FINANCIAL MANAGEMENT 2

CHAPTER 8: SHORT-TERM FINANCIAL DECISIONS

Objectives:
1. Discuss the Short-term financial management
2. Define Net working capital

Short-term financial management

Working capital (or short-term financial) management is the management of

current assets and current liabilities:
– Current assets include inventory, accounts receivable, marketable
securities, and cash.
– Current liabilities include notes payable, accruals, and accounts
payable.
– Organisations are able to reduce financing costs or increase the
funds available for expansion by minimising the amount of funds
tied up in working capital.
–
Chief financial officers (CFO’s) value working capital management:
– A survey of CFOs from organisations around the world suggests
that working capital management tops the list of most valued
finance functions.
– Among 19 different finance functions, CFOs viewed working capital
management as equally important as capital structure, debt
issuance and management, bank relationships, and tax
management.
– CFOs viewed the performance of working capital management as
only being better than the performance of pension management.
– Consistent with their view that working capital management is a high
value but low satisfaction activity, it was identified as the finance
function second most in need of additional resources.

Net working capital

Working capital refers to current assets, which represent the portion of

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investment that circulates from one form to another in the ordinary conduct of
business.

Net working capital is the difference between the organisation’s current assets
and its current liabilities; can be positive or negative.

Trade-off between profitability and risk

Profitability is the relationship between revenues and costs generated by using

the organisation’s assets – both current and fixed – in productive activities.
An organisation can increase its profits by (1) increasing revenues or
(2) decreasing costs.
Risk (of insolvency) is the probability that an organisation will be unable to
pay its bills as they come due.
Insolvent describes an organisation that is unable to pay its bills as they
come due.

1. Cash conversion cycle

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The cash conversion cycle (CCC) is the length of time required for a
company to convert cash invested in its operations to cash received as a
result of its operations.

An organisation’s operating cycle (OC) is the time from the beginning of

the production process to collection of cash from the sale of the finished
product.
It is measured in elapsed time by summing the average age of inventory
(AAI) and the average collection period (ACP). OC = AAI + ACP

An organisation can lower its working capital if it can speed up its

operating cycle.
For example, if an organisation accepts bank credit (like a Visa card), it
will receive cash sooner after the sale is transacted than if it has to wait
until the customer pays its accounts receivable.

Calculating the cash conversion cycle

• The process of producing and selling a product also includes the

purchase of production inputs (raw materials) on account, which
results in accounts payable.
• The time it takes to pay the accounts payable, measured in days, is
the average payment period (APP). The operating cycle less the
average payment period yields the cash conversion cycle. The
formula for the cash conversion cycle is:
CCC = OC – APP

Substituting for OC, we can see that the cash conversion cycle has three
main components, as shown in the following equation: (1) average age of
the inventory, (2) average collection period, and (3) average payment
period.
CCC = AAI + ACP – APP

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Funding requirements of the cash conversion cycle

A permanent funding requirement is a constant investment in operating

assets resulting from constant sales over time.
A seasonal funding requirement is an investment in operating assets
that varies over time as a result of cyclic sales.
An aggressive funding strategy is a funding strategy under which the
organisation funds its seasonal requirements with short-term debt and its
permanent requirements with long-term debt.
A conservative funding strategy is a funding strategy under which the
organisation funds both its seasonal and its permanent requirements with
long- term debt.
Work through the example of Shabalala Pump Company in Gitman (2010).

Strategies for managing the cash conversion cycle

The goal is to minimise the length of the cash conversion cycle, which
minimises negotiated liabilities. This goal can be realised through use of
the following strategies:

1. Turn over inventory as quickly as possible without stock-

outs that result in lost sales.

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2. Collect accounts receivable as quickly as possible without

losing sales from high-pressure collection techniques.
3. Manage mail, processing, and clearing time to reduce them
when collecting from customers and to increase them when
paying suppliers.
4. Pay accounts payable as slowly as possible without
damaging the organisation’s credit rating.

3. Inventory management

Differing viewpoints about appropriate inventory levels commonly exist

among an organisation’s finance, marketing, manufacturing, and
purchasing managers.
– The financial manager’s general disposition toward inventory
levels is to keep them low, to ensure that the organisation’s
money is not being unwisely invested in excess resources.
– The marketing manager, on the other hand, would like to have
large inventories of the organisation’s finished products.
– The manufacturing manager’s major responsibility is to
implement the production plan so that it results in the
desired amount of finished goods of acceptable quality
available on time at a low cost.
– The purchasing manager is concerned solely with the raw
materials inventories.

Common techniques for managing inventory

The ABC inventory system is an inventory management technique that

divides inventory into three groups – A, B, and C, in descending order of
importance and level of monitoring, on the basis of the dollar investment
in each.
– The A group includes those items with the largest dollar
investment. Typically, this group consists of 20 percent of
the organisation’s inventory items but 80 percent of its

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investment in inventory.
– The B group consists of items that account for the next largest
investment in inventory.
– The C group consists of a large number of items that
require a relatively small investment.
The inventory group of each item determines the item’s level of
monitoring.
– The A group items receive the most intense monitoring
because of the high dollar investment. Typically, A group
items are tracked on a perpetual inventory system that
allows daily verification of each item’s inventory level.
– B group items are frequently controlled through periodic,
perhaps weekly, checking of their levels.
– C group items are monitored with unsophisticated techniques,
such as the two-bin method; an unsophisticated inventory-
monitoring technique that involves reordering inventory
when one of two bins is empty.

The large rand investment in A and B group items suggests the need
for a better method of inventory management than the ABC system.

The economic order quantity (EOQ) model is an inventory

management technique for determining an item’s optimal order
size, which is the size that minimises the total of its order costs and
carrying costs.

– The EOQ model is an appropriate model for the

management of A and B group items.

EOQ assumes that the relevant costs of inventory can be

divided into order costs and carrying costs.
– Order costs are the fixed clerical costs of placing and
receiving an inventory order.
– Carrying costs are the variable costs per unit of holding an
item in inventory for a specific period of time.

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The EOQ model analyses the trade off between order costs and
carrying costs to determine the order quantity that minimises the
total inventory cost.
A formula can be developed for determining the organisation’s EOQ
for a given inventory item, where:
S = usage in units per period
O = order cost per order
C = carrying cost per unit per period
Q = order quantity in units

The order cost can be expressed as the product of the cost per
order and the number of orders. Because the number of orders
equals the usage during the period divided by the order quantity
(S/Q), the order cost can be expressed as follows:
Order cost = O  S/Q

The carrying cost is defined as the cost of carrying a unit of

inventory per period multiplied by the organisation’s average
inventory. The average inventory is the order quantity divided by 2
(Q/2), because inventory is assumed to be depleted at a constant
rate. Thus carrying cost can be expressed as follows:
Carrying cost = C  Q/2
The organisation’s total cost of inventory is found by summing the
order cost and the carrying cost. Thus the total cost function is
Total cost = (O  S/Q) + (C  Q/2)
Because the EOQ is defined as the order quantity that minimises
the total cost function, we must solve the total cost function for the
EOQ. The resulting equation is

The reorder point is the point at which to reorder inventory, expressed

as days of lead time x daily usage.

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Because lead times and usage rates are not precise, most organisations
hold safety stock – extra inventory that is held to prevent stock-outs of
important items.

Example
MAX Company, a producer of dinnerware, has an A group inventory item
that is vital to the production process. This item costs R1,500 and MAX
uses 1,100 units of the item per year. MAX wants to determine its optimal
order strategy for the item. To calculate the EOQ, we need the following
inputs:
– Order cost per order = R150
– Carrying cost per unit per year = R200
Thus, the reorder point for MAX depends on the number of days MAX
operates per year.
– Assuming that MAX operates 250 days per year and uses
1,100 units of this item, its daily usage is 4.4 units (1,100 ÷
250).
– If its lead time is 2 days and MAX wants to maintain a safety
stock of 4 units, the reorder point for this item is 12.8 units
[(2  4.4) + 4].
– However, orders are made only in whole units, so the order is
placed when the inventory falls to 13 units.

A just-in-time (JIT) system is an inventory management technique that

minimises inventory investment by having materials arrive at exactly the
time they are needed for production.
– Because its objective is to minimise inventory investment, a
JIT system uses no (or very little) safety stock.
– Extensive coordination among the organisation’s employees,
its suppliers, and shipping companies must exist to ensure
that material inputs arrive on time.
– Failure of materials to arrive on time results in a shutdown of
the production line until the materials arrive.
– Likewise, a JIT system requires high-quality parts from suppliers.

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Computerised systems for resource control

A materials requirement planning (MRP) system is an inventory

management technique that applies EOQ concepts and a computer to
compare production needs to available inventory balances and determine
when orders should be placed for various items on a product’s bill of
materials.

Manufacturing resource planning II (MRP II) is a sophisticated

computerised system that integrates data from numerous areas such as
finance, accounting, marketing, engineering, and manufacturing and
generates production plans as well as numerous financial and
management reports.

Enterprise resource planning (ERP) is a computerised system that

electronically integrates external information about the organisation’s
suppliers and customers with the organisation’s departmental data so that
information on all available resources – human and material – can be
instantly obtained in a fashion that eliminates production delays and
controls costs.
Accounts receivable management

The second component of the cash conversion cycle is the average

collection period. The average collection period has two parts:

1. The time from the sale until the customer mails the payment.

2. The time from when the payment is mailed until the

organisation has the collected funds in its bank account.

The objective for managing accounts receivable is to collect accounts

receivable as quickly as possible without losing sales from high-pressure
collection techniques. Accomplishing this goal encompasses three topics:
(1) credit selection and standards, (2) credit terms, and (3) credit
monitoring.

Credit selection and standards

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Credit standards are an organisation’s minimum requirements for

extending credit to a customer.

The five C’s of credit are as follows:

1. Character: The applicant’s record of meeting past obligations.

2. Capacity: The applicant’s ability to repay the requested credit.

3. Capital: The applicant’s debt relative to equity.

4. Collateral: The amount of assets the applicant has available

for use in securing the credit.

5. Conditions: Current general and industry-specific economic

conditions, and any unique conditions surrounding a specific
transaction.

Credit scoring is a credit selection method commonly used with

high-volume/small-rand credit requests; relies on a credit score
determined by

applying statistically derived weights to a credit applicant’s scores on

key financial and credit characteristics.

The organisation sometimes will contemplate changing its credit

standards in an effort to improve its returns and create greater value for
its owners. To demonstrate, consider the following changes and effects
on profits expected to result from the relaxation of credit standards.

Example

Dodd Tool Co. is currently selling a product for R10 per unit. Sales (all on
credit) for last year were 60,000 units. The variable cost per unit is R6. The
organisation’s total fixed costs are R120,000. The organisation is currently

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contemplating a relaxation of credit standards that is expected to result in

the following:

– A 5% increase in unit sales to 63,000 units

– An increase in the average collection period from 30 days (the

current level) to 45 days

– An increase in bad-debt expenses from 1% of sales (the

current level) to 2%.

The organisation’s required return on equal-risk investments, which is the

opportunity cost of tying up funds in accounts receivable, is 15%.

Because fixed costs are ‘sunk’ and therefore are unaffected by a change
in the sales level, the only cost relevant to a change in sales is variable
costs. Sales are expected to increase by 5%, or 3,000 units. The profit
contribution per unit will equal the difference between the sale price per
unit (R10) and the variable cost per unit (R6). The profit contribution per
unit therefore will be R4. The total

additional profit contribution from sales will be R12,000 (3,000 units  R4

per unit).

To determine the cost of the marginal investment in accounts receivable,

Dodd must find the difference between the cost of carrying receivables under
the two credit standards. Because its concern is only with the out-of-pocket
costs, the relevant cost is the variable cost. The average investment in
accounts receivable can be calculated by using the following formula:

Total variable cost of annual sales:

– Under present plan: (R6  60,000 units) = R360,000
– Under proposed plan: (R6  63,000 units) = R378,000
The turnover of accounts receivable is the number of times each year that

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the organisation’s accounts receivable are actually turned into cash. It is

found by dividing the average collection period into 365 (the number of
days assumed in a year).

Turnover of accounts receivable:

– Under present plan: (365/30) = 12.2
– Under proposed plan: (365/45) = 8.1
By substituting the cost and turnover data just calculated into the average
investment in accounts receivable equation for each case, we get the
following average investments in accounts receivable:
– Under present plan: (R360,000/12.2) = R29,508
– Under proposed plan: (R378,000/8.1) = R46,667

Cost of marginal investment in accounts receivable

Average investment under proposed plan R46,667
– Average investment under present plan
29,508
Marginal investment in accounts receivable R17,159
 Required return on investment

0.15 Cost of marginal investment in A/R R

2,574
The resulting value of R2,574 is considered a cost because it represents
the maximum amount that could have been earned on the R17,159 had it
been placed in the best equal-risk investment alternative available at the
organisation’s required return on investment of 15%.

Cost of marginal bad debts

Under proposed plan: (0.02  R10/unit  63,000 units) = R12,600
Under present plan: (0.01  R10/unit  60,000 units) =
6,000 Cost of marginal bad debts R
6,600

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Credit management is difficult enough for managers of purely domestic

companies, and these tasks become much more complex for companies
that operate internationally.

– This is partly because international operations typically expose

an organisation to exchange rate risk.
– It is also due to the dangers and delays involved in shipping
goods long distances and in having to cross at least two
international borders.

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