About a year ago soon after graduating with a college degree in finance, you joined a manufacturing company as an aide to the Vice President (Strategy). Your boss does not have any formal training in finance, but he has always been very receptive to new ideas that could improve the overall performance of the company. During the past year, you have had the opportunity to accompany your boss to several high level policy meetings. You noticed that when it came to finance-related items in the agenda, most attention was focused on long-term fixed investment and the company debt policy. Even though working capital in the company was running at around 34% of sales and was trending up over the past few years, you noticed an absence of urgency about this matter. There were only occasional short discussions on how to improve the performance of the receivable department or the need to negotiate better terms with the suppliers.
Since you were somewhat familiar with several well-known companies that had successfully introduced innovations in managing their working capital with remarkable results, you felt that a new approach was needed for your company to achieve better control over working capital level, which you considered was way too high. You have since done some reading of the related literature and have done some brainstorming. Now you want to prepare a brief memo for your boss on this subject.
Working capital position is often interpreted as an indicator of how easily company can meet its short-term obligations. Creditors generally subscribe to this view of working capital. Traditional approach to working capital has been to see it as a metric for evaluating a company's operating liquidity. One of the metric's shortcomings, however, is that current assets often cannot be liquidated in the short term. High working capital positions often indicate that there is too much money tied up in accounts receivables and inventory, rather than short-term liquidity. The idea of working capital as an indicator of liquidity is more meaningful in the context of a company facing liquidation than for a company as a going concern.
To begin with, you want to clarify the meaning(s) of the term working capital and explain what it means for the operation, profitability and growth of the company. You would like to use a simple cash conversion model to identify different components of operating cycle and show how these components can be influenced to better manage working capital.
You have also noted that working capital is often viewed by companies simply as cost. As a result, the company management reacts to a "cash squeeze" by slashing working capital expenditure without carefully considering its implications for sales, profitability and growth. You want to promote an integrated and value-creating approach to working capital management in which all elements of tied-up capital across the balance sheet (fixed assets, inventories, receivables, payables, and cash) have to be considered as a whole.
For example, it may be advantageous to acquire a new and more flexible machine (fixed asset) in order to reduce inventories.
You want to highlight the significance of efficient management of working capital (shown as short-term investment) for the company's long-term growth by showing working capital management as a lever for freeing up cash from inventory, accounts receivable, and accounts payable. By effectively managing various components of working capital, companies can sharply reduce their dependence on outside funding and can use the released cash for further investments and/or acquisitions. This will not only lead to more financial flexibility, but also create value and have a strong impact on a company's enterprise value by reducing capital employed and thus increasing asset productivity.
You want to make the point that growth-promoting potential of working capital management cannot be tapped by simply looking at the individual components of working capital in isolation. In this context, inventory has received a lot attention in recent years. Excess inventory is one of the most overlooked sources of cash. There is some evidence that suggests that better inventory management can potentially account for almost half of the savings from a working capital optimization process. By streamlining processes within the company-as well as processes involving suppliers and customers-companies can minimize inventory throughout the value chain. Such streamlining requires the applications of enhanced forecast accuracy and demand planning, advanced delivery and logistics concepts and optimized production processes to reduce work-in-progress inventory. As another example, negotiations in purchasing cannot only focus on payment targets. The company also has to consider the resulting prices and discount conditions. Therefore, a best-practice NWC optimization is not just a pure reduction of NWC.
Before you prepare your memo, you will first need to think through and develop the structure of your memo. You want to present your points in an organized manner. You would like to keep it short, and to the point, limiting the memo to a maximum of 12 pages, including a one-page executive summary. The memo could be shorter as long as you can communicate your ideas clearly and convincingly. To engage the readers' attention and make your points practically relevant, you would like to draw from real world evidence on best-practice working capital management as far as possible. You need to identify and retrieve more information to supplement what you already know. Good news is that you are quite proficient in navigating the internet and other sources of information.
In preparation for your forthcoming seminar, answer each of the questions below. Explain your answers carefully.
1. "About 60% of our investors are in the 55+ age group, Jill, so we should not have much trouble convincing them of the benefits of investing in bonds". Explain.
2. Why do the coupon rates for the various bonds in the above exhibit vary so much? Explain the relative coupon rates of each bond.
3. During the presentation one of the clients is puzzled why some bonds sell for less than their face value while others sell for a premium. She also asks whether the discount bonds are a bargain. How should Jill respond?
4. How are the ratings of these bonds determined? How is the rating of a bond relevant to the investor? What happens when the bond ratings get adjusted downwards? Identify a few recent cases of downgrading of corporate bonds by rating agencies.
5. What does the term "yield to maturity," mean? What is the yield to maturity of each of the above bonds? Should Jill's clients focus more on yield to maturity or on the coupon rate of a bond?
6. What is the difference between the current yield and yield to maturity for each bond listed in Table I? Which one should the investor use in selecting bonds?
7. Jill knows that the call period and its implications will be of particular concern to the audience. How should she go about explaining the call provision and its effects on bond risk and return potential?
8. How should Jill go about explaining the riskiness of each bond? Considering various sources of the risks of a bond, how should she rank the bonds in terms of their relative riskiness?
9. One of Jill's best clients poses the following question, "If I buy 10 of each of these bonds, reinvest any coupons received at the rate of 5% per year and hold them until they mature, what will my realized return be on each bond investment?" How should she proceed?