612 CHAPTER 16 Working Capital Management
The transactions balance is the cash necessary to conduct day-to-day business,
whereas the precautionary balance is a cash reserve held to meet random, un-
foreseen needs. A compensating balance is a minimum checking account balance
that a bank requires as compensation either for services provided or as part of a
loan agreement.
A cash budgetis a schedule showing projected cash inflows and outflows over
some period. The cash budget is used to predict cash surpluses and deficits, and it
is the primary cash management planning tool.
The twin goals of inventory managementare (1) to ensure that the inventories
needed to sustain operations are available, but (2) to hold the costs of ordering and
carrying inventories to the lowest possible level.
Inventory costscan be divided into three types: carrying costs, ordering costs,
and stock-out costs. In general, carrying costs increase as the level of inventory
rises, but ordering costs and stock-out costs decline with larger inventory
holdings.
When a firm sells goods to a customer on credit, an account receivableis created.
A firm can use an aging scheduleand the days sales outstanding (DSO)to help
keep track of its receivables position and to help avoid an increase in bad debts.
A firm’s credit policyconsists of four elements: (1) credit period, (2) discounts
given for early payment, (3) credit standards, and (4) collection policy.
Permanent net operating working capitalis the NOWC that the firm holds
even during slack times, whereas temporary NOWCis the additional NOWC
needed during seasonal or cyclical peaks. The methods used to finance permanent
and temporary NOWC define the firm’s short-term financing policy.
A moderateapproach to short-term financing involves matching, to the extent
possible, the maturities of assets and liabilities, so that temporary NOWC is
financed with short-term debt, and permanent NOWC and fixed assets are financed
with long-term debt or equity. Under an aggressiveapproach, some permanent
NOWC, and perhaps even some fixed assets, are financed with short-term debt.
Aconservativeapproach would be to use long-term sources to finance all perma-
nent operating capital and some of the temporary NOWC.
The advantages of short-term credit are (1) the speedwith which short-term loans
can be arranged, (2) increased flexibility,and (3) the fact that short-term interest
ratesare generally lowerthan long-term rates. The principal disadvantage of
short-term credit is the extra riskthe borrower must bear because (1) the lender
can demand payment on short notice and (2) the cost of the loan will increase if
interest rates rise.
Accounts payable,or trade credit,arises spontaneously as a result of credit pur-
chases. Firms should use all the free trade creditthey can obtain, but they should
use costly trade creditonly if it is less expensive than other forms of short-term
debt. Suppliers often offer discounts to customers who pay within a stated discount
period. The following equation may be used to calculate the nominal cost, on an
annual basis, of not taking discounts: Bank loansare an important source of short-term credit. When a bank loan is ap-
proved, a promissory noteis signed. It specifies: (1) the amount borrowed, (2) the
percentage interest rate, (3) the repayment schedule, (4) the collateral, and (5) any
other conditions to which the parties have agreed.Nominal
cost
Discount percent100
Discount
percent365 days
Days credit is
outstanding
Discount
period.