Working Capital – Finance and Accounts Receivable

In “Working Capital Primer: How is it that this Capital Works?”, we left with a promise to look a little more at the finance dynamics of working capital.

Back to Net Present Value – with a Twist

When we perform Net Present Value (NPV) calculation, we discount these cash flows at the appropriate cost of capital. Often we discount the net cash flow using a cost of capital that we have derived from the Capital Asset Pricing Model (CAPM) in one of its one-thousand plus manifestations.

While this is the usual practice, some theorists will tell us that we should discount each separate cash flow at its appropriate cost of capital, and build up to the result. This is very difficult to accomplish reliably and credibly.

When considering some of the components of working capital, however, we are not as constrained by such real-life practicalities.

Can We Re-Invent the Security?

Figure A

When preparing a valuation, we often use a “replicating portfolio” to confirm correct pricing. A replicating portfolio simply means a combination of other financial instruments that, when taken together, are identical to the original item.

The classic example is a forward contract, which has a payout profile shown in figure A:

Figure B

By combining a written put option, with a profile of that shown in Figure B, with a purchased call option, with a profile in figure C, we arrive at the same payout as the forward contract. In this case the options together are the “replicating portfolio” for the forward contract.

Figure C

The pricing of the put and the call need to be equivalent to the forward, otherwise an arbitrage opportunity occurs. Given that free money does not last forever, even when there is an arbitrage it is fleeting.

Why the Cost of Capital is Different

So let us assume that we have valued our firm’s cash flows at 10%, and this is based on a CAPM analysis using “cash-on-the-barrelhead” comparable companies. However, let’s assume that our firm is willing to extend 30-day payment terms to its customers. Is our firm’s cost of capital the same?

No, because for an investor to replicate our cash flow profile, they would need to both invest in a “cash-on-the-barrelhead” company and a 30-day debt obligation that matches the customer’s risk profile. Thus, the cost of capital of the two-firms is different.

We can evaluate this mathematically. Let us suppose that our “cash-on-the-barrelhead” firm has a 10% cost of capital, generates ²10 in cash inflows per year and ²9 in cash outflows per year, and we assume these will continue in perpetuity (to make the math really simple). The value of this firm is ²10, as shown in Figure D.

If we allow a 30-day payment period for our receivables, and the cost of obligations for similar rated entities as our customers is 5%, then our ²10 of cash inflows needs to be discounted by one month’s cost of capital at 5% in order for us to reflect the market’s valuation. The value of our firm is then ²9.59, as shown in Figure E.

We therefore lower our equity value by ²0.41 by allowing 30-day terms, due to the fact that we have taken on more risk.

Another way to look at this is from the balance sheet perspective. If both are financed at 50% debt, then the equity holder’s risk is lower for the cash-on-the-barrelhead firm than (13% vs. 13.8%).

Looking Closer – Pros and Cons

There are advantages and disadvantages to financing accounts receivable. In our just-completed valuation, it appears to be a disadvantage. However, if we generate additional sales because we grant customers credit, this disadvantage might be overcome.

Continuing with the previous example, what is the level of sales required (at 90% margin) to make our firm worth ²10? The answer to this is that if we generate enough sales to yield cash inflows of ²10.42292 per year, our firm will be valued at ²10, as in Figure F.

However, there are also additional operating costs associated with accounts receivable compared with a “cash-on-the-barrelhead” alternative. We need increased records management and accounting activity. We will incur collections expense. We will need to engage in a credit approval process. We are subject to invoice adjustments while the receivable remains outstanding. Inevitably, some customers will not pay.

Therefore, the decisions we make about accounts receivable policy become subject to a traditional cost/benefit analysis, where we include increase in sales, increased operating costs, and increased costs of additional risk.

Capital Structure Implications

Franco Modigliani and Merton Miller won a Nobel Prize for their insight that the financing of a firm does not matter in a world without taxes, bankruptcy costs, agency costs, asymmetric information, and efficient markets. In other words, not the real-world!

However, if we hold in abeyance this fact, we can explore the financing structure of our firm related to this accounts receivable issue.

If we obtain revolving type lines of credit, or debt with a collateral position in the more liquid assets, this can usually be obtained at lower rates, since the risk is lower because the assets are more liquid and more certain to be collected (there are laws that say if you got goods and services, you have to pay for them).

However, since this benefit was shared by the debtholders and equity holders in the Figure E capital structure, introducing a separate financing at lower rates merely pumps up the required rates of return of the remaining security holders. They are in a riskier position since they accepted lower rate financing, which is lower rate precisely for the fact that the lenders providing it have “first dibs”.

Reducing Days Sales Outstanding

If we want to lower our exposure to accounts receivable, or in other words reduce the Days Sales Outstanding, there are several actions we can consider:

Sell on shorter terms – payment in 15 days instead of 30.

Reminder and Collection Calls – make phone calls to those close to being overdue, or immediately upon becoming overdue, and then follow-up persistently.

Monitor Aging – look for companies that have balances in different aging “buckets”, and evaluate the feasibility of continuing business with them.

Subsequent Sales – do not make shipments to those overdue on bills.

Require Collateral – implement a collateral requirement with customers – they must keep an amount on deposit in order to purchase on credit terms, or they must have pre-paid the invoice prior to shipment occurring or service rendered.

Key Takeaways

Working Capital practices impact both the cost of capital and capital structure elements of our organization. We need to make decisions keeping the consequences in mind.

Questions

·         What practices have you seen that have reduced Days Sales Outstanding?

·         What consequences of Working Capital decisions have you witnessed?

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