Chapter 14

Receivables

Represents the amount owed by customers who have availed the firm's trade credit facility.

Payables

Represents the amount owed to the firm's vendors and suppliers for materials purchased on credit.

inventory carrying costs

expenses associated with maintaing inventory including interest forgone on money invested in inventory, storage costs, taxes and insurance

maturity matching strategy

financing strategy that matches the maturities of liabilities and assets

long term funding strategy

financing strategy that relies on long term debt and equity to finance both fixed assets and working capital

short term funding strategy

financing strategy that relies on short term debt to finance all seasonal working capital and a portion of permanent working capital and fixed assets

Financial managers use two types of strategies for current assets investments:

flexible and restrictive.

Working capital management

involves making decisions regarding the use and sources of current assets.

Current liabilities (or short-term liabilities)

obligations that the firm expects to pay off in an year or less.

Economic order quantity (EOQ)

order quantity that minimizes the total costs incurred to order and hold inventory

Net working capital (NWC)

refers to the difference between current assets and current liabilities. NWC is important because it is a measure of liquidity and represents the net short-term investment the firm keeps in the business.

Working capital efficiency

refers to the length of time between when a working capital asset is acquired and when it is converted into cash.

LOCKBOXES

A system allows geographically dispersed customers to send their payments to a post office box close to them. With a concentration account, a post office box is replaced by a local branch which receives the mailings, processes the payments, and makes the deposits. Either approach will reduce the collection time to an extent but there is a cost associated with it.

Accounts payable

Accounts payable (trade credit), bank loans, and commercial paper are common sources of short-term financing. Accounts payable constitute close to 35 percent of total current liabilities for all publicly traded manufacturing firms. The buyer needs to figure out whether it makes financial sense to pay early and take advantage of the discount or to wait and pay in full when the account is due.

ELECTRONIC FUNDS TRANSFERS

Another increasingly popular means of reducing cash collection time is through the use of electronic funds transfers. Such payments reduce cash collection times in every phase. First, mailing time is eliminated. Second, processing time is reduced or eliminated since no data entry is necessary. Finally, electronic funds transfers typically have little or no delay in funds availability.

OPERATING CYCLE

Begins when the firm uses its cash to purchase raw materials and ends when the firm collects cash payments on its credit sales. Described in two components: Days sales in Inventory and Days sales outstanding.

Commercial paper

Commercial paper is a promissory note issued by large financially secure firms, which have high credit ratings. Commercial paper is not "secured" which means that the issuer is not pledging any assets to the lender in the event of default. However, most commercial paper is backed by a credit line from a commercial bank. Therefore, the default rate on commercial paper is very low, resulting in an interest rate that is usually lower than what a bank would charge on a direct loan. For medium-size and small businesses, accounts-receivable financing is an important source of funds.

Accounts Receivables

Companies frequently make sales to customers on credit by delivering the goods in exchange for the promise of a future payment. The promise is an account receivable from the firm's point of view. Offering credit to customers can help a firm attract customers by differentiating the firm and its products from its competitors.

Inventory

Firms maintain inventory of raw materials, work in process, and finished goods.

Collection time can be broken down into three components:

First is delivery time, or mailing time. When a customer mails payment, it may take several days before that payment arrives. Second is processing delay. Once the payment is received, it must be opened, examined, accounted for, and deposited at the firm's bank. Finally, there is a delay between the time of the deposit and the time the cash is available for withdrawal.

Flexible Current Asset Management Strategy

Flexible Current Asset Management Strategy The flexible strategy has a high percent of current assets to sales, whereas a restrictive policy has a low percent of current assets to sales. The flexible strategy calls for management to invest large amounts in cash, marketable securities, and inventory. The strategy also promotes a liberal trade credit policy for customers, which results in high levels of accounts receivable. The flexible strategy is perceived to be a low-risk and low-return course of action for management. The advantage of this policy is the large working capital balances the firm holds. The strategy's downside is the high carrying cost associated with owning a high level of inventory and providing liberal credit terms to its customers. The higher carrying costs result from two reasons: The investment in low return current assets deprives higher returns that management could earn on long-term assets like plant and equipment. Higher amounts of inventory result in higher warehousing and storage costs.

JUST-IN-TIME INVENTORY MANAGEMENT

In this system the exact day-by-day, or even hour-by-hour raw material needs are delivered by the suppliers, who deliver the goods "just in time" for them to be used on the production line. A big advantage in this system is that there are essentially no raw material inventory costs and no chance of obsolescence or loss to theft. On the other hand, if the supplier fails to make the needed deliveries, then production shuts down. If this system works for a firm effectively, it cuts down their investment in working capital dramatically.

Cash

Includes cash and marketable securities like treasury securities. The higher the cash balance the better the ability of the firm to meet its short-term financial obligations.

CASH CONVERSION CYCLE =

Is related to the operating cycle, but it does not start until the firm actually pays for its inventory. That is, the cash conversion cycle is the length of time between the cash outflow for materials and the cash inflow from sales. To measure the cash conversion cycle we need another measure called the days payables outstanding. Days Payables Outstanding (DPO) tells how long a firm takes to pay off its suppliers for the cost of inventory. The cash conversion cycle is calculated as: Cash Conversion Cycle = DSO + DSI - DPO or; Cash Conversion Cycle = Operating Cycle - DPO

Aging schedule

The aging schedule shows the breakdown of the firm's accounts receivable by their date of sale; how long has the account not been paid in days. Its purpose is to identify and then track delinquent accounts and to see that they are paid. Aging schedules are also an important financial tool for analyzing the quality of a company's receivables. The aging schedule reveals patterns of delinquency and shows where collection efforts should be concentrated. Exhibit 14.6 shows aging schedules for three different firms.

SEQUENCE OF EVENTS IN A CASH CONVERSION CYCLE

The firm uses cash to pay for the cost of raw materials and the costs of conversion. Finished goods are held in finished goods inventory until they are sold. Finished goods are sold on credit to the firm's customers. Customers repay the credit the firm has extended them and the firm receives the cash.

Operating Cycle =

The operating cycle is calculated by summing the Days Sales Outstanding and the Days Sales in Inventory. Operating Cycle = DSO + DSI

RESTRICTIVE CURRENT ASSET MANAGEMENT STRATEGY

The restrictive strategy is a high-risk high-return alternative to the flexible strategy. The high risk comes in the form of shortage costs which can be either financial or operating. Financial shortage costs arise mainly from illiquidity, shortage of cash, and a lack of marketable securities to sell for cash. Current assets are kept at a minimum under the restrictive strategy. The firm barely invests in cash and inventory and has tight terms of sale intended to curb credit sales and accounts receivable. If there are unpaid bills that are due, the firm will be forced to use expensive external emergency borrowing. If funding cannot be secured, default occurs on some current liability and the firm runs the risk of being forced into bankruptcy by creditors. Operating shortage costs result from lost production and sales. If the firm does not hold enough raw materials in inventory, time may be wasted by a halt in production.

Cash on delivery

The simplest offer is cash on delivery (COD)—that is, no credit is offered.

GOALS OF FINANCIAL MANAGERS IN MANAGING THE CASH CONVERSION CYCLE

To delay paying accounts payable as long as possible without suffering any penalties. To maintain minimal raw material inventories without causing manufacturing delays. To use as little a labor as possible to manufacture the product while maintaining quality. To maintain minimal finished goods inventories without losing sales. To offer customers the most attractive credit terms possible on trade credit to maximize sales while minimizing the risk of non-payment. To collect cash payments on accounts receivable as fast as possible to close the loop.

Working capital management involves two key issues

What is the appropriate amount and mix of current assets for the firm to hold? How should these current assets be financed?

formal line of credit

a contractual agreement between a bank and a firm under which the bank has a legal obligation to lend funds to the firm up to a preset limit; also known as revolving credit

lockbox

a system that allows geographically dispersed customers to send their payments to a post office box near them

informal line of credit

a verbal agreement between a bank and a firm under which the firm can borrow an amount of money up to an agreed on limit

A common tool that credit managers use is called an

aging schedule

factor

an individual or a financial institution such as a bank or a business finance company, that buys accounts receivable without recourse

compensating balances

bank balances that firms must maintain to at least partially compensate banks for loans or services rendered

Days sales outstanding (DSO)

estimates how long it takes on an average for the firm to collect its outstanding accounts receivable balances. This ratio is also called the Average Collection Period (ACP).

Current assets

cash and other assets that the firm expects to convert into cash in a year or less.

shortage costs

costs incurred because of lost production and sales or liquidity

consumer credit

credit extended by a business to consumers

trade credit

credit extended by one business to another

flexible current asset management strategy

current asset management strategy that involves keeping high balances of current assets on hand

restrictive current asset management strategy

current asset management strategy that involves keeping the level of current assets a minimum

commercial paper

short term debt in the form of promissory notes issued by large, financially secure firms with high credit ratings

Days sales in inventory (DSI)

shows how long the firm keeps its inventory before selling it. It is the ratio of the inventory balance to the daily cost of goods sold.

Liquidity

the ability of a company to convert assets—real or financial—into cash quickly without suffering a financial loss.

operating cycle

the average time between receipt of raw materials and receipt of cash for the sale of finished goods made from those materials

Working capital

the funds invested in a company's cash account, account receivables, inventory, and other current assets (also called gross working capital).

cash conversion cycle

the length of time from the point at which a company pays for raw materials until the point at which it receives cash from the sale of finished goods made form those materials

permanent working capital

the minimum level of working capital that a firm will always have on its books

collection time (float)

the time between when a customer makes a payment and when the cash becomes available to the firm