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Working capital management

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The management of short-term assets (investments) and liabilities (financing sources).

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Working capital

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A firm's investments in short-term assets - cash, marketable securities, inventory and accounts receivable.

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Net working capital

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Current assets minus current liabilities - the amount of current assets financed by long term liabilities. CA - CL = net working capital

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Working capital accounts

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current assets = cash, A/R & Inv. current liabilities = A/P, Payroll (accruals), notes payable.

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Cash conversion cycle

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The length of time from the payment for the purchase of raw materials to manufacture a product until the collection of accounts receivable associated with the sale of the product.It represents the length of time between paying for labor and materials and collecting receivables.

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Cash conversion cycle

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Includes: inventory conversion period, receivables collection period and payables deferral period. Helps a company to see how well they are doing.

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Working capital investment and financing policies

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Relaxed current asset investment policy(fat cat) Restricted current asset investment policy (lean and mean) Moderate current asset investment policy (between two extremes)

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Relaxed current asset investment policy

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A policy under which relatively large amounts of cash, marketable securities, and inventories are carried and under which sales are stimulated by a liberal credit policy, resulting in a high level of receivables.

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Restricted current asset investment policy

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A policy under which holdings of cash, securities, inventories, and receivables are minimized

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Moderate current asset investment policy

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A policy between relaxed and restricted policies

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Compensating balance

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A minimum checking account balance that a firm must maintain with a bank to help offset the costs of services such as check clearing and cash management advicecredit balance that a bank may require a borrower to keep on deposit as a condition for granting a loan. (Like an insurance policy)

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Precautionary balances

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A cash balances held as a reserve for unforeseen fluctuations in cash inflows or outflows.

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Speculative balances

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A cash balance that is held to enable the firm to take advantage of any bargain purchases that might arise

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Cash budget

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A schedule showing cash receipts, cash disbursements, and cash balances for a firm over a specified time period. All businesses need to do these projections. Will show problem months.

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Cash management techniques

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Generally activities are performed jointly by the firm and its primary bank. Encompasses proper management of both the cash inflows and the cash outflows of a firm

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Float

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The difference between the balance shown in a firm's checkbook and the balance on the bank's record. (Difference between writing a check and time cashed)

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Disbursement float

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The value of the checks that have been written and disbursed but have not yet fully cleared through the banking system and thus have nit been deducted from the account on which they were written

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Collections float

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The amount of checks that have been received and deposited but have not yet been made available to the account in which they were deposited

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Net Float

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The difference between our checkbook balance and the balance shown on the bank's books.

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Lock-box arrangement

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A procedure used to speed up collections and reduce float through the use of post office boxes in payers' local areas.

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Marketable securities

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Securities that can be sold on short notice without loss of principal or original investment

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Marketable securities

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Extremely liquid, short term investments that earn positive returns on cash that is needed to pay bills.

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Credit policy

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A set of decisions that includes a firm's credit standards credit terms, methods used to collect credit accounts, and credit monitoring procedures

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Inventory management

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Requires coordination among the sales, purchasing, productions, and finance department. Lack of coordination among these departments, poor sales forecasts, or both can lead to financial ruin

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Inventory costs

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Carrying cost and ordering cost

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Inventory carrying costs

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Any expenses associated with having inventory, such as rent paid for the warehouse where inventory is stored and insurance on the inventory.

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Inventory ordering Costs

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Expenses associated with placing and receiving an order for new inventory, which include the costs of generating memos, fax transmissions.

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Economic Order Quantity (EOQ)

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The optimal quantity that should be ordered; it is this quantity that will minimize the total inventory costs

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Reorder Point

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The level of inventory at which an order should be placed

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Safety Stock

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Additional inventory carried to guard against unexpected changes in sales rates or production/shipping delays

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Compensating balance

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A minimum checking account balance that a firm must maintain with a bank to borrow funds - generally 10 to 20 percent of the amount of loans outstanding

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Promissory note

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A document specifying the terms and conditions of a loan including the amount, interest rate, and repayment schedule

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Line of credit

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An arrangement in which a bank agrees to lend up to a specified maximum amount of funds during a designated period

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Choosing a bank

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Business that borrow from banks need to consider: willingness to assume risk, advice counsel, loyalty to customers, specialization, maximum loan size, merchant banking.

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Commercial paper

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Unsecured, short-term promissory notes issued by large, financially strong firms, and it is sold primarily to other businesses, insurance companies, pension funds, money market funds, and banks. of large , financially sound firms to raise funds.

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Payback period

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The length of time required for an investment's net revenues to cover its cost

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Spontaneously Generated Funds

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Funds that are obtained from routine business transactions

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Lumpy Assets

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Assets that cannot be acquired in small increments; instead, they must be obtained in large, discrete amounts.

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Operating Leverage

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The existence of fixed operating costs, such that a change in sales will produce a larger change in operating income (EBIT)

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Quick Ratio

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Quick Ratio = Current Assets - Inventory / Current Liabilities - Measures the firm's ability to pay off short-term obligations WITHOUT RELYING on the sale of INVENTORIES is important.

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NPV

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Present Value of an asset's future cash flows minus its purchase price (initial investment). If the net benefit computed of present value basis, NPV, is positive, then the asset (project) is considered an acceptable investment. Project into the future in Cash Flow (Forecasts)The NPV shows by how much a firm's value , and thus stockholder's wealth, will increase if a capital budgeting project is purchased. If the net benefit computed on a present value basis-that is, NPV-is positive, then the asset (project) is considered an acceptable investment.

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Traditional Payback Period

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Traditional Payback Period: Expected number of years required to recover the original investment (the cost of the asset. It is the simplest and oldest formal method used to evaluate capital budgeting projects. A project is acceptable if PB < n (recovery period that the firm has determined is appropriate) Formula: PB = (# of years before full recovery of initial investment) + (Amount of initial investment that is unrecovered at the start of recovery year / total cash flow generated during the recovery year)

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Discounted Payback Period

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length of time it takes for a projects discounted cash flows to repay the cost of the investment. A project is acceptable if DPB < Project's Life.

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Payback Period

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Cost of investment/Annual Cash Flow

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IRR

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IRR is similar to the YTM on a bond. Rate of Return the firm expects to earn if a project is purchased and held for its economic life. The discount rate that equates the present value of a project's expected cash flows to the initial amount invested. As long as the project's IRR, which is its expected return, is greater than the rate of return required by the firm for such an investment, the project is acceptable. A project is acceptable if acceptable (IRR > required rate of return or HURDLE RATE).

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DISCOUNTED INTEREST (LOAN)

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The interest due is deducted "up front" so that the borrower receives less than the principal amount, or face value of the loan. The interest is calculated on the amount borrowed (principal), and is paid at the beginning of the loan period.

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NOMINAL (or quoted, risk-free rate)

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The nominal rate is the interest rate on a security that has absolutely no risk at all - that is, one that has a guarantee outcome in the future, regardless of the market conditions. No security exists; hence no observable, truly risk-free rate. However, a US Treasury bill, a short-term security issued by the US government, is free of most risk. A nominal risk-free rate has two components: "real" risk-free rate and inflation premium.

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EFFECTIVE RATE

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The effective annual rate is the actual interest rate, or rate of return, that an investment (loan) earns (costs) considering the effects of COMPOUNDED INTEREST. To find EAR, we adjust APR to include the effect of interest compounding.. If interest is compounded once each year (compounded annually), EAR = APR. But, if compounding occurs more than once per year, EAR > APR.

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COMPENSATING BALANCE

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A minimum checking account balance that a firm must maintain with a bank to borrow funds - generally 10 to 20 percent of the amount of loans outstanding. It is used to help offset the costs of providing services such as check clearing, cash management advice, bookkeeping, and maintaining a line of credit.

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TRADE CREDIT

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The credit created when one firm buys on credit from another firm. This credit is recorded as an ACCOUNT PAYABLE. Trade credit is a SPONTANEOUS source of financing in the sense that it arises from ordinary business transactions. Lengthening the credit period generates additional financing. Trade credit consists of two components: 1) FREE trade credit and 2) COSTLY trade credit, the credit received during the discount period and the costs of credit after the discount equal to the discount lost.

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Inventory Carrying Costs

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Include any expenses associated with having inventory, such as rent paid for the storage warehouse and the insurance on the inventory. These costs generally increase in DIRECT PROPORTION to the average amount of inventory carried.

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Inventory Ordering Costs

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Expenses associated with placing and receiving an order for new inventory, which include the costs of generating memos, fax transmissions, and so forth. For the most part, the costs associated with each order are FIXED regardless of the order size.

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EOQ

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The EOQ, or economic ordering quantity, model is used to determine the optimal amount of inventory that a firm should carry. If the firm orders the amount of inventory specified by the EOQ model, it will MINIMIZE THE COSTS associated with carrying inventory. At the EOQ, total carrying costs (TCC) EQUALS total ordering costs (TOC). EOQ is where TCC = TOC.

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TAX SAVINGS OF DEPRECIATION

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For tax purposes, the entire cost of an asset is expensed over its depreciable life. A major effect of MACRS (Modified Accelerated Cost Recovery System) has been to shorten the depreciable lives of assets, thus giving businesses larger tax deductions and thereby increasing their cash flows available for reinvestment.

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TOTAL INVENTORY COSTS

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The combination (sum) of total carrying costs (TCC) and the total ordering costs (TOC). The point where TIC is minimized is the EOQ (Economic Ordering Quantity).

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FINANCIAL LEVERAGE

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Considers how changing operating income affects earnings per share, or earnings available to common stockholders. Financial leverage represents the fixed financial costs of the firm. The degree of financial leverage (DFL) states these financial costs on a relative basis, and it indicates by what percent the firm's EPS will change if EBIT changes.

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OPERATING LEVERAGE

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In business terminology, a high degree of operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income. Operating leverage represents the fixed operating costs of the firm. The degree of operating leverage (DOL) states these operating costs on a relative basis, and it indicates by what percent the firm's operating income will change if sales change.

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SAFE INVESTMENTS FOR IDLE CASH

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Include short-term CDs and treasury bills. Long-term investments are not safe investments for idle cash.

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SPONTANEOUS SOURCES OF FINANCING USED IN FINANCIAL FORECASTING

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Funds that are obtained from routine business transactions such as ACCOUNTS PAYABLE and ACCRUED WAGES. They are current liabilities that change naturally with sales changes and increase at the same rate as sales. They do not include notes payable, long-term bonds, and common stock.

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Additional Funds Needed (AFN)

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Funds that a firm must raise externely through new borrowing or by selling stock.

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BASIS FOR FORECASTING OF ADDITIONAL FUNDS NEEDED (AFN)

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SALES

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