Working Capital Management

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Chapter 7

• Working Capital Management

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Working Capital

• Working capital consists of the current assets
  and the current liabilities of a business.
• Current assets are gross working capital.
• Cash, marketable securities, accounts receivable,
  and inventory
• Net working capital is the difference between a
  businesss total current assets and its total
  current liabilities.
• Working capital management is our ability to
  effectively and efficiently control current
  assets and current liabilities in a manner that
  will provide our firm with maximum return on its
  assets and will minimize payments for its
  liabilities.

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Current Asset Management

• Cash management
• Marketable securities management
• Accounts receivable management
• Inventory management

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Cash Management

• The goal of cash management is to obtain the
  highest return possible on cash. Cash consists
  of
• Petty cash
• Cash on hand
• Cash in bank, checking
• Cash in bank, savings
• http//www.youtube.com/watch?featureplayer_detail
  pagevr0eEQQNRcf4

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Cash Management (continued)

• Float
• The disbursement float is the time that elapses
  between payment by check and the checks actually
  clearing the bank, at which point funds are
  removed from our checking account.
• Collections float is the amount of time that
  elapses between your depositing a debtors check
  in your account and the checks clearing, at
  which point the funds are actually placed in your
  account.
• Managing collection float
• A lockbox is a post office box that is opened by
  an agent of the bank, and checks received there
  are immediately deposited in our account.
• Electronic funds transfer (EFT) is accomplished
  when funds are immediately transferred from one
  bank account to another via computer.

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Marketable Securities Management

• Marketable securities normally are those
  investment vehicles that include U.S. treasury
  bills, government and corporate bonds, and
  stocks.
• Excess cash should be placed in the above
  vehicles because they increase in value more than
  cash itself.

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Accounts Receivable Management

• The goal of accounts receivable management is to
  increase sales by offering credit to customers.
• Options to offering credit include
• The business issuing its own credit card or line
  of credit.
• Factoringselling accounts receivable to another
  firm at a discount off of the original sales
  price.
• The 3 Cs of credit
• A customers character is favorable if that
  customer has paid his or her bills on time in the
  past and has favorable credit references from
  other creditors.
• Capacity to pay refers to whether the customer
  has enough cash flow or disposable income to pay
  back a loan or pay off a bill.
• Collateral is the ability to satisfy a debt or
  pay a creditor by selling assets for cash.

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Accounts Receivable Management (continued)

• Credit terms are the requirements that our
  business establishes for payment of a loan (the
  use of credit by a customer).
• To speed up collections, cash discounts are often
  offered to a business customer. An example would
  be 2/10 net 30. If the customer pays the bill
  within 10 days of the invoice a 2 percent
  discount is given. Otherwise the entire net is
  due 20 days later or at the 30th day.

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Accounts Receivable Management (continued)

• Analyzing accounts receivable
• Accounts receivable turnover
• Example
• Collection days is 365 days in a year divided by
  accounts receivable turnover

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Accounts Receivable Management (continued)

• Use of collection days
• If collection days exceed our credit terms, then
  we have to speed up collections.
• Example If we give terms of 30 days and we
  collect in 61 days as previously shown, then we
  have to speed up collections in order to better
  manage accounts receivable. We may also have to
  re-evaluate our credit policies.
• If collection days are less then our terms, then
  we have increased our liquidity. May also
  consider loosening credit policy.

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Accounts Receivable Management (continued)

• Aging of accounts receivable is accomplished by
  determining the amounts of accounts receivable,
  the various lengths of time for which these
  accounts have been due, and the percentage of
  accounts that falls within each time frame.

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Inventory Management

• The overall goal of inventory management is to
  minimize total inventory costs while maximizing
  customer satisfaction.
• Two primary decisions must be made
• Establish the reorder quantity (the number of
  items to order)
• Establish the reorder point (that level of
  inventory at which a new order will be placed).

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Inventory Management (continued)

• Economic Order Quantity Formula
• Attempts to balance ordering costs against
  storage costs and provide us with the most
  economic quantity to order to minimize overall
  inventory costs.

• Where

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Inventory Management (continued)

• EOQ and Quantity Discounts
• If the business is large or uses items in
  quantity, then quantity discounts may override
  the EOQ formula. We will determine this by use of
  both the EOQ formula previously given and the
  total cost formula which is

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Inventory Management (continued)

• Determining EOQ with quantity discounts requires
  the following procedures
• Compute EOQ for each discounted price.
• If the computed EOQ falls within the discounted
  quantity area, then order the EOQ.
• If the EOQ does not fall within the discounted
  quantity area, then compute total inventory
  costs.
• Order the minimum quantity that provides the
  lowest overall total inventory costs.

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Inventory Management (continued)

• Reorder Point Calculations
• The reorder point (ROP) has three factors that
  are used in determining the quantity of an item
  that exists when we actually place an order
• Lead-time (L) is the time that lapses from order
  placement to order receipt.
• Daily demand (d) is the quantity of a product
  that is used per day.
• Safety Stock (ss) the quantity of stock you keep
  for variations in demand.

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Inventory Management (continued)

• Just-in-time (JIT) is an inventory system where
  orders are delivered to satisfy daily, and in
  some cases hourly, demand. It is primarily used
  in manufacturing.
• If daily demand can be accurately predicted
• If vendor delivery reliability is outstanding
• If vendors will deliver on an hourly or daily
  basis, then JIT inventory can be used

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Inventory Management (continued)

• Types of inventories
• Raw materials are the items that a company uses
  in producing its final product.
• Work-in-process inventories are made up of those
  items that are being produced.
• Finished goods inventories are made up of those
  items that are actually sold by the business.
• Maintenance, repair, and operating (MRO)
  inventories are made up of those items that are
  used by the firm in normal operations, but are
  not manufactured or sold by the firm.

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Inventory Management (continued)

• ABC inventory analysis is based on the 80-20 rule
  or Paretos Law
• A items 5 to 10 percent of the inventory items
  (i.e., individual stock numbers or stock keeping
  units) that make up approximately 75 percent of
  total costs
• B items 10 to 15 percent of the inventory stock
  numbers that make up 10 to 15 percent of the
  total costs
• C items The remaining 75 to 80 percent of the
  stock numbers account for only 10 to 15 percent
  of total costs (C items)

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Inventory Management (continued)

• Determining ABC items in inventory
• Take the total quantity purchased and multiply it
  by the unit cost to determine total cost for the
  item (Table 7-3).
• Take the inventory items and list them in
  descending order, based on total cost (Table
  7-4).
• Compute the percentage of total cost that each
  inventory item consumes.

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• Determine ABC by summing the percentages.

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Current Liabilities Management

• Current liabilities management consists of
  minimizing our obligations and payments for
  short-term debt, accrued liabilities, and
  accounts payable. It consists of
• Short-term debt management
• Accrued liabilities management
• Accounts payable management

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Current Liabilities Management (continued)

• Short-term debt management
• Short-term debt consists of business obligations
  that will be paid within the current accounting
  period. They consist of the following
• Current payments on long-term debt
• Bank lines of credit
• Notes payable
• Accounts payable
• Short-term loan for one year or less

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Current Liabilities Management (continued)

• Lines of credit
• A line of credit is similar to a credit card.
• With it, we obtain a credit limit, but we are not
  obligated to make payments unless we actually
  borrow the money.
• A line of credit is normally obtained from our
  primary bank.
• A line of credit is used when our cash outflow
  exceeds our cash inflow.

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Accrued Liabilities Management (continued)

• Accrued liabilities are those obligations of the
  firm that are accumulated during the normal
  course of business and are primarily payroll
  taxes and benefits, property taxes, and sales
  taxes.

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Accounts Payable Management

• Accounts payable are the debts of a business
  which are owed to vendors. Vendors offer several
  types of discounts. They are
• Trade discounts
• Cash discounts
• Quantity discounts

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Accounts Payable Management (continued)

• Trade discounts are amounts deducted from list
  prices of items when specific services are
  performed by the trade customer.
• Trade discounts may be expressed as a single
  amount, such as 30 percent, or in a series, such
  as 30/20/10.

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Accounts Payable Management (continued)

• Calculation of trade discounts
• Calculation of trade discounts can be
  accomplished by moving backward from the list
  price.
• If list price is 300 and trade discounts are
  30/20/10 then

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Accounts Payable Management (continued)

• Calculation of trade discounts (continued)
• The net cost rate factor is the actual percentage
  of the list price paid after taking all
  successive trade discounts50.4 percent in this
  case.
• One minus the net cost rate factor is the single
  equivalent discount.

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Accounts Payable Management (continued)

• Calculation of trade discounts (continued)
• A second simpler way of determining the net cost
  rate factor and the invoice price is to multiply
  the complements of the trade discounts as shown
  below

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Accounts Payable Management (continued)

• Cash discounts are offered to credit customers to
  entice them to pay promptly.
• The seller views a cash discount as a sales
  discount.
• The customer views it as a purchase discount.
• The terms of a cash discount play an important
  role in determining how the invoice will be paid.

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Accounts Payable Management (continued)

• Cash discounts will normally appear on an invoice
  in terms such as 2/10 n30.
• This means that the customer may deduct 2 percent
  off of the invoice price if he or she pays within
  10 days.
• If the customer does not pay within 10 days, he
  has the use of 98 of the money owed for the next
  20 days.
• If the customer pays within 30 days, the net, or
  total amount, of the invoice is due.
• If he or she pays after 30 days, the credit
  agreement with the seller normally stipulates
  that a monthly interest charge be added to the
  unpaid balance.

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Accounts Payable Management (continued)

• Calculations used in cash discounts
• A 10,000 invoice with terms of 2/10 n30
• Option 1 Pay off the 10,000 with a payment of
  9,800 within 10 days of the invoice date.
• This is computed by multiplying the invoice price
  by 1 minus the discount (1 - 0.02 0.98, and
  10,000 x 0.98 9,800).
• Or by taking the invoice price times the discount
  and subtracting it from the invoice price
  (10,000 x 0.02 200, and 10,000 - 200
  9,800).

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Accounts Payable Management (continued)

• Calculations used in cash discounts (continued)
• A 10,000 invoice with terms of 2/10 n30
• Option 2 Pay the invoice price of 10,000 on the
  30th day after the invoice date. If this option
  is chosen, he will pay the equivalent of 37.23
  percent annual interest because of his delaying
  payment. The logic is shown on the following
  page.

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Accounts Payable Management (continued)

• Calculations used in cash discounts (continued)
• 200 is the cost paid on 9,800 for 20 days, or
  an interest rate of 2.04 percent (200 ? 9,800
  x 100).
• This will result in an effective annual interest
  rate of 37.23 percent (2.04 x 365 ? 20days).
• The effective annual interest rate is obtained by
  multiplying the time period interest rate by the
  number of time periods in an accounting year (365
  ? 20).

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Accounts Payable Management (continued)

• Quantity discounts are offered by vendors to
  increase their own cash flow when they offer
  discounts to customers who purchase items in
  large quantities.

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Accounts Payable Management (continued)

• Cumulative discounts are normally discounts that
  are offered on total purchases of an item during
  the vendors fiscal year.