FM Students 10 working capital Spring 2010

nullWORKING CAPITALWORKING CAPITALTopic 10*Topic 10 Working Capital Spring 2010The Story so FarTopic 10 Working Capital Spring 2010*The Story so FarTo date we have covered many of the basic concepts and techniques essential to the understanding of finance and making sound financial decisions Further development of your financial skills depends upon your ability to apply your understanding of finance to the many day to day decisions faced by all business organisations Our last three topics cover three common areas of financial decision makingObjectivesTopic 10 Working Capital Spring 2010*ObjectivesUnderstand working capital management Operating cycle and cash cycle models for inventory and credit management Calculate the EAR for cash discounts Calculate Economic Order Quantity (EOQ) Calculate NPV of trade receivables policy Working Capital ManagementWorking Capital ManagementTo date we have emphasised that any increase in working capital is an investment In all business organisations today there is a great emphasis on managing working capital You should recall from topic 3 (Financial Ratios) that you can increase your Return on Assets by reducing your investment in Current AssetsTopic 10 Working Capital Spring 2010*Working Capital ManagementWorking Capital ManagementYou should recall that there is always a “trade off” in decisions relating to working capital Inventory High Levels of inventory has the benefit of improved customer service leading to improved sales but leads to higher carrying costs and opportunity costs Lower levels of inventory reduce carrying costs and opportunity costs but may lead to lost sales Receivables have a similar trade off between costs and benefitsTopic 10 Working Capital Spring 2010*Working Capital ManagementTopic 10 Working Capital Spring 2010*Working Capital ManagementFocuses on short-term financial management and planning Financial management of current assets and current liabilities Concentrates on decisions related to cash flows that occur within the near future operating cycle Decisions can be revised without any severe penalty, unlike capital budgeting decisionsMajor Components of - Working Capital ManagementMajor Components of - Working Capital ManagementManagement of Current Assets Cash and liquidity management Inventory management Receivables management Although the focus of working capital management is on current assets an important part of working capital and cash management is the management of accounts payableTopic 10 Working Capital Spring 2010*Working Capital Cycle & Cash CycleTopic 10 Working Capital Spring 2010*Working Capital Cycle & Cash CycleOperating cycle time span from the purchase of raw materials to the collection of receivables Operating cycle will go through periods of being "in-funds" to periods of being out of funds Timing of payments and receipts are not synchronised firms must planTotal Operating & Cash CycleTopic 10 Working Capital Spring 2010*Total Operating & Cash CycleInventory PurchasedInventory SoldCash ReceivedInventory Holding periodAccounts ReceivableAccounts PayableCash paid for inventoryOUT OF CASHCash Conversion CycleTopic 10 Working Capital Spring 2010*Cash Conversion CycleDifference between time firm pays its bills and time to receive payment Operating cycle is the time the firm takes to turn inventory into finished good and collect cash Measured by days in inventory plus average collection period. Operating Cycle = {inventory / cost of sales *365} + { Accounts Receivable / sales * 365}Cash Conversion Cycle continuedTopic 10 Working Capital Spring 2010*Cash Conversion Cycle continuedCash conversion cycle accounts for purchases on credit Days to pay creditors = accounts payable/ cost of sales *365 Cash Conversion Cycle = operating cycle - days to pay creditors. Stretching accounts payable will reduce the cash conversion cycleCash Conversion Cycle continuedCash Conversion Cycle continuedAs trade credit is in most cases interest free many businesses will stretch the payment terms But this may incur costs! Cash Discounts not taken Suppliers may increase the cost of products to known slow payers A company with a poor credit rating or poor payment history may be denied credit leading to an increase in the cash conversion cycleTopic 10 Working Capital Spring 2010*Cash DiscountsCash DiscountsThe real cost of not taking cash discounts is often not recognised or underestimated If you do not take your discount you are effectively borrowing an amount of money to pay a larger amount later with the additional amount being the interest for the period We can use our knowledge of financial maths to calculate an effective annual rate for the borrowingTopic 10 Working Capital Spring 2010*Cash Discounts Example 1Cash Discounts Example 1If a supplier quotes you terms of 2% discount for payment of an account within 14 days or net 30 (sometimes written 2/14, N30) what is the effective interest rate if you do not pay until 30 days after receipt of the account If you assume that the account is for $100 you have the option of paying $98 after 14 days or $100 16 days later 2/98 = 2.04% interest for 16 days!Topic 10 Working Capital Spring 2010*Cash Discounts Example 1Cash Discounts Example 1There are 365/16 = 22.8 periods in a year The nominal rate =22.8 x 2.04 = 46.51% The effective rate = (1.0204)22.8 – 1 = 58.48% If you do not take your discount you can reduce the effective interest rate by extending the repayment past the 16 days. You should also consider the cost to an organisation that offers cash discounts!Topic 10 Working Capital Spring 2010*Cash managementCash managementIn economics there are said to be three motives for holding cash: Speculative motive Precautionary motive Transaction motive In business today unused lines of credit and investments in marketable securities cover the first two but cash is needed to pay bills and meet the repayments of financing obligationsTopic 10 Working Capital Spring 2010*Cash managementCash managementIt is essential that companies forecast their short term requirements for cash to ensure that they will be able to meet their short term obligations Cash Budgets must be produced on a regular basis which forecast cash receipts and cash payments on a monthly basis Cash budgets include all cash flows including interest, dividends and repayments of loans Topic 10 Working Capital Spring 2010*Cash ManagementCash ManagementThe cost of holding too much cash is a reduced return to shareholders: Cash will not earn as much as investments in real assets even when invested in short term marketable securities. Shareholders investing in companies expect a higher return than that obtained by cash The cost of holding too little cash is the costs associated with bankruptcy and financial distress which will decrease shareholder wealthTopic 10 Working Capital Spring 2010*Cash ManagementCash ManagementThe text book covers cash management models to manage the balance between cash and marketable securities. Since 1980’s in Australia such models have generally not been necessary due to the fact that liquidity can be managed through efficient financial arrangements with banks Arrangements include the payment of interest on cheque accounts or nightly sweeps to ensure all spare cash is invested in interest bearing accountsTopic 10 Working Capital Spring 2010*Inventory ManagementTopic 10 Working Capital Spring 2010*Inventory ManagementInventory for a manufacturing company would consist of: Raw materials goods used in manufacturing process Work-in-progress partially completed goods Finished goods goods ready for saleInventory ManagementInventory ManagementThe management of inventory levels is critical to the operations of all trading and manufacturing companies. Reduced holdings of inventory will increase the return on assets and reduce carrying costs (Storage costs, costs of obsolescence or deterioration and opportunity costs) Reduced holdings of inventory may result in lost sales or production delays and will increase the order costsTopic 10 Working Capital Spring 2010*Costs associated with inventory shortages Costs associated with inventory shortages Stock-out costs: Run out of inventory -unable to supply Loss of sales -Customer may go elsewhere May shutdown production line Order costs: Increased orders leading to increased ordering costs. in placing an order Increased set up costs may be involved in setting up the production process, Increased handling costs and transport costsTopic 10 Working Capital Spring 2010*Costs associated with higher levels of inventoryTopic 10 Working Capital Spring 2010*Costs associated with higher levels of inventoryCarrying costs: storage costs / handling costs and insurance opportunity cost of funds losses attributable to deterioration or obsolescence The inventory problem What is the optimal level of inventory to continue normal operations How much should be ordered and when Optimal Inventory LevelOptimal Inventory LevelManagement’s aim is to find the inventory level which minimises the total of stock-out, order and, carrying costs Optimal inventory level Is a balance between the above three Inventory level versus customer service: lower the inventory the more back-orders and stock-outs higher the inventory, the better customer serviceTopic 10 Working Capital Spring 2010*Optimal Inventory LevelTopic 10 Working Capital Spring 2010*Optimal Inventory LevelInventory level versus cost of placing orders: low inventories -frequent placement of small purchase orders High set-up costs and order costs result Lost quantity discounts Inventory level versus cost of storing inventory: high inventories -high storage costs high risk of obsolescenceEconomic Order Quantity ModelEconomic Order Quantity ModelSolving the inventory problem in practice is a complex problem that in large manufacturing organisations is handled by a logistics department using many different mathematical techniques The Economic Order Quantity model is introduced to demonstrate how models can be used to calculate optimal order quantities and the resulting inventory levels The purpose of the model is to minimise the total of the order costs (or acquisition costs) and carrying costsTopic 10 Working Capital Spring 2010*Economic Order Quantity ModelTopic 10 Working Capital Spring 2010*Economic Order Quantity ModelModel assumes: Inventory demand (T) is certain Demand occurs at a constant rate Inventory replacement is instantaneous As order quantity (Q) increases, number of orders per period declines total order costs (F) per period decline Level of inventory held increase Total carrying costs (CC) increasenullTopic 10 Working Capital Spring 2010*EOQ & Inventory CostCosts $Order Size QTotal costs Carrying costs Order CostsEOQEOQ ModelTopic 10 Working Capital Spring 2010*EOQ ModelOrder cost = cost of placing order times number of orders per period Order Cost = F*T/Q Carrying costs = carrying costs per unit of inventory, (CC) times average inventory level Since demand is constant, average inventory level is Q/2: Total carrying costs = CC x Q/2 Total cost of holding inventory TC = Q(CC)/2 + T(F/Q)EOQ Model continuedTopic 10 Working Capital Spring 2010*EOQ Model continuedSelect order quantity, Q*, which will minimise the total cost. EOQ = Q* =√(2TF/CC) or (2TF/CC).5 Q* = economic order quantity Where Q = size of inventory T = total number of units sold or consumed for the year CC = caring cost per unit (opportunity cost) F = fixed cost of reordering and restocking inventorynullTopic 10 Working Capital Spring 2010*Typical Inventory Cycle Under EOQ AssumptionsTimeInventory LevelOrder SizeInstantaneous replacementConstant DemandAverage Inventory LevelExample 2Topic 10 Working Capital Spring 2010*Example 2Winkers Ltd a manufacturer of widgets orders components for use in manufacturing. The estimated demand for the components during the coming year is 10,000. Order costs are $150 per order; carrying costs are $15 per component. Using the economic order quantity model, What is Winkers Ltd optimum order quantity?Solution Example 2Topic 10 Working Capital Spring 2010*Solution Example 2EOQ = Q* =√(2TF/CC) or (2TF/CC).5 = √(2 * 10000 * 150 / 15) = 200,000 = 447.21 or 447 units Safety Stock and When-to-orderTopic 10 Working Capital Spring 2010*Safety Stock and When-to-orderEOQ model assumes Instantaneous replacement of inventory No lead time in ordering inventory Decision when to place an order = reorder point Or inventory level at which a new order should be placedSafety Stock exampleTopic 10 Working Capital Spring 2010*Safety Stock exampleIn Winkers Ltd , the supplier guarantees a one week delivery on any order that is placed. The one week delivery period represents a lead time for orders. Assuming a constant demand rate 10000/52 = 192 per week, Winkers expects to use 192 components during a week that it takes to receive a new order. In other words the lead time demand is 192 widgets Re-order point is 192 and re-order Qty is 447Accounts Receivable ManagementTopic 10 Working Capital Spring 2010*Accounts Receivable ManagementAccounts receivables are the result of a firm’s decision to sell goods on credit When setting company policy on credit sales the following decisions have to be made: Credit Terms: How many days credit will be allowed? Credit Standards: Which customers will be allowed credit? Credit Limit: Will companies be assessed on their ability to pay? What will be the procedure when customers do not pay on timeCredit TermsTopic 10 Working Capital Spring 2010*Credit Termslength of time credit will be extended, = credit period size of the cash discount, if any, for early payment period of time cash discount must be taken = cash discount period. 2/10, net 30 or 4/15, N60 Attractive to customers reduce cost of buy Attractive to seller, lowers cost of funds, may lower bad debts Credit Standards and limitsTopic 10 Working Capital Spring 2010*Credit Standards and limitsFirms generally do not discriminate between customers by offering different credit terms Decision is level of credit to be offered Need assurance customer is able to pay Number of ways can be determined Past behaviour Other suppliers Credit agency Financial statement analysisAcc Receivable Management contTopic 10 Working Capital Spring 2010*Acc Receivable Management contExtend credit only if benefits exceed the costs The benefit should be increased sales The costs will be: Increased cost of administration Default by customers who cannot pay (Bad Debts) Opportunity costs of funds tied up in working capitalAcc Receivable Management contTopic 10 Working Capital Spring 2010*Acc Receivable Management contOptimal credit policy - marginal costs of credit extension verses marginal benefit of increased sales It is a NPV problem What is the net present value of extending credit?Determine whether to extend credit. Topic 10 Working Capital Spring 2010*Determine whether to extend credit. Only granted when NPV is positive. In extending credit, firm receives incremental sales (S) and incurs incremental costs (C) Cost include -variable costs of goods and collection costs Net gain from extending credit is present value of S - C Present value determined by required rate of returnExtend credit? Topic 10 Working Capital Spring 2010*Extend credit? Cannot be certain customer will pay If defaults, firm loses incremental sales but still bears incremental costs If the probability that the customer will pay is p NPV is: NPV = p[PV (S)]- [PV(C)] Extend credit if NPV is non-negative Example 3Topic 10 Working Capital Spring 2010*Example 3Ajax Ltd. is seeking to determine whether to extend credit to a customer who wishes to purchase goods. The proposed credit terms are 30 days net. This is expected to result in an increase in sales revenue of $606. The incremental costs associated with these sales are $500, and these costs are incurred now. It is estimated that with the provision of credit there is a probability of 0.9 that the customer will pay within the 30 day credit period. If the firm's required rate of return is 1% per month would you recommend that Ajax grant the customer credit?Solution Example 3Topic 10 Working Capital Spring 2010*Solution Example 3PV of extending credit = .9(606)(1.01)-1 - 500 = $40 Since the expected net present value is non-negative Ajax should extend credit Analysis can be extended to incorporate different payment patterns QuestionTopic 10 Working Capital Spring 2010*Question Holding liquid assets and cash in anticipation of future profitable opportunities are related to: a) transaction motive b) precautionary motive c) speculative motive d) none of the above The answer is QuestionTopic 10 Working Capital Spring 2010*QuestionAverage collections should be extended to a point where the marginal revenue of additional sales _______ the marginal cost of _______: a) exceed; bad debt loss b) equal; bad debt loss c) less than; bad debt loss d) exceed; inventory in transit. The answer is QuestionTopic 10 Working Capital Spring 2010*QuestionJacob Corporation has $300,000 of receivables and $285,000 of payables. Jacob’s net credit position is: a) $25,000 b) $15,000 c) $585,000 d) none of the above. The answer is Workshop Question 1Topic 10 Working Capital Spring 2010*Workshop Question 1Alfa Fashions Ltd (AFL) is trying to expand sales and is looking if it should extend credit to all of their customers. Currently AFL is a cash business with sales of $50,000 a month and expenses of $33,000 a month. AFL believes if it moves to one month credit they will double sales to $100,000 a month but the cost will still have to be paid in cash and increase to a total of $60,000 a month. AFL believes if it extends credit some customers will pay late and some may never pay. AFL has assumed, existing cash customers will take advantage of the credit offering. The repayment assumptions are 80% will pay within the one month and 15% in the following month. If AFL has a required rate of return of 1% per month should they extend credit?Solution WQ1Solution WQ1What is the NPV of the present policy? What is the amount of sales to be collected in first and second month if they extend credit? Month 1= Month 2= What is the NPV of the credit policy if AFL goes ahead and grants credit? Topic 10 Working Capital Spring 2010*Workshop Question 2Workshop Question 2Billy Blue is a bread manufacturer and uses 200,000 kg of flour per year. The costs associated with raising an order are estimated to be $13.00 and the carrying cost is estimated to be $1.30 per kg. What is his EOQ?Topic 10 Working Capital Spring 2010*Solution Workshop Q2Solution Workshop Q2EOQ = √(2TF/CC) Topic 10 Working Capital Spring 2010*QuestionTopic 10 Working Capital Spring 2010*QuestionThe overall goal of cash management is to: a) reduce speculative demand for cash b) reduce precautionary demand for cash c) maximise shareholders wealth d) minimise the loss on short-term liquid assets The answer is QuestionTopic 10 Working Capital Spring 2010*QuestionAccounts receivable management should pursue a policy of: a) maximising sales b) minimising costs c) maximising shareholder wealth d) minimising the level of inventory The answer is QuestionTopic 10 Working Capital Spring 2010*QuestionTightening a firm’s credit standards is expected to result in: a) smaller bad-debt losses b) greater bad-debt losses c) lower sales d) both A and C The answer is QuestionTopic 10 Working Capital Spring 2010*QuestionCredit management involves evaluating all of the following decisions except: a) credit standards b) collection policy c) incentives (discounts) d) stretching accounts payable The answer is Workshop Question 3Workshop Question 3If a company is offered credit terms of 3/14, Net 60 but elects to pay promptly after 60 days what is the effective annual rate that the company is paying