6 Cash conversion cycle and working capital Flashcards
- Cash Conversion Cycle (= financing period) is a metric that expresses the length of time, in days, that it takes for a company to convert resource inputs into cash flows.
- Is the amount of time from:
ØThe purchase of inventory until it is sold, and the cash collected
ØLess the amount of time that creditors give to the company to pay for the purchase of inventory.
• The lower this number is, the better for the company.
• Example:
If it takes:
56 days to sell the Inventory
25 days to collect for the sale
Creditor allows 20 days for the payment of the purchased inventory
The financing period is 61 days (56 + 25 – 20)
By reducing its financing period, a company can improve its cash flow:
AR is essentially a loan to the customer,
Inventory products not sold should be the minimum possible
AP is essentially a loan from suppliers to the company
• Cash Conversion Cycle =
+ Days’ Inventory Outstanding
+ Days’ Sales Outstanding
- Days’ Payables Outstanding
Cash Conversion Cycle in a Manufacturing Company
•Cash Conversion Cycle in a Merchandising销售 Company
•Cash Conversion Cycle in a Service Providing Company
What is Working Capital?
Working Capital = Current Assets - Current Liabilities
• It measures ability to pay current liabilities with the current
assets.
- The larger the working capital, the better the ability to pay back (short-term) debts.
- Working capital is the surplus of current assets over current liabilities.
What is Cash Management?
- It is the corporate process of collecting and managing cash, as well as using it for (short-term) investing. It is a key component of ensuring a company’s financial stability and solvency.
- Successful cash management involves not only avoiding insolvency, but also…
- reducing the length of account receivables (AR), increasing collection rates
- selecting appropriate short-term investment vehicles,
- and increasing cash on hand to improve a company’s cash position.
Receivables Management:
- When a business issues an invoice to a customer it is reported as a receivable, which is cash to be received.
- Depending on the terms of the invoice, the business may have to wait 30, 60, or 90 days for the cash to be received.
- For a business with increasing sales, it is important to manage receivable growth.
- Very important for the financial plan of a new business
Things to do to accelerate Receivables:
- State clear billing and payment terms to customers,
- Use an automated billing service to bill customers immediately,
- Use electronic payment processing through a bank to collect payments,
- Evaluate credit risk by customer, establishing sales terms and limits to each customer,
- Use customers sales insurances and factoring process.
- Stay on top of collections with an aging receivables report.
Payables Management:
- Set of policies, procedures, and practices employed by a company to manage its trade credit purchases.
- They consist of seeking trade credit lines, close deals with favorable terms of purchase, manage the flow and timing of purchases.
• Purchasing inventory, raw materials and other goods on trade credit (贸易信贷） allows a company to defer its cash outs, while accessing resources immediately.
Financing through customers and suppliers:
ØIs called automatic and it is a consequence of ordinary activities of the company.
ØCustomer financing has a cost that is determined by the discount offered to customers when they pay immediately after the sale.
ØIn the case of financing through the suppliers, example:
(a) cash payment with a 5% discount for prompt payment of the invoiced amount
(b) 90 days without discount payment
Commercial discount (or trade discount or discount line):
ØIs a contract with a credit institution by which the company has the right to collect in advance (before the expiration of the invoices) the payment from its customers.
ØThe bank advances the money to the company and then retrieves it when it reaches maturity and collects it from the client.
ØThe agreement establishes the maximum amount that you can discount, the discount line time (after this period you can renewal or cancel) and cost (commissions and interest)
Factoring:
ØIs an assignment of accounts receivables from a company to another specialized company, called a factoring company.
ØThe factoring company is responsible for the management of the company’s receivables and may advance the amount payment of invoices to your company.
ØThe agreement establishes the maximum amount and the cost (commissions and interest).
ØThe factoring company pays the amount of the invoice to the customer and deducts its costs.
ØOnce the invoice expires, the factoring company collects the debt from the customer.
ØTwo types of Factoring:
üWith recourse: If the customer doesn’t pay the debt, the factoring entity may claim the money from the company.
üWithout recourse: the factoring entity assumes the risk of customer non-payment, so if the customer doesn’t pay, the factoring entity cannot claim the amount from the company. In this case, it is not only a source of financing but also credit insurance.
Inventory Management:
• It refers to the process of ordering, storing, and using a company’s inventory. These include the management of raw materials, components, and finished products, as well as warehousing and processing such items.
• The right stock, at the right levels, in the right place, at the right time, and at the right cost.
• For companies with complex supply chains and manufacturing processes, balancing the risks of excess inventory and shortages is especially difficult.
Accounting for Inventories:
• Inventories are assets because:
üAre owned by the firm
üAre expected to generate future economic benefits
üArise from past transactions
• For merchandising firms, inventories are valuated at cost, net of discounts, and including transportation
• Lower Cost or Market: After acquisition, the value of inventories could experience a decrease because of:
ØDamage
ØObsolescence过时
ØMarket conditions
- For that reason, accounting standards require an impairment 减值测试 test at year-end. This is a lower-cost-or-market test.
- That means to write-down inventory value if it is above current market value
- There is no doubt about how to account revenues: 400 ropes are sold at $80 each: $32,000 Sales Revenues.
- However, the accountant must make assumptions about which ropes have been sold, in order to estimate COGS. There are three alternatives:
卖出去的不知道是什么成本的衣服
Inventory cost flow assumption:
- Under U.S. GAAP the three methods are allowed: LIFO, FIFO and WAC.
- Under IFRS, only FIFO and WAC are allowed.
- Firms can choose any of the allowed methods as long as they use the selected method consistently over the time.
