Transcript Working Capital, PowerPoint Show

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CHAPTER 22
Working Capital Management
Alternative working capital policies
Cash, inventory, and A/R management
Accounts payable management
Short-term financing policies
Bank debt and commercial paper
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Illustration Example 2
Selected Ratios for SKI
Current
Quick
Debt/Assets
Turnover of cash
DSO (365-day basis)
Inv. turnover
F. A. turnover
T. A. turnover
Profit margin
ROE
Payables deferral
SKI
1.75x
0.83x
58.76%
16.67x
45.63
4.82x
11.35x
2.08x
2.07%
10.45%
30.00
Industry
2.25x
1.20x
50.00%
22.22x
32.00
7.00x
12.00x
3.00x
3.50%
21.00%
33.00
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Cash Conversion Cycle (Cont.)
Payables
CCC = Days per year + Days sales – deferral
Inv. turnover outstanding
period
CCC = 365 + 45.6 – 30
4.82
CCC = 75.7 + 45.6 – 30
CCC = 91.3 days.
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Shortening the Cash Conversion Cycle
 The firm’s goal should be to shorten its cash
conversion cycle as much as possible without hurting
operations.
 The cash conversion cycle can be shortened
1. By reducing the inventory conversion period by
processing and selling goods more quickly.
2. By reducing the receivables collection period by
speeding up collections.
3. By lengthening the payables deferral period by
slowing down the firm’s own payments.
 To the extent that these actions can be taken without
increasing costs or depressing sales, they should be
carried out.
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Benefits of shortening the Cash
Conversion Cycle
 Suppose RTC must spend approximately $197,250 on
materials and labor to produce one computer, and it
takes about 10 days to produce a computer.
 Thus, it must invest $197,250/9= $21,917 for each
day’s production.
 This investment must be financed for 67 days (the
length of the cash conversion cycle) so the company’s
working capital financing needs will be 67x $21,917 =
$1,468,439.
 If RTC could reduce the cash conversion cycle to 57
days, it could reduce its working capital financing
requirements by $219,170 ($21,917 x10).
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Alternative Net Operating
Working Capital Policies
 Relaxed working capital policy.
Under this policy, a firm would hold relatively large
amounts of each type of current asset
 Restricted working capital policy.
The firm would hold minimal amounts of these items.
 Moderate working capital policy
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Cash Management:
Approximately 1.5 percent of the
average industrial firm’s assets are held
in the form of cash, which is defined as
demand deposits plus currency.
Cash is often called a “nonearning
asset.” It is needed to pay for labor and
raw materials, to buy fixed assets, to
pay taxes, to service debt, to pay
dividends.
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Cash Management:
 Cash itself (and also most commercial
checking accounts) earns no interest. Thus,
the goal of the cash manager is to minimize
the amount of cash the firm must hold for use
in conducting its normal business activities.
 At the same time, to have sufficient cash:
(1)To take trade discounts,
(2)To maintain its credit rating.
(3)To meet unexpected cash needs.
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Cash Management:
Cash doesn’t earn interest,
so why hold it?
Transactions:
 Must have some cash to pay current bills.
 Cash balances associated with routine payments and
collections are known as transactions balances.
 Precaution: Cash inflows and outflows are
unpredictable, with the degree of predictability
varying among firms and industries. Therefore, firms
need to hold some cash in reserve for random,
unforeseen fluctuations in inflows and outflows.
These “safety stocks” are called precautionary
balances,
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Cash Management:
Cash doesn’t earn interest,
so why hold it?
Compensating balances: For loans
and/or services provided.
Speculation: To take advantage of
bargains, to take discounts, and so
on.
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What’s the goal of cash management?
To have sufficient cash on hand to
meet the needs listed on the
previous slides.
However, since cash is a non-earning
asset, to have not one dollar more.
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Cash Management Techniques
Ways to Minimize Cash Holdings
Synchronize inflows and outflows.
By improving their forecasts and by
timing cash receipts to coincide with cash
requirements, firms can hold their
transactions balances to a minimum.
This synchronization of cash flows
provides cash when it is needed and thus
enables firms to reduce the cash
balances needed to support operations.
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Cash Management Techniques
Ways to Minimize Cash Holdings
Speed Up the Check-Clearing
Process
When a customer writes and mails a
check, the funds are not available to the
receiving firm until the check-clearing
process has been completed.
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Cash Management Techniques
Ways to Minimize Cash Holdings



•
Using Float
Float is defined as the difference between the balance shown in a
firm’s (or individual’s) checkbook and the balance on the bank’s
records.
Delays that cause float arise because it takes time for checks
1. To travel through the mail (mail float).
2. To be processed by the receiving firm (processing float) .
3. To clear through the banking system (clearing, or availability,
float).
What is float? How do firms use float to increase cash management
efficiency?
(More…)
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Cash Management Techniques
Ways to Minimize Cash Holdings
 Speeding up Receipts
 Two major techniques are now used both to
speed collections and to get funds where they
are needed:
(1) lockbox plans.
(2) payment by wire or automatic debit.
• What are some methods firms can use to
accelerate receipts?
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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”).
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Selected ratios for SKI Inc.
SKI
1.75x
Ind. Avg.
2.25x
Debt/Assets
Turnover of cash & securities
58.76%
16.67x
50.00%
22.22x
DSO (days)
Inv. turnover
45.63
4.82x
32.00
7.00x
F. A. turnover
11.35x
12.00x
T. A. turnover
2.08x
3.00x
Profit margin
ROE
2.07%
10.45%
3.50%
21.00%
Current
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Cash Budget:
The Primary Cash Management Tool
 The cash budget shows the firm’s projected
cash inflows and outflows over some specified
period
 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.
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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.
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SKI’s Cash Budget for January and
February
Net Cash Inflows
January
February
Collections
$67,651.95 $62,755.40
Purchases
44,603.75 36,472.65
Wages
6,690.56
5,470.90
Rent
2,500.00
2,500.00
Total payments $53,794.31 $44,443.55
Net CF
$13,857.64 $18,311.85
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Cash Budget (Continued)
January
February
Cash at start if
no borrowing
$ 3,000.00 $16,857.64
Net CF (slide 13)
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
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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.
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What are some other potential cash
inflows besides collections?
Proceeds from fixed asset sales.
Proceeds from stock and bond
sales.
Interest earned.
Court settlements.
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Inventory Management:
Categories of Inventory Costs
 The twin goals of inventory
management are:1. To ensure that the inventories needed
to sustain operations are available.
2. To hold the costs of ordering and
carrying inventories to the lowest
possible level.
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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.
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Is SKI holding too much inventory?
SKI’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.
Moreover, the excess inventory must
be financed.
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Problem 1
The Zocco Corporation has an inventory
conversion period of 75 days, a receivables
collection period of 38 days, and a payables
deferral period of 30 days.
A. What is the length of the firm’s cash
conversion cycle?
B. If Zocco’s annual sales are $3,421,875 and
all sales are on credit, what is the firm’s
investment in accounts receivable?
C. How many times per year does Zocco turn
over its inventory?
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Solution
Cash
Inventory
Receivables Payables
a. conversion = conversion + collection - deferral
cycle
period
period
period
= 75 + 38 - 30 = 83 days.
Account Receivables
b. DSO =
Average sales per day
Average sales per day = $3,421,875/365 = $9,375.
Investment in receivables = $9,375  38 = $356,250.
Days per year
Inventory conversion period =
Inv. turnover
Inventory turnover = 365/75 = 4.87.
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Problem 2
 The Christie Corporation is trying to determine the
effect of its inventory turnover ratio and days sales
outstanding (DSO) on its cash flow cycle. Christie’s 2002
sales (all on credit) were $150,000, and it earned a net
profit of 6 percent, or $9,000. It turned over its inventory
5 times during the year, and its DSO was 36.5 days. The
firm had fixed assets totaling $35,000. Christie’s
payables deferral period is 40 days.
1. Calculate Christie’s cash conversion cycle.
2. Assuming Christie holds negligible amounts of cash and
marketable securities, calculate its total assets turnover
and ROA.
3. Suppose Christie’s managers believe that the inventory
turnover can be raised to 7.3 times. What would
Christie’s cash conversion cycle, total assets turnover,
and ROA have been if the inventory turnover had been
7.3 for 2002?
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Solution
a. Inventory conversion period = 365/Inventory
turnover ratio
= 365/5 = 73 days.
Receivables collection period = DSO = 36.5 days.
Cash
Inventory
Receivables Payables
conversion = conversion + collection - deferral
cycle
period
period
period
=73 + 36.5 - 40 = 69.5 days.
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Solution
b. Total assets = Inventory + Receivables + Fixed assets
= $150,000/5 + [($150,000/365)  36.5] + $35,000
= $30,000 + $15,000 + $35,000 = $80,000.
Total assets turnover = Sales/Total assets
= $150,000/$80,000 = 1.875.
Net Income
ROA = Total assets = 9000/150000 = 11.25%
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Solution
c. Inventory conversion period = 365/7.3 = 50 days.
Cash conversion cycle = 50 + 36.5 - 40 = 46.5 days.
Inventory = Sles / Inv.turn over = $150,000/7.3 = $20,548
Total assets = Inventory + Receivables + Fixed assets
= $20,548 + $15,000 + $35,000 = $70,548.
Total assets turnover = $150,000/$70,548 = 2.1262.
ROA = $9,000/$70,548 = 12.76%.
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Receivables Management
 Firms would, in general, rather sell for cash than on
credit, but competitive pressures force most firms to
offer credit. Thus, goods are shipped, inventories are
reduced, and an account receivable is created.
 Eventually The customer will pay the account, at which
time
(1) the firm will receive cash and (2) its receivables will
decline.
 Carrying receivables has both direct and indirect costs,
but it also has an important benefit (increased sales) .
 Receivables management begins with the credit policy,
but a monitoring system is also important.
 Corrective action is often needed, and the only way to
know whether the situation is getting out of hand is with
a good receivables control system.
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Receivables Management
 The success or failure of a business depends
primarily on the demand for its products.
 As a rule, the higher its sales, the larger its profits
and the higher its stock price.
 Sales, in turn, depend on a number of factors, some
exogenous but others under the firm’s control.
 The major controllable determinants of demand are
sales prices, product quality, advertising, and the
firm’s credit policy.
 Credit policy, in turn, consists of these four variables:
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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.
“2/10, net 30” ?????
(More…)
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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.
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Accounts Receivable Management:
Do SKI’s customers pay more or less
promptly than those of its
competitors?
SKI’s days’ sales outstanding (DSO)
of 45.6 days is well above the industry
average (32 days).
SKI’s customers are paying less
promptly.
SKI should consider tightening its
credit policy to reduce its DSO.
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Does SKI 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.
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If SKI 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.