Ch 13 Fin323 Working Capital And Current Assets Management

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Working Capital (current assets)

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includes a firm’s 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.

current assets, which represent the portion of investment that circulates from one to another in the ordinary conduct of business.

idea embraces the recurring transition from cash to inventories to receivables and back to cash.

marketable securities are consider part of working capital

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net working capital

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the difference btw the firm's current assets and its current liabilities; can be positive or negative

if current assets exceed current liabilities, the firm has positive net working capital.

it's easy to predict current liabilities but not cash inflow inwhich the conversion of the current assets to more liquid forms.

more net working capital means more liquid the firm and therefore the lower its risk of becoming technically insolvent

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Short-term financial management

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management of current assets and current liabilities.

is one of
the financial manager’s most important and time-consuming activities.

short time for both assets and liabilities

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profitability

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the relationship btw revenues and costs generated by using the firm's assets - both current and fixed - in productive activities

a firm's profits can be increased by:
1. increasing revenues or
2. decreasing costs.

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technically insolvent

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describes a firm that is unable to pay its bills as they come due

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Operating Cycle (OC)

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the time from the beginning of the production process to the collection of cash from the sale of the finished product.

it is measured by summing the average age of inventory (AAI) and the average collection period (ACP)

OC = AAI+ACP

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Cash Conversion Cycle (CCC)

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amount of time a firm's resources are tied up; calculated by subtracting teh average payment period from the operating cycle.

CCC = OC - APP or
CCC = AAI +ACP - APP

APP = time it takes to pay the accounts payable

AAI: average age of inventory
ACP: average collection period
APP: average payment period
OC: Operating cycle
CCC: cash conversion cycle

changes in any of the time periods will change the resources tied up in operations.

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 13.1.

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.

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 firm’s credit rating.
Inventory Management: Inventory Fundamentals

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permanent funding requirement

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a constant investment in operating assets resulting from constant sales over time.

If a firm’s sales are constant, then its investment in operating assets should also be
constant, and the firm will have only a permanent funding requirement.

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seasonal funding requirement

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an investment in operating assets that varies over time as a result of cyclic sales.

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.

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aggressive funding strategy

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a funding strategy under which the firm funds its seasonal requirements with short-term debt and its permanent requirements with long-term debt.

note... short-term funding exposes the firm to the risk that it may not be able to obtain the funds needed to cover its seasonal peaks.

Permanent vs. Seasonal Funding Needs
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. In addition, 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 + $1,250,000 + $750,000 - $425,000).
This amount would also equal the company’s permanent funding requirement.

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conservative funding strategy

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a funding strategy under which the firm funds both its seasonal and its permanent requirements with long-term debt.

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, Semper’s 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 $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
$990,000 = [($25,000 + $750,000 + $400,000 - $50,000) - $135,000].
Semper’s 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 + $990,000) as shown in Figure 13.2.

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.

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Financial managers

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would like to keep inventory levels low to ensure that funds are wisely
invested.

tries to keep inventory low to ensure that the firm's money is not being unwisely invested in excess resource.

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marketing manager

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would like to keep inventory levels high to ensure orders could be quickly
filled.

implement the production plan so that it results in the desired amount of finished goods of acceptable quality at a low cost. would keep raw materials inventories high to avoid production delay

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purchasing manager

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would like to keep raw materials levels high to avoid production
delays and to make larger, more economical production runs.

concerned solely with raw materials inventories. they may purchase larger quantites of resources than are actually needed at the time.

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abc inventory system

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inventory management technique that divides inventory into three groups - A, B, and C, in descending order of importance and level of monitoring, on the basis of the dollar investment in each.

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.

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economic order quantity (EOQ) model

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EOQ model model for management of A and B group items

inventory management technique for determining an item's optimal order size, which is the size that minimizes the total of its order costs and carrying costs.

order costs= fixed clerical costs of placing and receiving an inventory order

carrying costs = variable costs per unit of holding an item in inventory for a specific period of time

order costs decrease as the size of the order increases. carrying costs increases with increases in order size.

order cost = O x S/Q

carrying cost = C x Q/2

total cost = (O x S/Q) + (C x Q/2)

EOQ = square root of (2 x S x O)/C

S = usuage in units per period
O = order cost per order
C = carrying cost per unit per period
Q = order quantitly in units

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reorder point

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the point at which to reorder inventory, expressed as days of lead time x daily usage

it's the firm's daily usage of the inventory items and the number of days needed to place and receive an order

reorder point = days of lead time x daily usage

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/year, the order point can be determined as follows:
Daily usage = 1,600 / 360 = 4.44 units/day
Reorder point = 10*4.44 =44.44 or 45 units
Thus, when RIB’s 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.

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safety stock

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extra inventory that is held to prevent stockouts of important items.

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Just-in-time (JIT) system

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inventory management technique that minimizes inventory investment by having materials arrive at exactly the time they are neede for production.

the system uses no safety stock.

the goal of JIT system is manufacturing efficiency.

when JIT is working properly, it forces process inefficiencies to surface.

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.

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material requirement planning (MRP) system

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inventory management technique that applies EOQ comcepts and a computer to compare production needs to available inventory balances and determine when orders should be placed for variou items on a product's bill of material

determine what materials to order and when to order them

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 product’s bill of materials structure all of the product’s parts),
inventory status, and manufacturing process.

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manufacturing resource lanning II (MRP II)

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a sophisticated computerized system that intergrates data from numerous areas such as finance, accounting, marketing, engineering, and manufacturing and generates production plans as well as numerous financial and management reports

Computerized Systems for Resource Control
– Like the simple EOQ, the objective of MRP systems is to minimize a company’s 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.

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enterprise resource planning (ERP)

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a computerized system that electronically integrates external information about the firm's suppliers and customers with the firm's departmental data so that information on all available resources - human and material - can be instantly obtained in a fashion that eliminates production delays and controls costs.

system expand the focus to the external environment by including info. about suppliers and customers.

system can eliminate production delays and control costs

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accounts receivable management

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avg. collect period has two part. time form sale until the customer mails the payment. the second is time from when the payment is mailed until the firm has the collected funds in its bank account.

management want to collect account receivable as quickely as possible. by encompossing three topics

1. credit selection
2. credit terms
3. credit monitoring

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credit standards

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teh firm's minium requirements for extending credit to a customer.

determining which customers should receive credit.

five C's of credit

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five C's of credit

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Character: The applicant’s record of meeting past obligations.
• Capacity: The applicant’s ability to repay the requested credit.
• Capital: The applicant’s 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.

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credit scoring

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a credit selection method commonly used with high volume/ small dollar credit request; relies on a credit score determined by applying statistically derived weights to a credit applicant's scores on key financial and credit characteristics.

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

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credit terms

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the terms of sale for customers who have been extended credit by the firm.

terms of net 30 means the customer has 30 days from beginning of the credit period to pay full invoice amount.

A firm’s 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.

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cash discount

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a percentage deduction from the purchase price; available to the credit customer who pays its account within a specified time.

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.

popular way to achieve the goal of speeding up collections without putting pressure on customers.

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credit period

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number of days after the beginning of the credit period until full payment of the account is due.

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credit monitoring

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ongoing review of a firm's accounts receivable to determine whether customers are paying according to the stated credit terms

two techniques... avg. collection period and aging of accounts receivable.

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avg. collection period

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average number of days that credit sales are outstanding.
two components:
1. time from sale until customer places the payment in the mail
2. time to receive, process, and collect the payment once it has been mailed by the customer.

avg collection period = accounts receivable/avg. sales per day

knowing avg. collection period enables the firm to determine whether there is a general problem with accounts receivable.

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aging schedule

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a credit-monitoring technique that breaks down accounts receivalbe into groups on the basis of their time of origin; it shows the percentages of the total accounts receivable balance that have been outstanding for specified periods of time.

the purpose of the aging schedule is to enable the firm to pinpoint problems.

ex. pp 532

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collection technique

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letter
telephone calls
personal visits
collection agencies
legal action