PowerPoint to accompany CHAPTER 14 Working capital and current assets management.

PowerPoint to accompany

CHAPTER 14

Working capital and current assets

management

2

Learning Objectives

• Understand short term working finance

• Describe the cash conversion cycle

• Discuss inventory management

• Explain credit selection

• Analyse changes to credit terms

• Outline receipts and disbursements

3

Net working capital fundamentals

• short term financial management involves managing current assets and liabilities

• working capital = current assets• current assets are those that circulate from

one form to another in the course of business• net working capital:• = (current assets) – (current liabilities)

4

Basic Definitions

Gross working capital:

Total current assets. Net working capital:

Current assets - Current liabilities. Net operating working capital (NOWC):

Operating CA – Operating CL =

(Cash + Inv. + A/R) – (Accruals + A/P)

(More…)

5

Definitions (Continued)

Working capital management: Includes both establishing working capital policy and the day-to-day control of cash, inventories, receivables, accruals, and accounts payable.

Working capital policy: The level of each current asset. How current assets are financed.

6

Net working capital fundamentals

Profitability and risk

• there is a ‘tradeoff’ between profitability and risk

profitability is the relationship between revenues and costs by using the firm’s assets

risk (of technical insolvency) is the danger the firm will be unable to pay its bills due

7

The cash conversion cycle• the firm’s Operating Cycle (OC) is the time from the

beginning of production to the collection of cash from the sale of the finished product

OC = AAI + ACP• the firm’s Cash Conversion Cycle (CCC) is the

amount of time the firm’s resources are tied up

CCC = OC - APP• Therefore: CCC = AAI + ACP – APPCash

Conversion =Cycle

Inventory

Conversion +

Period

Receivables

Collection -Period

Payables

Deferral

.Period

8

Cash Management: Cash doesn’t earn interest, so why hold it? Transactions: Must have some cash to pay

current bills. Precaution: “Safety stock.” But lessened by

credit line and marketable securities. Compensating balances: For loans and/or

services provided. Speculation: To take advantage of bargains,

to take discounts, and so on. Reduced by credit line, marketable securities.

9

What’s the goal of cash management?

To have sufficient cash on hand to meet the needs listed on the previous slide.

However, since cash is a non-earning asset, to have not one dollar more.

10

Why might a company want to maintain a relatively high amount of cash?

If sales turn out to be considerably less than expected, the company could face a cash shortfall.

A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative.

The cash may be there, in part, to fund a planned fixed asset acquisition.

11

The cash conversion cycle MAX Company has annual sales of $10

million, a cost of goods sold of 75% of sales, and purchases that are 65% of cost of goods sold. MAX has an average age of inventory (AAI) of 60 days, an average collection period (ACP) of 40 days, and an average payment period (APP) of 35 days. Thus, the cash conversion cycle for MAX is 65 days (60 + 40 – 35).

Figure 14.1 presents MAX Company’s cash conversion cycle as a time line.

12

Figure 14.1 Time line for MAX Company’s cash conversion cycle—MAX Coy’s OC is 100 days and its CCC is 65 days

13

The cash conversion cycle

The resources MAX has invested in this CCC are

Changes in any of the time periods will change the resources tied up in operations. Eg, if MAX reduces the ACP on its accounts receivable by 5 days, it shortens the cash conversion time line and reduces the amount of resources invested in operations. A 5-day reduction in the ACP reduces the resources invested in the CCC by $136,986 [$10,

000,000 × (5/365)].

14

Exercises

Now try to do problems 14-4 and 14-5 from Gitman Ch 14 handout

15

The cash conversion cycle

Funding requirements of the CCC

• permanent (constant) versus seasonal (cyclical) funding

• aggressive (short/long debt mix) versus conservative (long debt only) funding

16

Funding requirements

Nicholson Company holds, on average, $50,000 in cash and marketable securities, $1,250,000 in inventory, and $750,000 in accounts receivable. Nicholson’s business is very stable over time, so its operating assets can be viewed as permanent.

Nicholson’s accounts payable of $425,000 are stable over time.

Nicholson has a permanent investment in operating assets of $1,625,000 ($50,000 + $1 250,0000 + $750,000 – $425,000). That amount also equals its permanent funding requirement.

17

Funding requirements

Semper Pump Coy has seasonal funding needs and seasonal sales, with peak sales driven by summertime purchases of bicycle pumps.

Semper holds, at minimum, $25,000 in cash and marketable secs, $100,000 in inventory and $60,000 in accounts receivable. At peak times, inventory increases to $750,000 and accounts receivable to $400,000.

Semper produces pumps at a constant rate throughout the year. Thus, accounts payable remain at $50,000 throughout the year, so Semper has a permanent funding requirement for its minimum level of operating assets of $135,000 ($25,000 + $100,000 + $60,000 – $50,000) and peak seasonal funding requirements of $990,000 [($25, 000 + $750,000 + $400,000 – $50,000) – $135,000].

Semper’s total funding requirements for operating assets vary from $135,000 (permanent) to a seasonal peak of $1,125,000 ($135,000 + $990,000) – see Fig 14.2

18

Figure 14.2 Semper Pump Coy’s total funding requirements—peak funds need is $1,125,000 and its minimum need is $135,000

19

Working Capital Financing Policies Moderate: Match the maturity of the

assets with the maturity of the financing.

Aggressive: Use short-term financing to finance permanent assets.

Conservative: Use permanent capital for permanent assets and temporary assets.

20

Years

$

Perm NOWC

Fixed Assets

Temp. NOWC

Lower dashed line, more aggressive.

} S-TLoans

L-T Fin:Stock &Bonds,

Moderate Financing Policy

21

Conservative Financing Policy

Fixed Assets

Years

$

Perm NOWCL-T Fin:Stock &Bonds

Marketable SecuritiesZero S-Tdebt

22

Aggressive funding strategy

A funding strategy where the firm funds its seasonal requirements with short-term debt and its permanent requirements with long-term debt.

If Semper has permanent funding needs of $135,000 and seasonal funding averaging $101,250. It can borrow short-term funds at 6.25% and long-term funds at 8%, and if it can earn 5% on the investment of any surplus balances, the annual cost of an aggressive strategy for seasonal funding will be

Note: Amount of funding = estimated funding needed. Therefore zero surplus

23

Conservative funding strategy

A funding strategy where the firm funds both its seasonal and its permanent requirements with long-term debt.

Semper can choose a conservative strategy, under which surplus cash balances are fully invested. (Fig 14.2, this surplus is the difference between the peak need of $1,125,000 and the total need, which varies between $135,000 and $1,125,000 during the year.) The cost of the conservative strategy will be

Ave surplus balance = Seasonal peak – permanent need – ave seasonal need

Ave surplus need = 1,125,000 – 135,000 – 101,250 = 888,750

24

Aggressive versus conservative funding

The aggressive strategy’s heavy reliance on short-term financing makes it riskier than the conservative strategy because of interest rate swings and possible difficulties in obtaining needed short-term financing quickly when seasonal peaks occur.

The conservative strategy avoids these risks through the locked-in interest rate and long-term financing, but is more costly because of the negative spread between the earnings rate on surplus funds (5% in the example) and the cost of the long-term funds that create the surplus (8% in the example).

25

What are the advantages of short-term debt vs. long-term debt?

Low cost-- yield curve usually slopes upward.

Can get funds relatively quickly. Can repay without penalty.

26

What are the disadvantages of short-term debt vs. long-term debt?

Higher risk. The required repayment comes quicker, and the company may have trouble rolling over loans.

27

The cash conversion cycleStrategies for managing the CCC

• turn over inventory quickly

• collect accounts receivable quickly

• receipts: minimise mail, processing and clearingpayments: maximise mail, processing and clearing

• pay accounts slowly (without harming credit rating)

28

Inventory management

Differing views of inventory management:

• financial manager – keep stocks low

• marketing manager – keep stocks of finished product high

• manufacturing manager – have big production runs

• purchasing manager – keep high raw materials stocks

29

Inventory Management: Categories of Inventory Costs

Carrying Costs: Storage and handling costs, insurance, property

taxes, depreciation, and obsolescence. Ordering Costs:

Cost of placing orders, shipping, and handling costs.

Costs of Running Short: Loss of sales, loss of customer goodwill, and the

disruption of production schedules.

30

Inventory managementCommon techniques of inventory management:

the ABC system

• divides inventory into three categories (A,B,C) in descending order of importance based on dollar investment in each

• A group receives intensive monitoring

B group is controlled by periodic checking

C group have unsophisticated monitoring (eg the ‘two bin’ method of re-ordering when one bin is empty)

31


Common techniques of inventory management: the Economic Order Quantity (EOQ) model

• determines the item’s optimal order quantity by minimising (order costs + carrying costs)

• order costs = fixed clerical costs of ordering carrying costs = variable costs of holding

inventory items for a time

32

Inventory managementThe EOQ model - graphically

33

Inventory managementThe EOQ model – algebraically order cost = O x S/Q carrying cost = C x Q/2 total cost = (O x S/Q) + (Cx Q/2) EOQ = √ (2.S.O)/C where: S = usage in units per period O = order cost per order C = carrying cost per unit per period Q = order quantity in units

34


The EOQ calculation helps management to minimise the total cost of inventory.

Lowering order costs causes an increase in carrying costs, and may increase total cost.

Likewise, an increase in total cost may result from reduced carrying costs.

The goal, facilitated by using the EOQ calculation, is to lower total cost.

35


The EOQ model • reorder point is the time at which to reorder

inventory and equalsreorder point = (lead time in days) x (daily

usage)• safety stocks are extra inventories that can

be drawn down when lead times or usage rate vary

36

Inventory management MAX Coy has an A group inventory item that is vital to the

production process. The item costs $1,500, and 1,100 units are used per year.

What is the optimal order strategy for the item? To calculate the EOQ, we need the following inputs:

37

Inventory management The reorder point depends on the number of days MAX

operates per year. Assuming 250 days per year and uses 1,100 units of

this item, its daily usage is 4.4 units (1,100 / 250). If lead time is two days and a safety stock of 4 units is

held, the reorder point for this item is 12.8 units [(2 × 4.4) + 4].

Therefore, the order is placed when the inventory falls to 13 units.

38

Exercise

Now try to do problem 14-18 from Gitman Ch 14 handout

39


Common techniques of inventory management: the Just-in-Time (JIT) system

• minimises inventory investment by having material inputs arrive exactly when needed

• JIT uses little or no safety stocks• involves the risk of shutting down production

if inventories fail to arrive

40

Inventory management Assume the same information as before for Max Coy,

but the marginal cost of placing an order is alternately (a) $11 or (b) $2.

a Order cost of $11

41

Inventory management As order cost falls, we should order fewer units per

order, more often. As the marginal order cost falls, place orders more

frequently for smaller amounts. Applying a marginal order cost, the EOQ model moves

towards a JIT system, where inventory arrives when it is needed, with an order cost based on the cost of a phone call to the supplier or a predetermined delivery schedule.

A pure JIT system assumes that suppliers will deliver on time, every time. Otherwise, pure JIT systems cause problems for manufacturers.

42

Accounts receivable management• the average collection period (ACP) is the second

component of the CCC and has two parts:

- the time from sale until the customer mails

payment

- the time from mailed payment to banking the

funds

• minimising the ACP involves:

- credit selection

- credit terms

- credit monitoring

43

Accounts receivable managementCredit selection: the five C’s of credit1. character – the applicant’s past record2. capacity – the ability to repay3. capital – the financial backing of the applicant4. collateral – assets available to act as security5. conditions – current business climate

44

Accounts receivable management

Changing credit standardsVariable direction effect on

of change profits

sales increase positive

accounts rec’ble increase negative

bad debts increase negative

45


• Credit scoring:• is a selection method that applies statistical weights

to an applicant’s scores on key financial measures

• Decision principle:• if the additional profit exceeds marginal costs, then

credit standards should be relaxed

• International credit:• exposes the firm to exchange rate risk

46

Changing credit standards

Dodd Tool is selling a product for $10 per unit. Credit sales last year were 60,000 units. Variable cost per unit is $6. Total fixed costs are $120,000. Dodd is considering a relaxation of credit standards that is expected to result in the following: a 5% increase in unit sales to 63,000 units; increases in the average collection period from 30 days to 45 days and in bad-debt expenses from 1% of sales to 2%. The firm’s required return on equal-risk investments, the opportunity cost of tying up funds in accounts receivable, is 15%.

To determine whether to relax its credit standards, Dodd Tool must calculate its effect on the firm’s additional profit contribution from sales, the cost of the marginal investment in accounts receivable, and the cost of marginal bad debts.

47


Additional profit contribution from sales Because fixed costs are ‘sunk’ and thereby

unaffected by a change in the sales level, the only cost relevant to a change in sales is variable cost.

Sales are expected to increase by 5%, or 3,000 units.

The profit contribution per unit will equal the difference between the sale price per unit ($10) and the variable cost per unit ($6). The profit contribution per unit will therefore be $4.

Thus, the total additional profit contribution from sales will be $12,000 (3,000 units × $4 per unit).

48


Cost of the marginal investment in accounts receivable is the difference between the cost of carrying receivables before and after the introduction of the relaxed credit standards. It is the out-of-pocket (variable) costs rather than the fixed (sunk) costs that are relevant in this analysis. The average investment in accounts receivable formula is:

49


The total variable cost of annual sales under the proposed and present plans using the variable cost per unit of $6 is

Total variable cost of annual sales: Under present plan: ($6 × 60,000 units) = $360,000 Under proposed plan: ($6 × 63,000 units) = $378,000 Implementation of the proposed plan will cause the

total variable cost of annual sales to increase from $360,000 to $378,000.

50


The turnover of accounts receivable is the number of times each year that the firm’s accounts receivable are turned into cash. It is found by dividing the average collection period into 365—the number of days in a year.

Turnover of accounts receivable (rounded to the nearest whole number):

Under present plan: 365/30 = 12 Under proposed plan: 365/45 = 8 With implementation of the proposed plan, the

accounts receivable turnover would drop from 12 to 8.

51


By substituting the cost and turnover data just calculated into Equation 14.9 for each case, we get the following average investments in accounts receivable:

Average investment in accounts receivable: Under present plan: $360,000/12 = $30,000 Under proposed plan: $378,000/8 = $47,250

52


The marginal investment in accounts receivable, and its cost, are calculated as follows:

Cost of marginal investment in accounts receivable: Average investment under proposed plan $47,250 – Average investment under present plan 30,000 Marginal investment in accounts receivable $17,250 × Required return on investment

0.15 Cost of marginal investment in A/R $2,588 The resulting value of $2,588 is considered a cost

because it represents the maximum amount that could have been earned on the $17,250 had it been placed in the best equal-risk investment alternative available at the firm’s required return on investment of 15%.

53


Cost of marginal bad debts The cost of marginal bad debts is the difference between the level of bad debts before and after the relaxation of credit standards:

Cost of marginal bad debts: Proposed: (0.02 × $10/unit × 63,000 units) = $12,600 Present: (0.01 × $10/unit × 60,000 units) = 6,000 Cost of marginal bad debts $6,600 The bad debts costs are calculated by using the sale price

per unit ($10) to identify not just the true loss of variable cost ($6) that results when a customer fails to pay its account, but also the profit contribution per unit— $4 ($10 sales prices – $6 variable cost)—that is included in the ‘additional profit contribution from sales’.

55

Exercise


56

Elements of Credit Policy Cash Discounts: Lowers price. Attracts new customers and reduces

days sales outstanding (DSO) or ACP. Credit Period: How long to pay? Shorter period reduces DSO and

average A/R, but it may discourage sales. Credit Standards: Tighter standards reduce bad debt losses, but may

reduce sales. Fewer bad debts reduces DSO. Collection Policy: Tougher policy will reduce DSO, but may damage

customer relationships.

57


• credit terms are the conditions of sale for customers extended credit by the firm

eg. ‘net 30’ means the customer has 30 days to pay

• cash discounts are percentage deductions for paying within a specified time

eg. ‘2/10 net 30’ means a 2% discount for payment made within the first ten days of 30 days

58

Cash discount

MAX Company has an average collection period of 40 days (turnover = 365/40 = 9.1). MAX is considering initiating a cash discount by changing its credit terms from net 30 to 2/10 net 30. The firm expects this change to reduce the amount of time until the payments are made, resulting in an average collection period of 25 days (turnover = 365/25 = 14.6).

59

Cash discount

As shown in the EOQ example, MAX has a raw material with current annual usage of 1,100 units. Each finished product unit requires one unit of this raw material at a variable cost of $1,500, plus $800 of variable cost per unit, to produce. The product sells for $3,000 on terms of net 30. MAX estimates that 80% of its customers will take the 2% discount for early payment and that offering the discount will increase sales of the finished product by 50 units (from 1,100 to 1150 units) per year but will not alter its bad-debt percentage. MAX’s opportunity cost of funds invested in accounts receivable is 14%.

Should MAX offer the proposed cash discount? An analysis similar to the credit standard decision shows a net

loss from the cash discount of $6,640. Thus, MAX should not initiate the proposed cash discount..

60

Analysis of initiating a cash discount for MAX Company

61


• cash discount period is the number of days after the start of the credit period during which a cash discount is available

increasing the discount period by ten days would increase sales but raise bad debt expense

• credit period is the number of days after the sale until full payment is due

increasing the credit period by ten days would increase sales but raise bad debt expense

62

Accounts receivable managementCredit monitoring is the ongoing review of the

accounts receivable to see if customers are keeping to the stated credit terms

• average collection period = (accounts receivable)/(average sales

per day)• ageing of accounts receivable = a schedule of accounts outstanding for

various periods of time

63

Popular collection techniques

64

Does a company face any risk if it tightens its credit policy?

YES! A tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

65

If a company succeeds in reducing DSO without adversely affecting sales, what effect would this have on its cash position?

Short run: If customers pay sooner, this increases cash holdings.

Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase the value of the company (EVA).

66

Exercise


67

Management of receipts and disbursementsMonitoring these flows

• daily financial position report – shows the previous day’s actual cash flow

strength: quick forecast information tool weakness: too much precision assumed

• weekly cash meetings

• monthly cash meetings

68

Management of receipts and disbursementsStrategies for keeping cash under control • revise forecasts to reflect new facts• change payback agreement with the bank• speed up cash receipts• alerts for key dates• check accounts receivable turnover rate• alter contingent items

69

Management of receipts and disbursements• ‘float’ = funds dispatched by the payer that are

not yet in a form that can be spent by the payee

mail float – ‘cheque is in the mail’

processing float – deposit delay

clearing float – bank processing delay

As more customers use electronic funds transfer methods, float is becoming less relevant.

70

Management of receipts and disbursements

Banking and funds transfer devices• EFTPOS

• BPay – on-line banking

• direct deposits

• automated periodic payment authorisations

• controlled disbursing

• overdraft facility

• zero balance account (ZBA)

72

Questions for review

• What is net working capital?• In what way is there a tradeoff between risk

and profit?• How can we manage the cash conversion

cycle?• What are three techniques for managing

inventory?• How should we approach the credit selection

process?

PowerPoint to accompany CHAPTER 14 Working capital and current assets management.

Documents

Transcript of PowerPoint to accompany CHAPTER 14 Working capital and current assets management.