Managing The Firm s Assets

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1 CHAPTER OUTLINE Spotlight: The United Companies (http://www.uniteddc.com) 1 The Working-Capital Cycle Describe the working-capital cycle of a small business. Working-capital management Define working capital and explain that the working capital cycle refers to the flow of a firm s resources through the cash, accounts receivable, and inventory accounts. Have students compare their take home pay with the working capital of a business. Working-capital cycle includes 5 step process Purchase or produce inventory for sale Sell the inventory for cash or credit Pay the accounts payable as well as operating expenses and taxes Collect the accounts receivable Begin the cycle again Steps graphically indicated in Exhibit 22-1 Working-Capital Cycle The Timing and Size of Working-Capital Investments Failure to understand the timing and size of these investments underlies many financial problems of small firms Exhibit 22-2 Working-Capital Time Line provides the chronological sequence of a hypothetical working-capital cycle Cash conversion period Examples of Working-Capital Management Exhibit Working Capital Time Lines for Pokey, Inc., and Quick Turn Company provides time lines for two companies Both firms order inventory on August 31, other information differs Pokey, Inc. Must pay supplier on September 3 before reselling it on October 15 Collects from customers on November 3 Firm needs to find a way to finance the investment in inventory and accounts receivable to avoid cash flow problems Quick Turn Company Must pay for inventory purchases by October 31, but sold product on September 3 Collected from customers on October 31 No cash conversion period 2 Managing Cash Flows Identify the important issues in managing a firm s cash flows. Effective cash flow management vital Core of working-capital management is monitoring cash flows Net cash flow may be determined by examining its bank account Exhibit 22-4 Flow of Cash through a Business Must distinguish between sales revenue and cash receipts (seldom the same) Cash budget essential to anticipate when cash will enter and leave the business 235

2 3 Managing Accounts Receivable Explain the key issues in managing accounts receivable How Accounts Receivable Affect Cash Have students discuss loaning $5 to a friend expecting to be paid back in 7 days. Then the friend forgets to pay the money back. What does that do to the student s individual cash flow? Allowing customers to delay payment (using credit) delays the inflow of cash Total amount of customers credit balances is carried on the balance sheet as accounts receivable, a current asset Typically accounts receivable become cash within 3-6 days following a sale The Life Cycle of Accounts Receivable Continue the discussion with the student loan of $5. Ask the students what happens as the length of time that they keep waiting for their $5 grows longer. Days sales outstanding (average collection period) is also called the average collection period Determine by dividing a firm s accounts receivable by daily credit sales (examples provided in text on page 656) Small companies are vulnerable to problems caused by slow collections Large companies typically take 6 or 9 days to pay an invoice regardless of the credit terms stated on the invoice Credit management practices that can have a positive effect on cash flows Minimize the time between shipping, invoicing, and sending notices on billings Review previous credit experiences to determine impediments to cash flows Provide incentives for prompt payment (granting cash discounts or charging interest on delinquent accounts) Age accounts receivable on a monthly or even weekly basis to quickly identify any delinquent accounts Use the most effective methods for collecting overdue accounts Use a lock box for receiving remittance Accounts Receivable Financing Pledged accounts receivable are used as collateral for a loan Factoring, business sells its accounts receivable to a finance company 4 Managing Inventory Discuss the key issues in managing inventory Reducing Inventory to Free Cash Inventory size and handling differs for businesses such as a service company as compared to a manufacturer or retailer Refer to Chapter 21 and inventory management techniques Monitoring Inventory Days in inventory is the number of days on average that a company holds inventory Computers can provide assistance in inventory Controlling Stockpiles 236 Overbuying of inventory Entrepreneur s enthusiasm may be forecast greater demand than is realistic

3 Customer relationship may motivate a manager to stock everything customers want Price-conscious manager may respond to a vendor s appeal to buy now, because prices are going up. 5 Managing Accounts Payable Explain key issues in managing accounts payable Negotiation Timing Exhibit 22-5 An Accounts Payable Timetable for Terms of 3/1, Net 3 6 Cash Conversion Period Revisited Calculate and interpret a company s cash conversion period. The time span during which the firm s investment in accounts receivable and inventory must be financed Key concern for any small business 7 Capital Budgeting Give examples of the types of capital budgeting decisions small business owners must make Capital budgeting decisions might include Develop and introduce a new product that shows promise but requires additional study and improvement Replace a firm s delivery trucks with new models Expand sales activity into a new territory Construct a new building Hire several additional salespersons to intensify selling in the existing market Nearly half of all long-term capital investments by small companies are made for replacement and maintenance 8 Capital Budgeting Techniques Discuss the techniques commonly used in making capital budgeting decisions. Accounting Return on Investment Technique compares the average annual after-tax profits a firm expects to receive with the average book value of the investment Easy to calculate, but two major shortcomings Based on accounting profits rather than actual cash flows received Ignores the time value of money Payback Period Payback period technique measures how long it will take to recover the initial cash outlay of an investment Many managers and owners use this technique in evaluating investment decisions Discounted Cash Flows Discounted cash flow (DCF) techniques compare the present value of future cash flows with the investment outlay Net present value (NPV) estimates the current value of the cash that will flow into the firm from the project in the future and deducts the amount of the initial outlay Internal rate of return (IRR) estimates the rate of return that can be expected from a contemplated investment 237

4 9 Capital Budgeting Practices in Small Firms Describe the capital budgeting practices of small firms. National Federation of Independent Business study Determined that 55% of small business owners indicated that they use some form of quantitative measure to assess a capital investment 25% indicated they use intuition SOURCES OF VIDEO AND OTHER INSTRUCTIONAL MATERIALS The Deloitte (member of Deloitte Touche Tohmatsu) Web site offers case studies and a list of books on topics useful to both small and large businesses. Check out their Web site at Type/Case-Studies/index.htm. ANSWERS TO END-OF-CHAPTER DISCUSSION QUESTIONS 1. List the events in the working-capital cycle that directly affect cash and those that do not. What determines the length of a firm s cash conversion period? Working-capital management primarily involves management of three assets cash, accounts receivable, and inventories and two sources of short-term debt accounts payable and accruals. We purchase or produce inventories; sell these inventories, either for cash or on credit; and collect the accounts receivable resulting from the credit sales. The purchasing of inventory or raw materials affects cash unless the purchases are made on credit. Sales also affect cash unless they are made on credit. When payment is made on a credit purchase or payment is received on a credit sale, cash is affected. The cash conversion period is the time between the payment of cash for materials or goods and the receipt of cash for the sale of those materials or goods. A company s credit sales policy and its credit purchasing policy (whether discounts are usually taken) affect the cash conversion period. Also, the credit sales policies of its suppliers and the credit purchasing policies of its customers affect the cash conversion period. 2. What are some examples of cash receipts that are not sales revenue? Explain how expenses and cash disbursements during a month may be different. Cash receipts that are not sales revenue include money obtained by borrowing, from additional investments, from the sale of assets, and from the collection of accounts receivable (indirect sales revenue). 238

5 Some expenses may be incurred without paying out cash for example, by purchasing office supplies that are used during the month but are not yet billed. Some disbursements are necessary to pay expenses incurred in earlier months for example, payment of last month s electric bill. 3. How may a seller speed up the collection of accounts receivable? Give examples that may apply to various stages in the life cycle of receivables. The seller may speed up the billing process by sending invoices promptly an early step. It may also screen customers to weed out slow-paying accounts and provide incentives for prompt payment. Or, the seller may use aggressive methods in collecting accounts a late step. 4. Suppose that a small firm could successfully shift to a just-in-time inventory system an arrangement in which inventory is received just as it is needed. How would this affect the firm s working-capital management? Shifting to a just-in-time inventory system would presumably reduce inventory requirements. If the system worked perfectly, inventory would approach zero. As a result, the total working capital needed would be reduced. Cash obtained from reducing inventory could be used for other purposes. 5. How do working-capital management and capital budgeting differ? Working-capital management has more to do with the short-term, day-to-day disbursements typically associated with normal operations. Capital budgeting usually involves long-term decisions and larger dollar amounts. This is not to say that capital budgeting is more important than working-capital management, but because larger dollar amounts are typically involved, more preparation and evaluation are needed. 6. Compare the different techniques that can be used in capital-budgeting analysis. All the techniques attempt to answer one general question: Do the future benefits from an investment exceed the cost of making the investment? However, each of the three measurements has its own specific question to answer. The techniques and the specific question each addresses may be stated as follows: Accounting return on investment: How many dollars in average profits are generated per dollar of average investment? Payback period: How long will it take to recover the original investment outlay? Discounted cash flow: How does the present value of future benefits from the investment compare to the investment outlay? 7. What does net present value measure? 239

6 Net present value estimates the current value of the cash that will flow into the firm from the project in the future and deducts the amount of the initial outlay. 8. Define internal rate of return. Internal rate of return is the rate earned on an investment or project. It is the rate that would give a project or investment a net present value of zero. Just as net present value gives a dollar value for comparative purposes; internal rate of return gives a percentage rate of return that may be used for comparing different opportunities. 9. a. Find the accounting return on investment for a project that costs $1,, will have no salvage value, and has expected annual after-tax profits of $1,. b. Determine the payback period for a capital investment that costs $4, and has the following after-tax profit. (The project outlay of $4, will be depreciated on a straight-line basis over seven years to a zero salvage value.) Year After-Tax Profits 1 $4, 2 5, 3 6, 4 6,5 5 6,5 6 6, 7 5, a. Accounting return on investment = ($1, [$1, + ]) =.2, or 2% b. After-Tax Cash Cumulative Year Profits Depreciation Flow Cash Flow 1 $4, $5,714 $9,714 $9, , 5,714 1,714 2, , 5,714 11,714 32, ,5 5,714 12,214 44,356 After Year 3, $7,858 (or $4, $32,142) remains to be repaid, and it is paid after 64.33% (or $7,858 $12,214) of Year 4 has elapsed. The total payback period is 3.64 years. 1. Why would owners of small businesses not be inclined to use the net present value or internal rate of return measurements? Such limited use of discounted cash flow techniques probably has more to do with the nature of the small firm itself than with the owners unwillingness to learn. For 24

7 many owners of small firms, the business is an extension of their lives, and what happens to the owners personally affects their decisions about the firm; several nonfinancial variables may play a significant part in owners decisions. The undercapitalization and liquidity problems of a small firm can directly affect the decision-making process, and survival often becomes the top priority. The greater uncertainty of cash flows within a small firm makes long-term forecasting and planning seem unappealing and even a waste of time, thus, calculating the cash flows for the entire life of a project is viewed as futile. The value of a closely held firm is less easily observed than that of a publicly held firm, thus, the owner might consider the market-value rule of maximizing net present values irrelevant. The smaller size of a small firm s projects may make net present value computations less feasible in a practical sense. Lastly, management talent within a small firm is a scarce resource; the perspective of owners is influenced greatly by their backgrounds. COMMENTS ON CHAPTER YOU MAKE THE CALL SITUATIONS Situation 1 1. What are the advantages and weaknesses of the minimum-cash-balance practice? The advantages are the ability to pay bills promptly and the chance to eliminate certain paperwork. A major weakness is the lower interest income resulting from maintaining such a large balance in a checking account. A commercial demand checking account cannot pay interest. 2. There is a saying If it ain t broke, don t fix it. In view of the firm s present success in paying bills promptly, should it be encouraged to use a cash budget? Be prepared to support your answer. The firm should be encouraged to use a cash budget in order to maximize its profits. It can then transfer excess cash into interest-bearing accounts until the money is needed to pay bills. The owner of this firm may be fearful of trying a financial tool with which he or she has no experience, but cash budgeting need not be complex or burdensome. Situation 2 1. Is offering a cash discount the equivalent of a bribe? A cash discount is not the equivalent of a bribe. It is a payment for use of money for a longer time period. 2. How would a cash discount policy relate to bad debts? 241

8 If payment that otherwise would be postponed can be encouraged to come in immediately with a cash discount, that receivable will never become a bad debt. However, most companies that have trouble paying their bills do not take advantage of cash discounts. Therefore, a cash discount policy would have minimal impact on this firm s bad-debt experience. (The company does appear to have a bad-debt problem.) 3. What cash discount policy, if any, would you recommend? In answering this question, the first step should be to examine the credit policies of competitors and the credit expectations of customers. There are probably standard credit terms that are commonly used in the industry. This firm may find that it is losing business from well-run companies that patronize its competitors in order to take advantage of cash discounts. Some reduction of revenue will occur as the company grants discounts to those already paying promptly. A careful estimate must be made of the degree to which payments can be accelerated and the extent to which new business can be obtained from well-managed customers. These benefits must be compared to the additional costs involved in such a policy change. 4. What other approaches might be used to improve cash flow from receivables? Cash flow might be improved by factoring accounts receivable funds would be obtained immediately and the factor would have to collect the receivables. Reducing bad debts through improved screening and/or collection practices would also improve cash flow. Situation 3 1. Based on the information in the balance sheets, what do you notice about the nature of the general contracting business in terms of their working capital? How are the two companies alike, and how do they differ? ASSUMPTIONS: Collection Experience Cash Sales % 25% 1 Month 35% 2 months 4% Purchases 75% of sales Utilities 3% of sales Short-term interest rate 1% Minimum cash balance 7, Cost of goods sold 75% Monthly sales $15, $175, Aug Sept Oct Nov Dec Jan $2, $22, $18, $2, 242

9 Cash receipts Cash sales 25% $5, $55, $45, 1 month 35% 61,25 7, 77, 2 months 4% 6, 7, 8, Total collections $171,25 $195, $22, Purchases 75% $15, $165, $135, $15, Cash disbursements Payments on purchases $15, $165, $135, Rent Wages and salaries 5, 25, 5, 5, 25, 25, Tax prepayment 1, Utilities 3% 6, 6,6 5,4 Interest long-term note 1,5 Total cash disbursements $196, $21,6 $171,9 Net change in cash ($24,75 ($6,6) $3,1 2. Have a general contractor explain to you what the financial ) statement say about this type of business Beginning cash balance $7, $7, $7, Short-term interest.833% Cash balance before borrowing -17, ,837 Short-term borrowing (payments) 24,75 6,86-29,837 Ending cash balance $7, $7, $7, $7, Cumulative short-term borrowing $24,75 $31,556 $1, Compute the cash conversion period for each company and interpret your findings. Assume that you calculate the cash conversion period for your own company, with the following results: Days sales outstanding.55 Days in inventory... Days in payables...(42) Cash conversion period (days) 13 If your company had the same days sales outstanding and days in payables, how much cash would be freed up to use for growth or to repay debt? SUGGESTED SOLUTION TO CASE 22: PEARSON AIR CONDITIONING & SERVICE 243

10 1. Evaluate the overall performance and financial structure of Pearson Air Conditioning & Service. The year s performance, as recorded in Figure C22-1 is excellent. The net income after taxes of $54,54 represents a 55 percent return on the equity of $99,625. Moreover, this amount is the profit after allowance for officers salaries. In other words, salary compensation was realized by the owners in addition to the stated profit. The current ratio of 2.1 to 1 indicates an apparently healthy current financial condition. The 1. to 1 acid-test ratio further confirms this assessment of current condition. The total debt is 57.8 percent of total assets a percentage that might be viewed with some concern. However, the fact that a substantial part of the debt represents a note being paid off to the former owner over a period of several years makes this figure less disturbing. 2. What are the strengths and weaknesses in this firm s management of accounts receivable and inventory? The fact that the firm has experienced no significant losses from bad debts indicates that control of accounts receivable has been reasonably successful. However, management of receivables could be improved. These accounts were not aged. The firm s accountant should be directed to age the accounts so that the manager has a clear picture of the extent to which customers are using Pearson s money by delaying payments. In the absence of a cash discount to encourage payment, Pearson s must be very aggressive in their collection procedures. The small interest charge on unpaid bills is not sufficient to provide a strong incentive for prompt payment. The practice of collecting payment for service calls at the time of service is to be commended. This practice, when successful, results in a cash sale and reduces bookkeeping and billing costs. In summary, Pearson s has been managing accounts receivable successfully, but there is some question about the aggressiveness of their collection methods and the lack of aging of receivables. Pearson s needs to improve the management of inventory. The use of an annual physical inventory indicates that the firm does not know inventory levels at other times. This situation needs to be remedied as quickly as possible by introducing a perpetual inventory system. The recognition that there may be some slack in inventory suggests a need for more rigorous control. Excessive inventory involves heavy carrying charges and a drain on profits when interest costs are high. Some 244

11 attempt should be made, therefore, probably through the firm s CPA, to locate standards that can be used to evaluate the quality of their inventory management. 3. Should the firm reduce or expand the amount of its bank borrowing? Bank borrowing is costly during periods of high interest rates. Profits can be improved by reducing borrowing, assuming that operations are not adversely affected. If Pearson s bank borrowing can be reduced by holding the cash balance at a lower level, by removing excess inventory, and by speeding up collection of receivables, the firm will benefit. Nonetheless, the firm should not pass up profitable opportunities merely for the sake of reducing borrowing. 4. Evaluate Pearson s management of accounts payable. Pearson s is apparently taking advantage of all credit being offered by suppliers. However, their failure to take cash discounts is costly when calculated in terms of the annual rate of return on the cash involved. (The 2/1, net 3 terms are equivalent to an annual rate of 36 percent.) If cash is desperately needed or if the amount is trivial, this practice is permissible. Otherwise, they should begin taking cash discounts. The suppliers offer quite different terms of payment. From the standpoint of financial management, Pearson s should order as much as possible under the floorplanning arrangement of Carrier. This involves no carrying cost. The next best terms are those offered by York 3 days to pay. The most severe terms are those offered by General Electric: payment after receipt of products. 5. Calculate Pearson s management of accounts payable. The cash conversion period equals the days in inventory plus the days in accounts receivable less the days in accounts payable. For Barton the cash conversion period is 68 days, computed as follows: Days in inventories [365 days (cost of goods sold/inventories)] 7 days Days in accounts receivable [365 days (sales/accounts receivable)] 28 days Days in accounts payable [365 days (cost of goods sold/accounts payable)] 3 days Cash conversion period 68 days 245

12 6. How can Pearson Air Conditioning & Service improve its working-capital situation? To answer this question, we must summarize a number of points discussed above. The Bartons should reduce the cash balance to the minimum necessary for effective operation because idle cash is costly. They should adopt a more efficient form of inventory control that will reduce the inventory level and thereby reduce carrying costs. Accelerated collection of receivables would improve the working-capital situation. And, to the extent that buying could be concentrated with suppliers who offer the most generous financing terms, the firm could also minimize the costs associated with payables and inventory. 246

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