Wcm assets & laiblities @ppt doms

1

Working Capital Management: Current Assets and Current Liabilities

2

CHAPTER 24

Working Capital Management: Current

Assets and Current Liabilities

3

Lecture Agenda Learning Objectives Important Terms Cash Management

Reasons for Holding Cash Determining the Optimal Cash Balance Cash Management Techniques

Accounts Receivable Management The Credit Decision Credit Policies The Collection Process

Inventory Management Inventory Management Approaches Evaluating Inventory Management

Short-Term Financing Considerations Summary and Conclusions

Concept Review Questions

4

Learning Objectives

You should understand the following: How to manage individual asset items, such as cash, receivables,

and inventory The nature of the major sources of short-term financing, such as

trade credit, bank loans, factoring arrangements, and money market securities

The fact that in evaluating current asset and current liability decisions, the final decision rests on the standard problem of trading off expected benefits and potential costs

5

Important Chapter Terms ABC approach Capacity Character Conditions Credit analysis Credit enhancements Economic Order Quantity Factoring arrangements Finance motive Float Just-in-time inventory

systems

Materials requirement planning

Open account Optimal cash balance Precautionary motive Prepayments Securitization Special purpose vehicles Speculative motive Terms of credit Transactions motive

6

Cash and Marketable Securities

Working Capital ManagementCurrent Assets and Current Liabilities

7

Cash and Marketable SecuritiesReasons for Holding Cash

1. Transactions motive

2. Precautionary motive

3. Finance motive

4. Speculative motive

8

Cash and Marketable SecuritiesDetermining the Optimal Cash Balance

The optimal cash balance is the amount of cash that balances the risks of illiquidity against the sacrifice in expected return that is associated with maintaining cash. Differs substantially across firms

Firms with predictable cash flows will have lower optimal cash balance requirement

Firms with excess borrowing capacity (unused line of credit for example) can hold less cash.

9

Cash and Marketable SecuritiesCash Management Techniques

Cash flow synchronization can free up cash (and lower the amount of capital a firm requires)

This is done by: Speeding up cash inflows:

Bill clients earlier each month Increase cash sales through incentives Encourage customers to pay using electronic payments systems such as

direct deposit, automatic debit, debit card, rather than cheque. Delaying outflows:

Arrange with suppliers for more liberal trade credit terms (net 40 rather than net 30 for example)

Paying employees once a month rather than twice.

10

Cash ManagementsFloat

Float is the time that elapses between the time the paying firm initiates payment, and the time the funds are available for use by the receiving firm.

It has three major sources:1. The time it takes the cheque to reach the firm after it is mailed by the

customer.2. The time it takes the receiving firm to process the cheque and deposit in

an account, and3. The time it takes the cheque to clear through the banking system so that

the funds are available to the firm. Float has been reduced or eliminated through:

Debit cards Preauthorized payments Electronic funds transfer (EFT) and electronic data interchange (EDI)

systems.

11

Accounts Receivable


12

Accounts Receivable

1. The decision to extend credit to customers has significant cash flow and credit risk implications for the firm.

Firms often don’t have a choice, if the availability of credit is an important factor in the customer’s purchase decision process (if competitors offer credit, then the firm must at least match those credit terms, and then choose to compete on another basis.)

2. The second decision (once the firm has decided to extend credit) is to determine which customers will be granted credit.

3. The credit terms must be established.

4. The collection process must be decided.

13

Accounts ReceivableThe Credit Decision

The decision to extend credit is determined: Nature of the product sold, The industry Practices of competitors.

14

Accounts ReceivableCredit Analysis

The process designed to assess the risk of non-payment by potential customers, which involves collecting information about potential customers with respect to their credit history, their ability to make payments as reflected in their expected cash flows, and their overall financial stability.

From the firm’s point of view: Often willing to extend credit on terms better than a bank because:

The potential for the firm developing a good customer into the future, and Losses are limited to production costs in the case of default.

15

Accounts ReceivableCredit Analysis

Variables that are weighed in the credit analysis process:

Capacity – the customer’s ability to pay Character – the customer’s willingness to pay Collateral – the security that could be seized to

satisfy payment Conditions – the state of the economy.

16

Accounts ReceivableCredit Policies

The firm must choose what terms of credit to offer its customers.

Terms of credit include: The due date The discount amount (if any)

Options include: Cash on delivery (COD) Cash before delivery (CBD) Net 30, net 40 - no incentive for early payment 2/10 net 30 - a 2% discount for early payment

17

Accounts ReceivableChange in Credit Policy Analysis

When extending more lenient credit terms the firm hopes to increase revenues through the sale of more units, and perhaps even charge higher prices.

These benefits are offset by financing costs and the increased risk of non-payment.

Evaluation of these decisions can use an NPV framework:

CF - CFs) PV(FutureNPV 0[ 24-1]

18

Accounts ReceivableThe Collection Process

The firm must monitor outstanding A/R by customer and by category.

The firm must then determine what action it will take when late payments occur. Charge interest on outstanding balances Notify customer of arrears (email, mail, telephone)

Actions on unpaid amounts: Allow no further purchases on credit Choose from a number of additional options to collect:

1. Take legal action2. Sell receivable to a collection agency3. Write off the debt as uncollectable.

19

Accounts ReceivableFactoring

It may not be cost-effective for a firm to manage the collection process itself.

Factoring arrangements are the sale of a firm’s receivables, at a discount, to a financial company called a factor, which specializes in collections, or the out-sourcing of the collections to a factor.

20

Evaluating Receivables Management

Use of productivity ratios introduced in Chapter 4 can give a tool for evaluating the firm’s ability to manage its accounts receivable.

21

Evaluating Receivables ManagementReceivables Turnover

Measures the sales generated by every dollar of receivables.

Receivable Accounts

Sales

turnover sReceivable

RT

AR

S

[4- 16]

22

Evaluating Receivables Management

Average Collection Period Estimates the number of days it takes a firm to collect on its accounts receivable.

If ACP is 40 days, and the firm’s credit policy is net 30, clearly, customers are not paying in keeping with the firm’s policy, and there may be concerns about the quality of the firm’s customers, and what might happen if economic conditions deteriorate.

turnoversReceivable

AR

Turnover sReceivable

365 Period Collection Average

ACP

ADS

AR

[4- 17]

23

Inventory


24

Inventory

The level of inventory a firm holds is a trade off between benefits and costs:

Benefits of Holding Inventory: Take advantage of large-volume discounts Reduce the probability of production disruptions because of lack of

inventory Minimize lost sales because of stock-outs

Costs of Holding Inventory: Financing costs associated with inventory investment Storage, handling, insurance, spoilage and obsolescence costs.

25

InventoryInventory Management Approaches

ABC Approach Economic Order Quantity (EOQ) Model Materials Requirement Planning (MRP) Just-in-time (JIT) Inventory systems.

26

InventoryEvaluating Inventory Management

Use of financial ratios can give some indication of the effectiveness of a firm’s inventory management.

Ratios, however, do not measure shortage costs, financing costs, etc.

These ratios include: Inventory turnover Average day’s sales in inventory.

27

Productivity RatiosInventory Turnover

Estimates the number of times, ending inventory was ‘turned over’ (sold) in the year.

A ratio that involves both ‘stock’ and ‘flow’ values Is strongly a function of ending inventory value…managers

often try to improve this ratio as they approach year end through inventory reduction strategies (cash and carry sales/inventory clearance, etc.)

Turnover Inventory INV

CGS

[4- 18]

28

Productivity RatiosInventory Turnover

When Cost of Goods Sold is not available, it may be necessary to estimate inventory turnover using sales.

Use of the sales figure is less valid than Cost of Goods Sold because Cost of Goods Sold is based on inventoried cost, but Sales includes a profit margin on top of inventoried cost.

Turnover Inventory INV

Sales

[4- 19]

29

Productivity RatiosAverage Days Sales in Inventory (ADSI)

Estimates the number of days of sales tied up in inventory (based on ending inventory values)

turnoverInventory

ADS

INV

365

(ADSI)inventory in sales days Average

[4- 20]

30

Short-Term Financing Considerations


31


Investment in current assets tend to rise and fall with the volume of activity.

Accruals and accounts payable (trade credit) are ‘spontaneous’ liabilities.

Other sources of financing must be ‘negotiated’ and before using the firm must evaluate the cost effectiveness of alternative financing mechanisms.

32


To estimate the annual effective rate of return or cost (k) of any financing alternative:

1cos

1 365 - )ricePurchase p

tfinancing n-Day(k /n[ 24-2]

33


Trade Credit Often a very important source of short-term financing. Offers a number of advantages:

Readily available Convenient Flexible Usually does not entail any restrictive covenants or pledges of

security.

There is no explicit cost associated with credit terms such as: Net 30 Net 40

34


Trade Credit There is usually a high implicit cost to a firm that forgoes discounts

on early payment such as: 2/10 Net 30

Example: assume (2/10 net 30)Approximate percentage cost = (2/98)(365/20) = 37.2%

The firm is being charged 2% for the use of funds from day 10 to day 30 (20 days).

35


Bank Loans and Factor ArrangementsOptions include:

Operating loans / lines of credit Secured by accounts receivable and inventory to a

maximum percent of those assets Interest only payments Balance can be retired at the firm’s discretion

Factor arrangements

36

Short-Term Financing ConsiderationsMoney Market Instruments

Large firms with high credit ratings may be able to by-pass financial institutions and borrow directly from the money market.

Two forms of money market instruments: Commercial paper Bankers’ acceptances

The firm pays a stamping fee, and is able to borrow based on their bank’s credit rating.

Money market securities: Sold at a discount from face value Maturities at time of issue of 30, 60, 90 days Face amounts of $100,000 or more.

37

Short-Term Financing ConsiderationsMoney Market Instruments

The annualized yield on a money market instrument:

365

yield annual eApproximatturityDays to mapriceMarket

Discount[ 24-3]

38


Securitizations Special purpose vehicles (SPVs) are conduits for packaging portfolios of receivables and selling them to investors in the money market; a recent innovation in financing trade credit.

Credit enhancements are actions taken to reduce credit risk, such as requiring collateral, insurance or other agreements.

Asset-backed commercial paper (ABCP) is an example. The sub-prime mortgage problems in the U.S. has exposed the

problems with ABCP where investors have become concerned about the underlying asset values (packages of receivables) and the market is actively repricing these money market instruments

In some cases the market has disappeared for some of these money market instruments.

39

Summary and Conclusions

In this chapter you have learned: That the optimal level of investment in cash,

receivables and inventory occurs when the benefits balance the costs

The advantages, the disadvantages and associated effective annual costs of the most common short-term financing options available to companies.

Wcm assets & laiblities @ppt doms

Economy & Finance

Transcript of Wcm assets & laiblities @ppt doms