© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron University of Ottawa

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.2 Working Capital Management Chapter Objectives 1.Define the meaning and importance of the cash conversion cycle. 2.Comment on managing cash and cash equivalents. 3.Discuss various techniques related to accounts receivable management. 4.Explain different strategies related to managing inventory. 5.Show how current liability accounts can be managed to improve the cash flow cycle. Chapter Reference Chapter 6: Working Capital Management

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.3 Net working capital is defined as current assets minus current liabilities. Meaning of Working Capital Working capital management involves the management of individual current assets, current liabilities, and interrelationships that link current assets with current liabilities and with other balance sheet accounts. Working capital Current assetsCurrent liabilities Cash$ 10,000Accounts payable$56,000 Accounts receivable 30,000Notes payable 20,000 Notes receivable 5,000Accrued expenses 4,000 Marketable securities 10,000Taxes payable 8,000 Inventory 70,000 Prepaid expenses 3,000 Total current assets$128,000Total current liabilities$88,000

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Cash Conversion Cycle Purchase decision and order Credit decision Purchase of raw materials Delivery of raw materials Inventory of raw materials Manufacturing Inventory of finished goods Shipment Payment to suppliers Billing Payment by customer Processing payment Deposit Cash Existing 209 days Target 160 days Reduction 49 days

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.5 Using Futurama Ltd. (Transparencies 3.5 & 3.6) Purpose Measures the amount of days in working capital a business holds in order to meet its average daily sales requirements. (Accounts Receivable + Inventory) - Accounts Payable Sales revenue / 365 ($300,000 + $218,000) - $195,000 $2,500,000 / 365 $323,000 $6,940 Days of Working Capital (DWC) = = =47.2 days

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.6 Using Futurama Ltd. (Transparencies 3.5 & 3.6) PurposeMeasures the efficiency with which a business converts sales revenue to cash flow from operations. Cash flow from operations Sales revenue $126,000 $2,500,000 Cash Conversion Efficiency (CCE) = =5.1 percent

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.7 $20,000 x 12% X = $ days late for payment 365 days Cash flows in connection with credit serve to introduce the concept of _________ which is the time lag or delay between the moment of disbursement of funds on the part of the customer and the moment of receipt of funds on the part of the seller (i.e., mail time, processing time, and clearing time with the banking system). The goal of cash management is to reduce the amount of cash that is being used within the firm so as to increase profitability, but without reducing business activities or exposing the firm to undue risk in its financial obligations. 2. Managing Cash FLOAT

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.8 A.Changing customer paying habits 1.Letters, telephone calls, or personal visits 2.Economic incentive for paying bills faster; offer discounts (i.e., 2/10, N/30) Ways to Improve Collection of Cash B.Improve the Delivery system (reduce the negative float) 1.Regional banking (customers pay bills to banks since they can transfer funds more quickly than mail order delivery). 2.Lockbox collection system (firm rents a post office box in a particular city and the bank monitors the lockbox periodically). 3.Electronic communications (i.e., data-phone wire systems). C.Bypass the problem (Factoring of receivables).

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.9 The goal of accounts receivable management is to set credit terms, grant credit to customers, monitor payment patterns, and apply necessary collection procedures so as to increase profitability. 3. Managing Accounts Receivable Credit policy consists of choosing the appropriate credit terms to offer to customers (present and future). Terms differ from product to product and industry to industry. Example:Selling price$ Cost of product$ Cost of capital 10% Should the company grant 2/10, net 30 days? $90.00 x 10% x = $ day delay 365 days Effective price Cost of product Credit cost Interest on money Profit -$ _________ _________ _________ + _________ $ _________ 10-day payment 60-day payment

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.10 Grant Credit to Customers (credit report) Summary Report Information Payments Finance History Banking Operations Classification code for line of business, year business started, rating, principal executives (owners). Payments, sales, worth, number of employees, trends. How business pays its bills (i.e., amounts owing, amounts past due, terms of sale, manner of payment, and supplier comments). Financial conditions and trend of business (balance sheet and income statement analysis). Names, birth dates and past business experience of the principals or owners, affiliation, ownership, outside interest of the principal owners. Outstanding loans. Nature of the premises, neighbourhood, size of floor space, production facilities.

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.11 Return on investment === 14.6% Changing Credit Terms Return on investment calculation for changing the firm’s credit terms Existing terms Proposed terms Expected volume (units) 400, ,000 Expected sales revenue ($10.00 per unit)4,000,0004,400,000 Expected profit before bad debts (10% of revenue) 400, ,000 Expected bad debt expense (% of revenue)20,000 (.5%)33,000 (.75%) Expected profit (after bad debts) 380, ,000 Incremental profit ,000 Expected collection period (days) Average accounts receivable 315, ,200 Incremental investment ,400 Incremental profit$27,000 Incremental investment$185,400

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Raw Materials (i.e., lumber, steel, rubber, plastics, chemicals, paint and other fishing substances, also includes supplies and parts). 4. Managing Inventory The goal of inventory management is to replenish stocking points in such a way as to minimize the total of all associated costs, and thereby enhance profitability of the business. Types of inventory 2.Work-in-Progress (i.e., partially assembled or partially processed, not yet completed). 3.Finished Goods (i.e., goods completed and ready to be sold for resale by wholesaling and retailing firms).

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.13 Minimum inventory level Inventory Levels LT Units in inventory Purchase RP SAP Maximum inventory level Quality SAP LT = Lead timeSAP = Stock arrival point RP = Reorder point = Depletion of stock Average number of units in inventory Q/2 RP LT

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.14 Inventory Decisions Order and set-up costs  Transportation costs  Clerical costs of making orders  Cost of placing goods in storage  Downtime on equipment  Quantity discounts Holding costs  Storage costs  Fire insurance  Property taxes  Spoilage and deterioration  Cost of borrowing  Rent of facilities  Obsolescence Typical costs of ordering and holding inventory $ $

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.15 Calculating the Economic Order Quantity Number Order AnnualAverage Average AnnualOrdering cost of quantity order cost unit dollar holding + orders (units) $50.00inventory investment costs Holding cost per order (2) ÷ 2 (4) x $ 5.35 (5) x 15% (3) + (6) ,000 2,500 1, ,500 1, ,375 6,687 2,675 2,226 1,669 1,337 2,006 1, ,056 1,

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 6.16 Here’s the proof: Annual order costs (6 times x $50.00)=$ Annual carrying costs ($5.35 x 790 = $4,226 ÷ 2 x 15%)=$ Total inventory costs=$ Economic Order Quantity F = Fixed costs per order (clerical, processing, payment, receiving, verification, shelving) =$50.00 U = Units sold per year = 5,000 C = Carrying costs per unit/per year = $0.80 (storage, insurance, rent, spoilage, interest charges) EOQ = EOQ == 790 units 2 FU C 2 x $50.00 x 5,000 $0.80 $5.35 x 15%

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Managing Current Liabilities  Accounts payable  Accruals  Salaries and wages payable  Taxes payable  Working capital loans