1% Factoring • Typically provide three key services • Sales ledger management • Assess credit risk of customers, send invoices, collect payments, recording ledger • Trade credit insurance • Covers the cost of bad debts in the event of default • Provision of finance • Advance fraction of invoice values to selling company with remainder paid upon receipt from debtors Creditors as a source of financing • Arises naturally within many firm’s operations • Once credit standing of a firm is established it can typically obtain supplies on ‘open account’ terms • Typically 30 days • Stretching credits arises where firm postpones payment beyond specified credit period • Alternative to borrowing and paying cash • Appears a free source of funding, but • Suppliers may be unwilling to deal with the company • Cost / quality of dealing with alternative suppliers • Loss of reputation in credit markets Discounts for early payment and cost of credit A supplier offers terms of a 1% discount for payment within 7 days, with payment due in 30 days if the discount is not taken. The implicit interest cost on this credit can be worked out as follows: where r* is the 23 day interest rate implied on the payment discount as being the difference between 7 days and 30 days )1( 110099 *r x + = Solving for r Rearranging the above: To find the annualised rate of interest: If the firm can borrow for less than 17.29% per annum it should take the discount and borrow the funds to settle the account within 7 days 0101.0 99 99100* =−=r ( ) %29.171729.011 23 365 * ==−+= rr ANNUAL