Small Business Management, 18e Longenecker/Petty/Palich/Hoy Small Business Management, 18e © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing the Firm’s Assets Chapter 22 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Learning Goals: 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. Discuss the key financial issues in managing inventory. Describe the key issues in managing account payable. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Learning Goals (cont.): Calculate and interpret a company’s cash conversion period. Discuss the techniques commonly used in making capital budgeting decisions. Describe the capital budgeting practices of small firms. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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) © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Working-Capital Cycle (cont.) The daily flow of resources through a firm’s working-capital accounts © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22.1 Working Capital Cycle © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22.3 Working Capital Time Lines for Pokey, Inc., and Quick Turn Company © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Pokey, Inc.’s Beginning Balance Sheet © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in Pokey’s Balance Sheet Change in the Balance Sheet Effect on Income Statement Increase accounts receivable of $900  Sales of $900 Decrease inventories of $500  Cost of goods sold of $500 Increase in accrued operating  Operating expenses of $250 expenses of $250 Increase accumulated depreciation of $50  Depreciation expense of $50 Increase accrued taxes of $25  Tax expense of $25 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Pokey’s November Income Statement Sales revenue 900 Cost of goods sold (500) Gross profit 400 Operating expenses: Cash (250) Depreciation expense (50) Total operating expenses (300) Operating income 100 Income tax (25%) (25) Net income 75 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Cash Flows The Nature of Cash Flows Revisited Net Cash Flow 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 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Cash Flows (cont.) Net Profit The difference between revenue and expenses The Growth Trap A cash shortage (cash crunch) resulting from rapid growth © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22.4 Flow of Cash Through a Business © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Accounts Receivable (cont.) 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 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Collections on Accounts Hire someone else to handle collections one day per week. Accept credit cards. Sell the receivables to a third party. Where possible, require prepayment. For a service business, write a detailed work plan and payment schedule and have it signed by the customer. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Accounts Receivable (cont.) 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. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Accounts Receivable (cont.) Accounts Receivable Financing (cont.) Factoring Advantage Immediate cash flow Disadvantages High interest costs for loans funds and discounts for factored receivables Loss of receivables as collateral in borrowing © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost of goods sold ÷ 365 days Managing Inventory 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 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Inventory (cont.) 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. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Accounts Payable Negotiation Ask 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. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Accounts Payable (cont.) Timing “Buy now, pay later”—pay early enough to get cash discounts and timely enough to avoid late-payment fees. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Annualized interest rate 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 = © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting Capital Budgeting Analysis Helps managers make decisions about long-term investments such as: Developing new products Constructing new facilities Replacing equipment Expanding sales territories © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting (cont.) Capital Budgeting Analysis (cont.) 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. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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? © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting Techniques (cont.) 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 = © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Budgeting Techniques (cont.) 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 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discounted Cash Flows 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. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discounted Cash Flows (cont.) Discounted Cash Flows (DCF) 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. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

accounting return on investment technique capital budgeting analysis cash conversion period days in inventory days in payables days sales outstanding (average collection period) discounted cash flow (DCF) techniques internal rate of return (IRR) lock box net present value (NPV) payback period technique pledged accounts receivable working capital cycle working capital management © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.