1. Supply Chains and Working Capital Management
Chapter 16
Supply Chains and Working Capital Management

2. Working Capital Policy: Overview
Financial management decisions are divided into the management of assets (investments) and management of liabilities (liabilities).
The short-term financial management (working capital management) involves the management of a firm’s current assets and current liabilities
The maximization of the firm’s value in the long run depends on its survival in the short-run, i.e. meeting its working capital needs.

3. Working Capital Policy: Definitions
Working capital, sometimes called gross working capital, generally refers to cur­rent as­sets, while net working capital is defined as current assets minus current liabilities—the amount of current assets financed by long-term liabilities.
The current ratio, calculated as current assets divided by current liabilities, is intended to measure a firm’s liquidity.
A high current ratio does not insure that a firm will have the cash required to meet its needs.
The best and most comprehensive picture of a firm’s liquidity position is obtained by examining its cash budget, which forecasts a firm’s cash inflows and outflows. It focuses on what really counts, the firm’s ability to generate sufficient cash inflows to meet its required cash outflows.

4. Working Capital Policy: Definitions
Distinction should be made between current liabilities, specifically used to finance current assets and current liabilities that represent (a) current maturities of long-term debt; (b) financing associated with a construction program, after its completion will be funded with proceeds of a long-term security issue; or (c) the use of short-term debt to finance fixed assets.
Even though we define long-term debt coming due in the next accounting period as a current liability, it is not a working capital decision variable in the current period.
Similarly, when construction is temporarily financed with a short-term loan and later replaced with mortgage bonds, the construction loan would not be considered part of working capital management.
Although such accounts are not part of the working capital decision process, they cannot be ignored because they are due in the current period, and they must be considered when the cash budget is constructed and the firm’s ability to meet its current obligations is assessed.

5. Relationship between the current asset levels and financing requirements and the business cycle
At the peak of a business cycle, business carry their maximum amounts of current assets
Financing needs decline during recessions and increase during booms

6. The firm’s accounts balance
Once a firm’s operations have stabilized and cash collections from credit sales and cash payments for credit purchases have begun, the balance in accounts receivable and accounts payable can be computed using the following equation:
A decision affecting one working capital account will have an impact on other working capital accounts.

7. The cash conversion cycle
The cash conversion cycle focuses on the length of time between when the company makes payments, or invests in the manufacture of inventory, and when it receives cash inflows, or realizes a cash return from its investment in production.

8. The cash conversion cycle - Definitions
Inventory conversion period is the average length of time required to convert materials into finished goods and then to sell these goods;
it is the amount of time the product remains in inventory in various stages of completion.

9. The cash conversion cycle – Inventory conversion period
Inventory conversion period is the average length of time required to convert materials into finished goods and then to sell these goods;
it is the amount of time the product remains in inventory in various stages of completion.

10. The cash conversion cycle – Receivables collection period
Receivables collection period is the average length of time required to convert the firm’s receivables into cash, that is, to collect cash following a sale. It is also called the days sales outstanding (DSO).

11. The cash conversion cycle – Payables deferral period
Payables deferral period is the average length of time between the purchase of raw materials and labor and the payment of cash for them.

12. Analysis of the cash conversion cycle
The cash conversion cycle, which nets out the three periods just defined, equals the length of time between the firm’s actual cash expenditures to pay for (invest in) productive resources (materials and labor) and its own cash receipts from the sale of its products. Thus, the cash conversion cycle equals the average length of time a dollar is tied up in current assets.
Using these definitions, the cash conversion cycle is defined as follows:

13. Analysis of the cash conversion cycle
If receivables (debtors) are collecred faster, then
cash is released from the cycle
If receivables (debtors) are collected slower
receivables soak up cash
If better credit (in terms of duration or amount) from suppliers is obtained
cash resources are increased
If inventory (stocks) is shifted faster
Cash is freed up
If inventory (stocks) move slower
more cash is being consumed

14. The cash conversion cycle - Example
Suppose it takes a firm an average of 79.0 days to convert raw materials and labor to widgets and to sell them, and it takes another 43.2 days to collect on receivables, while 8.8 days normally lapse between the receipt of materials (and work done) and payments for materials and labor. In this case, the cash conversion cycle is 79.0 days days – 8.8 days = days.

15. The cash conversion cycle and the goal of the corporation
The firm’s goal should be to shorten its cash conversion cycle as much as possible without increasing costs or depressing sales. This would maximize profits because the longer the cash conversion cycle, the greater the need for external, or nonspontaneous, financing and such financing has a cost.
The cash conversion cycle can be shortened
by reducing the inventory conversion period by processing and selling goods more quickly,
by reducing the receivables collection period by speeding up collections
by lengthening the payables deferral period by slowing down its own payments.

16. Cash conversion cycle: things to note
When taking actions to reduce the inventory conversion period, a firm should be careful to avoid inventory shortages that could cause good customers to buy from competitors.
When taking actions to speed up the collection of receivables, a firm should be careful to maintain good relations with its good credit customers.
When taking actions to lengthen the payables deferral period, a firm should be careful not to harm its own credit reputation.
Actions that affect the inventory conversion period, the receivables collection period, and the payables deferral period all affect the cash conversion cycle; hence, they influence the firm’s need for current assets and current asset financing.

17. Cash conversion cycle: Example 1
A firm purchases raw materials on June 1st. It converts the raw materials into inventory by the last day of the month, June 30th. However, it pays for the materials on June 20th. On July 10th, it sells the finished goods for inventory. Then the firm collects cash from the sale one month later on August 10th. If this sequence accurately represents the firm’s average working capital cycle, what is the firm’s cash conversion cycle?

18. Cash conversion cycle: Solution 1
Payables deferral period = 20 days (June 1 to June 20).
Inventory conversion period = 40 days (June 1 to July 10).
Receivables collection period = 31 days (July 10 to August 10).
Cash conversion cycle = – 20 = 51 days.

19. Cash conversion cycle: Example 2
The Cairn Corporation is trying to determine the effect of its inventory turnover ratio and days sales outstanding (DSO) on its cash flow cycle. Cairn’s sales (which were all on credit) were $750,000, and it earned a net profit margin of 12 percent, or $90,000. It turned over its inventory 9 times during the year, its DSO (receivables collection period) was 45 days, and the firm’s cost of goods sold (COGS) was two-thirds of sales. The firm had fixed assets totaling $60,000. Cairn’s payables deferral period is 30 days. What is Cairn’s cash conversion cycle?

20. Cash conversion cycle: Solution 2
DSO = 45 days; Payables deferral period = 30 days.
Because inventory is turned over 9 times during the year, the inventory conversion period must be 40 days = (360 days)/9.
Alternatively, calculate the average inventory balance:
Cost of goods sold (COGS) = $750,000(2/3) = $500,000.
Inventory = ($500,000)/9 = $55,556. So, the inventory conversion period is:

21. Credit Management Credit Policy
Credit Policy encompasses of a set of decisions that include a firm’s credit standards, credit terms, methods used to collect credit accounts, and credit monitoring procedures
In general, firms would rather sell for cash than on credit, but competitive pressures force most firms to offer credit. Firms prefer to delay their payments, especially if there are no additional costs associated with the delay.

22. Factors determining the Credit Policy
Credit Standards
Standards that indicate the minimum financial strength a customer must have to be credit worthy
Terms of Credit
The payment conditions offered to credit customers
Length of credit period and any cash discounts offered
Collection Policy
The procedures followed by a firm to collect its accounts receivables

23. Receivables Monitoring
Credit Management
Receivables Monitoring
The process of evaluating the credit policy and payment patterns to determine whether a shift in the customers’ payment pattern occurs or whether the credit policy needs modifications

24. Methods for monitoring receivables
The days sales outstanding (DSO) represents the average length of time required to collect accounts receivable.
The DSO is calculated by dividing accounts receivable by daily credit sales.
The DSO can be compared with the industry average and the firm’s own credit terms to get indication of how well customers are adhering to terms prescribed and how customers’ payments, on average, compare with the industry average.
An aging schedule is a breakdown of a firm’s receivables by age of account.
The report divides receivables into specified periods, which provides information about the proportion of receivables that are current and the proportion that are past due for given lengths of time.

25. Monitoring receivables
BEWARE! Things to note!
Both the DSO and aging schedule can be distorted if sales are seasonal or if a firm is growing rapidly. A deterioration in either the DSO or the aging schedule should be taken as a signal to investigate further, but not necessarily as a sign that the firm’s credit policy has weakened.
If a firm generally experiences widely fluctuating sales patterns, some type of modified aging schedule should be used to correctly account for these fluctuations.
If the average collection period or DSO is increasing the firm should consider toughening its credit policy to prevent credit to more customers

26. Analysis of changes in credit policy
Marginal Costs and Benefits (will revenues rise more than costs?)
Analyze change in sales, change in variable operating costs, change in average collection period and change in carrying cost of receivables
Proposed changes should be evaluated the same way as capital budgeting projects would be; changes should be made only if NPV Proposal > 0.
BEWARE: There is quite a bit of uncertainty in credit policy change analysis because the variables are very difficult to estimate. Further, the end result depends on competitors’ reactions. Thus, the final decision is based on the quantitative analysis plus a great deal of informed judgment.

27. Inventory Management Raw Materials Work In-Process Finished Goods
Types of inventory
Raw Materials
Inventories purchased from suppliers that will ultimately be transformed into finished goods
Work In-Process
Inventory in various stages of completion
Finished Goods
Inventories that have completed the production process and are ready for sale

28. Optimal inventory level
Inventory Management
Optimal inventory level
The goal of inventory management is to provide the inventories required to sustain operations at the lowest possible cost. Steps: (a) Identification of costs involved in purchasing and maintaining inventory, (b) Determination at what point those costs are minimized.
There are 3 categories of inventory costs.
Carrying costs are associated with having inventory, such as rent paid where the inventory is stored, and they generally increase in proportion to average amount of inventory carried.
Ordering costs are associated with placing and receiving an order for new inventory, including costs of generating memos etc. The costs of each order are fixed regardless of order size.
Costs associated with running short of inventory (stockouts).

29. Total inventory costs (TIC) Total carrying costs Total ordering costs
Optimal inventory level = +
Total inventory costs (TIC)
Total carrying costs
Total ordering costs
C – carrying cost as a percent O – cost per order
PP – purchase price of inventory T – total demand in units
Q – quantity

30. Optimal inventory level
Economic Order Quantity Model (EOQ)
The optimal quantity that should be ordered
It is the quantity that will minimize the total inventory costs.
The Formula for determining the order quantity that will minimize total inventory costs is the following:

31. Optimal inventory level
Assumptions of the EOQ model
sales are evenly distributed throughout the period examined and sales can be forecasted perfectly,
orders are received when expected
the purchase price, PP, of each item in inventory is the same regardless of the quantity ordered.
The following results occur:
As amount ordered increases, total carrying costs increase but total ordering costs decrease, and vice versa.
If less than the EOQ amount is ordered, then the higher ordering costs more than offset the lower carrying costs.
If greater than the EOQ amount is ordered, the higher carrying costs more than offset the lower ordering cost.

32. Optimal inventory level
But EOQ model should be extended because assumptions for the basic EOQ are unrealistic
If there is a delay between the time inventory is ordered and when it is received, the firm must reorder before it runs out of inventory. So, the reorder point is the level of inventory at which an order should be replaced.
Even if additional inventory is ordered at the appropriate reorder point, unexpected demand might cause it to run out of inventory before the new inventory is delivered. To avoid this, the firm could carry safety stocks.
Suppliers often offer discounts for ordering large quantities; such discounts are called quantity discounts. To evaluate taking or not taking a quantity discount, the savings of the quantity discount are compared against the increased costs of ordering (and holding) a nonoptimal amount.
For most firms, it is unrealistic to assume that demand for an inventory item is uniform throughout the year. Thus, the EOQ model cannot be used on an annual basis.

33. So, how to determine a successful inventory management?
A successful inventory management is a multi-management process that requires interaction with departments, such as sales and production, but also knowledge of the economy and the business cycles are important to be able to evaluate, for instance, unexpected demand.

34. Inventory Control Systems
Introduction
The EOQ model can be used to help establish the proper inventory level, but inventory management also involves the establishment of an inventory control system. These systems vary from the extremely simple to the very complex.

35. Inventory Control Systems
Control procedures
Red-Line Method
An inventory control procedure in which a red line is drawn around the inside of an inventory-stocked bin to indicate the reorder point level
Computerized Inventory Control System
A system of inventory control in which a computer is used to determine reorder points and to adjust inventory balances

36. Inventory Control Systems
Control procedures
Just-In-Time System
A system of inventory control in which a manufacturer coordinates production with suppliers so that raw materials or components arrive just as they are needed in the production process
OutSourcing
The practice of purchasing components rather than making them in-house

37. Short-term financing
Definition
Any liability originally scheduled for repayment within one year

38. Sources of short-term financing
Accruals
Continually recurring short-term liabilities
Liabilities, such as wages and taxes, that increase spontaneously with operations
Accounts Payable (Trade Credit)
Credit created when one firm buys on credit from another firm
Trade credit discounts should be taken when offered. Otherwise, the disadvantage is that the firm’s investment in accounts payable rises

39. Sources of short-term financing
“Free” Trade Credit
Credit received during the discount period
Costly Trade Credit
Credit taken in excess of “free” trade credit, the cost of which is equal to the discount lost
Short-Term Bank Loans

40. Short-term bank loans
Bank loans appear on a firm’s balance sheet as notes payable and they are second in importance to trade credit as a source of short-term financing. Bank loans are nonspontaneous funds. As a firm’s financing needs increase, it specifically requests additional funds from its bank.

41. Key features of bank loans
The bulk of banks’ commercial lending is on a short-term basis. Bank loans to businesses frequently are written as 90-day notes.
When a firm obtains a bank loan, a promissory note is executed specifying (1) the amount borrowed, (2) the percentage interest rate, (3) the repayment schedule, (4) any collateral offered as security, and (5) other terms and conditions of the loan to which the bank and borrower have agreed.
Banks sometimes require borrowers to main­tain a compensating balance (CB) equal to 10 to 20 per­cent of the face value of the amount borrowed. Such required balances generally increase the loan’s effective interest rate.
A line of credit is an arrangement in which a bank agrees to lend up to a specified maximum amount of funds during a designated period.

42. Key features of bank loans (continued)
A revolving credit agreement is a formal, or guaranteed, line of credit often used by large firms.
Unlike a line of credit, the bank has a legal obligation to provide the funds when requested by the borrower.
The borrower will pay the bank a commitment fee to compensate the bank for guaranteeing that the funds will be available. This fee is paid on the unused balance of the commitment in addition to the regular interest charge on funds actually bor­rowed.
Neither the legal obligation nor the fee exists under the general line of credit.
As a general rule, the interest rate on “revolvers” is pegged to the prime rate, so the cost of the loan varies over time as interest rates change.

43. The cost of bank loans
The costs of bank loans vary for different types of borrowers at any given point in time and for all borrowers over time. Rates charged will vary depending on economic con­ditions, the risk of the borrower, and the size of the loan. Interest paid on a bank loan generally is calculated in one of three ways: (1) simple interest, (2) discount interest, and (3) add-on interest.
The prime rate is a published interest rate charged by banks to short-term borrowers (usually large, financially secure corporations) with the best credit. Rates on short-term loans are generally scaled up from the prime rate.

44. Computing Cost of Short-Term Credit
The numerator represents the dollar amount that must be paid for using the borrowed funds, which includes the interest paid, application fees, charges for commitment fees, and so forth.
The denominator, the amount of usable funds, is not necessarily the same as the principal amount, or amount borrowed, because discounts or other costs might be deducted from the loan proceeds.

45. Computing Cost of Short-Term Credit
The EAR incorporates interest compounding in the calculation while the annual percentage rate (APR) does not.

46. Computing Cost of Short-Term Credit

47. The Cost of Trade Credit
Determining the cost of trade credit is accomplished by calculating the periodic cost and multiplying it by the number of periods in a year.
The following equation may be used to calculate the approximate annual percentage rate of not taking cash discounts:
APR = Periodic cost  Periods per year
APR =

48. The Cost of Trade Credit - Example
For example, the approximate cost of not taking the cash discount when the credit terms are 2/10, net 30, is
= (18) = = 36.7%.
The approximation formula does not consider compounding, so the result is the simple annual percentage rate, or APR.

49. Regular or simple interest rate loans
With a regular, or simple, interest loan the borrower receives the face value of the loan (amount borrowed, or principal) and repays both the principal and interest at maturity.
The face value is the amount of the loan, or the amount borrowed; it is also called the principal amount of the loan.
The only case in which the effective annual rate is the same as the simple interest rate is if the borrower has use of the entire face value of the loan for one full year, and the only cost associated with the loan is the interest paid on the face value.
In such cases, interest compounding occurs annually

50. Discount interest rate loans
A discount interest loan is one in which the interest, which is calculated on the amount borrowed, is paid at the beginning of the loan period; interest is paid in advance so the borrower receives less than the face value of the loan.
The effective annual rate for a discounted loan is considerably greater than the effective annual rate for a simple interest loan with the same quoted rate and the same maturity because the borrower does not get to “use” the entire face value of the loan.
If the discount loan is for a period of less than one year, interest compounding must be considered to determine the effective annual rate.
Discount interest imposes less of a penalty on shorter-term loans than on longer-term loans.

51. Installment loans: Add-on interest
Add-on interest is interest that is calculated and then added to the amount borrowed to obtain the total dollar amount to be paid back in equal installments.
The approximate rate for an add-on loan can be determined by dividing the total interest paid by one-half of the loan’s face amount.
To determine the precise effective annual rate of an add-on loan, the techniques of present value annuity calculations are used.
The face value of the loan is the present value (PV), the annuity payments (PMT) are the face value plus the interest divided by the number of periods the loan is outstanding, and N is the number of periods the loan is outstanding.
Once these values are entered in the calculator the periodic interest rate can be obtained. Then the periodic interest rate is used to determine the effective annual rate of the loan.

52. ( ) Bank loans: Computing the annual cost
Simple interest with compensating balances
Compensating
balance
requirement X
= CB =
Principal
amount ( )
Compensating balance
stated as a decimal
(Amount of usable funds needed)
1 - (CB as a decimal)
Required loan
(principal) amount =
The cost of loan with compensating balance is
APR = kPER  ,
APR =
where N is the number of months of the loan’s maturity and CB is the compensating balance as a decimal.

53. The effective cost of the loan
The effective cost of the loan is calculated as follows:
(where kper is the percentage cost per period) or
If a firm normally keeps a positive checking account balance at the lending bank, then less needs to be borrowed to have a specific amount of funds available for use and the effective cost of the loan will be lower.