1. Managing the Firm’s Assets
PART 5 Managing Growth in the Small Business

2. Looking Ahead After studying this chapter, you should be able to:
Describe the working-capital cycle of a small business.
Identify the important issues in managing a firm’s cash flows
Explain the key issues in managing accounts receivable, inventory, and accounts payable.
Calculate and interpret a company’s conversion period.
Discuss the techniques commonly used in making capital budgeting decisions.
Describe the capital budgeting practices of small firms.

3. The Working-Capital Cycle
Working-Capital Management
The management of current assets and current liabilities
Net 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 Cycle
The daily flow of resources through a firm’s working-capital accounts

4. The Working Capital Cycle1 2
Purchase or produce inventory for sale, which increases accounts payable. 3
Sell inventory for cash; sell inventory for credit (accounts receivable). 4
Pay the accounts payable (decreases cash and accounts payable). 5
Collect the accounts receivable (decreases accounts payable and increases cash).
Begin cycle again.

5. Exhibit 22.1 Working-Capital Cycle

6. Exhibit 22.2 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.

7. Exhibit 22. 3. Working-Capital Time Lines for Pokey, Inc
Exhibit 22.3 Working-Capital Time Lines for Pokey, Inc., and Quick Turn Company

8. Pokey, Inc.’s Beginning Balance Sheet

9. Pokey, Inc.’s Monthly Balance Sheets
July
Aug.
Sept.
Cash
400
(100)
Accounts receivable
Inventory
500
Fixed assets
600
Accumulated depreciation
TOTAL ASSETS
1,000
1,500
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
300
Common debt
700
Retained earnings
TOTAL DEBT AND EQUITY
Changes: August to September
–500

10. Pokey, Inc.’s Monthly Balance Sheets
July
Aug.
Sept.
Oct.
Cash
400
(100)
Accounts receivable
900
Inventory
500
Fixed assets
600
Accumulated depreciation
(50)
TOTAL ASSETS
1,000
1,500
1,350
Accounts payable
Accrued operating expenses
250
Income tax payable 25
Long-term debt
300
Common debt
700
Retained earnings 75
TOTAL DEBT AND EQUITY
Changes: September to October
+900
–500
–50
+250
+25
+75

11. Changes in Pokey’s Balance Sheet
Change in the Balance Sheet Effect 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

12. Pokey, Inc.’s Monthly Balance Sheets
Changes: October to November
+650
–900
–250
July
Aug.
Sept.
Oct.
Nov.
Cash
400
(100)
550
Accounts receivable
900
Inventory
500
Fixed assets
600
Accumulated depreciation
(50)
TOTAL ASSETS
1,000
1,500
1,350
1,100
Accounts payable
Accrued operating expenses
250
Income tax payable 25
Long-term debt
300
Common debt
700
Retained earnings 75
TOTAL DEBT AND EQUITY

13. Pokey’s November Income Statement
Sales revenue
900
Cost of goods sold
500
Gross Profit
400
Operating expenses:
Cash
250
Depreciation 50
Total operating expenses
300
Operating income
100
Income tax (25%) 25
Net income 75

14. The Nature of Cash Flows Revisited
Managing Cash Flows
The 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 Flow
The difference between inflow and outflows
Net Profit
The difference between revenue and expenses
The Growth Trap
A cash shortage (cash crunch) resulting from rapid growth

15. Exhibit 22.4 Flow of Cash through a Business

16. 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.

17. Managing Accounts Receivable (cont’d)
Days Sales Outstanding
Average collection period—number of days, on average, a firm is extending credit to its customers.
Days sales outstanding =
Accounts receivable
Annual credit sales ÷ 365 days
Example:
Fast Co.
Slow Co.
Total sales
$1,000,000
Credit sales
700,000
Average credit sales per day
1,918
Accounts receivable
48,000
63,300
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

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.

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

20. Cost of goods sold ÷ 365 days
Managing Inventories
Inventory is a “necessary evil.”
Product supply and consumer demand don’t always match up.
Monitoring 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.
Days in inventory =
Inventory
Cost of goods sold ÷ 365 days

21. Reducing Inventory to Free Cash
Managing Inventories
Reducing 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. Managing Accounts Payable
Negotiation
Asks 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.

23. Exhibit 22.5 An Accounts Payable Timetable for Terms of 3/10, Net 30
Annualized interest rate
discount%
Cash -
100 %
discount x
period
Net
year in
Days =
56.4% or
0.564, x
18.25 =

24. Capital 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.

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 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?

26. 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.

27. Capital Budgeting Techniques (cont’d)
Accounting Return on Investment
The average annual after-tax profits relative to the average book value of an investment.
Initial investment = $10,000
Year After-Tax Profits 1 1, , , ,000 2
000 10 4 3
500 1 + = ,
Accounting return on investment
42.5% or
0.425,
5,000
2,125 =

28. Capital Budgeting Techniques (cont’d)
Payback Period
Measuring the amount of time it will take to recover the cash outlay of an investment.
Original Investment = $15,000
Annual Depreciation = $1,500
Acceptable payback period= 5 years
Payback period = 4.86 years
After-Tax Year Profits 1–2 1,000 3–6 2,000 7–10 2,500
After-Tax Cash Flows 2,500 3,500 4,000
Investment Recovery Year 1-2 Year , ,500

29. 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.

30. A Firm’s 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.

31. Capital Budgeting Analysis in 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

32. Key Terms working-capital management working-capital cycle
cash conversion period
days sales outstanding (average collection period)
lock box
pledged accounts receivable
days in inventory
days in payables
capital budgeting analysis
accounting return on investment technique
payback period technique
discounted cash flow (DCF) techniques
net present value (NPV)
internal rate of return (IRR)