Working Capital and Cash Conversion Cycle Management

1. CHAPTER 14 Working capital and current assets management

2. Learning Objectives • Understand short term working finance • Describe the cash conversion cycle • Discuss inventory management • Explain credit selection • Analyse changes to credit terms • Outline receipts and disbursements

3. Net working capital fundamentals • short term financial management involves managing current assets and liabilities • working capital = current assets • current assets are those that circulate from one form to another in the course of business • net working capital: • = (current assets) – (current liabilities)

4. Basic Definitions • Gross working capital: Total current assets. • Net working capital: Current assets - Current liabilities. • Net operating working capital (NOWC): Operating CA – Operating CL = (Cash + Inv. + A/R) – (Accruals + A/P) (More…)

5. Definitions (Continued) • Working capital management: Includes both establishing working capital policy and the day-to-day control of cash, inventories, receivables, accruals, and accounts payable. • Working capital policy: • The level of each current asset. • How current assets are financed.

6. Net working capital fundamentals Profitability and risk • there is a ‘tradeoff’ between profitability and risk  profitability is the relationship between revenues and costs by using the firm’s assets  risk (of technical insolvency) is the danger the firm will be unable to pay its bills due

7. Cash Conversion = Cycle Inventory Conversion + Period Receivables Collection - Period Payables Deferral . Period The cash conversion cycle • the firm’s Operating Cycle (OC) is the time from the beginning of production to the collection of cash from the sale of the finished product OC = AAI + ACP • the firm’s Cash Conversion Cycle (CCC) is the amount of time the firm’s resources are tied up CCC = OC - APP • Therefore: CCC = AAI + ACP – APP

8. Cash Management: Cash doesn’t earn interest, so why hold it? • Transactions: Must have some cash to pay current bills. • Precaution: “Safety stock.” But lessened by credit line and marketable securities. • Compensating balances: For loans and/or services provided. • Speculation: To take advantage of bargains, to take discounts, and so on. Reduced by credit line, marketable securities.

9. What’s the goal of cash management? • To have sufficient cash on hand to meet the needs listed on the previous slide. • However, since cash is a non-earning asset, to have not one dollar more.

10. Why might a company want to maintain a relatively high amount of cash? • If sales turn out to be considerably less than expected, the company could face a cash shortfall. • A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative. • The cash may be there, in part, to fund a planned fixed asset acquisition.

11. The cash conversion cycle • MAX Company has annual sales of $10 million, a cost of goods sold of 75% of sales, and purchases that are 65% of cost of goods sold. MAX has an average age of inventory (AAI) of 60 days, an average collection period (ACP) of 40 days, and an average payment period (APP) of 35 days. Thus, the cash conversion cycle for MAX is 65 days (60 + 40 – 35). • Figure 14.1 presents MAX Company’s cash conversion cycle as a time line.

12. Figure 14.1 Time line for MAX Company’s cash conversion cycle—MAX Coy’s OC is 100 days and its CCC is 65 days

13. The cash conversion cycle • The resources MAX has invested in this CCC are • Changes in any of the time periods will change the resources tied up in operations. Eg, if MAX reduces the ACP on its accounts receivable by 5 days, it shortens the cash conversion time line and reduces the amount of resources invested in operations. A 5-day reduction in the ACP reduces the resources invested in the CCC by $136,986 [$10, 000,000 × (5/365)].

14. Exercises • Now try to do problems 14-4 and 14-5 from Gitman Ch 14 handout

15. The cash conversion cycle Funding requirements of the CCC • permanent (constant) versus seasonal (cyclical) funding • aggressive (short/long debt mix) versus conservative (long debt only) funding

16. Funding requirements • Nicholson Company holds, on average, $50,000 in cash and marketable securities, $1,250,000 in inventory, and $750,000 in accounts receivable. Nicholson’s business is very stable over time, so its operating assets can be viewed as permanent. • Nicholson’s accounts payable of $425,000 are stable over time. • Nicholson has a permanent investment in operating assets of $1,625,000 ($50,000 + $1 250,0000 + $750,000 – $425,000). That amount also equals its permanent funding requirement.

17. Funding requirements • Semper Pump Coy has seasonal funding needs and seasonal sales, with peak sales driven by summertime purchases of bicycle pumps. • Semper holds, at minimum, $25,000 in cash and marketable secs, $100,000 in inventory and $60,000 in accounts receivable. At peak times, inventory increases to $750,000 and accounts receivable to $400,000. • Semper produces pumps at a constant rate throughout the year. Thus, accounts payable remain at $50,000 throughout the year, so Semper has a permanent funding requirement for its minimum level of operating assets of $135,000 ($25,000 + $100,000 + $60,000 – $50,000) and peak seasonal funding requirements of $990,000 [($25, 000 + $750,000 + $400,000 – $50,000) – $135,000]. • Semper’s total funding requirements for operating assets vary from $135,000 (permanent) to a seasonal peak of $1,125,000 ($135,000 + $990,000) – see Fig 14.2

18. Figure 14.2 Semper Pump Coy’s total funding requirements—peak funds need is $1,125,000 and its minimum need is $135,000

19. Working Capital Financing Policies • Moderate: Match the maturity of the assets with the maturity of the financing. • Aggressive: Use short-term financing to finance permanent assets. • Conservative: Use permanent capital for permanent assets and temporary assets.

20. $ Temp. NOWC } S-T Loans L-T Fin: Stock & Bonds, Perm NOWC Fixed Assets Years Lower dashed line, more aggressive. Moderate Financing Policy

21. $ Marketable Securities Zero S-T debt L-T Fin: Stock & Bonds Perm NOWC Fixed Assets Years Conservative Financing Policy

22. Aggressive funding strategy • A funding strategy where the firm funds its seasonal requirements with short-term debt and its permanent requirements with long-term debt. • If Semper has permanent funding needs of $135,000 and seasonal funding averaging $101,250. It can borrow short-term funds at 6.25% and long-term funds at 8%, and if it can earn 5% on the investment of any surplus balances, the annual cost of an aggressive strategy for seasonal funding will be • Note: Amount of funding = estimated funding needed. Therefore zero surplus

23. Conservative funding strategy • A funding strategy where the firm funds both its seasonal and its permanent requirements with long-term debt. • Semper can choose a conservative strategy, under which surplus cash balances are fully invested. (Fig 14.2, this surplus is the difference between the peak need of $1,125,000 and the total need, which varies between $135,000 and $1,125,000 during the year.) The cost of the conservative strategy will be • Ave surplus balance = Seasonal peak – permanent need – ave seasonal need • Ave surplus need = 1,125,000 – 135,000 – 101,250 = 888,750

24. Aggressive versus conservative funding • The aggressive strategy’s heavy reliance on short-term financing makes it riskier than the conservative strategy because of interest rate swings and possible difficulties in obtaining needed short-term financing quickly when seasonal peaks occur. • The conservative strategy avoids these risks through the locked-in interest rate and long-term financing, but is more costly because of the negative spread between the earnings rate on surplus funds (5% in the example) and the cost of the long-term funds that create the surplus (8% in the example).

25. What are the advantages of short-term debt vs. long-term debt? • Low cost-- yield curve usually slopes upward. • Can get funds relatively quickly. • Can repay without penalty.

26. What are the disadvantages of short-term debt vs. long-term debt? • Higher risk. The required repayment comes quicker, and the company may have trouble rolling over loans.

27. The cash conversion cycle Strategies for managing the CCC • turn over inventory quickly • collect accounts receivable quickly • receipts: minimise mail, processing and clearing payments: maximise mail, processing and clearing • pay accounts slowly (without harming credit rating)

28. Inventory management Differing views of inventory management: • financial manager – keep stocks low • marketing manager – keep stocks of finished product high • manufacturing manager – have big production runs • purchasing manager – keep high raw materials stocks

29. Inventory Management: Categories of Inventory Costs • Carrying Costs: • Storage and handling costs, insurance, property taxes, depreciation, and obsolescence. • Ordering Costs: • Cost of placing orders, shipping, and handling costs. • Costs of Running Short: • Loss of sales, loss of customer goodwill, and the disruption of production schedules.

30. Inventory management Common techniques of inventory management: the ABC system • divides inventory into three categories (A,B,C) in descending order of importance based on dollar investment in each •  A group receives intensive monitoring  B group is controlled by periodic checking  C group have unsophisticated monitoring (eg the ‘two bin’ method of re-ordering when one bin is empty)

31. Inventory management Common techniques of inventory management: the Economic Order Quantity (EOQ) model • determines the item’s optimal order quantity  by minimising (order costs + carrying costs) • order costs = fixed clerical costs of ordering carrying costs = variable costs of holding inventory items for a time

32. Inventory management The EOQ model - graphically

33. Inventory management The EOQ model – algebraically order cost = O x S/Q carrying cost = C x Q/2 total cost = (O x S/Q) + (Cx Q/2)  EOQ = √ (2.S.O)/C • where: • S = usage in units per period • O = order cost per order • C = carrying cost per unit per period • Q = order quantity in units

34. Inventory management • The EOQ calculation helps management to minimise the total cost of inventory. • Lowering order costs causes an increase in carrying costs, and may increase total cost. • Likewise, an increase in total cost may result from reduced carrying costs. • The goal, facilitated by using the EOQ calculation, is to lower total cost.

35. Inventory management The EOQ model • reorder point is the time at which to reorder inventory and equals • reorder point = (lead time in days) x (daily usage) • safety stocks are extra inventories that can be drawn down when lead times or usage rate vary

36. Inventory management • MAX Coy has an A group inventory item that is vital to the production process. The item costs $1,500, and 1,100 units are used per year. • What is the optimal order strategy for the item? • To calculate the EOQ, we need the following inputs:

37. Inventory management • The reorder point depends on the number of days MAX operates per year. • Assuming 250 days per year and uses 1,100 units of this item, its daily usage is 4.4 units (1,100 / 250). • If lead time is two days and a safety stock of 4 units is held, the reorder point for this item is 12.8 units [(2 × 4.4) + 4]. • Therefore, the order is placed when the inventory falls to 13 units.

38. Exercise • Now try to do problem 14-18 from Gitman Ch 14 handout

39. Inventory management Common techniques of inventory management: the Just-in-Time (JIT) system • minimises inventory investment by having material inputs arrive exactly when needed • JIT uses little or no safety stocks • involves the risk of shutting down production if inventories fail to arrive

40. Inventory management • Assume the same information as before for Max Coy, but the marginal cost of placing an order is alternately (a) $11 or (b) $2. • a Order cost of $11

41. Inventory management • As order cost falls, we should order fewer units per order, more often. • As the marginal order cost falls, place orders more frequently for smaller amounts. • Applying a marginal order cost, the EOQ model moves towards a JIT system, where inventory arrives when it is needed, with an order cost based on the cost of a phone call to the supplier or a predetermined delivery schedule. • A pure JIT system assumes that suppliers will deliver on time, every time. Otherwise, pure JIT systems cause problems for manufacturers.

42. Accounts receivable management • the average collection period (ACP) is the second component of the CCC and has two parts: - the time from sale until the customer mails payment - the time from mailed payment to banking the funds • minimising the ACP involves: - credit selection - credit terms - credit monitoring

43. Accounts receivable management Credit selection: the five C’s of credit • character – the applicant’s past record • capacity – the ability to repay • capital – the financial backing of the applicant • collateral – assets available to act as security • conditions – current business climate

44. Accounts receivable management Changing credit standards Variabledirectioneffect on of changeprofits sales increase positive accounts rec’ble increase negative bad debts increase negative

45. Accounts receivable management • Credit scoring: • is a selection method that applies statistical weights to an applicant’s scores on key financial measures • Decision principle: • if the additional profit exceeds marginal costs, then credit standards should be relaxed • International credit: • exposes the firm to exchange rate risk

46. Changing credit standards • Dodd Tool is selling a product for $10 per unit. Credit sales last year were 60,000 units. Variable cost per unit is $6. Total fixed costs are $120,000. Dodd is considering a relaxation of credit standards that is expected to result in the following: a 5% increase in unit sales to 63,000 units; increases in the average collection period from 30 days to 45 days and in bad-debt expenses from 1% of sales to 2%. The firm’s required return on equal-risk investments, the opportunity cost of tying up funds in accounts receivable, is 15%. • To determine whether to relax its credit standards, Dodd Tool must calculate its effect on the firm’s additional profit contribution from sales, the cost of the marginal investment in accounts receivable, and the cost of marginal bad debts.

47. Changing credit standards • Additional profit contribution from sales • Because fixed costs are ‘sunk’ and thereby unaffected by a change in the sales level, the only cost relevant to a change in sales is variable cost. • Sales are expected to increase by 5%, or 3,000 units. • The profit contribution per unit will equal the difference between the sale price per unit ($10) and the variable cost per unit ($6). The profit contribution per unit will therefore be $4. • Thus, the total additional profit contribution from sales will be $12,000 (3,000 units × $4 per unit).

48. Changing credit standards • Cost of the marginal investment in accounts receivable is the difference between the cost of carrying receivables before and after the introduction of the relaxed credit standards. It is the out-of-pocket (variable) costs rather than the fixed (sunk) costs that are relevant in this analysis. The average investment in accounts receivable formula is:

49. Changing credit standards • The total variable cost of annual sales under the proposed and present plans using the variable cost per unit of $6 is • Total variable cost of annual sales: • Under present plan: • ($6 × 60,000 units) = $360,000 • Under proposed plan: • ($6 × 63,000 units) = $378,000 • Implementation of the proposed plan will cause the total variable cost of annual sales to increase from $360,000 to $378,000.

50. Changing credit standards • The turnover of accounts receivable is the number of times each year that the firm’s accounts receivable are turned into cash. It is found by dividing the average collection period into 365—the number of days in a year. • Turnover of accounts receivable (rounded to the nearest whole number): • Under present plan: 365/30 = 12 • Under proposed plan: 365/45 = 8 • With implementation of the proposed plan, the accounts receivable turnover would drop from 12 to 8.