Copyright © 2003 Pearson Education, Inc. Slide 14-0 Ch 14 Learning Goals 1.Impact of working capital management on liquidity, profitability and risk. 2.Cash conversion cycle. 3.Management of receipts and disbursements. 4.Evaluate a change in credit policy.

Copyright © 2003 Pearson Education, Inc. Slide 14-1 Working Capital management (or short-term financial management) is management of: –current assets –current liabilities Working Capital Mgt

Copyright © 2003 Pearson Education, Inc. Slide 14-2 Working Capital Management The goal of working capital management is to balance: –Liquidity –Profitability –Risk in a way that contributes to firm value.

Copyright © 2003 Pearson Education, Inc. Slide 14-3 Current Assets Fixed Assets Current Liabilities Long-Term Debt Equity low return high return low cost high cost highest cost Working Capital Mgt

Copyright © 2003 Pearson Education, Inc. Slide 14-4 Working Capital Mgt A high level of current assets means: –More liquidity –Lower profitability –Less risk

Copyright © 2003 Pearson Education, Inc. Slide 14-5 Working Capital Mgt A high level of current liabilities means: –Less liquidity –Higher profitability –More risk

Copyright © 2003 Pearson Education, Inc. Slide 14-6 Working Capital Mgt Relative levels of current assets (CA) and current liabilities (CL) are measured by: –Current ratio = CA / CL –Net working capital = CA - CL

Copyright © 2003 Pearson Education, Inc. Slide 14-7 Working Capital Mgt High current ratio and high net working capital mean: –More liquidity –Lower profitability –Less risk

Copyright © 2003 Pearson Education, Inc. Slide 14-8 Working Capital Mgt: the Cash Conversion Cycle Central to working capital management is understanding the cash conversion cycle (CCC).

Copyright © 2003 Pearson Education, Inc. Slide 14-9 The Cash Conversion Cycle The Operating Cycle (OC) is the time between ordering materials and collecting from customers. The Cash Conversion Cycle (CCC) is the time between paying suppliers and collecting from customers.

Copyright © 2003 Pearson Education, Inc. Slide Both the OC and CCC may be computed as shown below. The Cash Conversion Cycle

Copyright © 2003 Pearson Education, Inc. Slide MAX Company has an average age of inventory (AAI) of 60 days, an average collection period (ACP) of 40 days, and an average payment period (APP) of 35 days. Using these values, the operating cycle is 100 days and the cash conversion cycle is 65 days ( ). Both are shown on time lines in Figure The Cash Conversion Cycle

Copyright © 2003 Pearson Education, Inc. Slide The Cash Conversion Cycle

Copyright © 2003 Pearson Education, Inc. Slide Reducing AAI or ACP, or lengthening APP reduces the cash conversion cycle, thus reducing the amount of financing required to support operations. The Cash Conversion Cycle

Copyright © 2003 Pearson Education, Inc. Slide Accounts Receivable Management A key component of the cash conversion cycle is the average collection period, which consists of two parts: –the time period from the sale until the customer mails payment, (determined largely by our credit terms) and – the time from the payment being mailed until the firm collects funds in its bank account. This is referred to as “float.”

Copyright © 2003 Pearson Education, Inc. Slide Float Float occurs with both collections and payments. Float has 3 components: –Mail float –Processing float –Clearing float

Copyright © 2003 Pearson Education, Inc. Slide Lockbox system. Concentration banking system. Both systems reduce mail float and clearing float. Speeding Collections Management of Receipts & Disbursements

Copyright © 2003 Pearson Education, Inc. Slide Controlled Disbursing involves the use of distant mailing points and bank accounts to lengthen the mail float and clearing float respectively. This approach should be used carefully; it might strain supplier relations. Slowing Payments Management of Receipts & Disbursements

Copyright © 2003 Pearson Education, Inc. Slide A firm’s credit policy includes: –Credit terms –Credit standards –Collection policy Credit Policy

Copyright © 2003 Pearson Education, Inc. Slide Credit terms are composed of three parts: –the cash discount –the cash discount period –the credit period Example, if credit terms are 2/10 net 30, the discount is 2%, the discount period is 10 days, and the credit period is 30 days. Credit Terms

Copyright © 2003 Pearson Education, Inc. Slide Credit standards determine which customers qualify for trade credit (and for how much credit they qualify). Credit Standards

Copyright © 2003 Pearson Education, Inc. Slide Character Capacity Capital Collateral Conditions Five C’s of Credit

Copyright © 2003 Pearson Education, Inc. Slide Credit scoring is a procedure that awards points for various borrower attributes. The result is a score that measures the applicant’s overall credit strength. The purpose of credit scoring is to make consistent, unbiased credit decisions quickly and inexpensively. Credit Scoring

Copyright © 2003 Pearson Education, Inc. Slide Collection Policy Collection policy is a firm’s procedures for collecting receivables when they are due. The effectiveness of collection policy can be evaluated partly by the level of bad debts, however bad debts also depend on credit policy. Firms should spend money to collect bad debts beyond the point where the marginal cost exceeds the marginal benefit.