Presented By: Yaser Ali Hassan Awais Sharif Kamar Farooq Nadeem Nazir

Working Capital & Current Asset Management

Net Working Capital

Working Capital includes a firm’s current assets, which consist of cash and marketable securities in addition to accounts receivable and inventories.

It also consists of current liabilities, including accounts payable (trade credit), notes payable (bank loans), and accrued liabilities.

Net Working Capital is defined as total current assets less total current liabilities.

The Cash Conversion Cycle

Short-term financial management—managing current assets and current liabilities is one of the financial manager’s most important and time-consuming activities.

Central to short-term financial management is an understanding of the firm’s cash conversion cycle.

Cash Conversion Cycle

Inventory turnover ratio (IT):

56.3009,37

924,131

Inventory

Goods ofCost IT ===

days 0213.56

365

IT

365 DaysInventory ===

Cash Conversion Cycle

Accounts receivable turnover (ART):

05.9735,18

565,169

Rec. Acct.

Sales ART ===

days 0405.9

365

ART

365 Period Collection Average ===

Cash Conversion Cycle

Accounts payable turnover (APT):

22.24448,5

924,131

Payable Accts.

Goods ofCost APT ===

days 5122.24

365

APT

365 PeriodPayment Average ===

Calculating the Cash Conversion Cycle

Both the OC and CCC may be computed as shown below.OC = Inventory Days + ACP

OC = 102 + 40 = 142 days

CCC = OC – Average Payment Period CCC = 142 – 15 = 127 days

Cash Conversion Cycle

0Days 102 142

Average Collection Period (ACP)Average Age of Inventory (AAI)

Chromcraft Revington’s Operating Cycle

Problem # 1American Products is concerned about managing cash efficiently. On the average , inventories have an age of 90 days and account receivable are collected in 60 days . Accounts payable are paid approximately 30 days after they arise.

Operating cycle (OC) = Average age of inventories + Average collection period

= 90 days + 60 days

= 150 days Cash Conversion Cycle (CCC) = Operating cycle − Average payment period

= 150 days − 30 days

= 120 days

Funding Requirements of the CCC Permanent vs. Seasonal Funding Needs

If a firm’s sales are constant, then its investment in operating assets should also be constant, and the firm will have only a permanent funding requirement.

If sales are cyclical, then investment in operating assets will vary over time, leading to the need for seasonal funding requirements in addition to the permanent funding requirements for its minimum investment in operating assets.

Strategies for Managing the CCC1. Turn over inventory as quickly as possible

without stock outs that result in lost sales.

2. Collect accounts receivable as quickly as possible without losing sales from high-pressure collection techniques.

3. Manage, mail, processing, and clearing time to reduce them when collecting from customers and to increase them when paying suppliers.

4. Pay accounts payable as slowly as possible without damaging the firm’s credit rating.

Inventory Management: Inventory Fundamentals

Classification of inventories:

Raw materials: items purchased for use in the manufacture of a finished product

Work-in-progress: all items that are currently in production

Finished goods: items that have been produced but not yet sold

Inventory Management: Differing Views About Inventory The different departments within a firm (finance,

production, marketing, etc.) often have differing views about what is an “appropriate” level of inventory.

Financial managers would like to keep inventory levels low to ensure that funds are wisely invested.

Marketing managers would like to keep inventory levels high to ensure orders could be quickly filled.

Manufacturing managers would like to keep raw materials levels high to avoid production delays and to make larger, more economical production runs.

Techniques for Managing Inventory The ABC System

The ABC system of inventory management divides inventory into three groups of descending order of importance based on the dollar amount invested in each.

A typical system would contain, group A would consist of 20% of the items worth 80% of the total dollar value; group B would consist of the next largest investment, and so on.

Control of the A items would intensive because of the high dollar investment involved.

EOQ = 2 x S x O

C

Techniques for Managing Inventory (cont.) The Economic Order Quantity (EOQ) Model

Where: S = usage in units per period (year) O = order cost per order C = carrying costs per unit per period (year) Q = order quantity in units

Techniques for Managing Inventory (cont.) The Economic Order Quantity (EOQ) Model

Assume that KJB, Inc. uses 200 units of an item annually. Its

order cost is $25 per order, and the carrying cost is $1 per unit

per year. Substituting into the above equation we get:

EOQ = 2(200)($25) = 100

$1

The EOQ can be used to evaluate the total cost of inventory as shown on the following slides.

Techniques for Managing Inventory (cont.) The Economic Order Quantity (EOQ) Model

Ordering Costs = Cost/Order x # of Orders/Year

Carrying Costs = Carrying Costs/Year x Order Size 2

Total Costs = Ordering Costs + Carrying Costs

Ordering Costs = $25 x 2 = $50

Carrying Costs = ($1 x 100)/2 = $50

Total Costs = $50 + $50 = $100

Reorder point = lead time in days x daily usage

Daily usage = Annual usage/360

The Reorder Point Once a company has calculated its EOQ, it must

determine when it should place its orders. More specifically, the reorder point must consider

the lead time needed to place and receive orders. If we assume that inventory is used at a constant rate

throughout the year (no seasonality), the reorder point can be determined by using the following equation:

Techniques for Managing Inventory (cont.)

Reorder point = 5 x 0.56 = 2.78 or 3 units

Daily usage = 200/360 = 0.56 units/day

Using the KJB example above, if they know that it requires 5 days to place and receive an order, and the annual usage is 200 units per year, the reorder point can be determined as follows:

Thus, when RIB’s inventory level reaches 3 units, it should place an order for 100 units. However, if RIB wishes to maintain safety stock to protect against stock outs, they would order before inventory reached 3 units.

Techniques for Managing Inventory (cont.)

Just-In-Time (JIT) System The JIT inventory management system minimizes

the inventory investment by having material inputs arrive exactly at the time they are needed for production.

For a JIT system to work, extensive coordination must exist between the firm, its suppliers, and shipping companies to ensure that material inputs arrive on time.

In addition, the inputs must be of near perfect quality and consistency given the absence of safety stock.

Techniques for Managing Inventory (cont.)

Computerized Systems for Resource ControlMRP systems are used to determine what to

order, when to order, and what priorities to assign to ordering materials.

MRP uses EOQ concepts to determine how much to order using computer software.

It simulates each product’s bill of materials structure all of the product’s parts), inventory status, and manufacturing process.

Techniques for Managing Inventory (cont.)

Accounts Receivable Management The second component of the cash conversion

cycle is the average collection period – the average length of time from a sale on credit until the payment becomes usable funds to the firm.

The collection period consists of two parts: the time period from the sale until the customer mails

payment, and the time from when the payment is mailed until the

firm collects funds in its bank account.

Accounts Receivable Management:The Five Cs of Credit Character: The applicant’s record of meeting

past obligations. Capacity: The applicant’s ability to repay the

requested credit. Capital: The applicant’s debt relative to equity. Collateral: The amount of assets the applicant

has available for use in securing the credit. Conditions: Current general and industry-

specific economic conditions.

Accounts Receivable Management:Credit Scoring Credit scoring is a procedure resulting in a

score that measures an applicant’s overall credit strength, derived as a weighted-average of scores of various credit characteristics.

The procedure results in a score that measures the applicant’s overall credit strength, and the score is used to make the accept/reject decision for granting the applicant credit.

Accounts Receivable Management:Changing Credit Standards The firm sometimes will contemplate changing

its credit standards to improve its returns and generate greater value for its owners.

Changing Credit Terms

A firm’s credit terms specify the repayment terms required of all of its credit customers.

Credit terms are composed of three parts: The cash discount The cash discount period The credit period

For example, with credit terms of 2/10 net 30, the discount is 2%, the discount period is 10 days, and the credit period is 30 days.

Credit Monitoring

Credit monitoring is the ongoing review of a firm’s accounts receivable to determine whether customers are paying according to the stated credit terms.

Slow payments are costly to a firm because they lengthen the average collection period and increase the firm’s investment in accounts receivable.

Two frequently used techniques for credit monitoring are the average collection period and aging of accounts receivable.

Credit Monitoring: Average Collection Period The average collection period is the average

number of days that credit sales are outstanding and has two parts:

The time from sale until the customer places the payment in the mail, and

The time to receive, process, and collect payment.

Credit Monitoring:Collection Policy The firm’s collection policy is its

procedures for collecting a firm’s accounts receivable when they are due.

The effectiveness of this policy can be partly evaluated by evaluating at the level of bad expenses.

As seen in the previous examples, this level depends not only on collection policy but also on the firm’s credit policy.

Collection Policy