A B C D E F G H I J K

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2
3 Chapter 15. Model for managing and financing current assets
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5 Chapter 15 deals with working capital management. Two useful tools for working capital management are
6 (1) the cash conversion cycle and (2) the cash budget. This spreadsheet model shows how these tools are
7 used to help manage current assets.
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9 THE CASH CONVERSION CYCLE
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11 The cash conversion cycle model focuses on the length of time between when the company must make
12 payments and when it receives cash inflows. The cash conversion cycle is determined by three factors: (1)
13 The inventory conversion period, which is the average time required to convert materials into finished goods
14 and then to sell those goods. The inventory conversion period is measured by dividing inventory by the
15 average daily sales. (2) The receivables collection period, which is the length of time required to convert the
16 firm's receivables into cash, or how long it takes to collect cash from a sale. The receivables collection
17 period is measured by the days sales outstanding ratio (DSO), which is accounts receivable divided by
18 average daily sales. (3) The payables deferral period, which is the average length of time between the
19 purchase of materials and labor and payment for them. The payable deferral period is calculated by dividing
20 average accounts payable by purchases per day (cost of goods sold divided by 360 or 365 days). The cash
21 conversion cycle is determined by the following formula:
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23 Inventory conversion period Receivables collection Payables deferral
Cash conversion cycle + -
24 = period period
25
26 Problem
27 Calculate the cash conversion cycle for the Real Time Computer Company. Annual sales are $10 million,
28 and the annual cost of goods sold is $8 million. The average levels of inventory, receivables, and accounts
29 payable are $2,000,000, $666,667, and $666,667, respectively. RTCC uses a 365-day accounting year.
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31 Sales $10,000,000
32 COGS $8,000,000
33 Inventories $2,000,000
34 AR $666,667
35 AP $666,667
36 Days/year 365
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38 Cash conversion cycle (CCC) Inventory conversion period Receivables collection Payables deferral
= + -
39 period period
40
41 = Inventory/Sales per day + AR/Sales per day - AP/COGS per day
42 =
43 =

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 A B C D E F G H I J K
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45 It takes 73 days to make and then sell a computer, and another 24 days to collect cash after the sale, or a
46 total of 97 days between spending money and collecting cash. However, the company can delay payment for
47 parts and labor for 30 days. Therefore, the net days the firm must finance its labor and purchases is 97 - 30
48 = 67 days, which is the cash conversion cycle. Companies like to shorten their cash conversion cycles as
49 much as possible without adversely impacting operations. As noted in the chapter, Amazon.com and Dell
50 have been able to produce goods on demand, hence to reduce the inventory conversion period to close to zero.
51 In addition, since payments are made by credit card, the receivables collection period is also close to zero.
52 Then, if they pay suppliers after a 20 payables deferral period, they can end up with a NEGATIVE cash
53 conversion cycle. In that case, the faster the firms grow, the more cash they generate.
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55 Disregarding profits, how much capital does RTCC have tied up in working capital?
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57
58 =
59
60
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62 Question: If RTCC began selling on a credit card only basis, how would this affect its CCC, and what effect
63 would it have on the cost of carrying working capital?
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65
66
67 -
68
69 We could do sensitivity analysis to see how other changes would affect profitability.
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71 THE CASH BUDGET
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73 The cash budget is a statement that shows cash flows over a specified period of time. Generally, firms use a
74 monthly cash budget for the coming year, plus a more detailed daily or weekly cash budget for the coming
75 month. Monthly cash budgets are used for long-range planning, and daily or weekly budgets for actual cash
76 control. The following monthly cash budget examines Allied Foods for the last 6 months of 2002.
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78 Input Data
79 Collections during month of sale 20% Assumed constant. Don't change.
80 Collections during 1st month after sale 70% Formula. Don't change.
81 Collections during 2nd month after sale 10% Allow this value to change to reflect slower collections.
82 Discount on first month collections 2%
83 Purchases as a % of next month's sales 70%
84 Lease payments $15
85 Construction cost for new plant (Oct) 100
86 Target cash balance $10
87 Sales adjustment factor 0.00
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 A B C D E F G H I J K
89 THE CASH BUDGET
90 May June July August September October November December
91 Collections and purchases worksheet
92 Sales (gross)
93 Collections
94 During month of sale
95 During first month after sale
96 During second month after sale
97 Total collections
98
99 Purchases
100 70% of next months sales
101 Payments on last month's purchases
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103 Cash gain or loss for month
104 Collections
105 Payments for purchases
106 Wages and salaries
107 Lease payments
108 Other expenses
109 Taxes
110 Payment for plant construction
111 Total payments
112 Net cash gain (loss) during month
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114 Loan requirement or cash surplus
115 Cash at start of month if no borrowing
116 Cumulative cash
117 Target cash balance
118 Cumulative surplus cash or loans
119 outstanding to maintain $10 target cash balance
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121 Max loan:
122
123 Question: If the percent of customers who pay in the 2nd month after the sale increased due to poor credit
124 management, how would this affect the maximum required loan?
125
Loan Requirement

126 Answer: Do a sensitivity analysis.

127
128 % paying Max Req'd Loan Effect of Late Payment % on Loan Requirements
129 late $0
130 0% $0 $1
131 10% $0
$1
132 20% $0
133 30% $0 $1
134 40% $0 $0
135 50% $0 $0
136 60% $0 $0
137 70% $0 0% 10% 20% 30% 40% 50% 60% 70% 80%
% Paying Late

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 Loa
$1
$1
$1
$0
$0
$0
A B C D 0% 10%
E 20% 30%
F 40%
G 50% H60% 70%
I 80% J K
138 80% $0 % Paying Late
139

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141 You could do all sorts of "What if" analyses. For example, what if sales declined by 50%. How would that
142 affect the max loan requirement?
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144 Answer: Just change sales and observe the change in the max loan requirement. The max loan jumps from
145 $100 to $231. We would then have to ask, Would our lenders more than double our line of credit in the face
146 of a 50% drop in sales? If not, would we go bankrupt?
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148 Here is a sensitivity analysis for the effect of changes in sales on the max loan requirement:

Max Loan Required

149
150 % Change Max Loan
151 in Sales $0
-100% $0 Max Loan Vs. Change in Sales
152
153 -50% $0 $1
154 0% $0
155 50% $0 $1

156 100% $0 $1
157
$0
158
159 $0
160
$0
161
-100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%
162 % Change in Sales
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164
165 Question: If both sales and collections change, what will happen to the max loan requirement?
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167 Answer: Do a sensitivity analysis.
168
169 Change Maximum Loan Required
170 in Sales % Collections in 2nd month
171 $0 0% 10% 20% 30% 40% 50% 60% 70%
172 -100% $0 $0 $0 $0 $0 $0 $0 $0
173 -75% $0 $0 $0 $0 $0 $0 $0 $0
174 -50% $0 $0 $0 $0 $0 $0 $0 $0
175 -25% $0 $0 $0 $0 $0 $0 $0 $0
176 0% $0 $0 $0 $0 $0 $0 $0 $0
177 25% $0 $0 $0 $0 $0 $0 $0 $0
178 50% $0 $0 $0 $0 $0 $0 $0 $0
179 75% $0 $0 $0 $0 $0 $0 $0 $0
180 100% $0 $0 $0 $0 $0 $0 $0 $0
181
182
183 You can see from the table that, from the base case (collections = 10%, change in sales = 0), an increase
184 in late payers increases the loan requirement, as does a decline in sales.
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 A B C D E F G H I J K
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187 FINANCING WORKING CAPITAL
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189 In Chapter 15, we also address the topic of financing working capital. Using short-term financing to support the firm's
190 productive assets has both advantages and disadvantages. An aggressive policy entails heavy reliance upon short-term debt,
191 while a conservative policy would call for less use of short-term debt.
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193 At first glance, short-term debt financing offers firms greater speed, more flexibility, and generally lower interest rates.
194 However, short-term financing still carries a risk. Long-term financing allows firms to lock in an interest expense,
195 whereas short-term financing can expose a firm to a wildly fluctuating interest expense. Over reliance on short-term
196 could quickly lead to default if a substantial recession should hit.
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198 The major sources of short-term debt financing are short-term bank loans (notes payable), accruals, and trade credit
199 (accounts payable).
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201 TRADE CREDIT
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203 Accounts payable, or trade credit, is the largest single category of short-term debt on the balance sheet, representing
204 approximately 40 percent of the average nonfinancial corporation's current liabilities. Accounts payable, like accruals,
205 is a spontaneous liability because it generally experiences corresponding growth to a firm's productive assets. A firm's
206 credit policy tells us the terms by which they allow customers to purchase goods on credit. For example, Microchip
207 Electronics' credit policy is on terms of 2/10, net 30. This is interpreted as a 2% discount if paid within the first ten
208 days, but the full invoice amount is due within 30 days if the discount is not taken. If we are told that Microchip's
209 annual purchases of $11,760,000, we can calculate the firm's average daily A/P. (We will use a 365-day accounting
210 year)
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212 Annual chip purchases $11,760,000
213 Days/year 365
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215 Daily A/P
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217 From the firm's trade terms, we also know the following:
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219 % Discount 2%
220 Discount period (in days) 10
221 Days until due 30
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223 If Microchip's customers decide to take advantage of the discount, the average accounts payable can be determined by
224 multiplying the daily accounts payable by the discount period.
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226 Average A/P (w/discount)
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228 However, if the firm's customers decide to not take advantage of the discount, we assume that they will take the full term
229 to pay off the debt. We can determine the average accounts payable under this scenario, too.
230
231 Average A/P (w/o discount)
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233 The difference between these two average accounts payable figures tells the amount of credit Microchip offers to its
234 customers. Microchip's customers can use this trade credit to build up its cash account, to pay off debt, to expand

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 A B C D E F G H I J K
235 inventories, or to extend credit to its customers.
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237 Trade Credit
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239 We have previously stated that Microchip's annual sales to its customers amounted to $11,760,000, and that they offer a
240 2% discount for early payment. Dividing annual purchases by the percentage price paid (98%) gives us the total cost of
241 goods. This cost of goods is composed of an explicit cost ($11,760,000) and a finance charge (the 2%).
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243 Total cost of goods
244 Finance charge
245
246 Dividing the trade finance charge by the trade credit gives us the nominal annual cost of the additional trade credit.
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248 Nominal annual cost
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250 The nominal annual cost can broken into two components: the cost per period of trade credit (discount percent divided by
251 100% - discount percent) times the periods per year (365 divided by total days until required payment - the discount period).
252 To check ourselves, we will recalculate the nominal annual cost using this method.
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254 Cost per period of trade credit
255 Periods per year
256 Nominal annual cost
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258 Something we learned in Chapter 7 was that we are not as concerned with the nominal cost as we are with the effective cost.
259 We can calculate the effective cost by using the formula: (1 + cost per period of trade credit) periods per year
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261 Effective annual rate
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263 As always, we should not be solely concerned with the current situation. For example, suppose that Microchip extended
264 its trade policy to allow customers to take up to 60 days to make full payment. What would its new effective annual cost be?
265 Notice, that this change in policy has no effect on the cost per period of trade credit, but the periods per year does change.
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267 If payment due after …
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269 New effective annual rate
270
271 While we are considering how changes in trade policy changes the cost of credit, let us look at the following scenarios.
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273 Cost of additional credit if
274 the discount is not taken
275 Credit terms % discount discount ends payment due Nominal Effective
276 1/10, net 20 1% 10 20
277 1/10, net 30 1% 10 30
278 2/10, net 20 2% 10 20
279 3/15, net 45 3% 15 45
280

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