Working Capital and Cash Flow Management PDF

WORKING CAPITAL AND CASH FLOW MANAGEMENT Chapter 3.1  Financial Management Decisions 1.1  Capital budgeting  What long-term investments or projects should the business take on?  Capital structure  How should we pay for our assets?...

WORKING CAPITAL AND CASH FLOW MANAGEMENT Chapter 3.1  Financial Management Decisions 1.1  Capital budgeting  What long-term investments or projects should the business take on?  Capital structure  How should we pay for our assets?  Should we use debt or equity?  Working capital management  How do we manage the day-to-day finances of the firm?  WORKING CAPITAL 1.2 v is a portion of the firm’s capital continuously converted into cash fund, from inventories, to accounts receivables to cash.  Current assets used in operations.  Working capital typically means the firm’s holding of current or shor t-ter m assets suc h as cash, receivables, inventory and marketable securities.  These items are also referred to as circulating capital  Working capital management 1.3  controlling cash,  inventories,  and Accounts Receivable,  plus short-term liability management.  Importance of working capital: 1.4 1. For inventory replenishment 2. A provision for operating expenses for the day-to- day transactions. 3. A back up for credit sales 4. A provision for safety margin for unexpected expenses.  Inventory Cash sold received Inventory purchased Inventory Accounts receivable period period Time Accounts payable period Cash paid for inventory Operating cycle Cash cycle The operating cycle is the time period from inventory purchase until the receipt of cash. (Sometimes the operating cycle does not include the time from placement of the order until the arrival of stock.) The cash cycle is the time period from cash is paid out to cash is received. It must be financed from internal or external sources. (1) Finding the Inventory period Ave. Inventory Inventory period = --------------------------- Sales*/365 + * For trading companies, otherwise use COGS. (2) Finding the Accts. Receivables period Ave. Receivables Receivables period = ------------------------------- Sales/365 The Cash Cycle (3) Finding the payables turnover Ave. Payables Payables period = --------------------------- COGS/365 Cash cycle = Operating cycle - Payables period EXAMPLE Example: Amazing Boutique COGS per day = Php1,500.00/day Inventory conversion period = 72 days Receivables conversion period = 24 days Payables deferral period = 30 days 1. What is cash conversion cycle? 2. How much financing do they need? Amazing Boutique (Illustration) OPERATING CYCLE 72 + 24 = 96 days Inventory Receivables Conversion Collection Period (72 days) Period (24 days) Payables Deferral CASH CYCLE Period (30 days) ? DAYS Amazing Boutique (Illustration) OPERATING CYCLE 72 + 24 = 96 days Inventory Receivables Conversion Collection Period (72 days) Period (24 days) Payables Deferral CASH CYCLE Period (30 days) 96 - 30 = 66 days DAYS Amazing PC (Illustration) OPERATING CYCLE 72 + 24 = 96 days Inventory Receivables Conversion Collection Period (72 days) Period (24 days) Payables Deferral CASH CYCLE Period (30 days) 96 - 30 = 66 days 66 days x 1,500 per day = P99,000 1.*  Inventory Conversion period + Receivables Collection period - Payables Deferral Period= Cash Conversion Cycle  To look another way….  Cash inflow delay - Payment delay = Net delay  (72 + 24 days) - 30 days= 66 days  Cash Cycle x COGS= Financing Needs  66 days x 1500 = 99,000  NOTES: 1.13  Given the data, Amazing Boutique knows when it starts producing the dresses that it will have to finance the manufacturing cost for the 66 days period.  The goal should be to shorten its CCC as much as possible without hurting operations.  This would improve profits, because the longer the CCC, the greater the need for external financing, and that financing has a cost.  How can CCC be shortened? 1.14 1. By reducing the inventory conversion period by processing and selling goods more quickly. 2. By reducing the receivables collection period by speeding up collections. 3. Or by lengthening the payables deferral period by slowing down the firm’s own payment. *To the extent that these actions can be taken without increasing costs or decreasing sales, they should be carried out. SEATWORK: MAX’S CHOCOLATE FACTORY COGS per day = Php1,000.00/day Inventory conversion period = 60 days Receivables conversion period = 25 days Payables deferral period = 30 days What is cash conversion cycle? How much financing do they need?  ANSWERS: 1.16  CCC= 60 + 25 – 30 = 55 days qAmount to be financed = 55 days x Php1000 =Php55,000  Cash Management 1.17 What is the goal of cash management?  Minimize the amount of cash the firm must hold for use in conducting its normal business activities, yet have sufficient cash to: 1. Take trade discounts 2. Maintain its credit rating 3. Meet unexpected cash needs 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.  Data Required for Cash Budget 1. Sales forecast. 2. Information on collections delay. 3. Forecast of purchases and payment terms. 4. Forecast of cash expenses, taxes, etc. 5. Initial cash on hand. 6. Target cash balance. 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. 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. 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.  Managing Accounts Receivables 1.24 What is the goal of accounts receivables management?  Maximize sales, at the same time  Minimize accounts receivables level by  Setting the proper credit policy variables.  Accounts Receivable Management Determine its credit standards. If a company decides Set the credit terms. to offer trade credit, it Develop collection policy. must: Monitor its A/R on both individual and aggregate basis. Credit Apply techniques to determine which standards customers should receive credit. Credit selection Five C’s of Credit scoring techniques Credit 26 © 2010 South-Western, a part of Cengage Learning  Five C’s of Credit Framework for in-depth credit analysis that is typically used for large credit requests: 1. Collateral – land mortgage 2. Character or credit worthiness- image of debtor 3. Capital – equity of shareholders 4. Capacity – ability to pay ( company’s cash flows) 5. Condition - current economic condition 27 © 2010 South-Western, a part of Cengage Learning  Credit Scoring 1.28  A credit score is a numerical expression based on a level analysis of a person's credit files, to represent the creditworthiness of an individual. A credit score is primarily based on a credit report, information typically sourced from credit bureaus. Wikipedia  Credit Scoring Uses statistically-derived weights for key credit characteristics to predict whether a credit applicant will pay the requested credit in a timely fashion.  Used with high volume/small credit requests  Most commonly used by large credit card operations, such as banks and department stores 29 © 2010 South-Western, a part of Cengage Learning  Changing Credit Standards Increase in sales and profits (if positive Credit standards contribution margin), but higher costs relaxed from additional A/R and additional bad debt expense Credit standards Reduced investment in A/R and lower tightened bad debt, but lower sales and profit 30 © 2010 South-Western, a part of Cengage Learning  Credit Terms 31  Terms of sale for customers Net 30: Payment in full due in 30 days Cash discounts Example: 2/10 net 30 2% discount if payment made within 10-day cash discount period Otherwise, full payment due within 30-day credit period © 2010 South-Western, a part of Cengage Learning Collection Policy  Reminders, form letters, telephone calls, or personal visits may initiate customer payment.  At a minimum, the company should generally suspend further sales to the customer until the delinquent account is brought current. © 2010 South-Western, a part of Cengage Learning  Credit Monitoring The ongoing review of a firm’s accounts Credit receivable to determine if customers are monitoring paying according to stated credit terms Techniques 1. Average collection period for credit 2. Aging of accounts receivable monitoring 3. Payment pattern monitoring 33 © 2010 South-Western, a part of Cengage Learning 1.34 1. Average collection period: The average number of days credit sales are outstanding Accounts receivable Average collection period  Average sales per day 2. Aging of accounts receivable: Schedule that indicates the portions of total A/R balance outstanding © 2010 South-Western, a part of Cengage Learning  Credit Monitoring 3. Payment pattern: The normal timing within which a firm’s customers pay their accounts Percentage of monthly sales collected the following month Should be constant over time; if payment pattern changes, the firm should review its credit policies. 35 © 2010 South-Western, a part of Cengage Learning 1.36 END  To be continued next meeting.. 1.37 Topics  Managing Inventory  ABC  EOQ  JIT  Managing Accounts Payable