It is concerned with decisions relating to current assets and current liabilities
Best Buy Co, NA’s largest consumer electronics retailer, has performed extremely well over the past decade. Its stock sold for $50 in late 2007 up from $2 ten years earlier. Its excellent performance stemmed from sound financial and operating
practices, especially in working capital management.
WCM involves finding optimal levels for cash marketable securities, accounts receivable and inventory and then financing that working capital for the least cost. Most of best buy’s customers use credit cards, so neither in-store cash nor accounts receivable is significant. Therefore Best buy’s
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To maintain sales, its stores must be well stocked with the goods customers are seeking at the time they are shopping. This involves determining what new products are hot, determining where they can be obtained at the lowest cost and delivering them to stores in a timely manner.
Dramatic improvements in communications and computer technology have transformed the way Best Buy manages its inventories. It now collects real-time data from each store on how each
products is selling and its computers place orders automatically to keep the shelves full. Moreover, if sales of an item are slipping, prices are lowered to recue stocks of that item before the situation gets so bad that drastic price cuts are necessary.
Working capital needs to be managed to maximize profits and stock prices.
Inventories
Raw materials and components
Work-in-progress
Trade debtors
Loans and advances
Bills Receivable
Marketable securities
Sundry creditors
Bills payable
Outstanding expenses
Trade advances
Borrowings
Provisions
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Gross working capital is the total of all current assets
Net working capital = current assets - current liabilities
The working capital cycle can often be expressed as a period of time (60 days)
Current ratio and Quick ratio
Cash budget is an estimate of future cash inflows and outflows
Characteristics of current assets
Short life span
Swift transformation into other asset forms
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ROE = Profit margin x assets turnover x leverage factor
The top line has the steepest slope which indicates that the firm holds a great deal of cash,
marketable securities, receivables and inventories relative to its sales. When receivables are high, the firm has a liberal credit policy, which results in a high level of accounts receivable. It results in a low turnover, which in turn lowers ROE.
If the firm has a lean and mean investment policy, holdings of current assets are minimized. This
results in a high ROE. Risks – material shortages can lead to work stoppages, unhappy customers etc.
A moderate investment policy lies between the two
Relaxed current asset investment policy – under conditions of uncertainty, there is requirement for safety stock and tight credit policy to customers, hence large current assets are carried
Restricted current asset investment policy – under conditions of certainty, when sales, costs, lead
times, payment periods are all known for sure, current assets are turned over more frequently
Moderate current asset investment policy
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Operating cycle is the time that elapses between the purchase of raw materials and the collection of cash for sales. It is divided into 4 stages: raw
materials, WIP, finished goods inventory and debtors collection
= Inventory conversion period + accounts receivable period
Cash conversion cycle is the time length between the payment for raw material purchases and the collection of cash for sales
Inventory conversion period + accounts receivable period – accounts payable period
Jan: credit purchase of Raw Materials – creates accounts payable
Feb: labor used in production – wages not paid immediately – accrued wages
Mar: finished computers sold on credit – creates accounts receivable
Apr: payment of accounts payable through bank loan
May: collection of accounts receivable and repayment of bank loan
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Inventory conversion period is time required to convert materials into finished goods and to sell those goods
= average inventory/cost of goods sold per day
Accounts receivables period is time required to convert receivables into cash
= average AR/sales per day
Accounts payable period is time between purchase of materials and payment of cash for them
= average AP/cost of goods per day
Cash conversion cycle = inventory conversion
period + Average receivables (collection) period – Accounts payable (deferral) period
General nature of business
Seasonality of operations
Production cycle
Business cycle
Credit policy
Growth and expansion
Production policy
Market conditions
Reported as cash and cash equivalents in the balance sheet
Marketable securities - Very liquid securities that can be converted into cash quickly at a reasonable price.
They tend to have maturities of less than one year.
Furthermore, the rate at which these securities can be bought or sold has little effect on their prices.
Examples of marketable securities include commercial paper, banker's acceptances, bank certificates,
Treasury bills and other money market instruments.
Case of Microsoft – one time dividend, stock repurchase program, retiring debt, acquiring firms, financing major expansions etc.
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Short term securities that can be bought and
sold at short notice
Securities are held mostly for precautionary
purposes but earn returns
Invest in securities when interest rates are high
otherwise it is expensive and time consuming to
convert them into cash
Firm which have high growth rate
Firms with volatile cash flow
Small new firms which do not have exceptional credit ratings
Hold marketable securities rather than demand deposits to provide liquidity
Borrow on short notice by establishing lines of credit
Forecast payments and receipts better
Speed up receipts
Lockboxes
Wire transfer
Use credit cards, debit cards and direct deposits
Synchronize cash flows by using billing cycles
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Cash discounts on cash payment to suppliers
Maintain and improve its credit rating
Take advantage of favorable business opportunities
Meet emergencies
An estimate of receipts, disbursements and cash balances for a firm over a specified future period
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Goals of inventory management
To ensure that inventories needed to sustain
operations are available
To hold the costs of ordering and carrying
inventories to the lowest possible level
Types of costs
Ordering & Receiving costs (cost of placing orders, shipping and handling costs)
Carrying costs (warehouse rent, interest on capital locked up, insurance, property taxes, spoilage,
depreciation and obsolescence, pilferage)
Shortage or stockout costs (loss of sales, customer,
What should be the size of the order?
When should the order be placed?
Assumptions:
The forecast demand for a period is known
Orders can be replenished quickly
The only costs are ordering and carrying
The cost per order does not change with size
Cost of carrying is a percentage of inventory
value
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Inventory is divided into 3 groups:
‘A’ group consists of items with the largest dollar investment. This group consists of 20 percent of the firm’s inventory items but 80 percent of the investment in inventory
‘B’ group consists of items that account for the next largest investment in inventory.
The ‘C’ group consist of a large number of items that require a relatively small investment.
It implies that a firm should maintain a minimal level of inventory and rely on suppliers to provide parts and
components just in time to meet its assembly requirements
It requires
a strong and dependable relationship with suppliers who are geographically not very remote from the mfg facility
a reliable transportation system
an easy physical access in the form of enough doors and conveniently located docks and storage areas to dovetail incoming supplies to the needs of assembly line
impeccable quality maintenance of component parts by the supplier
Lowers the ordering cost and also the safety stock by forging stronger long term relationship with the
suppliers, average inventory level is lower
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Steady production vs seasonal production – average inventory higher for all round the year production than if production varies with change in sales
Outsourcing
Components purchased rather than made – in combination with JIT - lower inventory levels
Supply Chain Management
A sole trader having $800 capital buys stock for
$800. The next day he sells the stock on a 10
day credit for $1000 and takes an overdraft of
$800 for stock purchase.
Accounts receivable is determined by
Volume of credit sales
Average time between sales and collection
Increase in receivables must be financed in
some way
Entire amount of receivables need not be
financed because of the profit component
which does not involve any cash flow
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Credit period: 2 / 10, net 30; lengthening the credit period pushes sales up, lengthens cash conversion cycle, requires larger
investment in debtors, leads to higher incidence of bad debts loss
Cash discount and trade discount
Should attract new customers
Will increase cash flow
Credit standards: 5 C’s of credit are character, capacity, capital, collateral and conditions on which information is received from financial statements, bank references, firm experiences and stock market data
Collection policy: procedure that the firm follows to collect accounts receivable
Profit potential in granting credit through carrying charges levied on credit sales (nominal and effective interest rates) makes credit
Boston Lumber Company, wholesale distributor of lumber products has credit sales of $1000 per day and a collection period of 10 days. It must have capital to carry $10,000 worth of receivables.
Accounts Receivables = sales/day x length of collection period
What will be the impact if sales double or collection period increases?
DSO = Receivables / Average sales per day
Receivables is $375 and Annual Sales turnover is
$3000 , Days Sales Outstanding = 46 days
The DSO can be compared to industry average (36 days) or to the firm’s own credit terms (30 days)
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Accrued liabilities – outstanding rent
Accounts payable or trade credit from suppliers
Bank Finance
Cash credits / overdrafts
Loans
Bill discounting: the seller draws a bill on the
purchaser, on acceptance it is discounted with the
bank, who collects the full amount from the buyer on the due date
Letter of credit: an indirect form of financing whereby a bank undertakes the responsibility to honor the obligation of its customer, this helps the
Fixed or floating interest rate
Interest only vs amortized loans
Collateral Security in the form of hypothecation or pledge
Maturity period – may or may not have maturity period
Restrictive covenants
Loan guarantees by stockholders
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A formal line of credit where the customer pays a
commitment fee and is then allowed to use the funds when they are needed. It is usually used for operating purposes, fluctuating each month depending on
customer's current cash flow needs.
FI considers several factors that determine a borrower's ability to repay to decide on the maximum amount of credit (credit limit)
Revolving credit borrowers are only required to pay
interest on the amount borrowed, plus commitment fees on amount not borrowed
It is unsecured short term promissory notes of large firms with high credit rating having an interest rate
below the prime rate (a published interest rate charged by commercial banks to large, strong borrowers)
Maturity period ranges from 90 to 180 days
Generally sold at a discount from its face value and redeemed at its face value, difference constitutes interest.
No well developed secondary market
The minimum size of commercial paper issue is Rs.2.5 and in denominations of half a million or more
Commercial paper is not backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.
The proceeds from this type of financing can only be used on current assets (inventories) and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement.
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A factor is a financial institution which offers services relating to management and financing of debts arising from credit sales, which ensures a definite pattern of cash inflows from credit sales of an organization and eliminates the need for credit and collection
department
RBI authorized public sector banks that do factoring:
SBI, Canbank, PNB, Bank of Allahabad
selects the accounts of the client and establishes the credit limits
factor assumes responsibility for collecting the debt
Advances money against not yet collected / not yet due accounts
