Financial Management, Part 2

University of Santo Tomas

 Eugene

F. Brigham & Joel F. Houston

Lawrence
Sheridan

D. Martin

William

J. Gitman & Chad J. Zutter

Titman, Arthur J. Keown & John

Stevenson

Raymond
Stephen

M. Brooks

Foerster

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.
Firms are able to reduce financing costs or
increase the funds available for expansion by
minimizing the amount of funds tied up in
working capital.

 Working

capital refers to current

assets, which represent the portion
of investment that circulates from
one form to another in the ordinary
conduct of business.
Net working capital is the
difference between the firms current
assets and its current liabilities; can
be positive or negative.

 Profitability

is the relationship
between revenues and costs generated
by using the firms assetsboth current
and fixedin productive activities.
A firm can increase its profits by (1)

increasing revenues or (2) decreasing costs.

Risk

(of insolvency) is the probability

that a firm will be unable to pay its bills
as they come due.
A firm that is insolvent is unable to
pay its bills as they come due.

Part 1

Operating cycle and cash conversion

cycle determine how effectively a firm
has managed its working capital. The
shorter the cycles, the more efficient is
the firms working capital
management.

The operating cycle measures the

time period that elapses from the date
that an item of inventory is purchased
until the firm collects the cash from its
sale.

Accounts payable deferral period When the firm is able to purchase

items of inventory on credit, cash is
not tied up for the full length of its
operating cycle.

Cash conversion cycle is shorter

than the operating cycle as the firm
does not have to pay for the items in
its inventory for a period equal to the
length of the account payable deferral
period.

Calculations are based on the following

information:
Annual credit sales = $15 million
Cost of goods sold = $12 million
Inventory = $3 million
Accounts receivable = $3.6 million
Accounts payable outstanding = $

2million

Production cycle + Accounts receivable cycle

Payment cycle = Cash conversion cycle i.e. the
number of days between when a firm incurs an
outflow to start production until it receives payment
on a credit sale.

So if a firm can shorten its production cycle or its

collection cycle, or both, while keeping its payment
cycle constant or lengthened, it can shorten the
number of days that it would typically have to finance
its operations for, thereby reducing its financing costs
and increasing its profits.

Thus, shortening the cash conversion cycle

essentially requires the efficient management of
receivables (credit policy), inventory, and payables.

Measuring Cash Conversion Cycle.

Mark has just been appointed as the chief financial officer of
a mid-sized manufacturing company and is keen to measure
the firms cash conversion cycle, operating cycle, production
cycle, collection cycle, and payment cycle, so as to see if any
changes are warranted. He collects the necessary
information for the most recent fiscal year, and puts together
the table below:
Cash sales $200,000
Credit sales
$600,000
Total sales $800,000
Cost of goods sold
$640,000
Ending Balance
Beginning Balance
Accounts receivable
$40,000
$36,000
Inventory
$10,000
$6,000
Accounts payable
$ 9,000
$ 5,000

Answer
First, we calculate the average values of the 3 accounts:
Average A/R ($36,000 + $40,000)/2 = $38,000
Average inventory $(10000+6000)/2 = $8,000
Average A/P ($9 000 + $5,000)/2 = $7,000
Next, we calculate the turnover rates of each:
A/R Turnover = Credit Sales/Avg. A/R $600,000/$38,000 15.7895
Inventory Turnover = Cost of Goods Sold/Avg. Inv $640,000/$8,000
= 80
A/P Turnover = Cost of Goods Sold/Avg. A/P = $640,000/$7,000
= 91.43

Finally we calculate the collections cycle, the production cycle, and

the payment cycle by dividing each of the turnover rates into 365
days, respectively.

Answer (continued)
Collection cycle= 365/A/R Turnover365/15.7895 23.12
days
Production cycle = 365/Inv. Turnover365/80
4.56 days
Payment cycle = 365/A/P Turnover365/91.43
3.99 days

So the firms operation cycle = Collection cycle + Production cycle

= 23.12+4.56 = 27.68 days

Cash conversion cycle = Operating cycle Payment cycle

= 27.68-3.99 23.69 days.
So on average, the firm has to finance its credit sales for
about 24 days.

If GM were to have an average collection

period of 24.16 days, an inventory conversion
period of 39.84 days and accounts payable
deferral period of 131.42 days, what would its
operating and cash conversion cycles be?

We are given the following for GM:

Average collection period = 24.16 days
Inventory conversion period = 39.84 days
Accounts payable deferral period =
131.42 days

Operating Cycle = 39.84 days +

24.16 days
= 64 days

= 64 days 131.42 days

= -67.42 days

We observe that the operating cycle for GM is 64

days which indicates that 64 days elapse from
the date an item of inventory is purchased at GM
until the firm collects the cash from its sale.

The cash conversion cycle is negative as GM is

able to defer making payments on its account
payable.

The goal is to minimize the length of the cash

conversion cycle, which minimizes negotiated
liabilities. This goal can be realized through use of
the following strategies:
1. Turn over inventory as quickly as possible without

stockouts that result in lost sales.

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 firms credit rating.

Part 2

Raw materials & purchased parts

Partially completed goods called
work in progress
Finished-goods inventories

(manufacturing firms)
or merchandise
(retail stores)

 Replacement

parts, tools, &

supplies
Goods-in-transit

or customers

to warehouses

 To

meet anticipated demand

To

smooth production requirements

To

decouple components of the

production-distribution

To

protect against stock-outs

 To

take advantage of order cycles

To

help hedge against price

increases or to take advantage of
quantity discounts

To

permit operations

Differing viewpoints about appropriate inventory

levels commonly exist among a firms finance,
marketing, manufacturing, and purchasing
managers.

The financial managers general disposition toward

inventory levels is to keep them low, to ensure that

the firms money is not being unwisely invested in
excess resources.
The marketing manager, on the other hand, would
like to have large inventories of the firms finished
products.
The manufacturing managers 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.

Why inventory management is important:

Inventory

affects a firms sales and hence its

profitability
If

the firm doesnt have enough inventory, this is

an opportunity cost
Profitability

affects the overall value of the firm,

because investors are willing to pay more for a
company that turns a healthy profit

The ABC inventory system is an inventory

management technique that divides inventory
into three groupsA, 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 firms inventory items but 80
percent of its 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 items 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 items 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 dollar 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 items optimal
order size, which is the size that minimizes
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.

The EOQ model analyzes the tradeoff

between order costs and carrying costs to
determine the order quantity that minimizes
the total inventory cost.

A formula can be developed for determining the

firms 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

Measuring ordering cost.

Nigel Enterprises sells 1,000,000 copies per year. Each
order it places costs $40 for shipping and handling.
How will the total annual ordering cost change if the
order size changes from 1000 copies per order to
10000 copies per order.
Answer
At 1000 copies per order:
Total annual ordering cost = $40 X 1,000,000/1000
$40,000
At 10,000 copies per order:
Total annual ordering cost = $40 X 1,000,000/10,000
$4000
As order size increases, ordering costs decline due to
fewer orders

The carrying cost is defined as the cost of

carrying a unit of inventory per period
multiplied by the firms 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 firms 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)

Measuring carrying cost.

Nigel Enterprises has determined that it costs
them $0.10 to hold one copy in inventory each
period. How much will the total carrying cost
amount to with 1000 copies versus 10,000 copies
being held in inventory.
Answer
With 1000 copies in inventory
Total annual carrying cost = $0.10* 1000/2 = $50
With 10,000 copies in inventory
Total annual carrying cost = $0.10*10,000/2 =
$500
As order size increases carrying costs go up
proportionately.

Method to determine the optimal size of each order by

balancing ordering costs with carrying costs so as to
minimize the total cost of inventory.
The Trade-off between Ordering Costs and Carrying
Costs: occurs because with larger order sizes, fewer orders
are needed, reducing delivery
Inventory costs.
costs, and the costs resulting
from lost sales due to shortages.
However, higher levels of
inventory are held, thereby
increasing costs associated
with storage, handling,
spoilage and obsolescence.

Because the EOQ is defined as the

order quantity that minimizes the total
cost function, we must solve the total
cost function for the EOQ. The resulting
equation is

Calculating EOQ.
With annual sales of 1,000,000 copies, carrying
costs amounting to $0.10 per copy held and
order costs amounting to $40 per order. What
is Nigel Enterprises optimal order size? Please
verify that your answer is correct.

Answer
S = 1,000,000; OC = $40; CC = $0.10

EOQ = [(2*1000000*$40)/0.1]1/2= 28, 285

number)

(rounded to nearest whole

With order size = 28,285,

Total order cost = (1,000,000/28285)*$40 =
$1,414.2
Total carrying cost = 28,285/2*0.1= $1414.2
Total inventory cost = $2,828.4

Answer (continued)
Verification:
With Q = 28,000 OC = (1,000,000/28,000)*$40
$1428.6
CC28000/2*.11400
Total cost 2828.6>$2828.4
With Q = 29,000 OC= 1,000,000/29,000)*40
1379.31
CC1450
Total cost = $2,829.31>$2,828.4

Profile of Inventory Level Over Time

Usage
rate

Quantity
on hand
Reorder
point

Receive
order

Place Receive
order order

Lead time

Place
order

Receive
order

Time

Inventory gets used up every day lead time necessary

for additional supplies firms must determine a reorder
point to avoid a stock-out.
The reorder point = daily usage * days of lead time
Once the inventory hits the re-order point, the next
order is placed so that by time it is delivered, the firm
would be just about out of inventory.
An additional protection measure is to build in some
safety stock or buffer so as to be covered in case of
delivery delays as follows:

Average inventory = EOQ/2 + safety stock

Measuring re-order point and safety stock.

Calculate Nigel Enterprises re-order point and safety stock assuming that
deliveries take 4 days on average with a possibility of 2 day delays
sometimes.
Answer
EOQ = 28,285; daily usage rate = 1,000,000/3652740

Reorder point = 4*2740 = 10,960 (without safety stock)

With safety stock built in we calculate average inventory as

Average inventory = EOQ/2 + safety stock

Safety stock = 2 days usage = 2*2740 = 5480
So Nigel Enterprises should reorder when the inventory drops to
10,960 + 5480 16,440 copies.
copies

Part 3

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 firm 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.

 The

efficient management of accounts

receivable critical step in shortening
the cash conversion cycle.

Lax

credit policy
defaults
Strict credit policy Lost sales
Firms

have to establish well-balanced

credit and collection policies to
efficiently manage working capital.

Why accounts receivable management is important:

Providing

trade credit allows a firm to remain

competitive with other companies in the industry
that are doing the same
The

cost of providing trade credit is that the firm is

delayed in receiving money from its customers

The firm 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.

Dodd Tool is currently selling a product for $10 per

unit. Sales (all on credit) for last year were 60,000
units. The variable cost per unit is $6. The firms
total fixed costs are $120,000.The firm is currently
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 firms 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 ($10) and the
variable cost per unit ($6). The profit
contribution per unit therefore will be $4. The
total additional profit contribution from sales
will be $12,000 (3,000 units $4 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: ($6 60,000 units) =

$360,000
Under proposed plan: ($6 63,000 units) =
$378,000

The turnover of accounts receivable is the

number of times each year that the firms
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:

$29,508
Under proposed plan:
$46,667

($360,000/12.2) =
($378,000/8.1) =

Cost of marginal investment in accounts

receivable
Average investment under proposed plan
Average investment under present plan
Marginal investment in accounts receivable
Required return on investment
Cost of marginal investment in A/R

$46,667
29,508
$17,159
0.15
$ 2,574

The resulting value of $2,574 is considered a

cost because it represents the maximum
amount that could have been earned on the
$17,159 had it been placed in the best equalrisk investment alternative available at the
firms required return on investment of 15%.

Cost of marginal bad debts

Under proposed plan:

(0.02 $10/unit 63,000 units) = $12,600

Under present plan:

Cost of marginal bad debts

(0.01 $10/unit 60,000 units) =

6,000
$ 6,600

The net addition to total profits resulting from relaxing credit

standards would be $2,826 per year. Therefore, Dodd Tool should
relax its credit standards.

Credit terms are the terms of sale for

customers who have been extended credit by
the firm.
A cash discount is a percentage deduction
from the purchase price; available to the credit
customer who pays its account within a
specified time.
For example, terms of 2/10 net 30 mean the

customer can take a 2 percent discount from the

invoice amount if the payment is made within 10
days of the beginning of the credit period or can
pay the full amount of the invoice within 30 days.

A cash discount period is the number of days

after the beginning of the credit period during
which the cash discount is available.
The net effect of changes in this period is difficult
to analyze because of the nature of the forces
involved.
For example, if a firm were to increase its cash

discount period by 10 days (for example, changing

its credit terms from 2/10 net 30 to 2/20 net 30),
the following changes would be expected to occur:
(1) Sales would increase, positively affecting
profit. (2) Bad-debt expenses would decrease,
positively affecting profit. (3) The profit per unit
would decrease as a result of more people taking
the discount, negatively affecting profit.

MAX Company has annual sales of $10 million and an average

collection period of 40 days (turnover = 365/40 = 9.1). In accordance
with the firms credit terms of net 30, this period is divided into 32
days until the customers place their payments in the mail (not
everyone pays within 30 days) and 8 days to receive, process, and
collect payments once they are mailed. MAX is considering initiating a
cash discount by changing its credit terms from net 30 to 2/10 net 30.
The firm expects this change to reduce the amount of time until the
payments are placed in the mail, resulting in an average collection
period of 25 days (turnover = 365/25 = 14.6). Selling price is $3,000
with corresponding raw materials cost of $1,500 and production cost
of $800. The change is expected to increase sales by 50 units from
previous years sales of 1,100 units. It is expected that 80% of the
companys customers will take advantage of the discount. The firms
required return on equal-risk investments, which is the opportunity
cost of tying up funds in accounts receivable, is 14%.

What is the firm's marginal profit contribution

from sales under the proposed plan of initiating
the cash discount?
What is the marginal investment in accounts
receivable under the proposed plan?
What is the cost of marginal investment in
accounts receivable under the proposed plan?
What are the savings of marginal bad debts
under the proposed plan?
What is the cost of the marginal cash discount?
What is the net result of increasing the cash
discount?

Fizzy Animators, Inc. currently makes all sales on credit and

offers no cash discount. The firm is considering a 3 percent
cash discount for payment within 10 days. The firm's
current average collection period is 90 days, sales are 400
films per year, selling price is $25,000 per film, variable
cost per film is $18,750, and the average cost per film is
$21,000. The firm expects that the change in credit terms
will result in a minor increase in sales of 10 films per year,
that 75 percent of the sales will take the discount, and the
average collection period will drop to 30 days. The firm's
bad debt expense is expected to become negligible under
the proposed plan. The bad debt expense is currently 0.5
percent of sales. The firm's required return on equal-risk
investments is 20 percent. (Assume a 360-day year.)

Part 4

 Accounts

payable are the major source of

unsecured short-term financing for
business firms.
They result from transactions in which
merchandise is purchased but no formal
note is signed to show the purchasers
liability to the seller.
The average payment period has two
parts: (1) the time from the purchase of
raw materials until the firm mails the
payment and (2) payment float time (the
time it takes after the firm mails its
payment until the supplier has withdrawn
spendable funds from the firms account).

Accounts payable management is

management by the firm of the time that
elapses between its purchase of raw
materials and its mailing payment to the
supplier.
When the seller of goods charges no interest

and offers no discount to the buyer for early

payment, the buyers goal is to pay as slowly
as possible without damaging its credit rating.
This allows for the maximum use of an
interest-free loan from the supplier and will not
damage the firms credit rating (because the
account is paid within the stated credit terms).

Why accounts payable management is important:

Relying on accounts payable is a source of shortterm funding

A potential cost is that the firm might be foregoing

discounts for early repayment

Cost of foregoing cash discounts.

Lets say that a firm grants it customers credit on
terms of 1/10, net 45. You are one of the customers
who have an invoice due of $10,000. You have a
line of credit with your bank that is at the rate of 9%
per year on outstanding balances. Should you avail
of the discount and pay on day 11 or wait until the
45th day and make the full $10,000 payment?

Answer (continued)
Calculate the APR and EAR implied by the discount
being offered using Equations 13.12 and 13.13 as
follows:

APR = (1%/(1-1%)) * (365/days between payment

days)
= (.01/.99)* (365/(45-10) .0101*10.428
.1053 or 10.53%

EAR = (1+ (.01/.99)365/35 -1 = (1.0101)10.428 1 =

11.05%

Answer
If you pay by Day 11, you will owe $10,000*(.99)= $9900
If you pay by Day 45, you will owe $10,000
You benefit by $100 for a 35 day period.
If you could invest $9900 over a 35 day period and end
up with more than $10,000, you would be better off
holding off the payment and investing the money
rather than taking the discount.
The holding period return = $100/$9900 = 1.01% over a
35 day period
The APR = HPR * 365/35= 1.01*10.428% 10.53%
The EAR = (1+HPR)365/n -1 = (1.0101)365/35-1 =11.05%
Since you can borrow at 9% per year, it would be better
to borrow the money, pay on Day 10, and take
advantage of the discount.

Float refers to funds that have been sent by

the payer but are not yet usable funds to the
payee. Float has three component parts:
1. Mail float is the time delay between when

payment is placed in the mail and when it is

received.
2. Processing float is the time between receipt of
a payment and its deposit into the firms
account.
3. Clearing float is the time between deposit of a
payment and when spendable funds become
available to the firm.

Speeding up collections reduces customer

collection float time and thus reduces the
firms average collection period, which
reduces the investment the firm must
make in its cash conversion cycle.
A popular technique for speeding up
collections is a lockbox system, which is
a collection procedure in which customers
mail payments to a post office box that is
emptied regularly by the firms bank, which
processes the payments and deposits them
in the firms account. This system speeds
up collection time by reducing processing
time as well as mail and clearing time.

Float is also a component of the firms

average payment period.
Controlled disbursing is the
strategic use of mailing points and
bank accounts to lengthen mail float
and clearing float, respectively.

Cash concentration is the process used by the firm to bring

lockbox and other deposits together into one bank, often called
the concentration bank. Cash concentration has three main
advantages.
1.

2.
3.

First, it creates a large pool of funds for use in making shortterm cash investments. Because there is a fixed-cost
component in the transaction cost associated with such
investments, investing a single pool of funds reduces the firms
transaction costs. The larger investment pool also allows the
firm to choose from a greater variety of short-term investment
vehicles.
Second, concentrating the firms cash in one account improves
the tracking and internal control of the firms cash.
Third, having one concentration bank enables the firm to
implement payment strategies that reduce idle cash balances.

A depository transfer check (DTC) is an

unsigned check drawn on one of a firms
bank accounts and deposited in another.
An ACH (automated clearinghouse)
transfer is a preauthorized electronic
withdrawal from the payers account and
deposit into the payees account via a
settlement among banks by the automated
clearinghouse, or ACH.
A wire transfer is an electronic
communication that, via bookkeeping
entries, removes funds from the payers
bank and deposits them in the payees bank.

A zero-balance account (ZBA) is a

disbursement account that always has
an end-of-day balance of zero because
the firm deposits money to cover
checks drawn on the account only as
they are presented for payment each
day.