1.Describe the working-capital cycle of a small firm. 2.Identify the important issues in managing a firm’s cash flows 3.Explain the key issues in managing accounts receivable. 4.Discuss the key issues in managing inventory. 5.Explain the key issues in managing accounts payable. 6.Calculate and interpret a firm’s cash conversion period. 7.Discuss the techniques commonly used in making capital budgeting decisions. 8.Describe the capital budgeting practices of small firms. 22–2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Working-Capital Cycle Working-Capital ManagementWorking-Capital Management  The management of current assets and current liabilities Net Working CapitalNet Working Capital  The sum of a firm’s current assets (cash, account receivable, and inventories) less current liabilities (short-term notes, accounts payable, and accruals) Working-Capital CycleWorking-Capital Cycle  The daily flow of resources through a firm’s working- capital accounts 22–3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22–4 1 Collect the accounts receivable (decreases accounts payable and increases cash). Sell inventory for cash; sell inventory for credit (accounts receivable). The Working Capital Cycle Purchase or produce inventory for sale, which increases accounts payable. Pay the accounts payable (decreases cash and accounts payable). 234 Begin cycle again. 5 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22–5 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Working Capital Cycle 22.1

22–6 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Working Capital Time Line Day a. Inventory is ordered in anticipation of future sales. Day b. Inventory is received. Day c. Inventory is sold on credit. Day d. Accounts payable come due and are paid. Day e. Accounts receivable are collected Cash conversion period— the time required to convert paid- for inventories and accounts receivable into cash.

22–7 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Working Capital Time Lines for Pokey, Inc., and Quick Turn Company 22.3

Pokey, Inc.’s Beginning Balance Sheet © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22–8

Pokey, Inc.’s Monthly Balance Sheets © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22–9 JulyAug.Sept. Cash400 (100) Accounts receivable000 Inventory0500 Fixed assets600 Accumulated depreciation000 TOTAL ASSETS1,0001,5001,000 Accounts payable05000 Accrued operating expenses000 Income tax payable000 Long-term debt300 Common debt700 Retained earnings000 TOTAL DEBT AND EQUITY1,0001,5001,000 Changes: August to September –500

Pokey, Inc.’s Monthly Balance Sheets © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22–10 JulyAug.Sept.Oct. Cash400 (100) Accounts receivable Inventory Fixed assets600 Accumulated depreciation000(50) TOTAL ASSETS1,0001,5001,0001,350 Accounts payable Accrued operating expenses Income tax payable00025 Long-term debt300 Common debt700 Retained earnings00075 TOTAL DEBT AND EQUITY1,0001,5001,0001,350 Changes: September to October +900 –500 –

Changes in Pokey’s Balance Sheet © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22–11 Change in the Balance SheetEffect on Income Statement Increase accounts receivable of $900  Sales of$900 Decrease inventories of $500  Cost of goods sold of$500 Increase in accrued operating  Operating expenses of$250 expenses of $250 Increase accumulated depreciation of $50  Depreciation expense of$50 Increase accrued taxes of $25  Tax expense of$25

Pokey, Inc.’s Monthly Balance Sheets © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22–12

Pokey’s November Income Statement © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22–13 Sales revenue900 Cost of goods sold(500) Gross profit400 Operating expenses: Cash(250) Depreciation expense(50) Total operating expenses(300) Operating income100 Income tax (25%)(25) Net income75

Managing Cash Flows The Nature of Cash Flows RevisitedThe Nature of Cash Flows Revisited  The flow of actual cash through a firm determines whether or not the firm can meet its current obligations. Net Cash FlowNet Cash Flow  The difference between inflow and outflows Net ProfitNet Profit  The difference between revenue and expenses The Growth TrapThe Growth Trap  A cash shortage (cash crunch) resulting from rapid growth 22–14 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22–15 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Flow of Cash Through a Business 22.4

Managing Accounts Receivable How Accounts Receivable Affect CashHow Accounts Receivable Affect Cash  Accounts receivable represent the firm’s decision to delay the inflow of cash from customers who have been extended credit. Life Cycle of Accounts ReceivableLife Cycle of Accounts Receivable  Firm makes credit sale to customer.  Invoice is prepared and sent to customer.  Customer pays firm. 22–16 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Accounts Receivable (cont’d) Days Sales OutstandingDays Sales Outstanding  Average collection period—number of days, on average, a firm is extending credit to its customers. 22–17 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Days sales outstanding = Accounts receivable Annual credit sales ÷ 365 days Example: Fast Co. Slow Co. Total sales $1,000,000$1,000,000 Credit sales 700,000700,000 Average credit sales per day 1,9181,918 Accounts receivable 48,00063,300 Fast Co.’s Days Sales Outstanding =48,000 = 25 days 700,000 ÷ 365 Slow Co.’s Days Sales Outstanding =63,300 = 33 days 700,000 ÷ 365

Managing Collections on Accounts Hire someone else to handle collections one day per week.Hire someone else to handle collections one day per week. Accept credit cards.Accept credit cards. Sell the receivables to a third party.Sell the receivables to a third party. Where possible, require prepayment.Where possible, require prepayment. For a service business, write a detailed work plan and payment schedule and have it signed by the customer.For a service business, write a detailed work plan and payment schedule and have it signed by the customer. 22–18 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Credit Management Practices Minimize the time between shipping, invoicing, and sending notices on billings.Minimize the time between shipping, invoicing, and sending notices on billings. Review previous credit experiences to determine impediments to cash flows.Review previous credit experiences to determine impediments to cash flows. Provide incentives for prompt payment.Provide incentives for prompt payment. Age accounts receivable on a monthly or even a weekly basis to identify delinquent accounts.Age accounts receivable on a monthly or even a weekly basis to identify delinquent accounts. Use the most effective methods for collecting overdue accounts.Use the most effective methods for collecting overdue accounts. Use a lock box—a post office box for receiving remittances.Use a lock box—a post office box for receiving remittances. 22–19 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Accounts Receivable (cont’d) Accounts Receivable FinancingAccounts Receivable Financing  Pledged accounts receivable  Accounts receivable used as collateral for a loan.  Factoring  Obtaining cash by selling accounts receivable at a discount to another firm.  Advantage –Immediate cash flow  Disadvantages –High interest costs for loans funds and discounts for factored receivables –Loss of receivables as collateral in borrowing 22–20 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Inventory Inventory is a “necessary evil.”Inventory is a “necessary evil.”  Product supply and consumer demand don’t always match up. Monitoring InventoryMonitoring Inventory  Determine age and suitability for sale.  Slowing moving inventory can create cash flow problems.  Days in inventory—number of days, on average, that a company is holding inventory. 22–21 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Days in inventory =Inventory Cost of goods sold ÷ 365 days

Managing Inventory Reducing Inventory to Free CashReducing Inventory to Free Cash  Controlling stockpiles  Match on-hand inventory with demand.  Avoid personalizing the business-customer relationship.  Avoid forward purchasing of inventory; carrying cost for excess inventory may exceed any savings. 22–22 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Accounts Payable NegotiationNegotiation  Ask creditors for adjustments or additional time. TimingTiming  Creditors’ funds can supply short-term cash needs until payment is demanded.  Accounts with cash discounts for early payment should be examined for their savings potential.  “Buy now, pay later”—pay early enough to get cash discounts and timely enough to avoid late-payment fees. 22–23 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22–24 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. An Accounts Payable Timetable for Terms of 3/10, Net 30 Annualized interest rate discount% Cash %discount Cash x perioddiscount Cash - periodNet yearin Days  56.4% or 0.564, x 22.5

Capital Budgeting Capital Budgeting AnalysisCapital Budgeting Analysis  Helps managers make decisions about long-term investments such as:  Developing new products  Replacing equipment  Constructing new facilities  Expanding sales territories  Seeks to answer the question:  “Do future benefits from the investment exceed the cost of making the investment?”  Good decisions can add value to the firm; bad decisions can put the firm out of business. 22–25 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting Techniques Capital Budgeting Decisions Involve:Capital Budgeting Decisions Involve:  Accounting return on investment  How many dollars in average profits are generated per dollar of average investment?  Payback period  How long to recover the original profit outlay?  Discounted cash flows (net present value or internal rate of return)  How does the present value of future benefits from the investment compare to the investment outlay? 22–26 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Three Rules of Capital Budgeting Investors judging the attractiveness of an investment prefer:Investors judging the attractiveness of an investment prefer: 1. More cash rather than less cash. 2. Cash sooner rather than later. 3. Less risk rather than more risk. 22–27 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting Techniques (cont’d) Accounting Return on InvestmentAccounting Return on Investment  The average annual after-tax profits relative to the average book value of an investment. 22–28 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. YearAfter-Tax Profits 11,000 22,000 32,500 43, =,,,,, Accounting return on investment 42.5% or0.425, 5,000 2,125 = = Initial investment = $10,000

Capital Budgeting Techniques (cont’d) Payback PeriodPayback Period  Measuring the amount of time it will take to recover the cash outlay of an investment. 22–29 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. After-Tax YearProfits 1–21,000 3–62,000 7–102,500 After-Tax Cash Flows 2,500 3,500 4,000 Investment Recovery Year 1-2Year 3-5 5,000 10,500 Original Investment = $15,000 Acceptable payback period= 5 years Payback period = 4.86 years Annual Depreciation = $1,500

Discounted Cash Flows Discounted Cash Flows (DCF)Discounted Cash Flows (DCF)  Comparing the present value of future cash flows with the cost of the initial investment.  Cash received today is more valuable than cash to be received in the future—the time value of money.  Net present value (NPV)  The current value of cash that will flow from a project over time less the initial investment outlay.  Internal rate of return (IRR)  The rate of return that a firm expects to earn on a project; return rate must exceed cost of capital. 22–30 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Firm’s Cost of Capital Cost of CapitalCost of Capital  The rate of return required to satisfy a firm’s debt holders and investors. Opportunity CostOpportunity Cost  The rate of return that could be earned on another investment of similar risk. 22–31 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting Analysis in Small Firms Factors Affecting the Capital Budgeting Analysis Process:Factors Affecting the Capital Budgeting Analysis Process:  Nonfinancial (personal) variables  Undercapitalization and liquidity problems  Uncertainty of cash flows within the firm  Lack of established market value for the firm  Small size, scope, and length of firm’s projects  Lack of managerial experience and talent in firm 22–32 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Key Terms accounting return on investment technique capital budgeting analysis cash conversion period days in inventory days in payables days sales outstanding (average collection period) discounted cash flow (DCF) techniques internal rate of return (IRR) lock box net present value (NPV) payback period technique pledged accounts receivable working capital cycle working capital management 22–33 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.