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

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 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.

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–3 Working-CapitalWorking-Capital Working-Capital Management –The management of current assets and current liabilities Net Working Capital –The sum of a firm’s current assets (cash, accounts receivable, and inventories) less current liabilities (short-term notes, accounts payable, and accruals) Working-Capital Cycle –The daily flow of resources through a firm’s working- capital accounts

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–4 The Working-Capital Cycle (cont’d.) 1.Purchase or produce inventory for sale, which increases accounts payable. 2.a.Sell inventory for cash. b.Sell inventory for credit (accounts receivable). 3.Pay the accounts payable (decreases cash and accounts payable). 4.Collect the accounts receivable (decreases accounts payable and increases cash). 5.Begin the cycle again.

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–5 Exhibit 22.1 The Working Capital Cycle

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–6 Exhibit 22.2 Working-Capital Time Line Source: Adapted from Terry W. Maness and John T. Zeitlow, Short-Term Financial Management (New York: Dryden Press/Harcourt Brace, 1998), p. 4. Cash conversion period— the time required to convert paid-for inventories and accounts receivable into cash. 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.

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–7 Exhibit 22.3 Working-Capital Time Lines for Pokey, Inc., and Quick Turn Company

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–8 Pokey, Inc.’s Beginning Balance Sheet

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–9 Pokey, Inc.’s Monthly Balance Sheets 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

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–10 Pokey, Inc.’s Monthly Balance Sheets 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 –

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–11 Changes in Pokey’s Balance Sheet Change in the Balance SheetEffect on Income Statement Increase accounts receivable of $900  Sales$900 Decrease inventories of $500  Cost of goods sold$500 Increase in accrued operating  Operating expenses$250 expenses of $250 Increase accumulated depreciation of $50  Depreciation expense$50 Increase accrued taxes of $25  Tax expense$25

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–12 Pokey, Inc.’s Monthly Balance Sheets

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–13 Pokey’s November Income Statement Sales revenue900 Cost of goods sold500 Gross Profit400 Operating expenses: Cash250 Depreciation50 Total operating expenses300 Operating income100 Income tax (25%)25 Net income75

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–14 Managing Cash Flows The Nature of Cash Flows –The flow of actual cash through a firm Net Cash Flow –The difference between inflow and outflows Net Profit –The difference between revenue and expenses The Growth Trap –A cash shortage resulting from rapid growth

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–15 Exhibit 22.4 Flow of Cash Through A Business

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–16 Three-Month Cash Budget for the Davies Corporation for July–September May June JulyAugustSeptember Monthly Sales$100,000$120,000 $130,000 $130,000$120,000 Cash receipts Cash sales for month (40%) $ 52,000 $ 52,000 $ 48,000 1 month after sale (30%)36,000 39,000 39,000 2 months after sale (30%)30,000 36,00039,000 Step 1Total collections$118,000$127,000$126,000 Purchases (80% of sales)$104,000 $104,000 $ 96,000$ 80,000 Cash disbursements Step 2a Payments on purchases$104,000$104,000$ 96,000 Rent3,0003,0003,000 Wages and salaries18,00018,00016,000 Step 2bTax prepayment1,000 Utilities (2% of sales)2,600 2,600 2,400 Interest on long-term note800 Step 2cShort-term interest (1% of short-term debt) Total cash disbursements$128,600$127,706$118,313 Step 3Net change in cash$ 10,600$ 706$ 7,687 Step 4Beginning cash balance5,0005,0005,000 Step 5Cash balance before borrowing$ 5,600$ 4,294$ 12,687 Step 6Short-term borrowing (payments)10, ,687 Ending cash balance$ 5,000$ 5,000$ 5,000 Step 7Cumulative short-term debt outstanding$ 10,600$ 11,306$ 3,619 Exhibit 22.5

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–17 Managing Accounts Receivable How 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 Receivable –Firm makes credit sale to customer. –Invoice is prepared and sent to customer. –Customer pays firm.

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–18 Credit Management Practices Minimize the time between shipping, invoicing, and sending notices on billings. Review previous credit experiences to determine impediments to cash flows. Provide incentives for prompt payment. 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 a lock box—a post office box for receiving remittances.

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–19 Managing Accounts Receivable (cont’d.) Accounts 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

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–20 Managing Inventories Inventory is a “necessary evil.” –Product supply and consumer demand don’t always match up. Reducing Inventory to Free Cash –Monitoring current inventory Determine age and suitability for sale. –Controlling stockpiles Match on-hand inventory with demand. Avoid personalizing the business-customer relationship. Avoid forward purchasing of inventory; the carrying cost for excess inventory may exceed any savings.

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–21 Managing Accounts Payable Negotiation –Ask creditors for adjustments or additional time. Timing –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.

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–22 An Accounts Payable for Terms 3/10, Net 30 Exhibit 22.6 Annualized interest rate discount% Cash %discount Cash x perioddiscount Cash - periodNet yearin Days  56.4% or 0.564, x 

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–23 Capital Budgeting Capital Budgeting Analysis –An analytical method that helps managers make decisions about long-term investments such as: Developing new productsReplacing equipment Constructing new facilitiesExpanding 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.

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–24 Three Rules of Capital Budgeting Investors judging the attractiveness of an investment prefer: –More cash rather than less cash. –Cash sooner rather than later. –Less risk rather than more risk.

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–25 Capital Budgeting Techniques 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 will it take 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?

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–26 Capital Budgeting Techniques (cont’d.) Accounting return on investment –Evaluation of a capital expenditure based on the average annual after- tax profits relative to the average book value of an investment 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

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–27 Capital Budgeting Techniques Payback period –Measuring the amount of time it will take to recover the cash outlay of an investment 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

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–28 Discounted Cash Flows Discounted Cash Flows (DCF) –An analysis comparing the present value of future cash flows with the cost of the initial investment –Considers that 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

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–29 A Firm’s Cost of Capital Cost of Capital –The rate of return required to satisfy a firm’s debt holders and investors Opportunity Cost –The rate of return that could be earned on another investment of similar risk

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–30 Measuring the Cost of Capital Weighted Cost of Capital –The cost of capital adjusted to reflect the relative costs of debt and equity financing Weighted WeightCostCost Debt40%7.5%3.0 % Equity 60%18.0%10.8% Total100%13.8%

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–31 Using the Cost of Debt as an Investment Criterion Favorable Financial Leverage –A benefit gained by investing at a rate of return that is greater than the interest rate on a loan Debt Capacity –The limit at which a firm cannot assume more debt without additional equity investment by its owners

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–32 Capital Budgeting Practices of Small Firms 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

Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 22–33 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)