The most common meaning for the term working capital is the difference between current assets and current liabilities:
In this usage, working capital is the dollar amount of current assets left over after the remaining current assets are allocated to pay the company’s current liabilities. These “extra” current assets can be used to finance the ongoing work of the business, hence they represent the firm’s “working capital.” The second meaning for working capital is total current assets:
When working capital is used in this second way, the term net working capital is often used to stand for current assets minus current liabilities:
Even though each component of the current accounts (each dollar of cash, each account receivable, each item of inventory, each account payable, etc.) turns over several times each year, the overall balance of these accounts never goes to zero. Permanent working capital is the base level of these accounts: the dollar amount of current assets and current liabilities required at all times by a company. Temporary working capital is the remainder: the additional balances of working capital that comes and goes with the business cycle, the time of year (seasonality), or simply day-to-day events. The distinction is important to financial managers because the techniques used to analyze and manage permanent and temporary working capital differ; it is important to recognize the difference so the correct financial managing tools can be applied. Specifically, permanent working capital is analyzed in much the same way as capital budgeting decisions by applying time value of money analysis to a forecast of long-term changes to cash flows. This is the subject of this chapter. Temporary working capital, is analyzed using the tools of financial risk management.
In what ways is the cash flow table used to organize the data for permanent working capital asset decisions similar to and different from the cash flow table used in capital budgeting?
The two cash flow tables are similar in form. They both are spreadsheets that list each forecasted change to cash flows in a row identifying why the cash flow is changing and in a column identifying when the change is expected to occur. They both serve to organize the forecasted cash flows in a way that is amenable to time value analysis. The tables differ in two respects. First, capital budgeting projects have a finite time horizon. In the cash flow table, this is identified by the right-most column which is labeled “Year N,” where N is the last year of the project’s life. Permanent working capital proposals, on the other hand, typically will change the company’s cash flows for the lifetime of the firm. For a company considered a “going concern”, we usually treat this as an infinite time horizon and make the right-most column in the cash flow table “Years 1-N.” Second, the specifics of each cash flow differ due to the nature of the flows. The cash flows in a capital budgeting proposal come from the costs and benefits of fixed assets and require calculations dealing with such things as the tax shield from depreciation and operating efficiencies. By contrast, the cash flows from permanent working capital opportunities deal with the current accounts, hence the numbers we must obtain for the cash flow table come from such things as bad debts, discounts granted and taken by customers, and the costs of administering receivables, payables, and inventories.
What is a project’s “net annual benefit?” Why is this measure used in evaluating permanent working capital asset decisions?
Net annual benefit is the amount by which the annual cash flow from an investment project exceeds the amount required to finance the capital invested. It is particularly useful for permanent working capital decisions for two reasons. First, since it looks only at the upcoming year it addresses the potentially troublesome assumption that changes to cash flows from permanent working capital decisions continue forever. We can make a decision based on the costs and benefits the company will experience in the next year knowing that we can undo the decision in future years should conditions change. Second, by looking at the upcoming year, it focuses our attention on opportunities to further improve the permanent working capital balance on an ongoing basis.
Discuss how a corporate treasurer allocates the firm’s cash balance. What are the factors taken into account in making the allocation?
Corporate treasurers allocate a company’s cash by type and currency among the company’s offices, stores, and production facilities. Types of cash include coins and bills, demand (checking) deposits, and interest-bearing deposits or investments. Coins and bills are used for petty cash and retail transactions; the balance is kept to a minimum for safety considerations and since it earns no interest. Allocation depends on the nature and volume of business at each site and local financial customs. Demand deposits are used for a company’s transactions needs and are also kept to a minimum amount since no interest is generally earned. Allocation depends on the volume of transactions at each site, the variability of cash flows, efficiency of cash management, and access to financial markets. Extra cash is moved to investments to earn interest. Companies allocate cash by countries by looking at political risks that could prevent the firm from removing the cash, interest rate differentials among currencies, and forecasts of foreign exchange rate movements. Most companies net out amounts owed from one unit to another to minimize cash movements within the company.
Even though accounting principles encourage us to treat a corporation as a “going concern,” many people are not comfortable with this assumption. Few companies survive forever. The majority are proprietorships and partnerships that typically end with the retirement or passing of their founders. And most corporations cannot keep up with changing business and technological conditions forever; although they often live longer than proprietorships and partnerships, they too eventually perish. This is why many analysts prefer to use net annual benefit (NAB) and narrow down their decision to the coming year. On the other hand, if the forecast is for an initial cash flow followed by a perpetuity of flows, the perpetuity assumption leads to a correct decision since NPV always agrees with NAB.
Why is it of concern to the financial manager? Discuss the advantages and/or disadvantages to receivables float and payables float.
Float is money that is en route between parties. One party has written a check and released it to the other party (normally by putting the check in the mail), however the second party does not yet have the money to spend. We distinguish between receivables float, incoming checks that have not yet been collected, and payables float, outgoing checks that have not yet been paid. From a strict time value of money perspective, receivables float is bad we always want to receive money sooner, and payables float is good we do want to pay later. However, there may be other costs associated with float that must also be taken into account. These include the administrative costs of accelerating collections and delaying disbursements, and the more difficult to measure costs associated with customer and supplier satisfaction. Ultimately, every payment between two companies is a process involving both organizations. The best value of float is one that minimizes the joint costs of the two parties.
A lock box-concentration banking system is a traditional method of reducing receivables float. A lock box is a post office box to which customers address their payments. A messenger from the company’s bank empties the box, often several times a day, and takes the checks to the bank where they are immediately deposited to the company’s account. A company doing business in many locations might use concentration banking to further speed up the availability of funds. It’s primary bank would set up lock boxes in several cities and employ local banks to remove and deposit the checks. Then the primary bank would “concentrate” the funds, transferring them electronically to a central account. The net effect is to reduce significantly the time “the check is in the mail.”
When does a company move cash from its noninterest-bearing demand account to marketable securities?
All companies face a tradeoff between their need for liquidity, which argues for keeping cash in a demand account where it can be accessed immediately, and their desire to earn as much income as possible, which argues for keeping every last dollar of cash in an interest-bearing deposit. In general, a company moves cash from its non interest-bearing demand account to marketable securities whenever it determines that its cash balance is greater than required for liquidity. If there is no cost to make the transfer, then every cent above the minimum liquidity need should be moved to securities, as is done in some bank accounts that “sweep” all cash above a specified amount into a money market fund. However, if there is a brokerage cost or other fee to move the money, the company must include this cost in its analysis.
What special considerations enter the credit granting decision when the customer is paying in a foreign currency?
Granting credit delays the date on which a company receives payment for its goods or services. When payment is in a foreign currency, several things might happen during that time to reduce the value of the receipt. The foreign currency might depreciate, or local laws might change requiring that the transaction be at a special (and unfavorable) exchange rate or making it difficult or impossible to obtain payment. If any of these concerns exist, the selling company might elect not to grant credit, to grant credit only for a short period of time, or to insist that the sale be denominated in a stronger and safer currency.