CHAPTER 15 Managing Current Assets

1. CHAPTER 15Managing Current Assets Alternative working capital policies Cash management Inventory management Accounts receivable management

2. Working capital terminology • Gross working capital – total current assets used in operation. • Net working capital – current assets minus non-interest bearing current liabilities. • Working capital policy – deciding the level of each type of current asset to hold, and how to finance current assets. • Working capital management – controlling cash, inventories, and A/R, plus short-term liability management.

3. Inventory conversion period Receivables collection period Payables deferral period CCC = + – . Cash Management- Cash conversion cycle • Firm typically follow a cycle in which they purchase inventory, sell goods on credit, and then collect account account receivable- Cash conversion cycle • The cash conversion model focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers. • Working capital policy is designed to minimize the time between cash expenditures on materials and the collection of cash on sales. Average length of time Btwn. the purchase of material and labor and the pymt. Of cash for them Average time required to convert material into finished goods and then sell Average length of time required to convert a/c receivables into cash

4. Inventory conversion period Receivables collection period Payables deferral period CCC = + – CCC = + – CCC = days + 46 days – 30 days CCC = 76 + 46 – 30 CCC = 92 days. Payables deferral period Days per year Inv. turnover Days sales outstanding 365 4.82 Cash conversion cycle

5. Cash conversion cycle • CCC = (76 days + 46 days) – 30 days • CCC = 92 days. • It takes 76 days to convert raw material into finished goods and sell them and another 46 days to collect on receivables. • 30 days is the length between receipt of raw material and payment for them. Cash inflow delay Payment delay

6. Cash conversion model CCC = (76 days + 46 days) – 30 days Finish goods and sell them (2) Receivables collection Period (46 days) (1) Inventory conversion Period (76 days) (4) Cash conversion cycle (76 + 46 –30 = 92 days) (3) Payable deferral Period (30 days) Receive Raw materials Pay Cash Purchased materials Collect Account Receivables

7. Cash conversion cycle • CCC = (76 days + 46 days) – 30 days = • CCC = 92 days. • This company when it starts producing it goods, it will have to finance the cost for a 92 days period. • The firm goal is to shortens its cash conversion cycle as much as possible without hurting operations. Why? • This will improve profit, because the longer the cash conversion cycle, the greater the need for external financing, and that financing has cost.

8. Cash conversion cycle • For example, the company spend $12,000 on material and labor to produce one unit goods (takes 10 days to produce). Thus, it must invest $12,000/10=$1,200 for each of the production. This investment must be financed for 92 days –the length of the CCC, thus the company working capital financing needs 92 x $1,200=$110,400. • Let says the company can reduce the CCC to 80 days, it will reduce its working capital financing requirement by 80 x $1,200 = $96,000 • How to shorten the CCC :- • Reducing the inventory conversion period by processing and selling good more quickly • Reducing the receivables collection period by speeding up collection • By lengthening the payable deferral period by slowing down the firm’s own payments

9. Cash Management • Part of firm’s asset are held in the form of cash. • Why ? - Cash is needed in conducting firm normal business activities such as to pay for labor and raw material, to buy fixed asset, to service debt or to pay dividend • Cash also known as “nonearning asset”.Thus the firm must hold minimum cash to use in the business activities and not holding excess cash, since cash itself earns no interest (nonearning asset)

10. Cash doesn’t earn a profit, so why hold it? (Reason for holding Cash) • Transactions balance/routine payment and collection – must have some cash to operate. (Payments must made in cash , and receipts are deposited in the cash account) • Compensating balances – for loans and/or services provided by bank.(A bank balance that a firm must maintain to compensate the bank service rendered.) • Precaution (Cash is unpredictable)– “safety stock”. A cash balance held in reserve for random, unforeseen fluctuations in cash inflow or out flow. Reduced by line of credit and marketable securities ( the firm easy to access to borrow fund in short notice). • Speculation – a cash balance that is held to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities. Most firm cash account consist of these four balances.

11. What is the goal of cash management? • The goal of the cash management - minimize the amount of cash to use in the operation but have sufficient cash to take trade discount, maintain credit rating and to meet unexpected cash needs. • To meet above objectives, especially to have cash for transactions, yet not have any excess cash (Holding adequate cash). • To minimize transactions balances in particular, and also needs for cash to meet other objectives.

12. Ways to minimize cash holdings • Use a lockbox. • Insist on wire transfers from customers. • Synchronize inflows and outflows. • Use a remote disbursement account. • Increase forecast accuracy to reduce need for “safety stock” of cash. • Hold marketable securities (also reduces need for “safety stock”). • Negotiate a line of credit (also reduces need for “safety stock”).

13. Cash budget:The primary cash management tool • What: A table showing cash inflows and outflow ( receipts, disbursements, and cash balances) for a firm over a specified period. • purpose: Forecasts cash inflows, outflows, and ending cash balances. Used to plan loans needed or funds available to invest. (provide more detailed information regarding a firm’s future CF) • Timing: Daily, weekly, or monthly, depending upon purpose of forecast. Monthly for annual planning, daily for actual cash management.

14. SKI’s cash budget:For January and February Net Cash Inflows Jan Feb Collections $67,651.95$62,755.40 Purchases 44,603.75 36,472.65 Wages 6,690.56 5,470.90 Rent 2,500.002,500.00 Total payments $53,794.31$44,443.55 Net CF $13,857.64 $18,311.85

15. SKI’s cash budget Net Cash Inflows Jan Feb Cash at start if no borrowing $ 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 1,500.00 Surplus $15,357.64 $33,669.49

16. 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 0does affect taxes, which appear in the cash budget.

17. What are some other potential cash inflows besides collections? • Proceeds from the sale of fixed assets. • Proceeds from stock and bond sales. • Interest earned. • Court settlements.

18. Inventory • Inventory –supplies/raw materials/ WIP and finished goods • Inventory level depend upon sales and acquired a head of sales. • Management responsibility to raising capital needed to carry a inventory and the firm’s profitability. Thus, management should also focus on financial aspects of inventory management • The goals of inventory management are : • To ensure that the inventories needed to sustain operation are available • To hold the costs of ordering and carrying inventories to the lowest possible level.

19. Types 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 or customer goodwill, and the disruption of production schedules. Reducing the average amount of inventory generally reduces carrying costs, increases ordering costs, and may increase the costs of running short.

20. Receivables management • Account Receivables – a balance due from customer (offer credit sales to customer) • Whenever the goods are sold on credit and shipped to the customer the inventories are reduced and account receivable is created • Receivable management begins with the decision of whether or not to give a credit and monitoring the receivables account. • Monitoring important – to avoid the account receivable excessive levels which reduced the CF and potential bad debts (reduce the profit)

21. Elements of credit policy • Credit Period – How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. • Cash Discounts – Lowers price. Attracts new customers and reduces DSO. • Credit Standards – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO. • Collection Policy – How tough? Tougher policy will reduce DSO but may damage customer relationships.

22. CHAPTER 16Financing Current Assets Working capital financing policies Major Current Liabilities (S/t Financing Long Term Debt & Equity Have their own advtg. And disadvt. A/P (trade credit) Commercial paper S-T bank loans

23. Working capital financing policies • Moderate – Match the maturity of the assets with the maturity of the financing. • Ex. Inventory expected to be sold 30 days, thus the inventory should be finance by 30 days bank loan or spontaneous financing (a/c payable) • Aggressive – Use short-term financing to finance permanent assets. • Conservative – Use permanent capital for permanent assets and temporary assets. • Aggressive have the greatest use S/T debt • Conservative have the least use S/T debt

24. $ Temp. C.A. S-T Loans Perm C.A. L-T Fin: Stock, Bonds, Spon. C.L. Fixed Assets Years Lower dashed line would be more aggressive. Moderate financing policy

25. Marketable securities $ Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L. Perm C.A. Fixed Assets Years Conservative financing policy

26. Short-term credit • Any debt scheduled for repayment within one year. • Major sources of short-term credit • Accounts payable (trade credit) • Bank loans • Commercial Paper • Accruals • From the firm’s perspective, S-T credit is more risky than L-T debt. • Always a required payment around the corner. • May have trouble rolling over loans.

27. Advantages and disadvantages of using short-term financing • Advantages • Speed- obtained much faster than L/T loan • Flexibility-less restrictive (less provision and agreement) • Lower cost than long-term debt – interest rate • Disadvantages • Fluctuating interest expense – not stable as the L/T loan • Firm may be at risk of default as a result of temporary economic conditions- can’t extended the loan and could force to bankruptcy

28. Source of Short Term Financing • Accrued Liabilities • Account Payable (trade credit) • Bank Loan • Commercial Paper *Each of these financing have their own cost. Firm will choose the lowest cost these financing can offer

29. Accrued liabilities • The expenses already occurred but not yet paid. Continually recurring short-term liabilities, such as accrued wages or taxes. Dt. Wages Expenses (expenses) Cr. Accrued Wages (liability) • Is there a cost to accrued liabilities? • They are free in the sense that no explicit interest is charged. • However, firms have little control over the level of accrued liabilities.

30. What is trade credit? • Trade credit is credit furnished by a firm’s suppliers. • Trade credit is often the largest source of short-term credit, especially for small firms. • Spontaneous (it arises from ordinary business transactions, easy to get, but cost can be high).

31. The Cost of Trade Credit • Firm that sell on credit have a credit policy that includes certain terms of credit. • E.g: 2/10, net 30 – indicate that a 2% discount can be taken if the account is paid within 10 days; otherwise it must be paid within 30 days. • Failure to take the discount represents a cost to the customer • Nominal annual cost for not taking discount:- Nominal annual cost = a x 365 1-a c -b “interest period” per year Cost per period for the t/c

32. Where; a – discount percent b – discount period c – Days credit is outstanding • The nominal annual cost formula does not take account of compounding, and in effective annual interest terms, the cost of trade credit is even higher. • E.g: Nominal annual cost = 2/98 x 365/ (30 – 10) = 2.04% x 18.25 = 37.2% • This rate is paid 18.25 (365/30-20 – interest period) times each year so the effective annual cost of trade credit is • EAR = (1 + i/m)m - 1 = (1 + 0.204) 18.25 – 1 = 44.6% Thus the nominal cost (37.2%) understates the true cost (44.6%)

33. Commercial paper (CP) • Short-term notes issued by large, strong companies. B&B couldn’t issue CP--it’s too small. • Maturity- one to nine month • Cost (interest)- CP trades in the market at rates just above T-bill rate. • CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes.

34. Bank loans • This loan appears on balance sheet as note payable • The firm can borrow $100,000 for 1 year at an 8% nominal rate. • Interest may be set under one of the following scenarios: • Simple annual interest (not compounding) • Discount interest (interest pay in advance) • Discount interest with 10% compensating balance • Installment loan, add-on, 12 months

35. What is a secured loan? • In a secured loan, the borrower pledges assets as collateral for the loan. • For short-term loans, the most commonly pledged assets are receivables and inventories. • Securities are great collateral, but generally not available.