Asset & Liabilities Management Chapter 4

7/29/2019 Asset & Liabilities Management Chapter 4

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4

C

hapte The Management of

Working Capital

Slides Developed by:

Terry Fegarty

Seneca College


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2006 by Nelson, a division of Thomson Canada Limited

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Chapter 4 Outline (1)

Working Capital Basics Working Capital and the Current Accounts

Working Capital and Funding Requirements

Objective of Working Capital Management

Working Capital Trade-offs

OperationsThe Cash Conversion Cycle

The Operating Cycle and the Cash Conversion Cycle


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3


Permanent and Temporary Working Capital Maturity Matching Principle

Financing Net working Capital

Short-Term vs. Long-Term Financing

Working Capital Policy


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4


Cash Management Objectives of Cash Management

Marketable Securities

Yield on a Discounted Money Market Security

Components of Float

Cheque Disbursement and the Cheque Clearingprocess

Accelerating Cash Receipts Electronic Funds Transfer

Managing Cash Outflow

Evaluating Cash Management Services


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Managing Accounts Receivable Tradeoffs in Managing Accounts Receivable

Credit Policy

Terms of Sale

Collections policy


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Inventory Management Benefits and Costs of Carrying Adequate Inventory

Inventory Ordering Costs

Inventory Control and Management

Economic Order Quantity Model

Safety Stocks, Reorder Points and Lead Times

Inventory on Hand Including Safety Stock

Tracking InventoriesThe ABC System Just In Time (JIT) Inventory System


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7

Working Capital Basics

Working Capital Assets/liabilities required to operate

business on day-to-day basis Cash

Accounts Receivable

Inventory

Accounts Payable

Accruals

Short-term in natureturn over regularly


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Working Capital and the CurrentAccounts

Gross working capital = Current assets

Gross Working Capital (GWC) represents

investment in current assets

(Net) working capital =

Current assets Current liabilities


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Working Capital and FundingRequirements

Working Capital Requires Funds

Maintaining working capital balance requires

permanent commitment of funds Example: Firm will always have minimum level of

Inventory, Accounts Receivable, and Cashthisrequires funding


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Spontaneous Financing Firm will also always have minimum level of

Accounts Payablein effect, money you haveborrowed Accounts Payable (and Accruals) are generated

spontaneously Arise automatically with inventory and expenses

Offset the funding required to support current assets


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Net working capital is Gross WorkingCapital Current Liabilities (including

spontaneous financing)

Reflects net amount of funds needed tosupport routine operations


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Objective of Working CapitalManagement

To run firm efficiently with as little moneyas possible tied up in Working Capital

Involves trade-offs between easier operation

and cost of carrying short-term assets Benefit of low working capital

Money otherwise tied up in current assets can beinvested in activities that generate higher payoff

Reduces need for costly financing

Cost of low working capital

Risk of shortages in cash, inventory


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2006 by Nelson, a division of Thomson Canada Limited 13


InventoryHigh Levels Low Levels

Benefit:

Happy customers

Few production delays (always have neededparts on hand)

Cost:

Expensive

High storage costs

Risk of obsolescence

Cost:

Shortages

Dissatisfied customers

Benefit:

Low storage costs

Less risk of obsolescence

CashHigh Levels Low Levels

Benefit: Reduces risk

Cost:

Increases financing costs

Benefit: Reduces financing costs

Cost:

Increases risk


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Accounts ReceivableHigh Levels (favourable credit terms) Low Levels (unfavourable

terms)

Benefit:

Happy customers

High sales

Cost:

Expensive

High collection costs

Increases financing costs

Cost:

Dissatisfied customers

Lower Sales

Benefit:

Less expensive

Accounts Payable and Accruals

High Levels Low LevelsBenefit:

Reduces need for external finance--using aspontaneous financing source

Cost:

Unhappy suppliers

Benefit:

Happy suppliers/employees

Cost:

Not using a spontaneousfinancing source


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Current Assets High Level Low Level

Profitability Lower HigherRisk Lower Higher



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OperationsThe Cash ConversionCycle

Firm begins with cash which thenbecomes inventory and labour

Which then becomes product for sale Eventually this will turn into cash again

Firms operating cycle is time fromacquisition of inventory until cash iscollected from product sales


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Figure 4.1: The Cash ConversionCycle

Product is

converted intocash, which is

transformed intomore product,

creating the cashconversion cycle.

Figure 4 2 me ne ep esen a on


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Figure 4.2: me ne epresen a onof the Cash Conversion

Cycle


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The Operating Cycle and the CashConversion Cycle

Inventory conversion period

plus: Receivable collection period

equals: Operating cycleminus: Payables deferral period

equals: Cash conversion cycle

Shortening cash conversion cycle frees up cashto reinvest in business or to reduce debt andinterest


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InventoryConversion

Period=

365

Inventory Turnover

ReceivablesCollection

Period=

Accounts Receivable 365

Annual Credit Sales

Cash Conversion Cycle Analysis

PayablesDeferralPeriod

=Accounts Payable 365

Cost of Goods Sold


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Cash Conversion Cycle

PurchaseInventory

Pay forInventory

Sell Inventoryon Credit

CollectReceivables

Operating CycleInventory Conversion PeriodReceivables Collection PeriodPayables Deferral PeriodCash Conversion Cycle


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Figure 4.3: Working CapitalNeeds of Different Firms

d


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Permanent and TemporaryWorking Capital

Working capital is permanentto theextent that it supports constant or

minimum level of sales

Temporaryworking capital supports

seasonal peaks in business


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Maturity Matching Principle

Maturity (due date) of financing shouldroughly match duration (life) of asset

being financed Then financing /asset combination becomes

self-liquidating

Cash inflows from asset can be used to pay offloan


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Financing Net Working Capital

According to maturity matching principle Temporary(seasonal) should be financed

with short-term borrowing

Permanentworking capital should befinanced with long-term sources, such aslong-term debt and/or equity

In practice, firms may use more or lessshort-term funds to finance workingcapital


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Figure 4.4(a):Working CapitalFinancing Policies


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Figure 4.4(b):Working CapitalFinancing Policies


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Short-Term vs. Long-TermFinancing

The mix of short- or long-term workingcapital financing is a matter of policy

Use of long-term funds is a conservativepolicy

Use of short-term funds is an aggressivepolicy

Sh t T L T


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Short-term financing

Cheap but risky

Cheapshort-term rates generally lower thanlong-term rates

Riskybecause you are continually entering

marketplace to borrow Borrower will face changing conditions (ex; higher

interest rates and tight money)

Sh t T L T


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Long-term financing Safe but expensive

Safeyou can secure the required capital

Expensivelong-term rates generally higherthan short-term rates


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Working Capital Policy

Firm must set policy on following issues:

How much working capital is used

Extent to which working capital is supportedby short- vs. long-term financing

How each component of working capital is

managed The nature/source of any short-term

financing used


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Cash Management

Cash managementdetermining:

Optimal size of firms liquid asset balance

Appropriate types and amounts ofshort-term investments

Most efficient methods of controlling

collection and disbursement of cash


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Cash Management

Why have cash on hand?

Transactions demand: need money to pay bills(employees, suppliers, utility/phone, etc.)

Precautionary demand: to handle emergencies(unforeseen expenses)

Speculative demand: to take advantage ofunexpected opportunities (purchase of raw materialsthat are on sale)


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Objectives of Cash Management

Cash doesnt earn a return Want to maintain liquidity

Take cash discounts

Maintain firms credit rating

Minimize interest costs

Avoid insolvency

Good cash management implies maintaining

adequate liquidity with minimum cash in bank Can place portion of cash balance into marketable

securities (AKA: near cash or cash equivalents)


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Marketable Securities

Liquid investments that can be heldinstead of cash and earn a modest return

Examples include Treasury bills,commercial paper, bankers acceptances

Many are bought and sold at a discount inmoney market


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Examples of Marketable Securities

Treasury Bills Short-term government notes issued at a

discount with principal repaid at maturity

Commercial Paper Short-term unsecured promissory notes

issued by corporations with good credit

Bankers Acceptances Short-term promissory notes issued by a firm

and accepted (or guaranteed) by a bank

Yi ld Di t d M M k t


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Yield on a Discounted Money MarketSecurity

Annualized yield

100 P 365

P d

where P = Discounted price as apercentage of maturity value

d = Number of days to maturityr = Annualized yield

r =


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Components of Float

Mail Float delay between when cheque is sent to a payee and

is received by payee

Processing Float time between receipt of payment by a payee and the

deposit of the payment in the payees account

Clearing Float time between depositing a cheque and having

available spendable funds

Cheque Disbursement and the


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Cheque Disbursement and theCheque Clearing Process

When you pay a bill, You write cheque and mail to payee (2-3

days ofmail float)

Payee receives cheque and performs internalprocessing (1 day ofprocessing float)

Payee deposits cheque in its own bank (1 dayofprocessing float)

Payees bank sends cheque into interbankclearing system which processes cheque (2days ofclearing float)

Fi 4 5 The Cheq e Clea ing


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Figure 4.5: The Cheque-ClearingProcess


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Accelerating Cash Receipts

Lock-box systems Post office box(es) located near customers in

order to shorten mail and processing float

Local bank empties the box, deposits paymentsinto firms account, and reports payments to firm

May involve significant fees

More cost-effective if small number of largerdeposits

Fi 4 6 A Lock Box System in


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Figure 4.6:A Lock Box System inthe Cheque-Clearing Process


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Accelerating Cash Receipts

Concentration Banking Customers send cheques sent to firms local

collection centres, where they are deposited

Local deposits are transferred electronicallyinto one central concentration account

Reduces mail float

Funds available for paying loans or investingin marketable securities


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Electronic Funds Transfer

Electronic funds transfer mechanismsare reducing the importance of float

management techniques for manycompanies


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Electronic Funds Transfer

Wire Transfers Transferring money electronically

Preauthorized Cheques Customer gives payee signed cheque-like

documents in advance

When payee ships product, it deposits

preauthorized cheque in its bank account Eliminates mail float

Payee must trust payer


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Managing Cash Outflow

Zero balance accounts (ZBAs) Decentralization of cash payments can lead to large

number of cash balances around the country

Divisions write cheques on ZBAsfunded from

central account only when cheques are cleared

Solves problem of idle cash in decentralized bankaccounts

Remote disbursing Using bank in remote location for disbursement

chequing account Increases mail float

Evaluating Cash Management


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Evaluating Cash ManagementServices

Evaluation involves comparison of costsversus benefits of faster collection

Example 4 1: Evaluating Cash


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Example 4.1: Evaluating CashManagement Services

Q: Kelso Systems Inc. has customers in British Columbia that remitabout 500 cheques a year. The average cheque is for $10,000.West coast cheques currently take an average of eight daysfrom the time they are mailed to clear into Kelsos east coastaccount.

A British Columbia bank has offered Kelso a lock box system for$1,000 a year plus $0.20 per cheque. The system can beexpected to reduce the clearing time to six days.

Is the banks proposal a good deal for Kelso if it borrows at 8%?

E

xample

Example 4 1: Evaluating Cash


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Example 4.1: Evaluating CashManagement Services

A: The cheques represent revenue of: 500 $10,000 =$5,000,000 per year.

The average amount tied up in the cheque clearing process is:8/365 x $5,000,000 = $109,589.

The proposed lockbox system will reduce this to: 6/365 x$5,000,000 = $82,192, thus freeing up $27,397 of cash.

Kelso will be able to borrow $27,397 less, thus saving: $27,397x 0.08 = $2,192 in interest

The system is expected to cost: $1,000 + ($0.20 x 500) =$1,100.

The net saving is: $2,192 - $1,100 = $1,092

The banks proposal should be accepted

Exam

ple


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Managing Accounts Receivable

Generally firms like as little money as possibletied up in receivables Reduces costs (firm has to borrow to support the

receivable level)

Minimizes bad debt exposure

But, having good relationships with customersis important

Increases sales

Firm needs to strike a balance on these issues

Trade offs in Receivable

Trade-offs in Managing Accounts


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Trade-offsin ReceivableManagement

Liberal ManagementMore sales and grossmargin, but

More bad debtsHigher collection costs

More discountexpenses

Higher receivablesLonger collections

More interest expense

Strict Management

Less sales and grossmargin, but

Less bad debtsLower collection costs

Less discountexpenses

Lower receivablesShorter collections

Less interest expense

Trade offs in Managing AccountsReceivable


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Managing Accounts Receivable

Policy Decisions Influencing AccountsReceivable

Credit Policy Criteria used to screen credit applications

Controls quality of accounts to which credit is extended

Terms of Sale

Terms and conditions under which credit extended must berepaid

Collections Policy Methods employed to collect payment on past due accounts


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Credit Policy

Must examine creditworthiness of potentialcredit customers Credit report

Customers financial statements

Bank references Customers reputation among other vendors

Conflicts often arise between sales and credit

departments Sales departments job to generate sales

Credit department may refuse credit to high riskaccounts


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Terms of Sale

Credit sales are made according tospecified terms of sale Example: 2/10, net 30 means customer

receives 2% discount if payment is madewithin 10 days, otherwise entire amount isdue by 30 days

Customers pay quickly to save money Firms terms of sale generally follow

industry practice


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Collections Policy

Firms collection policymanner and aggressivenesswith which firm pursues payment from delinquentcustomers Being overly aggressive can damage customer relations

Function ofcollections department to follow up onoverdue receivables (called dunning) Mail polite letter

Follow up with additional dunning letters

Phone calls

Collection agency

Lawsuit


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Inventory Management

Inventory management establishes a balancebetween carrying enough inventory to meetsales or production requirements whileminimizing inventory costs

Inventory usually managed by manufacturingor operations

However, finance department has an oversightresponsibility

Monitor level of lost or obsolete inventory

Supervise periodic physical inventories

Benefits and Costs of Carrying


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Benefits and Costs of CarryingAdequate Inventory

Benefits Reduces stockouts and backorders

Makes operations run more smoothly, improves customerrelations and increases sales

Carrying Costs Interest on funds used to acquire inventory

Storage and security

Insurance

Taxes

Shrinkage Spoilage

Breakage

Obsolescence


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Inventory Ordering Costs

Inventory ordering costs Expenses of placing orders with suppliers,

receiving shipments, and processingmaterials into inventory

Excludes vendor charges

Relate to the number of orders placed

rather than to the amount of inventory held

Tend to vary inversely with carrying costs

Economic Order Quantity (EOQ)


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Economic Order Quantity (EOQ)Model

EOQ model recognizes trade-offs betweencarrying costs and ordering costs

Carrying costs increase with amount of inventory

held ( from larger orders)

Ordering costs increase with the number of ordersplaced (from more orders)

EOQ minimizes total of sum of ordering andcarrying costs

C d h OQ


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Inventory Costs and the EOQ

Q (Order Size)

Cost($)

TotalCost

EOQ

CarryingCost

Ordering

Cost



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EOQ model is:

whereQ= order size in units

D= annual quantity used in units

F= cost of placing one orderC= annual cost of carrying one unit in stock

denotes square root

c2F DQ

Figure 4 7: Inventory on Hand for a


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Figure 4.7:Inventory on Hand for aSteadily Used Item



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Other Inventory Formulas

Average Inventory =

Total Carrying Cost: =

Number of Orders =

Total Ordering Cost = FN =

Total Ordering and Carrying Cost =

2

Q

Qc

2

DN=

Q

D

FQ

Q DTC = c +F

2 Q

Example 4 3: Economic Order


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Example 4.3:Economic OrderQuantity

Exam

ple

Q: The Galbraith Corp. buys a part that costs $5. The carryingcost of inventory is approximately 20% of the parts dollar value

per year. It costs $50 to place, process and receive an order.The firm uses 900 of the $5 parts per year.

What ordering quantity minimizes inventory costs?How many orders will be placed each year if that order quantityis used?What inventory costs are incurred for the part with this orderingquantity?

Example 4.3: Economic Order


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p

Quantity

Example

A: Annual carrying cost per unit is 20% x $5 =$1

EOQ = 300 unitsThe annual number of reorders is 900 300 = 3Ordering costs are $50 x 3 = $150 per yearAverage inventory is 300 2 = 150 units

Carrying costs are 150 x $1 =$150 a yearTotal inventory cost of the part is $300

1

900502Q

Safety Stocks, Reorder Points and


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Safety Stocks, Reorder Points andLead Times

Safety stock provides insurance againstunexpectedly rapid use or delayeddelivery

Additional supply of inventory that is carriedat all times to be used when normal workingstocks run out

Rarely advisable to carry so much safety

stock that stockouts never happen Carrying costs would be excessive

Safety Stocks, Reorder Points and


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a y o , o d o a dLead Times

Ordering lead timeadvance noticeneeded so that an order placed will arrivewhen required Usually estimated by items supplier

Reorder pointlevel of inventory at

which order is placed

Figure 4.9: Inventory on Hand


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Figure 4.9: Inventory on HandIncluding Safety Stock



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Q y ( Q)Model

Other Inventory Formulas (with SafetyStock)

Average Inventory =

Total Carrying Cost: =

Total Ordering and Carrying Cost =

StockSafety2

Q

Qc Safety Stock

2

Q DTC = c SafetyStock + F

2 Q

Tracking InventoriesThe ABC


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gSystem Some inventory items (A items) require great

deal of attention Very expensive Critical to firms processes or to those of customers

Some inventory items do not require great dealof attention (C items) Commonplace, easy to obtain

B items fall between items A & C

ABC system segregates items by value andplaces tighter control on higher cost (value)pieces

Just In Time (JIT) Inventory


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( ) ySystem

Inventory supplied At exactly the right time In exactly the right quantities

Theoretically eliminates the need for factory inventory

Shortens operating cycle Reduces costs

Eliminate wasteful procedures

But:late delivery can stop factorys entire production line

Works best with large manufacturers who are powerfulwith respect to supplier Supplier is willing to do almost anything to keep the

manufacturers business

Asset & Liabilities Management Chapter 4

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