WORKING CAPITAL MANAGEMENT

Measuring Liquidity

• Working Capital– Current Assets – Current Liabilities

• Operating Capital– [Cash + MS + AR + Inv.]/[AP + AL]

• Current Ratio– Current Assets/Current Liabilities

• Quick Ratio– [Cash + MS + AR]/Current Liabilities

Cash Conversion Cycle

• Inventory Conversion – Convert raw materials up to selling finished goods– Inventory/Sales per day

• Receivables Conversion– Time to collect cash from the time of sale– Receivables/Sales per day

• Payables Deferral Period– Purchases on account up to payment of cash– Payables/Purchases per day

Other Formulas

• Inventory– Inventory Turnover = [COGS/Ave. Inventory]– Days in inventory = [365 days/ITO]

• Receivables– Receivable Turnover = [Sales/Ave. Receivables]– Days in receivables = [365 days/RTO]

• Payables– Payable Turnover = [Purchases/Ave. Payables]– Days in payables = [365 days/PTO]

Exercise 15-5 p. 603

McDowell Industries sells on terms of 3/10, net 30. Total sales for the year are $912,500. Forty percent of the customers pay on the 10th days and take discounts; the other 60 percent pay, on average, 40 days after their purchases.

a. What is the days sales outstanding?b. What is the average amount of receivables.

Solution to P15-5

a. [10 days x 40%] + [40 days x 60%] = 28 daysb. $ 912,500 / 365 days = $2,500 daily sales

$ 2,500 x 28 days = $ 70,000

Problem 15-8 p.604

The Zocco Corporation has an inventory conversion period of 75 days, a receivables collection period of 38 days, and a payables deferral period of 30 days.

a. What is the length of the firm’s cash conversion cycle?

b. If Zocco’s Annual sales are $3,421,875 and all sales are on credit, what is the firm’s investment in accounts receivable?

c. How many times per year does Zocco turn over its inventory?

Solution to Problem 15-8

a. 75 days + 38 days – 30 days = 83 daysb. 365 days / 38 days = 9.605263 (RTO)

3,421,875 / 9.605263 = $356,250c. 365 days / 75 days = 4.87 times

Shortening the Cash Conversion Cycle

• Reducing the inventory conversion period– Processing– Selling

• Reducing the receivables collection period• Lengthening the payable’s deferral period

Zero Working Capital

• Generates cash– Freeing cash from AR and Inv. Or prolonging AP– More Sales = More Earnings

• Speeds up production and make timely deliveries– Gains new business and charges for good service

• Efficient operation– Warehouse, workforce, obsolete and slow moving

inventories

Current Asset Investment Policies

• Relaxed (fat cat)– Larges amounts of current asset balances

• Moderate– In between the two extreme policies

• Restricted (lean and mean)– Minimization of current asset balances

• CA Policies and Uncertainty

Cash Management

• Reasons for Holding Cash– Transactions– Compensating Balances– Precautionary Balances– Speculative Balances

• Advantages in Holding Cash– Trade discounts– Good current and acid test ratio = good credit standing– Business opportunity– Emergencies / Financial Flexibility

Cash Management Techniques

• Synchronizing cash flows– Customer billing and Check-clearing

• Using Float• Accelerating Collections– Lockbox plan– Wire or Automatic Debit

• Getting available funds to where they are needed

• Controlling disbursements

Float

• The difference between the balance shown in a firm’s checkbook and the bank records.

• Deposit in Transits (collection float) and Outstanding Checks (disbursement float)

• Reasons for having float– Mail float– Processing float– Clearing or availability float

P15-1 p.603

• On a typical day, Troan Corporation writes $10,000 in checks. It generally takes 4 days for those checks to clear. Each day the firm typically receives $ 10,000 in checks that take 3 days to clear. What is the firm’s average net float?

Solution to P15-1

• Disbursement float (10,000 x 4) 40,000• Receipt float (10,000 x 3) 30,000• Net Float 10,000

Lockbox System P15-4 p.603I. Malitz and Associates operating a mail-order firm doing business

on the West Coast. Malitz receives an average of $325,000 in payments per day. On average, it takes 4 days from the time customers mail checks until Malitz receives and processes them. Malitz is considering the use of a lockbox system to reduce collection and processing float. The system will cost $6,500 per month and will consist of 10 local depository banks and a concentration bank located in San Francisco. Under this system, customers’ checks should be received at the lockbox locations 1 day after they are mailed, and daily totals will be transferred to San Francisco using wire transfers costing $9.75 each. Assume that Malitz has an opportunity cost of 10% and that there are 52 x 5 = 260 working days, hence 260 transfers from each lockbox location, in a year.

P15-4 cont.

a. What is the total annual cost of operating the lockbox system?

b. What is the benefit of the lockbox system to Malitz?

c. Should Malitz initiate the system?

Solution to 15-4

a. Annual CostsSystem Costs (6,500 x 12) 78,000Transfer costs (260 days x 9.75 x 10) 25,350Total Annual Operating Costs103,350

b. Benefit325,000 x (4 – 1) x 10% 97,500

c. No!!!

Marketable Securities

• Can be converted to cash on very short notice• Provide a modest return• Examples: Short-term time deposits and

trading securities• Principles in deciding marketable sec. vs cash– Reduced transaction costs– Needs for cash in times of opportunities

Inventories

• Classification– Supplies– Raw Materials– Work-in process– Finished Goods

• Inventory Costs– Carrying Costs– Ordering Costs– Opportunity costs in times of inventory shortage

Inventory Control System

• Control Procedures– Red-line method– Two-bin method

• Computerized Systems– Bar code and POS Terminals

• Just-In Time System• Out Sourcing

Receivables Management

• Average Receivables• Days sales outstanding (DSO)• Aging Schedule and Markov Analysis• Setting Credit Policy– Credit Period– Discount – Trade (Normal and seasonal) and Cash Discounts– Credit Standard– Collection policy (Out-pocket costs & Goodwill)– Profit Potential– Legal Consideration

END OF PRESENTATION