1 Working Capital Policy Helena Sůvová © [email protected] Guest lecture for the Czech University...

1

Working Capital Working Capital PolicyPolicy

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, 2006November, 2006

2

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• Working Capital – other issuesWorking Capital – other issues• Summary of the lectureSummary of the lecture• Assignments for the tutorialAssignments for the tutorial

3

Working Capital Working Capital TerminologyTerminology

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

• Working capital is also known as operating Working capital is also known as operating capital. It represents the amount of day-by-capital. It represents the amount of day-by-day operating liquidity available to a business. day operating liquidity available to a business.

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

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

4

Working Capital Working Capital TerminologyTerminology

• Working capital policy refers to decisions Working capital policy refers to 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: setting working Working capital management: setting working capital policy and carrying out that policy in capital policy and carrying out that policy in day-to-day operationsday-to-day operations

5

Working Capital Working Capital DecisionsDecisions

• The basic working capital decisions include:The basic working capital decisions include:1.1. manage collections from customers and disbursement to manage collections from customers and disbursement to

suppliers, employees, taxessuppliers, employees, taxes

2.2. bank relationsbank relations

3.3. liquidity management – determinate expected cash surplus or liquidity management – determinate expected cash surplus or deficicit deficicit

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

5.5. 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?

6

Cash Conversion CycleCash Conversion Cycle

7


Payable deferral period

Cash outlay

Cash conversion cycle

Operating cycle

Inventory conversion period

Purchase made Sale on

creditCash receivedReceivables

collection period

8


• Operating cycle = inventory collection period + Operating cycle = inventory collection period + avrg receivables collection periodavrg receivables collection period

• Cash conversion cycle = operating cycle – Cash conversion cycle = operating cycle – payable deferral periodpayable deferral period

• 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 inventory conversion (collection) period = 365/inventory

turnover ratioturnover 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

9


• LiquidityLiquidityongoing liquidity

protective liquidity

• Ongoing liquidity – inflows and outflows of cashOngoing liquidity – inflows and outflows of cash• Protective liquidity – ability to adjust rapidly to Protective liquidity – ability to adjust rapidly to

unforeseen cash demands unforeseen cash demands • Cash conversion cycle = quick and convenint Cash conversion cycle = quick and convenint

way to analyse ongoing liquidityway to analyse ongoing liquidity

10

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 enough Under perfect markets a firm would hold exactly enough

current assets and the value of the firm would be current assets and the value of the firm would be independent of its working capital decisions.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 assets= 40 % of total assets=>>

large investmentlarge investment• Current assets are relatively volatile and directly Current assets are relatively volatile and directly

and closely dependent on salesand closely dependent on sales• Working capital accounts are the most Working capital accounts are the most

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

capital accounts and the flow of cashcapital 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 obligationsfirm can meet its short-term maturity obligations

11

Working Capital StrategyWorking Capital Strategy

• There is a theoretical optimum for working There is a theoretical optimum for working capital.capital.

• Working Capital Working Capital >> optimum → + higher safety (lower optimum → + higher safety (lower risk)risk)

• - lower rate of return- lower rate of return

• = conservative working capital policy= conservative working capital policy• 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 policy= aggresive working capital policy

12

Working Capital Strategy – Working Capital Strategy – Current AssetsCurrent Assets

• Factors influencing the level of Factors influencing the level of current assets:current assets:– the nature of the firm´s businessthe nature of the firm´s business– the size of the firm (smaller firms the size of the firm (smaller firms

usually have higher proportions of usually have higher proportions of current assets … up to 70 %)current assets … up to 70 %)

– rate of increase in salesrate of increase in sales– stability of the firm´s sales (more stable stability of the firm´s sales (more stable

sales … lower lavel of current assets)sales … lower lavel of current assets)– current asset (working capital) policycurrent asset (working capital) policy

13


• Aggressive policyAggressive policy • Conservative Conservative policypolicy

Required minimum of current assets

Safety stock

Total current assets

Required minimum of current assets

Safety stock

Total current assets

14


• Aggressive current asset policy:Aggressive current asset policy:– low level of current assets, but effectively managedlow level of current assets, but effectively managed– short cash conversion cycleshort cash conversion cycle– lower expenses and potentially higher returnslower expenses and potentially higher returns– high risk … high required returnshigh risk … high required returns

• Conservative current asset policyConservative current asset policy– high level of current assetshigh level of current assets– long cash conversion cyclelong cash conversion cycle– higher expenses, lower EBIThigher expenses, lower EBIT– low risk… low required returnlow risk… low required return

• Remember: different types of current assets affect Remember: different types of current assets affect both risk and return differently (e. g. cash reduces both risk and return differently (e. g. cash reduces risk severely than receivables or inventory)risk severely than receivables or inventory)

15

Working Capital Strategy – Working Capital Strategy – Current LiabilitiesCurrent Liabilities

Aggressive liability Aggressive liability policypolicy

Conservative liability Conservative liability policypolicy

Stockholder´s equity

Long-term liabilities

Current liabilities

Current liabilities

Long-term liabilities

Stockholder´s equity

16

Working Capital Strategy – Working Capital Strategy – Current LiabilitiesCurrent Liabilities

• Aggressive liability policy:Aggressive liability policy:– high level of current liabilitieshigh level of current liabilities– short cash conversion cycleshort cash conversion cycle– lower interest costs if short-term rates lower than long-termlower interest costs if short-term rates lower than long-term– high risk … high required returnshigh risk … high required returns

• Conservative liability policyConservative liability policy– low level of current liabilitieslow level of current liabilities– long cash conversion cyclelong cash conversion cycle– higher interest costs if long-term rates higher than short-higher interest costs if long-term rates higher than short-

termterm– low risk… low required returnlow risk… low required return

• Current liabilities = accounts payable, short-term Current liabilities = accounts payable, short-term loans, notes payable, current principal of long-term loans, notes payable, current principal of long-term debt due.debt due.

17

Working Capital Strategy – Working Capital Strategy – AltogetherAltogether

• 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

18


• 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

19


• Working capital strategy:Working capital strategy:– 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.

20

Years

$

Permanent current assets

Fixed Assets

Fluctuating current assets

Lower dashed line, more aggressive.

} Short-termfinancing

Permanent (L-T financing):Stock & Bonds

Working Capital Strategy – Working Capital Strategy – ModerateModerate

21

Working Capital Strategy –Working Capital Strategy –ConservativeConservative

Fixed Assets

Years

$

Permanent current assetsL-T Fin:Stock &Bonds

Zero S-Tdebt

22

Working Capital – other Working Capital – other issuesissues

• Short term versus long term financingShort term versus long term financing– floating rate financing - interest rate tied on the floating rate financing - interest rate tied on the

bank prime lending ratebank prime lending rate– may reduce risks if the sales are correlated with may reduce risks if the sales are correlated with

the health of economythe health of economy

• Recognizing and dealing with liquidity Recognizing and dealing with liquidity problemsproblems– deferral of payments, reduce inventory and deferral of payments, reduce inventory and

receivables, reduce long term (planned) receivables, reduce long term (planned) expenditures, lay off employessexpenditures, lay off employess

– protective liquidity – e.g. line of creditprotective liquidity – e.g. line of credit

23

SummarySummary

• Working capital management involves Working capital management involves management of current assets and current management of current assets and current liabilitiesliabilities

• 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 policypolicy

• Working capital strategy – matching principle, Working capital strategy – matching principle, aggresive versus conservative strategyaggresive versus conservative strategy

24

Assignments for the Assignments for the tutorialtutorial

1.1. Give your reaction: „Merely increasing the level of Give your reaction: „Merely increasing the level of current assets does not necessarily reduce the 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 of What is the advantage of matching the maturities of assets and liabilities? What is the disadvantage? (Q assets and liabilities? What is the disadvantage? (Q 11.3.)11.3.)

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

25


5.5. Define and explainDefine and explain:: working capitalworking capital ongoing and protective liquidityongoing and protective liquidity 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 10receivables 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 and 2004? What is the main source of CEZ´s short-term financing? Can we recognize whether short-term financing? Can we recognize whether CEZ´s working capital strategy is conservative or CEZ´s working capital strategy is conservative or aggressive?aggressive?

26


8.8. Windsor Distributors have the following Windsor Distributors have the following financial statements.financial statements.

a)a) determine Windsor´s liquidity situation by determine Windsor´s liquidity situation by calculating the current ratio, net working calculating the current ratio, net working capital, cash conversion cyclecapital, cash conversion cycle

b)b) What is the current market price per share What is the current market price per share of Windsor stock if its P/E ratio is 8 times of Windsor stock if its P/E ratio is 8 times earnings?earnings?

c)c) CFO is conservative and wants to sell 2500 CFO is conservative and wants to sell 2500 shares at 20 EUR/Share.shares at 20 EUR/Share.

• What will be the new liquidity position?What will be the new liquidity position?• New market share?New market share?• Is the issue of the new shares goodIs the issue of the new shares good??

27


Cash25 000

Receivables 60 000

Inventory 65 000

Long-term asstes 350 000

Total assets 500 000

Accounts payable plus salaries, benefits and payroll taxes payable

80 000

Other current liabilities 20 000

Long-term debt 100 000

Stockholders´equity (50 000 shares) 300 000

Total liabilities and equity 500 000

Income statement (thousands EUR)

Sales 900 000

Cost of goods sold 400 000

General, selling and administrative expenses

100 000

All other expenses 250 000

Net income (EAT) 150 000

Windsor DistributorsBalance Sheet (thousands EUR)

28


9.9. 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.)

1 Working Capital Policy Helena Sůvová © [email protected] Guest lecture for the Czech University...

Documents

Transcript of 1 Working Capital Policy Helena Sůvová © [email protected] Guest lecture for the Czech University...