Managing the Firm’s Assets PART 5 Managing Growth in the Small Business

Looking Ahead After studying this chapter, you should be able to: Describe the working-capital cycle of a small business. Identify the important issues in managing a firm’s cash flows Explain the key issues in managing accounts receivable, inventory, and accounts payable. Calculate and interpret a company’s conversion period. Discuss the techniques commonly used in making capital budgeting decisions. Describe the capital budgeting practices of small firms.

The Working-Capital Cycle Working-Capital Management The management of current assets and current liabilities Net Working Capital The sum of a firm’s current assets (cash, account receivable, and inventories) less current liabilities (short-term notes, accounts payable, and accruals) Working-Capital Cycle The daily flow of resources through a firm’s working-capital accounts

The Working Capital Cycle 1 2 Purchase or produce inventory for sale, which increases accounts payable. 3 Sell inventory for cash; sell inventory for credit (accounts receivable). 4 Pay the accounts payable (decreases cash and accounts payable). 5 Collect the accounts receivable (decreases accounts payable and increases cash). Begin cycle again.

Exhibit 22.1 Working-Capital Cycle

Exhibit 22.2 Working-Capital Time Line Day a. Inventory is ordered in anticipation of future sales. Day b. Inventory is received. Day c. Inventory is sold on credit. Day d. Accounts payable come due and are paid. Day e. Accounts receivable are collected. Cash conversion period— the time required to convert paid-for inventories and accounts receivable into cash.

Exhibit 22. 3. Working-Capital Time Lines for Pokey, Inc Exhibit 22.3 Working-Capital Time Lines for Pokey, Inc., and Quick Turn Company

Pokey, Inc.’s Beginning Balance Sheet

Pokey, Inc.’s Monthly Balance Sheets July Aug. Sept. Cash 400 (100) Accounts receivable Inventory 500 Fixed assets 600 Accumulated depreciation TOTAL ASSETS 1,000 1,500 Accounts payable Accrued operating expenses Income tax payable Long-term debt 300 Common debt 700 Retained earnings TOTAL DEBT AND EQUITY Changes: August to September –500

Pokey, Inc.’s Monthly Balance Sheets July Aug. Sept. Oct. Cash 400 (100) Accounts receivable 900 Inventory 500 Fixed assets 600 Accumulated depreciation (50) TOTAL ASSETS 1,000 1,500 1,350 Accounts payable Accrued operating expenses 250 Income tax payable 25 Long-term debt 300 Common debt 700 Retained earnings 75 TOTAL DEBT AND EQUITY Changes: September to October +900 –500 –50 +250 +25 +75

Changes in Pokey’s Balance Sheet Change in the Balance Sheet Effect on Income Statement Increase accounts receivable of $900  Sales $900 Decrease inventories of $500  Cost of goods sold $500 Increase in accrued operating  Operating expenses $250 expenses of $250 Increase accumulated depreciation of $50  Depreciation expense $50 Increase accrued taxes of $25  Tax expense $25

Pokey, Inc.’s Monthly Balance Sheets Changes: October to November +650 –900 –250 July Aug. Sept. Oct. Nov. Cash 400 (100) 550 Accounts receivable 900 Inventory 500 Fixed assets 600 Accumulated depreciation (50) TOTAL ASSETS 1,000 1,500 1,350 1,100 Accounts payable Accrued operating expenses 250 Income tax payable 25 Long-term debt 300 Common debt 700 Retained earnings 75 TOTAL DEBT AND EQUITY

Pokey’s November Income Statement Sales revenue 900 Cost of goods sold 500 Gross Profit 400 Operating expenses: Cash 250 Depreciation 50 Total operating expenses 300 Operating income 100 Income tax (25%) 25 Net income 75

The Nature of Cash Flows Revisited Managing Cash Flows The Nature of Cash Flows Revisited The flow of actual cash through a firm determines whether or not the firm can meet its current obligations. Net Cash Flow The difference between inflow and outflows Net Profit The difference between revenue and expenses The Growth Trap A cash shortage (cash crunch) resulting from rapid growth

Exhibit 22.4 Flow of Cash through a Business

Managing Accounts Receivable How Accounts Receivable Affect Cash Accounts receivable represent the firm’s decision to delay the inflow of cash from customers who have been extended credit. Life Cycle of Accounts Receivable Firm makes credit sale to customer. Invoice is prepared and sent to customer. Customer pays firm.

Managing Accounts Receivable (cont’d) Days Sales Outstanding Average collection period—number of days, on average, a firm is extending credit to its customers. Days sales outstanding = Accounts receivable Annual credit sales ÷ 365 days Example: Fast Co. Slow Co. Total sales $1,000,000 Credit sales 700,000 Average credit sales per day 1,918 Accounts receivable 48,000 63,300 Fast Co.’s Days Sales Outstanding = 48,000 = 25 days 700,000 ÷ 365 Slow Co.’s Days Sales Outstanding = 63,300 = 33 days 700,000 ÷ 365

Credit Management Practices Minimize the time between shipping, invoicing, and sending notices on billings. Review previous credit experiences to determine impediments to cash flows. Provide incentives for prompt payment. Age accounts receivable on a monthly or even a weekly basis to identify delinquent accounts. Use the most effective methods for collecting overdue accounts. Use a lock box—a post office box for receiving remittances.

Managing Accounts Receivable (cont’d) Accounts Receivable Financing Pledged accounts receivable Accounts receivable used as collateral for a loan. Factoring Obtaining cash by selling accounts receivable at a discount to another firm. Advantage Immediate cash flow Disadvantages High interest costs for loans funds and discounts for factored receivables Loss of receivables as collateral in borrowing

Cost of goods sold ÷ 365 days Managing Inventories Inventory is a “necessary evil.” Product supply and consumer demand don’t always match up. Monitoring Inventory Determine age and suitability for sale. Slowing moving inventory can create cash flow problems. Days in inventory—number of days, on average, that a company is holding inventory. Days in inventory = Inventory Cost of goods sold ÷ 365 days

Reducing Inventory to Free Cash Managing Inventories Reducing Inventory to Free Cash Controlling stockpiles Match on-hand inventory with demand. Avoid personalizing the business-customer relationship. Avoid forward purchasing of inventory; carrying cost for excess inventory may exceed any savings.

Managing Accounts Payable Negotiation Asks creditors for adjustments or additional time. Timing Creditors’ funds can supply short-term cash needs until payment is demanded. Accounts with cash discounts for early payment should be examined for their savings potential. “Buy now, pay later”—pay early enough to get cash discounts and timely enough to avoid late-payment fees.

Exhibit 22.5 An Accounts Payable Timetable for Terms of 3/10, Net 30 Annualized interest rate discount% Cash - 100 % discount x period Net year in Days = 56.4% or 0.564, 0.030928 x 18.25 =

Capital Budgeting Analysis Helps managers make decisions about long-term investments such as: Developing new products Replacing equipment Constructing new facilities Expanding sales territories Seeks to answer the question: “Do future benefits from the investment exceed the cost of making the investment?” Good decisions can add value to the firm; bad decisions can put the firm out of business.

Capital Budgeting Techniques Capital Budgeting Decisions Involve: Accounting return on investment How many dollars in average profits are generated per dollar of average investment? Payback period How long to recover the original profit outlay? Discounted cash flows (net present value or internal rate of return) How does the present value of future benefits from the investment compare to the investment outlay?

Three Rules of Capital Budgeting Investors judging the attractiveness of an investment prefer: More cash rather than less cash. Cash sooner rather than later. Less risk rather than more risk.

Capital Budgeting Techniques (cont’d) Accounting Return on Investment The average annual after-tax profits relative to the average book value of an investment. Initial investment = $10,000 Year After-Tax Profits 1 1,000 2 2,000 3 2,500 4 3,000 2 000 10 4 3 500 1 + = , Accounting return on investment 42.5% or 0.425, 5,000 2,125 =

Capital Budgeting Techniques (cont’d) Payback Period Measuring the amount of time it will take to recover the cash outlay of an investment. Original Investment = $15,000 Annual Depreciation = $1,500 Acceptable payback period= 5 years Payback period = 4.86 years After-Tax Year Profits 1–2 1,000 3–6 2,000 7–10 2,500 After-Tax Cash Flows 2,500 3,500 4,000 Investment Recovery Year 1-2 Year 3-5 5,000 10,500

Discounted Cash Flows (DCF) Comparing the present value of future cash flows with the cost of the initial investment. Cash received today is more valuable than cash to be received in the future—the time value of money. Net present value (NPV) The current value of cash that will flow from a project over time less the initial investment outlay. Internal rate of return (IRR) The rate of return that a firm expects to earn on a project; return rate must exceed cost of capital.

A Firm’s Cost of Capital The rate of return required to satisfy a firm’s debt holders and investors. Opportunity Cost The rate of return that could be earned on another investment of similar risk.

Capital Budgeting Analysis in Small Firms Factors Affecting the Capital Budgeting Analysis Process: Nonfinancial (personal) variables Undercapitalization and liquidity problems Uncertainty of cash flows within the firm Lack of established market value for the firm Small size, scope, and length of firm’s projects Lack of managerial experience and talent in firm

Key Terms working-capital management working-capital cycle cash conversion period days sales outstanding (average collection period) lock box pledged accounts receivable days in inventory days in payables capital budgeting analysis accounting return on investment technique payback period technique discounted cash flow (DCF) techniques net present value (NPV) internal rate of return (IRR)