Financial

Management,
17e
Chapter 16: Supply Chains
and Working Capital
Management

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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

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Determinants of Intrinsic Value:
Working Capital and FCF

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 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.

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 Basic 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.

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 Selected Ratios for RR (1 of 2)

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
Average collection period* 45.63 32.00
Inv. Turnover 10.80 20.00
*Assume 365 day year

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Selected Ratios for RR (2 of 2)

RR Industry

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

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 Comparison with 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.
• This indicates that RR is following a relaxed policy.

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 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.

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 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 Payable

Conversi Conversio Collectio s
= + −
on Cycle n Period n Period Deferral
Period

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 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.

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Cash Conversion Cycle (3 of 3)

Inventory Days sales Payable

CCC = Conversio + outstandin − s
n Period g Deferra
l Period

= 33.8 + 45.6 − 30
= 49.4 days.

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 Is RR holding too much inventory?

• RR’s inventory turnover (10.80) is considerably lower than the

industry average (20.00).
• This means that RR is carrying a lot of inventory per dollar of sales.

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 Impact of Reducing Inventory

• 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.

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 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.

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 Elements of Credit Policy

• Cash Discounts: Lowers price for customers who pay early. Attracts
new customers and reduces DSO.
• Credit Period: How long do customers have to pay? Shorter period
reduces DSO and average A/R, but it may discourage sales.
• 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.

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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.

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 Impact of Reducing Days Sales
Outstanding (DS0) (1 of 2)
• Assume tightening credit policy doesn’t cause a loss of sales.
• Impact is 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.

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 Impact of Reducing Days Sales
Outstanding (DS0) (2 of 2)
• 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.

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 Higher Levels of Accruals

• Higher levels of accruals, such as accrued wages or accrued taxes,

increase FCF.
• Accruals are free in that no explicit interest is charged.
• But firms have little control over the level of accruals. Levels are
largely influenced by industry custom, economic factors, and tax laws.

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 Trade Credit

• Trade credit is credit provided 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.

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 Trade Credit Data for RR

• RR purchases $200,000 (net of discounts) of materials each year on

terms of 1/10, net 30.
• If RR chooses not to take the discounts, it can pay on the 40th day
(instead of the 30th day, when payment is due) because it is a major
customer and can pay late without consequences. (It’s not very
ethical, but not very uncommon.)
• How much free trade credit can the company get from its equipment
supplier, how much costly trade credit can it get, and what is the
percentage cost of the costly credit?
• Should RR take discounts?
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 RR’s Free Trade Credit and Costly
Trade Credit
• Annual net purchases = $200,000 on credit
• Net daily net purchases = $200,000/365 = $547.94
• Annual gross purchases are defined as the price if RR doesn’t take the
1% discount.
• Ann. gross purchases = $200,000/(1 – 0.01) = $202,020.
• Ann. gross purchases − net purchases = $202,020 – $200,000 =
$2,020

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 Gross vs. Net

• Company buys equipment worth $200,000, based on 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.
• How does that compare with the cost of a bank loan?

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 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

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 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:
• rNOM = $2,020/$16,439 = 0.1229 = 12.29%

• The next slide shows a formula to calculate rNom

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Nominal Cost Formula, 1/10, net 40

Discount % 365 days

rNOM  
1  Discount % Days Taken  Discount Period
1 365
  0.0101 12.1667
99 30
0.1229 12.29%

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Effective Annual Rate (EAR), 1/10, net
40
Periodic rate = 0.010.99 = 1.01%.
Periods/year= n = 365/(40 − 10) = 12.1667

EAR 1  Periodic rate  1.0

n

1.0101
12.1667
 1.0
13.01%.

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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 cash 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.

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 Ways to Minimize Target Cash Cash
Balance
• Synchronize inflows and outflows.
• Use float.
• Use lockboxes.
• Insist on wire transfers or automatic debit from customers.

(More…)

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 Minimizing Cash (Continued)

• 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”).

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 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.

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 Moderate Financing Policy

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 What are the advantages of short-
term debt vs. long-term debt?
• Low cost-- yield curve usually slopes upward.
• Can get funds relatively quickly.
• Can repay without penalty.

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 What are the disadvantages of short-
term debt vs. long-term debt?
• Higher risk. The required repayment comes quicker, and the company
may have trouble rolling over loans.

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 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.

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 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.

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 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.

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RR’s Cash Budget for January and
February
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

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 Cash Budget (Continued)

January February

Cash on hand at start of $3,000.00

forecast
Net CF (Collections − 13,857.64 18,311.85
Payments)
Cumulative NCF $16,857.64 $35,169.49

– Target cash 1,500.00 1,500.00

Surplus cash $15,357.64 $33,669.49

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 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.

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 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.

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 What are some other potential cash
inflows besides collections?
• Proceeds from fixed asset sales.
• Proceeds from stock and bond sales.
• Interest earned.
• Court settlements.

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Incorporating Interest Earned or Paid on Short-
term Securities or Loans into the Cash Budget

• Interest earned: Add line in the collections section.

• Interest paid: Add line in the payments section.
• Found as interest rate × surplus/loan line of cash budget for preceding
month.
• Note: Interest on any other debt would need to be incorporated as
well.

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 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.

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