Chapter 15 Managing Working Capital © 2003 John Wiley and Sons

2 Chapter Outcomes n Explain what is meant by a firm’s operating cycle and its cash conversion cycle. nDescribe the impact of the operating cycle on the size of investment in accounts receivable and inventories. nExplain how seasonal and cyclical trends affect the operating cycle, cash conversion cycle, and investments in current assets.

3 Chapter Outcomes n Explain how a cash budget is developed and how a treasurer will use it. n Describe the motives underlying the management of cash and marketable securities n Briefly explain what is involved in accounts receivable management and indicate how it is carried out. n Describe inventory management from the standpoint of the financial manager.

4 Importance of Working Capital Issues n Current assets typically comprise % of a firm’s assets n Main day-to-day focus of financial managers n Mismatch between current assets and financing  cash crunch, bankruptcy possibilities

5 Operating Cycle Operating cycle: time between ordering materials from suppliers and collecting cash following their sale as finished products = inventory conversion period + average collection period = 365 / inventory turnover + AR / (sales/365)

6 Operating Cycle Collection Period Materials Orders Manufacturing Process Selling Effort Cash Finished Inventory Accounts Receivable

7 Cash Conversion Cycle Cash conversion cycle: time between paying cash to suppliers for material and collecting cash from customers from their subsequent sale =Operating cycle - Avg payment period where Avg payment period = Accounts Payable / (COGS/365)

8 Cash Conversion Cycle, continued n The cash conversion cycle measures the financing gap in terms of time n As the cash conversion cycle increases, the firm’s financing needs grow larger

9 Timelines for the Operating and Cash Conversion Cycles RawFinished MaterialsGoodsCash OrderedSoldReceived Accounts Inventory PeriodReceivable Period Time Accounts Payable Period Cash Paid Operating Cycle Cash Conversion Cycle

10 Working Capital Needs Working capital requirements are affected if sales change or if the cash conversion cycle components change

11 n Receivables investment = net sales per day x average collection period n Inventory investment = COGS per day x inventory conversion period n Payables financing = COGS per day x average payment period

12 Effect of 10 Percent Increase in Sales and Cost of Goods Sold Assumptions: Average Collection Period = 52 days Inventory Period = 101 days Average Payment Period = 63 days Net sales per day= $1,918 Cost of goods sold per day=$1,233

13 Effect on investment, financing BASE 10% INCREASE IN CASE SALES & COGS Investment: AR $100,000$110,000 Inventories 125, ,000 Total $225,000$248,000 Financing: AP $ 78,000 $ 85,000 Net Investment: $147,000$163,000

14 Effect of 10 Percent Increase in Sales and Cost of Goods Sold Shorter cash conversion cycle assumptions: Average Collection Period = 50 days Inventory Period = 90 days Average Payment Period = 70 days Net sales per day= $1,918 Cost of goods sold per day=$1,233

15 Effect on investment, financing BASE 10% INCREASE IN CASE SALES & COGS Investment: AR $100,000$106,000 Inventories 125, ,000 Total $225,000$228,000 Financing: AP $ 78,000 $ 94,920 Net Investment: $147,000$133,080

16 Cash Budget n Short-term forecast of cash inflows and outflows n Daily, weekly, monthly, quarterly n Helpful in estimating short-term borrowing needs, lender repayments

17 Cash Budget Inputs n Minimum desired cash balance n Cash inflows –sales forecast –customer payment patterns n Cash outflows –fixed outflows (interest, rent, lease) –supplier payments –effect of seasonal vs. level production

18 Monthly Cash Inflows NOV. DEC. JAN.FEB. Sales $80,000 $100,000 $30,000 $40,000 Collections: (50% of sales of the previous month) 40,000 50,000 15,000 (50% of sales of the 2nd previous month) 40,000 50,000 Total Cash Receipts $90,000$65,000

19 Monthly Cash Outflows NOV.DEC.JAN.FEB. Sales$80,000$100,000$30,000$ 40,000 Materials and supplies purchases (50% of monthly sales) 40,000 50,000 15,000 20,000 Payments: (100% of purchases of the second previous month) 40,000 50,000 Salaries and overhead 20,000 20,000 Interest 7,000 Capital expenditures 50,000 Total Cash Payments$60,000 $127,000

20 Net Monthly Cash Flows JAN.FEB. Total Cash Receipts$90,000 $65,000 less: Total Cash Payments 60, ,000 Net Cash Flow $30,000 ($62,000)

21 Cash Budget, January and February JAN.FEB. Net cash flow$30,000 ($62,000) Beginning cash balance$25,000 $55,000 Cumulative cash balance$55,000 ($ 7,000) Monthly loan (or repayment)0 $32,000 Cumulative loan balance0 $32,000 Ending Cash Balance$55,000 $25,000

22 Seasonal vs. Level Production Issues for Firms with Seasonal Sales n Seasonal Production: –Raw materials purchased shortly before sales occur –Lower inventories –Idle plant, laid-off workers in slow season –Production bottlenecks in busy season

23 Level Production Issues n Produce equal amounts each month to meet annual sales forecast n Inventory build up prior to selling season n Cash outflows during year with little cash inflow

24 Management of Current Assets n Cash and Marketable Securities n Accounts Receivable Management n Inventory Management

25 Cash and Marketable Securities n Why should a business hold cash and marketable securities? n Transactions motive n Precautionary motive n Speculative motive

26 Desirable Characteristics of Marketable Securities n Highly liquid n Short-term maturity n High quality issuer

27 Types of Marketable Securities n U.S. Treasury bills n Commercial paper n Negotiable Certificates of Deposit n Bankers’ Acceptances n Eurodollars

28 Getting and Keeping the Cash n Goal: shorten cash conversion cycle by speeding up receipts, slowing disbursements n Float: delay between when funds are sent by a payer to the payee –Collection float –Disbursement

29 Reduce Collection Float n Lockbox system n Pre-authorized checks

30 Increase Disbursement Float n Zero Balance Account n Will float eventually disappear? –Electronic payment systems

31 Accounts Receivable Management n Credit Analysis n Setting Credit Terms n Collection Efforts

32 Credit Analysis n 5 C’s –Character –Capacity –Capital –Collateral –Conditions n Credit bureaus n Credit scoring

33 Credit Terms Payment terms and accounts receivable balance Terms of net 60 imply an AR turnover of about 6 (365/60) If net sales = $720,000, Average AR = $720,000/6 = $120,000 Impose net 50 credit terms; ARTO=7.3 Average AR = $720,000/7.3=$100,000 Reduction of $20,000; with a 15% financing cost, savings = $3,000

34 Collection n Changing exchange rates in global business n Selling firm can –Require payment in the selling firm’s home currency –Use futures or options contracts to reduce risk if customer pays in their own currency

35 Collection Effort n Cost of process n Customer alienation versus benefits

36 Changes in Credit Policy n Compare marginal benefits and marginal costs of changing credit policy, terms n Benefits: change in net sales, profits n Costs: changes in working capital accounts need to be financed n Consider changing policy if marginal benefits exceed marginal costs

37 Inventory Management n Production efficiency versus storage costs, insurance costs, financing costs n Economic Ordering Quantity (EOQ) Q * =  [(2 S O)/C] S=unit sales 0 = ordering costs per order C= carrying costs per unit

38 An example n Sales are 50,000 shirts/year n Ordering costs are $200 per order n Carrying costs (storage, insurance) are $2.00 per shirt n Q * =  [(2 S O)/C] =  [(2 x 50,000x200)/2.00] = 3,162.3 units; order 3,162 units/order

39 Modern Working Capital Management n JIT: Just-in-time n JIT II n B2B portals n XML n Firms have an incentive to reduce working capital to free up cash and reduce financing costs.