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TRANSCRIPT
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Copyright 2002 Harcourt, Inc. All rights reserved.
CHAPTER 22Current Asset Management
Alternative working capitalpolicies
Cash management Inventory management
Accounts receivable management
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Basic Definitions
Gross working capital:
Total current assets.
Net working capital:
Current assets - Current liabilities.
Working capital policy:
The level of each current asset.
How current assets are financed.(More)
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Working capital management:
Includes both establishing workingcapital policy and then the day-to-day
control of:Cash
Inventories
Receivables
Short-term liabilities
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SKI Industry
Current 1.75x 2.25xQuick 0.83x 1.20x
Debt/Assets 58.76% 50.00%Turnover of cash& securities 16.67x 22.22x
DSO (days) 45.00 32.00Inv. turnover 4.82x 7.00x
F.A. turnover 11.35x 12.00xT.A. turnover 2.08x 3.00xProfit margin 2.07% 3.50%ROE 10.45% 21.00%
Selected Ratios for SKI Incorporated
Pay. deferral period 30.00 33.00
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How does SKIs working capital policycompare with the industry?
Working capital policy is reflected in
a firms current ratio, quick ratio,turnover of cash and securities,inventory turnover, and DSO.
These ratios indicate SKI has largeamounts of working capital relativeto its level of sales. Thus, SKI isfollowing a relaxed (fat cat) policy.
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Alternative Current Asset
Investment Policies
Current Assets ($)
Sales ($)
Restricted
Moderate
Relaxed
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Is SKI inefficient or just conservative?
A relaxed policy may be appropriate
if it reduces risk more thanprofitability.
However, SKI is much less
profitable than the average firm inthe industry. This suggests that thecompany probably has excessiveworking capital.
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The cash conversion cycle focuses on thetime between payments made for materialsand labor and payments received fromsales:
Cash Inventory Receivables Payables
conversion = conversion + collection - deferral .cycle period period period
Cash Conversion Cycle
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Cash Conversion Cycle (Cont.)
CCC = +
CCC = + 45 30
CCC = 75 + 45 30
CCC = 90 days.
Days per yearInv. turnover
Payablesdeferralperiod
Days salesoutstanding
3604.82
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The cash conversion cycle focuses on thetime between payments made for materialsand labor and payments received fromsales:
Cash Inventory Receivables Payables
conversion = conversion + collection - deferral .cycle period period period
What does the cash conversion cycle tell
us about working capital management?
Cash Conversion Cycle
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Cash Management:
Cash doesnt earn interest,so why hold it?
Transactions: Must have some cash to pay
current bills. Precaution: Safety stock. But lessened
by credit line and marketable securities.
Compensating balances: For loans and/orservices provided.
Speculation: To take advantage of bargains,to take discounts, and so on. Reduced bycredit line, marketable securities.
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Whats the goal of cash management?
To have sufficient cash on hand tomeet the needs listed on theprevious slide.
However, since cash is a non-earning
asset, to have not one dollar more.
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Ways to Minimize Cash Holdings
Use lockboxes.
Insist on wire transfers fromcustomers.
Synchronize inflows and outflows.
Use a remote disbursementaccount.
(More)
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Increase forecast accuracy toreduce the need for a cash safetystock.
Hold marketable securities insteadof a cash safety stock.
Negotiate a line of credit (alsoreduces need for a safety stock).
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What is float and how can it be
affected by cash management?
Net float is the difference betweencash as shown on the firms booksand on its banks books.
If it takes SKI 1 day to deposit checks
it receives and it takes its bankanother day to clear those checks,SKI has 2 days ofcollections float.
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If it takes 6 days for the checks that SKIwrites to clear and be deducted fromSKIs account, SKI has 6 days ofdisbursement float.
SKIs net float is the difference betweenthe disbursement float and thecollections float:
Net float = 6 days - 2 days = 4 days.
If SKI wrote and received $1 million ofchecks per day, it would be able tooperate with $4 million less workingcapital than if it had zero net float.
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Cash Budget: The Primary Cash
Management Tool
Purpose: Uses forecasts of cash
inflows, outflows, and ending cashbalances to predict loan needs andfunds available for temporaryinvestment.
Timing: Daily, weekly, or monthly,depending upon budgets purpose.Monthly for annual planning, dailyfor actual cash management.
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Data Required for Cash Budget
1. Sales forecast.
2. Information on collections delay.
3. Forecast of purchases and paymentterms.
4. Forecast of cash expenses: wages,
taxes, utilities, and so on.5. Initial cash on hand.
6. Target cash balance.
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SKIs Cash Budget
for January and February
Net Cash FlowsJanuary February
Collections $67,651.95 $62,755.40
Purchases $44,603.75 $36,472.65
Wages 6,690.56 5,470.90
Rent 2,500.00 2,500.00
Total payments $53,794.31 $44,443.55
Net CF $13,857.64 $18,311.85
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Cash Budget (Continued)
January February
Cash at start $ 3,000.00 $16,857.64
Net CF 13,857.64 18,311.85
Cumulative cash $16,857.64 $35,169.49
Less: target cash 1,500.00 1,500.00Surplus $15,357.64 $33,669.49
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Should depreciation be explicitly
included in the cash budget?
No. Depreciation is a noncashcharge. Only cash payments andreceipts appear on cash budget.
However, depreciation does affecttaxes, which do appear in the cashbudget.
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What are some other potential cash
inflows besides collections?
Proceeds from fixed asset sales.
Proceeds from stock and bondsales.
Interest earned.Court settlements.
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How can interest earned or paid on
short-term securities or loans beincorporated in the cash budget?
Interest earned: Add line in the
collections section. Interest paid: Add line in the payments
section.
Found as interest rate x surplus/loan lineof cash budget for preceding month.
Note: Interest on any other debt wouldneed to be incorporated as well.
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How could bad debts be worked into
the cash budget?
Collections would be reduced by theamount of bad debt losses.
For example, if the firm had 3% baddebt losses, collections would totalonly 97% of sales.
Lower collections would lead tolower surpluses and higherborrowing requirements.
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SKIs forecasted cash budget
indicates that the companys cashholdings will exceed the targeted
cash balance every month, except forOctober and November.
Cash budget indicates the companyprobably is holding too much cash.
SKI could improve its EVA by eitherinvesting its excess cash in moreproductive assets or by paying itout to the firms shareholders.
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What reasons might SKI have for
maintaining a relativelyhigh amount of cash?
If sales turn out to be considerably less
than expected, SKI could face a cashshortfall.
A company may choose to hold largeamounts of cash if it does not have much
faith in its sales forecast, or if it is veryconservative.
The cash may be there, in part, to fund aplanned fixed asset acquisition.
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Inventory Management:
Categories of Inventory Costs
Carrying Costs: Storage and handling
costs, insurance, property taxes,depreciation, and obsolescence.
Ordering Costs: Cost of placing orders,shipping, and handling costs.
Costs of Running Short: Loss of sales,loss of customer goodwill, and thedisruption of production schedules.
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Effect of Inventory Size on Costs
Reducing the average amount of
inventory held generally: Reduces carrying costs.
Increases ordering costs.
Increases probability of a stockout.
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Is SKI holding too much inventory?
SKIs inventory turnover (4.82) isconsiderably lower than the industry
average (7.00). The firm is carrying alot of inventory per dollar of sales.
By holding excessive inventory, the
firm is increasing its operating costswhich reduces its NOPAT. Moreover,the excess inventory must befinanced, so EVA is further lowered.
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If SKI reduces its inventory, without
adversely affecting sales, what effectwill this have on its cash position?
Short run: Cash will increase asinventory purchases decline.
Long run: Company is likely tothen take steps to reduce its cashholdings.
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Accounts Receivable Management:
Do SKIs customers pay more or lesspromptly than those of its
competitors?
SKIs days sales outstanding (DSO)of45 days is well above the industryaverage (32 days).
SKIs customers are paying lesspromptly.
SKI should considertightening itscredit policy to reduce its DSO.
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Cash Discounts: Lowers price.
Attracts new customers andreduces DSO.
Credit Period: How long to pay?
Shorter period reduces DSO andaverage A/R, but it may discouragesales.
Elements of Credit Policy
(More)
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Credit Standards: Tighterstandards reduce bad debt losses,but may reduce sales. Fewer bad
debts reduces DSO.Collection Policy: Tougher policy
will reduce DSO, but may damagecustomer relationships.
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Does SKI face any risk if it tightens its
credit policy?
YES! A tighter credit policy maydiscourage sales. Some customersmay choose to go elsewhere if theyare pressured to pay their bills
sooner.
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If SKI succeeds in reducing DSO
without adversely affecting sales, whateffect would this have on its cash
position?
Short run: If customers pay sooner,this increases cash holdings.
Long run: Over time, the company
would hopefully invest the cash inmore productive assets, or pay itout to shareholders. Both of theseactions would increase EVA.