CHAPTER 21

1. CHAPTER 21 Working Capital Management

2. Topics in Chapter • Working capital policies • Cash, inventory, and A/R management • Accounts payable management • Short-term financing policies • Bank debt and commercial paper

3. Basic Definitions • Gross working capital: Total current assets • Net working capital (NWC): Current assets - Current liabilities • Net operating working capital (NOWC): Operating CA – Operating CL = (Cash + Inv. + A/R) – (Accruals + A/P)

4. Working Capital Management • Day-to-day control • Cash • Inventories • Accounts receivable • Accruals • Accounts payable • Working capital policy • The level of each current asset • How current assets are financed

5. The time between payments made for materials and labor and payments received from sales: Cash Conversion = Cycle Inventory Conversion + Period Receivables Collection − Period Payables Deferral Period Cash Conversion Cycle (21-4)

6. Inventory Conversion Period • Average time required to convert materials into finished goods and to sell those goods:

7. Receivables Collection Period • Average length of time required to convert the firm’s receivables into cash: Receivables Collection Period = DSO = Days Sales Outstanding

8. Payables Deferral Period • Average length of time between the purchase of materials and labor and the payment of cash for them:

9. Real Time Computer Cash Conversion Data

10. Inventory Conversion Period

11. Receivables Collection Period

12. Payables Deferral Period

13. Cash Conversion = Cycle Inventory Conversion + Period Receivables Collection − Period Payables Deferral Period Cash Conversion Cycle (21-4) CCC = 73 days + 24 days – 30 days CCC = 67 days

14. Cash Conversion Cycle Figure 21-1

15. Cash Conversion Objective • Shorten the cash conversion cycle as much as possible without hurting operations: • Reduce Inventory Conversion period • Process & sell goods quicker • Reduce Receivables Collection period • Speed up collections • Lengthen Payables Deferral Period • Slow firm’s payments

16. Real Time Computer TABLE 21.1

17. Real Time Computer

18. Alternative NOWC Policies

19. Cash Management: Cash = “Non-earning Asset” • Transactions: • Must have some cash to pay current bills. • Precautionary balances = “Safety stock” • Compensating balances: • For loans and/or services provided. • Speculation: • Take advantage of bargains • Take discounts

20. Cash Budget: The Primary Cash Management Tool • Projected cash inflows, outflows, and ending cash balances forecast loan needs and funds available for temporary investment • Daily, weekly, or monthly, depending upon budget’s purpose • Monthly for annual planning • Daily for actual cash management

21. Data Required for Cash Budget • Sales forecast • Information on collections delay • Forecast of purchases and payment terms • Forecast of cash expenses: wages, taxes, utilities, and so on • Initial cash on hand • Target cash balance

22. MicroDrive Cash Budget

23. Table 21-2

25. $300*20%*98% = $250*70% = $200*10% = $300*70% =

26. MicroDrive Cash Budget

27. Table 21-2

28. Other Cash Budget Line Items • Interest earned or paid • = Interest rate x surplus/loan line of cash budget for preceding month • Interest on any other outstanding loans • Bad debt expense • Collections reduced by bad debt losses. • For example, if 3% bad debt losses, collections would = 97% of sales

29. Cash Budget with Adjustments

30. Cash Management Techniques • Synchronize inflows and outflows • Billing cycle = Payment cycle • Use Float • Remote disbursement accounts (+) Net • Collections float (-) Float • Lockbox Plan • Payment by wire transfer or automatic debit • Reduce the need for a cash “safety stock”: • Increase forecast accuracy • Hold marketable securities instead of a cash • Negotiate a line of credit

31. Inventory Management Goals • Ensure that the inventory needed to sustain operations is available • Minimize the costs of ordering and carrying inventory Trade-off to balance goals

32. Inventory Management: Categories of Inventory Costs • Carrying Costs • Storage and handling • Insurance • Property taxes • Depreciation • Obsolescence

33. Inventory Management: Categories of Inventory Costs • Ordering Costs • Cost of placing orders • Shipping • Handling costs

34. Inventory Management: Categories of Inventory Costs • Costs of Running Short • Loss of sales • Loss of customer goodwill • Disruption of production schedules

35. Receivables Management A/R = Credit sales/day X Collection Period Depends on volume of credit sales Average time from credit sale to collection of cash • Credit policy • Receivables monitoring

36. Elements of Credit Policy • Credit Period = How long to pay? • Shorter period reduces DSO • Reduces average A/R • May discourage sales • Cash Discounts • Lowers price • Attracts new customers • Reduces DSO

37. Elements of Credit Policy • Credit Standards • Tighter standards reduce bad debt losses, • May reduce sales • Fewer bad debts reduces DSO • Collection Policy • Tougher policy will reduce DSO • May damage customer relationships

38. Receivables Monitoring Credit sale events: • Inventories reduced by COGS • A/R increased by sales price • Price – COGS = Profit Profit  Retained Earnings DSO = Days Sales Outstanding DSO = Average Collection Period

39. Days Sales Outstanding

40. Receivables Aging Schedule • Breaks down firm’s receivables by age TABLE 21.3

41. Accruals • Accrued wages and accrued taxes • Increase spontaneously • Accruals are free in that no explicit interest is charged • Firms have little control over the level of accruals • Levels influenced by industry custom, economic factors, and tax laws

42. Trade Credit • Credit furnished by a firm’s suppliers • Accounts Payable • Often largest source of short-term credit, especially for small firms • Spontaneously increases • Easy to get, but cost can be high • Example: 2/10, net 30 • 2% discount if paid within 10 days • Due in 30 days

43. The Cost of Trade Credit • Microchip sells on terms of 2/10, net 30 • True price = 98% of selling price • PCC buys $100 of memory chips from Microchip • If paid within 10 days  Cost = $98 • If PCC wants 20 extra days to pay  Cost = $100 • List price = $98 true cost + $2 finance charge

44. PCC’s Trade Credit Cost • PCC buys an average of $11,923,333 from Microchip • $32,666.67 per day • If PCC pays on day 10 • PCC A/P average = 10(32,667) = $326,667 • PCC is receiving $326,667 credit from Microchip

45. PCC’s Trade Credit Cost • If PCC takes the extra 20 days to pay • PCC A/P average = 30(32,667) = $980,000 • PCC is receiving $980,000 - 326,667 = $653,333 credit from Microchip • PCC is foregoing a 2% discount • PCC’s total cost = $11,923,333/0.98 = $12,166,666 • Annual finance cost = $12,166,666 – 11,923,333 = $243,333 = 37.2%

46. Discount % 365 days rNOM = × Days Taken Discount Period 1 - Discount % - 2 365 = × = 0.0204 × 18.25 98 20 = 0.372 = 37.2% Nominal Cost Formula2/10, net 30 PCC Pays 2.04% 18.25 times per year

47. Effective Annual Rate (EAR) 2/10, net 30 • Periodic rate = 0.02/0.98 = 2.04% • Periods/year = 365/(30 – 10) = 18.25 • EAR = (1 + Periodic rate)n – 1.0 = (1.0204)18.25 – 1.0 = 44.6%

48. The Cost of Trade Credit

49. Trade Credit • Two components: • Free trade credit = discount period credit • Costly trade credit = cost implied by foregone discount Firms should always use the free credit Use the costly credit only after careful analysis and comparison with other sources

50. Working Capital Financing Policies • Moderate = Match the maturity of the assets with the maturity of the financing • “Maturity matching” • “Self-liquidating” • Aggressive = Use short-term financing to finance permanent assets • Conservative = Use permanent capital for permanent assets and temporary assets