Supply Chains and Working Capital Management CHAPTER 21 Supply Chains and Working Capital Management

Definitions Working capital management: day-to-day control of cash, inventories, receivables, accruals, and accounts payable. Net operating working capital (NOWC): Operating CA – Operating CL = (Cash + Inventory + A/R) – (Accruals + A/P) 2

Basic Definitions Net operating working capital (NOWC): Operating CA – Operating CL = (Cash + Inv. + A/R) – (Accruals + A/P) Working capital: Total current assets used in operations. Net working capital: Current assets – Current liabilities. 2

Working capital management affects ROE ROE = Profit margin x Total assets turnover x Equity multiplier High current assets, low assets turnover results in low ROE Low current assets, high assets turnover results in high ROE

Cash Conversion Cycle (CCC) The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales: Cash Conversion = Cycle Inventory Conversion + Period Average Collection − Payables Deferral

CCC Inventory conversion period: the length of time from receiving material to finished product to selling to customer. Average collection period (days sales outstanding): the length of time from sale to receiving the payment from customer. Payable deferral period: the length of time from purchase to payment.

Cash Conversion Cycle (GBM on p.813) Annual sales = $1,216.7 COGS = 1,013.9 Inventory = 140.0 A/R= 445.0 A/P=115.0 Inv+A/R-A/P=(140+445-115)=470; financed by loans at 10%. So interest is 47 /y.

Cash Conversion Cycle (Cont.) CCC = + – CCC = 140/(1013.9/365) + 445/(1216.7/365) - 115/(1013.9/265) CCC = 50.4 + 133.5 – 41.4 CCC = 142.5 days Inventory conversion period Payables deferral period Days sales outstanding

Target CCC vs. realized CCC

Problems Average collection period is much higher than the target, indicating customers are not paying on time. This late payment increased GBM’s investment in working capital, which is financed by bank loans. This lowers the firm’s profits and thus stock price.

Benefit of reducing CCC Now, CCC is 142.5 days, resulting in $470 mil being tied up in net operating working capital and 47 million interest If working capital decreases, then…

Comparison

What’s the goal of cash management? Minimize the cash amount the firm must hold for conducting its normal business activities, yet, at the same time, have a sufficient cash reserve to: Take trade discounts. Pay promptly and maintain its credit rating. Meet any unexpected cash needs. 7

Ways to Minimize Cash Holdings Synchronize inflows and outflows. Using wire transfers to speeding up check-clearing process Use lockboxes (post office box). (More…) 8

Inventory management Produce components only after receiving an order and then send the parts directly to the final assembly line. Decrease money and time invested in this stage.

Receivable management Provide trade credit : 2/10, net 30 Cash discounts: Lower price. Attracts new customers and reduces DSO. Credit standards: tighter standards reduce bad debt losses, but may reduce sales Collection policy: tougher policy will reduce DSO, but may damage customer relationships.

Is there a cost to accruals? Can firms control accruals? Accruals are free in that no explicit interest is charged. Firms have little control over the level of accruals. Levels are influenced more by industry custom, economic factors, and tax laws.

Homework Assignment Chapter 21 problems: 1, 2, 5, 6, 11, 12.