Working CapitalCurrentAssetsCh14

8/12/2019 Working CapitalCurrentAssetsCh14

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Copyright 2009 Pearson Prentice Hall. All rights reserved.

Chapter 14Working Capitaland CurrentAssetsManagement


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Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-2

Learning Goals

1. Understand short-term financial management, networking capital, and the related trade-off between

profitability and risk.

2. Describe the cash conversion cycle, its fundingrequirements, and the key strategies for managing it.

3. Discuss inventory management: differing views,common techniques, and international concerns.


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Learning Goals (cont.)

4. Explain the credit selection process and thequantitative procedure for evaluating changes in creditstandards.

5. Review the procedures for quantitatively consideringcash discount changes, other aspects of credit terms,and credit monitoring.

6. Understand the management of receipts anddisbursements, including float, speeding upcollections, slowing down payments, cashconcentration, zero balance accounts, and investing inmarketable securities.


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Cur r ent A ssets:

CashMarketable Securities

PrepaymentsAccounts ReceivableInventory

Cur r ent L i abi li ties:

Accounts PayableAccruals

Short-Term DebtTaxes Payable

F i xed Assets:

InvestmentsPlant & MachineryLand and Buildings

Long-Term Financing:DebtEquity

Long & Short Term Assets & Liabilities


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Net Working Capital

Working Capital includes a firms current assets,which consist of cash and marketable securities inaddition to accounts receivable and inventories.

It also consists of current liabilities, including accounts payable (trade credit), notes payable (bank loans), andaccrued liabilities.

Net Working Capital is defined as total current assetsless total current liabilities.


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Current Assets

Net WorkingCapital > 0

Fixed Assets

CurrentLiabilities

Long-Term

Debt

Equity

lowreturn

highreturn

low

cost

highcost

highestcost

The Tradeoff BetweenProfitability & Risk

Positive Net Working Capital (low return and low risk)


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The Tradeoff BetweenProfitability & Risk (cont.)

Negative Net Working Capital (high return and high risk)

Current Assets

Fixed Assets

CurrentLiabilities

Net WorkingCapital < 0

Long-TermDebt

Equity

low

return

highreturn

lowcost

highcost

highestcost


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The Tradeoff BetweenProfitability & Risk (cont.)

Table 14.1 Effects of Changing Ratioson Profits and Risk


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The Cash Conversion Cycle

Short-term financial management managing currentassets and current liabilities is on of the financialmanagers most important and time -consuming activities.

The goal of short-term financial management is tomanage each of the firms current assets and liabilities toachieve a balance between profitability and risk thatcontributes positively to overall firm value.

Central to short-term financial management is anunderstanding of the firms cash conversion cycle.


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The Operating Cycle (OC) is the time between

ordering materials and collecting cash from

receivables.

The Cash Conversion Cycle (CCC) is the time between when a firm pays itssuppliers (payables) for inventory and collecting cash from the sale of the

finished product.- It shows the amount of time a firms resources are tied up (iaitu OC -APP).

Calculating the Cash Conversion Cycle


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Istilah2 dan Formula

OC= Kitaran Operasi AAI= Purata Usia Inventori

ACP= Tempoh kutipan Purata CCC= Kitaran Pertukaran Tunai



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Calculating the CashConversion Cycle (cont.)

Both the OC and CCC may be computed asshown below.


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MAX Company, a producer of paper dinnerware, hasannual sales of $10 million, cost of goods sold of 75% ofsales, and purchases that are 65% of cost of goods sold.MAX has an average age of inventory (AAI) of 60 days,an average collection period (ACP) of 40 days, and anaverage payment period (APP) of 35 days.

Using the values for these variables, the cash conversioncycle for MAX is 65 days (60 + 40 - 35) and is shown ona time line in Figure 14.1.



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Figure 14.1 Time Line for MAX Companys CashConversion Cycle


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The resources MAX has invested in the cash

conversion cycle assuming a 365-day year are:

Obviously, reducing AAI or ACP or lengthening APP will

reduce the cash conversion cycle, thus reducing the amount

of resources the firm must commit to support operations.



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Funding Requirements of the CCC

Permanent vs. Seasonal Funding Needs

If a firms sales are constant, then its investment in operatingassets should also be constant, and the firm will have only apermanent funding requirement.

If sales are cyclical, then investment in operating assets willvary over time, leading to the need for seasonal funding

requirements in addition to the permanent fundingrequirements for its minimum investment in operating assets.


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Nicholson Company holds, on average, $50,000 in cash and

marketable securities, $1,250,000 in inventory, and $750,000in accounts receivable. Nicholsons business is very stableover time, so its operating assets can be viewed aspermanent. In addition, Nicholsons accounts payable of

$425,000 are stable over time. Nicholson has a permanentinvestment in operating assets of $1,625,000 ($50,000 +$1,250,000 + $750,000 - $425,000). This amount would alsoequal the companys permanent funding requirement.

Funding Requirementsof the CCC (cont.)



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In contrast, Semper Pump Company, which produces bicycle pumps, has

seasonal funding needs. Semper has seasonal sales, with its peak salesdriven by purchases of bicycle pumps. Semper holds, at minimum,$25,000 in cash and marketable securities, $100,000 in inventory, and$60,000 in accounts receivable. At peak times, Sempers inventoryincreases to $750,000 and its accounts receivable increase to $400,000.To capture production efficiencies, Semper produces pumps at aconstant rate throughout the year. Thus, accounts payable remain at


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$50,000 throughout the year. Accordingly, Semper has a permanent

funding requirement for its minimum level of operating assets of$135,000 ($25,000 + $100,000 + $60,000 - $50,000) and peakseasonal funding requirements of $990,000(in excess of itspermanent need) ($25,000 + $750,000 + $400,000 - $50,000) -

$135,000]. Sempers total funding requirements for operating assetsvary from a minimum of $135,000 (permanent) to a a seasonal peakof $1,125,000 ($135,000 + $990,000) as shown in Figure 14.2.


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Figure 14.2

Semper PumpCompanysTotal FundingRequirements


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Aggressive funding strategy vsConservative funding strategy

Aggressive funding strategyFirma membiayai keperluan2

bermusim dengan hutang

jangka pendek dankeperluan2 tetap denganhutang jangka panjang.

Conservative funding strategyFirma membiayai kedua-dua

keperluan2 bermusim dan

tetap dengan hutang jangka panjang.



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Semper Pump has a permanent funding requirement of $135,000 and

seasonal requirements that vary between $0 and $990,000 andaverage $101,250. If Semper can borrow short-term funds at 6.25%and long term funds at 8%, and can earn 5% on any invested surplus,then the annual cost of the aggressive strategy would be:


Aggressive vs. Conservative Funding Strategies


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Alternatively, Semper can choose a conservative strategy under which

surplus cash balances are fully invested. In Figure 13.2, this surplus wouldbe the difference between the peak need of $1,125,000 and the total need,which varies between $135,000 and $1,125,000 during the year.


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Clearly, the aggressive strategys heavy reliance on short -termfinancing makes it riskier than the conservative strategy because ofinterest rate swings and possible difficulties in obtaining neededfunds quickly when the seasonal peaks occur.

The conservative strategy avoids these risks through the locked-ininterest rate and long-term financing, but is more costly. Thus thefinal decision is left to management.


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Strategies for Managing the CCC

1. Turn over inventory as quickly as possible withoutstock outs that result in lost sales.

2. Collect accounts receivable as quickly as possiblewithout losing sales from high-pressure collectiontechniques.

3. Manage, mail, processing, and clearing time to reducethem when collecting from customers and to increasethem when paying suppliers.

4. Pay accounts payable as slowly as possible withoutdamaging the firms credit rating.


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Inventory Management:Inventory Fundamentals

Classification of inventories:

Raw materials : items purchased for use in the

manufacture of a finished product Work-in-progress : all items that are currently in

production

Finished goods : items that have been produced butnot yet sold


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Inventory Management:Differing Views About Inventory

The different departments within a firm (finance, production,marketing, etc.) often have differing views about what is anappropriate level of inventory.

Financial managers would like to keep inventory levels low toensure that funds are wisely invested.

Marketing managers would like to keep inventory levels highto ensure orders could be quickly filled.

Manufacturing managers would like to keep raw materialslevels high to avoid production delays and to make larger, moreeconomical production runs.


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Techniques for Managing Inventory

The ABC System

The ABC system of inventory management divides inventoryinto three groups of descending order of importance based onthe dollar amount invested in each.

A typical system would contain, group A would consist of20% of the items worth 80% of the total dollar value; group Bwould consist of the next largest investment, and so on.

Control of the A items would intensive because of the highdollar investment involved.


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Techniques for ManagingInventory (cont.)


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The Economic Order Quantity (EOQ) Model

Assume that RLB, Inc., a manufacturer of electronic test equipment,uses 1,600 units of an item annually. Its order cost is $50 per order,

and the carrying cost is $1 per unit per year. Substituting into theabove equation we get:

EOQ = 2(1,600)($50) = 400

$1

The EOQ can be used to evaluate the total cost of inventory asshown on the following slides.


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The Economic Order Quantity (EOQ) Model

Ordering Costs = Cost/Order x # of Orders/Year

Carrying Costs = Carrying Costs/Year x Order Size2

Total Costs = Ordering Costs + Carrying Costs

Ordering Costs = $50 x 4 = $200

Carrying Costs = ($1 x 400)/2 = $200

Total Costs = $200 + $200 = $400


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Reorder point = lead time in days x daily usage

Daily usage = Annual usage/360

The Reorder Point Once a company has calculated its EOQ, it must determine

when it should place its orders.

More specifically, the reorder point must consider the leadtime needed to place and receive orders. If we assume that inventory is used at a constant rate

throughout the year (no seasonality), the reorder point can bedetermined by using the following equation:



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Reorder point = 10 x 4.44 = 44.44 or 45 units

Daily usage = 1,600/360 = 4.44 units/day

Using the RIB example above, if they know that it requires 10 days toplace and receive an order, and the annual usage is 1,600 units per

year, the reorder point can be determined as follows:

Thus, when RIBs inventory level reaches 45 units, it should place anorder for 400 units. However, if RIB wishes to maintain safety stockto protect against stock outs, they would order before inventoryreached 45 units.


The Reorder Point


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Just-In-Time (JIT) System

The JIT inventory management system minimizes theinventory investment by having material inputs arrive exactlyat the time they are needed for production.

For a JIT system to work, extensive coordination must exist between the firm, its suppliers, and shipping companies toensure that material inputs arrive on time.

In addition, the inputs must be of near perfect quality andconsistency given the absence of safety stock.



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Computerized Systems for Resource Control MRP systems are used to determine what to order,

when to order, and what priorities to assign toordering materials.

MRP uses EOQ concepts to determine how much toorder using computer software.

It simulates each products bill of materials structureall of the products parts), inventory status, andmanufacturing process.



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Computerized Systems for Resource Control Like the simple EOQ, the objective of MRP systems is to

minimize a companys overall investment in inventory

without impairing production. Manufacturing resource planning II (MRP II) is an

extension of MRP that integrates data from numerous areassuch as finance, accounting, marketing, engineering, andmanufacturing suing a sophisticated computer system.

This system generates production plans as well as numerousfinancial and management reports.



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Computerized Systems for Resource Control

Unlike MRP and MRP II, which tend to focus on internaloperations, enterprise resource planning (ERP) systems canexpand the focus externally to include information aboutsuppliers and customers.

ERP electronically integrates all of a firms departments sothat, for example, production can call up sales informationand immediately know how much must be produced to fillcertain customer orders.


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Inventory Management:International Inventory Management

International inventory management is typicallymuch more complicated for exporters and MNCs.

The production and manufacturing economies of scalethat might be expected from selling globally may proveelusive if products must be tailored for local markets.

Transporting products over long distances often resultsin delays, confusion, damage, theft, and otherdifficulties.


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Accounts Receivable Management

The second component of the cash conversion cycle isthe average collection period the average length oftime from a sale on credit until the payment becomes

usable funds to the firm. The collection period consists of two parts:

the time period from the sale until the customer mails payment, and

the time from when the payment is mailed until the firmcollects funds in its bank account.


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Accounts Receivable Management:The Five Cs of Credit

Character: The applicants record of meeting pastobligations.

Capacity: The applicants ability to repay the

requested credit. Capital: The applicants debt relative to equity. Collateral: The amount of assets the applicant has

available for use in securing the credit. Conditions: Current general and industry-specific

economic conditions.


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Accounts Receivable Management:Credit Scoring

Credit scoring is a procedure resulting in ascore that measures an applicants overall creditstrength, derived as a weighted-average ofscores of various credit characteristics.

The procedure results in a score that measuresthe applicants overall credit strength, and thescore is used to make the accept/reject decisionfor granting the applicant credit.


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Accounts Receivable Management:Credit Scoring (cont.)

The purpose of credit scoring is to make arelatively informed credit decision quickly and

inexpensively. For a demonstration of credit scoring, including

the use of a spreadsheet for that purpose, see the

books Web site at www.prenhall.com/gitman .
http://www.prenhall.com/gitmanhttp://www.prenhall.com/gitman


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Accounts Receivable Management:Changing Credit Standards

The firm sometimes will contemplate changing itscredit standards to improve its returns and generategreater value for its owners.

bl


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Accounts Receivable Management:Changing Credit Standards


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Dodd Tool, a manufacturer of lathe tools, is currently selling a productfor $10/unit. Sales (all on credit) for last year were 60,000 units. Thevariable cost per unit is $6. The firms total fixed costs are $120,000.

Dodd is currently contemplating a relaxation of credit standards that isanticipated to increase sales 5% to 63,000 units. It is also anticipatedthat the ACP will increase from 30 to 45 days, and that bad debtexpenses will increase from 1% of sales to 2% of sales. The

opportunity cost of tying funds up in receivables is 15%.

Given this information, should Dodd relax its credit standards?

Changing Credit Standards Example

Ch i C di


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Old Sales Level 60,000 Price/Unit 10.00$

New Sales Level 63,000 Variable Cost/Unit 6.00$

Increase in Sales 3,000 Contribution Margin/Unit 4.00$

Additional Profit Contribution from Sales (sales incr x cont margin) 12,000$

Dodd Tool Company

Analysis of Rexaxing Credit Standards

Additional Profit Contribution from Sales

Changing CreditStandards Example (cont.)

Additional Profit Contribution from Sales

C t f th M i l I t t i


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Cost of the Marginal Investment in Account Receivable(AR)

Difference between cost of carrying receivables under the two creditstandard(present and proposed standard)

Relevant cost is the variable cost(kos berubah) Average investment in AR (Purata pelaburan dalam akaun belumterima) Average investment in AR = Total variable cost of Annual Sales

Turnover of AR(Pusingganti akaunbelumterima)

Turnover of AR= 365

ACP(Tempoh Kutipan Purata)Turnover of AR tunjukkan bilangan dalam setahun di mana

AR bertukar kepada tunai.



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Ch i C di


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Cost of marginal investment in A/R:

Ch i C dit


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Cost of marginal bad debts:

Ch i C dit


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Cost of marginal investment in A/R:

Table 14.2 Effects on DoddTool of aRelaxation ofCredit Standards


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Changing Credit Terms

A firms credit terms specify the repayment termsrequired of all of its credit customers.

Credit terms are composed of three parts: The cash discount The cash discount period The credit period

For example, with credit terms of 2/10 net 30, thediscount is 2%, the discount period is 10 days, and thecredit period is 30 days.


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MAX Company has an average collection period of 40days (turnover = 365/40 = 9.1). In accordance with thefirms credit terms of net 30, this period is divided into 32days until the customers place their payments in the mail(not everyone pays within 30 days) and 8 days to receive,process, and collect payments once they are mailed.

MAX is considering initiating a cash discount by changing

its credit terms from net 30 to 2/10 net 30. The firmexpects this change to reduce the amount of time until thepayments are placed in the mail, resulting in an averagecollection period of 25 days (turnover = 365/25 = 14.6).

Changing Credit Terms Example

Changing Credit


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Changing CreditTerms Example (cont.)

Table 14.3 Analysis ofInitiating a Cash

Discount for MAXCompany


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Credit Monitoring

Credit monitoring is the ongoing review of a firmsaccounts receivable to determine whether customers are

paying according to the stated credit terms.

Slow payments are costly to a firm because theylengthen the average collection period and increase thefirms investment in accounts receivable.

Two frequently used techniques for credit monitoring

are the average collection period and aging of accountsreceivable.

Credit Monitoring:


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Credit Monitoring: Average Collection Period

The average collection period is the average number ofdays that credit sales are outstanding and has two parts:

The time from sale until the customer places the payment inthe mail, and

The time to receive, process, and collect payment.

Credit Monitoring:


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Credit Monitoring: Aging of Accounts Receivable

Credit Monitoring:


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Credit Monitoring:Collection Policy

The firms collection policy is its procedures forcollecting a firms accounts receivable when they aredue.

The effectiveness of this policy can be partly evaluated by evaluating at the level of bad expenses.

As seen in the previous examples, this level depends

not only on collection policy but also on the firmscredit policy.


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Collection Policy

Table 14.4 Popular Collection Techniques

Management of Receipts


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Management of Receipts& Disbursements: Float

Collection float is the delay between the time when a payer deducts a payment from its checking accountledger and the time when the payee actually receives

the funds in spendable form. Disbursement float is the delay between the time whena payer deducts a payment from its checking accountledger and the time when the funds are actually

withdrawn from the account. Both the collection and disbursement float have three

separate components.

Management of Receipts


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Mail float is the delay between the time when a payer places payment in the mail and the time when it isreceived by the payee.

Processing float is the delay between the receipt of acheck by the payee and the deposit of it in the firmsaccount.

Clearing float is the delay between the deposit of a

check by the payee and the actual availability of thefunds which results from the time required for a checkto clear the banking system.

Management of Receipts& Disbursements: Float (cont.)

Management of Receipts & Disbursements:


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Management of Receipts & Disbursements:Speeding Up Collections

Lockboxes

A lockbox system is a collection procedure in which payerssend their payments to a nearby post office box that isemptied by the firms bank several times a day.

It is different from and superior to concentration banking inthat the firms bank actually services the lockbox whichreduces the processing float.

A lockbox system reduces the collection float by shorteningthe processing float as well as the mail and clearing float.



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Management of Receipts & Disbursements:Slowing Down Payments

Controlled Disbursing

Controlled Disbursing involves the strategic use of

mailing points and bank accounts to lengthen themail float and clearing float respectively.

This approach should be used carefully, however, because longer payment periods may strain supplierrelations.

Management of Receipts &


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Management of Receipts &Disbursements: Cash Concentration

Direct Sends and Other Techniques Wire transfers is a telecommunications bookkeeping device

that removes funds from the payers bank and deposits theminto the payees bank thereby reducing collections float.

Automated clearinghouse (ACH) debits are pre- authorized electronic withdrawals from the payersaccount that are transferred to the payees account via asettlement among banks by the automated clearinghouse.

ACHs clear in one day, thereby reducing mail, processing,and clearing float.



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Management of Receipts & Disbursements:Zero-Balance Accounts

Zero-balance accounts (ZBAs) aredisbursement accounts that always have an end-of-day balance of zero.

The purpose is to eliminate non-earning cash balances in corporate checking accounts.

A ZBA works well as a disbursement accountunder a cash concentration system.


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Investing in Marketable Securities

Table 14.5 Features and Recent Yields on PopularMarketable Securities a (cont.)

Investing in Marketable


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Investing in MarketableSecurities (cont.)

Table 14.5 Features and Recent Yields on PopularMarketable Securities a (cont.)

Investing in Marketable


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Investing in MarketableSecurities (cont.)

Table 14.5 Features and Recent Yields on PopularMarketable Securities a

Documents

Working CapitalCurrentAssetsCh14