working capital management p3 and 4

8/11/2019 Working Capital Management p3 and 4

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TYPES OF ACCOUNTS RECEIVABLE

Trade or Commercial Credit - credit which thefirm extends to other forms

Consumer or retail credit - credit which thefirm extends to its final customers

CREDIT AND COLLECTION POLICIES OF THEFIRM

(1) AverageCollection Period

(2) Bad-debtLosses

CreditTerms

CollectionPolicy

Quality of

Trade Account

Delinquencyand Default

CREDIT STANDARDS

Credit Standards- The minimum quality of credit worthiness of a creditapplicant that is acceptable to the firm.

Why lower the firms credit standards?

The financial manager should continually lower the firms credit standards aslong as profitability from the change exceeds the extra costs generated by

the additional receivables until it achieves optimal credit policy.

What is being evaluated for credit worthiness?

A. Character

B. Capacity

C. Capital

D. Collateral

E. Conditions


(1) Average

Collection Period(2) Bad-debt

Losses

CreditTerms

CollectionPolicy

Quality ofTrade Account



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CREDIT TERMS AND DISCOUNTS

Credit Terms - Specify the length of time over which credit is extended toacustomer and the discount, if any, given for early payment.For example, 2/10, net 30.

Credit Period - The total length of time over which credit is extended to acustomer to pay a bill. For example, net 30 requires fullpayment to the firm within 30 days from the invoice date.

Discount Period -The period of time during which a cash discount can be takenfor early payment. For example, 2/10 allows a cashdiscount in the first 10 days from the invoice date.

Cash Discount - A percent (%) reduction in sales or purchase price allowed forearly payment of invoices. For example, 2/10 allows thecustomer to take a 2% cash discount during the cash discountperiod.

SEASONAL DATING

Seasonal Dating - Credit terms that encourage the buyer of seasonal productsto take delivery before the peak sales period and to deferpayment until after the peak sales period.

Avoids carrying excess inventory and the associatedcarrying costs.

Accept dating if warehousing costs plus the required returnon investment in inventory exceeds the required return onadditional receivables.


(1) Average


Losses

CreditTerms

CollectionPolicy



COLLECTION POLICY AND PROCEDURES

Collection Procedures

Letters

Phone calls Personal visits

Legal action

The firm should increase collection expenditures until the marginalreduction in bad-debt losses equals the marginal outlay to collect.

Collection Expenditures

Bad-DebtLosses

SaturationPoint


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(1) AverageCollection Period

(2) Bad-debtLosses

CreditTerms

CollectionPolicy

Quality of

Trade Account


COST ASSOCIATED WITH INVESTMENT INACCOUNTS RECEIVABLE

Credit Analysis, Accounting and Collection costs

Cost in maintaining the accounts department

Capital Costs

Cost in acquiring funds

Delinquency Costs

Costs incurred in extra actions in collecting delinquentaccounts

Default Costs (Bad Debts)


(1) Average


Losses

CreditTerms

CollectionPolicy



SUMMARY OF TRADE-OFFS IN CREDIT ANDCOLLECTION POLICIES


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MARGINAL OR INCREMENTAL ANALYSIS OFCREDIT POLICIES

All things being equal, the decision concerning the change in credit policy ismade using the following rules

MARGINAL OR INCREMENTAL ANALYSIS OFCREDIT POLICIES (EXAMPLE)

XYZ Co. is considering a more liberal extension of credit which willresult in slowing the monthly average collection period from 45 daysto two months. The firms current sales is P2M and if the new policy isto be implemented is expected to increase to P2.5M. Assume the

companys contribution margin is 25% and its hurdle rate is 20%before taxes. Bad debts from incremental sales is expected to be at5% and collection expenses will increase from P200,000 to P210,000.Should the company implement its new credit policy?


Therefore: Since Net Incremental Profit is greater than Required ROI then ACCEPT


EMSL Co. has 12% opportunity cost of capital and currently sells onterms n/20 It has current annual sales of P8M, of which 70% are oncredit. Current Average Collection period is 75 days. It is nowconsidering to offer terms of 2/10, n 30 in order to reduce thecollection period. It expects 50% of its customer to take advantage ofthe discount and the collection period to be reduced to 45 days.

Should the company relax its credit policy or not?


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Therefore: Since Net Incremental Cost between the current policy and the proposalthen EMSL should think indifferently between the current and the proposedpolicy

INVENTORY MANAGEMENT

INVENTORY MANAGEMENT AND CONTROL

Inventories form a link between production and sale of aproduct.

Inventory types:

For Manufacturing Firms

Raw-materials inventory

Work-in-process inventory

In-transit inventory

Finished-goods inventory

Factory Supplies

For Trading Firms

Merchandise Inventory

INVENTORY MANAGEMENT AND CONTROL

Inventories provide flexibility for the firm in:

Purchasing

Production scheduling

Efficient servicing of customer demands


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FUNCTIONS OF INVENTORY

Pipeline or Transit Inventories- supply pipelines betweenstages of the production-distribution system

Organizational or decoupling inventories- inventories

maintained to give a certain production line a degree ofindependence from the rest of the production lines.

Seasonal or anticipated stock- built in anticipation of aheavy selling season.

Batch or lot-size inventories- maintained when user buysmaterials in larger lots than its immediate needs.

Safety or buffer stock- maintained to protect the companyfrom uncertainties

COST ASSOCIATED WITH INVESTMENTS ININVENTORY

1. Carrying Costs

Cost of Capital tied up in inventory

Storage and handling costs

Insurance

Property taxes

Depreciation and obsolescence

Administrative costs

2. Ordering, shipping and receiving costs

Cost of placing orders including production and setup

Shipping and Handling costs

3. Costs of Running Short

Loss of Sales

Loss of Customer Googdwill

Description of production schedules

HOW DOES A FIRM DETERMINE THEAPPROPRIATE LEVEL OF INVENTORIES?

Employ a cost-benefit analysis

Compare the benefits of economies of production,purchasing, and product marketing against the cost of theadditional investment in inventories.

HOW MUCH TO ORDER?

The optimal quantity to order depends on:

Forecast usage

Ordering cost

Carrying cost

Ordering can mean either the purchase or production ofthe item.


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WHEN TO ORDER

Reorder Point = Lead Time Usage + Safety Stock

Lead Time Usage = Lead time X Periodic usage

Lead Time - The length of time between the

placement of an order for an inventory item and when

the item is received in inventory.

Safety Stock- Inventory stock held in reserve as a

cushion against uncertain demand (or usage) and

replenishment lead time.

ECONOMIC ORDER QUANTITY (EXAMPLE)

The ff. inventory information and relationships for the BaguioCorporation are available:

1. Orders can be placed only by multiples of 100 units2. Annual unit usage is 300,000. (Assume 50 week year for

the calculation)3. The carrying cost is 30% of the purchase price od goods4. The purchase price is P10 per unit5. The ordering cost is P50 per order6. The desired safety stock is 1,000 units7. Delivery Time is two weeks

a.) What is the optimal EOQ level?b.) How many orders are planned annually?c.) At what level should a reorder be made?d.) How much is the total inventory cost for the year?

ECONOMIC ORDER QUANTITY (EXAMPLE)

Solution

EOQ=2 (O) (S)

C

EOQ=

2 x300,000 xP50

P10 x 30%

EOQ= 3,162 therefore3,200 units

a.

No. of Orders = S / Q= 300,000/3,200= 93.75 orders per year

b.

Reorder Point = Lead Time + Safety Stock= 300,000/50 weeks x 2 weeks

+ 1,000 units= 12,000 units + 1000 units= 13 ,000 units

c.

T = C (Q / 2) + O (S / Q)= (P3.00) (3,200 / 2) + P50 (93.75)= 4,800 + 4,687.50= P9,487.50

d.

COST ASSOCIATED WITH SAFETY STOCK

Annual Carrying Cost = 20% of inventory

Inventory = P 50 per unit

Stockout cost = P 5 per unit

No. of Orders per year = 10

Total Cost = carrying cost + expected stockout cost

The probabilities are as follows

Using the above data estimate the total cost of safety stock on eachsafety stock margin.


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COST ASSOCIATED WITH SAFETY STOCK

Solution

SS = Safety Stock SC = Stockout costsCC = Carrying Cost per unit %P = Probability of StockoutSO = Stock Out Units Q = No. orders per year

LEVEL MONITORING AND INVENTORYCONTROL SYSTEM

Fixed Order Quantity System

Fixed Reorder Point

Fixed Quantity Ordered

Needs to have perpetual inventory system

Reorder Pt = Ave. Lead Time USage + Buffer Stock

Fixed Reorder Cycle

Periodic review or replacement system

Replenishment is done if if upon review inventory levelwent down

Replenishment is calculated as follows

M = B + D(R +L)

LEVEL MONITORING AND INVENTORYCONTROL SYSTEM

Optional Replenishment System

Combination of Fixed Order Quantity and Fixed OrderCycle

Replenishment is calculated as follows

P = B + D(L + R/2)ABC Classification System

A items - high value items; highest possible controls

B items - medium value items; normal controls

C items - low value items; simplest possible controls

ABC METHOD OF INVENTORY CONTROL

ABC method ofinventory control

Method which controlsexpensive inventory

items more closely thanless expensive items.

Review A itemsmost frequentlyReview B and Citems less rigorouslyand/or less frequently.

AB

C

Cumulative

Percentage

ofInventoryValue

100

90

70

0 15 45 100

Cumulative Percentageof Items in Inventory

A - High Value ItemsB - Middle Cost ItemsC - Low Cost items


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END OF PART 3

Part 4

SHORT TERM SOURCE FORFINANCING CURRENT ASSETS

INTRODUCTION

Short-term financing refers to debt originally scheduled forrepayment within one year.

FACTORS IN SELECTING SHORT-TERM FUNDS

1. The effective cost of credit2. The availability of credit, when needed

3. The influence of the use of a particular credit source on thecost and the availability of other sources of financing

4. Any additional covenants of the loans that are unique tothe sources mentioned previously,


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CLASSIFICATION OF FINANCING SOURCES

1. Unsecured Credit - are loans which the lenders faith in theability of the borrower to pay serves as security

2. Secured Credit - involves pledging go specific assets as

collateral in the event the borrower defaults in payment.3. Spontaneous Short-term Financing - arise from ordinary

business transaction. They do not require special effort ornegotiation on the part of the finance officer.

4. Non-Spontaneous Short-term Financing - requires specialeffort

TYPES OF SHORT TERM CREDIT AND THECOST ASSOCIATED WITH THEM

Accrued Liabilities

Continually recurring short-term liabilities, such as accruedwages or taxes.

Is there a cost to accrued liabilities?They are free in the sense that no explicit interest ischarged.

However, firms have little control over the level of accruedliabilities.

Opportunity losses is the only cost expected from this


Trade Credit

Trade credit is credit furnished by a firms suppliers.

Trade credit is often the largest source of short-term credit,especially for small firms.

Spontaneous, easy to get, but cost can be high.Implicit / Hidden Cost - cost of operating passed tocustomers

Opportunity cost / missed cash discount - cost of foregoingthe discount


Trade Credit (Example)

Calculate the nominal cost of non-free trade credit undereach of the following terms:

1.) 2/10 ; n/60

2.) 2/10 ; n/30


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Bank Loans

Interest in Bank Loans may be calculated in five ways:

1. Simple Interest

2. Discount Interest

3. Add-on Interest

4. Simple Interest with compensating balances

5. Discount Interest with compensating balances

SIMPLE INTEREST

The borrower receives the face value of the loan and repaysthe principal and interest at maturity date.

For maturity of exactly one yearEffective annual ratesimple= Interest / Face Value

For loan has less than one year maturity

Effective annual ratesimple= [1 + (nominal rate / m)]m

where m = 360 days over /term days

DISCOUNT INTEREST

The bank deducts in advance the interest in advance ordiscounts the loan.

For maturity of exactly one year

Effective annual ratediscount= Interest / (Face Value-Interest)

For loan has less than one year maturity

Effective annual ratediscount= [1 + (nominal ratediscount/ m)]m

where m = 360 days over /term days

ADD-ON INTEREST

Is the interest that is calculated and added to the fundsreceived to the face amount of the instalment.

Approx Annual Interest is calculated based on the ff.formula

Effective Interest rate is calculated getting the internal rateof return or effective yield


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ADD-ON INTEREST (EXAMPLE)

Determine the approximate and effective annual interest rateon Php 1 Million Loan on an add-on basis with a nominal rateof 9% payable in 4 quarterly installments.

Approx Annual Interest is calculated based on the ff. formula


Effective Annual Interest Rate Calculation

Monthly Payment (P) = 1,000,000 + 90,000

4= Php272,500

Php1,000,000 = 272,500 x PVIF

PVIF = 3.66972

If table is used Effective Rate is between 3% and 4%

By Interpolation

Effective Rate per period = 3% + (3.71710 - 3.66972) x 1%

(3.71710 - 3.62290)

= 3.5030%

[ ]


Effective Annual Interest Rate Calculation (Continued)

Effective Rate per period = 3.5030%

Effective Rate per annum = (1 + .035030)4-1Effective Rate per annum = 14.7656%

DISCOUNT INTERESTWITH COMPENSATING BALANCE

The compensating balance is the minimum account balance that alending balance that a lending bank requires the borrower tomaintain.

For maturity of exactly one year

Effective annual ratesimple-cb= InterestFace Value - Interest - compensating balance

or

Effective annual ratesimple-cb= Nominal Rate

1.0 - Nominal Interest -compensating balance %


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INTEREST WITH COMPENSATING BALANCE(EXAMPLE)

Assume the bank lends a 1 year loan amounting to Php 1Million at 10% interest rate but the company must maintain aguaranteed deposit of 20% of the loan value,

What is the effective rate of the loan if:

a.) Loan approved is on simple interest basis?

b.) Loan approved is on discount interest basis?

INTEREST WITH COMPENSATING BALANCE(EXAMPLE)

Solution:

a.) 10% or 100,000

100% - 20% 1,000,000 - 200,000

Effective Ratesimple= 12.5%

a.) 10% or 1,000,000

100% - 10% - 20% 1,000,000 - 100,000 - 200,000

Effective Ratediscount= 14.2857%


Line of Credit

Forms of Line of Credit

a.) Line of Credit - the bank informally agrees to lend up to aspecific maximum amount of funds during a designatedperiod. Interest is charged on actual borrowed and a servicefee may be charged on the amount unserviced.

b.) Revolving Credit Agreement - a legal commitment by thebank to extend credit up to specific limit for a period of time.Interest is charged on the drawdowns and as payments arereceived for the loan, the credit line is restored to the amountpaid. A commitment fee is charged on the unutilized portionof the line.


Commercial Paper

A marketable security which typically is an unsecuredpromissory note with a fixed maturity of no more than 270days.


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COMMERCIAL PAPER (EXAMPLE)

Company A uses commercial paper to regularly support itsneeds for short-term financing. The firm plans to sell P100Min 270 day maturity paper on which it expects to have to paydiscounted interest at an annual rate of 12% per annum. Inaddition, Company A expects to incur a cost of approximatelyP100,000 in dealer placement fees and other expenses ofissuing the paper. What is the effective cost of credit ofCompany A.

COMMERCIAL PAPER (EXAMPLE)

Solution:

SHORT-TERM FINANCING WITH SECURITY

1. Pledging or assignment of Accounts Receivable

2. Factoring of accounts receivable

3. Inventory Loans with

A. Floating or blanket lien

B. chattel mortgageC. field warehouse financing agreement

D. terminal warehouse receipt

ASSIGNMENT OF RECEIVABLES (EXAMPLE)

Company A sells supplies to its customer on terms of n/60.The firms average monthly sales are P200,000; thus itaverage accounts receivable balance is P 400,000, based ontwo months credit period. The company pledges all itsreceivables to a local bank, which interns advances up to

70% of the face value of the receivables at 3% over primeand 1% processing charge on all receivables pledged.Company A follows a practice pf borrowing the maximumamour possible. The current prime rate is 12%

What is the effective cost of using the facility for a full year?


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INVENTORY FINANCING (EXAMPLE)

Company A enters in a field warehousing agreementwith the bank to secure a two month loan usingP200,000 worth of its inventory as a collateral. The

bank lends up to 70% of the value of the inventory at14% interest plus a fixed fee of P2,000 to cover thecost of field warehousing agreement. What is theeffective annual cost of the financing agreement.

INVENTORY FINANCING (EXAMPLE)

Solution:

Effective Rate = (Interest + issue cost)/ Face Value x (360/terms)

= (200,000 x 70% x 14% x 60/360) + 2,000 x 360200,000 x 70% 60

= 3,266.67 + 2,000 x 360

140,000 60

= 22.57%

END OF PART 3 END OF DISCUSSION

working capital management p3 and 4

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