CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:

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Financial Management MGT201

Lesson 40

CASH MANAGEMENT AND WORKING CAPITAL FINANCING

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following topics:

· Cash Management &

· Working Capital Financing

Cash Dividend Payout Decision:

· Link between Dividend Policy & Cash Management Cash Dividends are paid out of Cash!

· Cash is an idle asset that do not generate any return for the company

· How should firm decide to pay Cash Dividend based on Its Impact on Share Price and Firm's

Value?

· Gordon's Formula:

Dividend policy issue of the company can be seen through Gordon's Formula.

Po (Share Price) = DIV1 / (rE g)

= EPS x (DIV1/EPS) / (rE (Pb x ROE)).

DIV1 = Forecasted dividend in the next year

rE = Required rate of return on equity

g = Growth rate in dividends

Pb = Plough back ratio

The two criteria that can help to decide about dividend are ROE and rE.

· ROE is financial accounting measure of the firm's ability to internally generate a return. rE

is the return that the firm's shareholders REQUIRE. Firms try to keep ROE HIGHER than

rE.

· If ROE < rE then firm is not generating enough return to meet shareholder requirements so it

is better to payout the dividend. Lower ROE means company is not finding sufficient

projects to generate enough return higher than rate of return on equity.

· If firm makes Dividend payout, in this case, share price Po (and Firm Value) will RISE as

dividend announcement has positive impact on company's share price.

· If ROE > rE then firm is better off to Plough the Retained Earnings back into the business

and investing in Positive NPV Projects or the Firm's core business. In this case, company

is generating higher return than the return shareholders require, so the best use of internally

generated retained earnings is to use them as a cheap source of capital or financing.

· In this case of ROE > rE if firm makes Dividend payout, share price (and Firm Value) Po

will FALL. Here it makes sense for the company to keep cash and invest it in investments

as company is generating positive higher returns on its projects rather than paying dividend.

· If ROE = rE then dividend payment has no impact on share price of the company.

Inventory Management:

In the last lecture we studied working capital and cash management in detail. Now we discuss inventory

management, another part of working capital.

· 3 Types of Inventories: Raw Material, Work in Process, Finished Goods

· Issues to Consider in Inventory Management:

Inventory is acquired BEFORE sales so estimates must be accurate. EOQ (Economic Order

Quantity) difficult to estimate otherwise:

· Shortfall in Inventories: interruptions in production and loss or sales orders

· Surplus Inventories: high carrying costs, wastage, and depreciation

Case of Eid Time Sales: Using Short-term Finance or Loan to buy extra inventory can be Risky

because if you can't sell it, you will be forced to sell at a Deep Discount. So sell at a loss. Cash

trickling in BUT Retained Earnings being wiped out. Not enough cash to pay interest on the

loan. Possibly default and bankruptcy.

Inventory Costs:

· Carrying Costs (cost of capital, storage / warehouse rent, insurance premium, wastage)

as high as 20 30 % of Inventory value!

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Financial Management MGT201

· Shipping Costs: Generally Less than 5% of Inventory value!

· Cost of Running Short Loss of sales, customers, and goodwill difficult to estimate.

Inventory Management Policies:

Technology Based: Dynamic Systems not only Static EOQ Software for inventory but

Dynamic Computer Software that considers Usage Growth Rates. MRP (Material Resource

Planning) and ERP (Economic Resource Planning) Software.

JIT: Just in Time. Developed by Toyota. Supplies arrive just a few hours before they are

used. Inventory and Working Capital is minimized. Improves overall Efficiency.

Outsourcing: Instead of making all the parts yourself, buy them from outside suppliers at a

lower cost and avoid any unionism issues. Example: IT Divisions of Large American

MNC's outsource the writing of computer software to Pakistani software houses.

Accounts Receivables Management:

This is another area of working capital. Accounts receivables are created out of credit sales.

· Most firms would prefer to sell for Cash BUT Competition forces them to sell on Credit.

Example: Fabric trading in Pakistan where sellers offer 1 to 3 months credit (and even longer).

· Account Receivables

= Credit Sales per day x Average Number of Days of Credit

Example:

Account Receivables

=Rs.10000 / day x 30 days

=Rs.300000 of fabric "Stuck in the market" or "In Rolling" at any given time.

· A/c Receivables (other than Profit portion which appears in Retained Earnings) need to be

Financed somehow i.e. Short-term loan, trade credit, etc.

· A/c Receivables = Daily Sales x ACP

ACP = Average Collection Period

= weighted average days of credit. Can be obtained from Ageing Schedule (Financial

Accounting)

Example: Firm makes 30% of sales on 30 day credit and 70% on 60 day credit. So

ACP

= (0.3x30) + (0.7x60)

= 9 + 42

= 51 Days

Try to Minimize Average Collection Period and daily credit sales.

Credit Policy:

· Factors considered for credit:

Credit Quality Aspect: Proper Assessment of Credit-worthiness of each credit customer

(Credit Quality)

Minimize Time (Credit Duration or ACP) and Value (Credit Given)

Creative Credit Terms

· Incentivize Customers to pay cash and to pay quickly

"Sell on 5/10.net 30 basis". 30 basis Means customer must pay full cash value within 30

days. 5/10.net means 5% discount for customers who pay within 10 days. So it is an

incentive for customer to pay cash quickly.

· Impose Carrying Charge on Late Payments

Example: 2% late payment Charges if bill is not paid within 30 days. Means 24% penal

interest per year! Example: If customer does NOT pay Rs.100000 bill within 1 month,

then he will have to pay Rs.2000 extra for every month that he is late!

Working Capital Financing Policies:

It involves the discussion regarding how firms should finance this working capital.

· Sales fluctuate with Nature of Business, Time, Season, State of Economy:

Economic Growth or Boom: High inventories and Current Assets

Economic Recession: Low inventories and Current Assets

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Financial Management MGT201

· Never drop to zero because always need minimal "Permanent Current Assets."

Total Assets = Fixed + Permanent Current + Temporary Current.

Total assets steadily grow with life of healthy company.

Temporary Current Assets fluctuate with time. Extra Spontaneous Inventory can be

financed by short-term debt financing or loan

3 Policies for Working Capital Financing (based on Maturity Matching Principle)

Aggressive

· Maximum Short-term financing at low cost (but risk of non-renewal of loan)

· Use short-term financing for Temporary Current Assets and even partly to buy

Permanent Current Inventory

Conservative

· Maximum Long-term financing. Safe but higher interest costs.

· Use long-term financing for Fixed Assets, entire Permanent Assets, and even

part of Temporary Current Assets

Moderate

· Balance of Long and Short-term Financing.

· Long Term Financing for Fixed and Permanent Current Assets. Use Short

Term Financing for Permanent Current Assets. Use Spontaneous Current

Liability Financing for Temporary Current Assets

Advantages of Short Term Debt or Loan

Speed of getting finance as they are short run

Flexibility (not locked in)

Lower Interest Rates (generally Upward Sloping or Normal Yield Curve)

Disadvantage of Short Term Debt is that cost of debt is uncertain and variable in long run.

Non-renewable.

Graphical View of Financing Maturity Matching Principle Match the Maturity of Financing to

Usage of Asset:

Graphical View of Financing

Maturity Matching Principle

Match the Maturity of Financing to Usage of Asset

Spontaneous

Value (Rupees)

TEMPORARY CURRENT ASSETS 

Current

Usage Less than 1 Year

Liabilities &

Short Term

Financing

Short Term

Financing

& Long

Term

"PERMANENT" CURRENT ASSETS

Financing

 Usage More than 1 Year

Long Term

Debt &

FIXED ASSETS 

Equity

Usage More than 1 Year

Time (Months)

Firms generally pursue moderate policy of financing. Basic logic behind this is MATURITY

MATCHING PRINCIPLE.

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