Short-term Financial Management

1
Short-term Financial Management
Terry S. Maness and John T. Zietlow Adapted by
Dorla Evans
Fall 2009
2
The Role of Working Capital
1 cause of business failure
3
Long-term Versus Short-term Decisions
Cash Accounts Payable Marketable
Securities Accruals Accounts Receivable Notes
Payable Prepaid Expenses Current Long-term
Debt Other Current Assets Other Current
Liabilities Current Assets Short-term
Liabilities Fixed Assets Long-term Debt
Total Assets Equity Total Claims
LT Decisions Capital budgeting and capital
structure ST Decisions Cash mgt, credit mgt,
inventory mgt, short-term investments, short-term
financing
4
View firm as a system of cash flows
Sales
Inv
A /R
Cash
5
The Cash Flow Timeline
Order Order Sale
Cash Placed Received
Received

lt Inventory gt
lt A/R collection period gt
ltholding periodgt Time gt lt
A/P payment period gt lt cash conversion cycle
gt Invoice
Cash
Received Paid
6
...in the beginning
Balance Sheet - June
1 Cash 1,000 Debt 500
Common Stock 500 Total
1,000 Total
1,000
7
The Next Day, June 2
Balance Sheet - June 2 Purchase Fixed
Assets and Inventory Cash
400 A/P 300 Inventory
300 Debt 500 Fixed Assets 600
Common Stock 500 Total
1,300 Total 1,300
8
End of June
Balance Sheet - June 30 Sale of
product, incur operating expenses, incur
depreciation, and generate profit Cash
325 A/P 300 A/R 700 Accruals
200 Inventory 0 Debt
500 Fixed Assets 600 Common
Stock 500 (Accum Depr) (100) Retained
Earnings 25 Total 1,525 Total 1,525
9
July 1
Balance Sheet - July 1 Pay
operating accruals with cash Cash
125 A/P 300 A/R 700 Accruals
0 Inventory 0 Debt
500 Fixed Assets 600 Common
Stock 500 (Accum Depr) (100) Retained
Earnings 25 Total
1,325 Total 1,325
10
July 15
Balance Sheet - July 15
Pay payables with cash Cash (
175) A/P 0 A/R 700 Accruals
0 Inventory 0 Debt
500 Fixed Assets 600 Common
Stock 500 (Accum Depr) (100) Retained
Earnings 25 Total 1,025 Total 1,025
11
July 31
Balance Sheet - July 31
Collect accounts receivable Cash
525 A/P 0 A/R 0 Accruals
0 Inventory 0 Debt
500 Fixed Assets 600 Common
Stock 500 (Accum Depr) (100) Retained
Earnings 25 Total 1,025 Total 1,025
12
Profit versus Cash Flow

• Question Why did the firm end up with 125 in
  additional cash while earning a profit of 25?
• Question Why did the firm run out of cash during
  its operating cycle?

LuSals Fashions
13
Important Points

• The firm must manage its cost structure to
  generate a profit
• WC accounts must be managed so that liquidity is
  maintained.

14
Re The Cash Flow Timeline
Order Order Sale
Cash Placed Received
Received

lt Inventory gt
lt A/R collection period gt
ltholding periodgt Time gt lt
A/P payment period gt lt cash conversion cycle
gt Invoice
Cash
Received Paid
15
Cash Conversion Cycle (CCC)

• Difference in time that cash is tied up in
  inventory and A/R (operating cycle) and the time
  that cash is provided by suppliers (A/P payment
  period)
• The longer the cash conversion cycle, the longer
  our customers have our funds in their hands, and
  the higher the financing requirement.

16
Conversion from Accrual Income to Cash Flow
Income Statement Adjustment Account Cash Flow
Account Sales - Change in accounts
receivable Cash collected Cost of goods sold -
Change in accounts payable Change in
inventory Cash paid to suppliers Operating
expenses - Change in operating accruals
Depreciation Cash paid for
operating expenses Interest - Change in
accrued interest Cash paid to
creditors Taxes - Change in accrued taxes -
Change in deferred taxes Cash paid for
taxes _________________ ___________________ Ne
t Profit Operating Cash Flow
17
Managing the Cash Cycle

• Managing Inventory
• Managing Receivables
• Managing Payables
• Electronic Commerce

18
Objectives of WC Manager

• Objectives of the firm
• Maximize stockholder wealth
• Maximize stock price
• Maximize the present value of the cash flows
  (size, timing, riskiness)
• Objectives of WC manager must be consistent
• Maximize net present value of net operating cash
  flows (cash inflows - cash outflows)
• Subject to Legal and ethical considerations,
  system capabilities, need for adequate liquidity,
  need to maintain good customer and supplier
  relations

19
How to Attain Objective

• Speed cash inflows
• Slow cash outflows
• Minimize idle cash
• Minimize transaction costs
• Minimize administrative costs

20
Complications

• Conflicts with actions Marketable securities
  require transaction costs but allow us to
  minimize idle cash
• Conflicts within firm Marketing wants the easy
  credit terms to maximize salary. Financial
  manager may find cost of easy credit terms
  outweighs benefits.

21
Summary

• Firm must operate at a profitable level
• A profitable firm may still struggle financially
• Working capital soaks up cash flow and may cause
  an otherwise profitable firm to fail
• A successful firms operation is managed from a
• profit and a
• cash flow perspective

22
Analysis of Solvency, Liquidity, and Financial
Flexibility
23
Solvency and its Measures

• Condition when firms assets are larger than its
  liabilities.
• Measures
• Current Ratio
• Quick Ratio
• Net Working Capital
• Working Capital Requirements
• Net Liquid Balance

24
Current Ratio
Current
assets Current ratio ------------------------
- Current
liabilities
60,403 Current ratio --------------
0.86
70,338 Current ratio 2003 2004 2005 2006 2007 G
M 1.79 1.81 1.51 0.71 0.86 Toyota 1.22 1.16 1.1
5 1.07 1.00
25
Quick Ratio
Current assets -
Inventories Quick ratio ---------------------
----------------
Current liabilities
60,403 - 14,939 Quick ratio
--------------------------- 0.65
70,338 Quick ratio
2003 2004 2005 2006 2007 GM 1.55 1.59 1.31 0.54
0.65 Toyota 0.96 0.89 0.87 0.81 0.76
26
Net Working Capital
Net working capital CA - CL Net working
capital 60,403 70,338
-9,935 NWC per share
-9,935/566 -17.55 NWC 2003 2004 2005 200
6 2007 GM 179.26 205.53 165.68 -42.66 -17.55 Toyo
ta 7.56 7.11 6.91 3.71 .09
27
Net Working Capital
CA CL

• CA - CL
• Portion of current assets financed with permanent
  funds

A/P
N/P
Accruals
28
Working Capital Requirements
Spontaneous assets liabilities
CA CL
A/P
Accruals
Accruals

WCR A/R INV Prepaids - A/P - Accruals
29
Working Capital Requirements to Sales
(9.714.90) -
(29.533.6) WCR/S ------------------------
---------------- 181.2 -38.5
----------- -.21
181.2 WCR/S 2003 2004 2005 2006 2007 GM .76
.85 .74 -.26 -.21 Toyota .19 .16 .17 .19 .19

30
Net Liquid Balance
Financial assets - nonspontaneous liabilities
CA CL
A/P
N/P
N/P
Accrual
Accrual
NLB Cash M/S- N/P - CMLTD
31
Net Liquid Balance
Net liquid balance Cash Equiv. - (N/P
CMLTD) Net liquid balance 27.0 - (4.1
1.9) (20.9 B) Net liquid balance
2003 2004 2005 2006
2007 GM (48.1) (57.1) (51.6)
18.6 20.9 Toyota (7.2) (10.1)
(13.4) (21.3) (29.7)
32
Liquidity

• Ingredients
• Time
• Amount of loss
• Cost
• Having enough financial resources to cover
  financial obligations in a timely manner with
  minimal costs
• Ability to generate cash to take advantage of
  investment opportunities.

33
Framework for Studying Liquidity

• Amount and trend of internal cash flow
• Aggregate available credit lines preapproved by
  bank
• Attractiveness of firms commercial paper and
  other financial instruments
• Overall expertise of management

34
Advantages of Liquidity

• Advantages
• Provides financing flexibility
• Many creditors interested in giving credit
• Lowers costs of borrowing

• Disadvantages of illiquidity
• Management spends more time on short-term cash
  crises
• Management not focused on future opportunities
• Increases borrowing costs
• Suppliers tighten credit terms
• Reduces float
• Management may be forced to declare bankruptcy

35
Liquidity Measures

• Cash Flow From Operations
• EBIT Depr Taxes
• NI Depr
• Cash Conversion Period

36
Cash Flow From Operations
GM 2003 2004 2005 2006 2007 (
Billions) 7.9 9.4 -16.9 -11.8
7.7 .04 .05 -.09 -.06
.04 Toyota ( Billions) 17.3 21.6
22.1 21.4 27.4 .13 .13 .13
.12 .14
Cash Conversion Efficiency CFFO/Sales
37
Cash Conversion Chart
Inventory
Inventory
Cash stocked
sold
received Days
inventory held Days
sales outstanding Days
payables outstanding Cash
conversion

period
Cash

disbursed
38
Cash Conversion Period Calculations
GM Cash conversion period DIH DSO -
DPO (Days) 2003
2004 2005 2006 2007 DIH
73 78 79 57
33 DSO 303 315
359 180 18
------- ------
------ ------ ------ Operating cycle
375 394 439 237
51 DPO 68 73 70
62 68 ------- -------
------- ------- ------- CCC
307 321 369
175 -17
39
Cash Conversion Period Calculations
Toyota Cash conversion period DIH DSO -
DPO (Days) 2003 2004
2005 2006 2007 DIH 30
28 31 35 35 DSO
94 89
94 98 94
------- ------ ------
------ ------ Operating cycle 124
117 125 133 128 DPO
48 49 49 48
45 ------- ------- -------
------- ------- CCC
76 68 76 85
83
40
Financial Flexibility
Sustainable Growth Rate
Concept
g ROE x b
------------------
1
ROE x b GM (2004) g .1012 x (1 - .4025)
.0605 .064
------------------------- --------
1 - .1012 x .5975
.9395 Toyota (2005) g .1295 x (1 - .1411)
.1112 .125
------------------------- --------
1 - .1295 x .8589
.8888 Much easier than textbook formula

41
Optimal Liquidity

• Optimal liquidity -- tradeoff between costs of
  liquidity and costs of illiquidity.
• Cost of liquidity caused by low returns on liquid
  assets and costs of credit arrangements and
  compensating balances.
• Express the cost of liquidity as a constant
  percentage of liquid resources
• Cost of liquidity K1 x LR
• where K1 is the constant cost per dollar of
  liquid resources, LR. K1 might be estimated as
  the difference between the current returns on
  capital projects and marketable securities.

42
Optimal Liquidity

• Expected illiquidity cost
• Where p (IL) is the probability of having a
  liquidity crisis (which is a function of the
  amount of liquid resources) K2 is the cost per
  dollar of insufficient funds (which declines with
  larger amounts of liquid resources) and LR is
  the amount of liquid resources.
• Optimal liquidity is the point at which total
  liquidity costs are minimized.
• Total expected liquidity costs

43
Optimal Liquidity -- Example

• The Trumball Co. currently earns 8 on marketable
  securities and 13 on capital projects.
• K1 .13 - .08 .05
• Net cash flow follows a uniform distribution
  between -100,000 and 500,000.
• ?(IL) LR - Minimum cash flow needed to meet
  maximum illiquidity needs
• Entire cash flow range, 600,000
• If LR ? 100 K, it will have no liquidity crisis
  ?(IL) 0
• If LR lt 100 K, ? (IL) f (cash deficiency
  meeting worst case cash flow)

44
Optimal Liquidity -- Example

• Example LR 50K
• Penalty costs for emergency credit if cash flows
  are -100,000 45,000
• Penalty declines with the level of liquid
  resources, .30 per dollar.
• K2 45,000 - .3LR

45
Optimal Liquidity -- Example

• Summarizing, the cost of liquid resources is
• .05LR
• Cost of having insufficient liquid resources is
• LR - 100,000/600,000 x 45,000 - .3LR
• Total costs are
• .05LR ? LR - 100,000? x (45,000 - .3 LR)
• 600,000

46
Optimal Liquidity -- Example

• We are only interested in the condition in which
  the difference in the terms within the absolute
  value brackets is negative we will reverse the
  order of the terms and drop the absolute value
  signs.
• .05LR 100,000 - LR x (45,000 - .3 LR)
• 600,000
• Use calculus to find the optimal level of
  liquidity. Take the 1st derivative and set equal
  to zero. Solve for LR.

47
Optimal Liquidity -- Example
TC .05 x LR 100K - LR x ( 45K - .3 LR )
600K .05 LR
1/6 - (LR/600K) x ( 45K - .3 LR )
.05 LR 7,500 - .075 LR - .05 LR .0000005
LR2 7,500 - .075 LR .0000005
LR2 ?TC/?LR -.075 .000001 LR 0 .075
.000001 LR LR 75,000
48
Optimal Level of Liquidity
49
Optimal Level of Liquidity
50
Summary

• Chapter introduced basic concepts of
• Solvency
• Liquidity
• Financial flexibility
• Solvency an accounting concept comparing assets
  to liabilities
• Liquidity related to a firms ability to pay for
  its current obligations in a timely fashion with
  minimal costs
• Financial flexibility related to a firms
  overall financial structure and if financial
  policies allows firm enough flexibility to take
  advantage of unforeseen opportunities.

51
Chapter 3 Valuation
52
Valuation Framework

• Maximize the present value of net operating cash
  flows
• sales transaction costs
• bad debt expense administrative costs
• opportunity costs discount costs
• value of trading partner relationships
• Maximize benefits minimize costs
• Maximize sales (to increase profit) and trading
  partner goodwill
• Minimize transaction costs (e.g., sales expense),
  bad debt expense, administrative costs,
  opportunity costs, and discount costs

53
Use a Cash Flow Timeline
Inventory
Inventory
Cash stocked
sold
received Days
inventory held Days
sales outstanding Days
payables outstanding Cash
conversion

period
Cash

disbursed
54
Valuation Framework

• Value maximizing approach
• PV of all relevant future cash flows (size,
  timing, riskiness)
• Decision criteria
• NPV gt 0 invest
• NPV lt 0 do not invest

55
NPV Calculations

• Simple interest
• FV
  FVPV -----------------------
  --------------------- 1 ( k x n /
  365) 1 (n x k/365)
• Compound interest
• FV PV -------------------
  (1 k / 365 ) n

56
Basic Valuation Model
note i k/365
CFo CF1 CF2
CF3 CFn
CF1
CF2 CF3
CFn NPV CFo -------------
------------- ------------ ....
------------ (1 i
x 1) (1 i x 2) (1 i x3)
(1 i x n)

57
Valuation Using NPV -- Floppi, Inc.

• Sue Bannif works for Floppi, Inc. She is
  evaluating whether to give a customer, Droste
  Stores, a discount for paying for its purchases
  earlier than required.
• Currently, Droste buys 100,000 of supplies and
  pays in 30 days (the terms offered). Droste
  wishes to take a 2 discount if it pays within 10
  days.
• The advantage to Floppi is that it will receive
  its cash sooner where it can be invested to earn
  a 9 return in the money market.

58
Floppi, Inc.

• The disadvantage is that Floppi will not receive
  the full 100,000. The discount will reduce the
  amount received to
• 100,000 x (1 - .02) 98,000.
• The question is whether the advantage
  (benefit) outweighs the disadvantage
  (cost).

59
Floppi, Inc.

• A time line is a very useful tool for helping Sue
  identify the relevant cash flows and their
  timing.
• Floppi may receive (a) 100,000 in 30 days or
  (b) 98,000 in 10 days.
• Can Floppi earn 2,000 on the 98,000 if it
  receives the money 20 days earlier than usual?
• If it can, then the present value of the 100,000
  discounted 20 days should be 98,000.
• If Floppi can earn more than 2,000, then the
  present value would be smaller than 98,000.

60
Floppi, Inc.
Current terms
100,000
Days
0 5 10 15
20 25 30
Proposed terms
98,000
Days
0 5 10 15
20 25 30
61
Simple Interest

• Floppi needs to receive 99,509 on day 10 to be
  equivalent to 100,000 on day 30 if the firm can
  invest the 99,509 at a 9 annual return for 20
  days.

Cash Flow
100,000 PV ------------------------
------------------------------------
99,509.27 1 k x (n / 365)
1 .09 x (20 / 365 days)
62
Compound Interest

• Answers are very close -- simple versus compound
  interest
• Simple interest model is easier
• Must use compound interest when
• we use large amounts of money
• compounding is frequent
• time horizons are long

Cash Flow
100,000 PV ------------------------
------------------------- 99,508.12
1 ( k / 365 ) n ( 1 .09/365 ) 20
63
Floppi, Inc.
Current terms
100,000
99,509.27
Days
0 5 10 15
20 25 30
Proposed terms
98,000
Days
0 5 10 15
20 25 30
64
Value of Policy Change
PV (policy change) PV (new policy) - PV (old
policy) 98,000
100,000 --------------------
----- - -------------------------
1 .09 x (10/365) 1 .09 x (30/365)
97,759 - 99,265.70 - 1,506.70
65
Adding Complexities to the Model

• Sue may be premature in her analysis. There is
  another source of benefit for Floppi which she
  excluded from her analysis -- increased sales.
• Droste may choose to buy more supplies from
  Floppi. Also some potential customers may not
  buy from Floppi because they can get better
  payment terms with other suppliers.
• Let's assume that Droste will increase sales by
  5, to 105,000. With a 2 discount, 102,900
  will be collected.

66
Added Complexities

• Sue determines that for every dollar in sales,
  60 of it covers the variable costs of doing
  business. That means that 40 covers fixed costs
  and creates profit (40 contribution margin).
• Sue finds that variable costs occur on the day
  the sale is made. Floppi's current variable
  costs are 60,000 (100,000 x .6) and will rise
  to 63,000 (105,000 x .6).

67
Added Complexities
.
Current terms
100,000
- 60,000
Days
0 5 10 15
20 25 30
Proposed terms
102,900
- 63,000
Days
0 5 10 15
20 25 30
68
Added Complexities
PV (policy change) PV (new policy) - PV (old
policy) 105,000 x .98
------------------------- - 63,000
1 .09 x (10/365)
100,000 - -------------------------
- 60,000 1 .09 x (30/365)
39,646.90 - 39,265.70 381.20
69
Choosing the Discount Rate

• Cost of capital may be inappropriate
• Long-term capital is rarely raised explicitly to
  finance working capital needs
• Short time horizon for working capital needs may
  preclude long-term financing
• Riskiness hard to assess for short-term needs
• One-shot projects
• If net borrower, use short-term borrowing rate
• If net investor, use short-term investment rate
• Multi-year projects -- maybe appropriate to use
  cost of capital
• kadj krf kavg k?

70
Summary

• Short-term financial decisions can impact firm
  value by
• altering operating cash flows
• changing the length of the cash conversion cycle
• changing company risk posture
• impacting net interest income
• and by changing accuracy and timeliness of
  critical information.
• Choosing appropriate discount rate is an issue
  when trying to assess valuation impact.

71
Managing Inventory
72
View firm as a system of cash flows
Sales
Inv
A /R
Cash
73
The Cash Flow Timeline
Order Order Sale
Cash Placed Received
Received

lt Inventory gt
lt A/R collection period gt
ltholding periodgt Time gt lt
A/P payment period gt lt cash conversion cycle
gt Invoice
Cash
Received Paid
74
Inventory Objectives

• Keep enough product on hand to prevent
  running out of stock, while
  avoiding excessive levels
  that would put a drain on profitability.
• Minimize costs associated with inventory
• Opportunity cost of inventory investment
• Storage costs
• Out-of-stock costs
• Purchase price of inventory
• Transaction costs
• Administrative costs

75
Inventory Cost Trade-offs

• Larger Levels of Inventory
• Fewer orders placed
• Lower probability of shortages
• Larger carrying costs
• Larger investment in inventory

• Smaller Levels of Inventory
• More frequent orders
• Higher probability of shortages
• Smaller carrying costs
• Smaller investment in inventory

76
Concept of Inventory

• Factor in the length of cash cycle
• Acts as a shock absorber
• Three types
• raw materials
• work-in-process
• finished goods
• Motives for holding inventory
• transaction
• precautionary
• speculative

77
Traditional Inventory Model

• Basic questions
• Proper level of investment in inventory -- a
  financial issue
• Quantity to order and when to order -- a
  production issue

78
Assumptions of Inventory Model

• Assumes annual usage (of raw material inventory)
  or sales rate (of finished goods inventory) of
  inventory, T.
• To replace our inventory as used, make orders of
  some quantity, Q.
• If usage rate is constant, orders of the same
  amount can be made at equal intervals. Inventory
  goes to zero just as the new order is received.

79
Inventory Costs

• Holding (or carrying) costs - costs associated
  with holding (owning) inventory. Examples
  storage costs, fire insurance, property taxes,
  spoilage, cost of capital, and deterioration.
• Holding costs holding cost x average inventory
  H Q/2
• Holding costs 0.85 x (50,000/2) 0.85 x
  25,000 21,250

80
Inventory Costs, Continued

• Ordering costs -- fixed costs based on the number
  of orders made. Examples transportation costs,
  clerical costs of making the orders, and costs of
  placing order in storage.
• Number of orders per period T/Q
• Number of orders per year 1,000,000/50,000 20
• F fixed costs per order
• T annual usage Q quantity ordered
• Ordering costs cost per order number of
  orders F T/Q
• Ordering costs 4.00 (1,000,000/50,000)
  4.00 20 80.00

81
Inventory Costs, Continued

• Total cost Order Cost Holding Cost
• Total Cost F x (T/Q) H x (Q/2)
• Total Cost 80 21,250 21,330
• Minimize total cost of inventory over period of
  time studied.

82
Order Cost and Holding Cost Trade-off
83
Economic Order Quantity

• Minimize total inventory costs with EOQ solution
• Total cost 4 x (1,000,000/3,068) (0.85 x
  3,068/2)
• 1,304 1,304
• 2,608

84
EOQ and Total Inventory Costs

• What if we order 2,500 units each time?
• Total cost 4 x (1,000,000/2,500) (0.85 x
  2,500/2)
• 1,600 1,063
• 2,663
• What if we order 3,500 units each time?
• Total cost 4 x (1,000,000/3,500) (0.85 x
  3,500/2)
• 1,143 1,488
• 2,630

85
EOQ Example
86
Data Table to Graph
87
Useful Concepts

• Average inventory Q/2 3,068/2 1,534 units
• Usage rate T/D 1,000,000/365 2,740
  (Ddays)
• Reorder point (T/D) x Delivery Time 2,740 x 1
  day
• 
  2,740 units
• Safety Stock -- if we keep 200 units of safety
  stock
• Average inventory 3,068/2 200 1,734 units
• Reorder point 2,740 x 1 day 200 2,940
  units

88
Quantity Discounts

• Quantity discounts -- supplier induces larger
  orders by offering reduced unit costs of the
  inventory. The more inventory we purchase, the
  greater the discount.
• We lower per unit cost of inventory and ordering
  costs.
• We increase average inventory holding costs.
  
  
• Do cost savings outweigh the cost increases?

TC Order Cost Holding Cost Item
Cost TC (F x (T/Q)) (H x (Q/2))
(CxT)
89
Quantity Discounts

• Suppose the supplier has given us the following
  schedule of unit costs
• Quantity Purchased Cost per Unit
• 1-999 units 1.00
• 1000-1999 units 0.96
• 2,000-3,499 units 0.90
• 3,500 units 0.82
• Construct a spreadsheet scenario analysis to
  determine the optimal amount of inventory to
  order.

TC 4x (1,000,000/3,500) .85 x (3,500/2)
.82 x 1,000,000 TC 1,142.86 1,487.50
820,000 822,630
90
EOQ with Quantity Discounts
91
Cash Flow Valuation Analysis

• Current inventory practices
• We purchase on credit 5,000 units of inventory
  which lasts for 10 days of production. Cash
  payment is due in 30 days of receipt.
• Annual cost of capital is 8.
• Inventory costs 3 per unit ordering costs are
  15 per order holding costs are 0.25 per unit
  of average inventory average inventory is 5000/2
  2,500.

Cash paid for inventory 30
Cash paid for holding ordering costs 10
Inventory ordered received 0
5,000 x 3 15,000
2,500 x 0.25 625 1 x 15 15
92
Cash Flow Analysis, Continued

• PV of the costs of one cycle of inventory is

PV PV order-hold costs PV purchase costs
625 15
15,000 -----------------------------
-------------------------- 1 .08 x
10/365 1 .08 x 30/365 639
14,902 15,541
93
Cash Flow Analysis, Continued

• If the purchasing agent suggests we order 2,500
  units every 5 days, compare PV of proposal costs
  with PV of current costs. Avg inventory is 1,250.

Cash paid for inventory 35
Inventory ordered received 0
Cash paid for inventory 30
Inventory ordered received 5
15
10
2,500 x 3
2,500 x 3
Cash paid for holding ordering costs
Cash paid for holding ordering costs
1,250 x 0.25 1 x 15
1,250 x 0.25 312.50 1 x 15
94
Cash Flow Analysis, Continued
PV PV order-hold costs PV purchase costs
312.50 15 312.50
15 -----------------------------
-------------------------- 1 .08 x
10/365 1 .08 x 15/365
7,500 7,500
-----------------------------
-------------------------- 1 .08 x
30/365 1 .08 x 35/365
326.78 326.43 7,451.01 7,442.90
15,547.12 Reject proposal. Why?
95
Monitor the Inventory Balance

• Inventory control systems -- point of sale
  terminals
• Inventory turnover ratio
• Sales or COGS / Inventory balance
• Days COGS in inventory
• Inventory balance / Daily COGS or Sales
• Balance fraction approach
• Develop monthly balance fractions based on the
  proportion of items remaining in inventory from a
  given months purchase.

96
Reducing Investment in Inventory

• Problems were solved by adding JIT inventory
  systems
• JIT redesigns system
• Redesign of production system
• eliminate waste
• eliminate production errors
• improving quality
• Need stable demand and dependable suppliers

97
9/11/03 Wall Street Journal

• Penneys invisible supplier, TAL Apparel in Hong
  Kong
• On Saturday a customer buys in Atlanta Penney
  store a white Stafford wrinkle-free dress shirt
  size 17 neck, 34/35 sleeve.
• On Monday TAL downloaded record of sale
• By Wednesday factory worker packed an identical
  replacement to be shipped
• Penneys now holds almost no extra inventory for
  its house-brand dress shirt

98
TAL Handles Penneys Inventory

• TAL collects the point-of-sale info, runs a
  computer program, then decides for Penneys
• How many shirts to make
• In what styles
• In what colors
• In what sizes
• Ships back to stores where inventory needed
• If Penneys is caught short, TAL pays extra to
  air ship shirts
• Other firms handled J. Crew, Calvin Klein,
  Banana Republic, Tommy Hilfiger, Liz Claiborne,
  Ralph Lauren, and Brooks Brothers

99
Savings for Penneys

• Penneys had up to 9 months of inventory in
  warehouse and in stores when agreement started
  now it is zero for certain shirt lines
• Penneys saves inventory costs doesnt have to
  mark down merchandise has on stock just what
  customers want
• Used to cost Penneys 0.29 to sort out the right
  shirt to ship at its warehouse. Costs with TAL
  only 0.14.
• TAL provides better sales forecasts. Penneys
  used to be off by 2 months worth of volume.
• TAL does test-marketing. It goes to N.Y. to pick
  up design ideas, tests them in 50 stores, then
  decides whether Penneys will expand selling them
  by evaluating sales data.

100
Summary

• Inventory decisions should be based on
• cost of holding inventory
• cost or ordering inventory
• opportunity cost of funds
• quantity discounts
• is quantity workable within inventory management
  system?
• Inventory, if properly managed can be a major
  contributor to cash flow...
• If mismanaged, can be a significant drain on
  cash.
• Some traditional inventory monitoring tools can
  be biased by sales and production trends