Corporate Finance

Working Capital Management

Reading - 40

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Managing and measuring Liquidity
Working capital management ensures that company has
enough funds to manage day to day operational expenses,
inventories, accounts receivable and payable and cash.
It involves a relationship between companys short term assets
and its short term liabilities.
Liquidity management refers to the ability of an organization to
generate cash so as to meet its financial obligations.
The key sources of liquidity are :
Primary sources which include cash in bank, short term funds and
other cash flows.
Secondary sources of liquidity include debt contracts, liquidating
assets .

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Liquidity Ratios
These ratios focus on the relationship between companys
current assets and current liabilities and also measure the
companys ability to meet short term liabilities.
Current ratio is the ratio of current assets to current liabilities.
Current Asset
Current Ratio =
Current Liabilities
Working capital equals current assets minus current liabilities.
Quick ratio (Acid test ratio) is the ratio of quick assets to
current liabilities where quick assets are those assets which
can be readily converted to cash.
cash + short term marketable securities + receivables
Quick Ratio =
current liabilites

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Turnover Ratios
The key ratios for asset management are turn over ratios.
Accounts Receivable turnover is the ratio of sales on credit to
the average balance in accounts receivable.
Credit Sales
Accounts receivable turnover =
Average receivables
Inventory turnover is the ratio of cost of goods sold to the
balance in inventory.
cost of goods sold
Inventory turnover =
Average inventory
No of days of receivables is the average number of days it
takes for the companys customer to pay their bills.

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Turnover Ratios
Accounts receivable
Number of days of receivables =
Average day's sales on credit
Number of days of inventory is the inverse of the
inventory turnover times 365 .
365 average inventory
Number of days of inventory = =
Payable turnover is the inventory
ratio turnover average day's COGS
of purchases to average
trade payables.

purchases
Payables turnover ratio =
average trade payables
365 average payables
Number of days of payables = =
payables turnover ratio average day's purchases
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Operating and Cash conversion cycles
The Operating cycle is the average number of days it takes to
convert raw materials into cash proceeds from sales.

Operating Cycle = Number of days of inventory + Number of days of receivables

The Cash conversion cycle or net operating cycle is a measure

of the time it takes to turn the firms cash investment from
paying suppliers for materials to collecting cash from sales of
inventory.
Net operating cycle =
Number of
+
Number of
-
Number of
days of inventory days of receivables days of payables

A conversion cycle that is too high shows that the company

has its excess amount invested as working capital.

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Investing Short Term Funds
Short term working capital portfolios consist of securities that
are less risky, highly liquid and shorter in maturity.
Examples such as U.S. Treasury Bills, Repurchase Agreements,
Commercial Paper, Eurodollar time deposits etc.
Nominal rate is a rate of interest based on securitys face
value.
Yield is the actual return on investment if it is held to
maturity.
Money market yield is annualized using the ratio of 360 to the
number of days to maturity.

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Yield Formulas
The percentage discount from face value is :

% discount =
( facefacevaluevalue- price )
The discount basis yield (bank discount yield) is:

discount basis yield = ( face value )( )

face value - price 360
days

The money market yield is :

money market yield = ( face value - price

price )( )360
days ( )
= holding period yield *
360
days

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Yield Formulas
The bond equivalent yield is annualized using the ratio of 365
to the number of days to maturity.

The BEY for short term discount securities is calculated as :

bond equivalent yield = ( price )( )

face value - price 365
days
= holding period yield *
( )
365
days

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Strategies
Short term investment strategies can be grouped into two
types:
Passive strategies prioritize safety and liquidity and it is
characterized by one or two decision rules for making daily
investments .
Passive strategies must be monitored and the yield from
investment portfolios should be benchmarked against suitable
standard such as T-Bill.
Active strategies include mismatching or matching the timing of
the cash outflows with investment securities .
Active strategies require more daily involvement and a wider
choice of investments.

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Inventory management
It involves maintaining the level of inventory resulting in
uninterrupted production, minimizing reordering costs and
increasing cash flows.
Two basic approaches in managing the levels of inventory are:
Economic order quantity reorder point(EOQ-ROP) method is
based on the expected demand and the predictability of
demand.
This method works when there is reliable short term forecast
and also for smaller items having low unit costs.
Just -in-time method (JIT) is a system that minimizes in process
inventory stocks and associated costs and the stocks are
reordered at a point when required .

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Accounts Payable Management
Accounts payable are the amounts due to the suppliers of
goods and services that have not been paid.
The term 4/11, net30 indicates that a 4 percent discount is
available if the amount is paid within 11 days , other wise the
full amount is due by the 30th day.
A company considers several factors as guidelines for an
effective management of accounts payable such as:
Financial organizations centralization.
Number, size and location of vendors.
Trade credit and cost of borrowing.
Inventory management.

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Accounts Payable Management
The Payables payment period or number of days of payables
is the average amount of time it takes the company to pay
their bills .
purchases
Payables turnover ratio =
average trade payables

365 average payables

Number of days of payables = =
payables turnover ratio average day's purchases

A company with a short payable period has low cost funds

available to finance its working capital needs.

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Short Term Financing - Sources
Uncommitted It is the weakest form of bank borrowing .
lines of credit Based on the circumstances a bank may decide to accept or reject a proposal.

Committed Here the bank offers credit for some committed period of time.
line of credit It is a more reliable source of short term financing and the interests rates are generally LIBOR or U.S. prime rate.

Revolving line It is the strongest form of short term bank borrowing facilities.
of credit It is typically for longer terms and revolving credit lines can be verified and be listed on firms financial statements

These are short term promissory trade notes which a bank promises to pay the holder the amount at maturity.
Bankers It is used by firms that export goods.
acceptance Exporting companies can sell the acceptance at a discount to generate immediate funds.

It is selling of the receivables to a financial institution at a discount from their face values.
Factoring The receivables are used as a collateral for a loan.
The buyer of the receivables has the responsibility for collecting receivables .

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Short Term Financing
Commercial paper :
Short term debt securities issued by large corporations.
The interests rates are less than the commercial bank.
CPs are sold through dealers having a line of credit ensuring
that it is paid off.

Non bank finance companies are sources generally used by

small and weak borrowers .

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Corporate Finance

The Corporate Governance of Listed

Companies :A Manual for Investors
Reading - 41

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Boards characteristics and Practices
The board should act in the interest of the shareholders and
investors should determine the following :
The board members meet without the presence of
management .
Majority of board of directors is comprised of independent
members and not management .
Independent board members have a lead member if the board
chair is not independent .
The chairman of the board is the also the CEO or a former CEO
of the firm.
Investors should determine whether board members distance
themselves on issues that may create a conflict.

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Boards characteristics and Practices . .
Investors should consider whether there are annual board
elections or multiple year terms.
Shareholders can remove a board member and whether the
board filled a vacant position without the shareholders
approval.
Investors should determine whether the board and its
committee have the authority to hire independent third party
consultants without receiving approval from management.
The remuneration committee has hired external advisers in
the past to determine appropriate compensation for key
executives.

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Board Independence and Importance
A board is independent when its decisions are not biased or
not influenced by the management of the firm .The board
member should not have any material benefit from :
Shareholders having controlling interest and can influence the
firms management.
The firms advisers auditors and their families.
The firm and its subsidiaries ,former employees and executives.
Executive management and their families.
Any decision benefiting the management and harming
shareholders interest reflects shows that board members are
not independent.
The firms should disclose all the commercial relationships it
has with the board members or nominees.

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Strong and Weak Code of Ethics
A companys code of ethics sets standards for ethical conduct
based on basic principles of integrity trust and honesty.
Ethical breaches result in fines ,sanctions and management
turnover affecting the companys performance.
Investors should determine whether board members and
management use company assets for personal reasons.
Companies with ethical codes post them on their public
websites ,in their annual reports.
Investors may find information about loans to company
executives board members in the Related party
transactions sections of a companys annual report.
The ethical code should prohibit advantages to the firms
insiders that are not offered to shareowners.

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Audit Committee
The audit committees objective is to ensure that the financial
information reported by the company to shareowners is
complete, reliable, relevant and timely.
Investors must determine the following:
Proper accounting and auditing procedures have been followed

All board members serving on the audit committee are independent

Committee members are financial experts

The audit committee controls the audit budget

The external auditor is free from management influence

Conflicts between auditor and firm are resolved in a manner that favors the shareholder

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Remuneration / Compensation Committee
It is responsible for ensuring that compensation and other awards
encourage executive management to act in ways that enhance the
companys long term profitability and value.
Investors when analyzing committee should determine whether :
Executive compensation is appropriate .
The firm has provided details to shareholders regarding compensation
in public documents.
Polices and procedures for this committee are in place .
The terms and conditions of options granted to management and
employees are reasonable.
The firm and the board receive shareholder approval for any share
based remuneration plans.
The firm has provided loans or the use of company property to board
members.

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Nominations Committee
The purpose of the nomination committee :
It is responsible for recruiting new board members with
qualities and experience .
Creating nomination policies and procedures.
Monitors the performance ,independence skills and expertise of
existing board members to determine whether they meet the
current and future needs of the company and the board.
Preparing for the succession of executive management .
Investors should review the following:
The criteria for the new board members.
Expertise and background of existing board members.
The attendance records of the board members at regular and
special meetings.
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Voting rules
The ability to vote ones share is fundamental right of the
share ownership. If the company makes it difficult for
shareowners to vote or express their views , it could affect
the companys performance.
Investors should consider whether the company:
Allows proxy voting by some remote mechanism.
Limits the ability to vote shares by requiring the presence at
annual general meeting.
Coordinating the timings of the AGM at different locations but
on the same day in order to prevent the shareholders from
casting their rights.

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Voting Rules . .
Confidential voting : Investors should determine if
shareholders are able to cast confidential votes to encourage
unbiased voting . Thus investors should consider :
The firm uses third party to tabulate shareowner votes.
Third party agent retains voting records.
The third party agent is subject to an audit to ensure accuracy.
Shareholders are entitled to vote only if they are present.
Cumulative voting: It enables shareholders to vote in a
manner that enhances the likelihood that their interests are
represented on the board.
Investors should consider whether the company has a significant
minority shareowner group that might be able to use
cumulative voting to serve it s own interests.

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Takeover Defenses
Take over defenses are provisions that make a company less
attractive to a hostile bidder or more difficult to acquire.
When reviewing a companys anti takeover measures
investors should :
Inquire whether the company is required to receive shareowner
approval for takeover measures.
Inquire whether the company has received any formal
acquisition interest in the past.
Inquire whether the firm may use its cash to pay off a hostile
bidder . Shareholders should take steps to discourage the
board doing the activity.

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Take over Defenses . .
Take over defenses include:
Golden parachutes is the provision where large severance
packages for top managers who lose their jobs as a result of a
takeover.
Poison pills are the provisions that grant rights to existing
shareholders in the event a certain percentage of a companys
shares are acquired
Greenmail is the provision for the use of corporate funds to
buy back the shares of a hostile acquirer at a premium to their
market value.
Their effect is to decrease the share value.

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 Thank You

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