Cash

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Cash A/P Management
Lecture 1

• The Importance of Cash Management
• Banking Relations
• Accounts Payable as a source of funding

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Resources for this unit

• Item 6, Electronic Reserve list
• Managing the Cash Gap, by Germain Boer, Journal
  of Accountancy, Oct. 1999, p. 27-32
• Strongly recommended!
• Also available AICPA Modules
• A-4 Cash Management
• A-5 Managing Banking Relations

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Optional Articles (e-reserve)

• 13 Cash Flow Management in a Leveraged
  Environment, by Marty Moore, Jan. 2002 Strategic
  Finance, pp. 31-33
• 12 A Bankers Perspective on Working Capital
  and Cash Flow Management, by Dev Strischer, Oct.
  2001 Strategic Finance, pp. 38-45

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Importance of Cash Management
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Cash is the lifeblood of an enterprise

• Cash management is the process whereby the cash
  inflows and outflows are controlled so that
  current obligations can be met in time and any
  excess cash will earn income

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Reasons to hold cash

• Transactions motive
• Precautionary motive
• Speculative motive
• Finance motive

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Cash Budget

• Cash budgeting is a continuous process to cover
  near-term and longer-term
• Daily
• Weekly
• Monthly
• Annual

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Investing Excess Cash Wisely

• Company needs clear guidelines on management of
  temporarily excess cash
• Objective balance between safety, profitability
  and liquidity
• Typical short-term investments

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Short-term investmentsExamples

• Typical short-term investments
• Savings account and other interest-bearing
  accounts
• Certificates of deposit
• Money market securities
• Commercial paper with a variety of maturity dates
• Any debt instrument due within 1 to 3 months

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Poor cash management can lead to bankruptcy

• Bankruptcy often caused by lack of funds to
  maneuver when
• Unexpected financial difficulties arise
• Expansion is very rapid
• There is a sudden economic turnaround

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Signs of trouble
You have learned from Acct 310 to help you spot a
company that might be getting into financial
difficulties.

• Decrease in employee productivity (perhaps
  excessive overtime without comparable increase in
  sales)
• Getting behind in loan or interest payments
• Overextending credit lines

• Increase in average age of receivables
• Increase in number of bad debts
• Accumulation of inventory
• Drop in sales
• Increased fixed costs as percentage of total
  operating costs

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Good cash management must involve entire
organization

• Basic understanding of cash flow levers or
  drivers is needed at all levels
• For example, awareness of loan covenants and
  severe problems that might result from violations
• Cash forecasts involve cooperation and input from
  all sectors of organization
• Timely bank reconciliations are essential

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Cash Gap
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IBC Slide Operating Cash Cycles
Order RM
RM arrive
FG Sold
Cash Recd
Inventory Period
Accounts Receivable Period
Cash Pd for RM
Invoice Recd
Invoice to Customer
Operating Cycle
Cash Cycle
Review Material Acct 310
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The Cash Gap
Inventory arrives
Cash Received
Cash Paid
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Cash Gap Cash Cycle

• Definition
• The length of time between the purchase of raw
  materials and the collection of account
  receivable generated in the sale of the final
  product

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Formula of Cash Gap

• Average collection period for account
  receivables (in days)
• Days in inventory
• average payment period for payables (in days)
• Cash Gap

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To Compute the Cash Gap

• You need to know
• Days of inventory on hand
• Divide days in year by inventory turnover
• Average collection period
• Divide days in year by receivables turnover
• Average payment period
• Divide days in year by payables turnover

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Example Owens Minor 2006
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Example Owens Minor
(315,570 389,504) 705,074/2
352,537
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Activity Ratios - Example

• Inventory Turnover
• Cost of Goods Sold Average Inventory
• 3,406,758 / 352,537 9.664
• To get days of inventory on hand, divide days in
  year by inventory turnover
• Days in inventory 365/9.664 38 days

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Activity Ratio - Example

• Receivables Turnover
• Net Credit Sales Average Net Receivables
• 3,814,994 / 263,070 14.5
• To get average collection period, divide days in
  year by receivables turnover
• Average collection period 365/14.5 25 days

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Activity Ratios - Example

• Payables Turnover
• Cost of Goods Sold Average Accounts Payable
• 3,406,758 / 289,082 11.78
• To get average payment period, divide days in
  year by payables turnover.
• Average payment period 365/11.78 31 days

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Operating Cycle

• The length of time between the purchase receipt
  of raw materials and the collection of account
  receivable generated in the sale of the final
  product
• Operating Cycle Average collection period for
  receivables (in days) days in inventory
• From the examples above 38 25 63 days

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Cash gap

• Average collection period for receivables (in
  days)
• Days in inventory
• - Average payment period for payables (in days)
• Cash Gap
• From the examples above 38 25 - 31 32 days

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The Cash Gap - Example
Inventory arrives
Inventory shipped
Cash Received
Cash Paid
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What does the cash gap cost?

• The cash gap directly impacts profit
• To estimate savings from cutting one day from
  cash gap
• Multiply cost of goods sold and divide by sales
  to get a percentage
• Divide sales by 365 days to get daily sales
• Multiply the daily sales by the COGS percentage
  this gives you the amount that must be financed
• Multiply by the cost to borrow short-term

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Our Example

• COGS 3,406,758 / 3,814,994 89
• Daily Sales 3,814,994 / 365 10,452
• Amount to financed 10,45289 9,302
• If short-term borrowing rate is 12, the savings
  in pretax profits would be over 1 million for
  only one day of cash gap
• 1,116 which is really 1,116,000 since our
  financial statement data was in thousands

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Shortening the cash gap

• Banking services
• Stretch out payments terms on purchases
• Shorten collection period from customers
• Reduce unbilled work-in-process
• Increase inventory turnover

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Example Nordstrom vs TJX
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Example Nordstrom vs TJX