1 The Balance-Sheet Model of the Firm How much short-term cash flow does a company need to pay its bills? The Net Working Capital Investment Decision Net Working Capital Current Assets Fixed Assets 1 Tangible 2 Intangibl Sharehold ers’ Equity Current Liabiliti es Long-Term Debt
32
Embed
1 The Balance-Sheet Model of the Firm How much short- term cash flow does a company need to pay its bills? The Net Working Capital Investment Decision.
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
1
The Balance-Sheet Model of the Firm
How much short-term cash flow does a company need to pay its bills?
The Net Working Capital Investment Decision
Net Working Capital
Current Assets
Fixed Assets
1 Tangible
2 IntangibleShareholders’
Equity
Current Liabilities
Long-Term Debt
2
Current Assets and current liabilities
Current Assets are cash and other assets that are expected to be converted to cash with the year.
Current Liabilities are obligations that are expected to require cash payment within the year.
Accounts payable Accrued wagesTaxes
3
Working CapitalWorking Capital
Net Working Capital - Current assets minus current liabilities. Often called working capital.
Cash Cycle - Period between firm’s payment for materials and collection on its sales.
Carrying Costs - Costs of maintaining current assets, including opportunity cost of capital.Shortage Costs - Costs incurred from shortages in current assets.
4
Working capital tension
5
Working Capital
Simple Cycle of operations
Finished goodsinventory
Receivables
Cash
Raw materialsinventory
6
The Operating Cycle and the Cash Cycle
TimeAccounts payable period
Cash cycle
Operating cycle
Cash received
Accounts receivable periodInventory period
Finished goods sold
Firm receives invoice Cash paid for materials
Order Placed
Stock Arrives
Raw material purchased
7
Operation cycle
raw material turnover period- trade credit given period+ production period+ finished goods turnover period+ trade credit taken period
8
Operating cycle
Raw material turnover period = Average raw material stockPurchase of raw material per day
Trade credit given period = Creditors
Purchase of raw material per day Production period = Work in progress
Cost of goods sold per day Finished goods turnover period = Finished goods stock
Cost of goods sold per day Trade credit taken period = Debtors
Sales per day
9
Operating cycle
Supermarket Manufacturer
(1) Raw material turnover 1 7
(2) Trade credit taken (6) (6)
(3) Production period 0 3
(4) Finished goods turnover 0 4
(5) Trade credit given 0 6
(5) 14
10
The Operating Cycle and the Cash Cycle
In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables and days in payables.
Cash cycle = Operating cycle –Accounts payable period
11
Short Term Financial Policy
Determining the amount of current assetsFinancing of current assets
How?
Trade-off between carrying costs and shortage costs
12
The Amount of the Investment in Current Assets
A flexible policy short-term finance policy would maintain a high ratio of current assets to sales.
Keeping large cash balances and investments in marketable securities.Large investments in inventory.Liberal credit terms.
A restrictive short-term finance policy would maintain a low ratio of current assets to sales.
Keeping low cash balances, no investment in marketable securities.Making small investments in inventory.Allowing no credit sales (thus no accounts receivable).
13
Carrying Costs and Shortage Costs
Total costs of holding current assets.
$
Investment in Current Assets ($)
Shortage costs
Carrying costs
CA*
Minimum point
14
Alternative Financing Policies for Current Assets
A flexible short-term finance policy means low proportion of short-term debt relative to long-term financing.A restrictive short-term finance policy means high proportion of short-term debt relative to long-term financing.
15
Matching for Current Assets
In an ideal world, short-term assets are always financed with short-term debt and long-term assets are always financed with long-term debt.In this world, net working capital is always zero.
16
Capital RequirementCapital Requirement
Lines A, B, and C show alternative amounts of long-term finance.
Dollars A
B
C
Year 2Year 1 Time
Cumulativecapital requirement
Strategy A: A permanent cash surplus
Strategy B: Short-term lender for part of year and borrower for remainderStrategy C: A permanent short-term borrower
17
Flexible and Restrictive Flexible and Restrictive PolicyPolicy
Carriage cost Vs Shortage costCarriage cost Vs Shortage cost
18
Inventory management
19
Inventory ModelF = The fixed ordering costT = The total amount of inventories neededK = The carrying cost
Time
C
If we start with $C, spend at a constant rate each period and replace our inventories with $C when we run out of stock, our average inventories balance will be .
2
C2
C
1 2 3
The carrying cost of holding is
2
CK
C
2
20
The Inventory ModelF = The fixed cost of ordering costT = The total amount of inventories neededK = The carrying cost.
Time
C
As we buy $C each period we incur a trading cost of F each period. If we need T in total over the planning period we will pay $F, T ÷ C times.
2
C
1 2 3
The total carrying cost is
FC
T
21
Costs of Holding Cash & Inventories
Holding Costs
Ordering costs
Total cost of holding inventories
C*
Costs in dollars of holding inventories
Size of order
Ordering costs decrease when the firm increases the ordering size
22
Inventories & Cash Balances
Value of re-order quantity = Q =
2 x annual demand x cost per order carrying cost
2 x 1260 x 20 .08
Weeks0
25
12.5
balance
Inventory
Average
inventory
=
= 25
1 2 3 4 5
23
The cash trade-off
24
Cash doesn’t earn a profit, so why hold it?
1. Transactions: Must have some cash to operate.
2. Precaution: “Safety stock.” But lessened by line of credit, marketable securities.
3. Compensating balances: For loans and/or services provided.
4. Speculation: To take advantage of bargains, to take discounts, etc. Reduced by credit lines, securities.
25
Terms of SaleTerms of Sale
Terms of Sale - Credit, discount, and payment terms offered on a
sale.
Example - 5/10 net 30
5 - percent discount for early payment10 - number of days that the discount is available
net 30 - number of days before payment is due
26
Estimation of the Cost of Estimation of the Cost of Short Term CreditShort Term Credit
Interest = principal x rate x time
Annual % rate = interest x 1 principal time
NOTE: Estimation only, not accurate
27
Terms of SaleTerms of Sale
A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier.
( )Effective annual rate
1 + - 1discountdiscounted price
365 / extra days credit=
We can calculate the implicit cost of this loan
28
The Interest Rate Implicit in 3/10 net 30A firm offering credit terms of 3/10 net 30 is
essentially offering their customers a 20-day loan.
To see this, consider a firm that makes a $1,000 sale on day 0
Some customers will pay on day 10 and take the discount.
Other customers will pay on day 30 and forgo the discount.
0 10 30
$970
0 10 30
$1,000
29
0 10 30
+$970 -$1,000
A customer that forgoes the 3% discount to pay on day 30 is borrowing $970 for 20 days and paying $30 interest:
36520)1(
000,1$970$
r
970$
000,1$)1( 36520 r
%35.747435.01970$
000,1$ 20
365
r
The Interest Rate Implicit in 3/10 net 30
30
Average Collection PeriodMeasures the average amount of time required to collect an account receivable.
salesdaily Average
receivable Accounts period collection Average
• For example, a firm with average daily sales of $20,000 and an investment in accounts receivable of $150,000 has an average collection period of
days 5.7day000,20$
000,150$
31
FactoringThe sale of a firm’s accounts receivable to a financial institution (known as a factor).The firm and the factor agree on the basic credit terms for each customer.
Firm
Factor
Customer
Customers send payment to the factor
The factor pays an agreed-upon percentage of the
accounts receivable to the firm. The factor bears the
risk of nonpaying customers
Goods
32
How to Decide the Working How to Decide the Working Capital PolicyCapital Policy