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A 15model

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12/15/2013 4:08

K 1/13/2003

Chapter 15. Model for managing current assets

This chapter 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 conversion cycle Inventory conversion period = + Receivables collection period Payables deferral period

Problem Calculate the cash conversion cycle for the Real Time Computer Company. Annual sales are $10 million, and the annual cost of goods sold is $8 million. The average levels of inventory, receivables, and accounts payable are $2,000,000, $657,534, and $657,534, respectively. RTCC uses a 365-day accounting year. Sales COGS Inventories AR AP $10,000,000 $8,000,000 $2,000,000 $657,534 $657,534

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A Days/year

B 365

Cash conversion cycle (CCC)

= = = =

Inventory conversion period

+ + +

Receivables collection period AR/Sales per day 24

Payables deferral period AP/COGS per day 30

Inventory/Sales per day 73 67

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-day 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. Disregarding profits, how much capital does RTCC have tied up in working capital? Answer: (C of GS / day) * (CCC) = = $ $ 21,918 1,468,493 * 67

If the cost of capital is 10%, then it costs RTCC $146,849 per year to carry working capital. Question: If RTCC began selling on a credit card only basis, how would this affect its CCC, and what effect would it have on the cost of carrying working capital? Answer: Receivables would go to zero, the CCC would fall to 43 days, and carrying costs would decline by 24 * $ 21,918 * 10% = 52,603

We could do sensitivity analysis to see how other changes would affect profitability.

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A B 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 Allied Foods for the last 6 months of 2003. 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 THE CASH BUDGET May 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 $200 June $250 July $300 59 175 20 $254 August $400 78 210 25 $313 September $500 98 280 30 $408 October $350 69 350 40 $459 November December $250 49 245 50 $344 $200 39 175 35 $249

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

$210

$280 $210

$350 $280

$245 $350

$175 $245

$140 $175

$140

$254

$313

$408

$459

$344

$249

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105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139

A B C Payments for purchases Wages and salaries Lease payments Other expenses Taxes Payment for plant construction Total payments Net cash gain (loss) during month

F 210 30 15 10

G 280 40 15 15

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

I 245 40 15 15 100 $415 $44

J 175 30 15 10

K 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 0% $ 80 10% $ 100 20% $ 120 30% $ 140 40% $ 160 50% $ 180 60% $ 206 70% $ 236 80% $ 266

Effect of Late Payment % on Loan Requirements

Loan Requirement

$ 300 $ 250 $ 200 $ 150 $ 100 $ 50 $0 0% 20% 40%

% Paying Late

60%

80%

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A 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174

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 Max Loan Required $ 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%

Maximum Loan Required

0% $ 535 $ 377 $ 219 10% $ 535 $ 378 $ 231 % Collections in 2nd month 20% 30% 40% $ 535 $ 535 $ 535 $ 380 $ 381 $ 382 $ 246 $ 261 $ 276 50% $ 535 $ 383 $ 291 60% $ 535 $ 385 $ 306 70% $ 535 $ 386 $ 321

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A 175 176 177 178 179 180 181 182 183 184

B -25% 0% 25% 50% 75% 100%

C $ 121 $ 80 $ 41 $2 -$ 33 -$ 48

D $ 143 $ 100 $ 66 $ 32 -$ 2 -$ 34

E $ 166 $ 120 $ 91 $ 62 $ 33 $5

F $ 188 $ 140 $ 116 $ 92 $ 68 $ 45

G $ 211 $ 160 $ 141 $ 122 $ 103 $ 85

H $ 233 $ 180 $ 166 $ 152 $ 138 $ 125

I $ 256 $ 206 $ 191 $ 182 $ 173 $ 165

J $ 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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