1. PowerPoint Presentation by Charlie Cook The University of West Alabama Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Part 6 Understanding the Numbers Managing Assets

2. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 22–2 Looking Ahead After studying this chapter, you should be able to: 1. Describe the working-capital cycle of a small business. 2. Identify the important issues in managing a firm’s cash flows, including the preparation of a cash budget. 3. Explain the key issues in managing accounts receivable, inventory, and accounts payable. 4. Discuss the techniques commonly used in making capital budgeting decisions. 5. Describe the capital budgeting practices of small firms.

3. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 22–3 The Working-Capital Cycle The working-capital cycle begins with the purchase of inventory and ends with the collection of accounts receivable. The cash conversion period is critical because it is the time period during which cash flow problems can arise and a firm can become insolvent.

4. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 22–4 Managing Cash Flow A firm’s cash flows consist of cash flowing into a business (through sales revenue, borrowing, and so on) and cash flowing out of the business (through purchases, operating expenses, and so on). Profitable small companies sometimes encounter cash flow problems by failing to understand the working- capital cycle or failing to anticipate the negative consequences of growth. Cash inflows and outflows are reconciled in the cash budget, which involves forecasts of cash receipts and expenditures.

5. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 22–5 Managing Accounts and Inventory Granting credit to customers, primarily a marketing decision, directly affects a firm’s cash account. A firm can improve its cash flows by speeding up collections from customers, minimizing inventories, and delaying payments to suppliers. Some small businesses speed up the cash flows from receivables by borrowing against them. A concerted effort to manage inventory can trim excess inventory and free cash for other uses.

6. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 22–6 Managing Accounts and Inventory (cont’d.) Accounts payable, a primary source of financing for small firms, directly affect a firm’s cash flow situation. Financial management of accounts payable hinges on negotiation and timing.

7. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 22–7 Capital Budgeting Decisions Capital budgeting techniques attempt to determine whether future benefits from an investment will exceed the initial outlay. Capital budgeting techniques include the accounting return on investment, the payback period, and the discounted cash flow techniques. The accounting return on investment technique has two significant shortcomings: It is based on accounting profits rather than actual cash flows received, and it ignores the time value of money.

8. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 22–8 Capital Budgeting Decisions (cont’d.) The payback period technique also has two major weaknesses: It ignores the time value of money, and it doesn’t consider cash flows received after the payback period. The discounted cash flow techniques—net present value and internal rate of return—provide the best accept– reject decision criteria in capital budgeting analysis.

9. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 22–9 Capital Budgeting Practices in Small Firms Few small firms use any type of discounted cash flow technique. In fact, the majority of small companies do not use any formal analysis whatsoever. The very nature of small firms may explain, to some degree, why they seldom use the conceptually richer techniques for evaluating long-term investments.

10. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 22–10 Key Terms working-capital management net operating working capital working-capital cycle cash conversion period cash budget lock box pledged accounts receivable capital budgeting analysis accounting return on investment technique payback period technique discounted cash flow (DCF) technique net present value (NPV) internal rate of return (IRR)