Chapter 12

(1) Total cost =

(Average Inventory)(Carrying costs per unit)+ (Reordering cost per order)(number of orders)

Total Carrying Cost =

(Average Inventory)(Carrying costs per unit).

Nominal rate for terms of sale =

(Discount/ 1-discount) * (365/Discount Period)

to compare the discount rate on factoring with other options for financing, the discount must be converted into an annual interest rate: Nominal interest rate =

(Discount/ 1-discount) *(receivables turnover)

Minimum carrying costs =

(EOQ/2)* C

(2) Total cost =

(Order size / 2) * (Carrying costs per unit)+(Reordering cost per order)(Unit sales per period/ Order size)

Total Reordering costs =

(Reordering cost per order)(number of orders).

The average value for any period can be computed as =

(Start value+Ending value) / 2

Formal line of credit

(a legal commitment by the bank, often described as "committed")

Informal line of credit

(often called "uncommitted").

Reasons for holding cash

-Speculative Motive -Precautionary Motive -Transaction Motive

Sales percentage collected in the current period

1-(accounts receivable period/number of days in period)

Accounts Payable Period =

365/Accounts Payable Turnover

Receivables Period =

365/Receivables Turnover

Inventory Period =

365/inventory Turnover Ratio

(2) Cash Cycle =

= Inventory Period + Accounts Receivable Period - Account Payable Period

Credit score or credit rating

A quantitative assessment of a customer's creditworthiness generated from these information sources

A revolving line of credit

A revolving credit arrangement If a line of credit is regularly renewed by the bank for multi-year periods

Working Capital Management

A set of policies intended to help a company operate efficiently by monitoring and using its current assets and liabilities optimally. T

Assigning accounts receivables

Also known as accounts receivables financing Means that a firm uses receivables as collateral for a secured short-term loan.

Float =

Available balance - book balance.

Accounts Payable Turnover =

COGS/(Average) Accounts Payable

Inventory Turnover =

COGS/Average Inventory (Inventory)

The term liquidity

Can refer to how quickly and easily a firm can raise cash.

Just-in-time (JIT) inventory

Common among Japanese manufacturer Inventory system in which companies manufacture or purchase goods just in time for use.

Receivables Turnover =

Credit Sales / Accounts Receivable

The EOQ model

Derives the optimal amount of inventory to order in order to minimize total costs.

Terms of sale=

Discount / Discount Period, net full period

Optimal average inventory level =

EOQ/2

Defaul

Failure to make payments on debt, can trigger a firm's bankruptcy

Precautionary motive

Firrms maintain liquidity in order to avoid the costs associated with running out of cash or other current assets.

When a firm invests its short-term cash surpluses, there are several factors that should be considered.

First, the investment should give a higher return than if the money is just left as cash. Second, the investment must be very liquid, so that it can be converted back to cash at short notice. Third, the investment should be safe.

Stock-out

If a firm runs out of inventory and loses sales

Operating Cycle =

Inventory Period + Accounts Receivable Period.

Cash-out

It a firm run out of cash and has to sell assets, borrow, or default

A conservative, or flexible, policy

Means that the firm has high liquidity by holding high levels of cash, lots of inventory, and being generous in extending credit to customers.

Transaction motive

Motivation for a firm to hold cash is to meet its day-to-day operating needs

(1) Cash Cycle =

Operating Cycle - Accounts Payable Period

Average inventory =

Order size / 2

Economic Order Quantity (EOQ) =

SQRT (2RU/C) R = the reordering cost C = carrying cost per unit U = unit sales per period

(1) Sales collected in future periods = ending accounts receivable balance =

Sales - Sales collected in the current period

Commercial Paper

Some large firms bypass banks for their short-term borrowing needs and go directly to investors in the capital markets. These firms issue short-term unsecured bonds

Book balance or ledger balance

The amount of cash shown in a company's record

Available balance or the collected balance

The amount that the bank records as being available

The net cash flows each period

The cash collections - the cash disbursements

The disadvantages include

The chance that some customers will not pay The lost time value of money The cost of monitoring and processing the credit.

The main shortage costs are

The costs involved in selling assets when the firm needs to raise cash, the costs involved in borrowing when the firm does not have enough cash, and the lost sales that may come from inadequate inventory or accounts receivable terms.

Collection Float

The delay between when a customer pays for a product (such as by writing a check) and when the firm actually has that money in its bank account Collection float is bad for the firm and is viewed as a negative dollar value

Float

The difference between the amount of cash in a company's records and the amount that is actually available at the bank

Factoring

The firm basically sells the accounts receivable to the lender (the lender is called the factor). The factor then collects the accounts receivable and takes any loss that comes from uncollected accounts receivable.

Disbursement float

The float that is generated by the delay in processing payments made by a firm Disbursement float is good for a firm and is viewed as a positive dollar value

Speculative motive

The motivation to hold cash in order to take advantage of unexpected opportunities Such as short-term projects, favorable interest rates, and favorable exchange rates

An aggressive, or restrictive, short-term financial policy

The opposite. Means to hold little cash, low levels of inventory, and to encourage customers to pay in cash.

Cash Budget

The overall plan for a firm's short-term cash levels

Cash management

The process of collecting and managing cash flows

Net Float =

The sum of disbursement float and collection float collection float + disbursement floa

A firm's credit policy typically has three components:

The terms of sale Credit analysis Collection policy.

Costs related to the lack of safety reserves

These are the lost sales and lost goodwill than occur when the firm does not have enough inventory or cannot extend credit to customers.

Trading and order costs

These are the transaction costs associated with having to raise cash (such as brokerage costs) or inventory (such as overtime for workers).

The main purpose of working capital management

To maintain sufficient cash flow so that a company can cover its short-term operating costs and short-term debt obligations.

The end goal of all credit policies is

To maximize shareholder value by facilitating revenues while minimizing the risk generated by extending credit.

Aging Schedule

To monitor accounts receivable, where all unpaid bills are classified according to the amount and the length of time that they are overduE

Shortage costs are often classified as arising from two sources:

Trading and order costs Costs related to the lack of safety reserves

Optimal orders per period =

U/EOQ

Number of orders =

Unit sales per period/ Order size

Conservative financial policies

Will increase the carrying costs for a firm

Effective rate for terms of sale =

[ (1 + (Discount/ 1-discount))^(365/Discount Period) ] -1

A financial manager can choose to pursue:

a conservative short-term financial policy or an aggressive policy

Cash disbursements divided into four categories:

accounts payable (materials and supplies), other operating expenses (wages, taxes, and other), capital expenditures (fixed assets), and financing costs (interest payments and dividends).

The accounting term for credit given to customers is

accounts receivable

(2) Sales collected in future periods = ending accounts receivable balance =

accounts receivable period/ number of days in period

A line of credit

allows for short-term unsecured loans up to some fixed amount and at some pre-arranged interest rate (the rate may be fixed relative to market interest rates such as LIBOR or the Fed Funds rate).

A cash budget is

an estimation of the cash flows of a business over a specific period of time intended to forecast any cash deficits that may occur so that the financial manager can prepare for them in advance.

Cash inflows

are referred to as cash collections and are not necessarily equal to the amount of sales each period

Carrying costs

are the costs associated with holding higher levels of current assets. Include things such as insurance and storage for inventory.

Cash flows can be classified as

arising from operations, capital spending, and changes in net working capital.

Cash Collections =

beginning accounts receivable + sales collected in current period.

A firm can generally raise cash in two ways:

by selling assets or by increasing liabilities and equity.

Total cost =

carrying cost + reordering costs

Credit analysis

concerns gathering information about customers and then analyzing that information in order to determine the creditworthiness of the customer.

A company's working capital is made up of its

current assets minus its current liabilities.

The optimal amount of current assets almost always fluctuates with

economic conditions, seasonal factors, and random events, so most firms will occasionally be faced with a surplus or a deficit of cash in some periods.

A firm's net collections and disbursements in a cash budget are helpful in

forecasting the transaction needs of a firm for cash

The cash budget should be analyzed alongside the

forecasts for cash inflows and disbursements in order to identify the trends in the firm's cash position

The line of credit may be

formal or informal

The terms of sale specify

how long the customer has until payment is due (called the credit period), the cash discount, and the type of credit instrument.

The operating cycle

is the time that it takes to produce inventory, to sell it, and to then collect this money from customers.

The advantage of offering credit is that

it can lead to increased sales

One of the main tasks of a financial manager is to

make sure that a firm has sufficient cash on hand to pays its bills as they come due

The credit instrument

refers to the type of legal or accounting document that is used to record the debt between the purchaser and the seller.

When a firm has excess cash due to a conservative policy,

some of the carrying costs can be offset by investing the cash in liquid securities, such as money market mutual funds or T-Bills.

The forecast of cash disbursements takes the

sum of cash outflows for accounts receivable, other operating expenses, capital expenditures, and financing expenses.

Shortage costs are

the costs that happen when a firm does not have enough current assets.

The items on a firm's financial statements can be used to measure

the inflows and outflows of cash each period.

Economic Order Quantity (EOQ)

the optimal order size to minimize the sum of ordering, carrying, and stockout costs

The accounts receivable period is

the time that it takes to collect money from customers after making a sale

The inventory period is

the time that it takes to produce and sell inventory.

When a firm faces a temporary cash deficit

they can minimize the shortage costs by preparing options for short-term borrowing.

Assigning and factoring accounts receivables are popular because

they provide off-balance sheet financing. The transaction normally does not appear in firm financial statements and a firm's customers may never know their accounts were assigned or factored.

The idea behind the cash budget is

to forecast cash inflow and cash outflows over the next couple periods.

The first step in preparing a cash budget is

to forecast the cash inflows

The effective rate is usually the more useful rate to compare

to other interest rates

Inventory management

unique to different firms and may include raw material, work-in-progress, and finished goods

The EOQ model helps managers decide

what is the optimal amount of inventory that needs to be ordered per operating cycle or production batch So a company does not have to make orders too frequently and there is not an excess of inventory sitting on hand.

One of the biggest problems for a firm is

when they fail to have enough cash on hand to make required payments

Aggressive financial policies

will minimize carrying costs, but may lead to shortage costs

Effective interest rate =

{ [ 1 + (Discount/ 1-discount) ] ^ receivables turnover }- 1