1. Copyright © 2011 Nelson Education Limited Finance for Non-Financial Managers, 6 th edition PowerPoint Slides to accompany Prepared by Pierre Bergeron, University of Ottawa

2. Copyright © 2011 Nelson Education Limited Finance for Non-Financial Managers, 6 th edition CHAPTER 6 WORKING CAPITAL MANAGEMENT

3. Copyright © 2011 Nelson Education Limited Working Capital Management Chapter Objectives 1.Define the meaning and importance of the cash conversion cycle. 2.Explain different strategies related to managing inventories. 3.Discuss various techniques related to trade receivables management. 4.Comment on managing cash and its cash equivalents. 5.Show how current liability accounts can be managed to improve the cash flow cycle. Chapter Reference Chapter 6: Working Capital Management

4. Copyright © 2011 Nelson Education Limited 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 statement of financial position accounts. Inventories $ 70,000 Trade receivables 30,000 Notes receivable 5,000 Prepaid expenses 3,000 Marketable securities 10,000 Cash 10,000 Total current assets$128,000 Working Capital Current assets Trade and other payables $ 56,000 Notes payables 20,000 Accrued expenses 4,000 Taxes payable 8,000 Total current liabilities $ 88,000 Current liabilities

5. Copyright © 2011 Nelson Education Limited 1. 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 5 5 19 10 8 9 15 4 - 30 60 12 5 60 7 Existing 209 days Target 160 days Reduction 49 days

6. Copyright © 2011 Nelson Education Limited 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. (Inventories + Trade receivables) - Trade payables Revenue ÷ 365 ($218,000 + $300,000) - $195,000 $2,500,000 ÷ 365 $323,000 $6,940 Days of Working Capital (DWC) = = =47.2 days

7. Copyright © 2011 Nelson Education Limited Using Futurama Ltd. (Transparencies 3.6 and 3.8) Purpose Measures the efficiency with which a business converts revenue to cash flow from operations. Cash flow from operations Revenue $126,000 $2,500,000 Cash Conversion Efficiency (CCE) = =5.1 percent

8. Copyright © 2011 Nelson Education Limited 1.Raw Materials (i.e., lumber, steel, rubber, plastics, chemicals, paint and other fishing substances, also includes supplies and parts). 2. Managing Inventories 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 inventories 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).

9. Copyright © 2011 Nelson Education Limited Minimum inventory level Inventory Levels LT Units in inventories 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

10. Copyright © 2011 Nelson Education Limited 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

11. Copyright © 2011 Nelson Education Limited 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) 1 2 3 4 5 6 7 1 2 5 6 8 10 5,000 2,500 1,000 833 625 500 50 100 250 300 400 500 2,500 1,250 500 416 312 250 13,375 6,687 2,675 2,226 1,669 1,337 2,006 1,003 401 334 250 200 2,056 1,103 651 634 650 700

12. Copyright © 2011 Nelson Education Limited Here’s the proof: Annual order costs (6 times x $50.00)=$300.00 Annual carrying costs ($5.35 x 790 = $4,226 ÷ 2 x 15%)=$317.00 Total inventory costs=$617.00 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%

13. Copyright © 2011 Nelson Education Limited The goal of trade receivables 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 Trade Receivables 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$120.00 Cost of product$ 90.00 Cost of capital 10% Should the company grant 2/10, net 30 days? $90.00 x 10% x = $1.48 60-day delay 365 days Effective price Cost of product Credit costs Finance costs Profit -$ _________ _________ _________ + _________ $ _________ 10-day payment 60-day payment 117.60 120.00 90.00 28.96 28.52 1.61 ---.25 1.48

14. Copyright © 2011 Nelson Education Limited 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.

15. Copyright © 2011 Nelson Education Limited Return on investment === 14.6% Changing Credit Terms Incremental profit $27,00 Incremental investment $185,400 Expected volume (units) Expected revenue ($10.00 per unit) Expected profit before bad debts (10% of revenue) Expected bad debt expense (% of revenue) Expected profit (after bad debts) Incremental profit Expected collection period (days) Average trade receivables Incremental investment Return on investment calculation for changing the firm’s credit terms Existing terms 400,000 4,000,000 400,000 20,000 (.5%) 380,000 --- 29 315,800 ----- Existing terms 440,000 4,400,000 440,000 33,000 (.75%) 407,000 27,000 42 501,200 185,400

16. Copyright © 2011 Nelson Education Limited $20,000 x 12% X = $131.51 20 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. 4. Managing Cash FLOAT

17. Copyright © 2011 Nelson Education Limited 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 trade receivables).

18. Copyright © 2011 Nelson Education Limited 5. Managing Current Liabilities  Trade and other payables  Accruals  Salaries and wages payable  Taxes payable  Working capital loans