WORKING CAPITAL MANAGEMENT Flashcards
OPERATING CYCLE
The average length of time between when a firm originally purchases its inventory and when it receives the cash back from selling its product.
CASH CYCLE
The length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory.
CASH CONVERSION CYCLE (CCC)
= Inventory Days + A/R Days - A/P Days
INVENTORY DAYS
= Inventory / Average Daily Cost of Goods Sold
ACCOUNTS RECEIVABLE DAYS
Accounts receivable / Average daily sales
ACCOUNTS PAYABLE DAYS
Accounts payable / Average daily cost of goods sold
How is firm value affected by working capital?
Any reduction in working capital requirements generates a positive free cash flow that the firm can distribute immediately to shareholders.
TRADE CREDIT
The difference between receivables and payables that is the net amount of a firm’s capital consumed as a result of those credit transactions.
The credit that a firm extends to its customers.
Example of trade credit terms:
2/10, Net 30
Cash Discount: a 2% cash discount is taken if paid during the discount period.
Discount period: in this example, 10 days.
Credit period:
The total length of time credit is extended to the buyer, in this example it is 30 days.
COST OF TRADE CREDIT
EAR = (1+2)^n - 1
What are the benefits of trade credit?
- It is simple and convenient to use, and it has lower transaction costs than alternative sources of funds.
- It is a flexible source of funds, and can be used as needed.
- It is sometimes the only source of funding available to a firm.
Why do firms offer trade credit?
- Providing financing at below-market rates is an indirect way to lower prices for certain customers.
- A supplier may have an ongoing business relationship with its customer, it may have more information about the credit quality of the customer than a traditional outside lender such as a bank would have.
- If the buyer defaults, the supplier may be able to seize the inventory as collateral.
MANAGING FLOAT
COLLECTION FLOAT
Mail float - customer mails check
Processing float - firm receives check
Availability float - firm deposits check
Finally, funds are credited to firm’s account.
DISBURSEMENT FLOAT
What three steps are involved in establishing a credit policy?
- Establishing credit standards.
- Establishing credit terms.
- Establishing a collection policy.
What are the 5 C’s of credit?
- Character
- Capacity
- Capital
- Collateral
- Conditions
ACCOUNTS RECEIVABLE DAYS
The average number of days that it takes a firm to collect its sales.
AGEING SCHEDULE
- Categorises accounts by the number of days they have been on a firm’s books.
- Can be prepared using either the number of accounts or the dollar amount of the accounts receivable outstanding.
PAYMENTS PATTERNS
Provides information on the percentage of monthly sales that the firm collects in each month after the sale.
How does a firm determine the accounts payable days outstanding?
Firms should monitor their accounts payable to ensure they are making their payments at an optimal time.
STRETCHING ACCOUNTS PAYABLE
When a firm ignores a payment due to period and pays later.
COD
Cash on delivery
CBD
Cash before delivery
What are the benefits of holding inventory?
- Inventory helps minimise the risk that the firm will not be able to obtain an input it needs for production and helps avoid stock outs.
- Factors such as seasonality and demand mean that customer purchases do not perfectly match the most efficient production cycle.
What are the costs of holding inventory?
- Acquisition costs
- Order costs
- Carrying costs
- “Just In Time” (JIT) Inventory management.