Working Capital Management Concepts Worksheet

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In the example of the Lawrence Sports simulation the company showed that their primary source of cash inflow came from their largest customer Mayo. Other cash income came from their investment income and the use of their loan arrangement with their bank when needed. Their primary sources of cash outflow came from their payments to their suppliers Gartner and Murray. Other expenses included repayment of their bank loan and interest payments. Lawrence preferred to keep at least a closing cash balance of $50,000 at all times and so any disruptions in their cash inflow and outflow had a dramatic impact on this figure. This simulation gave very good examples of the types of situations that can happen and create a dramatic impact on a company’s inflow/outflow of cash. A prime example was the financial impact that a Lawrence faced when their primary source of cash, a key client defaulted on their credit payments. Cash inflow and outflow for a company is typically stated through their sources and uses statements. Sources are defined as activities that contribute to net working capital and uses as activities that use up working capital. Working capital is usually referred to as funds, and a sources and uses of funds statement is presented. Examples of sources for cash can include such things as issued long-term debt, reduced inventory, increased accounts payable and cash from operations. Uses of cash include things such as repaid short-term bank loan, invested in fixed assets, purchased marketable securities, increased accounts receivable and dividends (Brealey, Myers & Allen, 2005, pg.846-847).
Examine the effects of credit policy on cash conversion cycle and revenue.

In regards to this simulation, Lawrence faced some effects on their cash cycle and revenue when they had to resort to their credit policy, which was borrowing money from their bank. Their arrangement with the bank was whenever they faced a cash deficit, money was automatically borrowed to maintain a positive cash balance of $50,000 on their cash balance sheet at the end of each week. While it was beneficial to Lawrence to have this pre-determined arrangement with Central Bank they also faced the impact of high loan payments and fairly large interest rates, ranging anywhere from 10-16%, depending on the amount borrowed. The objective was to keep the loan borrowing to a minimal to avoid large cash outflows to the bank. In the first part of the simulation the bank borrowing hit a high at $1.2 million and the company continued to face a fairly large cash deficit. The company had to negotiate with their business partners to get the loan under control. This could mean risking some of their positive relationships because Lawrence would need to ask for earlier payments from their key client, Mayo, and ask to delay payments to their key suppliers, Gartner and Murray, to compensate for the increased bank loan and high interest payments. I tried several scenarios to determine the impact it would have on the company. By asking to collect all receivables from Mayo I upset the positive relationship that Lawrence had and jeopardized future orders from them. By allowing them a reduced time or longer time to pay I reduced the ability to pay back the outstanding bank loan. By asking to extend payments to my vendors I also lessoned the relationships but more important, it made the company look as though they were not as reliable and competent as they had once been. After several attempts I was able to reach a somewhat favorable outcome however it was a challenge to continue to respect all my business relationships and continue to keep the company in a positive financial situation. Companies have several options when it comes to borrowing money. While banks are the most common choice credit option it is not the only source of short-term loans. Finance companies are also a major source of cash, particularly for financing receivables and inventories. In addition to borrowing from an intermediary like a bank or finance company, firms also sell short-term commercial paper or medium term notes.

1) Bank loans: bank loans can come in a variety or ways. Common differences include:
• Commitment: banks often establish a line of credit in advance with a bank so that the money is readily available when they need it.
• Maturity: loans can be short-term, such as a short-term bridge loan or self liquidating, or long term which typically has a maturity of four to five years.
• Rate of Interest: this can be a fixed or variable interest rate depending on the terms and length of the loan.
• Syndicated loans: when a loan may be to large for one single bank it can be arranged by multiple banks to fund.
• Loan sales: this occurs when the demand for loans may change and a bank sells a portion
of their excess loans to another institution.
• Security: when a bank may be concerned about a company’s credit risk they may ask for security on the loan which typically consists of liquid assets such as receivables, inventories or securities.
2) Commercial paper: these are owned short-term unsecured notes that are sometimes issued by large firms. Allows for the company to avoid going through a middle intermediary such as a bank.
3) Medium-Term Notes: consider a hybrid between corporate bonds and commercial paper and typically issued by large blue-chip companies. Like bonds, they are typically long-term.
(Brealey, Meyers & Allen, 2005, pp.856-851).

Examine the effects of account payable terms on cash conversion cycle and cost of goods. In the Lawrence simulation this became a problem when their key accounts receivable client, Mayo, asked for an extension on their terms of credit. If Lawrence refused they could risk dampening the close relationship that they have with their client however, by extending the terms to allow for additional time for them to pay they also risked the relationships that they had with their key vendors. They could consider stretching their payments on their own financial obligations however this could lower their favorable reputation as a company and risk future sales opportunities. According to the company’s cash flow plan Lawrence expected to receive $1,900,000 in cash inflow from Mayo during the period of March 10th through April 6th. During the week of March 10-16, assuming full payment from Mayo, the total cash inflow was not enough to cover their expenses and allow them to keep $50,000 in their closing cash balance so they would have to resort to borrowing from their line of credit at the bank either way. My goal was to keep the loan burden minimal throughout the year however without the full amount of payment coming in Lawrence would have to look for other ways to account for their cash loss. In the simulation I choose to allow Mayo the opportunity to delay 80% of their payments for an extra week. In turn Lawrence then went to Gartner and asked to extend 60% of their payment and co-operate with Murray to pay 15% on purchase, 40% in the next week and the remaining 45% in the week after, just long enough to receive additional income from Mayo. While their business relationships remained favorable Lawrence unfortunately was not able to pay back most of the outstanding bank loan therefore not putting their working capital in a very favorable condition. In the simulation this worked out somewhat favorable for Lawrence, however it could have easily turned out bad. As discussed above it could have hurt their current relationships and weakened the favorable reputation of the company. Longer term effects, had Mayo continued to delay their payments, could have further impacts on the company which could lead to an increase in their product costs, to compensate for loss of income as well as Lawrence themselves defaulting on their financial obligations. If a company continues to lose further control of their client’s accounts receivables and accounts payable accounts then eventually it could lead to bankruptcy for the organization. I found this simulation very challenging and it truly made you have to think about ever decision you made and how it impacted all aspects of your cash flow plan. A company always has to consider the effects that their credit policies will have on their cash conversion cycle and revenue stream. While companies frequently sell items on credit, the time it takes for them to actually receive the payment can vary from weeks to maybe even months. This waiting of funds is seen on their financial statements as their accounts receivable. Companies often rely on a certain amount of their accounts receivables to be paid each month so they can continue to have an adequate amount of cash inflow and so that they can meet their necessary debt and financial obligations (Brealey, Myers & Allen, 2005, pp.813-814).
Explain working capital practices.

The first problem that I encountered in the simulation in regards to the company’s working capital practices in relation to their credit management was that Mayo, a key and primary client to Lawrence, asked for an extension of payment on their account by about a month. This loss of incoming cash would have put Lawrence into the negative and jeopardized some of the financial obligations to two of their suppliers – Gartner and Murray. In this situation I choose to give Mayo an extra week to pay 80% payment for the weeks of March 10-16 and March 17-23. Mayo decreased sales slightly during the week of April 21-27 however ultimately were not that upset. Gartner was willing to allow Lawrence to split 60% of their outstanding payments over time and Murray allowed them to pay 15% on purchase, 40% in the next week and the remaining 45% in the week after, which did not put any undue pressure on their financial resources. Since Lawrence had a good reputation for paying back their debts this arrangement worked for all parties and did not jeopardize any of their key relationships. If however Mayo continued to delay their payments this would have had a big impact on Lawrence’s ability to pay their suppliers so, not only would they be losing a great deal of their cash inflow they would themselves have to look for other cash options to pay their suppliers if they did not want to jeopardize their relationships. A company’s credit management, inventory management, cash and marketable securities all play an important role on a company’s working capital practices. For this example I am going to relate to the management of trade credit and these five key factors. These include:
• Terms of sale: how long are you going to give your customers to pay their bills, will you offer a discount for prompt payment. An example of a term would be ‘2/10, net 30’ which means the company requires payment in 30 days but may offer a 2% discount if paid within 10 days.
• The promise to pay: as a company how you require a commitment of payment from your customers. Most sales are made on an open account, which is nothing more than a signed receipt and a record in the seller’s book. A company could require a commercial draft, which displays a clear commitment from the buyer before the delivery of goods. Two other options are a bankers’ acceptance and a irrevocable letter of credit.
• Credit analysis: ways to determine the likelihood a customer will repay
their debt. For new customers you can reference their financial statements however the simplest way to access a customer’s credit is to seek the views of a credit in credit assessment. For larger companies you can also view their bond rating from agencies such as Moody’s and Standard and Poors.
• The Credit Decision: during this period you must determine whether or not to extend credit to a customer. You can use the expected profit formula to help with your decision. This is stated as: pPV(REV-COST) – (1-p)PV(COST), where p is the probability that the customer will pay and 1-p is the probability they will default.
• Collection Policy: the final step which is to collect payment from your customers.

These decisions play an adverse role on a company’s cash conversion cycle and will help determine what type of cash problems they may encounter (Brealey, Myers & Allen, 2005. p.814-819).

Explain the relationship between short-term financing and working capital practices.

In the simulation regarding Lawrence Sports they had developed an agreement with their bank, as their short-term financing option, to automatically borrow funds so they can always maintain a minimum cash balance of $50,000. Their maximum credit limit is $1.2 million with a tiered interest rate approach of 10-16% depending on the amount borrowed. Repayment of the loan is done during the last week of each month after retaining a positive cash balance of $50,000. Lawrence Sports objective is to keep the bank borrowing at a minimum to avoid high interest costs. To do this they most negotiate short-term payment and collection arrangements with their business partners while continuing to maintain good working relationships. Another option that the company could have considered was the possibility of delaying or stretching their payments to their vendors, Gardner Products and Murray Leather Works to provide them with the additional cash flow would need. Gardner provides about 70% of Lawrence’s raw materials however since Lawrence is not a major client to this large supplier they may not have been as willing to work with them if they had decided on this option. Murray Leather Works on the other hand heavily relies on their relationship with Lawrence, which provides for about 75% of their sales and may have been a little more open to delaying some of their payments. The relationship manager for Murray however was concerned that this could cause deep financial trouble if payments to Murray where continued to stretch indefinitely. I choose to select the option to delay payments slightly but looked to the bank loan to supplement any additional cash needs. By selecting this option it allowed Lawrence Sports to maintain their $50,000 cash balance and did not jeopardize any of their outstanding relationships. When a company’s financial sheets display a cash budget problem they must find short-term financing to cover their forecasted cash requirements. A short term financing plan can be considered. In the text example for Dynamic Corporation we assume two short-term options, although there are other various options. These include a bank loan and the option to stretch payments. With a bank loan, Dynamic can arrange a relationship with their bank to borrow a certain amount of money at a stated percentage rate when needed. This allows the company to borrow and repay whenever needed. The second option, stretching payments, allows them to raise capital by putting off the payment of their bills into future quarters. This option is often costly as that suppliers may offer a discount for prompt payments and suppliers may begin to doubt Dynamic’s creditworthiness (Brealey, Myers & Allen, 2005, p.852-854).

References
Bresley, Myers & Allen. (2005). Financial Planning and the Management of Working Capital. New York: The McGraw-Hill Companies.

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