Working capital management Chapter 17

Key concepts and skills Understand how firms manage cash and various collection, concentration and disbursement techniques Understand how to manage receivables and the basic components of credit policy Understand various inventory types, different inventory management systems and what determines the optimal inventory level 17-2 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Chapter outline Cash and liquidity management Cash management: collection, disbursement and investment Credit and receivables Inventory management Inventory management techniques 17-3 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Reasons for holding cash John Maynard Keynes Speculative motive—hold cash to take advantage of unexpected opportunities Precautionary motive—hold cash in case of emergencies Transaction motive—hold cash to pay the day- to-day bills Trade-off between the opportunity cost of holding cash and the transaction cost of converting marketable securities to cash for transactions 17-4 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Understanding float Float—difference between cash balance recorded in the cash account and the cash balance recorded at the bank Disbursement float – Generated when a firm writes cheques – Available balance at bank – book balance > 0 Collection float – Cheques received increase book balance before the bank credits the account – Available balance at bank – book balance < 0 Net float = disbursement float + collection float 17-5 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Types of float—Example You have $3000 in your bank account. You just deposited $2000 and wrote a cheque for $2500. – What is the disbursement float? – What is the collection float? – What is the net float? – What is your book balance? – What is your available balance? 17-6 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Cash collection 17-7 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh Payment PaymentPayment Cash mailed receiveddeposited available Mailing timeProcessing delayAvailability delay Collection delay Float management goal = reduce collection delay

Cash collection (cont.) Faster with the introduction of electronic data interchange (EDI) ‘Over-the-counter collection’ – Point of sale collection – Cash – Credit card – Electronic funds transfer at point of sale (EFTPOS) 17-8 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Cash disbursements Disbursement float = desirable Slowing down payments can increase disbursement float, but it may not be ethical or optimal to do this Controlling disbursements – Zero-balance account – Controlled disbursement account 17-9 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Zero-balance accounts Firm maintains: – a master bank account – several subaccounts Bank automatically transfers funds from main account to subaccount as cheques are presented for payment Requires safety stock buffer in main account only Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Zero-balance accounts Figure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Investing idle cash Money market = financial instruments with original maturity ≤ one year Temporary cash surpluses – Seasonal or cyclical activities Buy marketable securities with seasonal surpluses Convert back to cash when deficits occur – Planned or possible expenditures Accumulate marketable securities in anticipation of upcoming expenses Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Seasonal cash demands Figure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Characteristics of short-term securities Maturity—firms often limit the maturity of short-term investments to 90 days to avoid loss of principal owing to changing interest rates Default risk—avoid investing in marketable securities with significant default risk Marketability—ease of converting to cash Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Credit management: Key issues Granting credit increases sales Costs of granting credit – Chance that customers won’t pay – Financing receivables Credit management examines the trade-off between increased sales and the costs of granting credit Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Components of credit policy Terms of sale – Credit period – Cash discount and discount period – Type of credit instrument Credit analysis—distinguishing between ‘good’ customers who will pay and ‘bad’ customers who will default Collection policy—effort expended on collecting receivables Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Credit period determinants Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Terms of sale Basic form: 2/10 net 60 – 2% discount if paid in 10 days – Total amount due in 60 days if discount not taken Buy $1000 worth of merchandise with the credit terms given above – Pay $1000(1 -.02) = $980 if you pay in 10 days – Pay $1000 if you pay in 60 days Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Cash discounts—Example Finding the implied interest rate when customers do not take the discount Credit terms of 2/10 net 45 and $500 loan – $10 interest (.02*500) – Period rate = 10 / 490 = % – Period = (45 – 10) = 35 days – 365 / 35 = periods per year – EAR = ( ) – 1 = 23.45% The company benefits when customers choose to forgo discounts Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Credit instruments Basic evidence of indebtedness Open account – Most basic form – Invoice only Promissory note – Basic IOU – Not common – Signed after goods delivered Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Credit instruments Commercial draft Sight draft = immediate payment required Time draft = not immediate When draft presented, buyer ‘accepts’ it – Indicates promise to pay – ‘Trade acceptance’ Seller may keep or sell acceptance Banker’s acceptance = bank guarantees payment Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Optimal credit policy Carrying costs – Required return on receivables – Losses from bad debts – Cost of managing credit and collections If restrictive credit policy: – Carrying costs low – Credit shortage = opportunity costs More liberal credit policy likely if: – Excess capacity – Low variable operating costs – Repeat customers Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Optimal credit policy (cont.) Figure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Credit analysis Process of deciding which customers receive credit Gathering information – Financial statements – Credit reports – Banks – Payment history with the firm Determining creditworthiness – 5 Cs of credit – Credit scoring Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Five Cs of credit Character—willingness to meet financial obligations Capacity—ability to meet financial obligations out of operating cash flows Capital—financial reserves Collateral—assets pledged as security Conditions—general economic conditions related to customer’s business Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Collection policy Monitoring receivables – Keep an eye on average collection period relative to your credit terms – Use an ageing schedule to determine percentage of payments that are being made late Collection policy – Delinquency letter – Telephone call – Collection agency – Legal action Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Inventory management Inventory can be a large percentage of a firm’s assets. Costs are associated with carrying too much inventory. Costs are associated with not carrying enough inventory. Inventory management tries to find the optimal trade-off between carrying too much inventory and not carrying enough Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Types of inventory Manufacturing firm – Raw material—starting point in production process – Work in progress – Finished goods—products ready to ship or sell Remember that one firm’s ‘raw material’ may be another company’s ‘finished good’. Different types of inventory can vary dramatically in terms of liquidity Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Inventory costs Carrying costs—range from 20–40% of inventory value per year – Storage and tracking – Insurance and taxes – Losses owing to obsolescence, deterioration or theft – Opportunity cost of capital Shortage costs – Restocking costs – Lost sales or lost customers Consider both types of costs and minimise the total cost Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Inventory management Classify inventory by cost, demand and need. Those items that have substantial shortage costs should be maintained in larger quantities than those with lower shortage costs. Generally maintain smaller quantities of expensive items. Maintain a substantial supply of less expensive basic materials Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Economic order quantity (EOQ) model EOQ minimises total inventory cost Q = inventory quantity in each order Q/2 = average inventory T = firm’s total unit sales per year T/Q = number of orders per year CC = inventory carrying cost per unit F = fixed cost per order Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

EOQ model (cont.) Total carrying cost = (Average inventory) x (Carrying cost per unit) = (Q/2)(CC) Total restocking cost = (Fixed cost per order) x (Number of orders) = F(T/Q) Total cost = Total carrying cost + Total restocking cost = (Q/2)(CC) + F(T/Q) Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

EOQ model (cont.) Total cost = Total carrying cost + Total restocking cost = (Q/2)(CC) + F(T/Q) Q*  Carrying costs = Restocking costs (Q*/2)(CC) = F(T/Q*) Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Cost of holding inventory Figure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

EOQ—Example Consider an inventory item that has carrying cost = $1.50 per unit. The fixed order cost is $50 per order and the firm sells units per year. – What is the economic order quantity? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Extensions to EOQ Safety stocks – Minimum level of inventory kept on hand – Increases carrying costs Reorder points – Inventory level at which you place an order so as to account for delivery time Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Safety stocks and reorder points Figure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Derived-demand inventories Materials requirements planning (MRP) – Computer-based ordering/scheduling – Works backwards from set finished goods level to establish required levels of work in progress Just-in-time inventory – Reorder and restock frequently – Japanese system Keiretsu = industrial group Kanban = card signalling reorder time Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Quick quiz What is the difference between disbursement float and collection float? What is credit analysis and why is it important? What is the implied rate of interest if credit terms are 1/5 net 30? What are the two main categories of inventory costs? What components are required to determine the economic order quantity? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Chapter 17 END 17-40