B3-FINANCIAL MANAGEMENT-Working Capital Management Flashcards
Net Working Capital
Current Assets - Current Liabilities
Aggressive Working Capital Management
Increase the ratio of current liabilities to noncurrent liabilities (more current assets financed with current liabilities).
i.e. less working capital, and lower current ratio and thus assuming more risk.
Conservative Working Capital Management
Increase the ratio of current assets to non current assets (more current assets financed by non current liabilities).
i.e. higher working capital, high current ratio. Assuming less risk.
Current Ratio
Way of measuring short term solvency.
Current Ratio= Current Assets / Current Liabilities.
A higher current ratio is better in terms of risk reduction. Generally considered the best single indicator of a company’s ability to meet short term obligations.
Deteriorating Current Ratio
Current Ratio going down, working capital going down, risk increasing
Improving Current Ratio
Current Ratio going up, working capital going up, and risk is going down.
Quick (Acid Test) Ratio
Cash+Marketable Securities+Receivables/ Current Liabilities
More rigorous test of liquidity than the current ratio b/c inventory and prepaids are excluded from current assets.
Primary Methods of Increasing Cash Levels (reducing the operating cycle)
- Better customer screening and credit policy-chose to extend credit to more responsible customers, who are more likely to pay bills promptly.
- Prompt Billing-timely billing serves to speed collections 3. Payment Discounts*(heavily tested) “When you give to a customer that is a cost” “When you receive from vendor & do not take advantage this is an opportunity cost” Offering payment discounts may influence customers to pay faster and can result in improved cash collections. Discounts forgone represent higher cost to the customer than a bank loan for similar financing.
* Formula APR of quick payment discount=*
* 360/pay period-discount period X discount/100-discount %* - Expedite Deposits a. Electronic Funds Transfer-ensure timely payment. Electronic movement of funds from one institution to another. b. Lockbox Systems (good if additional interest income> than bank fees) -expedite cash flows by having a bank receive payments from a company’s customers directly via mailboxes to which the bank has access. Payments that arrive in these mailboxes are deposited into the company’s account immediately.
Methods to Delay Disbursements
- Defer Payments
- Drafts
- Line of Credit
- Zero-Balance Accounts-helps to slow cash disbursements because a disbursement is made only when there is a demand.
Cash Conversion Cycle (net operating cycle)
Length of time from the date of the initial expenditure for production to the date cash is collected from customers and the vendors are paid for the initial expenditures.
Formula {Inventory conversion period (# days to sell) +
receivables collection period (# days to collect)}-these two together give subtotal that is operating cycle.
When we subtract number of days to pay this give us net operating cycle. Great way to increase liquidity.
Elements of Cash Conversion Cycle -Inventory Conversion Period
Inventory Turnover-COGS/Average Inventory.
Higher the turnover the better.
Inventory conversion period= 365/Inventory Turnover
Elements of Cash Conversion Cycle-Receivable Collection Period
Account Receivable Turnover= Sales/Avg Accounts Receivable
Receivables Collection Period= Days Sales Outstanding (DS0)= 365/ AR Turnover
Elements of Cash Conversion Cycle-Payables Deferral Period
AP Turnover= COGS/Avg AP
AP Deferral Period= 365/AP Turnover
Cash Conversion Cycle
Sell quick-inventory conversion period
Collect quick-Receivables Collection Period
Slow days to pay-increase days to pay payables all this will give you a lower net operating cycle
Management of Inventory
Too little-lost sales-cost Too much-carrying costs increase profits decrease
Optimal Levels of Inventory
- Inventory Turnover
- Safety Stock
- Reorder Point
- Economic order quantity
- Materials requirements planning
Safety Stock
ensure that manufacturing or customer supply requirements are met. determination depends on following:
- reliability of sales forecasts
- cost of running out of inventory
- lead time (time that elapse from the placement to the receipt of order)
In Inventory mgmt, the safety stock will tend to increase if the variability of lead-time increases. If lead times became more variable, the amount of safety stock needed to reduce the risk of stock outs will increase.
Reorder Point
inventory level at which a company should order or manufacture additional inventory to meet demand and avert incurring stockout costs.
Reorder point= safety stock + (lead time X sales during lead time)
*lead time can be days or weeks if lead time is days tell me avg units sold per day/if lead time is in weeks than avg unit sold per week
Economic Order Quantity
When I say two, you say “SOC” Minimizes both ordering and carrying costs. Assumes demand is known and is constant throughout the year.
E=Square Root(2SO/C)
E=Order size
S=Annual sales (units)
O=Cost per purchase order(primarily production set up costs) C=Carrying cost per unit
Just in Time inventory Model (Pull approach)
reduce lag time between inventory arrival and inventory use. JIT reduces the need of manufactures to carry large inventories, but requires considerable degree of coordination between manufacturer and supplier.
Marketable Securities
Provide much lower returns than operating assets but higher returns than cash
Common Marketable Securities
- US Treasury Bills-proxy for risk free rate-least risk
- Negotiable Certificates of Deposit
- Banker’s Acceptances-short term IOUs of large creditworthy corporations that are guaranteed by commercial banks
- Commercial paper-short term lending of idle cash-notes and drafts
- Equity Securities of Public Companies-risky b/c of the volatility of the stock market. Gains far greater than yields from other marketable securities, but losses are also more likely.
- Eurodollars-US dollars deposited in banks outside the US. and are free from US regulations
Elements of Cash Cycle Formula
