It is concerned with decisions relating to current assets and current liabilities
It is concerned with decisions relating to current
assets and current liabilities
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Best Buy Co, NA’s largest consumer electronics
retailer, has performed extremely well over the
past decade. Its stock sold for $50 in late 2007 up
from $2 ten years earlier. Its excellent performance
stemmed from sound financial and operating
practices, especially in working capital
management.
WCM involves finding optimal levels for cash
marketable securities, accounts receivable and
inventory and then financing that working capital
for the least cost. Most of best buy’s customers use
credit cards, so neither in-store cash nor accounts
receivable is significant. Therefore Best buy’s
working capital focuses on inventories.
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To maintain sales, its stores must be well stocked
with the goods customers are seeking at the time
they are shopping. This involves determining what
new products are hot, determining where they can
be obtained at the lowest cost and delivering them
to stores in a timely manner.
Dramatic improvements in communications and
computer technology have transformed the way
Best Buy manages its inventories. It now collects
real-time data from each store on how each
products is selling and its computers place orders
automatically to keep the shelves full. Moreover, if
sales of an item are slipping, prices are lowered to
recue stocks of that item before the situation gets
so bad that drastic price cuts are necessary.
Working capital needs to be managed to maximize
profits and stock prices.
Inventories
Raw materials and
components
Work-in-progress
Trade debtors
Loans and advances
Bills Receivable
Marketable securities
Cash and bank balances
Sundry creditors
Bills payable
Outstanding expenses
Trade advances
Borrowings
Provisions
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Gross working capital is the total of all current
assets
Net working capital = current assets - current
liabilities
The working capital cycle can often be expressed
as a period of time (60 days)
Current ratio and Quick ratio
Cash budget is an estimate of future cash inflows
and outflows
Characteristics of current assets
Short life span
Swift transformation into other asset forms
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ROE = Profit margin x assets turnover x leverage
factor
The top line has the steepest slope which indicates
that the firm holds a great deal of cash,
marketable securities, receivables and inventories
relative to its sales. When receivables are high, the
firm has a liberal credit policy, which results in a
high level of accounts receivable. It results in a low
turnover, which in turn lowers ROE.
If the firm has a lean and mean investment policy,
holdings of current assets are minimized. This
results in a high ROE. Risks – material shortages can
lead to work stoppages, unhappy customers etc.
A moderate investment policy lies between the two
Relaxed current asset investment policy – under
conditions of uncertainty, there is requirement for
safety stock and tight credit policy to customers,
hence large current assets are carried
Restricted current asset investment policy – under
conditions of certainty, when sales, costs, lead
times, payment periods are all known for sure,
current assets are turned over more frequently
Moderate current asset investment policy
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Operating cycle is the time that elapses between
the purchase of raw materials and the collection of
cash for sales. It is divided into 4 stages: raw
materials, WIP, finished goods inventory and
debtors collection
= Inventory conversion period + accounts receivable
period
Cash conversion cycle is the time length between
the payment for raw material purchases and the
collection of cash for sales
Inventory conversion period + accounts receivable
period – accounts payable period
Jan: credit purchase of Raw Materials –
creates accounts payable
Feb: labor used in production – wages not paid
immediately – accrued wages
Mar: finished computers sold on credit –
creates accounts receivable
Apr: payment of accounts payable through
bank loan
May: collection of accounts receivable and
repayment of bank loan
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Inventory conversion period is time required to convert materials into finished goods and to sell those goods = average inventory/cost of goods sold per day
Accounts receivables period is time required to convert receivables into cash = average AR/sales per day
Accounts payable period is time between purchase of materials and payment of cash for them = average AP/cost of goods per day
Cash conversion cycle = inventory conversion period + Average receivables (collection) period – Accounts payable (deferral) period
General nature of business
Seasonality of operations
Production cycle
Business cycle
Credit policy
Growth and expansion
Production policy
Market conditions
Conditions of supply
Appropriation of profits
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Reported as cash and cash equivalents in the balance
sheet
Marketable securities - Very liquid securities that can
be converted into cash quickly at a reasonable price.
They tend to have maturities of less than one year.
Furthermore, the rate at which these securities can be
bought or sold has little effect on their prices.
Examples of marketable securities include commercial
paper, banker's acceptances, bank certificates,
Treasury bills and other money market instruments.
Case of Microsoft – one time dividend, stock repurchase
program, retiring debt, acquiring firms, financing major
expansions etc.
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Short term securities that can be bought and sold at short notice
Securities are held mostly for precautionary purposes but earn returns
Invest in securities when interest rates are high otherwise it is expensive and time consuming to convert them into cash Firm which have high growth rate Firms with volatile cash flow Small new firms which do not have exceptional credit
ratings
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Hold marketable securities rather than
demand deposits to provide liquidity
Borrow on short notice by establishing lines of
credit
Forecast payments and receipts better
Speed up receipts Lockboxes
Wire transfer
Use credit cards, debit cards and direct
deposits
Synchronize cash flows by using billing cycles
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Cash discounts on cash payment to suppliers
Maintain and improve its credit rating
Take advantage of favorable business opportunities
Meet emergencies
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An estimate of receipts, disbursements and cash
balances for a firm over a specified future period
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Goals of inventory management
To ensure that inventories needed to sustain operations are available
To hold the costs of ordering and carrying inventories to the lowest possible level
Types of costs Ordering & Receiving costs (cost of placing orders,
shipping and handling costs)
Carrying costs (warehouse rent, interest on capital locked up, insurance, property taxes, spoilage, depreciation and obsolescence, pilferage)
Shortage or stockout costs (loss of sales, customer, goodwill, disruption of production schedules)
Inventories are supplies, raw materials, work-in-progress and finished goods
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What should be the size of the order?
When should the order be placed?
Assumptions:
The forecast demand for a period is known
Orders can be replenished quickly
The only costs are ordering and carrying
The cost per order does not change with size
Cost of carrying is a percentage of inventory value
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Inventory is divided into 3 groups:
‘A’ group consists of items with the largest dollar
investment. This group consists of 20 percent of
the firm’s inventory items but 80 percent of the
investment in inventory
‘B’ group consists of items that account for the
next largest investment in inventory.
The ‘C’ group consist of a large number of items
that require a relatively small investment.
Typically ‘A’ group items are tracked on a
perpetual inventory system that allows daily
verification of each item’s inventory level.
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It implies that a firm should maintain a minimal level of inventory and rely on suppliers to provide parts and components just in time to meet its assembly requirements
It requires a strong and dependable relationship with suppliers who are
geographically not very remote from the mfg facility
a reliable transportation system
an easy physical access in the form of enough doors and conveniently located docks and storage areas to dovetail incoming supplies to the needs of assembly line
impeccable quality maintenance of component parts by the supplier
Lowers the ordering cost and also the safety stock by forging stronger long term relationship with the suppliers, average inventory level is lower
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Steady production vs seasonal production – average inventory higher for all round the year production than if production varies with change in sales
Outsourcing
Components purchased rather than made – in combination with JIT - lower inventory levels
Supply Chain Management
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A sole trader having $800 capital buys stock for $800. The next day he sells the stock on a 10 day credit for $1000 and takes an overdraft of $800 for stock purchase.
Accounts receivable is determined by Volume of credit sales Average time between sales and collection
Increase in receivables must be financed in some way
Entire amount of receivables need not be financed because of the profit component which does not involve any cash flow
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Credit period: 2 / 10, net 30; lengthening the credit period pushes sales up, lengthens cash conversion cycle, requires larger investment in debtors, leads to higher incidence of bad debts loss
Cash discount and trade discount Should attract new customers
Will increase cash flow
Credit standards: 5 C’s of credit are character, capacity, capital, collateral and conditions on which information is received from financial statements, bank references, firm experiences and stock market data
Collection policy: procedure that the firm follows to collect accounts receivable
Profit potential in granting credit through carrying charges levied on credit sales (nominal and effective interest rates) makes credit sales more profitable than cash sales
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Boston Lumber Company, wholesale distributor of
lumber products has credit sales of $1000 per day
and a collection period of 10 days. It must have
capital to carry $10,000 worth of receivables.
Accounts Receivables = sales/day x length of
collection period
What will be the impact if sales double or collection
period increases?
DSO = Receivables / Average sales per day
Receivables is $375 and Annual Sales turnover is
$3000 , Days Sales Outstanding = 46 days
The DSO can be compared to industry average (36
days) or to the firm’s own credit terms (30 days) 27
Accrued liabilities – outstanding rent Accounts payable or trade credit from suppliers Bank Finance Cash credits / overdrafts Loans Bill discounting: the seller draws a bill on the
purchaser, on acceptance it is discounted with the bank, who collects the full amount from the buyer on the due date
Letter of credit: an indirect form of financing whereby a bank undertakes the responsibility to honor the obligation of its customer, this helps the customer to obtain credit from its suppliers
Commercial paper Factoring
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Fixed or floating interest rate
Interest only vs amortized loans
Collateral Security in the form of hypothecation or
pledge
Maturity period – may or may not have maturity period
Restrictive covenants
Loan guarantees by stockholders
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A formal line of credit where the customer pays a
commitment fee and is then allowed to use the funds
when they are needed. It is usually used for operating
purposes, fluctuating each month depending on
customer's current cash flow needs.
FI considers several factors that determine a borrower's
ability to repay to decide on the maximum amount of
credit (credit limit)
Revolving credit borrowers are only required to pay
interest on the amount borrowed, plus commitment fees
on amount not borrowed
Interest is pegged to T-bill or market rate
Generally contains a clean-up clause for banks to extend
this type of credit in future
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It is unsecured short term promissory notes of large firms with high credit rating having an interest rate below the prime rate (a published interest rate charged by commercial banks to large, strong borrowers) Maturity period ranges from 90 to 180 days
Generally sold at a discount from its face value and redeemed at its face value, difference constitutes interest.
No well developed secondary market
The minimum size of commercial paper issue is Rs.2.5 and in denominations of half a million or more
Commercial paper is not backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.
The proceeds from this type of financing can only be used on current assets (inventories) and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement.
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A factor is a financial institution which offers services relating to management and financing of debts arising from credit sales, which ensures a definite pattern of cash inflows from credit sales of an organization and eliminates the need for credit and collection department
RBI authorized public sector banks that do factoring: SBI, Canbank, PNB, Bank of Allahabad
selects the accounts of the client and establishes the credit limits
factor assumes responsibility for collecting the debt
Advances money against not yet collected / not yet due accounts
Factoring is on a recourse basis
Besides interest on advances against debt the factor charges a commission which maybe 1 – 2% of the face value of the debt factored
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