Copyright © 2014 Nelson Education Ltd. 6–1 PowerPoint Presentations for Finance for Non-Financial...

Copyright © 2014 Nelson Education Ltd. 6–1

PowerPoint Presentations for

Finance for Non-Financial Managers:

Seventh Edition

Prepared by

Pierre BergeronUniversity of Ottawa


CHAPTER 6

Working Capital Management


1. Explain the meaning of working capital and how it can be measured.

2. Discuss the flow of cash via the cash conversion cycle.

3. Describe several strategies for managing inventories.

4. Explore techniques for managing trade receivables.

5. Comment on managing cash and cash equivalents.

6. Explain how to manage current liability accounts to improve the cash flow cycle.

Learning Objectives


• Working capital management involves:– management of individual current assets, current

liabilities, and interrelationships that link current assets with current liabilities and with other statement of financial position accounts

Meaning of Working Capital LO 1


Net working capital is defined as current assets minus current liabilities.

Meaning of Working Capital

Inventories $ 70,000

Trade receivables 30,000

Notes receivable 5,000

Prepaid expenses 3,000

Marketable securities 10,000

Cash 10,000

Total current assets $128,000

Working Capital

Current assetsTrade and other payables $ 56,000

Notes payables 20,000

Accrued expenses 4,000

Taxes payable 8,000

Total current liabilities $ 88,000

Current liabilities

LO 1


Cash Conversion Cycle

Purchase decision and

order

Credit decision

Purchase of raw materials

Delivery of raw materials

Inventory of raw materials

Manufacturing

Inventory of finished goods

Shipment

Payment to suppliers

Billing

Payment by customer

Processing payment

DepositCash

5 5

19

10

8

9 15

4

- 30

60

12

5 60

7

Existing 209 days

Target 160 days

Reduction 49 days

LO 2


Cash Flow of Working Capital Accounts LO 2


Using Futurama Ltd. (Slides 3-8 and 3-10)

Purpose: Measures the amount of days in working capital a business holds in order to meet its average daily sales requirements.

(Inventories + Trade receivables) - Trade payables

Revenue ÷ 365

($218,000 + $300,000) - $195,000

$2,500,000 ÷ 365

$323,000

$6,940

Days of Working Capital (DWC)

=

=

= 47.2 days

LO 2


Using Futurama Ltd. (Slides 3-6 and 3-8)

Purpose Measures the efficiency with which a business converts revenue to cash flow from operations.

Cash flow from operations

Revenue

$126,000

$2,500,000

Cash Conversion Efficiency (CCE)

=

= 5.1%

LO 2


• Goal– to replenish stocking points in such a

way as to minimize the total of all associated costs, and thereby enhance profitability of the business

Managing Inventories LO 3


• Types of inventories1. Raw Materials

• lumber, steel, rubber, plastics, chemicals, paint and other finishing substances, supplies, and parts

2. Work-in-Progress • partially assembled or partially processed, not yet

completed

3. Finished Goods • goods completed and ready to be sold for resale by

wholesaling and retailing firms

Managing Inventories LO 3


Inventory Levels LO 3


Inventory Decisions LO 3

Order And Set-up Costs Holding Costs

Transportation costs Storage costs

Clerical costs of making orders Fire insurance

Cost of placing goods in storage Property taxes

Downtime on equipment Spoilage and deterioration

Quantity discounts Cost of borrowing

Rent of facilities

Obsolescence


Calculating the Economic Order Quantity

Number Order Annual Average Average Annual Ordering cost of quantity order cost unit dollar holding +orders (units) $50.00 inventory investment costs Holding cost

per order (2) ÷ 2 (4) × $ 5.35 (5) × 15% (3) + (6) 1 2 3 4 5 6 7

1

2

5

6

8

10

5,000

2,500

1,000

833

625

500

50

100

250

300

400

500

2,500

1,250

500

416

312

250

13,375

6,687

2,675

2,226

1,669

1,337

2,006

1,003

401

334

250

200

2,056

1,103

651

634

650

700

LO 3


Here’s the proof:

Annual order costs (6 × $50.00) = $300.00Annual carrying costs($5.35 × 790 = $4,226 ÷ 2 × 15%) = $317.00

Total inventory costs = $617.00

Economic Order QuantityF = Fixed costs per order

(clerical, processing, payment, receiving, verification, shelving) = $50.00

U = Units sold per year = 5,000

C = Carrying costs per unit/per year = $0.80(storage, insurance, rent, spoilage, interest charges)

EOQ =

EOQ = = 790 units

2 FU

C

2 × $50.00 × 5,000

$0.80

$5.35 ×15%

LO 3


• Goal:– to set credit terms, grant credit to

customers, monitor payment patterns, and apply necessary collection procedures so as to increase profitability

Managing Trade Receivables LO 4


Managing Trade Receivables

Credit policy consists of choosing the appropriate credit terms to offer to customers (present and future). Terms differ from product to product and industry to industry.

Example: Selling price $120.00

Cost of product $ 90.00

Cost of capital 10%

Should the company grant 2/10, net 30 days?

$90.00 × 10% × = $1.4860-day delay

365 days

Effective priceCost of productCredit costsFinance costsProfit

-$ _________ _________ _________

+ _________$ _________

-$ _________ _________ _________

+ _________$ _________

10-day payment 60-day payment

117.60 120.00 90.00 90.00

28.96 28.52 1.61 ---

.25 1.48

LO 4


Grant Credit to Customers (Credit Report)LO 4


Return on investment = = = 14.6%

Changing Credit Terms

Incremental profit $27,000

Incremental investment $185,400

Expected volume (units)

Expected revenue ($10.00 per unit)

Expected profit before bad debts (10% of revenue)

Expected bad debt expense (% of revenue)

Expected profit (after bad debts)

Incremental profit

Expected collection period (days)

Average trade receivables

Incremental investment

Return on investment calculation for changing the firm’s credit terms

Existing terms

400,000

4,000,000

400,000

20,000 (.5%)

380,000

---

29

315,800

-----

Existing terms

440,000

4,400,000

440,000

33,000 (.75%)

407,000

27,000

42

501,200

185,400

LO 4


• Goal: – To reduce the amount of cash that is

being used within the firm to increase profitability, but without reducing business activities or exposing the firm to undue risk in its financial obligations

Managing Cash and Cash Equivalents LO 5


Cash flows in connection with credit serve to introduce the

concept of _________, which is the time lag or delay

between the moment of disbursement of funds on the part

of the customer and the moment of receipt of funds on the

part of the seller (i.e., mail time, processing time, and

clearing time with the banking system).

Managing Cash and Cash Equivalents

$20,000 × 12% × = $131.5120 days late for payment

365 days

FLOAT

LO 5


Ways to Improve Collection of Cash

1. Change customer paying habits• Letters, telephone calls, or personal

visits• Economic incentive for paying bills

faster–offer discounts (i.e., 2/10, N/30)

continued…

LO 5



2. Improve the delivery system (reduce the negative float)• Regional banking

– customers pay bills to banks since they can transfer funds more quickly than mail order delivery.

• Lockbox collection system – firm rents post office box and bank monitors the

lockbox periodically• Electronic communications

– Example: data-phone wire systems

continued…

LO 5



3. Bypass the problem • Factoring of trade receivables

LO 5


Managing Current Liability Accounts

• Trade and other payables

• Working capital loans

• Short-term loans made to finance

working capital accounts

• Examples: inventories, trade

receivables

LO 6

Copyright © 2014 Nelson Education Ltd. 6–1 PowerPoint Presentations for Finance for Non-Financial...

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