Finance for Non-Financial Managers , 6 th edition

1. Finance for Non-Financial Managers, 6th edition PowerPoint Slides toaccompany Prepared by Pierre Bergeron, University of Ottawa

2. Finance for Non-Financial Managers, 6th edition CHAPTER 6 WORKING CAPITAL MANAGEMENT

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

4. 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. Working Capital Current liabilities 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 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 Net working capital is defined as current assets minus current liabilities.

5. 5 5 12 19 60 10 - 30 8 4 7 5 60 15 9 1. Cash Conversion Cycle Existing 209 days Target 160 days Reduction 49 days Cash Deposit Purchase decision and order Processing payment Payment by customer Credit decision Payment to suppliers Purchase of raw materials Billing Delivery of raw materials Inventory of raw materials Inventory of finished goods Manufacturing Shipment

6. Days of Working Capital (DWC) 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 = = = 47.2 days

7. Cash Conversion Efficiency (CCE) 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 = = 5.1 percent

8. 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 • Raw Materials (i.e., lumber, steel, rubber, plastics, chemicals, paint and other fishing substances, also includes supplies and parts). • Work-in-Progress (i.e., partially assembled or partially processed, not yet completed). • Finished Goods (i.e., goods completed and ready to be sold for resale by wholesaling and retailing firms).

9. Inventory Levels Units in inventories Average number of units in inventory Q/2 Maximum inventory level LT LT LT LT LT LT Purchase Quality RP RP RP RP RP RP Minimum inventory level SAP SAP SAP SAP SAP SAP SAP LT = Lead time SAP = Stock arrival point RP = Reorder point = Depletion of stock

10. Inventory Decisions Typical costs of ordering and holding inventory • 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

11. Calculating the Economic Order Quantity Number Order Annual Average Average Annual Ordering cost of quantity order cost unit dollar holding + orders (units) $50.00 inventory 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. 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 $5.35 x 15% 2 FU C 2 x $50.00 x 5,000 $0.80 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

13. 90.00 90.00 1.48 .25 --- 1.61 28.96 28.52 3. Managing Trade Receivables 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. 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 10-day payment 60-day payment Effective priceCost of productCredit costsFinance costsProfit • $ _________ _________ _________+ _________$ _________ • $ _________ _________ _________+ _________$ _________ 120.00 117.60

14. 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. Changing Credit Terms 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 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 Incremental profit $27,00 Incremental investment $185,400 Return on investment = = = 14.6%

16. 4. Managing Cash 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. 20 days late for payment 365 days $20,000 x 12% X = $131.51 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). FLOAT

17. Ways to Improve Collection of Cash • Changing customer paying habits • Letters, telephone calls, or personal visits • Economic incentive for paying bills faster; offer discounts (i.e., 2/10, N/30) • 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 a post office box in a particular city and the bank monitors the lockbox periodically). • Electronic communications (i.e., data-phone wire systems). • Bypass the problem (Factoring of trade receivables).

18. 5. Managing Current Liabilities • Trade and other payables • Accruals • Salaries and wages payable • Taxes payable • Working capital loans