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Chapter 22. Model for managing and financing current assetsChapter 22 deals with working capital management. Two useful tools for working capital management are (1) the cash conversion cycle and (2) the cash budget. This spreadsheet model shows how these tools are used to help manage current assets. THE CASH CONVERSION CYCLE The cash conversion cycle model focuses on the length of time between when the company must make payments and when it receives cash inflows. The cash conversion cycle is determined by three factors: (1) The inventory conversion period, which is the average time required to convert materials into finished goods and then to sell those goods. The inventory conversion period is measured by dividing inventory by the average daily sales. (2) The receivables collection period, which is the length of time required to convert the firm's receivables into cash, or how long it takes to collect cash from a sale. The receivables collection period is measured by the days sales outstanding ratio (DSO), which is accounts receivable divided by average daily sales. (3) The payables deferral period, which is the average length of time between the purchase of materials and labor and payment for them. The payable deferral period is calculated by dividing average accounts payable by purchases per day (cost of goods sold divided by 360 or 365 days). The cash conversion cycle is determined by the following formula:

Cash Inventory Receivables Payables = + conversion conversion collection deferral 21 cycle period period period 22 23 Problem 24 Calculate the cash conversion cycle for the Real Time Computer Company. Annual sales are $10 million, and the annual cost 25 of goods sold is $8 million. The average levels of inventory, receivables, and accounts payable are $2,000,000, $657,534, and 26 $657,534, respectively. RTCC uses a 365-day accounting year. 27 28 Sales $10,000,000 29 COGS $8,000,000 30 Inventories $2,000,000 31 AR $657,534 32 AP $657,534 33 Days/year 365 34 35 Cash conversion cycle (CCC) Inventory conversion Receivables collection = + 36 period period 37 38 = Inventory/Sales per day + AR/Sales per day 39 = + 73.00 24.00 40 = 67.00

Payables deferral period AP/COGS per day 30.00

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It takes 73 days to make and then sell a computer, and another 24 days to collect cash after the sale, or a total of 97 days between spending money and collecting cash. However, the company can delay payment for parts and labor for 30 days. Therefore, the net days the firm must finance its labor and purchases is 97 - 30 = 67 days, which is the cash conversion cycle. Companies like to shorten their cash conversion cycles as much as possible without adversely impacting operations. As noted in the chapter, Amazon.com and Dell have been able to produce goods on demand, hence to reduce the inventory conversion period to close to zero. In addition, since payments are made by credit card, the receivables collection period is also close to zero. Then, if they pay suppliers after a 20 payables deferral period, they can end up with a NEGATIVE cash conversion cycle. In that case, the faster the firms grow, the more cash they generate. Improvement in the Cash Conversion Cycle Suppose RTC can cut its inventory conversion period to 65 days and its receivables collection period to 23 days. Suppose it can also increase its payables deferral period by 1 day. Assuming sales and costs remain unchanged, what impact will this have on free cash flows? Original $10,000,000 8,000,000 73 24 30 67 $2,000,000 657,534 657,534 Improved 10,000,000 8,000,000 65 23 31 57 $1,780,822 630,137 679,452 $1,731,507 $268,493

Annual sales Costs of goods sold (COGS) Inventory conversion period (days) Receivables collection period (days) Payable deferral period (days) Cash conversion cycle (days) Inventory b Receivables c Payablesa

Net operating working capital (NOWC) $2,000,000 Improvement in FCF = Original NOWC - Improved NOWC

Notes: a Inventory = (Inventory conversion period)(Sales/365) b Receivables = (Receivables collection period)(Sales/365) c Payables = (Payables deferral period)(Sales/365) THE CASH BUDGET The cash budget is a statement that shows cash flows over a specified period of time. Generally, firms use a monthly cash budget for the coming year, plus a more detailed daily or weekly cash budget for the coming month. Monthly cash budgets are used for long-range planning, and daily or weekly budgets for actual cash control. The following monthly cash budget examines MicroDrive Inc. for the last 6 months of 2005. Input Data Collections during month of sale Collections during 1st month after sale Collections during 2nd month after sale Discount on first month collections Purchases as a % of next month's sales Lease payments Construction cost for new plant (Oct) Target cash balance Sales adjustment factor

20% Assumed constant. Don't change. 70% Formula. Don't change. 10% Allow this value to change to reflect slower collections. 2% 70% $15 100 $10 0.00

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A B THE CASH BUDGET Collections and purchases worksheet Sales (gross) Collections During month of sale During first month after sale During second month after sale Total collections Purchases 70% of next months sales Payments on last month's purchases Cash gain or loss for month Collections Payments for purchases Wages and salaries Lease payments Other expenses Taxes Payment for plant construction Total payments Net cash gain (loss) during month

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D May $200

E June $250

F July $300 59 175 20 $254

G August $400 78 210 25 $313

H September $500 98 280 30 $408

I October $350 69 350 40 $459

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November December $250 49 245 50 $344 $200 39 175 35 $249

$210

$280 $210

$350 $280

$245 $350

$175 $245

$140 $175

$140

$254 210 30 15 10

$313 280 40 15 15

$408 350 50 15 20 30 $465 ($57)

$459 245 40 15 15 100 $415 $44

$344 175 30 15 10

$249 140 30 15 10 20 $215 $34

$265 ($11)

$350 ($37)

$230 $114

Loan requirement or cash surplus Cash at start of month if no borrowing Cumulative cash Target cash balance Cumulative surplus cash or loans outstanding to maintain $10 target cash balance Max loan: $100

$ 15 $4 $10 ($6)

$4 ($33) $10 ($43)

($33) ($90) $10 ($100)

($90) ($46) $10 ($56)

($46) $68 $10 $58

$68 $102 $10 $92

Question: If the percent of customers who pay in the 2nd month after the sale increased due to poor credit management, how would this affect the maximum required loan? Answer: Do a sensitivity analysis. % paying Max Req'd Loan late $ 100 $ 80 0% 10% $ 100 20% $ 120 30% $ 140 40% $ 160 50% $ 180 60% $ 206 70% $ 236 80% $ 266

Effect of Late Payment % on Loan Requirements$ 300 $ 250 $ 200 $ 150 $ 100 $ 50 $0 0% 20% 40%% Paying Late

Loan Requirement

60%

80%

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You could do all sorts of "What if" analyses. For example, what if sales declined by 50%. How would that affect the max loan requirement? Answer: Just change sales and observe the change in the max loan requirement. The max loan jumps from $100 to $231. We would then have to ask, Would our lenders more than double our line of credit in the face of a 50% drop in sales? If not, would we go bankrupt? Here is a sensitivity analysis for the effect of changes in sales on the max loan requirement: % Change in Sales -100% -50% 0% 50% 100% Max Loan $ 100 $ 535 $ 231 $ 100 $ 32 -$ 34

Max Loan Vs. Change in Sales$ 600 $ 500 $ 400 $ 300 $ 200 $ 100 $0 -$ 100 -100% -50% 0% % Change in Sales 50% 100%

Question: Answer:

If both sales and collections change, what will happen to the max loan requirement? Do a sensitivity analysis. Change in Sales $100 -100% -75% -50% -25% 0% 25% 50% 75% 100%

Max Loan Required

Maximum Loan Required0% $ 535 $ 377 $ 219 $ 121 $ 80 $ 41 $2 -$ 33 -$ 48 10% $ 535 $ 378 $ 231 $ 143 $ 100 $ 66 $ 32 -$ 2 -$ 34 % Collections in 2nd month 20% 30% 40% $ 535 $ 535 $ 535 $ 380 $ 381 $ 382 $ 246 $ 261 $ 276 $ 166 $ 188 $ 211 $ 120 $ 140 $ 160 $ 91 $ 116 $ 141 $ 62 $ 92 $ 122 $ 33 $ 68 $ 103 $5 $ 45 $ 85 50% $ 535 $ 383 $ 291 $ 233 $ 180 $ 166 $ 152 $ 138 $ 125 60% $ 535 $ 385 $ 306 $ 256 $ 206 $ 191 $ 182 $ 173 $ 165 70% $ 535 $ 386 $ 321 $ 278 $ 236 $ 216 $ 212 $ 208 $ 205

You can see from the table that, from the base case (collections = 10%, change in sales = 0), an increase in late payers increases the loan requirement, as does a decline in sales.

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A B C D E F G H I J 192 193 194 TRADE CREDIT 195 196 Accounts payable, or trade credit, is the largest single category of operating current liabilities on the balance sheet, 197 representing approximately 40 percent of the average nonfinancial corporation's current liabilities. Accounts payable, like 198 accruals, is a spontaneous liability because it generally experiences corresponding growth to a firm's productive assets. A 199 firm's credit policy tells us the terms by which they allow customers to purchase goods on credit. For example, Microchip 200 Electronics' credit policy is on terms of 2/10, net 30. This is interpreted as a 2% discount if paid within the first ten days, but 201 the full invoice amount is due within 30 days if the discount is not taken. If we are told that Microchip's annual purchases of 202 $11,760,000, we can calculate the firm's average daily A/P. (We will use a 365-day accounting year.) 203 204 $11,760,000 205 Annual chip purchases 365 206 Days/year 207 $32,219 208 Daily A/P 209 210 From the firm's trade terms, we also know the following: 211 2% 212 % Discount 10 213 Discount period (in days) 30 214 Days until due 215 216 If Microchip's customers decide to take advantage of the discount, the average accounts payable can be determined by 217 multiplying the daily accounts payable by the discount period. 218 $322,192 219 Average A/P (w/discount) 220 221 However, if the firm's customers decide to not take advantage of the discount, we assume that they will take the full term to pay 222 off the debt. We can determine the average accounts payable under this scenario, too. 223 $966,575 224 Average A/P (w/o discount) 225 226 The difference between these two average accounts payable figures tells the amount of credit Microchip offers to its customers. 227 Microchip's customers can use this trade credit to build up its cash account, to pay off debt, to expand inventories, or to extend 228 credit to its customers. 229 $644,384 230 Trade Credit 231 232 We have previously stated that Microchip's annual sales to its customers amounted to $11,760,000, and that they offer a 2% 233 discount for early payment. Dividing annual purchases by the percentage price paid (98%) gives us the total cost of goods. 234 This cost of goods is composed of an explicit cost ($11,760,000) and a finance charge (the 2%). 235 $12,000,000 236 Total cost of goods $240,000 237 Finance charge 238 239 Dividing the trade finance charge by the trade credit gives us the nominal annual cost of the additional trade credit 240 37.24% 241 Nominal annual cost 242 243 The nominal annual cost can broken into two components: the cost per period of trade credit (discount percent divided by 100% - discount 244 percent) times the periods per year (365 divided by total days until required payment - the discount period). To check ourselves, we will 245 recalculate the nominal annual cost using this method. 246 2.04% 247 Cost per period of trade credit 18.25 248 Periods per year 37.24% 249 Nominal annual cost 250 251 We are not as concerned with the nominal cost as we are with the effective cost. periods per year 252 We can calculate the effective cost by using the formula: (1 + cost per period of trade credit) 253 44.59% 254 Effective annual rate 255 256 As always, we should not be solely concerned with the current situation. For example, suppose that Microchip extended its trade policy to 257 allow customers to take up to 60 days to make full payment. What would its new effective annual cost be? Notice, that this change in policy 258 has no effect on the cost per period of trade credit, but the periods per year does change. 259 60 260 If payment due after 261 15.89% 262 New effective annual rate 263 264 While we are considering how changes in trade policy changes the cost of credit, let us look at the following scenarios. 265 Cost of additional credit if 266 the discount is not taken 267 discount ends payment due Nominal Effective 268 Credit terms % discount 1% 10 20 36.87% 44.32% 269 1/10, net 20

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F 20.13% 109.05% 44.86%

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