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CHAPTER 22Working 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 2Selected Ratios for SKI

SKI IndustryCurrent 1.75x 2.25xQuick 0.83x 1.20xDebt/Assets 58.76% 50.00%Turnover of cash 16.67x 22.22xDSO (365-day basis) 45.63 32.00Inv. turnover 4.82x 7.00xF. A. turnover 11.35x 12.00xT. A. turnover 2.08x 3.00xProfit margin 2.07% 3.50%ROE 10.45% 21.00%Payables deferral 30.00 33.00

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Cash Conversion Cycle (Cont.)

CCC = + –

CCC = + 45.6 – 30

CCC = 75.7 + 45.6 – 30

CCC = 91.3 days.

Days per yearInv. turnover

Payablesdeferralperiod

Days salesoutstanding

3654.82

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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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Compensating balances: For loans and/or services provided.

Speculation: To take advantage of bargains, to take discounts, and so on.

Cash Management:Cash doesn’t earn interest,

so why hold it?

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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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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.

Cash Management TechniquesWays to Minimize Cash Holdings

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Cash Management TechniquesWays 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 TechniquesWays 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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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?

Cash Management TechniquesWays to Minimize Cash Holdings

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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 Ind. Avg.

Current 1.75x 2.25x

Debt/Assets 58.76% 50.00%

Turnover of cash & securities 16.67x 22.22x

DSO (days) 45.63 32.00

Inv. turnover 4.82x 7.00x

F. A. turnover 11.35x 12.00x

T. A. turnover 2.08x 3.00x

Profit margin 2.07% 3.50%

ROE 10.45% 21.00%

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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 FebruaryCollections $67,651.95 $62,755.40Purchases 44,603.75 36,472.65Wages 6,690.56 5,470.90Rent 2,500.00 2,500.00Total payments $53,794.31 $44,443.55Net 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.

b. DSO =

Average sales per day = $3,421,875/365 = $9,375.

Investment in receivables = $9,375 38 = $356,250.

Inventory conversion period =

Inventory turnover = 365/75 = 4.87.

Account Receivables Average sales per day

Days per yearInv. turnover

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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.

ROA = = 9000/150000 = 11.25%Net IncomeTotal assets

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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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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” ?????

Elements of Credit Policy

(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 maydiscourage sales. Some customersmay choose to go elsewhere if theyare pressured to pay their billssooner.

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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.