Introduction to Working Capital Flashcards
What is working capitals?
Working capital = CA - CL
Objective: Maintain level of working capital to meet on-going and financial needs
- Inventory to meet production requirements
- No over invest in working capital, which provides low returns or increase cost
- Excess AR- increase storage costs and risk becoming obsolete
What is a cash budget?
Analysis of your cash flow during various periods during the year and adjusting accordingly.
T/F: A firm should accelerate cash inflows and defer cash outflows?
TRUE
How do you accelerate cash inflows?
- Getting a customer to pay promptly
- Efficient handling of cash after its been received
What is float?
Time between when payment is initiated to a firm and when that payment is received
- Firms seek to reduce incoming float
Lock-box system: Firm leases office boxes in areas where it has a high volume of cash inflow by main
- Customer remits payment to the local post office box
- Payments are collected and processed by firm bank
- Bank notifies the firm of sources and amounts received
Advantages: Cash is available sooner than it would be otherwise. Handling of cash is reduced and security improved. Incident of dishonored checks.
What is pre-authorized checks?
Customer authorize checks in advance for payment of obligations.
usefully is the same each period.
- Mortgage payments
Advantage:
- Cash is available sooner and is highly predictable
- Firm handing of cash and collection is reduced
- Customer may automatic bill paying
What is concentration banking?
Accelerate the flow of funds from multiple local bank to a firm’s primary bank by regular automatic transfer of funds
Cash is amiable sooner to use firm-wide
Arrangement are possible for aggregate are possible
What is the depository transfer checks?
Transfer between a firms accounts:
- Also called “Official Bank Checks”
- Check is unsigned, non-negotiable and payment only to an account of the firm
Example:
- Firm makes a local bank deposit
- Simultaneously it writes a depository transfer check payable
- Check moves the funds from the bank to the alternate bank
What are wire transfers?
Electronic means of transferring funds
How do you defer cash outflow?
- Increasing time between receiving a benefit and when they pay
- Seek to increase outgoing float
Management of purchases and payment process is fundamental and includes:
- Establishing and using charge accounts
- Selecting suppliers that provide generous payment terms
- Pay bill only when due
- “stretch” payments by making payments after start date
Remote banking:
- Increase float on checks used to pay obligations by establishing checking accounts in remote locations and making payments by checks written on those accounts
- Checks written on those accounts take longer to process
Zero balance accounts:
1) By agreement: Agreement with bank, a firm will have an account with a zero balance
* Checks are written on an account with no balance
* Checks are processed by the bank resulting in “overdrawn” account.
- Bank transfers funds from another account to again “zero out” the account daily.
2) By deposit- A firm into an account exactly equal to checks written on that account
* Puts money into the account to cover that balance going out
Advantage:
- Nearly eliminate all excess cash balance
- Less monitoring
- Less reconciling
Payment through draft:
- A firm uses a legal instrument- like a check- but drawn on an account of issuing bank or another bank, not the firm’s account
Common form of drafts include:
- Bank draft: A order to pay drawn by a bank on itself or on correspondent bank with which the issuing bank has an account
- Cashiers check
- certified checks
- Money orders - sold by non-banking institutions
Advantages:
- Assures the instrument will be honored at stated value
- May not require having a check account or disclosure of bank account information
- Can be automated to facilitate recurring payments
Disadvantage:
- Associated fee may be more costly than other forms of payment
Positive pay system:
- Entity sends its bank an electronic file of checks written on its account with bank
- Bank compares presented checks with information on the electronic file
if elements match, the check is paid
- if they do not match, the issuing firm has to approve payment
- If not approved, then it is returned
Advantage:
- Detect unauthorized or authorized checks
- Prevents inappropriate payments
What are short term investments? What are the major instruments?
Investments held for one year or less. Used for excess cash. They must be made prudently.
Criteria:
- Safety of principle- Little risk of default by the issuer. They should have price stability that would result in a loss if sold. Investment should be marketable.
What are the major instruments:
1) US Treasury Bill- Direct obligations of the US Government. Risk Free. Are available periodically through the federal reserve or in the secondary market. offer safety of principle.
2) Federal Agency Securities- Securities issued by and obligation of the individual federal agency (Fannie Mae, Federal Home Loan Bank). Not backed the federal government. Slightly higher risk, higher return.
3) Negotiable certificates of deposit (CS)- Securities issued by a bank in return for a fixed time despot with bank.
- Negotiable means they can be bought and sold in the secondary market
4) Bankers acceptances- is a draft drawn on a bank by a firm with an account at the bank. It becomes a negotiable instrument available for investment. Higher risk= Higher return
5) Commercial paper- Short-term, unsecured, promissory notes, established by high credit rated firms. maturities from a few days up to 270 days. Provide greater return than other short-term investments.
6) Repurchase agreements- securities issued for loans with a simultaneous commitment by the buyer to resell the loan security to the issuer at the original contract plus an agreed interest
How can you manage AR?
Concerned with:
1) Conditions leading to the recognition of receivables
2) Process that results in elimination of receivables
Involves these activities:
- Establishing general terms of credit
- Determine credit worthiness of customers
- Setting credit limits
General Terms: These terms will be influenced by those in the firms industry (total credit period, discounts to be offered for early payment, penalty for late payment, nature of credit sales documentation)
For each customer the firm must determine whether or not to grant credit. The goal is maximize profits, not losses. If it is too strict, it may result in credit sales being lost
There are two major approaches to determine whether or not to grant credit:
1) Use credit rating service- obtain and use a rating report from a credit agency (Equifax, Experion, Transunion, Dun & Bradstreet)
2) Do own financial analysis- undertake an analysis of the prospective client
Collection on account have to be managed- objective is to keep post sale losses to a minimum.
- Monitor AR continuously
- At the aggregate level - use averages and ratios
- Average collection period
- Days sales in AR
- AR Turnover
- Accounts receivable as
What are the two general approaches for inventory management?
MRP- Materials Requirement Planning: Supply push- goods are produced in anticipation of their sale. The use of inventory buffers is maintained. Production based on long-set up times. Quantity standards et up an acceptable level. Use traditional cost accounting; the emphasis is on job order.
JIT- Just in time inventory: Produce only as needed. Demand pull- goods are produced only when needed by the end user. Reduce inventory considerably- even eliminated in some cases. There is a close working relationship with limited number of suppliers who are located close to production facility. Use implied cost accounting and more items are considered direct costs.
Reduce lead time in replenishing production inputs
What is Inventory Economic Order Quantity?
Inventory order cost and inventory carrying cost has a trade off
- The larger the quantity ordered, the lower the unit order cost
- The larger the quantity ordered, the higher the carrying cost
Total order cost + Total carrying cost = Total Admin Cost
T/F: Short-term liabilities should be used to finance assets which generate cash in the short-term; the principle of self-liquidating debt
TRUE!!
