Transcript Financial Management for Entrepreneurs

Ch 14 Learning Goals
1. Impact of working capital management on
liquidity, profitability and risk.
2. Cash conversion cycle.
3. Management of receipts and disbursements.
4. Evaluate a change in credit policy.
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Working Capital Mgt
• Working Capital management (or short-term
financial management) is management of:
– current assets
– current liabilities
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Working Capital Management
• The goal of working capital management is to
balance:
– Liquidity
– Profitability
– Risk
in a way that contributes to firm value.
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Working Capital Mgt
low
return
Current
Assets
Current
Liabilities
Long-Term
Debt
high
return
Fixed
Assets
Equity
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low
cost
high
cost
highest
cost
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Working Capital Mgt
• A high level of current assets means:
– More liquidity
– Lower profitability
– Less risk
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Working Capital Mgt
• A high level of current liabilities means:
– Less liquidity
– Higher profitability
– More risk
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Working Capital Mgt
• Relative levels of current assets (CA) and
current liabilities (CL) are measured by:
– Current ratio = CA / CL
– Net working capital = CA - CL
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Working Capital Mgt
• High current ratio and high net working capital
mean:
– More liquidity
– Lower profitability
– Less risk
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Working Capital Mgt: the Cash
Conversion Cycle
• Central to working capital management is
understanding the cash conversion cycle
(CCC).
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The Cash Conversion Cycle
The Operating Cycle (OC) is the time between
ordering materials and collecting from customers.
The Cash Conversion Cycle (CCC) is the time
between paying suppliers and collecting from
customers.
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The Cash Conversion Cycle
Both the OC and CCC may be computed
as shown below.
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The Cash Conversion Cycle
MAX Company has an average age of inventory (AAI) of
60 days, an average collection period (ACP) of 40 days,
and an average payment period (APP) of 35 days.
Using these values, the operating cycle is 100 days and
the cash conversion cycle is 65 days (60 + 40 - 35). Both
are shown on time lines in Figure 13.1.
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The Cash Conversion Cycle
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The Cash Conversion Cycle
Reducing AAI or ACP, or lengthening APP reduces the
cash conversion cycle, thus reducing the amount of
financing required to support operations.
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Accounts Receivable Management
• A key component of the cash conversion cycle is the
average collection period, which consists of two parts:
– the time period from the sale until the customer
mails payment, (determined largely by our credit
terms) and
– the time from the payment being mailed until the
firm collects funds in its bank account. This is
referred to as “float.”
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Float
• Float occurs with both collections and
payments.
• Float has 3 components:
– Mail float
– Processing float
– Clearing float
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Management of Receipts & Disbursements
Speeding Collections
• Lockbox system.
• Concentration banking system.
• Both systems reduce mail float and clearing float.
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Management of Receipts & Disbursements
Slowing Payments
• Controlled Disbursing involves the use of distant mailing
points and bank accounts to lengthen the mail float and
clearing float respectively.
• This approach should be used carefully; it might strain
supplier relations.
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Credit Policy
• A firm’s credit policy includes:
– Credit terms
– Credit standards
– Collection policy
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Credit Terms
• Credit terms are composed of three parts:
– the cash discount
– the cash discount period
– the credit period
• Example, if credit terms are 2/10 net 30, the discount is
2%, the discount period is 10 days, and the credit period
is 30 days.
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Credit Standards
• Credit standards determine which customers qualify for
trade credit (and for how much credit they qualify).
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Five C’s of Credit
• Character
• Capacity
• Capital
• Collateral
• Conditions
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Credit Scoring
• Credit scoring is a procedure that awards points for
various borrower attributes.
• The result is a score that measures the applicant’s
overall credit strength.
• The purpose of credit scoring is to make consistent,
unbiased credit decisions quickly and inexpensively.
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Collection Policy
• Collection policy is a firm’s procedures for collecting
receivables when they are due.
• The effectiveness of collection policy can be evaluated
partly by the level of bad debts, however bad debts also
depend on credit policy.
• Firms should spend money to collect bad debts beyond
the point where the marginal cost exceeds the marginal
benefit.
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