Cash and Working Capital Management www.AssignmentPoint.com

Working Capital Management = current assets – current liabilities Working capital management refers to choosing the levels and mix of: cash, marketable securities, receivables and inventories. different types of short-term financing. www.AssignmentPoint.com

Considerations in Working Capital Management Sales impact Liquidity Relations with stakeholders suppliers customers Short-term financing mix profitability risk considerations www.AssignmentPoint.com

Working Capital Management Maturity matching approach Conservative approach Aggressive approach www.AssignmentPoint.com

Maturity Matching Approach Hedge risk by matching the maturities of assets and liabilities. Permanent current assets are financed with long-term financing, while temporary current assets are financed with short-term financing. There are no excess funds. www.AssignmentPoint.com

Conservative Approach Long-term funds are used to finance both permanent as well as some temporary short-term assets. When there are excess funds, they are invested in marketable securities. www.AssignmentPoint.com

Aggressive Approach Use less long-term and more short-term financing than the conservative approach. www.AssignmentPoint.com

Cash Conversion Cycle The cash conversion cycle is the length of time between payment of accounts payable and the receipt of cash from accounts receivable. www.AssignmentPoint.com

Cash Conversion Cycle Purchase Inventory Sale on Credit Collect Acct. Receivable Inventory Conversion Period Receivables Collection Period Time Payment of Accts. Payable Cash Conversion Cycle Payables Deferral Period www.AssignmentPoint.com

Cash Conversion Cycle www.AssignmentPoint.com

Inventory Conversion Period The inventory conversion period is the length of time from the purchase of inventory to the time the sales are made on credit. www.AssignmentPoint.com

Receivables Collection Period The receivables collection period is the average number of days it takes to collect on accounts receivable. Equal to days sales outstanding (DSO) www.AssignmentPoint.com

Payables Deferral Period The payables deferral period is the average length of time between the purchase of materials and labor and the payment of cash for the same. www.AssignmentPoint.com

Cash Conversion Cycle Given the following information about Vision Opticals, compute the firm’s cash conversion cycle. Inventory Accounts Receivable Accounts Payable Wages, Benefits, Payroll Taxes Sales Cost of Sales Selling & Other Expenses $19,000 $21,000 $5,600 $9,000 $227,000 $93,000 $22,000 www.AssignmentPoint.com

Inventory Conversion Period www.AssignmentPoint.com

Receivables Collection Period www.AssignmentPoint.com

Payables Deferral Period www.AssignmentPoint.com

Cash Conversion Cycle www.AssignmentPoint.com

Cash Management How much liquidity (cash plus marketable securities) should the firm have? What should be the relative proportions of cash and marketable securities? www.AssignmentPoint.com

Demands for Cash Transactions demand Precautionary demand Speculative demand Compensating balances www.AssignmentPoint.com

Short-Term Financing Trade Credit Secured and Unsecured Bank Loans Commercial Paper www.AssignmentPoint.com

Corporate Financial Management 2e Emery Finnerty Stowe Accounts Receivable and Inventory Management Corporate Financial Management 2e Emery Finnerty Stowe www.AssignmentPoint.com

Why Grant Credit? Financial intermediation Collateral Information costs Product quality information Employee theft Steps in the distribution process Convenience, safety, and buyer psychology www.AssignmentPoint.com

The Basic Credit Granting Decision Credit should be granted if the NPV of granting credit is positive. The NPV depends on: amount of the sale investment in the sale probability of payment payment period required return collection efforts www.AssignmentPoint.com

The NPV of the Basic Credit Granting Decision Let R = amount of sale p = probability of payment C = the firm’s investment in the sale r = the required return t = time at which payment is expected www.AssignmentPoint.com

The Basic Credit Granting Decision Mohawk Carpets is considering extending $5,000 of credit to a customer. Mohawk has invested $3,750 in the sale and it estimates that the customer has a 75% probability of making the payment. The payment is due in 2 months, and the required rate of return in 20% APY. Should Mohawk grant credit to this customer? www.AssignmentPoint.com

The Basic Credit Granting Decision What is the minimum probability of payment that Mohawk would require from this customer? www.AssignmentPoint.com

Credit Policy Decisions Choice of credit terms Setting evaluation methods and credit standards Monitoring receivables Taking actions for slow payments Controlling & administering the firm’s credit functions www.AssignmentPoint.com

Sources of Credit Information A credit application, including references Applicant’s payment history Information from sales representatives Financial statements for recent years Reports from credit rating agencies Dun & Bradstreet Credit Services Credit bureau reports Industry association credit files www.AssignmentPoint.com

Judgmental Approach to Credit Decisions The five C’s of credit: Character Capacity Capital Collateral Conditions www.AssignmentPoint.com

Credit Scoring Models These combine several financial variables to create a single score or index. Credit is granted if the score is above a pre-specified cut-off value. Advantages: Easy to compute Easy to change standards Avoids bias or discrimination Requires large samples to “calibrate.” www.AssignmentPoint.com

Monitoring Accounts Receivables Aging schedules Average age of receivables Collection fractions and receivables balance fractions Pursuing delinquent credit customers Changing credit policy www.AssignmentPoint.com

Aging Schedule An aging schedule shows the dollar amount and the percentage of receivables in several age classifications. Age (days) Amount Percent 0 to 30 31 to 60 61 to 90 over 90 $23,200 $9,300 $3,500 $0 64.44% 25.83% 9.72% 0.00% Total $36,000 100.00% www.AssignmentPoint.com

Average Age The average age is computed by using the mid-points of the age ranges: Average Age = (0.6444)(15) + (0.2583)(45) + (0.0972)(75) = 28.58 days www.AssignmentPoint.com

Collection & Receivables Fraction Balances Collection fractions are the percentage of sales collected during various months after the sale. Receivables Balance fractions are the percentage of a month’s sales that remain uncollected at the end of the month of the sale and at the end of successive months. www.AssignmentPoint.com

Pursuing Delinquent Accounts Letters Telephone calls Personal visits Collection agencies Legal proceedings www.AssignmentPoint.com

Changing Credit Policy Credit policy can be changed by changing: credit terms credit standards collection policies A change in the credit policy affects: sales cost of goods sold bad debt expense carrying costs of receivables administrative costs www.AssignmentPoint.com

Changing Credit Policy Sales of Mabry Fireplace Co. are currently $500,000 under credit terms of “net 30.” Bad debt losses amount to 1.50% and the balance is collected in 1.50 months on average. Under the proposed policy of “2/10, net 30,” sales would increase by 12% and bad debts would decline to 0.75% of sales. About 65% of the customers are expected to take the discount. About 65% of sales would be collected within 0.5 months and the remainder within 1.5 months. Assume that Mabry’s investment in sales equals 60% and that the required rate of return is 1.50% per month. Should Mabry change its credit policy to the proposed one? www.AssignmentPoint.com

Changing Credit Policy Under the current policy, Mabry’s investment in sales is $300,000. 60%×$500,000 = $300,000. Bad debts are $7,500. $7,500 = 1.50%×$500,000 Sales collections are $492,500. = $500,000 – $7,500 = $492,500 (in 1.50 months). www.AssignmentPoint.com

Changing Credit Policy Under the new policy, sales = $560,000. 1.12×$500,000 = $560,000. Mabry’s investment in sales = $336,000. 60%×$560,000 = $336,000. Bad debt losses = $4,200. 0.75%×$560,000 = $4,200. Discounts taken = 7,280. 65%×2%×($560,000) = $7,280. www.AssignmentPoint.com

Changing Credit Policy Sales collected = $548,520. $560,000 – $4,200 – $7,280 = $548,520. Amount collected in 0.5 months: $356,720. 65%×0.98×$560,000 = $356,720. Amount collected in 1.5 months = (100% – 65% – 0.75%)×$560,000 = $191,800. www.AssignmentPoint.com

Changing Credit Policy NPV of current policy = $181,623 so switch. www.AssignmentPoint.com

Inventory Management Types of inventories: Raw materials Work-in-process Finished goods www.AssignmentPoint.com

Just-In-Time (JIT) Inventory Systems Materials should arrive exactly as they are needed in the production process. Reduces inventory holding costs Important factors determining success of JIT systems: Planning requirements Supplier relations Setup costs Other cost factors Impact on credit terms www.AssignmentPoint.com