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Supply Chains and Working Capital Management

CHAPTER 16

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Topics in Chapter

Alternative current operating assets investment and financing policies

Cash, inventory, and A/R management

Accounts payable management

Short-term financing

Bank loans, their costs, and commercial paper

Determinants of Intrinsic Value: Working Capital and FCF

Basic Definitions (1 of 2)

Net operating working capital (NOWC):

Operating CA – Operating CL =

(Cash + Inv. + A/R) – (Accruals + A/P)

Working capital:

Total current assets used in operations.

Net working capital:

Current assets – Current liabilities.

Definitions (2 of 2)

Working capital management:

Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable.

Working capital policy:

The level of each current asset.

How current assets are financed.

Selected Ratios for RR

	RR	Industry
Current	1.75	2.25
Quick	0.92	1.16
TL/Assets	58.76%	50.00%
Turnover of Cash	16.67	22.22
DSO(365-day year)	45.63	32.00
Inv. Turnover	10.80	20.00
F.A. Turnover	7.75	13.22
T.A. Turnover	2.60	3.00
Profit Margin	2.07%	3.50%
ROE	10.45%	21.00%
Payables deferral	30.00	33.00

How does RR’s current asset usage policy compare with the industry?

The current asset usage policy is reflected in a firm’s current ratio, quick ratio, turnover of cash and securities, inventory turnover, and DSO.

These ratios indicate RR has large amounts of operating current assets relative to its level of sales. Thus, RR is following a relaxed policy.

Is RR inefficient or just conservative?

A relaxed policy may be appropriate if it reduces risk more than profitability.

However, RR is much less profitable than the average firm in the industry. This suggests that the company probably has excessive working capital.

Cash Conversion Cycle (1 of 3)

The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales:

Cash		Inventory		Average		Payables
Conversion	=	Conversion	+	Collection	−	Deferral
Cycle		Period		Period		Period

Cash Conversion Cycle (2 of 3)

Data:

Annual sales = $660,000

COGS/Sales = 90%

Inventory turnover = COGS/Inventory = 10.8

COGS = (0.9)($660,000) = $594,000.

Inventory = $594,000/10.8 = $55,000.

Inv. Conv. = $55,000/($594,000/365)

= 33.8 days.

Cash Conversion Cycle (3 of 3)

CCC	=	Inventory conversion period	+	Days sales outstanding	−	Payables deferral Period
CCC	=	33.8+45.6-30
CCC	=	49.4 days.

Is RR holding too much inventory?

RR’s inventory turnover (10.80) is considerably lower than the industry average (20.00). The firm is carrying a lot of inventory per dollar of sales.

If RR reduces its inventory, without adversely affecting sales, what effect will this have on free cash flow?

Short run: A one-time reduction in inventory causes an identical one-time increase in free cash flows.

Long run: If sales grow and inventory improvement processes are maintained, future FCF each year will be greater than it otherwise would have been.

An improvement in a working capital process is a gift that keeps on giving.

Accounts Receivable Management: Do RR’s customers pay more or less promptly than those of its competitors?

RR’s days’ sales outstanding (DSO) of 45.6 days is well above the industry average (32 days).

RR’s customers are paying less promptly.

RR should consider tightening its credit policy to reduce its DSO.

Elements of Credit Policy (1 of 2)

Cash Discounts: Lowers price. Attracts new customers and reduces DSO.

Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales.

Elements of Credit Policy (2 of 2)

Credit Standards: Tighter standards reduce bad debt losses, but may reduce sales. Fewer bad debts reduces DSO.

Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships.

Does RR face any risk if it tightens its credit policy?

YES! A tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

If RR succeeds in reducing DSO without adversely affecting sales, what effect would this have on its free cash flows?

Similar to the situation with inventory

Short run: A one-time reduction in DSO causes an identical one-time increase in free cash flows.

Long run: If sales grow and DSO remains at it new level, then future FCF each year will be greater than it otherwise would have been.

Higher Levels of Accruals

Higher levels of accruals, such as accrued wages, increase FCF.

Accruals are free in that no explicit interest is charged.

Firms have little control over the level of accruals. Levels are influenced more by industry custom, economic factors, and tax laws.

What is trade credit?

Trade credit is credit furnished by a firm’s suppliers.

Trade credit is often the largest source of short-term credit, especially for small firms.

Spontaneous, easy to get, but cost can be high.

RR buys $200,000 of materials net, on terms of 1/10, net 30 but pays on Day 40. Find free and costly trade credit.

Net daily purchases = $200,000/365 = $547.94.

Ann. gross purch.= $200,000/(1 – 0.01) = $202,020.

Gross/Net Breakdown

Company buys equip worth $200,000. That’s the equipment’s cash price.

The firm must pay $2,020 more if it doesn’t take discounts.

Think of the extra $2,020 as a financing cost similar to the interest on a loan.

Want to compare that cost with the cost of a bank loan.

Free and Costly Trade Credit

Payables level for equipment if take discount:

Payables = $547.94(10) = $5,479.

Payables level if don’t take discount:

Payables = $547.94(40) = $21,918.

Total trade credit = $21,918

Free trade credit = 5,479

Costly trade credit = $16,439

Nominal Cost of Costly Trade Credit, rNOM

Firm loses 0.01($202,020) = $2,020 of discounts to obtain $16,439 in extra trade credit, so:

But the $2,020 is paid all during the year, not at year-end, so effective annual rate is higher.

Nominal Cost Formula, 1/10, net 40

Effective Annual Rate (EAR), 1/10, net 40

Periodic rate = 0.01/0.99 = 1.01%.

Periods/year = 365/(40 – 10)

= 12.1667.

EAR = (1 + Periodic rate)n – 1.0

= (1.0101)12.1667 – 1.0

= 13.01%.

Cash Management: Cash doesn’t earn interest, so why hold it?

Transactions balances

Must have some cash to pay current bills.

Precautionary balances (i.e.,“Safety stock”)

Not as much needed if company has credit line or other holdings of short-term securities.

Essential that the firm have sufficient cash to take trade discounts.

Compensating balances: For loans and/or services provided.

Ways to Minimize Target Cash Cash Balance (1 of 2)

Synchronize inflows and outflows.

Use float.

Use lockboxes.

Insist on wire transfers or automatic debit from customers.

Ways to Minimize Target Cash Cash Balance (2 of 2)

Increase forecast accuracy to reduce the need for a cash “safety stock.”

Hold marketable securities instead of a cash “safety stock.”

Negotiate a line of credit (also reduces need for a “safety stock”).

Current Operating Assets Financing Policies

Moderate: Match the maturity of the assets with the maturity of the financing.

Aggressive: Use short-term financing to finance permanent assets.

Conservative: Use permanent capital for permanent assets and temporary assets.

Moderate Financing Policy

What are the advantages of short-term debt vs. long-term debt? (1 of 2)

Low cost-- yield curve usually slopes upward.

Can get funds relatively quickly.

Can repay without penalty.

What are the advantages of short-term debt vs. long-term debt? (2 of 2)

Higher risk. The required repayment comes quicker, and the company may have trouble rolling over loans.

Commercial Paper (CP)

Short term notes issued by large, strong companies. RR couldn’t issue CP--it’s too small.

CP trades in the market at rates just above T-bill rate.

CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes.

Cash Budget: The Primary Cash Management Tool

Purpose: Uses forecasts of cash inflows, outflows, and ending cash balances to predict loan needs and funds available for temporary investment.

Timing: Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management.

Data Required for Cash Budget

Sales forecast.

Information on collections delay.

Forecast of purchases and payment terms.

Forecast of cash expenses: wages, taxes, utilities, and so on.

Initial cash on hand.

Target cash balance.

RR’s Cash Budget for January and February (1 of 2)

Net Cash Inflows

	January	February
Collections	$67,651.95	$62,755.40
Purchases	44,603.75	36,472.65
Wages	6,690.56	5,470.90
Rent	2,500.00	2,500.00
Total Payments	$53,794.31	$44,443.55

RR’s Cash Budget for January and February (2 of 2)

	January	February
Cash on hand at start of forecast	$3,000.00
Net CF (Coll – Pymt)	13,857.64	18,311.85
Cumulative NCF	$16,857.64	$35,169.49
– Target cash	1,500.00	1,500.00
Surplus cash	$15,357.64	$33,669.49

What does the cash budget show regarding the target cash level?

Forecasted cash balances are higher than the target.

RR could invest this excess cash in short-term securities.

Should depreciation be explicitly included in the cash budget?

No. Depreciation is a noncash charge. Only cash payments and receipts appear on cash budget.

However, depreciation does affect taxes, which do appear in the cash budget.

What are some other potential cash inflows besides collections?

Proceeds from fixed asset sales.

Proceeds from stock and bond sales.

Interest earned.

Court settlements.

How can interest earned or paid on short-term securities or loans be incorporated in the cash budget?

Interest earned: Add line in the collections section.

Interest paid: Add line in the payments section.

Found as interest rate x surplus/loan line of cash budget for preceding month.

Note: Interest on any other debt would need to be incorporated as well.

How could bad debts be worked into the cash budget?

Collections would be reduced by the amount of bad debt losses.

For example, if the firm had 3% bad debt losses, collections would total only 97% of sales.

Lower collections would lead to lower surpluses and higher borrowing requirements.

NOM

$2,020

r0.122912.29%

$16,439

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