© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.1

Finance for Non-Financial ManagersFifth Edition

Slides prepared by

Pierre G. BergeronUniversity of Ottawa


Working Capital Management

Chapter Objectives

1. Define the meaning and importance of the cash conversion cycle.

2. Comment on managing cash and cash equivalents.

3. Discuss various techniques related to accounts receivable management.

4. Explain different strategies related to managing inventory.

5. Show how current liability accounts can be managed to improve the cash flow cycle.

Chapter Reference

Chapter 6: Working Capital Management


Net working capital is defined as current assets minus current liabilities.

Meaning of Working CapitalWorking capital management involves the management of individual current assets, current liabilities, and interrelationships that link current assets with current liabilities and with other balance sheet accounts.

Working capitalCurrent assets Current liabilities

Cash $ 10,000 Accounts payable $56,000

Accounts receivable 30,000 Notes payable 20,000

Notes receivable 5,000 Accrued expenses 4,000

Marketable securities 10,000 Taxes payable 8,000

Inventory 70,000

Prepaid expenses 3,000

Total current assets $128,000 Total current liabilities $88,000


1. Cash Conversion Cycle

Purchase decision and

order

Credit decision

Purchase of raw materials

Delivery of raw materials

Inventory of raw materials

Manufacturing

Inventory of finished goods

Shipment

Payment to suppliers

Billing

Payment by customer

Processing payment

DepositCash

5 5

19

10

8

9 15

4

- 30

60

12

5 60

7

Existing 209 days

Target 160 days

Reduction 49 days


Using Futurama Ltd. (Transparencies 3.5 & 3.6)

Purpose Measures the amount of days in working capital a business holds in order to meet its average daily sales requirements.

(Accounts Receivable + Inventory) - Accounts Payable

Sales revenue / 365

($300,000 + $218,000) - $195,000

$2,500,000 / 365

$323,000

$6,940

Days of Working Capital (DWC)

=

=

= 47.2 days


Using Futurama Ltd. (Transparencies 3.5 & 3.6)

Purpose Measures the efficiency with which a business converts sales revenue to cash flow from operations.

Cash flow from operations

Sales revenue

$126,000

$2,500,000

Cash Conversion Efficiency (CCE)

=

= 5.1 percent


$20,000 x 12% X = $131.5120 days late for payment

365 days

Cash flows in connection with credit serve to introduce the concept

of _________ which is the time lag or delay between the moment of

disbursement of funds on the part of the customer and the moment

of receipt of funds on the part of the seller (i.e., mail time, processing

time, and clearing time with the banking system).

The goal of cash management is to reduce the amount of cash that is

being used within the firm so as to increase profitability, but without

reducing business activities or exposing the firm to undue risk in its

financial obligations.

2. Managing Cash

FLOAT


A. Changing customer paying habits

1. Letters, telephone calls, or personal visits

2. Economic incentive for paying bills faster; offer discounts (i.e., 2/10, N/30)

Ways to Improve Collection of Cash

B. Improve the Delivery system (reduce the negative float)

1. Regional banking (customers pay bills to banks since they can transfer funds more quickly than mail order delivery).

2. Lockbox collection system (firm rents a post office box in a particular city and the bank monitors the lockbox periodically).

3. Electronic communications (i.e., data-phone wire systems).

C. Bypass the problem (Factoring of receivables).


The goal of accounts receivable management is to set credit terms, grant credit to customers, monitor payment patterns, and apply necessary collection procedures so as to increase profitability.

3. Managing Accounts Receivable

Credit policy consists of choosing the appropriate credit terms to offer to customers (present and future). Terms differ from product to product and industry to industry.

Example: Selling price $120.00

Cost of product $ 90.00

Cost of capital 10%

Should the company grant 2/10, net 30 days?

$90.00 x 10% x = $1.4860-day delay

365 days

Effective priceCost of productCredit costInterest on moneyProfit

-$ _________ _________ _________

+ _________$ _________

-$ _________ _________ _________

+ _________$ _________

10-day payment 60-day payment

117.60 120.00 90.00 90.00

28.96 28.52 1.61 ---

.25 1.48


Grant Credit to Customers (credit report)

Summary

Report Information

Payments

Finance

History

Banking

Operations

Classification code for line of business, year business started, rating, principal executives (owners).

Payments, sales, worth, number of employees, trends.

How business pays its bills (i.e., amounts owing, amounts past due, terms of sale, manner of payment, and supplier comments).

Financial conditions and trend of business (balance sheet and income statement analysis).

Names, birth dates and past business experience of the principals or owners, affiliation, ownership, outside interest of the principal owners.

Outstanding loans.

Nature of the premises, neighbourhood, size of floor space, production facilities.


Return on investment = = = 14.6%

Changing Credit TermsReturn on investment calculation

for changing the firm’s credit terms

Existing terms Proposed terms

Expected volume (units) 400,000 440,000

Expected sales revenue ($10.00 per unit) 4,000,000 4,400,000

Expected profit before bad debts (10% of revenue) 400,000 440,000

Expected bad debt expense (% of revenue) 20,000 (.5%) 33,000 (.75%)

Expected profit (after bad debts) 380,000 407,000

Incremental profit ------ 27,000

Expected collection period (days) 29 42

Average accounts receivable 315,800 501,200

Incremental investment ----- 185,400Incremental profit $27,000

Incremental investment $185,400


1. Raw Materials (i.e., lumber, steel, rubber, plastics, chemicals, paint and

other fishing substances, also includes supplies and parts).

4. Managing Inventory

The goal of inventory management is to replenish stocking points in such a way as to minimize the total of all associated costs, and thereby enhance profitability of the business.

Types of inventory

2. Work-in-Progress (i.e., partially assembled or partially processed, not yet

completed).

3. Finished Goods (i.e., goods completed and ready to be sold for resale by

wholesaling and retailing firms).


Minimum inventory level

Inventory Levels

LT

Units in inventory

Purchase

RP

SAP

Maximum inventory level

Quality

SAP SAP SAP SAP SAP SAP

LT = Lead time SAP = Stock arrival point

RP = Reorder point = Depletion of stock

Average number of units in inventory Q/2

RP RP RP RP RP

LT LT LT LT LT


Inventory Decisions

Order and set-up costs

Transportation costs

Clerical costs of making orders

Cost of placing goods in storage

Downtime on equipment

Quantity discounts

Holding costs

Storage costs

Fire insurance

Property taxes

Spoilage and deterioration

Cost of borrowing

Rent of facilities

Obsolescence

Typical costs of ordering and holding inventory

$ $


Calculating the Economic Order Quantity

Number Order Annual Average Average Annual Ordering cost of quantity order cost unit dollar holding +orders (units) $50.00 inventory investment costs Holding cost

per order (2) ÷ 2 (4) x $ 5.35 (5) x 15% (3) + (6) 1 2 3 4 5 6 7

1

2

5

6

8

10

5,000

2,500

1,000

833

625

500

50

100

250

300

400

500

2,500

1,250

500

416

312

250

13,375

6,687

2,675

2,226

1,669

1,337

2,006

1,003

401

334

250

200

2,056

1,103

651

634

650

700


Here’s the proof:

Annual order costs (6 times x $50.00) =

$300.00Annual carrying costs($5.35 x 790 = $4,226 ÷ 2 x 15%) = $317.00

Total inventory costs = $617.00

Economic Order QuantityF = Fixed costs per order

(clerical, processing, payment, receiving, verification, shelving) =$50.00

U = Units sold per year = 5,000

C = Carrying costs per unit/per year = $0.80(storage, insurance, rent, spoilage, interest charges)

EOQ =

EOQ = = 790 units

2 FU

C

2 x $50.00 x 5,000

$0.80

$5.35x 15%


5. Managing Current Liabilities

Accounts payable

Accruals

Salaries and wages payable

Taxes payable

Working capital loans

Documents

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron