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After reading this chapter, students should be able to: • Define basic working capital terminology. • Calculate the inventory conversion period, the receivables collection period, and the payables deferral period to determine the cash conversion cycle. • Briefly explain the basic idea of zero working capital. • Briefly explain how a negative cash conversion cycle works. • Distinguish among relaxed, restricted, and moderate current asset investment policies, and explain the effect of each on risk and expected return. • Explain how EVA methodology provides a useful way of thinking about working capital. • List the reasons for holding cash. • Construct a cash budget, and explain its purpose. • Briefly explain useful tools and procedures for effectively managing cash inflows and outflows. • Explain why firms are likely to hold marketable securities. • State the goal of inventory management and identify the three categories of inventory costs. • Identify and briefly explain the use of several inventory control systems. • Monitor a firm’s receivables position by calculating its DSO and reviewing aging schedules. • List and explain the four elements of a firm’s credit policy, and identify other factors influencing credit policy.
After reading this chapter, students should be able to: • Define basic working capital terminology. • Calculate the inventory conversion period, the receivables collection period, and the payables deferral period to determine the cash conversion cycle. • Briefly explain the basic idea of zero working capital. • Briefly explain how a negative cash conversion cycle works. • Distinguish among relaxed, restricted, and moderate current asset investment policies, and explain the effect of each on risk and expected return. • Explain how EVA methodology provides a useful way of thinking about working capital. • List the reasons for holding cash. • Construct a cash budget, and explain its purpose. • Briefly explain useful tools and procedures for effectively managing cash inflows and outflows. • Explain why firms are likely to hold marketable securities. • State the goal of inventory management and identify the three categories of inventory costs. • Identify and briefly explain the use of several inventory control systems. • Monitor a firm’s receivables position by calculating its DSO and reviewing aging schedules. • List and explain the four elements of a firm’s credit policy, and identify other factors influencing credit policy. Learning Objectives: 15 - 1 Chapter 15 Managing Current Assets LEARNING OBJECTIVES We have never found working capital an interesting topic to students, hence it is, to us, a somewhat more difficult subject to teach than most. Perhaps that’s because it comes near the end of the course, when everyone is tired. More likely, though, the problem is that working capital management is really more a matter of operating efficiently than thinking conceptually correctly i.e., it is more practice than theory and theory lends itself better to classroom teaching than practice. Still, working capital management is important, and it is something that students are likely to be involved with after they graduate. Since we have only one chapter on current asset management, we try to go all the way through it. However, the chapter is modular, so it is easy to omit sections if time pressures require. Assuming you are going to cover the entire chapter, the details of what we cover, and the way we cover it, can be seen by scanning Blueprints, Chapter 15. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes. DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods) Lecture Suggestions: 15 - 2 LECTURE SUGGESTIONS 15-1 When money is tight, interest rates are generally high. This means that near-cash assets have high returns; hence, it is expensive to hold idle cash balances. Firms tend to economize on their cash balance holdings during tight-money periods. 15-2 The two principal reasons for holding cash are for transactions and compensating balances. The target cash balance is not equal to the sum of the holdings for each reason because the same money can often partially satisfy both motives. 15-3 a. Better synchronization of cash inflows and outflows would allow the firm to keep its transactions balance at a minimum, and would therefore lower the target cash balance. b. Improved sales forecasts would tend to lower the target cash balance. c. A reduction in the portfolio of U. S. Treasury bills (marketable securities) would cause the firm’s cash balance to rise if the Treasury bills had been held in lieu of cash balances. d. An overdraft system will enable the firm to hold less cash. e. If the amount borrowed equals the increase in check-writing, the target cash balance will not change. Otherwise, the target cash balance may rise or fall, depending on the relationship between the amount borrowed and the number of checks written. f. The firm will tend to hold more Treasury bills, and the target cash balance will tend to decline. 15-4 A lockbox would probably make more sense for a firm that operated nationwide. Lockboxes reduce the time required for a firm to receive incoming checks, to deposit them, and to get them cleared through the banking system so that the funds are available for use. However, even a local firm with enough volume may want its bank to receive and process checks before the firm adjusts its accounts receivable ledgers. 15-5 False. Both accounts will record the same transaction amount. 15-6 The four elements in a firm’s credit policy are (1) credit standards, (2) credit period, (3) discount policy, and (4) collection policy. The firm is not required to accept the credit policies employed by its competition, but the optimal credit policy cannot be determined without considering competitors’ credit policies. A firm’s credit policy has an Integrated Case: 15 - 3 ANSWERS TO END-OF-CHAPTER QUESTIONS important influence on its volume of sales, and thus on its profitability. 15-7 The latest date for paying and taking discounts is May 10. The date by which the payment must be made is June 9. 15-8 a. goutstandin sales Days = Sales/365 receivable Accounts = /365000,920,2$ 000,312$ = $8,000/day 000,312$ = 39 days. b. False. While it appears that most customers pay on time (because 39 days is less than the 40 days stipulated in the credit terms), this does not mean that all customers are paying on time. In fact, it is very likely that some are not, since some customers are paying on the tenth day and are taking the discount. 15-9 False. An aging schedule will give more detail, especially as to what percentage of accounts are past due and what percentage of accounts are taking discounts. 15-10 No. Although B sustains slightly more losses due to uncollectible accounts, its credit manager may have a wise policy that is generating more sales revenues (and thus profits) than would be the case if he had a policy which cut those losses to zero. 15-11 A/R Sales Profit a. The firm tightens its credit standards. - - 0 b. The terms of trade are changed from 2/10, net 30, to 3/10, net 30. 0 + 0 c. The terms are changed from 2/10 net 30, to 3/10, net 40. 0 + 0 d. The credit manager gets tough with past-due accounts. - - 0 Explanations: a. When a firm “tightens” its credit standards, it sells on credit more selectively. It will likely sell less and certainly will make fewer credit sales. Profit may be affected in either direction. b. The larger cash discount will probably induce more sales, but they will likely be from customers who pay bills quickly. Further, some of the current customers who do not take the 2 percent discount may be induced to start paying earlier. The effect of this would be to reduce accounts receivable, so accounts receivable and profits could go either way. c. A less stringent credit policy in terms of the credit period should stimulate sales. The accounts receivable could go up or down Integrated Case: 15 - 4 depending upon whether customers take the new higher discount or delay payments for the 10 additional days, and depending upon the amount of new sales generated. d. If the credit manager gets tough with past due accounts, sales will decline, as will accounts receivable. 15-12 The firm could have its suppliers ship by air freight, reducing lead time, or on consignment, reducing the firm’s purchasing costs. The firm can reduce its finished goods inventory by manufacturing to meet orders, or by shipping goods to customers at the firm’s discretion, or by using seasonal dating in its accounts receivable policy. Unless the firm is in a strong bargaining position, or offers some financial incentive, shifting inventory burdens to suppliers and customers may result in higher costs and fewer sales. If a supplier has to carry larger raw material inventory, it may charge a higher price to the firm to cover its increased inventory costs. Shifting inventory burdens to customers may result in lost sales if customers can obtain better service from other firms. Integrated Case: 15 - 5 15-1 Net Float = Disbursement float - Collections float = (4 × $10,000) - (3 × $10,000) = $10,000. 15-2 Sales = $10,000,000; S/I = 2×. Inventory = S/2 = 2 000,000,10$ = $5,000,000. If S/I = 5×, how much cash is freed up? Inventory = S/5 = 5 000,000,10$ = $2,000,000. Cash freed = $5,000,000 - $2,000,000 = $3,000,000. 15-3 DSO = 17; Credit sales/Day = $3,500; A/R = ? DSO = S/365 A/R 17 = $3,500 A/R A/R = 17 × $3,500 = $59,500. 15-4 a. Cost = (Number of locations)(Number of transfers)(Cost per transfer) + (Monthly cost)(12) = (10)(260)($9.75) + ($6,500)(12) = $25,350 + $78,000 = $103,350. b. Reduction in days of float = 3 days. Benefit = cost yOpportunit scollection Daily float of days in Reduction = (3)($325,000)(0.10) = $97,500. c. Net gain (loss) = $97,500 - $103,350 = -$5,850. Malitz should not initiate the lockbox system since it will cost the firm $5,850 more than it will earn on the freed funds. Integrated Case: 15 - 6 SOLUTIONS TO END-OF-CHAPTER PROBLEMS 15-5 a. 0.4(10) + 0.6(40) = 28 days. b. $912,500/365 = $2,500 sales per day. $2,500(28) = $70,000 = Average receivables. c. 0.4(10) + 0.6(30) = 22 days. $912,500/365 = $2,500 sales per day. $2,500(22) = $55,000 = Average receivables. Sales may also decline as a result of the tighter credit. This would further reduce receivables. Also, some customers may now take discounts further reducing receivables. 15-6 a. Setting up the formula for the cash conversion cycle, sales can be calculated. CCC = COGS Daily Avg. Pay. Acct. Sales Daily Avg. Inv. Sales Daily Avg. Rec. Acct. −+ 16.79 = ($47,000/ADS) + ($66,000/ADS) - ($72,000/0.8ADS) 16.79 = ($47,000/ADS) + ($66,000/ADS) - ($90,000/ADS) 16.79 = $23,000/ADS 16.79ADS = $23,000 ADS = $1,369.863. Therefore, annual sales equal $500,000 ($1,369.863 × 365 = $500,000). b. Based upon the given information, the firm's current assets equal $148,750 ($35,750 + $47,000 + $66,000). Therefore, for its current ratio to increase to 2.0, it must reduce accounts payable to a level such that current liabilities total $74,375 ($148,750/2). If accrued liabilities on the balance sheet equal $13,000, accounts payable must be reduced to $61,375 ($74,375 - $13,000). The firm's new average daily cost of goods sold would equal $1,369.863 × 0.70 = $958.90. Combined with the original information, the new CCC can be determined as follows: CCC = (AR/Avg. Daily Sales) + (Inv/Avg. Daily Sales) - (AP/Avg. Daily COGS) CCC = ($47,000/$1,369.863) + ($66,000/$1,369.863) - ($61,375/$958.90) CCC = 34.31 + 48.18 - 64.01 CCC = 18.48 days. 15-7 a. Cash conversion cycle = 22 + 40 - 30 = 32 days. b. Working capital financing = 1,500 × 32 × $6 = $288,000. c. If the payables deferral period was increased by 5 days, then its cash conversion cycle would decrease by 5 days, so its working capital financing needs would decrease by Integrated Case: 15 - 7 Decrease in working capital financing = 1,500 × 5 × $6 = $45,000. d. Cash conversion cycle = 20 + 40 - 30 = 30 days. Working capital financing = 1,800 × 30 × $7 = $378,000. 15-8 a. CCC = period deferral Payables period collection sReceivable period conversion Inventory −+ = 75 + 38 - 30 = 83 days. b. Average sales per day = $3,421,875/365 = $9,375. Investment in receivables = $9,375 × 38 = $356,250. c. Inventory turnover = 365/75 = 4.87×. 15-9 a. Inventory conversion period = 365/Inventory turnover ratio = 365/6 = 60.83 days. Receivables collection period = DSO = 36.5 days. CCC = period deferral Payables period collection sReceivable period conversion Inventory −+ = 60.83 + 36.5 - 40 = 57.33 days. b. Total assets = Inventory + Receivables + Fixed assets = $150,000/6 + [($150,000/365) × 36.5] + $35,000 = $25,000 + $15,000 + $35,000 = $75,000. Total assets turnover = Sales/Total assets = $150,000/$75,000 = 2×. ROA = Profit margin × Total assets turnover = 0.06 × 2 = 0.12 = 12%. c. Inventory conversion period = 365/7.3 = 50 days. Cash conversion cycle = 50 + 36.5 - 40 = 46.5 days. Total assets = Inventory + Receivables + Fixed assets = $150,000/7.3 + $15,000 + $35,000 = $20,548 + $15,000 + $35,000 = $70,548. Total assets turnover = $150,000/$70,548 = 2.1262×. ROA = $9,000/$70,548 = 12.76%. Integrated Case: 15 - 8 15-10 a. Return on equity may be computed as follows: Tight Moderate Relaxed Current assets (% of sales × Sales) $ 900,000 $1,000,000 $1,200,000 Fixed assets 1,000,000 1,000,000 1,000,000 Total assets $1,900,000 $2,000,000 $2,200,000 Debt (60% of assets) $1,140,000 $1,200,000 $1,320,000 Equity 760,000 800,000 880,000 Total liab./equity $1,900,000 $2,000,000 $2,200,000 EBIT (12% × $2 million) $ 240,000 $ 240,000 $ 240,000 Interest (8%) 91,200 96,000 105,600 Earnings before taxes $ 148,800 $ 144,000 $ 134,400 Taxes (40%) 59,520 57,600 53,760 Net income $ 89,280 $ 86,400 $ 80,640 Return on equity 11.75% 10.80% 9.16% b. No, this assumption would probably not be valid in a real world situation. A firm’s current asset policies, particularly with regard to accounts receivable, such as discounts, collection period, and collection policy, may have a significant effect on sales. The exact nature of this function may be difficult to quantify, however, and determining an “optimal” current asset level may not be possible in actuality. c. As the answers to Part a indicate, the tighter policy leads to a higher expected return. However, as the current asset level is decreased, presumably some of this reduction comes from accounts receivable. This can be accomplished only through higher discounts, a shorter collection period, and/or tougher collection policies. As outlined above, this would in turn have some effect on sales, possibly lowering profits. More restrictive receivable policies might involve some additional costs (collection, and so forth) but would also probably reduce bad debt expenses. Lower current assets would also imply lower liquid assets; thus, the firm’s ability to handle contingencies would be impaired. Higher risk of inadequate liquidity would increase the firm’s risk of insolvency and thus increase its chance of failing to meet fixed charges. Also, lower inventories might mean lost sales and/or expensive production stoppages. Attempting to attach numerical values to these potential losses and probabilities would be extremely difficult. Integrated Case: 15 - 9 15-11 a. Firm’s Bank’s checkbook records Day 1 Deposit $1,200,000; write check for $1,600,000. -$ 400,000 $1,200,000 Day 2 Write check for $1,600,000. -$2,000,000 $1,200,000 Day 3 Write check for $1,600,000. -$3,600,000 $1,200,000 Day 4 Write check for $1,600,000. -$5,200,000 $1,200,000 Day 5 Write check for $1,600,000; deposit $1,600,000. -$5,200,000 $1,200,000 After the firm has reached a steady state, it must deposit $1,600,000 each day to cover the checks written four days earlier. b. The firm has four days of float. c. The firm should try to maintain a balance on the bank’s records of $1,200,000. On its own books it will have a balance of minus $5,200,000. d. For any level of sales, the firm will probably have a higher rate of return on assets and equity if it can reduce its total assets. By using float, SSC can reduce its cash account, by (4 × $1,600,000) - $1,200,000 = $5,200,000. However, they actually can reduce equity and debt by $6,000,000 as the firm has gross float of $6,400,000 - $400,000 (increase in the amount deposited in the bank) = $6,000,000, so earnings per share will be higher. In terms of the Du Pont equation, the rate of return on equity will be higher because of the reduction in total assets. 15-12 a. Presently, HGC has 5 days of collection float; under the lockbox system, this would drop to 2 days. $1,400,000 × 5 days = $7,000,000 $1,400,000 × 2 days = 2,800,000 $4,200,000 HGC can reduce its cash balances by the $4,200,000 reduction in negative float. b. 0.10($4,200,000) = $420,000 = the value of the lockbox system on an annual basis. Integrated Case: 15 - 10 [...]... minimum needs (borrowing needs) $ 55,200 $ 68,400 ($ 53,700)($ 47,100) $ d The months preceding peak sales would show a decreased current ratio and an increased debt ratio due to additional short-term bank loans In the following months as receipts are collected from sales, the current ratio would increase and the debt ratio would decline Abnormal changes in these ratios would affect the firm’s ability . assets = $150 ,000/7.3 + $15, 000 + $35,000 = $20,548 + $15, 000 + $35,000 = $70,548. Total assets turnover = $150 ,000/$70,548 = 2.1262×. ROA = $9,000/$70,548 = 12.76%. Integrated Case: 15 - 8 15- 10. Receivables + Fixed assets = $150 ,000/6 + [( $150 ,000/365) × 36.5] + $35,000 = $25,000 + $15, 000 + $35,000 = $75,000. Total assets turnover = Sales/Total assets = $150 ,000/$75,000 = 2×. ROA =. “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes. DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods) Lecture Suggestions: 15 - 2 LECTURE SUGGESTIONS 15- 1 When money is