Chapter 15 Managing Current Assets

LEARNING OBJECTIVES

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 categories of inventory costs. Identify systems. and briefly explain management the use of by and identify the three control DSO and

several

inventory its

Monitor a firms receivables reviewing aging schedules.

position

calculating

List and explain the four elements of a firms credit policy, and identify other factors influencing credit policy.

Learning Objectives: 15 - 1

LECTURE SUGGESTIONS

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 thats 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

ANSWERS TO END-OF-CHAPTER QUESTIONS

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. 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. 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 firms 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.

15-2

15-3

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. False. Both accounts will record the same transaction amount.

15-5 15-6

The four elements in a firms 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 firms credit policy has

Integrated Case: 15 - 3

15-7

an important influence on its volume of sales, and thus on its profitability. The latest date for paying and taking discounts is May 10. The date by which the payment must be made is June 9. a.

15-8

$312, 000 Accountsreceivable D a y ss a l e s = = outs tandg n i $2 920, , 000 /365 Sales/365

=

$312 000 , = 39 days. $8,000/day

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. The firm tightens its credit standards. b. The terms of trade are changed from 2/10, net 30, to 3/10, net 30. c. The terms are changed from 2/10 net 30, to 3/10, net 40. d. The credit manager gets tough with past-due accounts. 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 A/R 0 0 Sales + + Profit 0 0 0 0

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 firms purchasing costs. The firm can reduce its finished goods inventory by manufacturing to meet orders, or by shipping goods to customers at the firms 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

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

15-1

Net Float = Disbursement float - Collections float = (4 $10,000) - (3 $10,000) = $10,000. Sales = $10,000,000; S/I = 2 . Inventory = S/2 =

15-2

$10, 000, 000 2

= $5,000,000.

If S/I = 5 , how much cash is freed up? Inventory = S/5 =

$10, 000, 000 5

= $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 = ?

A/R S/365 A/R 17 = $3,500 A/R = 17 $3,500 = $59,500.

DSO = 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 =

on n R e d u c t ii n D a i l y O p p o r t u y i t d a y s f f l o a t c o l l e c t s o n c o s t o i

= (3)($325,000)(0.10) = $97,500. c. Net gain (loss) = $97,500 - $103,350 = -$5,850.

Integrated Case: 15 - 6

15-5

Malitz should not initiate the lockbox system since it will cost the firm $5,850 more than it will earn on the freed funds. 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 = 16.79 16.79 16.79 16.79ADS ADS = = = = =

Acct. Rec. Inv. Acct. Pay. + Avg. Daily Sales Avg. Daily Sales Avg. Daily COGS ($47,000/ADS) + ($66,000/ADS) - ($72,000/0.8ADS) ($47,000/ADS) + ($66,000/ADS) - ($90,000/ADS) $23,000/ADS $23,000 $1,369.863.
annual sales equal $500,000 ($1,369.863 365 =

Therefore, $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 = COGS) CCC = CCC = CCC = 15-7 (AR/Avg. Daily Sales) + (Inv/Avg. Daily Sales) - (AP/Avg. Daily ($47,000/$1,369.863) + ($66,000/$1,369.863) - ($61,375/$958.90) 34.31 + 48.18 - 64.01 18.48 days.

a. Cash conversion cycle = 22 + 40 - 30 = 32 days. b. Working capital financing = 1,500 32 $6 = $288,000.

Integrated Case: 15 - 7

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 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.

I n v e n t o r y R e c e i v a b l eP a y a b l e s s 15-8 a. CCC = c o n v e r s i + nc o l l e c t i o nd e f e r r a l o period period period

= 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.

I n v e n t o r y R e c e i v a b l eP a y a b l e s s CCC = c o n v e r s i + nc o l l e c t i o nd e f e r r a l o period period period

= 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

Integrated Case: 15 - 9

15-10 a. Return on equity may be computed as follows: Tight Current assets (% of sales $1,200,000 Fixed assets Total assets Sales) 1,000,000 $1,900,000 $ Moderate 900,000 1,000,000 $2,000,000 $1,140,000 760,000 $1,900,000 $ $ 800,000 $2,000,000 $ Relaxed $1,000,000 1,000,000 $2,200,000 $1,200,000 880,000 $2,200,000 240,000 $ $ $

Debt (60% of assets) $1,320,000 Equity Total liab./equity EBIT (12% 240,000 Interest (8%) Earnings before taxes Taxes (40%) Net income Return on equity $2 million)

240,000 $

91,200 148,800 59,520 $ 89,280 11.75%

96,000 144,000 57,600 $ 86,400 10.80%

105,600 134,400 53,760 80,640 9.16%

b. No, this assumption would probably not be valid in a real world situation. A firms 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 firms ability to handle contingencies would be impaired. Higher risk of inadequate liquidity would increase the firms 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 - 10

15-11 a. Day 1 Deposit $1,200,000; write check for $1,600,000. Write check for $1,600,000. Write check for $1,600,000. Write check for $1,600,000. Write check for $1,600,000; deposit $1,600,000.

Firms checkbook -$ 400,000

Banks records $1,200,000 $1,200,000 $1,200,000 $1,200,000

Day 2 Day 3 Day 4 Day 5

-$2,000,000 -$3,600,000 -$5,200,000

-$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 banks 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 $1,400,000 2 days = $7,000,000 = 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 - 11

c. $420,000/12 = $35,000 = maximum monthly charge HGC can pay for the lockbox system. 15-13 a. Helens Fashion Designs Cash Budget, July-December 2003 I.
Sales

Collections and Payments:

May $180,000 June $180,000 18,000 135,000 0 90,000 90,000 July $360,000 36,000 135,000 27,000 $198,000 126,000 90,000 August $540,000 54,000 270,000 27,000 $351,000 882,000 126,000 September October $720,000 $360,000 72,000 405,000 54,000 $531,000 306,000 882,000 36,000 540,000 81,000 $657,000 234,000 306,000 November $360,000 36,000 270,000 108,000 $414,000 162,000 234,000 December January $ 90,000 $180,000 9,000 270,000 54,000 $333,000 90,000 162,000

Collections: 1st month 18,000 2nd month 0 3rd month 0 Total collections Purchases Payments (1-mo. lag) 90,000

II.

Gain or Loss for Month:

July $198,000 90,000 27,000 9,000 2,700 0 0 $128,700 $ 69,300 August $351,000 126,000 27,000 9,000 2,700 0 0 $164,700 September $531,000 882,000 27,000 9,000 2,700 63,000 0 $983,700 October $657,000 306,000 27,000 9,000 2,700 0 180,000 $524,700 November $414,000 234,000 27,000 9,000 2,700 0 0 $272,700 $141,300 December $333,000 162,000 27,000 9,000 2,700 63,000 0 $263,700 $ 69,300

Receipts: Collections Payments: Labor and raw materials Administrative salaries Lease payment Misc. expenses Income tax Progress payment Total payments Net cash gain (loss)

$186,300 ($452,700) $132,300

III.

Cash Surplus or Loan Requirements:

July $132,000 201,300 90,000 $111,300 August $201,300 387,600 90,000 September October November $387,600 ($ 65,100) $ 67,200 (65,100) 90,000 67,200 90,000 208,500 90,000 December $208,500 277,800 90,000 $187,800

Cash at start of month w/o loans Cumulative cash Less: Target cash balance Cumulative surplus cash or total loans outstanding to maintain target balance

$297,600 ($155,100) ($22,800) $118,500

b. The cash budget indicates that Helen will have surplus funds available during July, August, November, and December. During September the company will need to borrow $155,100. The cash surplus that accrues during October will enable Helen to reduce the loan balance outstanding to $22,800 by the end of October. c. In a situation such as this, where inflows and outflows are not synchronized during the month, it may not be possible to use a cash budget centered on the end of the month. The cash budget should be set up to show the cash positions of the firm on the 5th of each month. In this way the company could establish its maximum cash requirement and use these maximum figures to estimate its required line of credit. The table below shows the status of the cash account on selected dates within the month of July. It shows how the inflows accumulate steadily throughout the month and how the requirement of paying all Integrated Case: 15 - 12

the outflows on the 5th of the month requires that the firm obtain external financing. By July 14, however, the firm reaches the point where the inflows have offset the outflows, and by July 30 we see that the monthly totals agree with the cash budget developed earlier in Part a.
Opening balance Cumulative inflows (1/30 receipts no. of days) Total cash available Outflow Net cash position Target cash balance 7/2/03 $132,000 7/4/03 $132,000 7/5/03 $132,000 7/6/03 $132,000 7/14/03 $132,000 7/30/03 $132,000

13,200 $145,200 0 $145,200 90,000

26,400 $158,400 0 $158,400 90,000

33,000 $165,000 128,700 $ 36,300 90,000

39,600 $171,600 128,700 $ 42,900 90,000

92,400 $224,400 128,700 $ 95,700 90,000 5,700

198,000 $330,000 128,700 $201,300 90,000 $111,300

Cash above 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 firms ability to obtain bank credit.

Integrated Case: 15 - 13