## Evaluating Interest Rates

Management of working capital requires evaluating factors affecting cash flows — including the evaluation of appropriate interest rates.

### Learning Objectives

Evaluate a company’s interest rates based on its stage of development

### Key Takeaways

#### Key Points

• The interest rate most commonly used in working capital management is the cost of capital.
• Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions.
• Working capital decision criteria that focus on interest rates include debtors management and short-term financing.
• The discount rates typically applied to different types of companies show significant differences.

#### Key Terms

• cost of capital: The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
• credit rating: An estimate, based on a company or person’s history of borrowing and repayment and/or available financial resources, that is used by creditors to determine the maximum amount of credit it can extend to a without undue risk.
• cash conversion cycle: how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales.

### Evaluating Interest Rates

The management of working capital takes place in the realm of short-term decision-making. These decisions are, therefore, based primarily on profitability, cash flows and their management. Many criteria go into the management of cash flows and subsequently the management of working capital — including the evaluation of appropriate interest rates.

The interest rate most commonly used in working capital management is the cost of capital. The cost of capital, in a financial market equilibrium, will be the same as the market rate of return on the financial asset mixture the firm uses to finance capital investment. In other words, a company’s cost of capital is the cost of obtaining funds for operation through the sale of equity or debt in the marketplace. In market equilibrium, investors will determine what return they expect from providing funds to a company. The return expected on debt depends upon the credit rating of the company, which takes into account a number of factors to determine how risky loaning funds to a company will be. The return expected from equity also involves a number of factors, usually centered around the operation of the company and its prospects for profitability. Some conventional rates of return expected for various types of companies include:

• Startups seeking money: 50% – 100%
• Early startups: 40% – 60%
• Late startups: 30% – 50%
• Mature companies: 10% – 25%

When evaluating short-term profitability, company’s may use measures such as return on capital. ROC is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed. Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making.

As mentioned, working capital decisions are made with the short-term in mind. Thus, working capital policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable. Decision criteria that focus on interest rates include debtors management and short-term financing.

Interest: Interest rates of working capital financing can be largely affected by discount rate, WACC and cost of capital.

Debtors management involves identifying the appropriate credit policy — i.e. credit terms which will attract customers — such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and, hence, return on capital (or vice versa). Interest rates can affect this decision because of the time value of money. If inflation is at a high level or there are opportunities foregone because of lack of working capital, a firm will more than likely have a stricter credit policy.

Short-term financing involves identifying the appropriate source of financing, given the cash conversion cycle. For instance, inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan or to “convert debtors to cash.”. Another possible solution is to use services from companies sell outstanding invoices to raise working capital for their clients. Obviously interest rates will play a vital role in determining whether an option such as a bank loan is viable for obtaining short-term financing.

## Decision Criteria

The main considerations of working capital management decisions are (1) cash flow/ liquidity and (2) profitability/return on capital.

### Learning Objectives

Identify which factors influence a company’s working capital management decisions

### Key Takeaways

#### Key Points

• The decisions relating to working capital are always current (i.e., short-term decisions.
• The most useful measure of profitability is return on capital (ROC).
• One measure of cash flow is provided by the cash conversion cycle (CCC)–the net number of days from the outlay of cash for raw material to receiving payment from the customer.
• The most useful measure of profitability is return on capital (ROC).

#### Key Terms

• working capital: A financial metric that is a measure of current assets of a business that exceeds its liabilities and can be applied to its operation.
• liquidity: Availability of cash over short term: ability to service short-term debt.

Working capital is the amount of capital which is readily available to an organization. That is, working capital is the difference between resources in cash or readily convertible into cash (current assets), and cash requirements (current liabilities). As a result, the decisions relating to working capital are always current (i.e., short-term decisions). In addition to the time horizon, working capital decisions differ from capital investment decisions in terms of discounting and profitability considerations; they are also “reversible” to some extent.

Working capital management decisions are, therefore, not made on the same basis as long-term decisions, and working capital management applies different criteria in decision making: the main considerations are (1) cash flow/ liquidity and (2) profitability/ return on capital (of which cash flow is generally the most important).

### 1. Cash Conversion Cycle (CCC)

One measure of cash flow is provided by the cash conversion cycle—the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the interrelatedness of decisions regarding inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm’s cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.

Cash cycle: Cash conversion cycle is a main criteria for working capital management.

### 2. Return On Capital (ROC)

In this context, the most useful measure of profitability is return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; return on equity (ROE) shows this result for the firm’s shareholders. Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are, therefore, useful as a management tool, in that they link short-term policy with long-term decision making.

### Credit policy

Another factor affecting working capital management is credit policy of the firm. It includes buying of raw materials and selling of finished goods either in cash or on credit. This affects the cash conversion cycle.

## Identifying Varying Conditions

Management uses policies and techniques for the management of working capital such as cash, inventory, debtors and short term financing.

### Learning Objectives

Identify the four main areas of variability of working capital management

### Key Takeaways

#### Key Points

• The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
• Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.
• Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials – and minimizes reordering costs – and hence increases cash flow.
• Identify the appropriate credit policy and the appropriate source of financing, given the cash conversion cycle.

#### Key Terms

• Finished good: Finished goods are goods that have completed the manufacturing process but have not yet been sold or distributed to the end user.
• Work in process: Work in process (WIP) or in-process inventory includes the set at large of unfinished items for products in a production process. These items are not yet completed but either just being fabricated or waiting in a queue for further processing or in a buffer storage.

Decisions relating to working capital and short-term financing are referred to as working capital management. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors ) and the short-term financing, such that cash flows and returns are acceptable.

### There are four main areas of variability that must be managed

Inventory: Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and minimizes reordering costs and, hence, increases cash flow.

1. Cash management

Identify the cash balance that allows for the business to meet day-to-day expenses, but reduces cash holding costs.

2. Inventory management

Identify the level of inventory that allows for uninterrupted production but reduces the investment in raw materials and minimizes reordering costs and, hence, increases cash flow. Besides this, the lead times in production should be lowered to reduce work in process (WIP) and similarly, the finished goods should be kept on as low level as possible to avoid over production.

3. Debtors management

Identify the appropriate credit policy (i.e., credit terms which will attract customers such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence return on capital or vice versa).

4. Short-term financing

Identify the appropriate source of financing, given the cash conversion cycle. The inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to “convert debtors to cash” through “factoring. ”

## Calculating Expected Value

The main accounts which affect the value of working capital are accounts receivable, inventory, and accounts payable.

### Learning Objectives

Calculate a company’s working capital

### Key Takeaways

#### Key Points

• Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.
• The management of working capital involves managing inventories, accounts receivable and payable, and cash.
• Current assets and current liabilities include three accounts which are of special importance: accounts receivable, inventory, and accounts payable.
• Working capital is equal to accounts receivable plus the value of inventory, minus accounts payable.

#### Key Terms

• M&A: Mergers and acquisitions (M&A) are aspects of corporate strategy, corporate finance, and management dealing with the buying, selling, dividing, and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity or using a joint venture.
• balance sheet: A summary of a person’s or organization’s assets, liabilities and equity as of a specific date.

Working capital (WC) is a financial metric which represents operating liquidity available to a business, organization, or other entity – including a governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital that is commonly used in valuation techniques, such as DCFs (Discounted Cash Flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a “working capital deficit. ”

A company can be endowed with assets and profitability but short on liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

### Calculation

Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

• accounts receivable (current asset)
• inventory (current assets)
• accounts payable (current liability)

Therefore, in this context, we calculate available working capital using the following formula:

Working Capital Equation: Working capital is equal to accounts receivable, plus current inventory, minus accounts payable.

These values can be readily found on a company’s balance sheet. The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit.

As an example, imagine a company has accounts receivable of $10,000, current inventory that has a value of$5,000, and accounts payable of $7,000. We can find working capital by: Working Capital =$10,000 + $5,000 –$7,000 = \$8,000

An increase in working capital indicates that the business has either increased current assets (that it has increased its receivables, or other current assets) or has decreased current liabilities, for example, has paid off some short-term creditors.

### Implications on M&A

The common commercial definition of working capital for the purpose of a working capital adjustment in a mergers and acquisitions transaction (i.e., for a working capital adjustment mechanism in a sale and purchase agreement) is equal to:

Current Assets – Current liabilities (excluding deferred tax assets/liabilities, excess cash, surplus assets, and/or deposit balances).

Cash balance items often attract a one-for-one purchase-price adjustment.