1 working capital management helena sůvová © [email protected] guest lecture for the czech...

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Working Capital Working Capital ManagementManagement

Helena Sůvová ©Helena Sůvová ©[email protected]@centrum.cz

Guest lecture for the Czech Guest lecture for the Czech University of AgricultureUniversity of Agriculture

Course: Corporate FinanceCourse: Corporate FinanceNovember, 2007November, 2007

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Content of the lectureContent of the lecture

• Working Capital TerminologyWorking Capital Terminology• Working Capital DecisionsWorking Capital Decisions• Cash Conversion CycleCash Conversion Cycle• Importance of Working CapitalImportance of Working Capital• Working Capital StrategyWorking Capital Strategy• Inventory managementInventory management• Summary of the lectureSummary of the lecture• Assignments for the tutorialAssignments for the tutorial

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Working Capital Working Capital TerminologyTerminology

• Working capital (operating capital), sometimes Working capital (operating capital), sometimes called gross working capital, simply refers to called gross working capital, simply refers to the firm's the firm's total current assets.total current assets.

• Working capitalWorking capital also consists of also consists of current current liabilitiesliabilities, including accounts payable (trade , including accounts payable (trade credit), notes payable (bank loans), and credit), notes payable (bank loans), and accrued liabilitiesaccrued liabilities. .

• Typical current assets include :cash and cash Typical current assets include :cash and cash equivalents, accounts receivable,inventoryequivalents, accounts receivable,inventory..

• (Net) Working capital = current assets - (Net) Working capital = current assets - current liabilities.current liabilities.

• Current assets are closely related to sales. Current assets are closely related to sales. Moreover influenced by the size of the firm, the Moreover influenced by the size of the firm, the naturere of the firm, firm´s market position etc.naturere of the firm, firm´s market position etc.

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Working Capital Working Capital DecisionsDecisions

• Working capital policy/strategy refers to Working capital policy/strategy refers to decisions decisions – Target levels of each category of current Target levels of each category of current

assetsassets– How current assets will be financedHow current assets will be financed– FlexibleFlexible rate financingrate financing versus fixed rate versus fixed rate

financingfinancing

• Working capital management Working capital management = = setting setting working capital policy and carrying out that working capital policy and carrying out that policy in day-to-day operationspolicy in day-to-day operations

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Working Capital Working Capital DecisionsDecisions

• The basic working capital decisions include in The basic working capital decisions include in day-to-day operations the following areas:day-to-day operations the following areas:

1.1. manage collections from customers and disbursement to manage collections from customers and disbursement to suppliers, employees, taxessuppliers, employees, taxes

2.2. bank and credit relationsbank and credit relations3.3. liquidity management – determinate expected cash surplus liquidity management – determinate expected cash surplus

or deficicit or deficicit 4.4. receivables management – firm´s credit policy, collection receivables management – firm´s credit policy, collection

proceduresprocedures5.5. inventory management – investments in inventory and inventory management – investments in inventory and

financing financing

• Q: Which financial ratios reflect working Q: Which financial ratios reflect working capital management?capital management?

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Cash Conversion CycleCash Conversion Cycle((Working Capital Working Capital /Operating /Operating

CCycle)ycle)

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Cash Conversion CycleCash Conversion Cycle

Payable deferral period (avrg payment period)

Cash outlay

Cash conversion cycle

Operating cycle

Inventory collection period

Purchase made Sale on

creditCash receivedReceivables

collection period

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Cash Conversion CycleCash Conversion Cycle• Operating cycle = inventory collection period + avrg Operating cycle = inventory collection period + avrg

receivables collection periodreceivables collection period• Cash conversion cycle = operating cycle – payable Cash conversion cycle = operating cycle – payable

deferral period……deferral period……• ……. quick and convenient way to analyse ongoing . quick and convenient way to analyse ongoing

liquidityliquidity• How can we calculate cash conversion cycle?How can we calculate cash conversion cycle?

– accounts receivable turnover = net credit sales/avrg accounts accounts receivable turnover = net credit sales/avrg accounts receivablereceivable

– receivable collection period = 365/accounts receivable turnoverreceivable collection period = 365/accounts receivable turnover– inventory turnover = cost of goods sold/ avrg inventoryinventory turnover = cost of goods sold/ avrg inventory– inventory conversion (collection) period = 365/inventory turnover ratioinventory conversion (collection) period = 365/inventory turnover ratio– payables turnover = (cost of goods sold + general, selling, payables turnover = (cost of goods sold + general, selling,

administrative expenses)/current liabilitiesadministrative expenses)/current liabilities– payable deferral period = 365/payables turnoverpayable deferral period = 365/payables turnover

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Importance of Working Importance of Working CapitalCapital

• Why do firms have working capital?Why do firms have working capital?– Under perfect markets a firm would hold exactly Under perfect markets a firm would hold exactly

enough current assets and the value of the firm would enough current assets and the value of the firm would be independent of its working capital decisions.be independent of its working capital decisions.

– But the world is not perfect…But the world is not perfect…• Current assets typically Current assets typically >> 40 % of total 40 % of total

assets=assets=>> large investment large investment• Working capital accounts are the most Working capital accounts are the most

manageablemanageable• The firm´s well-being shows up first in its The firm´s well-being shows up first in its

working capital accounts and the flow of cashworking capital accounts and the flow of cash• Working capital management must ensure that a Working capital management must ensure that a

firm can meet its short-term maturity firm can meet its short-term maturity obligationsobligations

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Working Capital Strategy – Working Capital Strategy – in terms of volumein terms of volume

• Working Capital Strategy Working Capital Strategy in terms of volumein terms of volume::• There is a There is a theoretical optimumtheoretical optimum for working for working

capital…..=> capital…..=> moderate working capital strategy moderate working capital strategy • Working Capital Working Capital >> optimum → + higher safety (lower risk) optimum → + higher safety (lower risk)• - lower rate of return- lower rate of return

• = conservative working capital strategy= conservative working capital strategy• Working Capital Working Capital << optimum → - lower safety (higher risk) optimum → - lower safety (higher risk)• ? rate of return? rate of return• rate of return depends upon the degree of reduction in rate of return depends upon the degree of reduction in

salessales

• = aggresive working capital strategy= aggresive working capital strategy

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Working Capital Strategy Working Capital Strategy

• Aggressive Aggressive strategystrategy

• Conservative Conservative strategystrategy

Required minimum of current assets

Safety stock

Total current assets

Required minimum of current assets

Safety stock

Total current assets

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Working Capital Strategy – Working Capital Strategy – in terms of financing in terms of financing

• Idealized model for Idealized model for agricultureagriculture

• Fixed assets Fixed assets growing steadilygrowing steadily

• Current assets Current assets jump at seasonjump at season

XX• In real world In real world

different different patternspatterns

• But seasonal But seasonal patterns exist patterns exist and cause and cause fluctuationsfluctuations

Fixed assets

Current assets Short-

term credit

Long-term debt plus equity

EUR

Time

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• Permanent current assets – some Permanent current assets – some (minimum) level of current assets that is (minimum) level of current assets that is always maintainedalways maintained

• Matching principle:Matching principle:– Permanent assets (= fixed assets + permanent Permanent assets (= fixed assets + permanent

current assets) financed with permanent current assets) financed with permanent sources of financingsources of financing

– Temporary assets – temporary financingTemporary assets – temporary financing– The idea is to match the cash flow generating The idea is to match the cash flow generating

characterics with the maturity of the financingcharacterics with the maturity of the financing

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• Working capital strategy .. in terms Working capital strategy .. in terms of financingof financing– ModerateModerate: Match the maturity of the assets : Match the maturity of the assets

with the maturity of the financing.with the maturity of the financing.– AggressiveAggressive: Use short-term financing to : Use short-term financing to

finance permanent assets.finance permanent assets.– ConservativeConservative: Use permanent capital for : Use permanent capital for

permanent assets and temporary assets.permanent assets and temporary assets.

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Years

$

Permanent current assets

Fixed Assets

Fluctuating current assets

Lower dashed line, more aggressive.

} Short-term(temporary)financing

Permanent (L-T financing)Equity + LT debt

Working Capital Strategy – Working Capital Strategy – Moderate and AggressiveModerate and Aggressive

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Working Capital Strategy –Working Capital Strategy –ConservativeConservative

Fixed Assets

Years

$

Permanent current assetsPermanent (L-T financing)Equity + LT debt

Zero or very low S-Tdebt

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Inventory ManagementInventory Management

• Inventory management … control of Inventory management … control of investments in inventoriesinvestments in inventories

• Common major determinants of Common major determinants of inventory level:inventory level:– level of saleslevel of sales– length and technical nature of production processlength and technical nature of production process– durability, perishabilitydurability, perishability

• Examples:Examples:– Large inventories: machinery , precious metalsLarge inventories: machinery , precious metals– Seasonal: agriculture, canningSeasonal: agriculture, canning– Low: oil and gas production, bakingLow: oil and gas production, baking

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• Ways of improvement in inventory control?Ways of improvement in inventory control?• Effective inventory mgmt = turning over inventory Effective inventory mgmt = turning over inventory

as quickly as possible without losing sales from as quickly as possible without losing sales from inventory stockouts (return versus risk)inventory stockouts (return versus risk)

• EOQ approachEOQ approach• Costs of storage and carrying rise with larger and Costs of storage and carrying rise with larger and

less frequent ordersless frequent orders• Costs of placing orders are lower with larger and Costs of placing orders are lower with larger and

less frequent ordersless frequent orders• ! Find a good classification of costs and ! Find a good classification of costs and

determinate the minimum of costsdeterminate the minimum of costs

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Inventory ManagementInventory ManagementA. Carrying costs

B. Ordering costs C. Costs related to safety stocks

storage cost of placing order or production setup costs

loss of sales

insurance shipping and handling costs

loss of customer goodwill

cost of tied up capital

quantity discounts taken or lost

disruption or production schedules

depreciation

Prevailing character:variable

Prevailing character:fixed

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Inventory Management Inventory Management • Economic order quantity (EOQ) modelEconomic order quantity (EOQ) model• S… usage in units per periodS… usage in units per period• O…order cost per orderO…order cost per order• C …carrying cost per unit per periodC …carrying cost per unit per period• Q…quantity orderQ…quantity order

• Order cost = O . number of orders = O . S/QOrder cost = O . number of orders = O . S/Q• Carrying cost = C . Q/2Carrying cost = C . Q/2• (it is supposed that inventory is depleted at a constant (it is supposed that inventory is depleted at a constant

rate)rate)

• Total costTotal cost = = O . S/Q + C . Q/2O . S/Q + C . Q/2• We are looking for the quantity Q that minimizes total We are looking for the quantity Q that minimizes total

costs costs

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• .. basic .. basic EOQ modelEOQ model

• EOQ model = technique for EOQ model = technique for determining the optimal order size, determining the optimal order size, i.e. order size that minimizes total i.e. order size that minimizes total order costs and carrying costorder costs and carrying cost

C

OSQ

2

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Other approaches to inventory Other approaches to inventory management:management:

• The ABC systemThe ABC system

• Just-in-Time systemJust-in-Time system• Computerized systems for resource controlComputerized systems for resource control

Size of investment in the type of inventory

Level and intensity of monitoring

A high Perpetual – usually daily

B middle Periodic (weekly, monthly)

C low Unsophisticated, unregular

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SummarySummary

• Working capital management involves management Working capital management involves management of current assets and current liabilitiesof current assets and current liabilities

• Net working capital = current assets – current Net working capital = current assets – current liabilitiesliabilities

• Cash conversion cycle is a way to analyse the Cash conversion cycle is a way to analyse the liquidity and helps to set the level of net working liquidity and helps to set the level of net working capital.capital.

• Conservative versus aggressive working capital Conservative versus aggressive working capital strategy/policystrategy/policy

• Inventory management = control of investments in Inventory management = control of investments in inventoriesinventories

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Assignments for the Assignments for the tutorialtutorial

1.1. Give your reaction: „Merely increasing the level Give your reaction: „Merely increasing the level of current assets does not necessarily reduce the of current assets does not necessarily reduce the riskiness of the firm, rather, composition of the riskiness of the firm, rather, composition of the currenr assets is important to consider.“ (Q 11.1.)currenr assets is important to consider.“ (Q 11.1.)

2.2. How does seasonal nature of a firm´s sales How does seasonal nature of a firm´s sales influence the level of current assets and the influence the level of current assets and the decision amount of short-term credit? (Q 11.2.)decision amount of short-term credit? (Q 11.2.)

3.3. What is the advantage of matching the maturities What is the advantage of matching the maturities of assets and liabilities (fixed assets – long term of assets and liabilities (fixed assets – long term financing; current assets – ST financing)? What is financing; current assets – ST financing)? What is the disadvantage? (Q 11.3.)the disadvantage? (Q 11.3.)

4.4. There have been times when short-term rates There have been times when short-term rates were higher than long-term rates. Does this imply were higher than long-term rates. Does this imply that a firm should use only long-term debt and no that a firm should use only long-term debt and no short-term? (Q 11.4.)short-term? (Q 11.4.)

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5.5. Define and explainDefine and explain:: working capital, net working capitalworking capital, net working capital cash conversion cyclecash conversion cycle permanent current assetspermanent current assets seasonal, or temporary current assetsseasonal, or temporary current assets matching principlematching principle

6.6. A firm´s cash conversion cycle is 40 days. The A firm´s cash conversion cycle is 40 days. The receivables turnover is 8, payables turnover is 10.receivables turnover is 8, payables turnover is 10.

What is the firm´s inventory turnover?What is the firm´s inventory turnover? What are accounts receivable if credit sales are 920 000 What are accounts receivable if credit sales are 920 000

EUR?EUR?

7.7. What was the net working capital of ČEZ in 2005 What was the net working capital of ČEZ in 2005 and 2004? What is the main source of CEZ´s short-and 2004? What is the main source of CEZ´s short-term financing? Can we recognize whether CEZ´s term financing? Can we recognize whether CEZ´s working capital strategy is conservative or working capital strategy is conservative or aggressive?aggressive?

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8.8. The Warner Flooring sales 1.2 mil. USD. Fixed The Warner Flooring sales 1.2 mil. USD. Fixed assets total 500 000 USD, it wishes to maintain 60 assets total 500 000 USD, it wishes to maintain 60 % debt ratio, interest cost is 10 % on both S-T and % debt ratio, interest cost is 10 % on both S-T and L-T debt. Three alternatives regarding projected L-T debt. Three alternatives regarding projected current assets: 1) aggressive (current asstes = 45 current assets: 1) aggressive (current asstes = 45 % of sales), 2) average (50 % of sales), 3) % of sales), 2) average (50 % of sales), 3) conservative (60 % of sales). Expected EBIT is 12 % conservative (60 % of sales). Expected EBIT is 12 % of sales, tax rate is 40 %.of sales, tax rate is 40 %.

a)a) What is the expected ROE under each strategy?What is the expected ROE under each strategy?b)b) There is an assumption that earnings rate and level There is an assumption that earnings rate and level

of expected sales are independent of current asset of expected sales are independent of current asset policy. Is this a valid assumption?policy. Is this a valid assumption?

c)c) How would the overall riskiness of the firm vary How would the overall riskiness of the firm vary under each policy? (P 11.2.)under each policy? (P 11.2.)

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9.9. Inventory management: Describe the basic nature of the Inventory management: Describe the basic nature of the fundamental inventory control model, discussing specifically the fundamental inventory control model, discussing specifically the nature of increasing costs, decreasing costs and total costs.nature of increasing costs, decreasing costs and total costs.

10.10. What are the probable effects of the following decisions on What are the probable effects of the following decisions on invetory holdings?invetory holdings?

• Changing the structure of suppliersChanging the structure of suppliers• Greater use of of intermediate goods for production instead of raw Greater use of of intermediate goods for production instead of raw

mtlmtl• Substantial increase of the number of styles producedSubstantial increase of the number of styles produced• Starting to manufacture for specific ordersStarting to manufacture for specific orders

11.11. EOQ analysis: Tiger Corp purchases 1 200 000 units per year of EOQ analysis: Tiger Corp purchases 1 200 000 units per year of one component. the fixed xcost per order is 25one component. the fixed xcost per order is 25$$. The annual . The annual carrying cost of the item is 27 % of its 2 carrying cost of the item is 27 % of its 2 $$ cost. a) Determine the cost. a) Determine the EOQ model under: (1)no changes, (2) order cost of zero, and (3) EOQ model under: (1)no changes, (2) order cost of zero, and (3) carrying cost of zero. b) What do your answers illustrate about carrying cost of zero. b) What do your answers illustrate about the EOQ model. Explain. the EOQ model. Explain.

1 working capital management helena sůvová © [email protected] guest lecture for the czech...

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