Taylor's University Dual Degree Program Introduction to Finance - Lecture Slides PDF

Taylor’s University Dual Degree Program Introduction to Finance Topic 7...

Taylor’s University Dual Degree Program Introduction to Finance Topic 7 Introduction to Working Capital Management 0 Acknowledgement Ross et al, 2008, Essentials of Corporate Finance, 6th Ed, McGraw-Hill Companies, Inc..  1-115-1 Learning objectives At the end of the lesson, students should be able to: describe basic working capital management discuss the determinants of a firm’s investment in accounts receivable and how changes in credit policy are determined. discuss the reasons for carrying inventory and how inventory management decisions are made.  1-215-2 Topic and structure of the lesson Cash conversion cycle Cash management Inventory management Receivable’s management  1-315-3 Key terms you must be able to use Cash conversion cycle Inventory conversion Cash budget Credit policy Days sales outstanding  1-415-4 Introduction Introduction working capital management What is working capital  1-515-5 Figure 2.1  1-615-6 Three types of questions fall under short-term financing What is a reasonable level of cash to keep o hand to pay bills? How much should the firm borrow in the short term? How much credit should be extended to customers? 6 Figure 30.2 simple cycle of 15-7 1-7 operations Figure 30.3 cash conversion15-8 1-8 cycle  cash conversion cycle, u.s. 1-915-9 manufacturing, 2011 ($ billions) 30-1 working capital and the 1-10 15-10 cash conversion cycle  15-11 1-11 Quick Quiz - 1 Suppose your average inventory is $10,000, your average receivables balance is $9,000, and your average payables balance is $4,000. Net sales are $100,000 and cost of goods sold is $50,000. What are the operating cycle and cash conversion cycle? 16-11  15-12 1-12 Quick Quiz 1 – Problem Solution Inventory turnover = 50,000 / 10,000 = 5 x Inventory period = 365 / 5 = 73 days Receivables turnover = 100,000 / 9,000 = 11.11x Average collection period = 365 / 11.11 = 33 days Payables turnover = 50,000 / 4,000 = 12.5 x Payables period = 365 / 12.5 = 29 days Operating Cycle = 73 + 33 = 106 days Cash Cycle = 106 days – 29 days = 77 days 16-12  15-13 1-13 Alternative Formulae Inventory period = Average Inv/ Daily COGS = Average Inv/(COGS/365) = 365/(COGS/Average Inv) = 365 / Inventory turnover Av collection period = 365 / Receivables turnover Payables period = 365 / Payables turnover 16-13  15-14 1-14 Working capital terminology Net working capital – current assets minus current liabilities. Working capital policy – deciding the level of each type of current asset to hold, and how to finance current liabilities. Working capital management – controlling cash, inventories, and account receivables, plus short-term liability management.  15-15 1-15 Cash Cash Does Not Pay Interest – Move money from cash accounts to short-term securities – Concentration banking – Lock-box system Financial manager wants to hold cash balances up to the point where the marginal value of the liquidity is equal to the value of the interest foregone Trade off the cost of keeping an inventory of cash (the lost interest) against the benefits (the saving on transaction costs)  15-16 1-16 Cash doesn’t earn a profit, so why hold it? 1. Transactions – must have some cash to operate. 2. Precaution – “safety stock”. Reduced by line of credit and marketable securities. 3. Compensating balances – for loans and/or services provided. 4. Speculation – to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities.  15-17 1-17 What is the goal of cash management? To meet above objectives, especially to have cash for transactions, yet not have any excess cash. To minimize transactions balances in particular, and also needs for cash to meet other objectives.  15-18 1-18 Ways to minimize cash holdings Use a lockbox. Insist on wire transfers from customers. Synchronize inflows and outflows. Increase forecast accuracy to reduce need for “safety stock” of cash. Hold marketable securities (also reduces need for “safety stock”). Negotiate a line of credit (also reduces need for “safety stock”). What is “float”, and how is 15-19 1-19 it affected by the firm’s cash manager? Float is the difference between cash as shown on the firm’s books and on its bank’s books. If SKI collects checks in 2 days but those to whom SKI writes checks don’t process them for 6 days, then SKI will have 4 days of net float. If a firm with 4 days of net float writes and receives $1 million of checks per day, it would be able to operate with $4 million less capital than if it had zero net float.  15-20 1-20 Cash budget:The primary cash management tool Purpose: Forecasts cash inflows, outflows, and ending cash balances. Used to plan loans needed or funds available to invest. Timing: Daily, weekly, or monthly, depending upon purpose of forecast. Monthly for annual planning, daily for actual cash management.  15-21 1-21 SKI’s cash budget: For January and February Net Cash Inflows Jan Feb Collections (sales) $67,651.95 $62,755.40 Purchases 44,603.75 36,472.65 Wages 6,690.56 5,470.90 Rent 2,500.00 2,500.00 Total payments $53,794.31 $44,443.55 Net Cash Flow $13,857.64 $18,311.85  15-22 1-22 SKI’s cash budget Net Cash Inflows Jan Feb Add:Beginning Bal. $ 3,000.00 $16,857.64 Net CF 13,857.64 18,311.85 16,857.64 35,169.49 Less: Min. require 1,500.00 1,500.00 Surplus/(Financing) $15,357.64 $33,669.49  15-23 1-23 Should depreciation be explicitly included in the cash budget? No. Depreciation is a noncash charge. Only cash payments and receipts appear on cash budget. However, depreciation does affect taxes, which appear in the cash budget.  15-24 1-24 What are some other potential cash inflows besides collections? Proceeds from the sale of fixed assets. Proceeds from stock and bond sales. Interest earned. Court settlements.  15-25 1-25 How could bad debts be worked into the cash budget? Collections would be reduced by the amount of the bad debt losses. For example, if the firm had 3% bad debt losses, collections would total only 97% of sales. Lower collections would lead to higher borrowing requirements.  15-26 1-26 Analyze SKI’s forecasted cash budget Cash holdings will exceed the target balance for each month Cash budget indicates the company is holding too much cash. SKI could improve its EVA by either investing cash in more productive assets, or by returning cash to its shareholders. EVA – Economic value added  Why might SKI want to 15-27 1-27 maintain a relatively high amount of cash? If sales turn out to be considerably less than expected, SKI could face a cash shortfall. A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative. The cash may be used, in part, to fund future investments.  15-28 1-28 Inventory Management Components of inventories: Raw materials inventory - basic materials to be used in the firm’s production operations. Work-in-process inventory - partially finished goods requiring additional work before becoming finished goods. Finished-goods inventory - completed products that are not 28 yet sold.  15-29 1-29 Types of inventory costs Carrying costs – storage and handling costs, insurance, property taxes, depreciation, and obsolescence. Ordering costs – cost of placing orders, shipping, and handling costs. Costs of running short – loss of sales or customer goodwill, and the disruption of production schedules. Reducing the average amount of inventory generally reduces carrying costs, increases ordering costs, and may increase the costs of running short.  Determining optimal 15-30 1-30 order size (EOQ Model)  15-31 1-31 INVENTORY MODEL The economic order quantity( EOQ) model is the order size that minimizes total inventory costs. The intersection point = minimal total cost which is the EOQ The main assumptions of EOQ are: – Sales can be forecasted perfectly – Sales are evenly distributed throughout the year – Orders are received with no unexpected delays 31  15-32 1-32 Inventories Economic Order Quantity (EOQ) – Order size that minimizes total inventory costs 2  annual sales  cost per order Economic order quantity = carrying cost Economic Order Quantity (EOQ) = inventory order size in units Annual Sales = total demand in units over planning period Cost per order = ordering cost per order Carrying cost = cost of carrying 1 unit in inventory  15-33 1-33 Inventories (Example) 2  annual sales  cost per order Economic order quantity = carrying cost Annual sales/total demand in units over planning = 100,000 units Ordering cost per order = $250 Cost of carrying 1 unit in inventory = $2.25 Purchase of inventory must be in multiple of 100 units  15-34 1-34 EOQ Example 2x100,000x250 EOQ*= 2.25 = 4,714 units ≈ 4,800 units  15-35 1-35 Elements of credit policy 1. Credit Period – How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. 2. Cash Discounts – Lowers price. Attracts new customers and reduces DSO. 3. Credit Standards – Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO. 4. Collection Policy – How tough? Tougher policy will reduce DSO but may damage customer relationships. DSO – Day sales outstanding  15-36 1-36 Does a firm face any risk if it tightens its credit policy? Yes, a tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.  15-37 1-37 If SKI succeeds in reducing DSO without adversely affecting sales, what effect would this have on its cash position? Short run: If customers pay sooner, this increases cash holdings. Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders  15-38 1-38 Reading Ross Chapter 14 and 15 38