PowerPoint Presentation by Charlie Cook The University of West Alabama Longenecker Moore Petty Palich © 2008 Cengage Learning. All rights reserved. CHAPTER 22 Managing the Firm’s Assets Understanding What the Numbers Mean Part 6

© 2008 Cengage Learning. All rights reserved.22–2 Looking AHEAD 1.Describe the working-capital cycle of a small business. 2.Identify the important issues in managing a firm’s cash flows, including the preparation of a cash budget. 3.Explain the key issues in managing accounts receivable, inventory, and accounts payable. 4.Discuss the techniques commonly used in making capital budgeting decisions. 5.Describe the capital budgeting practices of small firms. After you have read this chapter, you should be able to:

© 2008 Cengage Learning. All rights reserved.22–3 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

© 2008 Cengage Learning. All rights reserved.22–4 Risk Management… (cont’d) 1 Collect the accounts receivable (decreases accounts payable and increases cash). Sell inventory for cash; sell inventory for credit (accounts receivable). The Working Capital Cycle Purchase or produce inventory for sale, which increases accounts payable. Pay the accounts payable (decreases cash and accounts payable). 234 Begin cycle again. 5

© 2008 Cengage Learning. All rights reserved.22–5 Working-Capital Cycle 22-1

© 2008 Cengage Learning. All rights reserved.22–6 Working-Capital Time Line 22-2 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.

© 2008 Cengage Learning. All rights reserved.22–7 Working-Capital Time Lines for Pokey, Inc., and Quick Turn Company 22-3

© 2008 Cengage Learning. All rights reserved.22–8 Pokey, Inc.’s Beginning Balance Sheet

© 2008 Cengage Learning. All rights reserved.22–9 Pokey, Inc.’s Monthly Balance Sheets JulyAug.Sept. Cash400 (100) Accounts receivable000 Inventory0500 Fixed assets600 Accumulated depreciation000 TOTAL ASSETS1,0001,5001,000 Accounts payable05000 Accrued operating expenses000 Income tax payable000 Long-term debt300 Common debt700 Retained earnings000 TOTAL DEBT AND EQUITY1,0001,5001,000 Changes: August to September –500

© 2008 Cengage Learning. All rights reserved.22–10 Pokey, Inc.’s Monthly Balance Sheets JulyAug.Sept.Oct. Cash400 (100) Accounts receivable Inventory Fixed assets600 Accumulated depreciation000(50) TOTAL ASSETS1,0001,5001,0001,350 Accounts payable Accrued operating expenses Income tax payable00025 Long-term debt300 Common debt700 Retained earnings00075 TOTAL DEBT AND EQUITY1,0001,5001,0001,350 Changes: September to October +900 –500 –

© 2008 Cengage Learning. All rights reserved.22–11 Changes in Pokey’s Balance Sheet Change in the Balance SheetEffect 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

© 2008 Cengage Learning. All rights reserved.22–12 Pokey, Inc.’s Monthly Balance Sheets

© 2008 Cengage Learning. All rights reserved.22–13 Pokey’s November Income Statement Sales revenue900 Cost of goods sold500 Gross Profit400 Operating expenses: Cash250 Depreciation50 Total operating expenses300 Operating income100 Income tax (25%)25 Net income75

© 2008 Cengage Learning. All rights reserved.22–14 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

© 2008 Cengage Learning. All rights reserved.22–15 Flow of Cash Through a Business 22-4

© 2008 Cengage Learning. All rights reserved.22–16 Three-Month Cash Budget for the Davies Corporation for July–September 22-5

© 2008 Cengage Learning. All rights reserved.22–17 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.

© 2008 Cengage Learning. All rights reserved.22–18 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.

© 2008 Cengage Learning. All rights reserved.22–19 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

© 2008 Cengage Learning. All rights reserved.22–20 Managing Inventories Inventory is a “necessary evil.”  Product supply and consumer demand don’t always match up. Reducing Inventory to Free Cash  Monitoring current inventory  Determine age and suitability for sale.  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.

© 2008 Cengage Learning. All rights reserved.22–21 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.

© 2008 Cengage Learning. All rights reserved.22–22 An Accounts Payable Timetable for Terms of 3/10, Net Annualized interest rate discount% Cash %discount Cash x perioddiscount Cash - periodNet yearin Days  56.4% or 0.564, x 

© 2008 Cengage Learning. All rights reserved.22–23 Capital Budgeting 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.

© 2008 Cengage Learning. All rights reserved.22–24 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.

© 2008 Cengage Learning. All rights reserved.22–25 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?

© 2008 Cengage Learning. All rights reserved.22–26 Capital Budgeting Techniques (cont’d) Accounting Return on Investment  The average annual after-tax profits relative to the average book value of an investment. YearAfter-Tax Profits 11,000 22,000 32,500 43, =,,,,, Accounting return on investment 42.5% or0.425, 5,000 2,125 = = Initial investment = $10,000

© 2008 Cengage Learning. All rights reserved.22–27 Capital Budgeting Techniques (cont’d) Payback Period  Measuring the amount of time it will take to recover the cash outlay of an investment. After-Tax YearProfits 1–21,000 3–62,000 7–102,500 After-Tax Cash Flows 2,500 3,500 4,000 Investment Recovery Year 1-2Year 3-5 5,000 10,500 Original Investment = $15,000 Acceptable payback period= 5 years Payback period = 4.86 years Annual Depreciation = $1,500

© 2008 Cengage Learning. All rights reserved.22–28 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.  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.

© 2008 Cengage Learning. All rights reserved.22–29 A Firm’s Cost of Capital 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.

© 2008 Cengage Learning. All rights reserved.22–30 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

© 2008 Cengage Learning. All rights reserved.22–31 Key TERMS working-capital management working-capital cycle cash conversion period cash budget lock box pledged accounts receivable capital budgeting analysis accounting return on investment technique payback period technique discounted cash flow (DCF) technique net present value (NPV) internal rate of return (IRR)