ZeePedia Add to Favourites   |   Contact us


Financial Management

<<< Previous WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget Next >>>
 
img
Financial Management ­ MGT201
VU
Lesson 39
WORKING CAPITAL MANAGEMENT
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following topic:
·  Working Capital Management
Working Capital Management is another important area of financial management.
·  Financial Management Course
Earlier in the course we studied:
­  Capital Budgeting: Focuses on Fixed Assets side of Balance Sheet
­  Capital Structure (& Corporate Financing): Focuses Liabilities Side (Long Term Debt
& Equity) of Balance Sheet
Now another important area is:
­  Working Capital Management: Focuses Current Assets & Liabilities of Balance Sheet
in day-to-day operation
·  Generally Working Capital (Gross) = Current Assets
­  Current Assets = Inventory + Accounts Receivables + Cash + Marketable Securities +
...(The mentioned items are four major items)
­  Working Capital is different from "Capital" (as used in Capital Budgeting) which refers
to Capital Expenditure in Fixed Assets
­  Also it is different from "Capital" (as used in Capital Structure) which refers to
Financing in the form of Debt or Equity (Loans or share capital)
·  Net Working Capital = Current Assets ­ Current Liabilities
Net working capital is slightly different from gross working capital.
­  working capital is different from Net Worth
= Assets ­ Liabilities = Equity
= Stock + Retained Earnings
­  Current Liabilities
= Accounts Payables + Accruals + Short Term Loans + ... (as well as other minor
items)
·  Important Measure of the Short-term Liquidity of a Firm
­  Working capital is a measure of how easy it is for a firm to convert short-term assets
into "Liquid" Cash in order to meet the Current Obligations by selling assets
­  Some ratios to measure liquidity of firm are:
Current Ratio = Current Assets / Current Liabilities
Acid Test or Quick Ratio = Quick Assets / Current Liabilities
·  Quick Assets = Current Assets ­ Inventory
·  Fundamental Tradeoff in Working Capital (or Current Assets)
Decision in working capital management is how much working capital should be maintained by
a firm. It requires how much money needs to be invested in Inventory, Accounts Receivables,
Marketable Securities and how much cash should be maintained.
­  Advantages of Large Current Assets: less risk of shortages & interruptions and less loss
of sales due to availability of funds for loan payments and purchases and inventory.
High Liquidity so better CREDIT Rating.
­  Advantages of Small Current Assets: Less investment in current assets means less
amount of money tied to the assets which are generating no return. So lower
Opportunity Cost of Capital.
­  Find the Optimum Current Assets (working capital) At Any Given Time and for a
Given Level of Sales & Growth:
·  For this Alternative Investment Policies have been proposed and a good
business judgment is required
Working Capital Policies:
·  What is the Optimum Working Capital (or Current Assets) for a Firm at any given time given in
level of Sales and Growth Strategy? This requirement fluctuates with time depending on sales
and seasons.
162
img
Financial Management ­ MGT201
VU
Practically the following policies are used by the mangers to decide what is the best amount of
current assets or mix of assets to be kept for the firm:
·  "Fat Cat" or Relaxed Policy
­  It requires Large Amount of Current Assets not to loose any sales i.e. when a customer
places order for a large amount, there is no shortage of inventory
­  Occurs when High sales driven by lot of credit facility to buyers
­  Good Credit Rating because High Liquidity and good Current Ratio
­  Case: Wall Mart retail chain during New Year and Christmas
·
"Lean & Mean" or Restricted Policy
­  Small Amount of Current Assets
­  It increases turnover and therefore Profits
·  Current Asset Turnover = Sales / Current Assets. Higher than 20.
·  Lowers Carrying Costs of Inventory
­  Frees up cash and speeds up production (operational efficiency)
­  Small Current Assets means Lower Opportunity Cost of Capital. Firms have raised
Capital from Investors (Debt Holders and Shareholders) which comes at a Cost (the
WACC includes Interest paid to Debt Holders and Dividends paid to Shareholders).
Firms must mobilize the capital in high-return investments in order to repay their
investors.
­  "Zero Working Capital Policy" (Extreme form of Lean & Mean Policy)
It can not be 0 in reality but its objective is to minimize.
·  Japanese Just in Time (JIT) i.e. Toyota Motor Co. It means the spare partsreach
just a few hours ago from the assembly time.
·  Moderate Policy
­  In between the Fat Cat and Lean & Mean Policies
Impact of working capital on Firm Value:
There is a link between working capital policy and our basic objective of financial management of
maximizing shareholder's wealth.
·
EVA (Economic Value Added)
­  EVA (in Rupees)
= Net Operating Income discounted by the Tax ­ (WACC x Total Capital)
= (NOI x (1-Tc)) - (WACC % x Tot Capital)
In other words, EVA (in Rupees)
= Revenues generated by firm ­ Cost of capital by firm
­  Total Capital = Market Value of Debt + Market Value of Equity
­  If Working Capital is reduced, then cash is freed up from the assets to which it was tied
up and can be used to reduce dependence on External Financing (Debt and Equity).
Total External Capital is reduced and WACC is reduced. It raises EVA of the firm.
­  Higher EVA means Higher Market Value of Firm (V) and Maximization of Shareholder
Wealth which is a fundamental objective of Financial Management.
·
ROE (Return on Equity)
­  DuPont Formula:
ROE
= Profit Margin x Asset Turnover x Leverage Factor (or Equity Multiplier)
= (Net Income/Sales) x (Sales/Assets) x (Total Assets/Equity)
= Net Income / Equity
­  If Working Capital is reduced, then cash which is freed up can be used to reduce
requirement for External Capital and Total Liabilities. By Total Assets reduced, Asset
Turnover Rises, and ROE Rises
163
img
Financial Management ­ MGT201
VU
­
Objective is to keep ROE Higher than rE (Required Return) and this means keeping
capital mobilized and invested at all times to generate returns higher than WACC
(which can not be done by simple cash holdings).
Cash Management:
First we talk about first item of working capital in balance sheet i.e. cash
·  Advantages of Cash
­  Need cash for Liquidity, Good Credit Rating, and Meet Unexpected Expenses & to Get
Trade Discounts. "Need Cash to Pay the Bills."
­  BUT cash (and even Current Business Accounts in banks) earns NO RETURN (i.e.
Interest or Markup)
·  When Interest Rates are high, the Opportunity Cost of holding cash rises.
­  Business Competition forces firms to sell on CREDIT but that leads to Problems in
RECOVERY of Receivables (i.e. Bad Debts and Write-offs).
·  Balance Sheet Perspective
­  "Cash is King" and "Only Cash Can Pay the Bills"
·
Cash Budget (Detailed Short Term)
­  Projected Cash Inflows and Outflows to estimate Monthly Cumulative Net cash Surplus
or Shortfall
·  Take into account Credit Purchases and Credit Sales and Expected Collection
(Cash Recovery) Time
·  Shortfall tells you how much Short-term Financing is required
­  Importance of Timing of Collections and Payments and Target Cash Balance
Monthly Cash Budget
Jan
Feb
Mar
Apr
Sales (Expected Forecasts `000 Rs.)
100
200
300
400
Collections (`000 Rs.)
-Current month Sales (30%)
30
60
90
120
-Previous month Sales (70%)
21
140
210
TOTAL COLLECTIONS
30
81
230
330
Purchases Raw Material (`000 Rs.)
-70% of Next Month Sales
140
210
280
-Payments (paid next month)
140
210
280
Other Expenses (`000 Rs.)
-Wages
10
10
10
10
-Rent
10
10
10
10
-Taxes
10
10
10
10
- Interest & Dividends
0
0
0
0
TOTAL PAYMENTS
170
380
240
310
Net Cash for Month
(140)
(299)
(10)
20
Cumulative Cash
(439)
(449)
(429)
Target Cash Balance
20
20
20
20
Net Cumulative Cash
(459)
(469)
(449)
The above is the cash budget for a firm for a period of four months with the most important
items. We have forecasted the cash in the form of cash receipts from sales and in the form of cash
payments for expenses. Shortfall or negative balance tells you how much Short-term Financing is
required to fill the gap.
Cash Management Policies:
·  Interest-based Policy (Minimize Cash holdings when Interest rates are High)
­  When Interest Rates are high, the Opportunity Cost of keeping capital in form of Cash
(generating zero returns) is higher.
­  Try to make Collections quickly and keep as much cash as possible in profit-earning
Marketable securities and Investments in Projects
164
img
Financial Management ­ MGT201
VU
·
Cash Flow Synchronization Policy
­  Use "Billing Cycles" to time the Cash Outflows just after the Cash Inflows
­  Example: Salaries paid on 3rd of Every Month. Electricity Bill paid on the 18th of
Every Month. Aim for Cash Collections on the 1st and 15th of every month just few
days before Cash Outflows.
·
Speed up Cash Collection Policy
­  Business Competition forces firms to Sell on CREDIT but that leads to Problems in
RECOVERY of Receivables (i.e. Bad Debts and Write offs).
­  Collection Staff, Letters, Collection Agency
­  Use Technology: Electronic Wire Transfer, Automatic Debit, Credit Cards
·
Float Policy (Keep Track of Cheques Clearance)
­  Takes 1-2 days in Pakistan for cheque to turn into cash in your account from the date of
deposit.
­  Aim to make your own Cheque Clearing process quicker (minimize your Collections
Float) than your Supplier's. That way, you will encash cheques before others can
encash yours.
­  So, you will have a Positive Net Float in your Bank account. This cash can be used for
emergency expenses.
165
Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios