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1 It is concerned with decisions relating to current assets and current liabilities

2 Best Buy Co, NA s largest consumer electronics retailer, has performed extremely well over the past decade. Its stock sold for $50 in late 2007 up from $2 ten years earlier. Its excellent performance stemmed from sound financial and operating practices, especially in working capital management. WCM involves finding optimal levels for cash marketable securities, accounts receivable and inventory and then financing that working capital for the least cost. Most of best buy s customers use credit cards, so neither in-store cash nor accounts receivable is significant. Therefore Best buy s working capital focuses on inventories. 2

3 To maintain sales, its stores must be well stocked with the goods customers are seeking at the time they are shopping. This involves determining what new products are hot, determining where they can be obtained at the lowest cost and delivering them to stores in a timely manner. Dramatic improvements in communications and computer technology have transformed the way Best Buy manages its inventories. It now collects real-time data from each store on how each products is selling and its computers place orders automatically to keep the shelves full. Moreover, if sales of an item are slipping, prices are lowered to recue stocks of that item before the situation gets so bad that drastic price cuts are necessary. Working capital needs to be managed to maximize profits and stock prices. 3

4 Inventories Raw materials and components Work-in-progress Trade debtors Loans and advances Bills Receivable Marketable securities Cash and bank balances Sundry creditors Bills payable Outstanding expenses Trade advances Borrowings Provisions 4

5 Gross working capital is the total of all current assets Net working capital = current assets - current liabilities The working capital cycle can often be expressed as a period of time (60 days) Current ratio and Quick ratio Cash budget is an estimate of future cash inflows and outflows Characteristics of current assets Short life span Swift transformation into other asset forms 5

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7 ROE = Profit margin x assets turnover x leverage factor The top line has the steepest slope which indicates that the firm holds a great deal of cash, marketable securities, receivables and inventories relative to its sales. When receivables are high, the firm has a liberal credit policy, which results in a high level of accounts receivable. It results in a low turnover, which in turn lowers ROE. If the firm has a lean and mean investment policy, holdings of current assets are minimized. This results in a high ROE. Risks material shortages can lead to work stoppages, unhappy customers etc. A moderate investment policy lies between the two 7

8 Relaxed current asset investment policy under conditions of uncertainty, there is requirement for safety stock and tight credit policy to customers, hence large current assets are carried Restricted current asset investment policy under conditions of certainty, when sales, costs, lead times, payment periods are all known for sure, current assets are turned over more frequently Moderate current asset investment policy 8

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11 Operating cycle is the time that elapses between the purchase of raw materials and the collection of cash for sales. It is divided into 4 stages: raw materials, WIP, finished goods inventory and debtors collection = Inventory conversion period + accounts receivable period Cash conversion cycle is the time length between the payment for raw material purchases and the collection of cash for sales Inventory conversion period + accounts receivable period accounts payable period 11

12 Jan: credit purchase of Raw Materials creates accounts payable Feb: labor used in production wages not paid immediately accrued wages Mar: finished computers sold on credit creates accounts receivable Apr: payment of accounts payable through bank loan May: collection of accounts receivable and repayment of bank loan 12

13 Inventory conversion period is time required to convert materials into finished goods and to sell those goods = average inventory/cost of goods sold per day Accounts receivables period is time required to convert receivables into cash = average AR/sales per day Accounts payable period is time between purchase of materials and payment of cash for them = average AP/cost of goods per day Cash conversion cycle = inventory conversion period + Average receivables (collection) period Accounts payable (deferral) period 13

14 General nature of business Seasonality of operations Production cycle Business cycle Credit policy Growth and expansion Production policy Market conditions Conditions of supply Appropriation of profits 14

15 Reported as cash and cash equivalents in the balance sheet Marketable securities - Very liquid securities that can be converted into cash quickly at a reasonable price. They tend to have maturities of less than one year. Furthermore, the rate at which these securities can be bought or sold has little effect on their prices. Examples of marketable securities include commercial paper, banker's acceptances, bank certificates, Treasury bills and other money market instruments. Case of Microsoft one time dividend, stock repurchase program, retiring debt, acquiring firms, financing major expansions etc. 15

16 Short term securities that can be bought and sold at short notice Securities are held mostly for precautionary purposes but earn returns Invest in securities when interest rates are high otherwise it is expensive and time consuming to convert them into cash Firm which have high growth rate Firms with volatile cash flow Small new firms which do not have exceptional credit ratings 16

17 Hold marketable securities rather than demand deposits to provide liquidity Borrow on short notice by establishing lines of credit Forecast payments and receipts better Speed up receipts Lockboxes Wire transfer Use credit cards, debit cards and direct deposits Synchronize cash flows by using billing cycles 17

18 Cash discounts on cash payment to suppliers Maintain and improve its credit rating Take advantage of favorable business opportunities Meet emergencies 18

19 An estimate of receipts, disbursements and cash balances for a firm over a specified future period 19

20 Goals of inventory management To ensure that inventories needed to sustain operations are available To hold the costs of ordering and carrying inventories to the lowest possible level Types of costs Ordering & Receiving costs (cost of placing orders, shipping and handling costs) Carrying costs (warehouse rent, interest on capital locked up, insurance, property taxes, spoilage, depreciation and obsolescence, pilferage) Shortage or stockout costs (loss of sales, customer, goodwill, disruption of production schedules) Inventories are supplies, raw materials, work-inprogress and finished goods 20

21 What should be the size of the order? When should the order be placed? Assumptions: The forecast demand for a period is known Orders can be replenished quickly The only costs are ordering and carrying The cost per order does not change with size Cost of carrying is a percentage of inventory value 21

22 Inventory is divided into 3 groups: A group consists of items with the largest dollar investment. This group consists of 20 percent of the firm s inventory items but 80 percent of the investment in inventory B group consists of items that account for the next largest investment in inventory. The C group consist of a large number of items that require a relatively small investment. Typically A group items are tracked on a perpetual inventory system that allows daily verification of each item s inventory level. 22

23 It implies that a firm should maintain a minimal level of inventory and rely on suppliers to provide parts and components just in time to meet its assembly requirements It requires a strong and dependable relationship with suppliers who are geographically not very remote from the mfg facility a reliable transportation system an easy physical access in the form of enough doors and conveniently located docks and storage areas to dovetail incoming supplies to the needs of assembly line impeccable quality maintenance of component parts by the supplier Lowers the ordering cost and also the safety stock by forging stronger long term relationship with the suppliers, average inventory level is lower 23

24 Steady production vs seasonal production average inventory higher for all round the year production than if production varies with change in sales Outsourcing Components purchased rather than made in combination with JIT - lower inventory levels Supply Chain Management 24

25 A sole trader having $800 capital buys stock for $800. The next day he sells the stock on a 10 day credit for $1000 and takes an overdraft of $800 for stock purchase. Accounts receivable is determined by Volume of credit sales Average time between sales and collection Increase in receivables must be financed in some way Entire amount of receivables need not be financed because of the profit component which does not involve any cash flow 25

26 Credit period: 2 / 10, net 30; lengthening the credit period pushes sales up, lengthens cash conversion cycle, requires larger investment in debtors, leads to higher incidence of bad debts loss Cash discount and trade discount Should attract new customers Will increase cash flow Credit standards: 5 C s of credit are character, capacity, capital, collateral and conditions on which information is received from financial statements, bank references, firm experiences and stock market data Collection policy: procedure that the firm follows to collect accounts receivable Profit potential in granting credit through carrying charges levied on credit sales (nominal and effective interest rates) makes credit sales more profitable than cash sales 26

27 Boston Lumber Company, wholesale distributor of lumber products has credit sales of $1000 per day and a collection period of 10 days. It must have capital to carry $10,000 worth of receivables. Accounts Receivables = sales/day x length of collection period What will be the impact if sales double or collection period increases? DSO = Receivables / Average sales per day Receivables is $375 and Annual Sales turnover is $3000, Days Sales Outstanding = 46 days The DSO can be compared to industry average (36 days) or to the firm s own credit terms (30 days) 27

28 Accrued liabilities outstanding rent Accounts payable or trade credit from suppliers Bank Finance Cash credits / overdrafts Loans Bill discounting: the seller draws a bill on the purchaser, on acceptance it is discounted with the bank, who collects the full amount from the buyer on the due date Letter of credit: an indirect form of financing whereby a bank undertakes the responsibility to honor the obligation of its customer, this helps the customer to obtain credit from its suppliers Commercial paper Factoring 28

29 Fixed or floating interest rate Interest only vs amortized loans Collateral Security in the form of hypothecation or pledge Maturity period may or may not have maturity period Restrictive covenants Loan guarantees by stockholders 29

30 A formal line of credit where the customer pays a commitment fee and is then allowed to use the funds when they are needed. It is usually used for operating purposes, fluctuating each month depending on customer's current cash flow needs. FI considers several factors that determine a borrower's ability to repay to decide on the maximum amount of credit (credit limit) Revolving credit borrowers are only required to pay interest on the amount borrowed, plus commitment fees on amount not borrowed Interest is pegged to T-bill or market rate Generally contains a clean-up clause for banks to extend this type of credit in future 30

31 It is unsecured short term promissory notes of large firms with high credit rating having an interest rate below the prime rate (a published interest rate charged by commercial banks to large, strong borrowers) Maturity period ranges from 90 to 180 days Generally sold at a discount from its face value and redeemed at its face value, difference constitutes interest. No well developed secondary market The minimum size of commercial paper issue is Rs.2.5 and in denominations of half a million or more Commercial paper is not backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue. The proceeds from this type of financing can only be used on current assets (inventories) and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement. 31

32 A factor is a financial institution which offers services relating to management and financing of debts arising from credit sales, which ensures a definite pattern of cash inflows from credit sales of an organization and eliminates the need for credit and collection department RBI authorized public sector banks that do factoring: SBI, Canbank, PNB, Bank of Allahabad selects the accounts of the client and establishes the credit limits factor assumes responsibility for collecting the debt Advances money against not yet collected / not yet due accounts Factoring is on a recourse basis Besides interest on advances against debt the factor charges a commission which maybe 1 2% of the face value of the debt factored 32

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