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RISK MANAGEMENT 14

CHAPTER 16: Working Capital Management

Successful Firms Efficiently Manage Their Working Capital

Working capital management involves finding the optimal levels for cash, marketable securities, accounts receivable, and inventory, and then financing that working capital at the least cost. Effective working capital management can generate considerable amounts of cash.

As any small business person can tell you, one way to generate cash is to have your customers pay you more quickly than you pay your suppliers. Recognizing this point on a much larger scale, Amazon has created strong competitive advantages through its effective use of working capital management. When customers order books online from Amazon, they must provide a credit card number. Amazon then receives next-day cash, even before the product is shipped and before it has paid its suppliers.

Another key component of working capital management is efficient inventory usage. Best Buy, the large consumer electronics retailer, pays particular attention to inventories. To maintain sales, its stores must be well stocked with the goods customers are seeking at the time they are shopping. This involves determining what new products are hot, finding where they can be obtained at the lowest cost, and delivering them to stores in a timely manner. Dramatic improvements in communications and computer technology have transformed the way Best Buy manages its inventories. It now collects real-time data from each store on how each product is selling, and its computers place orders automatically to keep the shelves full. Moreover, if sales of an item are slipping, prices are lowered to reduce stocks of that item before the situation deteriorates to the point that drastic price cuts are necessary.

Working capital management has become particularly difficult in the declining economic environment following the recent financial crisis. Some companies have been stuck with unused inventory, while others are reluctant to purchase additional inventory until they see clear evidence that consumer spending has rebounded. Still other companies have found it more difficult to obtain short-term loans from financial institutions, so they have increasingly relied on trade credit from their suppliers as a substitute form of financing. At the same time, many suppliers are faced with a dilemma—in order to generate new sales they find it necessary to provide their customers with generous payment terms—but in doing so, they worry that in a weak economy many of these customers may not be able to pay them back in a timely fashion.

As you can see, effective working capital management is a continual balancing act that has an important influence on the company’s value. After studying this chapter, you should understand how working capital should be managed so as to maximize profits and stock prices.

Putting Things in Perspective

About 50% of the typical industrial or retail firm’s assets are held as working capital, and many students’ first jobs focus on working capital management. This is particularly true in smaller businesses, where the majority of new jobs are being created.

When you finish this chapter, you should be able to:

· Explain how different amounts of current assets and current liabilities affect firms’ profitability and thus their stock prices.

· Explain how companies decide on the proper amount of each current asset—cash, marketable securities, accounts receivable, and inventory.

· Discuss how the cash conversion cycle is determined, how the cash budget is constructed, and how each is used in working capital management.

· Discuss how companies set their credit policies, and explain the effect of credit policy on sales and profits.

· Describe how the costs of trade credit, bank loans, and commercial paper are determined and how that information impacts decisions for financing working capital.

· Explain how companies use security to lower their costs of short-term credit.

16-1: Background on Working Capital

The term working capital originated with the old Yankee peddler who would load up his wagon and go off to peddle his wares. The merchandise was called “working capital” because it was what he actually sold, or “turned over,” to produce his profits. The wagon and horse were his fixed assets. He generally owned the horse and wagon (so they were financed with “equity” capital), but he bought his merchandise on credit (that is, by borrowing from his supplier) or with money borrowed from a bank. Those loans were called working capital loans, and they had to be repaid after each trip to demonstrate that the peddler was solvent and worthy of a new loan. Banks that followed this procedure were said to be employing “sound banking practices.” The more trips the peddler took per year, the faster his working capital turned over and the greater his profits.

This concept can be applied to modern businesses, as we demonstrate in this chapter. We begin with a review of three basic definitions that were first covered in Chapter 3 :

· 1. Working capital. Current assets are often called working capital because these assets “turn over” (i.e., are used and then replaced during the year). 1

· 2. Net working capital is defined as current assets minus current liabilities. Recall from Chapter 3 that Allied Food Products has $690 million in net working capital:

· 3. Net operating working capital (NOWC) represents the working capital that is used for operating purposes. As we saw in Chapters 9 and 12 , NOWC is an important component of the firm’s free cash flow. NOWC differs from net working capital because interest-bearing notes payable are deducted from current liabilities in the calculation of NOWC. The reason for this distinction is that most analysts view interest-bearing notes payable as a financing cost (similar to long-term debt) that is not part of the company’s operating free cash flows. In contrast, the other current liabilities (accounts payable and accruals) are treated as part of the company’s operations, and therefore are included as part of free cash flow. 2 Once again, here is the 2015 net operating working capital for Allied Food Products, the firm we discussed in Chapter 3 :

SELF TEST

How did the term working capital originate?

Differentiate between working capital and net working capital.

Differentiate between net working capital and net operating working capital.

16-2: Current Assets Investment Policies

In this section, we discuss how the amount of current assets held affects profitability. To begin, Figure 16.1 shows three alternative policies regarding the size of current asset holdings. The top line has the steepest slope, which indicates that the firm holds a great deal of cash, marketable securities, receivables, and inventories relative to its sales. When receivables are high, the firm has a liberal credit policy, which results in a high level of accounts receivable. This is a relaxed investment policy . On the other hand, when a firm has a restricted investment policy (or tight or “lean-and-mean”) investment policy, holdings of current assets are minimized. A moderate investment policy lies between the two extremes.

FIGURE 16.1: Current Assets Investment Policies (Millions of Dollars)

Note: The sales/current assets relationship is shown here as being linear, but the relationship could be curvilinear.

Relaxed Investment Policy

Relatively large amounts of cash, marketable securities, and inventories are carried, and a liberal credit policy results in a high level of receivables.

Restricted Investment Policy

Holdings of cash, marketable securities, inventories, and receivables are constrained.

Moderate Investment Policy

An investment policy that is between the relaxed and restricted policies.

We can use the DuPont equation to demonstrate how working capital management affects ROE:

A restricted (lean-and-mean) policy indicates a low level of assets (hence, a high total assets turnover ratio), which results in a high ROE, other things held constant. However, this policy also exposes the firm to risks because shortages can lead to work stoppages, unhappy customers, and serious long-run problems. The relaxed policy minimizes such operating problems, but it results in a low turnover, which in turn lowers ROE. The moderate policy falls between the two extremes. The optimal strategy is the one that maximizes the firm’s long-run earnings and the stock’s intrinsic value.

Note that changing technologies can lead to changes in the optimal policy. For example, when a new technology makes it possible for a manufacturer to produce a given product in 5 rather than 10 days, work-in-progress inventories can be cut in half. Similarly, retailers typically have inventory management systems in which bar codes on all merchandise are read at the cash register. This information is transmitted electronically to a computer that records the remaining stock of each item, and the computer automatically places an order with the supplier’s computer when the stock falls to a specified level. This process lowers the “safety stocks” that would otherwise be necessary to avoid running out of stock, which lowers inventories to profit-maximizing levels.

SELF TEST

Identify and explain three alternative current assets investment policies.

Use the DuPont equation to show how working capital policy affects a firm’s expected ROE.

16-3: Current Assets Financing Policies

Investments in current assets must be financed; and the primary sources of funds include bank loans, credit from suppliers (accounts payable), accrued liabilities, long-term debt, and common equity. Each source has advantages and disadvantages, so each firm must decide which sources are best for its situation.

To begin, note that most businesses experience seasonal and/or cyclical fluctuations. For example, construction firms tend to peak in the summer, retailers peak around Christmas, and the manufacturers who supply construction companies and retailers follow related patterns. Similarly, the sales of virtually all businesses increase when the economy is strong; hence, they build up current assets at those times but let inventories and receivables fall when the economy weakens. Note, though, that current assets rarely drop to zero—companies maintain some permanent current assets , which are the current assets needed at the low point of the business cycle. Then as sales increase during an upswing, current assets are increased, and these extra current assets are defined as temporary current assets as opposed to permanent current assets. The manner in which these two types of current assets are financed is called the firm’s current assets financing policy .

Permanent Current Assets

Current assets that a firm must carry even at the trough of its cycles.

Temporary Current Assets

Current assets that fluctuate with seasonal or cyclical variations in sales.

Current Assets Financing Policy

The manner in which current assets are financed.

16-3a: Maturity Matching,or “Self -Liquidating,” Approach

The maturity matching, or “self-liquidating,” approach calls for matching asset and liability maturities as shown in panel a of Figure 16.2 . All of the fixed assets plus the permanent current assets are financed with long-term capital, but temporary current assets are financed with short-term debt. Inventory expected to be sold in 30 days would be financed with a 30-day bank loan; a machine expected to last for 5 years would be financed with a 5-year loan; a 20-year building would be financed with a 20-year mortgage bond; and so forth. Actually, two factors prevent an exact maturity matching: (1) There is uncertainty about the lives of assets. For example, a firm might finance inventories with a 30-day bank loan, expecting to sell the inventories and use the cash to retire the loan. But if sales are slow, the cash would not be forthcoming, and the firm might not be able to pay off the loan when it matures. (2) Some common equity must be used, and common equity has no maturity. Still, when a firm attempts to match asset and liability maturities, this is defined as a moderate current assets financing policy.

Maturity Matching, or “Self-Liquidating,” Approach

A financing policy that matches the maturities of assets and liabilities. This is a moderate policy.

FIGURE 16.2: Alternative Current Assets Financing Policies

16-3b: Aggressive Approach

Panel b of Figure 16.2 illustrates the situation for a more aggressive firm that finances some of its permanent assets with short-term debt. Note that we used the term relatively in the title of panel b because there can be different degrees of aggressiveness. For example, the dashed line in panel b could have been drawn below the line designating fixed assets, indicating that all of the current assets—both permanent and temporary—and part of the fixed assets were financed with short-term credit. This policy would be a highly aggressive, extremely nonconservative position, and the firm would be subject to dangers from loan renewal as well as problems with rising interest rates. However, short-term interest rates are generally lower than long-term rates, and some firms are willing to sacrifice some safety for the chance of higher profits.

The reason for adopting the aggressive policy is to take advantage of the fact that the yield curve is generally upward sloping; hence, short-term rates are generally lower than long-term rates. However, a strategy of financing long-term assets with short-term debt is really quite risky. To illustrate, suppose a company borrows $1 million on a 1-year basis and uses the funds to purchase machinery that will reduce labor costs by $200,000 per year for 10 years. 3 Cash flows from the equipment would not be sufficient to pay off the loan at the end of only 1 year, so the loan would have to be renewed. If the company encountered temporary financial problems, the lender might refuse to renew the loan, which could lead to bankruptcy. Had the firm matched maturities and financed the plant with a 10-year loan, the required loan payments would have been better matched with the cash flows, and the loan renewal problem would not have arisen.

16-3c: Conservative Approach

Panel c of the figure shows the dashed line above the line designating permanent current assets, indicating that long-term capital is used to finance all the permanent assets and to meet some of the seasonal needs. In this situation, the firm uses a small amount of short-term credit to meet its peak requirements, but it also meets part of its seasonal needs by “storing liquidity” in the form of marketable securities. The humps above the dashed line represent short-term financings, while the troughs below the dashed line represent short-term security holdings. This is a very safe, conservative financing policy.

16-3d: Choosing Between the Approaches

Because the yield curve is normally upward sloping, the cost of short-term debt is generally lower than that of long-term debt. However, short-term debt is riskier to the borrowing firm for two reasons: (1) If a firm borrows on a long-term basis, its interest costs will be relatively stable over time. But if it uses short-term credit, its interest expense can fluctuate widely, perhaps reaching such high levels that profits are extinguished. (2) If a firm borrows heavily on a short-term basis, a temporary recession may adversely affect its financial ratios and render it unable to repay this debt. Recognizing this point, if the borrower’s financial position is weak, the lender may not renew the loan, which could force the borrower into bankruptcy. Many companies faced this adverse effect firsthand when their short-term sources of lending disappeared in the midst of the recent financial crisis.

Note too that short-term loans can generally be negotiated much faster than long-term loans. Lenders need to make a more thorough financial examination before extending long-term credit, and the loan agreement must be spelled out in detail because a great deal can happen during the life of a 10- to 20-year loan.

Finally, short-term debt may offer greater flexibility. If the firm thinks that interest rates are abnormally high, it may prefer short-term credit to gain flexibility in changing the debt contract. Also, if its needs for funds are seasonal or cyclical, it may not want to commit itself to long-term debt. Although provisions for repaying long-term debt can be built into the contract, prepayment penalties are also generally built into long-term debt contracts to permit the lender to recover its setup costs. Finally, long-term loan agreements generally contain provisions, or covenants, that constrain the firm’s future actions in order to protect the lender, whereas short-term credit agreements generally have fewer restrictions.

The relative benefits of short-term debt and long-term debt are likely to vary over time. For example, in the credit crunch following the recent financial crisis, many companies found it difficult to roll over their short-term loans coming due. We suspect that many of these companies had wished that they had instead adopted a much more conservative approach toward managing their working capital. However, prior to the crisis, overly conservative firms relying on long-term debt often found themselves at a competitive disadvantage because short-term debt was consistently cheaper than long-term debt, and the rollover risk was minimal because credit was readily available.

All things considered, it is not possible to state that long-term or short-term financing is better than the other. The firm’s specific conditions will affect the choice, as will the preferences of managers. Optimistic and/or aggressive managers will probably lean more toward short-term credit to gain an interest cost advantage, while more conservative managers will lean toward long-term financing to avoid potential loan renewal problems. The factors discussed here should be considered, but the final decision will reflect managers’ personal preferences and judgments.

SELF TEST

Differentiate between permanent current assets and temporary current assets.

What does maturity matching mean, and what is the advantage of this financing policy?

What are advantages and disadvantages of short-term versus long-term debt as identified in this section?

16-4: The Cash Conversion Cycle

All firms follow a “working capital cycle” in which they purchase or produce inventory, hold it for a time, and then sell it and receive cash. This process is similar to the Yankee peddler’s trips, and it is known as the cash conversion cycle (CCC) .

Cash Conversion Cycle (CCC)

The length of time funds are tied up in working capital, or the length of time between paying for working capital and collecting cash from the sale of the working capital.

16-4a: Calculating the Targeted CCC

Assume that Great Fashions Inc. (GFI) is a start-up business that buys ladies’ golf outfits from a manufacturer in China and sells them through pro shops at high-end golf clubs in the United States, Canada, and Mexico. The company’s business plan calls for it to purchase $100,000 of merchandise at the start of each month and have the merchandise sold within 60 days. The company will have 40 days to pay its suppliers, and it will give its customers 60 days to pay for their purchases. GFI expects to just break even during its first few years, so its monthly sales will be $100,000, the same as its purchases. Any funds required to support operations will be obtained from the bank, and those loans must be repaid as soon as cash is available. This information can be used to calculate GFI’s cash conversion cycle, which nets out the three time periods described below: 4

· 1. Inventory conversion period . For GFI, this is the 60 days it takes to sell the merchandise. 5

Inventory Conversion Period

The average time required to convert raw materials into finished goods and then to sell them.

· 2. Average collection period (ACP) . This is the length of time customers are given to pay for goods following a sale. The ACP is also called the days sales outstanding (DSO). GFI’s business plan calls for an ACP of 60 days, which is consistent with its 60-day credit terms.

Average Collection Period (ACP)

The average length of time required to convert the firm’s receivables into cash, that is, to collect cash following a sale.

· 3. Payables deferral period . This is the length of time GFI’s suppliers give GFI to pay for its purchases (40 days in our example).

Payables Deferral Period

The average length of time between the purchase of materials and labor and the payment of cash for them.

On Day 1, GFI buys merchandise and expects to sell the goods and thus convert them to accounts receivable in 60 days. It should take another 60 days to collect the receivables, making a total of 120 days between receiving merchandise and collecting cash. However, GFI is able to defer its own payments for only 40 days. We combine these three periods to find the planned cash conversion cycle, shown here as an equation and in Figure 16.3 as an illustration.

FIGURE 16.3: The Cash Conversion Cycle

Although GFI must pay $100,000 to its suppliers after 40 days, it will not receive any cash until 60 + 60 = 120 days into the cycle. Therefore, it will have to borrow the $100,000 cost of the merchandise from its bank on Day 40, and it will not be able to repay the loan until it collects from customers on Day 120. Thus, for 120 − 40 = 80 days—which is the cash conversion cycle (CCC)—it will owe the bank $100,000 and will pay interest on this debt. The shorter the cash conversion cycle, the better because that will lower interest charges. Note that if GFI could sell goods faster, collect receivables faster, or defer its payables longer without hurting sales or increasing operating costs, its CCC would decline, its interest expense would be reduced, and its profits and stock price would be improved.

16-4b: Calculating the CCCfrom Financial Statements

The preceding section illustrates the CCC in theory, but in practice we would calculate the CCC based on the firm’s financial statements. Moreover, the actual CCC would almost certainly differ from the theoretically forecasted value because of real-world complexities such as shipping delays, sales slowdowns, and customer delays in making payments. Moreover, a firm such as GFI would start a new cycle before the earlier one ended, and this too would muddy the waters.

To see how the CCC is calculated in practice, assume that GFI has been in business for several years and is now in a stable position—placing orders, generating sales, collecting cash receipts, and paying vendors on a recurring basis. The following data were taken from its latest financial statements:

Some Real-World Examples of the Cash Conversion Cycle

The table below summarizes some recent estimates of the cash conversion cycle (CCC) for 16 companies in seven industries. As you would expect, the CCC tends to be higher in retailing industries that require more inventory. On the plus side, many retail companies benefit from a low DSO because most of their customers pay with cash or credit cards that are quickly collected. Large differences in CCC can also arise within a given industry. For example, in the computers and peripherals industry, IBM, which relies heavily on consulting and business services, has a much higher CCC than does Apple, which has streamlined inventory systems and a lot of direct sales to customers. Indeed, Apple has a negative CCC, which means that instead of using cash, working capital provides cash to the firm.

Likewise, taking a look at the three firms in the clothing retail business, we see that Abercrombie & Fitch has an abnormally high CCC because of its relatively large inventory holdings. This is no doubt a concern to the company’s management.

Company	Industry	Inventory Conversion Period	Average Collection Period = DSO	Payables Deferral Period	Cash Conversion Cycle (CCC)
Delta Air Lines	Airline	15.79	16.85	35.39	−2.75
Southwest Airlines	Airline	10.96	7.09	25.87	−7.82
Coca-Cola	Beverages	73.32	37.96	43.25	68.03
PepsiCo Inc.	Beverages	43.66	38.22	160.52	−78.64
Abercrombie & Fitch	Clothing Retailing	148.14	6.03	36.53	117.64
American Eagle Outfitters	Clothing Retailing	49.19	8.16	34.40	22.95
Gap	Clothing Retailing	71.93	0.00	46.81	25.12
Best Buy	Computer Retailing	60.79	11.26	58.02	14.03
Apple Inc.	Computers and Peripherals	6.45	27.98	81.77	−47.34
IBM	Computers and Peripherals	18.11	116.49	58.48	76.11
CVS Caremark Corp.	Food and Staples Retailing	39.72	19.19	18.72	40.19
Safeway	Food and Staples Retailing	29.67	12.23	47.95	−6.04
Walgreen	Food and Staples Retailing	50.21	13.30	33.96	29.55
Walmart	Food and Staples Retailing	46.89	5.12	39.11	12.90
Alcoa Inc.	Metal Manufacturing	51.54	19.35	56.40	14.49
U.S. Steel Corp.	Metal Manufacturing	51.42	39.47	36.98	53.91
Source: Authors’ calculations based on data from Value Line Investment Survey for year-end 2013 available May 7, 2014.
Annual sales	$1,216,666
Cost of goods sold	1,013,889
Inventory	250,000
Accounts receivable	300,000
Accounts payable	150,000

We begin with the inventory conversion period:

Thus, it takes GFI an average of 90 days to sell its merchandise, not the 60 days called for in its business plan. Note also that inventory is carried at cost, so the denominator of the equation is the cost of goods sold, not sales.

The average collection period (or days sales outstanding) is calculated next:

Note that it takes GFI 90 days after a sale to receive cash, not the 60 days called for in its business plan. Because receivables are recorded at the sales price, we use sales rather than cost of goods sold in the denominator.

The payables deferral period is found as follows, again using cost of goods sold in the denominator because payables are recorded at cost:

GFI is supposed to pay its suppliers after 40 days, but it is a slow payer, delaying payment on average until Day 54.

We can combine the three periods to calculate GFI’s actual cash conversion cycle:

Cash conversion cycle CCC = 90 days + 90 days − 54 days = 126 days

GFI’s actual 126-day CCC is quite different from the planned 80 days. It takes longer than planned to sell merchandise, customers don’t pay as quickly as they should, and GFI pays its suppliers slower than it should. The end result is a CCC of 126 days versus the planned 80 days.

Although the planned 80-day CCC is “reasonable,” the actual 126 days is too high. The CFO should push salespeople to speed up sales and the credit manager to accelerate collections. Also, the purchasing department should try to get longer payment terms. If GFI could take those steps without hurting its sales and operating costs, the firm would improve its profits and stock price.

Two professors, Hyun-Han Shin and Luc Soenen, studied more than 2,900 companies over a 20-year period. They found that shortening the cash conversion cycle resulted in higher profits and better stock price performances. 6 Their study demonstrates that good working capital management is important to a firm’s financial position and performance.

QUICK QUESTION

QUESTION:

Direct Furnishings Inc. has the following data:

Annual sales	$10,000,000
Cost of goods sold	6,000,000
Inventory	2,547,945
Accounts receivable	1,643,836
Accounts payable	1,200,000

What is the firm’s cash conversion cycle?