1. 20 - 1 Copyright © 2002 South-Western CHAPTER 20 Current Asset Management Alternative working capital policies Cash management Inventory management Accounts receivable management

2. 20 - 2 Copyright © 2002 South-Western Basic Definitions Gross working capital: Total current assets. Net working capital: Current assets - Current liabilities. Working capital policy: The level of each current asset. How current assets are financed. (More…)

3. 20 - 3 Copyright © 2002 South-Western Working capital management: Includes both establishing working capital policy and then the day-to-day control of: Cash Inventories Receivables Short-term liabilities

4. 20 - 4 Copyright © 2002 South-Western PEI. Industry Current1.75x2.25x Quick0.83x1.20x Debt/Assets58.76%50.00% Turnover of cash & securities16.67x22.22x DSO (days)45.0032.00 Inv. turnover4.82x7.00x F.A. turnover11.35x12.00x T.A. turnover2.08x3.00x Profit margin2.07%3.50% ROE10.45%21.00% Selected Ratios for PEI Incorporated Pay. deferral period30.0033.00

5. 20 - 5 Copyright © 2002 South-Western How does PEI’s working capital policy compare with the industry? Working capital policy is reflected in a firm’s current ratio, quick ratio, turnover of cash and securities, inventory turnover, and DSO. These ratios indicate PEI has large amounts of working capital relative to its level of sales. Thus, PEI is following a relaxed (fat cat) policy.

6. 20 - 6 Copyright © 2002 South-Western Alternative Current Asset Investment Policies Current Assets ($) Sales ($) Restricted Moderate Relaxed

7. 20 - 7 Copyright © 2002 South-Western Is PEI inefficient or just conservative? A relaxed policy may be appropriate if it reduces risk more than profitability. However, PEI is much less profitable than the average firm in the industry. This suggests that the company probably has excessive working capital.

8. 20 - 8 Copyright © 2002 South-Western The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales: Cash Inventory Receivables Payables conversion = conversion + collection - deferral. cycle period period period Cash Conversion Cycle

9. 20 - 9 Copyright © 2002 South-Western Cash Conversion Cycle (Cont.) CCC = + – CCC = + 45 – 30 CCC = 75 + 45 – 30 CCC = 90 days. Days per year Inv. turnover Payables deferral period Days sales outstanding 360 4.82

10. 20 - 10 Copyright © 2002 South-Western The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales: Cash Inventory Receivables Payables conversion = conversion + collection - deferral. cycle period period period What does the cash conversion cycle tell us about working capital management? Cash Conversion Cycle

11. 20 - 11 Copyright © 2002 South-Western Cash Management: Cash doesn’t earn interest, so why hold it? Transactions : Must have some cash to pay current bills. Precaution : “Safety stock.” But lessened by credit line and marketable securities. Compensating balances : For loans and/or services provided. Speculation : To take advantage of bargains, to take discounts, and so on. Reduced by credit line, marketable securities.

12. 20 - 12 Copyright © 2002 South-Western What’s the goal of cash management? To have sufficient cash on hand to meet the needs listed on the previous slide. However, since cash is a non-earning asset, to have not one dollar more.

13. 20 - 13 Copyright © 2002 South-Western Ways to Minimize Cash Holdings Use lockboxes. Insist on wire transfers from customers. Synchronize inflows and outflows. Use a remote disbursement account. (More…)

14. 20 - 14 Copyright © 2002 South-Western Increase forecast accuracy to reduce the need for a cash “safety stock.” Hold marketable securities instead of a cash “safety stock.” Negotiate a line of credit (also reduces need for a “safety stock”).

15. 20 - 15 Copyright © 2002 South-Western What is float and how can it be affected by cash management? Net float is the difference between cash as shown on the firm’s books and on its bank’s books. If it takes PEI 1 day to deposit checks it receives and it takes its bank another day to clear those checks, PEI has 2 days of collections float.

16. 20 - 16 Copyright © 2002 South-Western If it takes 6 days for the checks that PEI writes to clear and be deducted from PEI’s account, PEI has 6 days of disbursement float. PEI’s net float is the difference between the disbursement float and the collections float: Net float = 6 days - 2 days = 4 days. If PEI wrote and received $1 million of checks per day, it would be able to operate with $4 million less working capital than if it had zero net float.

17. 20 - 17 Copyright © 2002 South-Western Cash Budget: The Primary Cash Management Tool Purpose: Uses forecasts of cash inflows, outflows, and ending cash balances to predict loan needs and funds available for temporary investment. Timing: Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management.

18. 20 - 18 Copyright © 2002 South-Western Data Required for Cash Budget 1.Sales forecast. 2.Information on collections delay. 3.Forecast of purchases and payment terms. 4.Forecast of cash expenses: wages, taxes, utilities, and so on. 5.Initial cash on hand. 6.Target cash balance.

19. 20 - 19 Copyright © 2002 South-Western PEI’s Cash Budget for January and February Net Cash Flows JanuaryFebruary Collections$67,651.95$62,755.40 Purchases $44,603.75 $36,472.65 Wages6,690.565,470.90 Rent 2,500.00 Total payments$53,794.31$44,443.55 Net CF$13,857.64$18,311.85

20. 20 - 20 Copyright © 2002 South-Western Cash Budget (Continued) January February Cash at start$ 3,000.00$16,857.64 Net CF 13,857.64 18,311.85 Cumulative cash $16,857.64$35,169.49 Less: target cash 1,500.00 Surplus $15,357.64$33,669.49

21. 20 - 21 Copyright © 2002 South-Western Should depreciation be explicitly included in the cash budget? No. Depreciation is a noncash charge. Only cash payments and receipts appear on cash budget. However, depreciation does affect taxes, which do appear in the cash budget.

22. 20 - 22 Copyright © 2002 South-Western What are some other potential cash inflows besides collections? Proceeds from fixed asset sales. Proceeds from stock and bond sales. Interest earned. Court settlements.

23. 20 - 23 Copyright © 2002 South-Western How can interest earned or paid on short-term securities or loans be incorporated in the cash budget? Interest earned: Add line in the collections section. Interest paid: Add line in the payments section. Found as interest rate x surplus/loan line of cash budget for preceding month. Note: Interest on any other debt would need to be incorporated as well.

24. 20 - 24 Copyright © 2002 South-Western How could bad debts be worked into the cash budget? Collections would be reduced by the amount of bad debt losses. For example, if the firm had 3% bad debt losses, collections would total only 97% of sales. Lower collections would lead to lower surpluses and higher borrowing requirements.

25. 20 - 25 Copyright © 2002 South-Western PEI’s forecasted cash budget indicates that the company’s cash holdings will exceed the targeted cash balance every month, except for October and November. Cash budget indicates the company probably is holding too much cash. PEI could improve its EVA by either investing its excess cash in more productive assets or by paying it out to the firm’s shareholders.

26. 20 - 26 Copyright © 2002 South-Western What reasons might PEI have for maintaining a relatively high amount of cash? If sales turn out to be considerably less than expected, PEI could face a cash shortfall. A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative. The cash may be there, in part, to fund a planned fixed asset acquisition.

27. 20 - 27 Copyright © 2002 South-Western Inventory Management: Categories of Inventory Costs Carrying Costs: Storage and handling costs, insurance, property taxes, depreciation, and obsolescence. Ordering Costs: Cost of placing orders, shipping, and handling costs. Costs of Running Short: Loss of sales, loss of customer goodwill, and the disruption of production schedules.

28. 20 - 28 Copyright © 2002 South-Western Effect of Inventory Size on Costs Reducing the average amount of inventory held generally: Reduces carrying costs. Increases ordering costs. Increases probability of a stockout.

29. 20 - 29 Copyright © 2002 South-Western Is PEI holding too much inventory? PEI’s inventory turnover (4.82) is considerably lower than the industry average (7.00). The firm is carrying a lot of inventory per dollar of sales. By holding excessive inventory, the firm is increasing its operating costs which reduces its NOPAT. Moreover, the excess inventory must be financed, so EVA is further lowered.

30. 20 - 30 Copyright © 2002 South-Western If PEI reduces its inventory, without adversely affecting sales, what effect will this have on its cash position? Short run: Cash will increase as inventory purchases decline. Long run: Company is likely to then take steps to reduce its cash holdings.

31. 20 - 31 Copyright © 2002 South-Western Accounts Receivable Management: Do PEI’s customers pay more or less promptly than those of its competitors? PEI’s days’ sales outstanding (DSO) of 45 days is well above the industry average (32 days). PEI’s customers are paying less promptly. PEI should consider tightening its credit policy to reduce its DSO.

32. 20 - 32 Copyright © 2002 South-Western Cash Discounts: Lowers price. Attracts new customers and reduces DSO. Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. Elements of Credit Policy (More…)

33. 20 - 33 Copyright © 2002 South-Western Credit Standards: Tighter standards reduce bad debt losses, but may reduce sales. Fewer bad debts reduces DSO. Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships.

34. 20 - 34 Copyright © 2002 South-Western Does PEI face any risk if it tightens its credit policy? YES! A tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

35. 20 - 35 Copyright © 2002 South-Western If PEI succeeds in reducing DSO without adversely affecting sales, what effect would this have on its cash position? Short run: If customers pay sooner, this increases cash holdings. Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase EVA.