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
working capital focuses on inventories.
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
Inventories
Raw materials and components
Work-in-progress
Trade debtors
Loans and advances
Bills Receivable
Marketable securities
Cash and bank balances
Sundry creditors
Bills payable
Outstanding expenses
Trade advances
Borrowings
Provisions
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
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
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.
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
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
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, goodwill, disruption of production schedules)
Inventories are supplies, raw materials, work-in-
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
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
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
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 sales more profitable than cash sales
It is unsecured short term pro 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
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
Factoring is on a recourse basis