LectL~i-e
Introduction to Working Capital
Content Author: Louise August, CPA, PhD
Pa};e 1 cif 2
Our topic this week is Working Capital: how to manage it and how to finance it …and yes, Cash Flow. It’s still all about cash flow.
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The term Working Capital (WC) refers to the short term accounts that keep daily operations going —Current Assets (i.e., Cash, Receivables, Inventory) and Current Liabilities (i.e., Payables and Accruals). Remember that the definition of current is an account that will be settled (collected or paid) in cash within one year. No matter what kind of business we operate, we’ll have them, though not every business will necessarily have each one: For example, a service business such as a CPA firm isn’t likely to have inventory and a Cash & Carry, as the name implies, isn’t likely to have receivables.
Of course there are other balance sheet accounts that are classified as current — assets such as prepaid expenses and marketable securities, and liabilities such as short-term debt and notes payable. They are properly classified as current but are usually excluded from the calculations of Net Operating Working Capital (NOWC) because they are not directly related to operations. Whether they are considered operating ornon-operating, all of these current asset and liability accounts need to be managed and financed.
For calculations of NOWC we include only those current accounts that are directly operations-related —only the Operating Current Assets and Operating Current Liabilities. To further complicate things, sources will differ as to how they title various components of Working Capital. Notice in the graphic below the term Working Capital can be used to refer to just the asset accounts or to the net of assets —liabilities. Very confusing.
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SNorking Capital Gross working capita[
Gash EquivaEents are high q uality, I~~~r risk se~~rities th e are readily converted intca c~-ash, such ~s bank cert~Fscates of deposit:, commercial paper and treasu ry bills.
Cash and Cash Equivalents can be a problem area. This balance sheet line item includes actual coin and currency, checking account balances and near cash items collectively referred to as Cash Equivalents. Obviously, some amount of cash is needed to run the business but companies often have cash balances far in excess of the amount needed to meet liquidity needs, particularly in times of economic uncertainty. The problem is that in reported financial data companies rarely disclose the level necessary for operations vs. the additional portion. Ideally we’d analyze the make-up of this account and exclude to excess portion. An even more conservative approach would be to exclude cash balances entirely. While you should be aware of this issue, for this course, we’ll overlook the nuances surrounding cash to keep the NOWC computations simple and
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SNorkletg Ca~titaE
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Lecture
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include cash and cash equivalents along with Receivables and Inventory as Operating Current Assets.
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Lecture
Managing Current Assets &Liabilities
Content Author: Louise August, CPA, PhD.
The overall objective of managing Working Capital (WC) accounts is to run the firm efficiently and effectively. This means that we’ll need to find a balance between two competing goals: maintaining appropriate levels in each of these accounts while at the same time minimizing the amount of capital tied up in them.
Setting Target Levels: Remember that regardless of whether a WC account is included or excluded from various calculations such as NOWC and intrinsic value, all these accounts need the attention of management to see that they are analyzed, controlled and financed appropriately.
CURRENT ASSETS
Pa~c 1 oi~ 2
Cash: Whether its checking account balances or actual currency in cash registers, cash is non-interest bearing, so the firm will want to minimize these amounts. However, a certain amount of cash will be necessary to meet the needs of daily operations —paying invoices, covering payroll, etc.
Cash Equivalents and Marketable Securities: These two captions refer to various types of instruments that can be readily bought or sold. They tend to be high-quality and have maturities of less than one year, and therefore have low-risk (that also means they’ll be low-yielding). Examples of marketable securities include commercial paper, bankers’ acceptances, treasury bills, and other money market instruments.
Receivables: If the firm extends trade credit to its customers there will be capital tied up in Accounts Receivable (AR). The level of AR is the result of several factors: credit terms offered, credit granting standards, payment incentives offered, and collection practices.
Inventory: Most firms have inventories and, depending on the type of business, it may be the largest asset on the balance sheet after Property, Plant &Equipment. Having too much inventory will obviously tie up a lot of capital, but having too little can be a disaster. Consider the consequences of empty shelves and poor selection, or worse shutting
down a production line.
CURRENT LIABILITIES
On the other side of WC management are the Current Liabilities —Accounts Payable and Accruals. They are often referred to as spontaneous liabilities, because they arise in normal course of business without much overt action on the
part of the firm. These balances represent a deferral of payments to be made, so the higher the balances are, the less cash that needs to be paid out — at least for a short period of time. The amounts owed will need to be paid on a timely
basis, so the balances in these accounts really aren’t entirely within managements control. However, they are free sources of financing in the sense that there is no interest due on these unpaid balances.
PAYABLES: Just as the firm extends credit to its customer, so do the firm’s vendors and suppliers. While we don’t want
to pay any sooner than we have to, we also don’t want to develop a reputation as a slow payer… its a small world.
ACCRUALS: These accounts are typically the result of taxes and wages that are owed but haven’t yet been paid.
Determining WC Practice
This is a matter of how much time and effort will be devoted to the management of WC accounts on a regular, ongoing basis. Its a classic trade-off between effort and cost.
For example, its certainly easier to just keep a lot of inventory on hand so you’ll never have to worry about running low. On
the other hand, having more capital tied up is obviously more costly. It will be more challenging in terms of time and effort to
maintain minimal inventory amounts while also keeping shelves looking well-stocked or the production lines running smoothly.
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Lecture
Relaxed: ~~Restrictiue:
easier challenging less time more time higher cost lo4ve~- cost
Monitoring &Controlling Activity
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Once the decisions have been made about target levels and management practice, managers will need ways to keep track of in the WC accounts and assess the success of their efforts. We’ll look at the various tools and techniques available shortly.
Financing the Capital Invested
The firm will also need to consider how the capital invested in WC accounts is to be financed. Some of the capital needed in WC Asset accounts will be covered by the spontaneous liabilities of Payables and Accruals. But if those sources are not enough, and often they are not, then the firm will likely turn to short term bank debt. We’ll consider this topic separately.
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Managing Cash
Content Author: Louise August, CPA, PhD
Cash is the first of the current assets that we II be discussing. It is necessary for firms to hold cash. However, since cash is anon-earning asset, it is important that the level of cash balances held be minimal. However, the firm does need to have enough cash to meet its obligations on a timely basis. Cash balances are determined by the cash flow cycle, and the cash budget is the tool used to track those cash flows. Having enough cash to pay bills is very important for firms. Many companies have problems because they aren’t able to generate enough cash.
_… Financial managers attempt to minimize cash balances, while optimizing the use of the cash by speeding up the cash inflows and slowing down cash outflows.
! ~ Managing Cash
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How can management speed up cash inflows?
Click here for answer
How can management slow down cash outflows?
Click here for answer
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Managing Cash
Content Author: Louise August, CPA, PhD
Cash is the first of the current assets that we’ll be discussing. It is necessary for firms to
hold cash. However, since cash is anon-earning asset, it is important that the level of cash
balances held be minimal. However, the firm does need to have enough cash to meet its
obligations on a timely basis. Cash balances are determined by the cash flow cycle, and
the cash budget is the tool used to track those cash flows. Having enough cash to pay bills
is very important for firms. Many companies have problems because they aren’t able to
generate enough cash.
Financial managers attempt to minimize cash balances, while optimizing the use of the
cash by speeding up the cash inflows and slowing down cash outflows.
~ ~ Managing Cash
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1 /29 00:00/14:15 OUTLINE
How can management speed up cash inflows?
Speeding up collections:
1. Decentralized collection centers may speed up the collection of accounts receivable by reducing mailing time. The collection centers are often located in areas with large numbers of customers.
2. Wire transfer of funds is used to transfer from collection points to a centralized banking location.
3. Lock-box systems can be used to collect customers’ payments. With alock-box system, customers mail payment to a post office box serviced by a local bank in their geographical area.
4. Streamlining in-house processes can help to eliminate wasted time in getting checks deposited.
How can management slow down cash outflows?
Slowing disbursements:
Firms may attempt to extended disbursement time by sending checks from distant locations. This method, however, is not as effective as it once was. Management can also carefully look at paying bills towards the end of the credit period offered rather than paying as soon as a bill is received.However, it is important to evaluate any discounts provided by paying early.
Keep in mind that paying late is rarely a good idea. We will not endear ourselves to our vendors and suppliers by making them wait.
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Managing Cash
ConlenlAUlhor. i_omceA :~St. G;”.. ~’LO :: …’. ~ .~..•,
Monitoring and Controlling
Working Capital
Cash ~’~ 3rketable ;
I Securities i
Accounts ~~~ventory Receivable
~.,~
Cash
o Checking account balances
o Actual coin and currency
• Type of business is a determinant
• Examples: • K-Mart ~A
• Doctor’s office .’~~y
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~ Cash: The Goal
o To maintain sufficient but not excessive cash balance
o Corporate checking account balance does nol earn interest
• Opportunity cost because losing out on interest that could be earned elsewhere
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Reasons Firms Hold Cash Balances
1 . Transaction motive Payments in regular course of business
2. Precautionary motive Take care of the unexpected
3. Offset compensating balance requirements Bank requirement in lieu of fees and charges
~ Cash Management
Antjcipate the cash flows
• Know your firm’s patterns of inflows and outflows
• Use of the cash budget
_. r~ inflow
Cash
outflow,… _ _ ;
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Zero Balance Accounts
o Cash management at the bank • Also known as Sweep Accounts
o Maintain two accounts at the bank 1. Interest bearing account 2, Checking account
o Checks paid as they clear Balance swept to interest bearing account
~ Cash Management
2. Managing Float The time that a check spends in “limbo”
• Receipt of check —interval between when check is received and $$ is available to us
• Payment with check —interval between when check is written and $$ is withdrawn from our account
~ Types of Float
1. Mail float ~
• US Postal Service
2. Processing floai • Within the firm -accounting a
department
3. Transit floai • Banking system ~
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( Managing Float
o Time period to collecting cash
o Minimizing “collections fioaY’
a Accelerate collections
,~~~ i
Managing Float ~~o~~~~
o Exert control over things that happen within the firm
o Streamlining in-firm processes
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( Streamline the In-firmProcesses o USPS and mailroom operations-
~, Lfmiled conlyd over delivery time
Consitleroptlons tlependent on melt arrival time
WwIIDsT~0f6Y iEs~siTavicr
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( Streamline the In-firmProcesses c~o~~u o USPS and mailroom operations . Delivery (why wait?)
• Pick-up yourself • Greater control • Large cash receipts in the mail
WN)fD Sid1E5 iosiu t”rirvicr..
Streamline the In-firm Processes c~o~r~
o USPS and mailroom operations . Delivery or pick-up
• Priority delivery to the accounting department
Remember clerical staff may not ~ share our sense of urgency about
cash receipts.
;, I Streamline the In-firmProcesses in Accounting o Processing cash receipts
~~;
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,, I Streamline the In-firmProcesses in Accounting «a~,~~; o Processing cash receipts . Process checks imrnediateiy
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Streamline the In-firm Processes in Accounting «o„~~;
o Processing cash receipts • Process checks immediately
. Prepare the bank deposit
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Streamline the In-firm Processes in Accounting ,~o~~~;
o Processing cash receipts . Process checks immediately . Prepare the bank deposit
• Get [o the bank on time • Find out when the bank daily prxessing
timeculofl happens
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Streamline the In-firm Processes for Account Receivable Management
o Sound credit policy
o Monitoring and following up on overdue accounts
o Appropriate level of colleciians effort
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I Lockbox o Customer payments go directly to the bank instead of our offices
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~ Lockbox Example
c011ection float now =….._. ~_ _….._.. _ ……- da with lockbox –
10 … __
7 …..–r–…
so, 3 days “saved”
X avg daily receipts of t.~mil
3.0 mil
X 10% Cost of c2pital 10°Jo
300,000
divided by 12 months – 25,000
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~ Payment by Wire
o Customer agrees to wire the amount due by a certain dale • Heips to eliminate:
Mail fipat
• Accounting department processing
ep8y
Automatic Debits
o Pre-authorized debits to the customers bank account or charge card
• Saves customer time and costs
• Can oiler customer an incentive
err . ‘4….~+’,
spay
Managing Float: Disbursements
o Maximizing “Disbursements FIoaC’
o Slowing the in-firm payments processes
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Slowing the Payments Processes
o Paying on time
5bw ~rayng custort~er ~ ,..
~,
HWden cosEs ‘.
Slowing the Payments Processes ~~ont,
o Choosing a disbursing bank
• With electronic age, it’s less effective
~__ ~ ~-= ~!~_ t~~’
~~: ~ – ‘:.
~ Goals in Managing Float
o Accelerate collections
o Control payments
o Synchronize of cash flows
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Printable Present~ui~~n
~ Managing Float
t. Collections Fioat -cash inflows
goal is to minimize float time
2. Disbursements Float -cash
outflows goal is to maximize float time
~~ , ..+;
Net Float
Disbursements Float > Collections Float
Positive net float
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Managing Marketable Securities
~,~ ~’ Content Author: Louise August, CPA, PhD
‘ Marketable securities include various types of debt or equity instruments that are listed on an ~, exchange and can be readily bought or sold. They tend to have maturities of less than one year,
..~ and be high-quality and therefore low-risk (that also means they’ll be low-yielding). Examples of marketable securities include commercial paper, bankers’ acceptances, treasury bills, and other
money market instruments.
• I Marketable Securities
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C Marketable Securities
ConICM Aulbor.lowse 1. CPA. Ph0
Marketable Securities
o Typically investments that are:
. High quality • {risk and j yielding
• Highly liquid • Highly marketable
I `3,
~. ‘ ~~ ~ Liquidity vs. Marketability
o Marketability is the ability to quickly convert an investment into cash • Example: Common stock
o Liquidity is the ability to convert an investment into cash without loss • Example: Bank CD ~M~+~
o/mepoHe
.~~_
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,, ( Why hold MarketableSecurities? As a place to:
o “Park” excess cash as it builds and earns interest so it’s not idle
o Temporarily invest the proceeds of a
. Sale
. Loan until they’re needed `,~r
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What types of investments?
Things to consider:
1. Maturity matching
• When will the funds be needed
I Don’t finance a short term need with a long term investment
What types of investments?
Things to consider: 1. Maturity matching ~ ~ ~
2. Volume of funds to be invested • Only cornes in large denominations
Commercial paprr .n blocks of $t00K May not be suitable for excess cash flow
• May be better suited for sales or loan proceeds
P~be 2 of 3
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~, (What types of investments?
Things to consider: 1. Maturity matching
2. Volume of funds to be invested
3. Management expertise
Analysis of marketable securities is time consuming Money market funds may be the preference for smaller firms that lack the time and expertise
Cash and Marketable Securities
o Summary ~~ ‘`
• Cash • Coin and currency
• Bank deposits • Checking and Sweep accounts
. Marketable Securities • Highly liquid and marketable
• Substitute for cash
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I.,ecture
Managing Accounts Receivable
Content Author: Louise August, CPA, PhD
Page 1 of 2
Of course Accounts Receivable (AR) is an asset – we have a right to receive payment (and our customers have an obligation to pay) for our product or services that were purchased on credit. But you can also think of Accounts Receivable as an investment. And indeed, we do have dollars tied up in AR from the time a credit sale is made until iYs collected. Just like any investment, it should earn a suitable return. Although iYs not an entirely straightforward process to determine the level of that return, it is relatively easy to think about. Offering credit terms attracts customers and encourages larger purchases, so we’ll reap the benefit in terms of more customers and higher sales.
Accounts Receivable
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Let’s recap. There are four aspects a company needs to consider when determining a credit policy:
1. Credit Period: This is the length of time we allow before payment is expected. AR will increase as the credit period (length of time given to pay) increases.
2. Discounts: The firm may also offer cash discounts to encourage early payment and accelerate collections. Credit terms such as: 2/10 net 30 mean that the purchaser can take a 2°/o discount if paid within 10 days; otherwise the full amount is due within 30 days.
What does 3/15 net 45 mean?
If the terms of trade are: 3/15 net 45, the customer can take a 3% deduction from their bill if they pay within 15 days. Otherwise, the full amount is due within 45 days.
3. Credit standards: The firm evaluates a customer’s credit application based on their prior record of payment, financial stability, current net worth, etc. in order to asses the customer’s ability to pay their obligations. The 5 C’s of credit are often used to decide whether or not to extend credit.
4. Collection practices: How vigorously we pursue delinquent or slow-paying customers. A variety of measures can be used to assess how efficiently the firm’s credit department is collecting receivables:
Days of Sales in Receivables: This is measured by Days’ Sales Outstanding and is the average time it takes to collect amounts owed from customers. This measure is the result not only of collection efforts, but also the
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firm’s decisions about credit terms, the quality of credit administration, etc. An increasing average collection period may be the result of extending credit to less qualified customers. Ratio of bad debts to sales: Extending credit to less qualified customers may result in an increasing ratio of bad debts to sales. An increasing ratio may also be the result of an aggressive market expansion .policy. Aging of accounts receivable: An aging schedule shows the firm’s accounts receivables by age of account. Reviewing an aging schedule helps the firm to identify trends that may need to be addressed. However, a change in the aging schedule does not necessarily indicate that the firm’s credit policy has weakened.
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Accounts Receivable
Conicnl Author. L – Zr3u;i. C~’~. PI~iJ
I II. Accounts Receivable
o Almost every business has accounts receivables
o Arise from sales made on credit instead of cash. check or bankcard
• Debit card is a substitute for written checks
. Credit card is another form of cash sale
Accounts Receivable
o Credit sales —offering trade credit to
customers
o Why do firms sell on credit?
• Advantages • Ai~ract customers 1
• Encourages sales 1_, + .
• Stay competitive y P , ~,•
.~1, ~~ 1 ~~~
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,. I Managing AccountsReceivable o Making sales on credit Creates an
accounts receivables
o Customers will have balances
o Manage accounts receivables
1. Controlling the credit and collections (unctions
2. Monitoring accounts receivable
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Credit and Collections Policies
o Credit period offered ~ ~ s
• Dependent on: ” Y, ‘: • Industry standards “”,y”ès
~~~•• Local competitlon ~ ‘t’~
o Interval length between:
• Making the sale
+ Payment from customer
o Typically 30 days
Credit and Collections f~0~IC18S {con t)
o Credit period offered
o Early payment incentives
2/10; net 30
__…. _…… ……: ~ Otherwise the Two ao ‘, ~ paid N,~~h~~ (balance is due In 30
discount il… ‘. ten days ~aYs_.. _ _.__ I_ … …._ .. __
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Credit and Collections Policies ~~~”n o Cretlil period offered
o Early payment incentives
o Collection activities on slow paying customers
• Actions — calls, letters, finance charges, etc.
. Trade-offs -customer relations
Credit and Collections Policies ;~o~,~~,
o Credit period offered o Early payment incentives o CollectionacUvities
o Credit standards policy
W ho will we alicw to have credit?
W ill they be able to pay?
Credit Standards Policy: The Five C’s
Description:
1 . Character ~eve~othonesryandintegNty
2. CapdClty Liquidity antl cash flow
3. C8pit81 Likely ~o slay in business
4. Gollateral OHer asset as security for grade cretlit
5. Conditions Economic wends
_ _ __ ___. Higbiysubjectivejudgments
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Credit and Collections Policies ;~o~o o Credit period o8ered
o Early payment incenliv¢s
o Coilectionactivities o Credit standards policy ~~
o Our cost of capital . Accounts receivables iAR) =cash that
customers owe us • Opportunity cost
. If cost of capital is t ,need to manage accounts receivables more closely
Page 4 of 6
Monitoring AR: Aged Receivables Listing
o Balance sheet tells us the amount in total only
o Aged Receivables listing tells us:
•Which customers owe us . How m uch the customer owes us
• How old the invoices are
. Helps to flag potential problems
Monitoring AR: Using Average Collections Period
Accounts Receivable
ACP =
Average Daily Sales
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Monitoring AR: Using ACP ~~o~~~;
o Calculate on a regular basis
o Trend over time
o Investigate changes in ACP
. Look for upward creep
o Compare ACP to firm’s credit policy
.3.
Monitoring AR: Using ACP c~on~t~
Calculate what ACP should be, based on the percentage of customers taking the discount
Lets look at an example…
Monitoring AR Using ACP ~~~~,,;
Assume that the firm offers 2110, nel 30 __ Two percent discount if invo ce is pa d in 70 day otherwise the invoice balance is due in 30 days
We believe that: • 70~a of customers take the discount
• 30% of customers pay in 30 days
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Monitoring AR: Using ACP ,~a~,,~
ACP _ 70% # 10 days = 7 days
+ 30% t 30 days = 9 days
= 16 days
It the ACP > 16 days. then:
. Are more customers paying late?
. Do 70 % of customers really pay early?
• is the two percent discount enough?
o Revise expectations or credit policy
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Lecture
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Managing Inventory
Content Author: Louise August, CPA, PhD
Of all the current assets, inventory is the least liquid and very often the largest component. The appropriate level of inventory depends on the nature of the firm’s
sales. If a firm has seasonal sales but uses level production, they will likely have time
periods of high inventory levels. The firm makes the production decisions based on
the trade-off of cost savings with level production versus the additional costs of
carrying the inventory.
• ~ Inventory
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-~ = Inventory
Content Author: Lc~uiSe Au ~~. Gf :1. Fl:t:
~ Inventory
o Nigh value asset on balance sheet
o Constantly turning over
o Needs careful managing
ra:. ‘.d
_. (Goals of Inventory t: r:: •~
Management
1. Maintain adequate levels of inventory • Not too much, not too little
2. Minimize inventory costs eq;i_ ,.
c } a~’ L
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Maintain Adequate Levels
o Too little inventory
. interrupts the manufacturing process • Potentially shut down line
• Expensive!
• Retail • Empty sheh~es, poor selection
• Unattractively shelved store
• Potential loss of customers ~_– ;
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~ Maintain Adequate Levels
o Too little Inventory
• Interrupts the manufaclunng process
. Empty shelves, poor selection
o Too much inventory
Unnecessarily high costs
• Storage issues
• Obsolescence; spoilage _
~ Other Inventory Strategies
o JIT — “just in time” . Takes items only as needed for
manufacturing process • Pushes the stocking burdens onto the supplier
o Out sourcing • Delegates portion: _ ‘~..- ̀_ manufacturing pre • Hands-on ‘•~~, s • Ready-made com ‘ ~ ~ ~ ~ ”
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~ Minimize the Cost of Inventory
o Two main components.
t . The cost of having inventory
2. The cost of maintaining inventory
~~’
~+ f~+ .̂ ~~a« ::
~ Cost of Having Inventory
o High level of dollars of working capital tied up
Can we make do with less?
o What if we could …
• Operate effectively with lower levels of inventory and still maintain goals
Maintain adequate levels of nventory ~ We woultl be more _ -.. ~. eflective and more
Maintain adequate levels of sales efficient
The Costs of Maintaining Inventory
Two major categories:
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Printable Yr~seutation
Carrying Costs
o The cost of holding stocks of merchandise: • Cos1 of capital tied up . Insurance . Facilities cost • Storage and handing . Obsolescence or spoilage
o Variable in nature • 20`;6 – 30°~ of inventory ~~alur.
Order Costs
o The cost of replacing inventory:
• ciericai cost of placir;g order
• shipping and handling charges
• taking delivery: checKing the order
o Fixed in nature
• 5 – 10 % of inventory value per order
_ .
_. _ ~. . ,~
~ Total Inventory Costs
‘ Carrying costs;+ Ordering costs ‘ = Total costs_ _
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~ How to minimize costs?
o To minimize order cost
• Order a huge amount once a year
• But have high carrying costs
o To minimize carry cost
• Order every day —similar [o JIT
• But would have high ordering costs
Balance would be needed between
order and carrying costs
Economic Order Quantity.. ~,..~ ~EOQ)
o Formula driven
o Optimizes between carrying costs and ordering costs to minimize total costs
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Learning Objectives
Chapter Opening
~ .r ~r ~ r`
ar ~ ~ ‘~`
Working capital management involves financing and
controlling current assets
Distinguishing between current assets easily
converted to cash and those that are more
permanent
x Financing of assets should be tied to assets’ time on
~ the balance sheet
t ~ Long-term financing is more costly than short-term
Risk and profitability determines financing plans i
Expected value analysis used in working capital
management ,.. – -:~::.a
The Nature of Asset Growth
62,
Working Capital Management
• Financing and management of current assets of
firm
• Current assets change constantly, requiring
decisions made by management
s Short-term decisions on working capital
determines whether a firms gets to long-term
Requires immediate action
Key to current asset planning —matching production
schedules with accurate sales forecast
Differences in actual sales and forecasted sales can
result in
Unexpected buildup
Reduction in inventory, affecting receivables and
cash flow
Firm’s current assets can be
Self-liquidating
‘Permanent’ current assets
– .. ..h:.. .^~ .. fi3. ~~~ .., …. ,.>- cam— o„” 6-0′. ‘ _ ‘.: .. ..-_, ?~81~wr.«”‘~ ra° iivkP.ma spa ~ ”
Figure 6-1 The Nature of Asset Growth Controlling Assets —Matching Sales
and Production
Fixed assets grow slowly with
I ncrease in productive capacity
Replacement of old equipment
a~ Current assets fluctuate in short run, depending on
Level of production versus level of sales
When production is higher than sales, inventory rises
When sales are higher than production, inventory
declines and receivables increase
06
Controlling Assets —Matching Sales Controlling Assets —Matching Sales and
and Production Production
• Cash budgeting process a Level production method
• Smooth production schedules
Use of manpower and equipment efficiently to lower cost
• Match sales and production as closely as possible in short run
g Allows current assets to increase or decrease with level of sales
Eliminates large seasonal bulges or sharp reductions in current assets
Figure 6-2 Quarterly Sales and Earnings Per
Share for Briggs and Stratton Corporation
~~~ Earnin hare Sales In millions of $ 1 ~’
gs per s
ryp 0.6 .
o< s~ o
-0 ~ o ~
100 ~ -0.4
Q ~ ~ a ~~ a ~ a a a F “a £ ~ o~ o E F 9 E ‘^ f
.- _q~ ,~ w s LL as~s LL ~s u~ & ~~? a _ ,.a `s a aa~_
b3
Figure 6-3 Quarterly Sales and Earnings Per
Share, Target and Macy’s
iS.pMi Sales in millions$ ~Ta~det ~,.tacys
Earnin~Pe~share ia~;e~ –~r~inc Y’s
=o.a~~ ~=o z.~
IS,nx~
l.~ :.
~o.~. ,.~
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_ o.~s ~ wad s mm_ ,. ~ ~ .. .~ u ~. d – R a ,. g .. _ s_ a a a ,. _ g
g Briggs and Stratton Corporation example of
seasonal sale
Sells most of their products early in the year to
other manufacturers
Figure 6-2
Sales are lowest in July to September quarter
Peak sales are in January to March quarter
• First quarter of the year always generates negative
earnings per share
Cost of production outweigh the revenue produced
6.7 _. ,. :bib
Controlling Assets —Matching Sales
and Production
• Retail firms like Target and Macy’s also have
seasonal sales patterns
ffi Figure 6-3
u Sell products that are manufactured for them
I nvolved in matching sales with inventory
Selling seasons affected by weather and holidays,
therefore retailers cannot avoid inventory risk
Fourth quarter (Nov —Jan) is their biggest quarter
and amounts to approx. one-half of their sales
s.,a
Controlling Assets —Matching Sales
and Production • Retail-oriented firms use new, computerized
inventory control systems linked to online point-
of-sales terminals
Allow either digital input or use of optical scanners
to record inventory code numbers and amount of
each item sold.
Managers can examine sales and inventory levels by
item and adjust orders or production schedules
s Predictability of the market wil l influence to speed of
manager’s response
Complexity of production will dictate speed of production
changes – 672
Temporary Assets under Level
Production – An Example
Yawakuzi Motorcycle Company
• Sales fluctuations
High sales demand during early spring and summer
Sales drop during October through March
Decision
Apply level production method
• 12-month sales forecast issued
Result
Level production and seasonal sales combine to
produce fluctuating inventory
Table 6-1 Yawakuzi Sales Forecast (in units)
— …..– —1
oc~ober …………… soo aa~~~y …………_.. o aprii ……………._… i.000 dory ……………….._ ¢.000
November………._ 150 february ………….. 0 May…………………. 2000 August ……………_ 1.000
Oeoember ………… 50 March ……………… eoo June ………………… 2.000 September ……….. 5oD
To1~ axles o~ g.600 Mks el f3,000 ead, = 528.800.000 h ads.
-x.: .,. .. .. .n„ikn+rv* .:i. i~.i:rTr-°i5.-: a¢..13.. r -:iR ~ ~. .ie ~. ,.. “” ‘,<. ~ •. ,… 6t4;:
Table 6-2 Yawakuzi’s Production Table 6-3 Sales Forecasts, Cash Receipts
Schedule and Inventory and Payments, and Cash Budget
~’ d w ?a~il~ve~t~.ory ~’+ pr~ductlo~} ~ ,= ‘ it
Oc.`tObef ……. 9~~ ……. 900 ….. 30~ ….. 1 r30~ ….. .~2~6~.004
November …. 1.300 ……. 800 ….. 150 ….. 1,950. ….. 3,900.000
December …. 1.950 ……. 8~0 ….. 50 ….. 2,700 ….. 5,400.000
January …….. 2.70 ……. 800 ….. 0 ….. 3,500 ….. 7,00,000
February …… 3.500 ……. 800 ….. 0 ….. 4.30D ….. 8:600,000
March ………. 4.300 ……. 800 ….. 600 ….. 4,SOD ….. 9.000,000
April …………. 4.500 ……. 800 ….. 1,00 ….. 4.300 ….. 8,600.000
May ………….. 4.300 ……. S00 ….. 2.00 ….. 3.100 ….. 6,200.W0
June …………. 3.100 ……. 800 ….. 2.000 ….. Y,900 ….. 3.BOO.WO
guy ………….. 7.x00 ……. soo z.000 ….. goo …_ i,aoo,000
August ……… 700 ……. 800 ….. t,00D ….. 50D ….. 1,000,00
September … 500 ……. 800 ….. 500 ….. 800 ….. 1,600,000
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,.. _ 6×75:. … _. . . _ – 6-76..
Temporary Assets Under Level Table 6-4 Total Current Assets, First Production – An Example Year ($ millions)
Table 6-3 examines buildup in accounts receivable and cash ~’ ~` a~u~~ ~ 8
Cash Seaeigahle ~ Inventory ~’ ~ ~ts~ Sales forecast ~ ~” ~ ` ‘ ~”
October ……………………….. $025 S0.450 $2.6 $ 3.30 Based on assumptions taken earlier (Table 6-1) November …………………….. 025 oz25 a.9 a.s~s
Cash receipts o~„t~~ …………………….. o.z5 o.ozs s.a s.72s
50% cash collected during month of sale and 50% pertains to prior January ………………………… ozs o.o0 7.0 ~zs February ………………………. 025 0:00 &.6 8.85
inontfl Meroh ………………………….. 0.25 0.90 9.0 10.15
Cash payments Apr~i …………………………….. o.2s i.so s.s io.ss Assumptions of level of production plus payments for overhead, Msy ……………………………… 025 3.00
s.2 a.45
dividends, interest, and taxes Juna …………………………….. 025 3.~ 3.s 7.0.5
~~y ……………………………… i.io s.00 i.a s.5o Cash budget August …………………………. 2.fi0 i.so i.o s.io
Comparison of cash receipt and payment schedules to determine September ……_ …………….. z.as o.~s i.s 520
617 c~,e
Table 6-5 Cash Budget and Assets for Second Figure 6-4 The Nature of Asset Growth
Year With No Growth in Sales ($ millions) (Yawakuzi)
Sapt. OeL Nov. Dea Jan. Fab. March April May June July Aug. Sept.
cse~,now…………_….. Sots s(~.i; &~.azs 35~.~) S(aszs~ kz.c~ si~.~; s o.i szs Sn.o sa.~ S~.s sots — ——–Beginning cash…__… 2.60 2.85 1.750 0.42b 025 Q25 026 025 025 025 025 S.7 52
Qmulative cash balance ……………… 1.75 0.425 (1275) 41.975) ;1.75) (0.551 0.35 2.75 425 5.95 52 5.45
MwRhy loan (a reparme~a~ …………. – – ~.sxs x.x2s z.o i.i {o.r~ ~z.$) la.o~ (o.zs) – –
Llmulative loan……… – – 1.525 3.750 5.75 6.85 6.75 425 025 0 – –
Efdlnp Ca9h balance ……………… $2.85 S 1.75 $0.425 5025 50.25 30.25 S 025 S 025 $025 3025 53.70 $52 $5.45
Toth GLm~t Asseb
Ending cash balance ……………… $2.85 E 1.75 $ 0.425 $ 025 S 0.25 $ 0.25 S 0.25 4 025 30.25 $0 25 .59.70 f52 $SAS
Accounts receivable …………. 0.75 OAS 0225 0.075 0 0 0.95 1.50 3.0 3.0 1.0 1.5 0.75
Invenbry ……………….. 1.6 2.6 3.9 5.4 7.0 8.6 9.0 B.6 62 3.8 1.6 1.0 1.60
Tote)wrtent aeseb……….._…. $52 S 49 $ 4.55 S 5.725 $ 725 5 8.05 Ei 0.20 410.35 39.45 $7.05 $8.1 a7.7 $7.80
Patterns of Financing
6t9. ., _ .:-…… „; <.;s_ :’:’:. ~~ .,=.::.:.siir~…. :,.a4:fa~: . .:iaia+:,~.. H;fl$4>I
Figure 6-5 Matching Long-Term and
Short-Term Needs
• Selecting of external sources to finance assets
is important
• Most appropriate financing pattern
Matching asset buildup and financing terms length
Figure 6-S
Alternative Plans
Challenge of constructing financial plan is
categorizing current assets into temporary and
permanent
Predicting exact timing of asset liquidation is
difficult
Difficult to determine amount of short-term
and long-term financing available
Long-Term Financing
Can assure adequate capital at all times
May rely on long-term funds to cover part of
short-term needs
Can finance
_° Fixed assets
~~ Permanent current assets
_° Part of temporary current assets
~_ 6za
Figure 6-6 Using Long-Term Financing
for Part of Short-Term Needs
– — — – —~ Ddlars
Temporary current assets Short-term ~ ~ financing
Lang-term financing
i (debt end equity)
T~ ~~~
Short-Term Financing
(Opposite Approach)
Small businesses do not have total access to
long-term financing
a Rely on short-term bank and trade credit
• Advantage: Interest rates are lower
Short-term finances used for
g Temporary current assets
Part of permanent working-capital needs
~~, ~ _~-~-.~.~ .~.~s. ,,. .: ,::~.
Figure 6-7 Using Short-Term Financing for
Part of Long-Term Needs Term Structure of Interest Rates
Yield curve —shows relative level of short-term and long-term interest rates
U.S. government securities used; free of default risks
Corporate debt securities move in same direction as
US government securities
• Has higher interest rates due to more financial risk
Yield curves for both securities change daily to reflect
Current competitive conditions
r Expected inflation
Changes in economic conditions
. ,~r..~ .. . . ,.., . .s -.-.,~,bc:, , .
..ca. ‘ ..~., – _a .. . ,. 6.28 ,
Term Structure of Interest Rates Figure 6-9 Treasury Yield Curve
Three basic theories —shape of yield curve
Liquidity premium theory
Long-term rates should be higher than short-term rates
I ncentive to hold less liquid and price-sensitive securities
Market segmentation theory
• Treasury securities are divided into market segments by various financial institutions investing in market
Expectations hypothesis Yields on long-term securities are function of short-
term rates
Over the time period long-term security is outstanding
Percent as ,
~ Dec 2013
2.8 { ~a~ 2015
oec r.ia i.a
i .,~C~ 2073 o.~
3m tY zY 5Y ‘h
a~T~~
‘TAe traas;~• yk10 awe la December 2011 is almost itlenYW fa Ihel la tlw week eMYq 177!!015.
goy
628: ,.,w .::Mai, .,~ …. … ~.~. _ ~.~ ,~ ,.~.: zttc :mom .-„w..i:~+. . 630;
Figure 6-10 Long- and Short-Term
Annual Interest Rates
Relative volatility and historical level of short-
term/long-term rates Percent
‘ Moodys~aa <~rpo~ate bonds ~o
i
z /~ Consumer Prueindev
p i…….. _… ……:._ .. … ………. .. ……._. .. ..__~… ……………. .. … ……………~
.: { us.smanm come:,rn wn. i
a ~ 1965 19W 1955 ioW Iro9 101a
Table 6-7 Alternative Financing Plans
• Decision Process— comparing alternative
working capital financing plans
EDWARDS CARPOMTION ~ ~~. ~ ~~
Plan A Plan B
Pert 1. Curtent assets
Temporary ………………………………………………………………….. 325C.Oiac S25e CCU
Pierma~nt …………………………………………………………………. 25Q.000 iS0::C0
ToW artanl assetc ………………………………………………. SSW.000 SY~O.:tA
Short-term finencirg ~6%) …………………………………………._. ti(IC.OxI t5:::~CO
Lorg~telm financing(10%j …………………………….._………….. C 2~. a’SO
SSOO.fu)o 9.~:Oc~(CO
Pert 2. Fixed asset8……._……_………._…_……….._……_._. S10C.OJG 314~~, ‘+~i
Lorg-tertri fnancitg(70%1 ………………………. .:.. ………… St(IO.OJC SIGG,’CO
Pad 3. Total financing (summery of perte 1 and 2j
ShoA term(6%1 ………………………………………………………….. $500.0)0 $15,.~CO
Lorg term (10%) …..:………………………………………………….._ SOQ~09C AS:;:;r0
. . .: … ~~: .,mnr < ., ~ ‘-‘ ” .. . .6-32~~w ..’= .~ , ~t ~ _.a _ .
Table 6-8 Impact of Financing Plans
on Earnings
EDWARDS CORPORATION
Plan A
Earnings tefore interest and taxes ……………………………………………………… . … . R200,000
Intarast (,l~rt cerm). 8% < $500,000 …………………………………………………… _.._. 30,Ofi0
Interest Eiong term), t0~o ~: $1CA,OOG ………………………………………………………_ 10.000
Enrnings before taxes …. ………………………………………………………………………….. $18Q000
Taxes(50 /) …………………………………………………………………………………………… 80.Ofi0
Eamirgs after taxe^> …………………………………………………………………………………. $ 80.00
Plan B
E~;,-ni~gs bafae interest and taxes _………… …. _.._ ………………….. …………………. $200.~~6
Ini~re~t(stxxt’.ertnJ.6% i 5150.00(}._._……._…………_._._ .. . 9.OpD
Interest (twig termj. tU°r:. .: g450.t:C~ ………. ………….__.._… ………_…..__… …_ d5.000 —
E ~nF1gsl~Aforetazttc…..,….. …………. ……… ………………… …. ………_…….. _.. . $1dG.00D
E ~~nc~gsr~ftert:rxes…….__……….._.____ ………………… .. ._. .._……….. …_ _.. . $ 7s.ORo
Introducing Varying Conditions
• Tight money periods
• Capital is scarce,
• Short-term financing may be difficult to find or
may have very high rates
Inadequate financing may mean loss of sales or
financial embarrassment
s•~a
Table 6-9 Expected Returns under Table 6-10 Expected Returns for
Different Economic Conditions High-Risk Firms
Expected value represents sum of expected
outcomes under both conditions
+ ~ ~ ~iIARDS TIOM
1. Normal Expected higher return Probability of Expected
co~dtions under Plan A normal conditions outcome
57.000 x 0.80 55.600
2, Tight Expected lower return Probability of
money under Plan A light money
($15.000) is 020 = (3,000)
Expected value of return for Plan A versus Plan 6 = +$2,600
F~FORATI4N
1. Normal Expected higher return Probability of Expected conditions under Plan A normal conditions outcome
57,000 x 0.80 = S 5,600
2. Tight Expected lower return Probability of tight money under Plan A money
(550,000) X 020 = (1Q00(ij
Negative exp?cted value of return for Plan A versus Plan B = ‘,S A,400j
. . 635 .636
Shifts in Asset Structure
During recession
Sales decline or stay even
• Cash, receivables, and inventory fall
Short-term debt may rise
Causes large decline in net working capital to sales ratio
m During upswing
Cash, receivables, and inventory rise
Short-term debt may fall or be replaced by low-cost long-
term debt
• These two effects cause a firm’s profitability to increase ~ ~ ~ ~ 8 ~ ~ ~ ~ ~ ~ ~ .. ~,
and net-working-capital-to-sales ratio to rise ~ Q ~ R Rd a o g a d o ~ a Q d a
~.cu ,~~ _ ~ s~~ .. ~ – _~ ~ . .:, -~~~_, – ,. =t:f~ ,.,- ~ .
Toward an Optimal Policy
g A firm should:
Attempt to relate asset liquidity to financing patterns
and vice versa
Decide how it wishes to combine asset liquidity and
financing needs
• Risk-oriented firm borrow will short-term and
maintain low level of liquidity
• Conservative firm will establish long-term
financing and maintain high degree of liquidity
Table 6-11 Asset Liquidity and
Financing Assets
Asset Liruid~ty
Financing P(an Low Liquidity Hgh Liquidity ‘;
Shat term High profs Moderate profit
Hic,~ nsk Moderffie risk
3 4
Lony term Moderate profit Low profit
Moderate risk Low risk
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Learning Objectives
~Ut”~”Gf1 ~i~S~E’~
al’~~E?C~’l~’~’~
~,~.: Block, Hirt, and Danielsen
Foundations of Financial Management
• Current assets management involves cash, marketable
securities, accounts receivable and inventory
• Cash management and minimizing nonearning cash
balances
Management of marketable securities involves selecting
between short-term investments
Management of accounts receivable requires credit
policy decisions for maximizing profitability
I nventory management —determining level of inventory
16t~’ edition to enhance sales and profitability Less liquid assets have higher required return
Chapter Opening
Companies that manage current assets well establish
competitive advantage
Helps increase market share
Creates increase in shareholder value through rising stock price
Requires careful allocation of resources among
current assets of firm
Cash, marketable securities, accounts receivable and inventory
Chapter Opening
Managing cash and marketable securities
• Primary concern is safety and liquidity
• Secondary attention is on maximizing profitability
Managing accounts receivable and inventory
I nvestment level should not be result of happenstance or historical determination Must meet same return-on-investment criteria applied to any decision
Different decision techniques applied to various forms of current assets
a te ,. ~ …:: . .. ._ . . .~„ ., . _.~. ~,~. ~.
Cash Management
Financial managers actively attempt to keep
cash (non-earning asset) to minimum
Critical to have sufficient cash for emergencies
To improve overall profitability of firm
Minimize cash balances
• Have accurate knowledge of when cash moves
i n and out of firm
Reasons for Holding Cash Balances
• Transactions balances
Payments towards planned expenses
Compensating balances for banks
Compensate bank for services provided rather than
paying directly for them
Precautionary needs
~~ Emergency purposes when cash inflows are less than
projected
I mportant in seasonal and cyclical industries
7.5 7,6
Cash Flow Cycle Cash Flow Cycle
• Cash moves through a firm on a daily, weekly Cash inflows driven by sales and influenced by
and monthly cycle •Type of customers
• Relies on: •Customers’ geographical location
• Product being sold Payment pattern of customers
• Industry • Speed at which suppliers and creditors process ~ Firms use cash to make various payments to checks
Interest to lenders • Efficiency of banking system • Dividends to stockholders
• Inflows and outflows of cash must be a Taxes to the government
synchronized properly for transaction purposes tl Accounts payable to suppliers
. .~e:…. ,_.,.: ;. . ‘~ ;;aLsrA…~„~W~ . ,:. ..~ s’.sv~ ‘Lw’
s Wages to workers and replace inventory
iiYtwwiwea~.e/~rnw4ei~ ..a irw+aiiii~…. £~.~:~: ~.: .. .:-:.. .. ,.,…
Figure 7-1 The Cash Flow Cycle
~.g
Figure 7-2 Expanded Cash Flow Cycle
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Collections and Disbursements
Critical function of financial manager is
managing cash inflows and payment outflows
Electronic transfer mediums change time period
between payment and collection
a Cash flow cycle still affected by collection
mechanisms
Lockboxes
US mail system
I nternational sales, etc.
Float
Difference between firm’s recorded amount and amount credited to firm by bank
m Two types of float a Mail float
• Occurs because of time mail takes to be delivered
Clearing float • Occurs because of time check takes to be cleared
u Small businesses and individuals encounter this most often
Float Improving Collections and
Extending Disbursements
• Large corporations avoid these two floats Improving collection
because of widespread use of electronic •Setting up multiple collection centers at different
payments locations
• Check Clearing for the 21St Century Act of
2003 (Check 21 Act)
• Allows banks and others to electronically process checks
• Float will eventually be eliminated altogether
Adopt lockbox system for fast check clearance at
lower costs
Extending disbursement
• General trend
• Speedup processing of incoming checks
• Slow down payment procedures
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Figure 7-3 Cash Management Network
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Electronic Funds Transfer
Funds moved between computer terminals
without use of ‘check’
Reduces float through use of terminal
communications between store and the bank
Automatically charged against bank account before
leaving the store
Automated clearinghouses (ACH)
4 Transfers information between financial institutions and between accounts using computer tape
Cost-Benefit Analysis
• Expenses from use of remote collection and
disbursement centers involve additional costs
Expenses must be compared to benefits that
may accrue through use of these operations
Electronic Funds Transfer
I nternational electronic fund transfer carried out
through SWIFT (Society for Worldwide Interbank
Financial Telecommunications)
Proprietary secure messaging system
Encrypts each message
~° Authenticates every money transaction
Assumes financial liability for accuracy,
completeness, and confidentiality of transaction
International Cash Management Figure 7-4 Ten-year SWIFTNet FIN
Message Traffic
• International cash management vs. domestic „~, based systems ~~ ~ ,,~
• Payment methods differ from country to country
• Subject to international boundaries, time zones, currency fluctuations, interest rate changes
Differing banking systems and check-clearing processes
• Differing account balance management and information reporting systems
• Cultural, tax, and accounting differences
I nternational Cash Management Marketable Securities
• Hold cash balances in one currency vs.
another to take advantages of high interest
rates
Financial managers try to keep cash in country
with strong currency
• Sweep account
Allows companies to maintain zero balances
Excess cash swept into interest-earning account
Funds held for other than immediate transaction purposes should be invested in interest-earning securities
Types of short-term investments • Treasury bills
• Federal agency securities
Certificates of deposit
• Commercial paper
• Banker’s acceptances
Eurodollar certificates of deposit
• Passbook savings accounts
Money market funds
Money market accounts
h ~ .,
Figure 7-S Examination of Yield and Table 7-1 Types of
Maturity Characteristics Short-Term Investments
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Management of Accounts Receivable
• Accounts receivable as an investment
• Based on level of return on investment equals or
exceeds potential gain from other investments
• Optimizing return based on appropriate risk and
liquidity considerations
Credit policy administration has three primary
policy variables to consider
• Credit standards
Terms of trade
• Collection policy
Figure 7-6 Financing Growth in
Accounts Receivable
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Credit Standards Credit Standards
Determine nature of credit risk based on
• Prior records of payment and financial stability, current net worth, other related factors
5 Cs of credit to indicate whether a loan will be paid on time, late or not at all
m Character
• Capital
• Capacity
• Conditions
• Collateral
Table 7-2 Dun &Bradstreet Report
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• Dun &Bradstreet Information Services (DBIS)
• Most prominent source of business information
• Produces business information analysis tools
• Publishes reference books
Provides computer access to information
• Assigns Data Universal Number System (D-U-N-S)
Unique nine-digit code for each business in information
base
• Used to track whole families of companies related
through ownership
Figure 7-7 Dun’s Numerical Tracking
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Terms of Trade
• Stated term of credit extension
Has strong impact on eventual size of accounts-
receivable balance
Creates need for firms to consider use of cash
discounts
Collection Policy
A number of quantitative measures are applied to
asses credit policy:
Average collection period
An increase would indicate poor credit administration
Average collection period =Accounts receivable
Average daily credit sales
Ratio of bad debts to credit sales
An increasing ratio may indicate too many weak
accounts or an aggressive market expansion policy
Aging of accounts receivable
An Actual Credit Decision
p Brings together various elements of accounts
receivable management P.dditional sales ……………………………………………………………………….. $70.000
Accounts uncollectibla (10Wo of new sales) ………………………………….. 7.000
Annual inaen78ntal revenue ………………………………………………………. 9.000
Collection costs (5% of naw sales) …………………………………………….. 500
%oduction and selling costs (77% of new sales) …………………………. 7.700
Mnuel income Aefore taues ………………………………………………………. 800
Takes{40%) …………………………………………………………………………….. 320
Mnual incremental income after taxes ……………………………………….. $ 480
Accounts receivable = Sales = 10 000 = $1,667
Turnover 6
An average investment of $1,667 is fetching a post tax profit
of $480, which is approximately 28.8%.
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Level versus Seasonal Production
Inventory Management
I nventory has three basic categories
Raw materials —used in products
e Work in progress —partially completed products
• Finished goods —ready for sale
• Amount of inventory affected by
• Sales
• Production
• Economic conditions
~~ Inventory is least liquid of current assets;
should provide highest yield 7-33
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• Level (even) production Allows maximum efficiency in manpower and machinery usage
May result in high inventory buildup before shipment particularly in seasonal business
Seasonal production Eliminates inventory buildup problems
May result in unused capacity during slack periods
May result in overtime wages and inefficiencies arising out of overused equipment
Inventory Policy in Inflation (and Deflation)
I nventory position can be protected in an
environment of price instability by
Taking moderate inventory positions
Hedging with a futures contract to sell at a
stipulated price some months from now
~° Rapid price movements in inventory may
have a major impact on the reported income
of the firm
The Inventory Decision Model
Two basic costs associated with inventory
• Carrying costs
I nterest on funds tied up in inventory
• Cost of warehouse space, insurance premiums, and
material handling expenses
* Implicit cost associated with the risk of obsolescence or
perishability and price change
• Ordering costs
x Cost of ordering
• Cost of processing inventory into stock
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Economic Ordering Quantity
EOQ = 2S0
C
Where,
S =Total sales in units
0 =Ordering cost for each order
C =Carrying cost per unit in dollars
Assuming:
S= 2000 units; 0=$8; C= $0.20;
EOQ = 2 X 2,000 X $8 = 32 000 = 160,000 = 400 units
$0.20 $0.20
Figure 7-8 Determining Optimum
Inventory Level
cost o~ ardnnrq nne c~nylnq irnonrory (S)
Figure 7-9 Inventory Usage Pattern
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Safety Stocks and Stock Outs
• Stock out occurs when firm is
Out of specific inventory item
U nable to sell or deliver product
~~ Safety stock of inventory reduces risk of losing
sales
I ncreases cost of inventory due to rise in carrying
costs
• Cost should be offset by
Eliminating lost profits due to stockouts
Increased profits from unexpected orders
Safety Stocks and Stockouts
• Assuming that; EOQ = 400 units and safety stock =
50 units
Average inventory = EO~C +Safety stock
z Average inventory = 400 + 50
z • The inventory carrying costs will now increase to $50
Carrying costs =Average inventory in units X Carrying cost per
unit
= z5o x So.zo = $so
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Just-in-Time Inventory Management
A Basic requirements for JIT
• Quality production that continually satisfies
customer requirements
• Close ties between suppliers, manufacturers, and
customers
Minimizes level of inventory
Cost savings from lower inventory
On average, JIT has reduced inventory to sales
ratio by 10% over last decade
Other Benefits
a Reduction of warehouse spaced for inventory
ff Reduction of construction and overhead expenses for utilities and manpower
Better technology with development of electronic data interchange systems (EDI)
Between suppliers, production and manufacturing departments
Reduction in re keying errors and form duplication
Reduction in costs from quality control
• Elimination of waste
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The Downside of JIT
• Integration costs of JIT system
= Parts shortages could lead to lost sales and
slow growth
Un-forecasted increase in sales
I nability to keep up with demand
Un-forecasted decrease in sales
fi Inventory can pile up during recession
p Revaluation may be needed in high-growth
industries fostering dynamic technologies
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