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Financial Decisions
Working Capital Management

⊸ Management of current assets (inventory,

accounts receivable, marketable securities
and cash) and current liabilities (notes
payable, accruals, and accounts payable)
Goal of Working Capital Management

⊸ To manage each of the firm’s current assets

and current liabilities to achieve a balance
between profitability and risk that contributes
positively to the firm’s value
Working Capital Management
Current Ass ets Current Liabilities

⊸ represent the portion of ⊸ Current liabilities represent

investment that the firm’s short-term
circulates from one form financing, because they
include all debts of the firm
to another in the
that come due (must be
ordinary conduct of
paid) in 1 year or less
⊸ suppliers (accounts
⊸ Cash -inventories- payable)
accounts receivable-
⊸ Employees and
cash governments (accruals)
⊸ Marketable securities; ⊸ Banks (notes payable)
cash substitutes
Net Working Capital

⊸ Difference between the firm’s current assets

and current liabilities

CA > CL; positive net working capital

CA < CL; negative net working capital

⊸ Inventory – accounts receivable – cash –

current liabilities
Trade-off between Poss ibility & Risk

⊸ Profitability – the relationship between

revenues and costs generated by using the
firm’s assets – both current and fixed – in
productive activities. A firm can increase its
profits by (1) increasing revenues or (2)
decreasing costs
⊸ Risk (of insolvency) – the probability that a
firm will be unable to pay its bills as they
come due
Trade-off between Poss ibility & Risk

⊸ Insolvent – a firm that cannot pay its bills as

they come due
⊸ The greater the firm’s net working capital,
the lower its risk; the more net working
capital, the more liquid the firm and therefore
the lower its risk of becoming insolvent
Changes in CA & CL






Cas h Convers ion Cycle
Cash Conversion Cycle

⊸ Measures the length of time required for a

company to convert cash invested in its
operations to cash received as a result of its


Payables Receivables

Calculating the Cash Conversion Cycle
OPERATING CYCLE (OC) However, the process of
producing and selling a
⊸ The time from the
product also includes the
beginning of the purchase of production inputs
production process (raw materials) on account,
to collection of cash which results in accounts
from the sale of the payable.
finished product.
⊸ OC = AAI + ACP ⊸ CCC = OC – APP or
Example 1

⊸ In 2007, International Business Machines

Corp. (IBM) had annual revenues of $98,786
million, cost of revenue of $57,057 million,
and accounts payable of $8,054 million. IBM
had an average age of inventory (AAI) of
17.5 days, an average collection period
(ACP) of 44.8 days, and an average
payment period (APP) of 51.2 days. (IBM’s
purchases were $57,416 million).
Getting IBM’s Cash Conversion Cycle

⊸ AAI = 17.5 days CCC = AAI + ACP - APP

⊸ ACP = 44.8 days CCC = 17.5 + 44.8 -
⊸ APP = 51.2 days 51.2
CCC = 11.1 days
Resources IBM Invested in the Cash
Conversion Cycle

INV = $57,057 M * (17.5 / 365) = $ 2,735,609,589

+AR = 98,786 M * (44.8 / 365) = 12,124,966,575
- AP = 57,416 million * (51.2 / 365) = (8,053,970,411) .
= Resources invested =$ 6,806,605,753
Funding Requirements
Permanent Funding Seas onal Funding

⊸ A constant ⊸ An investment in
investment in operating assets
operating assets that varies over time
resulting from as a result of cyclic
constant sales over sales.
Permanent Funding Example
Nicholson Company holds, on average:
⊸ Cash and marketable securities $50,000
⊸ Inventory $1,250,000
⊸ Accounts receivable $750,000

Nicholson’s business is very stable over time, so its operating

assets can be viewed as permanent. In addition, Nicholson’s
accounts payable of $425,000 are stable over time.

How much is Nicholson Company’s Permanent Investment in

Operating Asset?
Permanent Funding Solution

Permanent Investment in Operating Asset

= ($50,000 + $1,250,0000 + $750,000 -


= $1,625,000
Seas onal Funding Example
Semper Pump Company, which produces bicycle pumps, has
seasonal funding needs. Semper has seasonal sales, with its
peak sales being driven by the summertime purchases of
bicycle pumps. Semper holds, at minimum,
⊸ Cash and marketable securities $25,000
⊸ Inventory $100,000
⊸ Accounts receivable $60,000
At peak times, Semper’s inventory increases to $750,000, and
its accounts receivable increase to $400,000. To capture
production efficiencies, Semper produces pumps at a constant
rate throughout the year. Thus accounts payable remain at
$50,000 throughout the year.
Seas onal Funding Solution

Permanent funding requirement for its minimum level of

operating assets
= ($25,000 + $100,000 + $60,000 - $50,000)
= $135,000

Peak seasonal funding requirements (in excess of its

permanent need)
= ($25,000 + $750,000 + $400,000 - $50,000) - $135,000
= $990,000
Seas onal Funding Solution

Total funding requirements for operating assets

vary from a minimum of $135,000 (permanent) to
a seasonal peak of $1,125,000 ($135,000 +
Aggress ive vs. Conservative Seas onal Funding
Aggressive funding strategy Conservative funding strategy
⊸ A funding strategy under ⊸ A funding strategy under
which the firm funds its which the firm funds
seasonal requirements both its seasonal and its
with short-term debt and permanent requirements
its permanent with long-term debt.
requirements with long-
term debt.
Aggress ive Funding Strategy Example
Conservative Funding Strategy Example
Conservative Funding Strategy Example
Inventory Management
Differing Viewpoints About
Inventory Level

Financial Managers
• keep them inventory low, to ensure that the firms money is not
being unwisely invested in excess resources

Marketing Manager
• would like to have large inventories of the firm’s finished

Manufacturing Manager
• implement the production plan so that it results in the desired
amount of finished goods of acceptable quality available on
time at a low cost.

Purchasing Manager
• concerned solely with the raw materials inventories.
Techniques for Inventory Management

ABC Inventory System

⊸ Inventory Management technique that divides
inventory into three groups- A, B, and C, in
descending order of importance and level of
monitoring, on the basis of the dollar investment in

Two-bin method – unsophisticated inventory-monitoring

technique that is typically applied to C group items and
involves reordering inventory when one of two bins is
Techniques for Inventory Management

Economic Order Quantity (EOQ) Model

⊸ Inventory Management technique for determining on
item’s optimal order size, which is the size that
minimizes the total of its order costs and carrying

D = Annual Demand (Units)
S = Cost per Order
C = Cost per Unit
I = Holding Cost (%)
H = Holding Cost = I * C
Order Cost Carrying Costs

The fixed clerical costs The variable costs per

of placing and unit of holding an item
receiving on inventory in inventory for a
order specific period of time
Reorder Point Safety Stock

The point at which to Extra inventory that is

reorder inventory, held to prevent
expressed as days of stockouts or important
lead time x daily usage items
Techniques for Inventory Management

Just-in-Time System
⊸ Inventory management technique that minimizes
inventory investment by having materials arrive at
exactly the time they are needed for production
Just-in-Time Sys tem

⊸ Ideally, the firm would have only work-in-process

⊸ JIT system uses no (or very little) safety stock
⊸ Extensive coordination among the firm’s employees,
its suppliers, and shipping companies must exist to
ensure that material inputs arrive on time
Computerized Systems
Res ource Control
Materials Requirement Planning Sys tem

⊸ Inventory management technique that

applies (EOQ) concepts and a computer to
compare production needs to available
inventory balances and determine when
orders should be placed for various items on
a product’s bill of materials.
Materials Resource Planning (MRP) Sys tem II

⊸ A sophisticated computerized system that

integrates data from numerous areas such
as finance, accounting, marketing,
engineering, and manufacturing and
generates production plans as well as
numerous financial and management reports
Enterprise Resource Planning

⊸ A computerized system that electronically

integrates external information about the
firm’s suppliers and customers with the firm’s
departmental data so that the information on
all available resources – human and material
– can be instantly obtained in a fashion that
eliminates production delays
Accounts Receivable
Credit Collection & Standard

Conditions Character

Collateral Capacity

⊸ Credit Scoring - method of credit selection
that firms commonly use with high
volume/small-dollar credit requests. Credit
scoring applies statistically derived
weights to a credit applicant’s scores on
key financial and credit characteristics to
predict whether he or she will pay the
requested credit in a timely fashion.
⊸ Changing Credit Standards - The firm
sometimes will contemplate changing its
credit standards to improve its returns and
create greater value for its owners.
To demonstrate, consider the following changes and
effects on profits expected to result from the relaxation
of credit standards.
⊸ CYNICISM, a manufacturer of lathe tools, is
currently selling a product for $10 per unit. Sales
(all on credit) for last year were 60,000 units.

The variable cost per unit is $6. The firm’s total

fixed costs are $120,000.

The firm is currently contemplating a relaxation of

credit standards that is expected to result in the
following: a 5% increase in unit sales to 63,000
units; an increase in the average collection period
from 30 days (the current level) to 45 days; an
increase in bad-debt expenses from 1% of sales (the
current level) to 2%.

The firm determines that its cost of tying up funds

in receivables is 15% before taxes.
⊸ Additional Profit Contribution from Sales
⊸ Cost of the Marginal Investment in
Accounts Receivable

⊸ Cost of Marginal Bad Debts

Credit Terms

⊸ Credit terms - The terms of sale for customers who

have been extended credit by the firm.
⊸ Cash discount - A percentage deduction from the
purchase price; available to the credit customer
who pays its account within a specified time.
⊸ Cash discount period - The number of days after
the beginning of the credit period during which the
cash discount is available.
⊸ Credit period -The number of days after the
beginning of the credit period until full payment of
the account is due.
⊸ A firm’s business strongly influences its regular credit
terms. For example, a firm selling perishable items
will have very short credit terms because its items
have little long-term collateral value; a firm in a
seasonal business may tailor its terms to fit the
industry cycles. A firm wants its regular credit terms
to conform to its industry’s standards. If its terms are
more restrictive than its competitors’, it will lose
business; if its terms are less restrictive than its
competitors’, it will attract poor-quality customers
that probably could not pay under the standard
industry terms. The bottom line is that a firm should
compete based on quality and price of its product and
service offerings, not its credit terms. Accordingly, the
firm’s regular credit terms should match the industry
standards, but individual customer terms should
reflect the riskiness of the customer.
⊸ MAX Company has annual sales of $10 million and
an average collection period of 40 days (turnover ). In
accordance with the firm’s credit terms of net 30, this
period is divided into 32 days until the customers
place their payments in the mail (not everyone pays
within 30 days) and 8 days to receive, process, and
collect payments once they are mailed. MAX is
considering initiating a cash discount by changing its
credit terms from net 30 to 2/10 net 30. The firm
expects this change to reduce the amount of time
until the payments are placed in the mail, resulting
in an average collection period of 25 days (turnover ).
⊸ As noted earlier in Example 15.5, MAX has a raw
material with current annual usage of 1,100 units.
Each finished product produced requires one unit of
this raw material at a variable cost of $1,500 per
unit, incurs another $800 of variable cost in the
production process, and sells for $3,000 on terms of
net 30. Variable costs therefore total $2,300 ($1,500
$800). MAX estimates that 80% of its customers
will take the 2% discount and that offering the
discount will increase sales of the finished product
by 50 units (from 1,100 to 1,150 units) per year but
will not alter its bad debt percentage. MAX’s
opportunity cost of funds invested in accounts
receivable is 14%. Should MAX offer the proposed
cash discount?
Credit Monitoring

⊸ An ongoing review of the firm’s accounts

receivable to determine whether customers
are paying according to the stated credit

⊸ Average Collection Period

Credit Monitoring

⊸ Aging of Accounts Receivable - A credit-

monitoring technique that breaks down
accounts receivable into groups on the
basis of their time of origin; it indicates the
percentages of the total accounts
receivable balance that have been
outstanding for specified periods of time.
Letters After a certain number of days, the firm sends a polite letter reminding the
customer of the overdue account. If the account is not paid within a certain
period after this letter has been sent, a second, more demanding letter is
Telephone If letters prove unsuccessful, a telephone call may be made to the customer
calls to request immediate payment. If the customer has a reasonable excuse,
arrangements may be made to extend the payment period. A call from the
seller’s attorney may be used.
Personal visit This technique is much more common at the consumer credit level, but it
may also be effectively employed by industrial suppliers. Sending a local
salesperson or a collection person to confront the customer can be very
effective. Payment may be made on the spot.
Collection A firm can turn uncollectible accounts over to a collection agency or an
agencies attorney for collection. The fees for this service are typically quite high; the
firm may receive less than 50 cents on the dollar from accounts collected in
this way.
Legal action Legal action is the most stringent step, an alternative to the use of a
collection agency. Not only is direct legal action expensive, but it may force
the debtor into bankruptcy without guaranteeing the ultimate receipt of the
overdue amount.
Management of Receipts
& Disburs ements
Management of Receipts and Disburs ements

⊸ Average Collection Period (2nd component of the cash

conversion cycle) :
1. time from sale until the customer mails the payment
2. the receipt, processing, and collection time

⊸ Average Payment Period (3rd component of the cash

conversion cycle) :
1. the time from purchase of goods on account until the
firm mails its payment
2. the receipt, processing, and collection time required
by the firm’s suppliers

⊸ Refers to funds that have been sent by the payer but are not
yet usable funds to the payee.
⊸ Float is important because its presence lengthens both the
firm’s average collection period and its average payment

• Mail float – payment is placed in the mail -> when it is received

• Processing float – receipt of payment -> deposited to the firm’s
• Clearing float – deposit to the firm’s account -> it becomes a
spendable fund available to the firm
How do we speed up Collections ?

⊸ Lockbox System

Lockboxes reduce mail time and often

clearing time by being near the firm’s

Lockboxes reduces processing time to

nearly zero because the bank deposits
payments before the firm processes them.
How do we slow down Payments?

⊸ Controlled Disbursing – involves the

strategic use of mailing points and bank
accounts to lengthen mail float and clearing
float, respectively.

⊸ Stretching accounts payable – paying

beyond the due date. This can occur when
the firm has way too much power over the
supplier. Company may face ethical and
moral issues.
Cash Concentration

⊸ Is the process used by the firm to bring

lockbox and other deposits together into one
bank, often called the concentration bank.

⊸ Advantages:
1. Investing a single pool of funds reduces the firm’s
transaction costs
2. Concentrating the firm’s cash in one account
improves the tracking and internal control of the firm’s
3. Having one concentration bank enables the firm to
implement payment strategies that reduce idle cash
(3) Mechanis ms for transferring cas h from the
lockbox bank to the concentration bank

I. Depository transfer check (DTC)

⊸ - DTC is drawn on each lockbox or other
collecting bank account and deposited in the
concentration bank account.
(3) Mechanis ms for transferring cas h from the
lockbox bank to the concentration bank

II. Automated clearinghouse (ACH)

▫ preauthorized electronic withdrawal from
the payer’s account. ACH settles
accounts among participating banks;
both banks must be members of the
clearing house. ACH clears in one day.
(3) Mechanis ms for transferring cas h from the
lockbox bank to the concentration bank

III. Wire transfer

▫ electronic communication that, via
bookkeeping entries, removes funds
from the payer’s bank and deposits
them in the payee’s bank. Substitute for
DTC and ACH but is more expensive.
Zero-Balance Accounts

- ZBAs are disbursement accounts that always have an

end-of-day balance of zero. The purpose is to eliminate
nonearning cash balances in corporate checking
- Once all of a given day’s checks are presented for
payment from the firm’s ZBA, the bank notifies the firm
of the total amount of checks, and the firm transfers
funds into the account to cover the amount of the day’s
- A firm that used a ZBA in conjunction with a cash
concentration system would need two accounts.
Current Liabilities
Spontaneous Liabilities

⊸ Arises from the normal course of business

Example: A retailer orders goods for inventory

The manufacturer extends a short-term loan

instead of demanding immediate payment.
Unsecured short-term financing

⊸ Obtained without pledging specific assets as

Accounts Payable Management

⊸ Refers to the set of policies, procedures, and

practices employed by a company with respect
to managing its trade credit purchases.

Accounts payable are the major source of

unsecured short-term financing
⊸ Interest-free

o When the seller of goods charges no

interest and offers no discount, the
buyer’s goal is to pay as slowly as
possible without damaging its credit

o Some firms offers grace period that

extends a few days beyond the stated
payment date.
Analyzing Credit Terms
⊸ With Cash Discount

 Early payment cash discount – pay on the last day of

discount period
 Giving up cash discount – pay on the last day of credit

 The cost of giving up cash discount is implied

rate of interest paid to delay payment of an
account payable for additional number of days.

⊸ Without Cash Discount

 Pay on the last day of credit period

CD – stated cash discount in percentage terms
N – number of days that payment can be delayed by
giving up cash discount
Effects of Stretching Accounts Payable

⊸ Paying credits as late as possible without

damaging credit rating can reduce the cost
of giving up a cash discount

⊸ Are liabilities for services received for which payment

has yet to be made

⊸ The second spontaneous source of short-term

business financing

 The most common items accrued by a firm

are wages and taxes
 Taxes cannot be manipulated unlike wages
 Wages can be manipulated by delaying the
payment, thereby receiving interest-free
loan from employees
Uns ecured Sources of
Short-Term Loans
Bank Loans
 Short-term, self-liquidating loan

 an unsecured short term loan in whereby the

funds borrowed are used to buy some asset,
which is in turn sold at the loan’s maturity to
repay the loan
Loan Interest Rates
 Prime rate of interest (prime rate) – the
lowest rate of interest charged by leading
banks on business loans to their most
important business borrowers

 Fixed-rate loan – a loan with a rate of

interest that is determined at a set
increment above the prime rate and remains
unvarying until maturity
Loan Interest Rates

 Floating-rate loan – a loan with a rate of interest initially set at

an increment above the prime rate and allowed to “float”, or
vary, above prime as the prime rate varies until maturity

Method of Computing Interest

Interest paid at maturity

𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑜𝑟 𝑡𝑟𝑢𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 =
𝐴𝑚𝑜𝑢𝑛𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑
Method of Computing Interest

Interest paid in advance

𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 𝑓𝑜𝑟 𝑎 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑙𝑜𝑎𝑛

𝐴𝑚𝑜𝑢𝑛𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Single-Payment Note
⊸ A short-term, one-time loan made to a
borrower who needs funds for a specific
purpose for a shot period

⊸ Has a maturity of 30 days to 9 months or

Lines of Credit
⊸ An agreement between a commercial bank and a
business specifying the amount of unsecured short-
term borrowing the bank will make available to the
firm over a given period of time

⊸ Interest rate = prime rate + premium

⊸ Operating- change restrictions – contractual

restrictions that a bank may impose on a firm’s
financial condition or operations as part of a line-of-
credit agreement
Lines of Credit
⊸ Compensating balance – a required checking account
balance equal to a certain percentage of the amount
borrowed from a bank under a line-of-credit or
revolving credit agreement

⊸ Annual cleanup – requirement that for a certain

number of days during the year borrowers under a
line of credit carry a zero loan balance (that is, owe
the bank nothing)
Revolving Credit Agreements
 A line of credit guaranteed to a borrower by a
commercial bank regardless of the scarcity of money

 Commitment Fee – the fee that is normally charge on

a revolving credit agreement; it often applies to
average unused portion of the borrower’s credit line
Commercial Paper
 A form of financing that consists of short-term,
unsecured promissory notes issued by firms with a
high credit standing.

 Commitment Fee – the fee that is normally charge on

a revolving credit agreement; it often applies to
average unused portion of the borrower’s credit line
International Loans
International Transactions
⊸ The important difference between international and
domestic transactions is that payments are often
made or received in a foreign currency.

Financing International Trade

⊸ Letter of credit – a letter written by a company’s bank
to the company’s foreign supplier, stating that the
bank guarantees payment of am invoiced amount if
all the underlying agreements are met

Transactions Between Subsidiaries