Working capital Working capital (accounting terms) Liquidity Liquidation Working capital cycle Cash flow Insolvent Debtor

The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers. Working capital = current assets - current liabilities

The ability of a firm to pay its short-term debts When a firm ceases trading and its assets are sold for cash. Turning assets into cash may be insisted on by courts if suppliers have not been paid. The period of time between spending cash on the production process and receiving cash payments from customers The sum of cash payments to a business (inflows) less the sum of cash payments made by it (outflows) When a firm cannot meet its short-term debts Cash inflows Payments in cash received by a business, such as those from customers (debtors) or from the bank; e.g. receiving a loan An individual or an organisation who has bought on credit (or received a loan) from the business and owes the business money An individual or organisation to whom money is owed by the business Payments in cash made by a business, such as those to suppliers or workers

Creditor Cash outflows

Examples of cash outflows include: Lease payments for premises Annual rent payment Electricity, gas and telephone/internet bills Labour cost payments Variable cost payments (e.g., raw materials) Estimate of the firm's future cash inflows and outflows Estimated difference between monthly cash inflows and outflows Cash held by the business at the start of the month Cash held at the end of the month becomes next month's opening balance

Cash flow forecast Net monthly cash flow Opening cash balance Closing cash balance

Benefits of cash flow forecasts: - By showing periods of negative cash flow, plans can be put into place to provide additional finance; e.g. arranging a bank overdraft or preparing to inject owner's capital - If negative cash flow appears to be too great, then plans can be made for reducing these; e.g., by cutting down on purchases of new materials or reducing credit sales - A new business proposal will never progress beyond the initial planning stage unless investors and bankers have access to a cash flow forecast (and the assumptions behind it) Limitations of cash flow forecasts:

- Mistakes can be made in preparing the revenue and cost forecast (inexperience, seasonal variations, etc) - Unexpected cost increases can lead to major inaccuracies (e.g. fluctuations in oil prices affecting cash flows of airline companies) - Wrong assumptions can be made in estimating the sales of a business (e.g., poor market research) Causes of cash flow problems: 1. Lack of planning 2. Poor credit control 3. Allowing too much credit 4. Expanding too rapidly 5. Unexpected events Credit control Monitoring of Bad debt debts to ensure that credit periods are not exceeded Unpaid customers' bills that are now very unlikely to ever be paid

Ways to improve cash flow: 1. Increase cash inflows 2. Reduce cash outflows (careful! its the cash position of a business, NOT sales revenues or profits) Methods to increase cash flow: 1. 2. 3. 4. 5. 6. Overdraft Short-term loan Sale of assets Sale and leaseback Reduce credit terms to customers Debt factoring Short term liquidity problem, sell debt to a factoring agency, instant inflow of cash but the cost is a fee payable to the agency that lowers the profit on the original business A negative balance in a business's bank account An ability to have a negative balance up to an agreed limit in a business's bank account Assets can be sold (e.g. to a finance company), but the asset can be leased back from the new owner

Debt factoring Overdraft Overdraft facility Sale and leaseback

Evaluation of overdraftas a way to increase cashflow 1. Interest rates can be high 2. Overdrafts can be withdrawn by the bank and this often causes insolvency

Evaluation of short-term loan as a way to increase cashflow 1. The interest costs have to be paid 2. The loan must be repaid at the due date

Evaluation of sale of assets 1. Selling assets quickly can result in a low price 2. The assets may be required at a later date for expansion 3. The assets could have been used ascollateral for future loans An asset that is the subject of a secured loan, and can be sold by the lender to recover the amount owed A loan backed by an asset of value, such as property or vehicles

Collateral Secured loan

Evaluation of sale and leaseback as a way to increase cashflow 1. The leasing costs add to the annual overheads 2. There could be loss of potential profit if the asset rises in price 3. The assets could have been used ascollateral for future loans

Evaluation of reduce credit terms to customers as a way to increase cashflow 1. Customers may purchase products from firms that offer extended credit terms Evaluation of debt factoring as a way to increase cashflow 1. Only about 90-95% of the debt will n ow be paid by the debt factoring company - this reduces profit 2. The customer has the debt collected by the finance company - this could suggest (give the perception) that the business is in trouble Methods to reduce cashflow 1. 2. 3. 4. Delay payment to suppliers Delay spending on capital equipment Use leasing, not outright purchase of capital equipment Cut overhead spending that does not directly affect output; e.g. promotion costs

Evaluation of delay payments to suppliers (creditors) as a way to reduce cashflow 1. Suppliers may reduce any discount offered witht he purchase 2. Suppliers can either demand cash on delivery or refuse to supply at all if they believe the risk of not getting paid is too great

Evaluation of delay spending on capital equipment as a way to reduce cashflow 1. The business may become less efficient if outdated and inefficient equipment is not replaced 2. Expansion becomes very difficult Evaluation of use leasing, not outright purchase of capital equipment as a way to reduce cashflow 1. The asset is not owned by the business 2. Leasing charges include an interest cost and add to annual overheads

Evaluation of cut overhead spending that does not directly affect output as a way to reduce cashflow 1. Future demand may be reduced by failing to support products effectively How do you calculate the working capital cycle? There are five stages. Average raw material time in inventory MINUS credit days from suppliers PLUS time in production PLUS time finished goods in inventory PLUS time allowed for customers to pay

Liquidity

the extent to which a company is able to meet its short-term obligations using assets that can be readily transformed into cash

Primary source of liquidity Secondary source of liquidity

the most readily accessible resources to meet liquidity requirements, such as cash or near cash securities a source of liquidity that may affect the normal operations of the company, and that may change the company's financial and operating positions

Drag on liquidity Pull on liquidity

when receipts lag, creating pressure from the decreased available funds when disbursements are paid too quickly or trade credit availability is limited

Credit-worthiness

the perceived ability of the borrower to pay what is owed on the borrowing in a timely manner and represents the ability of a company to withstand adverse impacts on its cash flows

Liquidity ratios

a measure of the ability of a company is able to meet its short-term obligations using assets that can be readily transformed into cash

Current ratio = Quick ratio (or acidtest ratio) Quick assets Accounts receivable t/o = Inventory t/o = Number of days of receivables = Number of days of

current assets / current liabilities cash + short-term marketable investments + receivables / current liabilities assets that can be most readily converted to cash credit sales / average receivables

cost of goods sold / average inventory number of days in period / accounts receivable t/o

number of days in period / inventory t/o

1. - Interest is tax deductible - Interest payment is subject to less control 2. Equity Advantage 3. Equity Advantage 4. Equity Disadvantage 5. External Fund 6. External Fund

Why do MNCs prefer a parental loan to an equity when their foreign subsidiaries need additional working capital?

Why do MNCs want to provide working capital in terms of equity? Credit rating is not jeopardized Dividend payment is subject to more control than interest payment PROBLEM: Paren'ts payment guarantee needed Subsidiary borrows in international market - Subsidiary borrows a local loan from a local bank (most preferred by MNCs)

7. MNCs prefer local loan from local bank 8. Problems with manipulating Transfer Price

Avoids possible political risk that the host country may block the interest payment in the future Problems: - conflict with host gov't - subsidiary's performance distorted - need to keep dual set of A/C book - objectives can conflict each other

9. Transfer Price

Intra-corporate price charged on the goods & services transacted among the affiliated units *** Primary reason to use T/P is to avoid government control

10. Ways to use T/P

- Provide working capital to their subsidiaries - Repatriate blocked fund - Reduce income tax - Reduce tariff (ad valorem)