Managerial Finance

Chapter 14
Working Capital
and Current
Assets
Management
Copyright 2009 Pearson Prentice Hall. All rights reserved.
Learning Goals
1. Understand short-term financial management, net
working capital, and the related trade-off between
profitability and risk.
2. Describe the cash conversion cycle, its funding
requirements, and the key strategies for managing it.
3. Discuss inventory management: differing views,
common techniques, and international concerns.
14-2
Learning Goals (cont.)

4. Explain the credit selection process and the quantitative
procedure for evaluating changes in credit standards.
5. Review the procedures for quantitatively considering cash
discount changes, other aspects of credit terms, and credit
monitoring.
6. Understand the management of receipts and
disbursements, including float, speeding up collections,
slowing down payments, cash concentration, zero balance
accounts, and investing in marketable securities.
14-3
Long & Short Term Assets & Liabilities

Current Assets:
Cash
Marketable Securities
Prepayments
Accounts Receivable
Inventory
Current Liabilities:
Accounts Payable
Accruals
Short-Term Debt
Taxes Payable
Fixed Assets:
Investments
Plant & Machinery
Land and Buildings
Long-Term Financing:
Debt
Equity
14-4
Net Working Capital

Working Capital includes a firms current assets,
which consist of cash and marketable securities in
addition to accounts receivable and inventories.
It also consists of current liabilities, including accounts
payable (trade credit), notes payable (bank loans), and
accrued liabilities.
Net Working Capital is defined as total current assets
less total current liabilities.
14-5
The Tradeoff Between

Profitability & Risk
Positive Net Working Capital (low return and low risk)
low
return
Current
Assets
Net Working
Capital > 0
Current
Liabilities
Long-Term
Debt
high
return
Fixed
Assets
Equity
low
cost
high
cost
highest
cost
14-6

Profitability & Risk (cont.)
Negative Net Working Capital (high return and high risk)
low
return
Current
Assets
high
return
Fixed
Assets
Current
Liabilities
Net Working
Capital < 0
low
cost
Long-Term
Debt
high
cost
Equity
highest
cost
14-7

Profitability & Risk (cont.)
Table 14.1 Effects of Changing Ratios
on Profits and Risk
14-8
The Cash Conversion Cycle

Short-term financial managementmanaging current
assets and current liabilitiesis one of the financial
managers most important and time-consuming activities.
The goal of short-term financial management is to
manage each of the firms current assets and liabilities to
achieve a balance between profitability and risk that
contributes positively to overall firm value.
Central to short-term financial management is an
understanding of the firms cash conversion cycle.
14-9
Calculating the Cash Conversion Cycle

The Operating Cycle (OC) is the time between
ordering materials and collecting cash from
receivables.
The Cash Conversion Cycle (CCC) is the time
between when a firm pays its suppliers (payables)
for inventory and collecting cash from the sale of the
finished product.
14-10
Calculating the Cash

Conversion Cycle (cont.)
Both the OC and CCC may be computed as
shown below.
14-11

MAX Company, a producer of paper dinnerware, has
annual sales of $10 million, 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.
Using the values for these variables, the cash conversion
cycle for MAX is 65 days (60 + 40 - 35) and is shown on
a time line in Figure 14.1.
14-12

Figure 14.1 Time Line for MAX Companys Cash
Conversion Cycle
14-13

The resources MAX has invested in the cash
conversion cycle assuming a 365-day year are:
Obviously, reducing AAI or ACP or lengthening APP will

reduce the cash conversion cycle, thus reducing the amount
of resources the firm must commit to support operations.
14-14
Funding Requirements of the CCC

Permanent vs. Seasonal Funding Needs
If a firms sales are constant, then its investment in operating
assets should also be constant, and the firm will have only a
permanent funding requirement.
If sales are cyclical, then investment in operating assets will
vary over time, leading to the need for seasonal funding
requirements in addition to the permanent funding
requirements for its minimum investment in operating assets.
14-15
Funding Requirements
of the CCC (cont.)
Nicholson Company holds, on average, $50,000 in cash and
marketable securities, $1,250,000 in inventory, and $750,000
in accounts receivable. Nicholsons business is very stable
over time, so its operating assets can be viewed as
permanent. In addition, Nicholsons accounts payable of
$425,000 are stable over time. Nicholson has a permanent
investment in operating assets of $1,625,000 ($50,000 +
$1,250,000 + $750,000 - $425,000). This amount would also
equal the companys permanent funding requirement.
14-16
of the CCC (cont.)
In contrast, Semper Pump Company, which produces bicycle pumps,
has seasonal funding needs. Semper has seasonal sales, with its peak
sales driven by purchases of bicycle pumps. Semper holds, at minimum,
$25,000 in cash and marketable securities, $100,000 in inventory, and
$60,000 in accounts receivable. At peak times, Sempers inventory
increases to $750,000 and its accounts receivable increase to $400,000.
To capture production efficiencies, Semper produces pumps at a
constant rate throughout the year. Thus, accounts payable remain at
14-17
of the CCC (cont.)
$50,000 throughout the year. Accordingly, 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 $900,000 [($125,000 + $750,000 +
$400,000 - $50,000) - $135,000]. Sempers total funding
requirements for operating assets vary from a minimum of $135,000
(permanent) to a a seasonal peak of $1,125,000 ($135,000 +
$900,000) as shown in Figure 14.2.
14-18
of the CCC (cont.)
Figure 14.2
Semper
Pump
Companys
Total Funding
Requirements
14-19
of the CCC (cont.)
Aggressive vs. Conservative Funding Strategies
Semper Pump has a permanent funding requirement of $135,000 and
seasonal requirements that vary between $0 and $990,000 and
average $101,250. If Semper can borrow short-term funds at 6.25%
and long term funds at 8%, and can earn 5% on any invested surplus,
then the annual cost of the aggressive strategy would be:
14-20
of the CCC (cont.)
Alternatively, Semper can choose a conservative strategy under which
surplus cash balances are fully invested. In Figure 13.2, this surplus would
be 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.
14-21
of the CCC (cont.)
Clearly, the aggressive strategys heavy reliance on short-term
financing makes it riskier than the conservative strategy because of
interest rate swings and possible difficulties in obtaining needed
funds quickly when the seasonal peaks occur.
The conservative strategy avoids these risks through the locked-in
interest rate and long-term financing, but is more costly. Thus the
final decision is left to management.
14-22
Strategies for Managing the CCC

1. Turn over inventory as quickly as possible without stock
outs that result in lost sales.
2. Collect accounts receivable as quickly as possible without
losing sales from high-pressure collection techniques.
3. Manage, mail, processing, and clearing time to reduce
them when collecting from customers and to increase
them when paying suppliers.
4. Pay accounts payable as slowly as possible without
damaging the firms credit rating.
14-23
Inventory Management:
Inventory Fundamentals
Classification of inventories:
Raw materials: items purchased for use in the
manufacture of a finished product
Work-in-process: all items that are currently in
production
Finished goods: items that have been produced but
not yet sold
14-24
Differing Views About Inventory
The different departments within a firm (finance, production,
marketing, etc.) often have differing views about what is an
appropriate level of inventory.
Financial managers would like to keep inventory levels low to
ensure that funds are wisely invested.
Marketing managers would like to keep inventory levels high
to ensure orders could be quickly filled.
Manufacturing managers would like to keep raw materials
levels high to avoid production delays and to make larger, more
economical production runs.
14-25
Techniques for Managing Inventory

The ABC System
The ABC system of inventory management divides inventory
into three groups of descending order of importance based on
the dollar amount invested in each.
A typical system would contain, group A would consist of 20%
of the items worth 80% of the total dollar value; group B
would consist of the next largest investment, and so on.
Control of the A items would intensive because of the high
dollar investment involved.
14-26
Techniques for Managing

Inventory (cont.)
14-27

Inventory (cont.)
14-28

Inventory (cont.)
The Economic Order Quantity (EOQ) Model
Assume that RLB, Inc., a manufacturer of electronic test equipment,
uses 1,600 units of an item annually. Its order cost is $50 per order,
and the carrying cost is $1 per unit per year. Substituting into the
above equation we get:
EOQ = 2(1,600)($50) = 400

$1
The EOQ can be used to evaluate the total cost of inventory as
shown on the following slides.
14-29

Inventory (cont.)
The Economic Order Quantity (EOQ) Model
Ordering Costs = Cost/Order x # of Orders/Year
Ordering Costs = $50 x 4 = $200
Carrying Costs = Carrying Costs/Year x Order Size
2
Carrying Costs = ($1 x 400)/2 = $200
Total Costs = Ordering Costs + Carrying Costs
Total Costs = $200 + $200 = $400
14-30

Inventory (cont.)
The Reorder Point
Once a company has calculated its EOQ, it must determine
when it should place its orders.
More specifically, the reorder point must consider the lead
time needed to place and receive orders.
If we assume that inventory is used at a constant rate
throughout the year (no seasonality), the reorder point can be
determined by using the following equation:
Reorder point = lead time in days x daily usage
Daily usage = Annual usage/360
14-31

Inventory (cont.)
The Reorder Point
Using the RIB example above, if they know that it requires 10 days to
place and receive an order, and the annual usage is 1,600 units per
year, the reorder point can be determined as follows:
Daily usage = 1,600/360 = 4.44 units/day

Reorder point = 10 x 4.44 = 44.44 or 45 units
Thus, when RIBs inventory level reaches 45 units, it should place an
order for 400 units. However, if RIB wishes to maintain safety stock
to protect against stock outs, they would order before inventory
reached 45 units.
14-32

Inventory (cont.)
Just-In-Time (JIT) System
The JIT inventory management system minimizes the
inventory investment by having material inputs arrive exactly
at the time they are needed for production.
For a JIT system to work, extensive coordination must exist
between the firm, its suppliers, and shipping companies to
ensure that material inputs arrive on time.
In addition, the inputs must be of near perfect quality and
consistency given the absence of safety stock.
14-33

Inventory (cont.)
Computerized Systems for Resource Control
MRP systems are used to determine what to order,
when to order, and what priorities to assign to
ordering materials.
MRP uses EOQ concepts to determine how much to
order using computer software.
It simulates each products bill of materials structure
all of the products parts), inventory status, and
manufacturing process.
14-34

Inventory (cont.)
Like the simple EOQ, the objective of MRP systems is to
minimize a companys overall investment in inventory
without impairing production.
Manufacturing resource planning II (MRP II) is an
extension of MRP that integrates data from numerous areas
such as finance, accounting, marketing, engineering, and
manufacturing suing a sophisticated computer system.
This system generates production plans as well as numerous
financial and management reports.
14-35

Inventory (cont.)
Unlike MRP and MRP II, which tend to focus on internal
operations, enterprise resource planning (ERP) systems can
expand the focus externally to include information about
suppliers and customers.
ERP electronically integrates all of a firms departments so
that, for example, production can call up sales information
and immediately know how much must be produced to fill
certain customer orders.
14-36
International Inventory Management
International inventory management is typically
much more complicated for exporters and MNCs.
The production and manufacturing economies of scale
that might be expected from selling globally may prove
elusive if products must be tailored for local markets.
Transporting products over long distances often results
in delays, confusion, damage, theft, and other
difficulties.
14-37
Accounts Receivable Management

The second component of the cash conversion cycle is
the average collection period the average length of
time from a sale on credit until the payment becomes
usable funds to the firm.
The collection period consists of two parts:
the time period from the sale until the customer mails
payment, and
the time from when the payment is mailed until the firm
collects funds in its bank account.
14-38
Accounts Receivable Management:

The Five Cs of Credit
Character: The applicants record of meeting past
obligations.
Capacity: The applicants ability to repay the requested
credit.
Capital: The applicants debt relative to equity.
Collateral: The amount of assets the applicant has
available for use in securing the credit.
Conditions: Current general and industry-specific
economic conditions.
14-39

Credit Scoring
Credit scoring is a procedure resulting in a
score that measures an applicants overall credit
strength, derived as a weighted-average of
scores of various credit characteristics.
The procedure results in a score that measures
the applicants overall credit strength, and the
score is used to make the accept/reject decision
for granting the applicant credit.
14-40

Credit Scoring (cont.)
The purpose of credit scoring is to make a
relatively informed credit decision quickly and
inexpensively.
For a demonstration of credit scoring, including
the use of a spreadsheet for that purpose, see the
books Web site at www.prenhall.com/gitman.
14-41

Changing Credit Standards
The firm sometimes will contemplate changing its credit
standards to improve its returns and generate greater
value for its owners.
14-42

Changing Credit Standards
14-43
Changing Credit Standards Example

Dodd Tool, a manufacturer of lathe tools, is currently selling a product
for $10/unit. Sales (all on credit) for last year were 60,000 units. The
variable cost per unit is $6. The firms total fixed costs are $120,000.
Dodd is currently contemplating a relaxation of credit standards that is
anticipated to increase sales 5% to 63,000 units. It is also anticipated
that the ACP will increase from 30 to 45 days, and that bad debt
expenses will increase from 1% of sales to 2% of sales. The
opportunity cost of tying funds up in receivables is 15%.
Given this information, should Dodd relax its credit standards?
14-44
Changing Credit
Standards Example (cont.)
Additional Profit Contribution from Sales
14-45
Changing Credit
Cost of marginal investment in A/R:
14-46
Changing Credit
14-47
Changing Credit
Cost of marginal bad debts:
14-48
Changing Credit
Table 14.2
Effects on Dodd
Tool of a
Relaxation of
Credit Standards
14-49
Changing Credit Terms

A firms credit terms specify the repayment terms
required of all of its credit customers.
Credit terms are composed of three parts:
The cash discount
The cash discount period
The credit period
For example, with credit terms of 2/10 net 30, the discount
is 2%, the discount period is 10 days, and the credit period
is 30 days.
14-50
Changing Credit Terms Example

MAX Company has an average collection period of 40
days (turnover = 365/40 = 9.1). In accordance with the
firms credit terms of net 30, this period is divided into 32
days until the customers place their payments in the mail
(not everyone pays within 30 days) and 8 days to receive,
process, and collect payments once they are mailed.
MAX is considering initiating a cash discount by changing
its credit terms from net 30 to 2/10 net 30. The firm
expects this change to reduce the amount of time until the
payments are placed in the mail, resulting in an average
collection period of 25 days (turnover = 365/25 = 14.6).
14-51
Changing Credit
Terms Example (cont.)
Table 14.3
Analysis of
Initiating a Cash
Discount for MAX
Company
14-52
Credit Monitoring
Credit monitoring is the ongoing review of a firms
accounts receivable to determine whether customers are
paying according to the stated credit terms.
Slow payments are costly to a firm because they
lengthen the average collection period and increase the
firms investment in accounts receivable.
Two frequently used techniques for credit monitoring
are the average collection period and aging of accounts
receivable.
14-53
Credit Monitoring:
Average Collection Period
The average collection period is the average number of
days that credit sales are outstanding and has two parts:
The time from sale until the customer places the payment in
the mail, and
The time to receive, process, and collect payment.
14-54
Credit Monitoring:
Aging of Accounts Receivable
14-55
Credit Monitoring:
Collection Policy
The firms collection policy is its procedures for
collecting a firms accounts receivable when they are
due.
The effectiveness of this policy can be partly evaluated
by evaluating at the level of bad expenses.
As seen in the previous examples, this level depends
not only on collection policy but also on the firms
credit policy.
14-56
Collection Policy
Table 14.4 Popular Collection Techniques
14-57
Management of Receipts
& Disbursements: Float
Collection float is the delay between the time when a
payer deducts a payment from its checking account ledger
and the time when the payee actually receives the funds in
spendable form.
Disbursement float is the delay between the time when a
payer deducts a payment from its checking account ledger
and the time when the funds are actually withdrawn from
the account.
Both the collection and disbursement float have three
separate components.
14-58
Management of Receipts
& Disbursements: Float (cont.)
Mail float is the delay between the time when a payer
places payment in the mail and the time when it is
received by the payee.
Processing float is the delay between the receipt of a
check by the payee and the deposit of it in the firms
account.
Clearing float is the delay between the deposit of a check
by the payee and the actual availability of the funds which
results from the time required for a check to clear the
banking system.
14-59
Management of Receipts & Disbursements:

Speeding Up Collections
Lockboxes
A lockbox system is a collection procedure in which payers
send their payments to a nearby post office box that is emptied
by the firms bank several times a day.
It is different from and superior to concentration banking in
that the firms bank actually services the lockbox which
reduces the processing float.
A lockbox system reduces the collection float by shortening
the processing float as well as the mail and clearing float.
14-60

Slowing Down Payments
Controlled Disbursing
Controlled Disbursing involves the strategic use of
mailing points and bank accounts to lengthen the
mail float and clearing float respectively.
This approach should be used carefully, however,
because longer payment periods may strain supplier
relations.
14-61
Management of Receipts &

Disbursements: Cash Concentration
Direct Sends and Other Techniques
Wire transfers is a telecommunications bookkeeping device
that removes funds from the payers bank and deposits them
into the payees bankthereby reducing collections float.
Automated clearinghouse (ACH) debits are
pre-authorized electronic withdrawals from the payers
account that are transferred to the payees account via a
settlement among banks by the automated clearinghouse.
ACHs clear in one day, thereby reducing mail, processing,
and clearing float.
14-62

Zero-Balance Accounts
Zero-balance accounts (ZBAs) are

disbursement accounts that always have an endof-day balance of zero.
The purpose is to eliminate non-earning cash
balances in corporate checking accounts.
A ZBA works well as a disbursement account
under a cash concentration system.
14-63
Investing in Marketable Securities

Table 14.5 Features and Recent Yields on Popular
Marketable Securitiesa (cont.)
14-64
Investing in Marketable
Securities (cont.)
Marketable Securitiesa (cont.)
14-65
Investing in Marketable
Securities (cont.)
Marketable Securitiesa
14-66

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Chapter 14

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Learning Goals (cont.)

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Long & Short Term Assets & Liabilities

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Net Working Capital

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The Tradeoff Between

The Tradeoff Between

The Tradeoff Between

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The Cash Conversion Cycle

Calculating the Cash Conversion Cycle

Calculating the Cash

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Calculating the Cash

Calculating the Cash

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Calculating the Cash

Obviously, reducing AAI or ACP or lengthening APP will

Funding Requirements of the CCC

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Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Strategies for Managing the CCC

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Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Techniques for Managing Inventory

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Techniques for Managing

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Techniques for Managing

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Techniques for Managing

EOQ = 2(1,600)($50) = 400

Techniques for Managing

Techniques for Managing

Techniques for Managing

Daily usage = 1,600/360 = 4.44 units/day

Techniques for Managing

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Techniques for Managing

Techniques for Managing

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Techniques for Managing

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Accounts Receivable Management

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Accounts Receivable Management:

Accounts Receivable Management:

Accounts Receivable Management:

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Accounts Receivable Management:

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Accounts Receivable Management:

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Changing Credit Standards Example