Other Topics in Working Capital Management

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Chapter 18

• Other Topics in Working Capital Management

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CHAPTER 18 Other Topics in Working Capital
Management

• Cash conversion cycle
• Setting the target cash balance
• Receivables management
• Days sales outstanding (DSO)
• Aging schedules
• Payments pattern approach

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The Operating Cycle and The Cash Cycle

• The primary concern in short-term finance is the
  firms short-run operating and finance activities.

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The Operating and Cash Cycles
Accts. Payable Period
Inventory Period
Cash Cycle
Accounts Receivable Period

• This entire 105 day process is the operating cycle

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The Operating Cycle The length of time it takes
to acquire inventory, sell it and collect on it
Accounts Receivable Period
Operating Cycle
Inventory Period


Accounts Payable Period
Operating Cycle
Cash Cycle


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Cash Cycle

• Cash flows and other events are not synchronized
• We do not actually pay for inventory for 30 days
  after acquiring
• We do not collect on sales for 45 days
• The cash cycle is the amount of time that passes
  between paying for inventory and then actually
  collecting
• Out-of-Pocket time

Accounts Payable Period
Cash Cycle
Operating Cycle

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Accts. Payable Period
Cash Cycle
Accts. Rec. Period
Inventory Period
Operating Cycle
Raw Materials Purchased
Payment for Raw Materials
Sale of Finished Goods
Cash Collection
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The Average US Manufacturing Firm (1993 figures
in millions of dollars)
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The Operating Cycle
Operating Cycle
Inventory Period
Accounts Receivable Period


Inventory Period
It takes on average 50 days to produce and sell
inventory
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Receivables Turnover
It Takes on average 44 days to collect on a sale
once it has been made
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The Operating Cycle
Inventory Period
Operating Cycle
Receivables Period


94.4 days
50.3 days
44.1 days


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The Cash Cycle
Payable Period
Cash Cycle
Operating Cycle
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• Payables Period
• This represents the portion of our operating
  cycle financed by our suppliers

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On Average we take 29.5 days to pay for inventory
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• Cash Cycle

Operating Cycle
Cash Cycle
Payables Period
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64.9 days
94.4 days
29.5 days

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We need two months financing to fund our
operating cycle
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• Cash Cycle Again

Operating Cycle
Cash Cycle
Payables Period
-

Inventory Period
Pay. Period
Rec. Period
Cash Cycle


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Current Liability Management
Current asset Management
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Interpreting the Cash Cycle

• The cash cycle depends on inventory, receivables,
  and payables periods.
• Increases w/inventory and receivables
• Decreases w/ payables

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• The link to profitability

• Increasing the cash cycle will generally reduce
  asset turnover
• Increases in inventory and accounts receivable
  increase the operating cycle and cash cycles.
• Increases in current asset accounts reduce asset
  turnover which reduces ROE.

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Examples

• Dell
• 1996 Dell underwent a major revamping of their
  working capital management policies.
• At the end of 1996 Dells Cash Cycle looked like
  this

Inventory Period
Pay. Period
Rec. Period
Cash Cycle


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31
33
42
40


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• What does this mean?
• Dell needs to finance about 40 days of
  operations.
• ROE is lagging the industry
• High Inventory and A/R are holding Asset Turnover
  down.
• High carrying costs are holding Profit Margin
  Down.

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• What did Dell Do?
• Examined their Inventory management and
  Inventory Drivers to determine where Inventory
  was being held
• Reduced Inventory from 31 days to 13 days.
• Realized that vendors could hold much of the
  inventory instead.
• JIT Inventory
• How does this impact vendors?
• Examined Accounts Receivable Management
• Pared down DSO from 42 days to 37 days

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• Finally Dell increased the Payables Period from
  33 days to 54 days.
• Discovered that the company was paying vendors
  sooner than negotiated.
• Stretched payables to the maximum of terms.
• What impact would this have on vendors?

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• The new Cash Cycle

Inventory Period
Pay. Period
Rec. Period
Cash Cycle


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13
54
37
-4


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• What does this mean?

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• A Look at the change from the vendors
  perspective
• Remember that Dells payables period is the
  vendors collection period.
• Collection period increases from 33 days to 54
  days
• Remember that Dell shifted its inventory back to
  vendors.
• Lets assume that Inventory periods increased from
  30 days to 45 days.
• Lets assume that vendors cannot change their
  payables period and they remain at 33 days.

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Vendors Original Cash Cycle
Inventory Period
Pay. Period
Rec. Period
Cash Cycle


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30
33
33
30


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• Vendors need to finance about 30 days of their
  operating cycle.

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Vendors New Cash Cycle
Inventory Period
Pay. Period
Rec. Period
Cash Cycle


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45
33
54
66


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• Vendors need to finance about 66 days of their
  operating cycle.
• Operating Cycle increases 50

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Setting the Target Cash Balance

• Theoretical models such as the Baumol model have
  been developed for use in setting target cash
  balances. The Baumol model is similar to the EOQ
  model, which will be discussed later.
• Today, companies strive for zero cash balances
  and use borrowings or marketable securities as a
  reserve.
• Monte Carlo simulation can be helpful in setting
  the target cash balance.

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Receivables Monitoring
Assume the following sales estimates
January 100 April 300 February
200 May 200 March 300 June 100
Terms of sale Net 30.
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Expected Collections

• 30 pay on Day 10 (month of sale).
• 50 pay on Day 40 (month after sale).
• 20 pay on Day 70 (2 months after sale).
• Annual sales 18,000 units _at_ 100/unit.
• 360-day year.

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What is the firms expected DSO and average daily
sales (ADS)?

• DSO 0.30(10) 0.50(40) 0.20(70)
• 37 days.
• How does this compare with the firms credit
  period?

18,000(100) 360
ADS 5,000 per day.
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What is the expected average accounts receivable
level? How much of this amount must be financed
if the profit margin is 25?
A/R (DSO)(ADS) 37(5,000)
185,000.
0.75(185,000) 138,750.
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If notes payable are used to finance the A/R
investment, what does the firms balance sheet
look like?

• A/R 185,000 Notes payable 138,750
• Retained
• earnings 46,250
• 185,000

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If bank loans cost 12 percent, what is the annual
dollar cost of carrying the receivables?
Cost of carrying receivables

• 0.12(138,750)
• 16,650.
• In addition, there is an opportunity cost of not
  having the use of the profit component of the
  receivables.

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What are some factors which influence a firms
receivables level?

• Receivables are a function of average daily sales
  and days sales outstanding.
• State of the economy, competition within the
  industry, and the firms credit policy all
  influence a firms receivables level.

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What are some factors which influence the dollar
cost of carrying receivables?

• The lower the profit margin, the higher the cost
  of carrying receivables, because a greater
  portion of each sales dollar must be financed.
• The higher the cost of financing, the higher the
  dollar cost.

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What would the receivables level be at the end of
each month?
A/R 0.7(Sales in that month) 0.2(Sales in
previous month).
Month Sales A/R Jan 100 70 Feb 200
160 Mar 300 250 April 300 270 May 200
200 June 100 110
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What is the firms forecasted average daily sales
(ADS) for the first 3 months? For the entire
half-year?
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What DSO is expected at the end of March? At the
end of June?
1st Qtr 250/6.67 37.5 days. 2nd
Qtr 110/6.67 16.5 days.
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What does the DSO indicate about customers
payments?

• It appears that customers are paying
  significantly faster in the second quarter than
  in the first.
• However, the receivables balances were created
  assuming a constant payment pattern, so the DSO
  is giving a false measure of payment performance.
• Underlying cause is seasonal variation.
• This affects the cash conversion cycle
  calculations mentioned previously.

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Construct an aging schedule for the end of March
and the end of June.
Age of Account March June
(Days) A/R A/R
0 - 30 210 84 70 64
31-60 40 16 40 36 61-90 0
0 0 0 250 100 110 100

Do aging schedules tell the truth?
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Construct the uncollected balances schedules for
the end of March and June.

• Contrib. A/R
• Mos. Sales to A/R to Sales
• Jan 100 0 0
• Feb 200 40 20
• Mar 300 210 70
• End of Qtr. A/R 250 90

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Contrib. A/R Mos. Sales to A/R to
Sales Apr 300 0 0 May 200
40 20 June 100 70 70 End of
Qtr. A/R 110 90
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Do the uncollected balances schedules properly
measure customers payment patterns?

• The focal point of the uncollected balances
  schedule is the receivables -to-sales ratio.
• There is no difference in this ratio between
  March and June, which tells us that there has
  been no change in payment pattern.

(More...)
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• The uncollected balances schedule gives a true
  picture of customers payment patterns, even when
  sales fluctuate.
• Any increase in the A/R-to-sales ratio from a
  month in one quarter to the corresponding month
  in the next quarter indicates a slowdown in
  payment.
• The bottom line gives a summary of the changes
  in payment patterns.

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• Assume it is now July and you are developing pro
  forma financial statements for the following
  year.
• Furthermore, sales and collections in the first
  half-year matched predicted levels. Using Year 2
  sales forecasts, what are next years pro forma
  receivables levels for the end of March and June?

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March 31
Predicted Predicted Predicted A/R-to-
Contrib. Mos. Sales Sales Ratio
to A/R Jan 150 0 0 Feb
300 20 60 Mar 500 70
350 Projected March 31 A/R balance 410
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June 30
Predicted Predicted Predicted A/R-to-
Contrib. Mos. Sales Sales Ratio
to A/R Apr 400 0 0 May
300 20 60 June 200 70
140 Projected June 30 A/R balance 200
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What four variables make up a firms credit
policy?

• Cash discounts
• Credit period
• Credit standards
• Collection policy

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Disregard any previous assumptions.

• Current credit policy
• Credit terms Net 30.
• Gross sales 1,000,000.
• 80 (of paying customers) pay on Day 30.
• 20 pay on Day 40.
• Bad debt losses 2 of gross sales.
• Operating cost ratio 75.
• Cost of carrying receivables 12.

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The firm is considering a change in credit policy.

• New credit policy
• Credit terms 2/10, net 20.
• Gross sales 1,100,000.
• 60 (of paying customers) pay on Day 10.
• 30 pay on Day 20.
• 10 pay on Day 30.
• Bad debt losses 1 of gross sales.

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What is the DSO under the current and the new
credit policies?

• CurrentDSO0 0.8(30) 0.2(40) 32 days.
• NewDSON 0.6(10) 0.3(20) 0.1(30) 15
  days.

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What are bad debt losses under the current and
the new credit policies?

• CurrentBDL0 0.02(1,000,000) 20,000.
• NewBDLN 0.01(1,100,000) 11,000.

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What are the expected dollar costs of discounts
under the current and the new policies?

• Discount0 0.
• DiscountN 0.6(0.02)(0.99)(1,100,000)
  13,068.

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What are the dollar costs of carrying receivables
under the current and the new policies?

• Costs of carrying receivables0 (1,000,000/360)
  (32)(0.75)(0.12) 8,000.
• Costs of carrying receivablesN (1,100,000/360)(
  15)(0.75)(0.12) 4,125.

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What is the incremental after-tax profit
associated with the change in credit terms?
New Old
Diff. Gross
sales 1,100,000 1,000,000 100,000 Less
Disc. 13,068 0 13,068
Net sales 1,086,932 1,000,000 86,932 Prod.
costs 825,000 750,000 75,000 Profit
before credit costs and taxes
261,932 250,000 11,932
(More...)
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New Old
Diff. Profit before credit
costs and taxes 261,932
250,000 11,932 Credit-related
costs Carrying costs 4,125
8,000 (3,875) Bad debts
11,000 20,000 (9,000) Profit
before taxes 246,807
222,000 24,807 Taxes (40)
98,723 88,800 9,923 Net
income 148,084 133,200
14,884 Should the company make the change?
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Assume the firm makes the policy change, but its
competitors react by making similar changes. As
a result, gross sales remain at 1,000,000. How
does this impact the firms after-tax
profitability?
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• Gross sales 1,000,000
• Less discounts 11,880
• Net sales 988,120
• Production costs 750,000
• Profit before credit
• costs and taxes 238,120
• Credit costs
• Carrying costs 3,750
• Bad debt losses 10,000
• Profit before taxes 224,370
• Taxes 89,748
• Net Income 134,622

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• Before the new policy change, the firms net
  income totaled 133,200.
• The change would result in a slight gain of
  134,622 - 133,200 1,422.

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Why is inventory management vital to the
financial health of most firms?

• Insufficient inventories can lead to lost sales.
• Excess inventories means higher costs than
  necessary.
• Large inventories, but wrong items leads to both
  high costs and lost sales.
• Inventory management is more closely related to
  operations than to finance.

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• The End

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