1. Copyright © 2014 Nelson Education Ltd. 6–1 PowerPoint Presentations for Finance for Non-Financial Managers: Seventh Edition Prepared by Pierre Bergeron University of Ottawa

2. Copyright © 2014 Nelson Education Ltd. 6–2 CHAPTER 6 Working Capital Management

3. Copyright © 2014 Nelson Education Ltd. 6–3 1.Explain the meaning of working capital and how it can be measured. 2.Discuss the flow of cash via the cash conversion cycle. 3.Describe several strategies for managing inventories. 4.Explore techniques for managing trade receivables. 5.Comment on managing cash and cash equivalents. 6.Explain how to manage current liability accounts to improve the cash flow cycle. Learning Objectives

4. Copyright © 2014 Nelson Education Ltd. 6–4 Working capital management involves: –management of individual current assets, current liabilities, and interrelationships that link current assets with current liabilities and with other statement of financial position accounts Meaning of Working Capital LO 1

5. Copyright © 2014 Nelson Education Ltd. 6–5 Net working capital is defined as current assets minus current liabilities. Meaning of Working Capital 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 LO 1

6. Copyright © 2014 Nelson Education Ltd. 6–6 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 LO 2

7. Copyright © 2014 Nelson Education Ltd. 6–7 Cash Flow of Working Capital Accounts LO 2

8. Copyright © 2014 Nelson Education Ltd. 6–8 Using Futurama Ltd. (Slides 3-8 and 3-10) 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 LO 2

9. Copyright © 2014 Nelson Education Ltd. 6–9 Using Futurama Ltd. (Slides 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% LO 2

10. Copyright © 2014 Nelson Education Ltd. 6–10 Goal –to replenish stocking points in such a way as to minimize the total of all associated costs, and thereby enhance profitability of the business Managing Inventories LO 3

11. Copyright © 2014 Nelson Education Ltd. 6–11 Types of inventories 1.Raw Materials lumber, steel, rubber, plastics, chemicals, paint and other finishing substances, supplies, and parts 2.Work-in-Progress partially assembled or partially processed, not yet completed 3.Finished Goods goods completed and ready to be sold for resale by wholesaling and retailing firms Managing Inventories LO 3

12. Copyright © 2014 Nelson Education Ltd. 6–12 Inventory Levels LO 3

13. Copyright © 2014 Nelson Education Ltd. 6–13 Inventory Decisions LO 3 Order And Set-up CostsHolding Costs Transportation costsStorage costs Clerical costs of making ordersFire insurance Cost of placing goods in storageProperty taxes Downtime on equipmentSpoilage and deterioration Quantity discountsCost of borrowing Rent of facilities Obsolescence

14. Copyright © 2014 Nelson Education Ltd. 6–14 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) × $ 5.35 (5) × 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 LO 3

15. Copyright © 2014 Nelson Education Ltd. 6–15 Here’s the proof: Annual order costs (6 × $50.00)=$300.00 Annual carrying costs ($5.35 × 790 = $4,226 ÷ 2 × 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 × $50.00 × 5,000 $0.80 $5.35 × 15% LO 3

16. Copyright © 2014 Nelson Education Ltd. 6–16 Goal: –to set credit terms, grant credit to customers, monitor payment patterns, and apply necessary collection procedures so as to increase profitability Managing Trade Receivables LO 4

17. Copyright © 2014 Nelson Education Ltd. 6–17 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 × 10% × = $1.48 60-day delay 365 days Effective price Cost of product Credit costs Finance costs Profit -$ _________ _________ _________ + _________ $ _________ 10-day payment 60-day payment 117.60 120.00 90.00 28.96 28.52 1.61 ---.25 1.48 LO 4

18. Copyright © 2014 Nelson Education Ltd. 6–18 Grant Credit to Customers (Credit Report) LO 4

19. Copyright © 2014 Nelson Education Ltd. 6–19 Return on investment === 14.6% Changing Credit Terms Incremental profit $27,000 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 LO 4

20. Copyright © 2014 Nelson Education Ltd. 6–20 Goal: –To reduce the amount of cash that is being used within the firm to increase profitability, but without reducing business activities or exposing the firm to undue risk in its financial obligations Managing Cash and Cash Equivalents LO 5

21. Copyright © 2014 Nelson Education Ltd. 6–21 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). Managing Cash and Cash Equivalents $20,000 × 12% × = $131.51 20 days late for payment 365 days FLOAT LO 5

22. Copyright © 2014 Nelson Education Ltd. 6–22 Ways to Improve Collection of Cash 1.Change customer paying habits Letters, telephone calls, or personal visits Economic incentive for paying bills faster –offer discounts (i.e., 2/10, N/30) continued… LO 5

23. Copyright © 2014 Nelson Education Ltd. 6–23 Ways to Improve Collection of Cash 2.Improve the delivery system (reduce the negative float) Regional banking –customers pay bills to banks since they can transfer funds more quickly than mail order delivery. Lockbox collection system –firm rents post office box and bank monitors the lockbox periodically Electronic communications –Example: data-phone wire systems continued… LO 5

24. Copyright © 2014 Nelson Education Ltd. 6–24 Ways to Improve Collection of Cash 3.Bypass the problem Factoring of trade receivables LO 5

25. Copyright © 2014 Nelson Education Ltd. 6–25 Managing Current Liability Accounts Trade and other payables Working capital loans Short-term loans made to finance working capital accounts Examples: inventories, trade receivables LO 6