Copyright © 1999 Addison Wesley Longman CHAPTER CHAPTER 16 The Management of Working Capital How to Manage Inventory Reasons to Hold Inventories Costs of Holding Inventory Optimal Inventory Level Other Inventory Methods (cont.) Copyright © 1999 Addison Wesley Longman 1

How to Manage Accounts Receivable Why Credit Is Offered How to Manage Cash Two Types of Float Managing Float How to Manage Accounts Receivable Why Credit Is Offered Developing a Credit Policy Cost of Credit Total Cost of Credit Curve and the Optimal Amount of Credit Five Cs of Credit Analysis Collection of Accounts Receivable (Monitoring) Short-Term Financing Alternatives Bank Loans Trade Credit 2

Objectives Use economic order quantity to compute optimal inventory Understand float

Use Baumol model to estimate optimal cash Use Miller-Orr model to estimate optimal cash

Inventory Management Inventory is held to prevent stockouts and to increase sales There are costs to holding inventory Opportunity cost of funds Storage cost

Insurance cost Obsolescence, damage, and theft

(Beginning Inventory - Ending Inventory) Average Inventory is Computed as (Beginning Inventory - Ending Inventory) 2

The next figure shows how average inventory falls as order frequency increases

FIGURE 16.1 Relationship of Average Inventory and Order Frequency 3

FIGURE 16.1 (continued) 4

The optimal inventory balances the carrying cost of inventory against the reordering cost

FIGURE 16.2 Costs of Holding Inventory 5

Example Order cost is $15.00. Carrying Cost is $3.00. The firm sells 10,000 units per year. What is the optimal inventory?

Solution

To provide a safety stock the first order can be increased

FIGURE 16.3 Reorder Point with Safety Stock

Other Inventory Methods Include Just-in-time Basket method

Cash Management 1. Types of float a. Disbursement float The delay between when a firm issues a check and when the funds are removed from the bank

b. Collection float The delay between when you receive payment and when the bank gives you credit c. Net Float = Available Balance– Firm’s Book Value

Float management includes speeding up collections and slowing down disbursement

Speeding Up Collections Lockbox Customers mail payment to a mailbox controlled by the bank

FIGURE 16.4 Lockbox Arrangement 7

Concentration banking Regional banks receive payments and transfer funds to concentration bank

FIGURE 16.5 Concentration Banking 8

Electronic funds transfer (EFT) Electronically moves funds between accounts Selecting banks that minimize float because of either location or popularity with customers

Slowing Disbursements Increases Cash Balance but Has Hidden Costs Lost discounts Loss of supplier goodwill may result in increased costs or poor service

Optimal Cash Balance Cash is held To meet transaction needs As a precaution against unexpected events To take advantage of unexpected opportunities

The Baumol Model Provides a Method to Compute the Optimal Cash Conversion Amount

The Baumol model assumes cash is used at a steady rate The Baumol model assumes cash is used at a steady rate. If this model does not fit the firm an alternative is the Miller-Orr model When cash on hand reaches an upper limit it is invested When cash reaches a lower limit investments are sold to raise cash

FIGURE 16.6 Using the Miller–Orr Model to Compute the Economic Order Quantity 9

x Transaction cost x Variance of Cash Flow interest rate The spread between the lower limit and upper limit is computed as: spread = 3 [ 3 3 x Transaction cost x Variance of Cash Flow interest rate 4

The return point is computed as: spread 3 Return Point = Lower Limit +

Managing Accounts Receivable Credit is offered to increase sales A credit policy sets the condition for extending credit and must balance credit losses against lost sales

FIGURE 16.8 Net Cost of Extending Credit 11

A Credit Policy Includes Credit period Cash discount Cost of credit

Credit Applicants Are Often Evaluated Based on the Five Cs. 1. Character 2. Capacity 3. Capital 4. Conditions 5. Collateral

Monitoring Accounts Receivable Every firm offering credit should regularly prepare an aging schedule

Table 16.1 Aging Schedule Age of Account Amount Number of Accounts 0–10 days $100,000 60 11–30 days 75,000 40 31–45 days 10,000 5 46–60 days 3,000 2 Over 60 days 1,500 1

The collection effort must balance credit losses against losing customers. It usually includes the following: Past due letter Personal phone call Account turned over to collection agency Customer sued for payment

Short-Term Sources of Funds 1. Bank loans a. Self-liquidating loans b. Lines of credit 2. Trade credit