FINANCIAL MANAGEMENT

FINANCIAL MANAGEMENT Working capital management

Introduction • The “March to cash” in a company consists in: • (1) produce a product [create thre finished goods]; • (2) sell the product [turn inventory into accounts receivable] • (3) collect on those sales [turn accounts receivable into cash]. • This process involves techniques such as credit policies, payment styles or inventory management; • All of them need to be managed.

The cash conversion cycle • Working capital management: managing a firm’s current assets and liabilities as to improve the flow of funds. • It is not only the amount of cash flow that is important but also the timing of the cash flow. • Managing working capital = operational side of budgeting. • How long a company must finance its operation before it gets paid? • Cash conversion cycle: measures the amount of time money is tied up in the production and collection processes before it can be converted into cash.

The cash conversion cycle • Cash conversion cycle is composed of three sub-cycles: • A. The production cycle: the time it takes to build and sell the product; • B. The collection cycle: the time it takes to collect from customers (collecting accounts receivable); • C. The payment cycle: the time we take to pay for supplies and labor (paying account payable); • Cash conversion cycle (CCC): Production cycle + collection cycle - payment cycle; • Essentially, it measures how quickly a company can convert its products or services into cash.

The cash conversion cycle • Business operating cycle: starts at the time production begins and ends with the collection of cash from the sale of the product = production cycle + collection cycle. • [Read the explanations of business cycle at page 381] ; • Not all the customers pay in the same periods after the order: some pay sooner others later compared to the standard credit policy => we need average time for collection;

The average production cycle Conclusion: the average order is received about seven and one-half days prior to required delivery time. It takes, on average, 7.6 days to produce and sell the company product. Average production cycle: • Compute average inventory for the year (quick estimate): average inventory = (beginning inventory + ending inventory)/2 average inventory = (5,000 + 8,000 ) /2 = 6,500 $; 2. Determine how quickly the company turns over the inventory: inventory turnover = cost of goods sold / average inventory; inventory turnover = 312,000 / 6,500 = 48 times; 3. Estimate the average production period in days: production cycle = 365 /inventory turnover = 365 / 48 = 7.6 days.

The average collection cycle Conclusion: On average, the credit customers take nearly two weeks to pay their Corporate Seasonings bills. Average collection cycle (accounts receivable cycle) – apply only for credit sales: 1. Determine the average accounts receivable for the year (quick estimate): average acc receivable = (beginning acc receivable + ending acc receiv)/2 average acc receivable = (16,000 + 18,000 ) /2 = 17,000 $; 2. Determine the accounts receivable turnover rate: accounts receivable turnover = credit sales / average accounts receivable; accounts receivable turnover = 450,000 / 17,000 = 26.5 times; 3. Estimate the average collection cycle in days: collection cycle = 365 /accounts receivable turnover = 365 / 26.5 = 13.8 days.

The average payment cycle Conclusion: On average, Corporate Seasonings takes an average of one week to pay its suppliers. Accounts payable cycle: we pay suppliers after delivery not when placing orders: 1. Determine the average accounts payable for the year (quick estimate): average acc payable = (beginning acc payable + ending acc payable)/2 average acc payable = (5,000 + 7,000 ) /2 = 6,000 $; 2. Determine the accounts payable turnover rate: accounts payable turnover = cost of goods sold / average acc payable; accounts payable turnover = 312,000 / 6,000 = 52 times; 3. Estimate the average accounts payable cycle in days: payment cycle = 365 /accounts payable turnover = 365 / 52 = 7.0 days.

Putting all together: CCC • How long does it typically take between the outflow of cash needed to start production and the receipt of payment for the credit sales? • Or, What is the average cash conversion cycle in days for a company’s credit sales? • Average CCC = production cycle + collection cycle - payment cycle = 7.6 + 13.8 – 7.0 = 14.4 days; • Conclusion: On average, the company must finance its credit sales for two weeks. Some customers will take longer to pay and may require additional incentives to pay sooner.

Managing accounts receivable and setting credit policy Observations: January has the lowest sales but highest cash flows. With March is the reverse. • Collecting accounts receivable: • Starting from the above sales forecasts, estimate the cash flows for the first quarter of the next year (See results bellow).

Managing accounts receivable and setting credit policy • Credit: A Two-Sided Coin • If a company only deals in cash transactions the CCC comprise only the production cycle. • In managing the credit portion of the CCC we have two options: • 1. Speed up receivables: 2. Slow down payments: • One’s company account receivable is another’s accounts payable. What is good for us not always good for the suppliers or the customers. • Extending credit to a customer has three major components: • 1. The company must have a policy on how customers will qualify for credit; • 2. Once credit is extended, the company must have a policy on the payment plan allowed creditors. • 3. When customers do not pay on time, the company must have procedures and policies for attempting to collect overdue bills.

Managing accounts receivable and setting credit policy • A. Qualifying for credit: Which customer should receive credit? Never paying for the products = bad debts; • Amount of potential business & customer background = essentials • Also the common practices of the competing firms; • Some customers are good credit risk and some are not: => we need to use screening before offering credit; Different levels of screening with different costs. • The rationale for increasing the cost to review a potential customer’s creditworthiness is to eliminate bad debts, but the benefits from denying credit may come at too high a cost and the company may be worse off. • The challenge is to determine the appropriate level of credit-screening costs so that good customers are not turned away when bad customers do not receive credit. [Analyze example 13.2, pg. 388-389]

Managing accounts receivable and setting credit policy • B. Setting payment policy: When one business buys on credit from another business, the seller will often offer an extended payment period and an incentive to pay the bill early [consider competition]; Important: Peak Construction has 60 days to make payment, but if it chooses, it can pay the bill in the first ten days and deduct 1% of the invoice total for paying early. 1/10 net 60 If you are the manager of Peak you can pay the entire bill of 7,572 $ on August 30 (60 days later) or the discounted amount of 7,496.28 on July 11 (10 days later). Actually only these two dates are consider a rational choice. [Analyze example at pages 390-391].

Managing accounts receivable and setting credit policy • What is the implied interest rate on the loan from Space Lumber? • What interest would you have to earn on the 7,496.28 $ over the 50 days between your two payment to make you indifferent about the payment dates? • 7,572.00 $ - 7,496.00 $ = 75.72 $. If you can earn more than 75.72 $ on your 50 days deposit of 7,496.00$ you should pay on August 30. • Interest needed is: 75.72 $ / 7,496.00 $ = 0.010101 or 1.01%. [50 days] • On annual basis: (1.01% / 50) x 365 = 0.0737 or 7.37%. This is the so called APR (annual percentage rate – simple interest without compounding) as opposed to the EAR (Effective annual rate). • So, Peak should pay this bill on July 11, only if it cannot earn more than 7.37% (APR) on the account over the next fifty days.

Managing accounts receivable and setting credit policy • The implied interest rate for a given discounts can be found also: • The usage of the effective annual rate (implying compounding): • Paying on time (August 30) is a choice to slow down outflow if the terms of the discount are not sufficiently high (advantageous). • The company issuing the discount option is trying to speed up inflow, so the discount as a cost should not be too high.

Managing accounts receivable and setting credit policy • C. Collecting overdue debt: if a customer fails to pay on time, the account becomes delinquent and the company must either take action or write off the debt as uncollectible; • Action to take: • (1): letter to the customer: the account is past due and a financing charge or fee has been assessed; • (2): if the client does repeat business the firm should suspend the customer’s credit activity; this can act as a motivation but also damage the relation with clients on cash shortages; • (3): A collection agency // Court action // Writing off the bill as bad debt; • Collection agency: 1/3 from the collected amount; • Court is even expensive: sometimes it doesn’t worth the amount due; • Write off has a certain tax benefit since it can be a deductible expense. • A company should select credit-screening choice, credit terms, and collection plans to create a credit policy that maximizes benefits over costs.

13.3 The Float • Read pages 392 – 395.

Inventory management: carrying costs, ordering costs • Inventory is one of the most important assets because it generates revenue; • raw materials -> work-in-progress products -> finished goods; • Holding too much inventory for too long is not a good thing because of the costs of storage, potential spoilage and obsolescence. • Optimum inventory level = trade-off between the additional cost of carrying too many items in inventory and the lost sales resulting from inventories running out or stoppage costs resulting from raw materials running out. • Example: bottles for packaging beverages-[avoid production stop]

Inventory management: carrying costs and ordering costs • Models for inventory management: • 1. The ABC inventory management model • 2. Redundant inventory • 3. The economic order quantity (EOQ) method • 4. The just-in-time (JIT) method. • 1. ABC Inventory management: • It divides inventory into three categories: • A type: large dollar items, or critical inventory items; • B type: moderate dollar items, or essentially inventory items; • C type: small-dollar items, or non-essential inventory items. • The groups require different levels of monitoring and different levels of items in inventory. A (daily/perpetual); B (on a periodic basis); C (infrequently and ordered when the level is zero).

Inventory management: carrying costs and ordering costs • Example with Corporate Seasonings: • Type A: meats, cheeses, drinks, breads; • Type B: spreads [mayo, mustard, ketchup], containers, plastic ware • Type C: cleaning supplies, menus, invoices, office supplies. • Read explanations at page 396 for further detailing. • 2. Redundant inventory items: items not used in current operations but is serving a backup role just in case the current item fails during operations. • Critical inventory items may need to be kept as redundant items to avoid expensive delays or stoppages in production.

Inventory management: carrying costs and ordering costs • 3. Economic order quantity (EOQ): evaluate the trade-off between the carrying costs and the ordering costs. • The actual cost of the item is ignored but the costs associated with holding inventory are considered. • Cost of inventory levels are divided into two categories: • 1. The cost of ordering and delivery of the inventory; • 2. The cost of storage or carrying the inventory item until it is sold or used in production; • The EOQ model assume usage or sales rate of an inventory item to be constant. It doesn’t work so well with sales rate that vary daily, monthly, or seasonally for a particular inventory item. • When ordering inventory in large batches, delivery costs are lower per item. But with large inventories the cost to store and carry goes up as more space and facilities are needed. Vice-versa.

Inventory management: carrying costs and ordering costs • Measuring ordering costs: • OC=cost of each individual order; • S = annual sales; • Q = quantity of each order; order size. • Example 13.3 page 398: • 10.95$ is the shipping/handling fee for each order regardless of quantity; • The company uses 12,000 cartridges a year; • If the order quantity varies between 400, 300, 200 and 100: ordering cost ? • 400 cartridges: => 10.95$ x (12,000/400) = 328.50 $; • 300 cartridges: => 10.95$ x (12,000/300) = 438.00 $; • 200 cartridges: => 10.95$ x (12,000/200) = 657.00 $; • 100 cartridges: => 10.95$ x (12,000/100) = 1,314.00 $; Total ordering costs go up as the order size goes down.

Inventory management: carrying costs and ordering costs • Measuring carrying costs: • CC= average carrying cost per item per year; • Q/2 = average inventory level. [analyze figure 13.6 – Inventory flow] • Example 13.4 page 399: • 2.00$ is the yearly cost for holding one cartridge in inventory; • If the order quantity varies between 400, 300, 200 and 100: carrying cost ? • 400 cartridges: => 2.00 $ x (400/2) = 400.00 $; • 300 cartridges: => 2.00 $ x (300/2) = 300.00 $; • 200 cartridges: => 2.00 $ x (200/2) = 200.00 $; • 100 cartridges: => 2.00 $ x (100/2) = 100.00 $; • Total cost = Ordering costs + Carrying costs; • 400 units [728.50 $] -> 300 units [738.00 $] -> 200 units [857.00 $] and 100 units [1,414.00 $]; • It looks like from these 4 alternatives the 400 units order size is the best; Total carrying costs go down as the order size goes down.

Inventory management: carrying costs and ordering costs • The optimal solution for the order size is given by the equation: • S=annual sale; OC=individual order cost; CC=carrying cost /item; • Total costs for 362.49 units is 725.00 $ < 728.50 $ for 400 units. • Analyze figure 13.7 - Inventory costs, page 400: the optimal quantity is the one in which “carrying costs = ordering costs”. • Because of the usual necessary time to wait when ordering, the reorder point shouldn’t be the zero level of inventory because of possible production stoppages; [the company uses 24,000 boxes of paper /year; 80/day ] • Reorder point = (days of lead time) x (daily usage rate) • E.g.: 5 days x 80 boxes per day = 400 boxes.

Inventory management: carrying costs and ordering costs • If there are delays in the usual delivery time, the production will be stopped with great costs in loosing customers/market share. • Safety stock = additional inventory kept on hand so that if an inventory order is delayed in arrival, the current inventory is sufficient to cover the delay. • Safety stock = (days of delay) x (daily usage rate ) = 2 x 80 =160; • So, the reorder point is 400 boxes + 160 boxes = 560 units; • Finally: we can define the average inventory level as follows: • Average inventory = EOQ /2 + safety stock; • 2000/2 + 160 = 1,160 boxes of paper; [2000 = monthly order] • 4. Just in time (JIT): attempts to minimize inventory carrying costs by having companies work with both their suppliers and their customers to reduce the time items are in inventory as finished goods and the overall amount of inventory carried by a company. [Continue reading pg. 401]

The effect of working capital on capital budgeting • When a new project and business begins, it is necessary to consider the funding of the working capital that is part of the project. • The increase of working capital at the beginning of a project is offset by a reduction of the same amount at the end of the project. [Capital assets vs. Current assets]; • Ordering and paying supplies => increase an asset account (inventories, supplies); • When used in production or sold => it moves into the COGS; • But the inventory is replaced => increase in working capital needs it is also a cash outflow not captured by the sales side. • The final “recapture” of working capital is in fact a reduction in the cash outflow associated with final year COGS because the supplies were purchased in the prior period.

The effect of working capital on capital budgeting • Example 13.5, page 404: Corporate Seasonings wants to add the pick-up meal service to the existing portfolio; INPUTS: • Annual revenue: 1,200 meals at 20$ per meal = 24,000$; • Annual COGS: 1,200 meals at 12 $ per meal = 14,400 $; • Capital expansion costs for kitchen: 16,000 $ (a second walk-in refrigerator with a MACRS life of five years); the refrigerator will be sold for 6,000 $ at the end of the third year; • Working capital costs: 2,000 $ for packing supplies; • Cost of capital: 8%; • Corporate tax rate: 40% • Compute the NPV for the project.

The effect of working capital on capital budgeting • Depreciation schedule from MACRS: • Year 1: 16,000 $ x 0,20 = 3,200 $; • Year 2: 16,000 $ x 0,32 = 5,120 $; • Year 3: 16,000 $ x 0.192 = 3,072 $.

The effect of working capital on capital budgeting • Incremental cash flows for the project: • Determine the cash flow of recapture of depreciation for the refrigerator: • Book Value = 16,000 – 3,200 – 5,120 – 3,072 = 4,608 $; • Sale price – Book value = gain on sale = 6,000 – 4,608 = 1,392$; • Tax on gain = 1,392 $ x 40% = 557 $; • Cash flow at disposal = 6,000 – 557 = 5,443 $.

FINANCIAL MANAGEMENT