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FIN 2004 Finance Tutorial 10 :

Working Capital Management

Conducted by : Mr Chong Lock Kuah, CFA

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Key Concepts

• Working capital management decides the level of each type of current asset to hold and how to finance them.

• Operating cycle : time between acquiring the inventory and collecting the cash.

Operating cycle = inventory period + accounts receivable period

• Inventory period : time required to acquire and sell the inventory.

• Accounts receivable period (DSO or ACP) : time required to collect on credit sales.

• Cash Conversion Cycle : time between firm’s payment for inventory and collection on its sales.

cash conversion cycle or cash cycle = operating cycle – accounts payable period

= inventory period + account receivable period – accounts payable period

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The Operating Cycle

turnover sreceivable

365

Sales/365

sReceivable

=turnover

COGS/365

Inventoryor

Sales/365

Inventory

inventory

365=

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Key Concepts

• A cash budget is a weekly, monthly, or quarterly forecast of cash inflows and outflows.

• The budget indicates deficient or excessive cash balances, and financing plans are formulated based on it.

• Float is difference between cash balance in the bank and the cash balance recorded in the books

Float = Bank balance – Book balance

• Disbursement float is generated when a firm writes cheques

� Bank balance > book balance � Disbursement Float > 0

• Collection float occurs when the firm receives cheque

� Bank balance< book balance � Collection Float < 0

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Key Concepts

• Net float = Disbursement float + Collection float

• The net float at a point in time is simply the overall difference between the firm’s bank balance and its book balance

• If the firm is efficient, it will have positive net float.

• Firm can make use of float. This will save on financing cost.

• The disbursement float = the average dollar amount of cheques written x the average number of days for the cheques to clear

• The collection float is the average dollar amount of cheques received x the average number of days for the cheques to clear

Key Concepts

• Credit term includes (1) credit period and (2) discount given for early payment.

For example : 5/10 net 30

5 - percent discount for early payment

10 - number of days that the discount is available

net 30 - number of days before payment is due

DSO or ACP

= percentage of accounts taking the discount x the discount period + the percentage of accounts not taking the discount x the days’ until full payment is required.

The interest rate for the term of the discount can be calculated as :

Periodic interest rate = discount (%)/discount price (%) = 5/95 = 0.0526 for (30 -10) days

The effective annual rate = [ ( 1 + (discount/discount price) 365/extra day credit – 1 ]

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RWJ Chap 18 Q6

Consider the following financial statement information for the Mediate Corporation:

Calculate the operating and cash cycles. How do you interpret your answer?

56,384Cost of goods sold

$89,804Credit sales

7,9277,636Accounts payable

4,9384,108Accounts receivable

$11,380$9,780Inventory

EndingBeginningItem

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The operating cycle is the inventory period plus the receivables period. The inventory turnover and inventory period are:

Inventory turnover = COGS/Average inventoryInventory turnover = $56,384/[($9,780 + 11,380)/2] = 5.3293 times

Inventory period = 365 days/Inventory turnoverInventory period = 365 days/5.3293 = 68.49 days

And the receivables turnover and receivables period are:

Receivables turnover = Credit sales/Average receivablesReceivables turnover = $89,804/[($4,108 + 4,938)/2] = 19.8550 times

Receivables period = 365 days/Receivables turnoverReceivables period = 365 days/19.8550 = 18.38 days

So, the operating cycle is:

Operating cycle = 68.49 days + 18.38 days = 86.87 days

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The cash cycle is the operating cycle minus the payables period.

The payables turnover and payables period are:

Payables turnover = COGS/Average payablesPayables turnover = $56,384/[($7,636 + 7,927)/2] = 7.2459 times

Payables period = 365 days/Payables turnoverPayables period = 365 days/7.2459 = 50.37 days

So, the cash cycle is:

Cash cycle = 86.87 days – 50.37 days = 36.50 days

The firm is receiving cash on average 36.50 days after it pays its bills.

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RWJ Chap 18 Q11

Here are some important figures from the budget of Nashville Nougats, Inc., for the second quarter of 2009:

The company predicts that 5 percent of its credit sales will never be collected, 35 percent of its sales will be collected in the month of the sale, and the remaining 60 percent will be collected in the following month. Credit purchases will be paid in the month following the purchase.

In March 2009, credit sales were $245,000, and credit purchases were $168,000. Using this information, complete the following cash budget:

0147,00087,000Equipment purchases

13,10013,10013,100Interest

78,30051,00053,800Wages, taxes, and expenses

Cash disbursements

208,500176,300147,800Credit purchases

$438,000$364,000$390,000Credit sales

JuneMayApril

Sales collections = 0.35(current month sales) + 0.60(previous month sales)

Cash disbursements

Total cash available

Cash collections from credit sales

Cash receipts

$140,000Beginning cash balance

JuneMayApril

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Explanation:The sales collections each month will be:Sales collections = 0.35(current month sales) + 0.60(previous month sales)

$208,100$104,100$101,600Ending cash balance

$267,700$358,900$321,900Total cash disbursements

0147,00087,000Equipment purchases

13,10013,10013,100Interest

78,30051,00053,800Wages, taxes, and expenses

$176,300$147,800$168,000Purchases

Cash disbursements

475,800463,000$423,500Total cash available

371,700361,400283,500Cash collections from

credit sales

Cash receipts

$104,100$101,600$140,000Beginning cash balance

JuneMayApril

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RWJ Chap 18 Q13

You’ve worked out a line of credit arrangement that allows you to borrow up to $50 million at any time. The interest rate is 0.64% per month. In addition, 5% of the amount that you borrow must be deposited in a non-interest-bearing account. Assume that your bank uses compound interest on its line of credit loans.

a. What is the effective annual interest rate on this lending arrangement?b. Suppose you need $15million today and you repay it in six months. How

much interest will you pay?

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a. If you borrow $50,000,000 for one month, you will pay interest of:

Interest = $50,000,000(0.0064) = $320,000

However, with the compensating balance, you will only get the use of:

Amount received = $50,000,000 – 50,000,000(0.05)= $47,500,000

This means the periodic interest rate is:

Periodic interest = $320,000/$47,500,000 = 0.006737 or 0.674%

So, the EAR is:

EAR = [1 + ($320,000/$47,500,000)]12 – 1= 0.0839 or 8.39%

b. To end up with $15,000,000, you must borrow:

Amount to borrow = $15,000,000/(1 – 0.05) = $15,789,473.68

The total interest you will pay on the loan is:Total interest paid = $15,789,473.68(1.0064)6 – 15,789,473.68= 616,100.02

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RWJ Chap 19 Q2

Each business day, on average, a company writes checks totaling $14,000 to pay its suppliers. The usual clearing time for the checks is four days. Meanwhile, the company is receiving payments from itscustomers each day, in the form of checks, totaling $26,000. The cash from the payments is available to the firm after two days. (Do not include the dollar signs ($). Negative amounts should be indicated by a minus sign.)

a. Calculate the company’s disbursement float, collection float, and net float.

b. How would your answer to part (a) change if the collected funds were available in one day instead of two?

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(a) The disbursement float is the average monthly checks written times the average number of days for the checks to clear, so:

Disbursement float = 4($14,000) = $56,000

The collection float is the average monthly checks received times the average number of days for the checks to clear, so:

Collection float = 2(–$26,000) = –$52,000

The net float is the disbursement float plus the collection float, so:

Net float = $56,000 – 52,000 = $4,000

(b) The new collection float will be:

Collection float = 1(–$26,000) = –$26,000

And the new net float will be:

Net float = $56,000 – 26,000 = $30,000

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RWJ Chap 20 Q3

Kyoto Joe, Inc., sells earnings forecasts for Japanese securities. Its credit terms are 2/10, net 30. Based on experience, 65 percent of all customers will take the discount

a. What is the average collection period for Kyoto Joe?

b. If Kyoto Joe sells 1,300 forecasts every month at a price of $1,700 each, what is its average balance sheet amount in accounts receivable?

(a) The average collection period is the percentage of accounts taking the discount times the discount period, plus the percentage of accounts not taking the discount times the days’ until full payment is required, so:

Average collection period = 0.65(10 days) + 0.35(30 days)Average collection period = 17 days

(b) And the average daily balance is:

Average balance = 1,300($1,700)(17)(12/365)Average balance = $1,235,178.08

We multiply by 12 to calculate the average yearly AR. To calculate average daily we divide by 365

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RWJ Chap 20 Q5

A Firm offers terms of 1/10, net 35. What effective annual interest rate does the firm earn when a customer does not take the discount? Without doing any calculations, explain what will happen to this effective rate if:

a. This discount is changed to 2%.

b. The credit period is increased to 60 days.

c. The discount period is increased to 15 days.

The interest rate for the term of the discount is:

Interest rate = 0.01/0.99Interest rate = 0.0101 or 1.01%

And the interest is for:35 – 10 = 25 daysm=365/25

So, using the EAR equation, the effective annual interest rate is:

EAR = (1 + Periodic rate)m – 1EAR = (1.0101)365/25 – 1EAR = 0.1580 or 15.80%

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(a) This discount is changed to 2%.

From the equation, it can be seen that EAR will increase

(b) The credit period is increased to 60 daysFrom the equation, extra day credit will increase, EAR will decrease

(c) The discount period is increased to 15 days.

From the equation, extra day credit will decrease, EAR will increase

The effective annual rate =

[ ( 1 + (discount/discount price) 365/extra day credit – 1 ]