Working Capital ManagementWorking Capital Management

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Working Capital ManagementWorking Capital Management

Presented by John Lafare

John.Lafare@SCORE114.org

SCORE®

The ingredients of sound financial managementThe ingredients of sound financial management

Financial Management

Financial Analysis

Financial Planning

Working Capital

Management

Why is working capital management critical?Why is working capital management critical?

• Businesses of any size experience working capital problems

• Small businesses struggle the most, especially during the start-up phase

• Working capital is your lifeblood:– You may have assets and be profitable– But liquidity can be a serious problems if

assets cannot converted into cash

What do we know about business failures?What do we know about business failures?• Findings from an SBA study:

– 1/3 of startups fail within 2 years– Less than half make it to 4 years

• Dominant causes of failure:– Inadequate working capital – Poor cash flow management

• The good news (?):– 90% of failures are due to poor decisions– Understanding the causes of failure can help

avoid repeating them

Workshop objectivesWorkshop objectives

1. Explore methods used to make optimal working capital decisions.

2. Explain how current asset and liability accounts affect cash management.

3. Learn to make working capital decisions based on forecasted financial data.

The dimensions of working capital managementThe dimensions of working capital management

Working Capital Management

Managing Current Assets

Financial Forecasting

Financing Current Assets

Accounting 101: the one-minute balance sheetAccounting 101: the one-minute balance sheetCurrent Assets Cash Marketable Securities Accounts Receivable Inventory

Current Liabilities Accounts Payable Accruals Short-Term Debt Taxes Payable

Fixed Assets Investments Plant & Machinery Land & Buildings

Long-Term Financing Debt

Equity

What is net working capital?What is net working capital?

Total Current Assets:– cash– marketable securities– accounts receivable– inventories

Total Current Liabilities: – accounts payable (trade credit)– notes payable (bank loans)– accrued liabilities

Less

Working capital policiesWorking capital policies

1. Account receivables management2. Inventory management3. Cash management4. Accounts payable management5. Funding current assets6. Working capital requirements7. Working capital strategies

Managing accounts receivableManaging accounts receivable

1. Cost of carrying receivables

2. Relaxing Credit Standards

3. Changing Credit Terms

4. Factoring

5. Pledging of receivables

What is the cost of carrying receivables?What is the cost of carrying receivables?• Receivables represent credit sales that

have trapped valuable cash• They are an indirect free loan to clients

• Average investment in receivables:

Variable cost of annual sales

Turnover of receivables

• Variable costs are the relevant costs since we are concerned about out-of-pocket costs

Turnover of receivablesTurnover of receivables

• Calculated as: 365

Average collection period

• Meaning of the ratio:– A high ratio implies you operate on a cash basis or

that your extension of credit and collection of receivables is efficient

– A low ratio may point to the need to re-assess credit policies to ensure timely collection

Relaxing credit standardsRelaxing credit standards

• Can have a significant influence on sales • Lower the quality standard for accounts

accepted as long as the profitability of additional sales exceeds the added costs

Variable Change Impact on Profits

Sales Volume Increase Positive

Investment in receivables Increase Negative

Bad-debt expenses Increase Negative

Effects of Relaxing Credit Standards

Calculating the impact of relaxing credit standardsCalculating the impact of relaxing credit standards

Initial Data

Sales price / unit $10

Credit sales for the last 12 months 60,000 units

Variable cost / unit $6

Total fixed costs $120,000

Expected Impact of Proposed Credit Standards

Variable Change Change

Sales Increase +5% to 63,000 units

Average collection period Increase 30 -> 45 days

Bad debt expense Increase 1% -> 2% of sales

Tying up funds in receivables Increase Opportunity cost: 15%

Step 1: profit contribution from increased salesStep 1: profit contribution from increased sales

Additional Profit Contribution from SalesOld Sales Level 60,000 Price/Unit $ 10.00

New Sales Level 63,000 Variable Cost/Unit $ 6.00

Increase in Sales 3,000 Contribution Margin/Unit

$ 4.00

Additional profit contribution from sales (sales inc. x cont. margin)

$ 12,000

Step 2: cost of marginal investment in receivablesStep 2: cost of marginal investment in receivables

Total Variable Cost = Variable Cost x # of Units

Total VC under present plan $6 x 60,000 = $360,000

Total VC under proposed plan $6 x 63,000 = $378,000

A/R Turnover under current plan 365/30 = 12.2

A/R Turnover under proposed plan 365/45 = 8.1

Current average investment $360,000/12.2 = $29,508

Proposed average investment $378,000/ 8.1 = $46,667

Additional receivables investment $17,519

Opportunity cost 15%

Marginal cost of receivables $ 2,628

Step 3: cost of increased bad debtsStep 3: cost of increased bad debts

Cost of Increased Bad Debts

Total sales under present plan $10 x 60,000 = $600,000

Total sales under proposed plan $10 x 63,000 = $630,000

Bad debt% under current plan 1%

Bad debt% under proposed plan 2%

Cost of bad debt under present plan $600,000 x 1% = $6,000

Cost of bad debt under proposed plan

$630,000 x 2% = $12,600

Marginal cost of bad debts $ 6,600

Step 4: making the decisionStep 4: making the decision

Additional profit contribution from sales $ 12,000

Marginal cost of investment in receivables (2,628)

Marginal cost of bad debts (6,600)

Net impact from implementation of proposed credit standards

$ 2,826

Changing credit termsChanging credit terms

• Credit terms are composed of:1. The cash discount

2. The cash discount period

3. The credit period

Example: credit terms of 2/10 net 304. Discount = 2%

5. Discount period = 10 days

6. Credit period is 30 days

• Discount has to be meaningful to motivate early payment

Changing credit terms: costs vs. benefitsChanging credit terms: costs vs. benefits• Offering a cash discount means giving up a

percentage of the invoice amount

• Potential benefits:1. You get cash sooner, reduce borrowing needs,

more cash for investment

2. Since the discount is a price reduction, sales may increase

3. Inducing customers to pay early may reduce bad debt losses

4. May encourage customers to pay cash, avoiding credit card processing fees

Changing credit terms: calculating the costsChanging credit terms: calculating the costs

• Average collection period is 40 days:1. 32 days until the customers mail payments2. 8 days to receive, process, and collect

payments once they are mailed.

• Initiate a cash discount by changing credit terms from net 30 to 2/10 net 30

• The change is expected to result in an average collection period of 25 days

Example

Additional dataAdditional data

• Current production = 1,100 units.

• Product sells for $3,000, terms of net 30

• Variable costs = $2,300

• You estimate that:a) 80% of customers will take the 2% discount b) Sales will increase by 50 unitsc) The bad-debt percentage will be unchanged

• Opportunity cost of funds invested in accounts receivable = 14%

Changing credit terms: analysisChanging credit terms: analysis

1. Additional profit contribution from sales:50 units x ($3,000 - $2,300) = $35,000

2. Cost of marginal investment in receivables:Current: $2,300 x 1,100 units / (365 / 40) = $278,022Proposed: $2,300 x 1,150 units / (365 / 25) = 181,164

Reduction in A/R investment: $ 96,858

3. Savings from reduced investment in receivables:Savings = 14% x $96,859 = $13,560

4. Cost of cash discount:2% x 80% x 1150 x $3,000 = ($55,200)

Net profit from proposed credit terms: ($ 6,540)

Factoring of receivablesFactoring of receivables

• Outright sale of receivables at a discount to a factor

• Value assigned a function of the age of the receivables

• Anything older than 90 days typically not financed

• Factors may be either departments of banks or factoring companies

• Normally done on a notification basis where customers pay the factor directly

Pledging receivablesPledging receivables

• Accounts receivable used as collateral

• Banks may fund between 50 - 90% of the face value of acceptable receivables

• In addition, to protect its interests, the lender files a lien on the collateral

• Receivables financing transfers the default risk to the financing company

• The focus shifts from trying to collect receivables to value-added business activities

Managing inventoryManaging inventory

1. Alternative Views About Inventory2. Consignment Inventory3. Just-In-Time (JIT)4. Economic Order Quantity

Alternative views about inventoryAlternative views about inventory

PerspectiveInventory

Target Level Objective

Financial Low Efficient use of funds

Marketing High Ensure orders are quickly filled

Manufacturing HighAvoid production delays, more economical production runs

The systemThe system

• Divide inventory into three groups of descending order of importance based on the dollar amount invested in each

• Typical system contains:– Group A: 20% of the items worth 80% of the total

dollar value– Group B: the next largest investment– And so on

• Control of the A items more intensive because of the high dollar investment

Consignment inventoryConsignment inventory

• Inventory in possession of the client, but still owned by the supplier

• Supplier: – Places inventory in client’s possession– Allows selling / consumption from stock – Needs high degree of confidence in sales potential

• Client: – Buys inventory only after sale/ consumption – Does not have to tie up capital in inventory

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

• Extensive coordination must exist between the business, 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

Just-in-Time (JIT) systemJust-in-Time (JIT) system

Economic Order Quantity model (EOQ)Economic Order Quantity model (EOQ)

• 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

EOQ = 2 x S x O

C

Used to determine what order size minimizes inventory costs

EOQ calculation exampleEOQ calculation example

• Units used per year (S) = 1,600• Cost per order (O) = $50• Carrying Cost (C) = $1 per unit

EOQ = (2 * 1,600 * $50) = 400 units

$1

Key EOQ inputsKey EOQ inputs

• Carrying Costs Of Inventory: rent, utilities, insurance, taxes, employee costs, and the opportunity cost of having your capital tied up in inventory

• Order Costs:– For purchased items, the cost to create purchase

orders, process receipts, conduct incoming inspections, process invoices & vendor payments, and shipping costs

– In manufacturing, the cost of the time to initiate the work order, time associated with picking & issuing components, production scheduling time, machine set up time, and inspection time.

Reorder point = lead time in days x daily usage

where daily usage = annual usage / 360

• Once a firm has calculated its EOQ, it must determine when to place orders.

• 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 as follows:

EOQ: the reorder pointEOQ: the reorder point

Daily usage = 1,600 / 360 = 4.44 units/day

Reorder Point = 10*4.44 = 44.44 => 45 units

Reorder point calculation exampleReorder point calculation example

• It takes 10 days to place and receive an order• Annual usage = 1,600 units / year

Cash managementCash management

1. Categories of float

2. Managing float

3. Float management techniques

4. Zero-balance accounts

Categories of float (1 of 2)Categories of float (1 of 2)

• Collection float: delay between the time when a payer deducts a payment from its checking account ledger and the time when the payee actually receives the funds in spendable form

• Disbursement float: delay between the time when a payer deducts a payment from its checking account ledger and the time when the funds are actually withdrawn from the account

• Mail float: delay between the time when a payer places payment in the mail and the time when it is received by the payee

• Processing float: delay between the receipt of a check by the payee and the deposit of it in the firm’s account

• Clearing float: delay between the deposit of a check by the payee and the actual availability of the funds due to the time required for a check to clear

Categories of float (2 of 2)Categories of float (2 of 2)

Managing floatManaging float

• The presence of float lengthens:– The average collection period – The average payment period

• The goal is to:1. Shorten the average collection period2. Lengthen the average payment period

Speeding up collections with lockboxesSpeeding up collections with lockboxes• Payers send their payments to a nearby post office

box

• Lockbox is serviced by the bank several times a day

• Lockboxes reduce collection float by:1. shortening the processing float2. shortening mail and clearing float

Slowing down payments with controlled disbursingSlowing down payments with controlled disbursing• Involves strategic use of mailing

points and bank accounts to lengthen mail float and clearing float

• Should be used carefully, however, as longer payment periods may strain supplier relations

Cash concentration: direct sends & other techniquesCash concentration: direct sends & other techniques• Wire transfers: removes funds from the payer’s

bank and deposits them into the payees bank, reducing collections float.

• Automated clearinghouse (ACH) debits: pre-authorized electronic transfers from the payer’s account to the payee’s account via settlement among banks

• ACHs clear in one day, thereby reducing mail, processing, and clearing float

Zero-balance accountsZero-balance accounts

• Disbursement accounts that always have an end-of-day balance of zero

• The purpose is to eliminate non-earning cash balances in corporate checking accounts

• A ZBA works well as a disbursement account under a cash concentration system

Managing accounts payableManaging accounts payable

1. Spontaneous liabilities2. Managing accounts payable3. Taking or not taking the cash discount4. Cost of giving up the cash discount5. Effect of stretching payables6. Using the cost of giving up the cah

discount in decision making

Spontaneous liabilitiesSpontaneous liabilities

• Arise from the normal course of business

• Two major sources: accounts payable, accruals

• Accruals:

–Liabilities for services received for which payment has yet to be made

– Most common accruals: wages and taxes

• As sales increase, liabilities increase in response to increased purchases, wages, and taxes

Managing accounts payableManaging accounts payable

• Credit terms offered by suppliers allow for delays in payment for purchases

• Major source of unsecured short-term financing

• Pay as slowly as possible without damaging credit rating or relationships

• Suppliers may impute the cost of offering terms in the selling price

• Analyze terms to determine best credit strategy

Taking or not taking the cash discountTaking or not taking the cash discount

1.Take the cash discount:• Pay on the last day of the discount period• No associated costs• Can be a source of additional profitability

2.Give up the cash discount:• Pay on the final day of the credit period • The cost is the implied rate of interest for delaying

payment an additional number of days

Cost of giving up a cash discountCost of giving up a cash discount

• Annualized cost can be calculated as:

CD x 365

100% - CD N

WhereCD = stated cash discount in percentage terms

N = # of days payment can be delayed by giving up the cash discount

• Assuming terms of 2/10, net 30:

Annualized Cost = 2% x 365 = 37.24%

100% - 2% 20

Effect of stretching payablesEffect of stretching payables

• Credit terms are 2/10 net 30• Assume payments can be stretched to 70 days

without damaging the credit rating or raising issues with suppliers

• New cost of giving up the cash discount:

Annualized Cost = 2% x 365 = 12.42%

100% - 2% 60

• Stretching payables reduces the implicit cost of giving up the cash discount

Using the cost of giving up a cash discount in decision makingUsing the cost of giving up a cash discount in decision making

• You need short-term funds• Short-term credit is available at 13%• Borrow funds, take discounts from A/C/D• Give up discount from B as opportunity cost is less

than cost of borrowing

Supplier

Credit Terms Cost of giving up discount

A 2/10 net 30 37.24%

B 1/10 net 55 8.19%

C 3/20 net 70 22.58%

D 4/10 net 60 30.42%

Funding with bank loansFunding with bank loans

1. Unsecured short-term loans2. Loan interest rates3. Fixed and floating rate loans4. Payment of interest5. Computing the effecting rate of interest6. Single payment notes7. Lines of credit8. Revolving credit agreements

Unsecured short-term loansUnsecured short-term loans

• Short-term, self-liquidating loans for seasonal peaks in financing needs

• Used during inventory build ups or when experiencing growth in receivables

• The loans are retired as receivables and inventories are converted into cash

• Three basic forms:– Single-payment notes– Lines of credit– Revolving credit agreements

Loan Interest RatesLoan Interest Rates

• Most banks loans are based on the prime rate of interest

• The lowest rate of interest charged by the nation’s leading banks on loans to their most reliable business borrowers

• Banks determine the rate to be charged by adding a premium to the prime rate to adjust for borrower “riskiness”

Fixed and Floating-Rate LoansFixed and Floating-Rate Loans

• Fixed-rate loan: rate determined at set increment above prime, remains at that rate until maturity

• Floating-rate loan: increment above the prime rate initially established and then allowed to float until maturity

• The increment above prime is generally lower on floating rate loans

Payment of InterestPayment of Interest

• Interest can be paid at loan maturity or in advance

• If paid in advance, it is deducted from the loan so that the borrower actually receives less money than requested

• Loans of this type are called discount loans

Interest / (Amount Borrowed – Interest)

Method of computing interestMethod of computing interest

• If paid at maturity, the effective (true) rate of interest for a one-year loan is:

• The effective rate of interest on a one-year discount loan is:

Interest / Amount Borrowed

Computing interest exampleComputing interest example

• You need to borrow $10,000 at a stated rate of 10% for 1 year

1. Interest paid at maturity, the effective interest rate is:

2. Discount loan, the effective interest rate is:

(10% X $10,000) / ($10,000-$1,000) = 11.1%

(10% X $10,000) / $10,000 = 10.0%

Single payment notesSingle payment notes

• Short-term, one-time loan payable as a single amount at its maturity

• The “note” states the terms of the loan, including the length of the loan and the interest rate

• Most have maturities of 30 days to 9 or more months

• Interest is usually tied to prime, may be fixed or floating

Computing interest on single payment notes: initial dataComputing interest on single payment notes: initial data

• You borrow $100,000 from each of 2 banks — A and B

• Loan A is a fixed rate note, loan B is a floating rate note

• Both loans are 90-day notes with interest due at the end of 90 days

• Prime is at 6% and the rates are:– 1.5% above prime for A

– 1.0% above prime for B

Computing interest on loan AComputing interest on loan A

• The total interest cost on loan A is: $100,000 x 7.5% x (90/365)] = $1,849

• The effective cost is 1.85% for 90 days

• The effective annual rate is:

EAR = (1 + periodic rate)m - 1

= (1+. 0185)4.06 - 1 = 7.73%

Computing Interest on Loan BComputing Interest on Loan B

Periodic rate = rate x (30/365)

• Total interest cost: $100,000 x (.575% + .616% + .596%) = $1,787

• Effective cost = 1.787% for 90 days

• EAR = (1+.01787)4.06 - 1 = 7.46%

Period Prime Rate Periodic Rate

First 30 days 6.00% 7.00% .575%

Next 30 days 6.50% 7.50% .616%

Final 30 days 6.25% 7.25% .595%

Lines of Credit (LOC)Lines of Credit (LOC)

• Agreement for a specific amount of unsecured short-term borrowing over a given period of time

• Usually made for a period of 1 year, with various operating restrictions on borrowers

• The interest rate on a LOC is normally floating and pegged to prime.

• Although not guaranteed, the amount of the LOC is the maximum you can owe the bank at any point in time

Lines of credit and compensating balancesLines of credit and compensating balances• LOCs often require the borrower to maintain

compensating balances

• A compensating balance is a certain checking account balance equal to a certain percentage of the amount borrowed (typically 10 to 20%).

• This requirement effectively increases the cost of the loan to the borrower

Line of credit: effective costsLine of credit: effective costs

• You get an LOC of $1 million, at 10%, compensating balance of 20% ($200K)

• You have access to only $800,000 and must pay $100, 000 as interest

• With the compensating balance, the effective cost of the loan is 12.5% ($100,000/$800,000)

• That’s 2.5% more than the stated rate of interest

Revolving credit agreementsRevolving credit agreements

• Essentially a guaranteed line of credit, also sometimes called a “revolver”

• The bank guarantees the funds will be available and typically charge a commitment fee on the unused portion of the credit line

• A typical fee is around 0.5% of the average unused portion of the funds

• More expensive than the LOC, but less risky from the borrower’s perspective

Effective annual cost of revolving credit agreementEffective annual cost of revolving credit agreement• You have a $2 million RCA

• Average borrowing for the past year = $1.5 million

• The bank charges:– A commitment fee of 0.5% on the unused balance of

$500,000 or $2,500

– Interest of $112,500 on the $1.5 million used

• Effective annual cost:

[($112,500 + $2500)/$1,500,000] = 7.67%

Working capital requirementsWorking capital requirements

• Estimating working capital requirements

• Alternative scenarios:

1. 20% sales growth

2. 0% sales growth

3. 20% sales decline

Estimating working capital requirementsEstimating working capital requirements• Changes in working capital can be

unstable• Big increases in some years, followed by

big decreases in following years

• Look at working capital per dollar of sales

• Then determine the approximate amount of working capital required to support sales

Working capital requirements Alternative ScenariosWorking capital requirements Alternative Scenarios

• Working capital = $900,000• Total Sales = $4,500,000• Working Capital / Total Sales = 20%• For every $1,000 of new sales, $200

required to support the sales increaseExpected Growth

Projected Sales

Working Capital / Total Sales

Working CapitalRequirements

+20% $5,400,500 20% $1,080,000

0% $4,500,000 20% $ 900,000

-20% $3,600,000 20% $ 720,000

Working capital strategiesWorking capital strategies

• Profitability and risk trade-offs• Impact of working capital strategies• Short-term financial management

objectives• The cash conversion cycle• Financial forecasts

Profitability and risk trade-offsProfitability and risk trade-offs

1. Profitability vs. risk trade-off

2. Components of cash cycle:a. Average collection periodb. Average age of inventoryc. Average payment period

3. Managing the cash conversion cycle

Current Assets

Net WorkingCapital > 0

Fixed Assets

Current Liabilities

Long-TermDebt

Equity

low return

high return

low cost

high cost

highest cost

Lower return / lower risk profileLower return / lower risk profile

Positive Net Working Capital: Lower Return / Lower Risk

Current Assets

Fixed Assets

Current Liabilities

Net WorkingCapital < 0

Long-TermDebt

Equity

low return

high return

low cost

high cost

highest cost

High return vs. high risk profileHigh return vs. high risk profile

Negative Net Working Capital: Higher Return / Higher Risk

Effect of working capital strategies on profits and riskEffect of working capital strategies on profits and risk

Ratio Change Profits Impact Risk Impact

Current Assets / Total Assets

Increase Decrease Decrease

Decrease Increase Increase

Current Liabilities /Total Assets

Increase Increase Increase

Decrease Decrease Decrease

Short-Term financial management objectivesShort-Term financial management objectives

• Manage current assets and liabilities to balance profitability and risk

• Central to short-term financial management is an understanding of the cash conversion cycle

Average collection periodAverage collection period

• Average length of time from a sale on credit until the collection of funds

• Consists of two parts:1. Time from a sale until the customer mails payment

2. Time from mailing of payment until the collection of funds in the bank account

• Calculated as:

Accounts Receivable

Average Sales Per Day

Average age of inventoryAverage age of inventory

• # of days an average inventory item takes to sell

• Calculated as :

• Example: average inventory is $47,500, and cost of goods sold is $500,000.

$47,500

x 365 days = 34.7 days

$500,000

Average Inventory x 365 days

Cost of Goods Sold

Average payment periodAverage payment period

• The average payment period has two parts: 1. the time from purchase of goods on account

until the firm mails its payment2. the receipt, processing, and collection time

required by the firm’s suppliers• Calculated as:

Accounts Payable

Average Purchases per Day

Operating & cash conversion cyclesOperating & cash conversion cycles• Operating Cycle: time between ordering

materials & collections from receivablesAverage Age of Inventory

+ Average Collection Period

• Cash Conversion Cycle: time between payments to suppliers and collection of cash from sales

= Operating Cycle – Average Payment Period

Calculating the cash conversion cycleCalculating the cash conversion cycle

Variable DataAverage Age of Inventory 60 daysAverage Collection Period 40 daysAverage Payment Period 35 days

Cash Conversion Cycle:= 60 + 40 – 35 = 65 days

Cash conversion cycle: graphic illustrationCash conversion cycle: graphic illustration

Time = 0 100 daysOperating Cycle

Average Age of Inventory

60 days

Average Collection Period

40 days

Purchase of Materials on Account

Sell Goods on Account

Collect Receivables

Average Payment Period

35 days

Cash Conversion Cycle

65 days

Pay AccountsPayable

Cash Inflow

Cash Outflow

Reducing the cash conversion cycle reduces the amount of resources required to support operations

Resources invested in the cash conversion cycleResources invested in the cash conversion cycle

Sales forecastsSales forecasts

• Forecasting steps:1. Project on the basis of historical growth2. Assess the level of economic activity in the

relevant marketing areas3. Planning: market share targets, production and

distribution capacity, competition, pricing strategies, inflation, impact of government policies, …

4. Factor in advertising campaigns, promotional discounts, credit terms, ….

• Serious impacts when forecast is off

Financial statement forecastingFinancial statement forecasting

1. Forecasted income statement– Assume that costs increase at the same rate

as sales, or– Forecast specific costs separately

2. Forecast the balance sheet– If sales increase, assets must also grow– Liabilities and equity must also increase

3. Determine additional funds needed4. Analyze the forecast

Forecasting Additional Funds Needed (AFN Formula)Forecasting Additional Funds Needed (AFN Formula)

1) Pct of assets tied to sales / change in sales

2) Pct of liabilities that increase with sales / change in sales

3) Profit margin * sales (1- dividend payout)

Additional Funds Needed

Required increasein assets

Spontaneousincrease inliabilities

Increase inretainedearnings

= - -

(3)(2)(1)

Using AFNUsing AFN

1. ($2 mill. / 3 mill.) * $300K = $200K2. [($60K+$140K) / $3 mill.] * $300K = $20K3. ($114K / $ 3 mill.) * [1 – ($58K/$114K)] = $62K

AFN = $200K - $20K - $62K = $118K

From Income Statement From Balance Sheet2009 Sales $ 3 mill. Cash: $ 10K Payables: $ 60K 2010 Forecast 3.3 mill. Receivables: 75K Accruals: 140K

Change $ 300K Inventories: 615K Current Assets $ 1 mill.

‘09 Net income $ 114K Plant/Equip.: 1 mill. Dividends 58K Total Assets $ 2 mill.

Use of regression analysis in forecastingUse of regression analysis in forecasting

Year Sales Inventories Receivables

2005 $ 2,058 $ 387 $ 268

2006 2,534 398 297

2007 2,472 409 304

2008 2,850 415 315

2009 3,000 615 375

Regression on Inventories  Coefficients

Intercept -35.7X Variable 1 0.186

Regression on Receivables  Coefficients

Intercept 62.0X Variable 1 0.097

Correlation 71%

Correlation 89%

Application of regression analysisApplication of regression analysis

Year Sales Inventories Ratio Receivables Ratio

2005 $ 2,058 $ 387 19% $ 268 13%

2006 2,534 398 16% 297 12%

2007 2,472 409 17% 304 12%

2008 2,850 415 15% 315 11%

2009 3,000 615 21% 375 13%

2010E 3,300 578 18% 382 12%

Inventory Estimate = -35.7+0.186*Sales

Receivables Estimate = 62+0.097*Sales

Visualizing the forecastVisualizing the forecast

$2,000 $2,500 $3,000 $3,500 $4,000 $-

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Sales vs Inventories Line Fit

Sales

Invento

ries

$2,000 $2,200 $2,400 $2,600 $2,800 $3,000 $3,200 $3,400 $-

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Sales vs. Receivables Line Fit

Sales

Invento

ries