Finance for NonFinancial Managers Fifth Edition

1
Finance for Non-Financial ManagersFifth Edition

• Slides prepared by
• Pierre G. Bergeron
• University of Ottawa

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Working Capital Management

• Chapter Objectives
• Define the meaning and importance of the cash
  conversion cycle.
• Comment on managing cash and cash equivalents.
• Discuss various techniques related to accounts
  receivable management.
• Explain different strategies related to managing
  inventory.
• Show how current liability accounts can be
  managed to improve the cash flow cycle.

Chapter Reference Chapter 6 Working Capital
Management
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Meaning of Working Capital

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

Working capital Current assets Current
liabilities Cash 10,000 Accounts
payable 56,000 Accounts receivable
30,000 Notes payable 20,000 Notes receivable
5,000 Accrued expenses 4,000 Marketable
securities 10,000 Taxes payable
8,000 Inventory 70,000 Prepaid expenses
3,000 Total current assets 128,000 Total
current liabilities 88,000
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1. Cash Conversion Cycle
Existing 209 days Target 160
days Reduction 49 days
Cash
Deposit
Purchase decision and order
Processing payment
Payment by customer
Credit decision
Billing
Purchase of raw materials
Payment to suppliers
Delivery of raw materials
Inventory of raw materials
Inventory of finished goods
Manufacturing
Shipment
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Days of Working Capital (DWC)
Using Futurama Ltd. (Transparencies 3.5
3.6) Purpose Measures the amount of days
in working capital a business holds
in order to meet its average daily sales
requirements. (Accounts Receivable
Inventory) - Accounts Payable Sales revenue /
365 (300,000 218,000) -
195,000 2,500,000 / 365 323,000 6,940


47.2 days
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Cash Conversion Efficiency (CCE)
Using Futurama Ltd. (Transparencies 3.5
3.6) Purpose Measures the efficiency with which
a business converts sales revenue to cash flow
from operations. Cash flow from
operations Sales revenue 126,000 2,500,000

5.1 percent
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2. Managing Cash
The goal of cash management is to reduce the
amount of cash that is being used within the firm
so as to increase profitability, but without
reducing business activities or exposing the firm
to undue risk in its financial obligations.
20 days late for payment 365 days
20,000 x 12 X 131.51
Cash flows in connection with credit serve to
introduce the concept of _________ which is the
time lag or delay between the moment of
disbursement of funds on the part of the customer
and the moment of receipt of funds on the part of
the seller (i.e., mail time, processing time, and
clearing time with the banking system).
FLOAT
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Ways to Improve Collection of Cash

• Changing customer paying habits
• Letters, telephone calls, or personal visits
• Economic incentive for paying bills faster offer
  discounts (i.e., 2/10, N/30)

• Improve the Delivery system (reduce the negative
  float)
• Regional banking (customers pay bills to banks
  since they can transfer funds more quickly than
  mail order delivery).
• Lockbox collection system (firm rents a post
  office box in a particular city and the bank
  monitors the lockbox periodically).
• Electronic communications (i.e., data-phone wire
  systems).

• Bypass the problem (Factoring of receivables).

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3. Managing Accounts Receivable
The goal of accounts receivable management is to
set credit terms, grant credit to customers,
monitor payment patterns, and apply necessary
collection procedures so as to increase
profitability.
Credit policy consists of choosing the
appropriate credit terms to offer to customers
(present and future). Terms differ from product
to product and industry to industry. Example S
elling price 120.00 Cost of product
90.00 Cost of capital 10 Should the
company grant 2/10, net 30 days? 90.00 x 10
x 1.48
60-day delay 365 days
10-day payment
60-day payment
Effective priceCost of productCredit
costInterest on moneyProfit

• _________ _________ _________ _________
  _________

• _________ _________ _________ _________
  _________

117.60
120.00
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Grant Credit to Customers (credit report)
Summary Report Information Payments Finance H
istory Banking Operations
Classification code for line of business, year
business started, rating, principal executives
(owners). Payments, sales, worth, number of
employees, trends. How business pays its bills
(i.e., amounts owing, amounts past due, terms of
sale, manner of payment, and supplier
comments). Financial conditions and trend of
business (balance sheet and income statement
analysis). Names, birth dates and past business
experience of the principals or owners,
affiliation, ownership, outside interest of the
principal owners. Outstanding loans. Nature of
the premises, neighbourhood, size of floor space,
production facilities.
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Changing Credit Terms
Return on investment calculation for changing the
firms credit terms Existing
terms Proposed terms Expected volume
(units) 400,000 440,000 Expected sales
revenue (10.00 per unit) 4,000,000 4,400,000 Ex
pected profit before bad debts (10 of revenue)
400,000 440,000 Expected bad debt expense (
of revenue) 20,000 (.5) 33,000 (.75) Expected
profit (after bad debts) 380,000
407,000 Incremental profit ------
27,000 Expected collection period (days)
29 42 Average accounts receivable
315,800 501,200 Incremental investment
----- 185,400
Incremental profit 27,000 Incremental
investment 185,400
Return on investment 14.6
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4. Managing Inventory
The goal of inventory management is to replenish
stocking points in such a way as to minimize the
total of all associated costs, and thereby
enhance profitability of the business.
Types of inventory

• Raw Materials (i.e., lumber, steel, rubber,
  plastics, chemicals, paint and other fishing
  substances, also includes supplies and parts).

• Work-in-Progress (i.e., partially assembled or
  partially processed, not yet completed).

• Finished Goods (i.e., goods completed and ready
  to be sold for resale by wholesaling and
  retailing firms).

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Inventory Levels
Units in inventory
Average number of units in inventory Q/2
Maximum inventory level
LT
LT
LT
LT
LT
LT
Purchase
Quality
RP
RP
RP
RP
RP
RP
Minimum inventory level
SAP
SAP
SAP
SAP
SAP
SAP
SAP
LT Lead time SAP Stock arrival point RP
Reorder point Depletion of stock
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Inventory Decisions
Typical costs of ordering and holding inventory

• Order and set-up costs
• Transportation costs
• Clerical costs of making orders
• Cost of placing goods in storage
• Downtime on equipment
• Quantity discounts

• Holding costs
• Storage costs
• Fire insurance
• Property taxes
• Spoilage and deterioration
• Cost of borrowing
• Rent of facilities
• Obsolescence

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Calculating the Economic Order Quantity
Number Order Annual Average
Average Annual Ordering cost
of quantity order cost unit
dollar holding
orders (units)
50.00 inventory investment
costs Holding cost per order (2)
2 (4) x 5.35 (5) x 15 (3)
(6) 1 2
3 4 5 6
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1 2 5 6 8 10
5,000 2,500 1,000 833 625 500
50 100 250 300 400 500
2,500 1,250 500 416 312 250
13,375 6,687 2,675 2,226 1,669 1,337
2,006 1,003 401 334 250 200
2,056 1,103 651 634 650 700
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Economic Order Quantity
F Fixed costs per order (clerical, processing,
payment, receiving, verification, shelving)
50.00 U Units sold per year
5,000 C Carrying costs per unit/per year
0.80 (storage, insurance, rent, spoilage,
interest charges) EOQ EOQ 790
units
5.35 x 15
2 FU C
2 x 50.00 x 5,000 0.80
Heres the proof Annual order costs (6 times x
50.00) 300.00 Annual carrying costs (5.35 x
790 4,226 2 x 15) 317.00 Total
inventory costs 617.00
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5. Managing Current Liabilities

• Accounts payable
• Accruals
• Salaries and wages payable
• Taxes payable
• Working capital loans