Chapter 6: Working Capital Management Flashcards
Ready funds necessary for working of the enterprise
Working Capital
consists of funds invested in current assets or those assets and current liabilities
Working Capital
those assets which in the ordinary course of business can be turned into cash within a brief period without undergoing diminution in value and without disruption of the organization.
Current Assets
are those intended to be paid in the ordinary course of business within a short time.
Current liabilities
Factors of Working Capital
- Cost and quantity of raw materials
- Duration of manufacturing period
- Payment of wages
- Sales turnover
- Credit of cash sales and purchases
- Type of business
- banking connection
- growth and expansion
Formula of Gross Working Capital
= Total Current Assets
What is Net Working Capital
= Excess of Current Assets from Current Liabilities
indicates the liquidity position of the firm
Net working Capital
Ability to meet current obligation
Liquidity position
Uses of adequate working capital
- cash discount / trade discount
- sense of security, morale and confidence
- solvency and continuous production
- exploitation of good opportunities
- meeting unseen contingencies
- increased in efficiency of Financial Asssets and production
Inadequate of Working Capital
- Loss of creditworthiness and goodwill
- failure to avail favorable opportunities
- operating inefficiencies
Operating Cycle
- Collections of AR
- Purchase in inventory
- Sell in inventory
is the length of time it takes a company’s investment in inventory to be collected in cash from customers.
operating cycle
Cash Conversion Cycle
- Acquire inventory in account
- Sell inventory in account
- Collections of AR
- Pay suppliers
is the length of time it takes for a company’s investment in inventory to generate cash, considering that some or all of the inventory is purchased using credit.
CASH CONVERSION CYCLE
is a factor that determines how much liquidity a company needs.
The length of the company’s operating and cash conversion cycles
Excessive of Working Capital
- Idle funds
- Loss of confidence and Goodwill
- Misapplication of Funds
- Inefficient Mgt.
length of time needed to convert asset to cash
Liquidity
degree associated with the conversion ratio or
price paid for the asset
Liquidity
the firm’s ability to pay its maturing obligations on time
Liquidity
company’s cash position and its ability to pay its bills as the come due
Liquidity
Deciding the level of each type of Current Assets to hold and how to finance current liabilities
Working Capital Policy
controlling cash, inventories, and A/R, plus short-term liability management.
Working capital management
A suitable measure to evaluate the management
of networking capital.
Profitability
Refers to money in physical form of currency
Cash
In finance, __________ refers to current assets comprising currency or currency equivalents can be accessed immediately.
Cash
is seen either as a reserve for payments, in case of a structural or incidental negative cash flow or as a way to avoid a downturn on financial markets.
Cash
Funds that are immediately available to a business can be spent as needed as opposed to assets that must be sold to generate cash.
Cash-on-hand
Unrestricted liquid funds that have been placed on deposit
Cash-in-bank
The sum of all coins, currency and others
Cash-in-bank
Balances that are held by the bank
Compensating balance
Assets that can be quickly liquidated into cash and whose maturity period is less than a year
Near-cash/Marketable
securities
Legally enforceable claim for payment to a business by its customers/clients for goods supplied and/or services rendered in the execution of the customers’ orders
Accounts receivable
stock refers to the goods and materials that a business holds for the ultimate purpose of resale or production
Inventory
average length of time it takes to convert inventory or materials into finished goods and sell them
Inventory Conversion Period
Formula of Inventory Conversion Period
= Total inventory/sales per day
average length of time required to convert a firm’s receivable into cash
Receivables Collection Period
Formula of Receivables Collection Period
=(Accounts Receivable/sales per day)
Number of times inventory is sold or used in a period.
Inventory Turnover
Formula of Inventory Turnover
= Cost of goods sold or net assets/ average inventory
Number of days that a company takes to collect revenue after sales has been made
Days Sales Outstanding
Formula of Days Sales Outstanding
=(Accounts Receivable/total credit sales) X number of days
focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.
cash conversion model
The length of time between the firm’s actual cash expenditures on productive resources and its own cash receipts from the sale of its product.
cash conversion model
This equals the length of time the firm has funds tied up in current assets
cash conversion model
Formula of Cash conversion Cycle
CCC = Inventory conversion period + Receivables collection period – Payables deferral period
Involves planning of cash inflows and outflows and determining the optimal balances of cash and near-cash accounts
Managing cash
The goal of Cash Management
- to meet objectivesespecially to have cash for transaction yet not have any excess cash
- to minimize transactions
Budgeting and forecasting; maintaining additional cash balances to pay predictable day-to-day cash needs
Transactions motive
3 motives for holding cash
- Transactions Motive
- Safety Motive
- Speculative Motive
Budgeting and forecasting; maintaining additional cash balances to pay predictable day-to-day cash needs
Transactions motive
Maintaining additional cash balances for unforeseen day-to-day cash needs
Safety motive
Maintaining additional cash balances in interest-carving marketable securities in order to take advantage of unexpected investment opportunities.
Speculative motive
Managing cash
- managers use cash forecasting system
- managers monitor cash uses and levels
- Company’s cash management policies
- other influences on cash flows
~ capital expenses
~ mergers and acquisitions
~ disposition of assets
Benefits of Cash Deposits
- Interest earned
- Protected by compensation scheme
- Liquidity
Risks of Cash Deposits
- Collapse of institutions
- Inflation
- Interest rate changes
- Exchange rate movements
Accounts receivable management
- process and maintain records efficiently
- control accuracy and security of accounts receivable
- collect on accounts and coordinate with treasury management
- coordinate and communicate with credit managers
- Prepare performance measurement reports
Credit Policy
- Credit Standards
- Credit Terms
- Cash Discounts
- Collection Policy
Refers how long to pay.
Credit Period
True or False
Shorter period reduces DSO and average accounts receivable but encourages sales.
False
Shorter period reduces DSO and average accounts receivable but discourages sales.
Pertains lower price. Attracts new customers and reduces DSO
Cash Discounts
tighter standards tend to reduce sales, but reduce bad debt expense.
Credit Standards
Pertains how tougher policy will reduce DSO but may damage customer relationships.
Collection Policy
Evaluate of creditworthiness of customers who are purchasing goods or services on credit.
Credit Standards
- screening or pre-qualification standard used as basis for assessing credit worthiness.
Credit Standard
Time frame reports of customers repaying the money
Credit Terms
Evaluating credit function
- ordinary
- cash before delivery
- cash on delivery
- bill-to-bill
- monthly billing
- Credit scoring model
Net days or, if a discount for paying within a period,
discount/discount period, net days (for example, 2/10, net 30).
Ordinary
Prior bill must be paid before next delivery.
Bil-to-bill
Similar to ordinary, but the net days are the end of the month..
Monthly Billing
Management of Inventory
- Raw materials
- Work in process
- Finished goods
Models and Techniques of Inventory Management
- ABC method
- Economic Order Quantity model
- use of safety stock
- Computerized Inventory Control System
- Just-in-time System
system of categorization, with similarities to Pareto analysis, and the method usually categorizes inventory into three classes with each class having a different management control associated
ABC Method
is to grouping items according to annual issue value (in terms of money)
ABC Method
to put their efforts where greates benefits, in terms of cost reduction as well as maintaining a smooth availability of stock are attained.
ABC Method
Aims to minimize total inventory costs of holding costs, order costs; to reduce the various inventory costs.
Model & Techniques
Optimal order quantity that minimizes total holding and ordering
Economic Order Quantity model
Formula Economic Order Quantity model
EOQ = √2SO / CI
Dean’s corporations annual usage of a raw material item is 10,000 units. The cost per order is P 180 and the company buys each unit at P220. Carrying cost is 25%
EOQ = √2(10,000)(180) / 220 (25%)
= √3, 600, 000 / 55
= 256
In the formula Economic Order Quantity model:
S = ?
O = ?
C = ?
I = ?
S = Annual usage of item
O = Ordering cost
C = Cost per unit
I = Annual carrying COA
A system will normally document quantity and value, but may also specify reorder points and order quantities.
Computerized Inventory Control System
This is helpful particularly to firms that have numerous lines of inventory.
Computerized Inventory Control System
Minimum stock to be matured to take care of stock out of situations due to variation on the consumption as well as supply.
Safety stock
Is the stock level of an item at which the procurement activity is initiated
Reorder point
- quanityt required for the consumption during the lead time of procurement plus safe stock
Reorder point
Formula of Reorder point
= Average daily use x lead-time in days + safety stock
Dean’s Corporation uses 32 units daily on the average and the lead time or the reordering time is 10 days, the company should place on order when the inventory is at the 384 level if the safety stock is 64 units
reorder point = (32x10) + 64
= 320 + 64
= 384
An arrangement with suppliers for inventory to be delivered at the time where it is needed for production
Just-in-time system
This maintains a minimal raw materials inventory in order to minimize the associated holding costs
Just-in-time system
The key benefits of JIT
- low inventory
- low wastage
- high quality production
is a visual signal that indicates it is time to replenish stock and possibly reorder
kanban
are overarching programs that help you take a detailed look at every point of the production process and identify ways to make improvements.
Total Quality Management and Six Sigma
Evaluating Inventory Management
- Inventory Turnover Ratio
- Number of Days of Inventory
tells us how many times inventory is created and
sold during the period
Inventroy turnover ratio
average time it takes to create and sell the inventory
Number of days of inventory
True or False
When comparing turnover and number of days of inventory among companies, the analyst should consider the different product mixes among companies.
True
Formula of Inventory Turnover Ratio
Cost of goods sold / Average Inventory
Formula of no. of days of inventory
Option 1 = Inventory / average days of Cost of Goods Sold
Option 2 = 365 / Inventory Turnover
arise from trade credit and are a spontaneous form of credit.
Accounts payable
may vary among industries and among companies, although these tend to be similar within an industry because of competitive pressures.
Credit terms
Any debt scheduled for repayment within one year.
Short-term credit
Major sources of ST credit
– Accounts payable (trade credit)
– Bank loans
– Commercial paper
– Accruals
Factors to consider when Managing Accounts Payable
- Company’s centralization of the financial function
- Number, size, and location of vendors
- Trade credit and the cost of alternative forms of short-term financing
- Control of disbursement float (i.e., amount paid but not yet credited to the payer’s account)
- Inventory management system
3 Costs of borrowing
- Cost of a loan without fees
- Cost of a loan with commitment fee
- Cost of a loan with a dealer’s commission and bank-up costs
Formula of Cost of a loan without fees
Cost = Interest / loan amount
Formula of Cost of a loan with commitment fee
Cost = interest + commitment fee / loan amount
Formula of Cost of a loan with a dealer’s commission and bank-up costs
Cost = Interest + Dealers commission + Back-up costs / loan amount
Average length of time that cash is tied up in net working capital
Cash conversion cycle (CCC)
Formula of Cash conversion cycle (CCC)
Calculated as (AAI + ACP – APP)
Average length of time to pay for materials and labor consumed.
Average payment period (APP)
Average length of time between the sale of inventory and the receipt of cash for payment from the customer.
Average collection period (ACP)
Average length of time between the purchase and sale of inventory.
Average age of inventory (AAI)
Method of recording financial transactions.
Accounting system
Formula of Average payment period (APP)
APP= Accounts payable/ Average purchases per day
Formula of Average collection period (ACP)
ACP= Accounts receivable/ Average credit sales per day
Formula of Average age of inventory (AAI)
AAI = Inventory/ Average materials purchased per day
Three Policies can be devised for managing the cash conversion cycle
- Minimize the average age of inventory
- Minimize the average collection period
- Maximize the average payment period
This can be achieved by increasing sales relative to inventory levels, by reducing production time, or by reducing inventory. However, it is important to avoid stocks-out that can result in lost.
Minimize the average age of inventory
Collect accounts receivable as quickly as feasible. However, avoid using overly harsh collection tactics that may jeopardize future sales.
Minimize the average collection period
Pay accounts payable as late as possible. However, do not pay so late as to jeopardize the future supply of goods, or to damage the firmʼs credit reputation. When credit and trading conditions are difficult, average payment period tends to lengthen as business attempt to manage their cash flows. Once established, slow payment practices can be hard to break, yet many impair a firms ability to operate efficiently.
Maximize the average payment period
These strategies represent an attempt to achieve a balance between profitability and risk, and these theme should be kept in mind when considering the management of cash, accounts receivable, inventory and current liabilities.
Maximize the average payment period
