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Working capital management.


Frequently, capital budgeting projects consume much of the time of a firm's management group to the detriment of the quality of the working capital decisions. There are many logical reasons for this to be the case. First of all, the dollars involved in each individual decision are usually considerably greater than those in an accounts receivable transaction. For instance, the purchase of new equipment will dwarf the size of the average receivable granted.

Secondly, the capital budgeting decisions often almost scream out for attention. The equipment may be obviously close to completely breaking down in spite of the most careful maintenance. A new building may be imperative because the existing structure is clearly inefficient or on the verge of collapse. Furthermore, sales may be increasing at such a rate that obviously additional facilities must be provided for the future of the business.

However, working capital management decisions are made continuously rather than on relatively infrequent occasions like capital budgeting decisions. The sum total of those decisions can be just as important, if not more important, to the financial health of the firm and to the wealth position of the owners (stockholders). Financial theory and practice dictate that the firm must be operated for the maximization of the wealth position of the owners as opposed to the maximization of the income of the firm because the former considers the riskiness of business activities; whereas, the latter does not specifically do so.

The goal of this essay is to encourage business executives to become more specifically cognizant of the working capital decisions that their firms face every day. To illustrate the type of thinking that should be used, two examples will be discussed. The first will deal with an accounts receivable decision, and the other will involve marketable securities.


The investment of resources in accounts receivable is increased or decreased by many different parameters including:

(1) The financial stability required.

(2) The length of credit allowed

(3) The cash discount given

(4) The intensity of the collection effort

For instance, if the firm requires a high level of financial stability in its customers, the level of investment in accounts receivable will be lower than if a moderate financial standing is required. Also, the level of receivables will be reduced if the length of the credit terms is shortened and vice versa. Further, if the cash discount is increased, the number of customers paying in the discount period (perhaps ten days) will rise and the investment in accounts receivable will be reduced considerably in many situations; whereas, the opposite is true if discounts are reduced or dropped entirely. Finally, a considerable extension of effort to collect receivables will generally tend to have the effect of relieving the firm of a considerable amount of the asset investment in that particular area, but at a significant cost.

However, in the interest of space and time, only one receivables decision-making problem will be covered in this essay. The principles of problem-solving will be basically the same in all of the other decision areas mentioned above, that is, to determine whether or not a proposed change will be beneficial for the firm.

Specifically then, let us assume that our firm is considering the possibility of a change in our credit terms. The current terms are a one percent cash discount for paying within ten days and full payment within thirty days if the discount is not taken (1/10;n/30).

Currently the management is concerned that the average collection period is fifty-four days in spite of the thirty-day credit period. Therefore, the management is contemplating what effect increasing the cash discount to two percent for the same ten-day period might have on the speed with which customers would pay their accounts. The same thirty-day outside terms would be maintained under the currently anticipated shift in policy. Thus the terms would be 2/10;n/30.

If we assume that we research the potential effects of the possible change, we might come up with the results mentioned below. (Keep in mind that these results are purely hypothetical, but those that your firm would uncover would be quite similar). The higher cash discount might encourage 80% of the customers to take the discount as opposed to only 40% prior to the increase. Also, the average collection period would be shortened to twenty-eight days, and the bad debt experience would drop from 3.5% of sales to 3.0%. The return needed on receivables investments would be 14%. Finally, because of the attraction of the higher discount, there would be an initial increase of 5% in the current level of $10,800,000 in sales, assuming for simplicity that all are on open account. Whether or not the firm would maintain the increase would depend on the reaction of other firms in the industry to the change initiated by the firm. However, the firm that initiates a move favorable to the customers would have a good chance of maintaining the new business. If our firm has significant excess capacity at the time, only the variable costs, say 60% of sales, should be charged against the added sales, leaving a marginal contribution of 40% toward profitability and fixed costs.

Now that we have summarized the fruits of our research, we can begin to analyze the benefits and costs of the change that we are considering. First of all, the main cost would be the increased cash discounts. The existing cash discounts would be $43,200 (1% x 40% x 10,800,000). Because the level of sales would increase (10,800,000 x 105%) as well as the percentage of customers taking the discount, the change would bring the assumed higher level of cash discounts to $181,440 (2% x 80% x 11,340,000). Thus, one of the major cost elements of receivables financing would rise by $138,240 ($181,440-43,200) which shows that the increased discounts would be a significant figure to overcome if the change were to be beneficial.

Moving on to one of the aspects of receivables financing that led to a consideration of a change in the level of cash discounts, the length of the average collection period, we find a more satisfactory situation. The dollars tied up in accounts receivables currently total $1,620,000 resulting from the fifty-four day average collection multiplied by the average daily sales of $30,000. ($10,800,000 divided by 360 days per year assumed). After the change the receivables investment would be $882,000 resulting from the twenty-eight day collection period and the daily sales of $31,500. (11,340,000 divided by 360). In this case the $738,000 reduction in receivables investment ($1,620,000 - $882,000) would result in a cost of money alleviation of $103,320 ($738,000 x 14% return objective). Some would maintain that only the variable costs of production should be considered in the receivables asset investment. This contention has some reasonableness to it because those costs are the only out-of-pocket or cash costs tied up in the inventory that is sold to the customer. However, if the inventory is sold on a cash basis, the firm would collect the full sales price immediately. Therefore, if the firm sells on accounts receivable basis, it is trying up the full amount of the sales price, that is, it is forgoing the collection of the full amount not just the variable cost of production.

Another potential cost reduction coming from the contemplated change would be the level of bad debts expense. As outlined above, the bad debts currently are likely to be $378,200 (10,800,000 sales x 3.5% bad debts rate). Because the change will shorten the average days' receivables outstanding, it will most likely reduce the bad debts experience also to $340,000 even on the higher sales level that is anticipated ($11,340,000 x 3%). Thus this cost factor will adjust in a favorable direction by $37,800 ($378,000-$340,200). It seems reasonable that the bad debts might drop to an even lower percentage of sales, but this example illustrates the point very satisfactorily.

Finally, it is mentioned above that the sales would increase by 5% or $540,000 (10,800,000 x 5%). In view of the fact that there is extra capacity to take advantage of this business, there would be no need for additional investment in fixed facilities. Thus, the marginal contribution of 40% toward fixed costs and profitability would be the benefit from the sales impact of the change in discount. The amount of marginal contribution on the additional sales would be $216,000 ($540,000 x 40%).

Of course, the amounts arrived at can never be considered to be precise. In spite of the most careful research and simulation, the results of the cash discount change will seldom, if ever, be exactly what we anticipate. Therefore, the firm may want to make the above calculations for a range of results from least optimistic to most optimistic as well as for the "most likely". This essay has been limited to the "most likely" as a single calculation because only one example was necessary for illustrative purposes.

To summarize the results of this working capital change, we must gather the four parts of the analysis together. We have seen that the only cost of the change would be the increase of $138,240 in cash discounts. On the benefit side would be the $103,320 reduction in the cost of money for carrying accounts receivable, the $37,800 reduction in bad debts expense and the $216,000 increase in marginal contribution. Therefore, the net benefit before taxes from the adjustment of the credit terms would be $218,880 ($357,120 of benefits - $138,240 of costs). Even if we would need to assume that no increase in sales was likely, there would be slight net benefit before taxes of $2,880 ($141,120 of benefits - $138,240 of costs). Certaintly there would be no reason to expect at reduction in sales from a change that would make our terms more favorable to the customer. In addition to the above, there mist be some reduction in credit collection costs, but they are assumed to stay the same in this case.


Moving now to the marketable securities working capital area, let us assume that we have funds available for three months until we need to make a percentage-of-completion payment on a new building under construction. We could invest the money in a number of different types of marketable securities, such as commercial paper, negotiable certificates of deposits, banker's acceptances and United States Treasury bills among others. For purposes of this presentation we will deal only with U. S. Treasury bills.

Of course, the initial reaction would be to invest the funds in three-month Treasury bills in order to match the length of time for which the monay will be available with the time to maturity of the marketable securities. However, that may not represent the most beneficial use of the money. For instance, perhaps six-month Treasury bills should be purchased, even through they would need to be sold in three months time rather than maturing like the three-month securities would.

At a particular time, discount rates on three-month and six-month Treasury bills might be 8.30% and 8.50% respectively. As with most short-term marketable securities, Treasury bills do not bear interest but are sold at a discount from face value with the discount being the return that is earned on the securities. Thus, assuming $10,000 as the face value and using an informal approach rather than exact formulas, we would find that the three-month Treasury bill could be purchased for $9,792.50 as follows:

Face or Par Value $10,000.00 Discount 207.50 ($10,000 x 8.30% x 3/12 of a year) Purchase Price $9,792.50

The effective yield on the securities would be determined by dividing the gain during the holding period by the dollars actually invested and then annualizing. Because the bills are going to be held to maturity, the gain or interest will be the difference between the purchase price and the maturity value or the $207.50 of discount and the investment will be the purchase price. Therefore, the effective yield will be 8.48% ($207.50/$9792.50 x 4 x 100%) over the three months. The factor of four in the calculation represents the annualizing of the quarterly results to a full year. As a result of the purchase below face value, the yield is increased by eighteen basis points above the discount rate (100 basis points equals 1.0%). Thus, the return is somewhat higher than one might at first expect and there is no uncertainty as to its amount and percentage.

Referring back to our original example, we find that the discount rate on six-month Treasury bills is even higher than the rate on three-month bills. Perhaps they would give us an even better yield, though they would necessarily have to be sold halfway to maturity. The necessity of selling the securities means that we must develop an expectation of discount rates in three months. For our purposes, we will assume that economic projections indicate that discount rates of 8.30% and 8.50% will likely persist on three-month and six-month bills at the end of the next three months.

Today, then we would pay $9,575.00 to purchase the six-month Treasury bills as follows:

Face on par value $10,000.00 Discount 425.00 ($10,000 x 8.5% x 6/12) Purchase price $9,575.00

However, the securities would have to be sold to secure the funds needed to make the payment previously mentioned above. With the discount rates projected to stay the same over the three months, or at least to end up at the same level, the former six-month bills which would then actually be selling as three-month bills because there would only be three months to maturity could be sold for $9,792.50 as follows:

Face or par vale $10,000.00 Discount 207.50 ($10,000 x 8.3% x 3/12) Sale Price $9,792.50

In this situation, the gain on the Treasury bills will be found by taking the difference between the sale price and the purchase price which is $217.50 ($9,792.50 - $9,575.00). Thus the effective yield will be 9.09% ($217.50/$9575.00 x 4 x 100%) or 61 basis points more (9.09% - 8.48%) than on the purchase of three-month bills held to maturity. This higher yield comes from two sources, namely the lower investment needed for longer-term securities with a larger amount of discount and the lower discount rate given up to the seller as compared to what was received on the purchase. This latter results from a process that has various names including "riding the yield curve", which really means benefitting from the generally-typical upward-sloping yield curve.

What happens if discount rates on three-month Treasury bills rise after we have purchased the six-month bills? Will we have drastic losses? No! If discount rates rise to 8.88% on three-month bills at the crucial sale time, we will still be just as well off as in purchasing three-month bills originally and letting them mature. As discount rates rise to 8.88%, we would sell for $9,778.00 as follows:

Face on par value $10,000.00 Discount 222.00 ($10,000 x 8.88% x 3/12) Sale price $9,778.00

That selling price would result in a gain of $203.00 for the three-month holding period which translates into an effective yield of 8.48% ($203.00/$9575.00 x 4 x 100%) (Thus a very significant increase in the expected discount rate will leave us at the same effective yield level as the supposedly obvious and "safe" approach of buying three-month bills for our three-month holding period. Of course, an increase above 8.88% would cause us to obtain a lower effective yield and experience an opportunity loss, but it would take an unthinkable increase to result in an actual loss on "riding the yield curve."
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Author:Oppedahl, Richard A.
Publication:South Dakota Business Review
Date:Dec 1, 1990
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