LongCh1 - Christian Brothers University



22 Managing Assets

|— |CHAPTER 22 LECTURE NOTES |

|1 |Describe the working-capital cycle of a small business. | |

|PPT 22-1 |The working-capital cycle |

|Chapter 22 |Define working capital and explain that the working-capital cycle refers to the flow of a firm’s |

|Managing Assets |resources through the cash, accounts receivable, and inventory accounts. |

|PPT 22-2 |The key to working-capital management is to avoid running out of cash. |

|Looking Ahead |Go through the five-step overview of the working-capital cycle, and then lead the students through |

|PPT 22-3 |Figure 22-1. |

|Working-Capital |The timing and size of working capital investments (Discuss the chronological sequence for a |

|PPT 22-4,5 |hypothetical working-capital cycle.) |

|The Working-Capital Cycle |Examples of working-capital management (Compare and contrast the working-capital time lines for Pokey, |

|[Acetate 22-5] |Inc. and Quick Turn Company.) |

|PPT 22-6 | |

|Working-Capital Time Line | |

|[Acetate 22-6] | |

|PPT 22-7,8/TM 22-8,9/TM 22-9,10/TM | |

|22-10,11/TM 22-11,12/TM 22-12,13/TM| |

|22-13 | |

|Pokey, Inc. (Various Titles) | |

|[Acetate 22-7] | |

|2 |Identify the important issues in managing a firm’s cash flows. | |

|PPT 22-14 |Managing cash flows |

|Managing Cash Flows |The nature of cash flows revisited |

| |Explain why a profitable business may run out of money. |

|PPT 22-15, 16/TM 22-16 |Ask a student to explain the cash-flow system of a business, including various types of inflows and |

|Flow of Cash Through |outflows. |

|a Business |Point out that a firm’s cash-flow system may also be explained with reference to the firm’s bank |

|[Acetate 22-15,16] |account. |

| |How may business revenues and cash receipts differ? (One example: Borrowing money produces cash |

| |receipts but no revenues.) |

| |2. The cash budget |

| |Discuss the importance of the cash budget |

| |Cash budgets are tools for managing cash flows. |

| |By using a cash budget, a manager can predict and plan cash flow. |

| |Analyze the cash budget for Davies Corporation (see the chapter). |

| | |

| | |

|3 |Explain the key issues in managing accounts receivable, inventory, and | |

| |accounts payable. | |

| |Managing accounts receivable |

|PPT 22-17 |How accounts receivable affect cash |

|Managing Accounts Receivable |Selling on credit creates receivables and delays receipt of cash. |

| |Subsequent collection of receivables produces cash receipts. |

|PPT 22-18 |Growth of receivables, therefore, soaks up cash. |

|Credit Management Practices |The life cycle of accounts receivable |

| |The life cycle begins with a cash sale. |

| |Review the credit-management practices that improve cash flows. |

| |Discuss the value of using a lockbox for receiving payments. |

| |Accounts-receivable financing |

| |Pledged accounts receivable as collateral for a loan |

| |Selling accounts receivable to a finance company (i.e., factoring) |

|PPT 22-19 |Managing inventories |

|Managing Accounts Receivable |Reducing inventory to free cash |

| |Monitoring inventory |

| |Controlling stockpiles |

|PPT 22-20 |Managing accounts payable |

|Managing Inventory |Negotiation—postponing payment in emergency situations |

| |Timing—delaying repayment for as long as possible |

|PPT 22-21 | |

|Managing Accounts Payable | |

|PPT 22-22/TM 22-22 | |

|An Accounts Payable | |

|for Terms 3/10, Net 30 | |

|4 |Discuss the techniques commonly used in making capital budgeting decisions. | |

|PPT 22-23/TM 22-23 |Capital budgeting |

|Capital Budgeting |Capital budgeting techniques |

|PPT 22-24/TM 22-24 |Accounting return on investment—How many dollars in average profits are generated per dollar of average|

|Three Rules of |investment? |

|Capital Budgeting |Payback period—How long will it take to recover the original investment? |

| |Discounted cash flow—How does the present value of future benefits from the investment compare to the |

|PPT 22-25/TM 22-25, 26/TM 22-26, |investment outlay? |

|27/TM 22-27 |Net present value |

|Capital Budgeting Techniques |Internal rate of return |

| | |

|PPT 22-28 | |

|Discounted Cash Flows | |

|5 |Describe the capital budgeting practices of small firms. | |

|PPT 22-29/TM 22-29 |Capital budgeting analysis in small firms |

|A Firm’s Cost of Capital |Discuss the lack of capital budgeting analysis in small firms – Ask students to discuss why many small |

| |businesses do not use discounted cash flows to make decisions. They may mention some of the following |

|PPT 22-30/TM 22-30 |reasons: |

|Measuring the Cost of Capital |The small firm and its owner are inseparable--personal issues come into play. |

| |Survival focus crowds out long-term planning interests. |

|PPT 22-31 |Greater uncertainty of cash flows makes long-term planning unappealing. |

|Using the Cost of Debt as an |Market-value rule of maximizing net present values is irrelevant for closely held small firms. |

|Investment Criterion |Small projects make net present value computations less feasible. |

| |Small business owner may not have a business or finance orientation. |

|PPT 23-32 | |

|Capital Budgeting | |

|Practices of Small Firms | |

|— |SOURCES OF AUDIO, VIDEO, AND OTHER INSTRUCTIONAL MATERIALS |

Deloitte & Touche has issued a book called Financing Business Growth: An Entrepreneur’s Guidebook. You can order it from the Emerging Business Services Department of Deloitte & Touche, at (202) 879-5381. Among other ways of financing growth, this book looks at internal financing. Various ways of improving cash flows by squeezing cash out of current operations are discussed.

For a current treatment of profitable growth strategies for small firms, see Ernesto J. Poza, Smart Growth: Critical Choices for Business Continuity and Prosperity (San Francisco: Jossey-Bass Publishers, 1989).

|— |Answers to end-of-chapter |

| |discussion questions |

1. a. List the events in the working-capital cycle that directly affect cash and those that do not.

b. What determines the length of a firm’s cash conversion period?

p. 481 - 483 Working-capital management primarily involves management of three assets—cash, accounts receivable, and inventories—and two sources of short-term debt—accounts payable and accruals. We purchase or produce inventories; sell these inventories, either for cash or on credit; and collect the accounts receivable resulting from the credit sales. The purchasing of inventory or raw materials affects cash unless the purchases are made on credit. Sales also affect cash unless they are made on credit. When payment is made on a credit purchase or payment is received on a credit sale, cash is affected.

The cash conversion period is the time between the payment of cash for materials or goods and the receipt of cash for the sale of those materials or goods. A company’s credit sales policy and its credit purchasing policy (whether discounts are usually taken) affect the cash conversion period. Also, the credit sales policies of its suppliers and the credit purchasing policies of its customers affect the cash conversion period.

2. a. What are some examples of cash receipts that are not sales revenue?

b. Explain how expenses and cash disbursements during a month may be different.

p. 487-488 Cash receipts that are not sales revenue include money obtained by borrowing, from additional investments, from the sale of assets, and from the collection of accounts receivable (indirect sales revenue).

Some expenses may be incurred without paying out cash—for example, by purchasing office supplies that are used during the month but are not yet billed. Some disbursements are necessary to pay expenses incurred in earlier months—for example, payment of last month’s electric bill.

3. How may a seller speed up the collection of accounts receivable? Give examples that may apply to various stages in the life cycle of receivables.

p. 491-492 The seller may speed up the billing process by sending invoices promptly—an early step. It may also screen customers to weed out slow-paying accounts and provide incentives for prompt payment. Or, the seller may use aggressive methods in collecting accounts—a late step.

4. Suppose that a small firm could successfully shift to a just-in-time inventory system—an arrangement in which inventory is received just as it is needed. How would this affect the firm’s working-capital management?

p. 493 Shifting to a just-in-time inventory system would presumably reduce inventory requirements. If the system worked perfectly, inventory would approach zero. As a result, the total working capital needed would be reduced. Cash obtained from reducing inventory could be used for other purposes.

5. How do working-capital management and capital budgeting differ?

p. 481,495 Working-capital management has more to do with the short-term, day-to-day disbursements typically associated with normal operations. Capital budgeting usually involves long-term decisions and larger dollar amounts. This is not to say that capital budgeting is more important than working-capital management, but because larger dollar amounts are typically involved, more preparation and evaluation are needed.

6. Compare the different techniques that can be used in capital-budgeting analysis.

p. 496 All the techniques attempt to answer one general question: Do the future benefits from an investment exceed the cost of making the investment? However, each of the three measurements has its own specific question to answer. The techniques and the specific question each addresses may be stated as follows:

• Accounting return on investment: How many dollars in average profits are generated per dollar of average investment?

• Payback period: How long will it take to recover the original investment outlay?

• Discounted cash flow: How does the present value of future benefits from the investment compare to the investment outlay?

7. What does net present value measure?

p. 497 -- 498 Net present value estimates the current value of the cash that will flow into the firm from the project in the future and deducts the amount of the initial outlay.

8. Define internal rate of return.

p. 498 Internal rate of return is the rate earned on an investment or project. It is the rate that would give a project or investment a net present value of zero. Just as net present value gives a dollar value for comparative purposes, internal rate of return gives a percentage rate of return that may be used for comparing different opportunities.

9. a. Find the accounting return on investment for a project that costs $10,000, will have no salvage value, and has expected annual after-tax profits of $1,000.

b. Determine the payback period for a capital investment that costs $40,000 and has the following after-tax profit. (The project outlay of $40,000 will be depreciated on a straight-line basis to a zero salvage value.)

Year After-Tax Profits

1 $4,000

2 5,000

3 6,000

4 6,500

5 6,500

6 6,000

7 5,000

a. Accounting return on investment = ($1,000 ( [$10,000 + 0]) = 0.20, or 20%

b. After-Tax Cash Cumulative

Year Profits Depreciation Flow Cash Flow

1 $4,000 $5,714 $9,714 $9,714

2 5,000 5,714 10,714 20,428

3 6,000 5,714 11,714 32,142

4 6,500 5,714 12,214 44,356

After Year 3, $7,858 (or $40,000 – $32,142) remains to be repaid, and it is paid after 64.33% (or $7,858 ( $12,214) of Year 4 has elapsed. The total payback period is 3.64 years.

10. Why would owners of small firms not be inclined to use the net present value or internal rate of return measurements?

p. 498-499 Such limited use of discounted cash flow techniques probably has more to do with the nature of the small firm itself than with the owners’ unwillingness to learn. For many owners of small firms, the business is an extension of their lives, and what happens to the owners personally affects their decisions about the firm; several nonfinancial variables may play a significant part in owners’ decisions. The undercapitalization and liquidity problems of a small firm can directly affect the decision-making process, and survival often becomes the top priority. The greater uncertainty of cash flows within a small firm makes long-term forecasting and planning seem unappealing and even a waste of time, thus, calculating the cash flows for the entire life of a project is viewed as futile. The value of a closely held firm is less easily observed than that of a publicly held firm, thus, the owner may consider the market-value rule of maximizing net present values irrelevant. The smaller size of a small firm’s projects may make net present value computations less feasible in a practical sense. Lastly, management talent within a small firm is a scarce resource; the perspective of owners is influenced greatly by their backgrounds.

|— |COMMENTS ON CHAPTER “YOU MAKE THE CALL” SITUATIONS |

Situation 1

1. What are the advantages and weaknesses of the minimum-cash-balance practice?

The advantages are the ability to pay bills promptly and the chance to eliminate certain paperwork. A major weakness is the lower interest income resulting from maintaining such a large balance in a checking account. A commercial demand checking account cannot pay interest.

2. There is a saying “If it ain’t broke, don’t fix it.” In view of the firm’s present success in paying bills promptly, should it be encouraged to use a cash budget? Be prepared to support your answer.

The firm should be encouraged to use a cash budget in order to maximize its profits. It can then transfer excess cash into interest-bearing accounts until the money is needed to pay bills. The owner of this firm may be fearful of trying a financial tool with which he or she has no experience, but cash budgeting need not be complex or burdensome.

Situation 2

1. Is offering a cash discount the equivalent of a bribe?

A cash discount is not the equivalent of a bribe. It is a payment for use of money for a longer time period.

2. How would a cash discount policy relate to bad debts?

If payment that otherwise would be postponed can be encouraged to come in immediately with a cash discount, that receivable will never become a bad debt. However, most companies that have trouble paying their bills do not take advantage of cash discounts. Therefore, a cash discount policy would have minimal impact on this firm’s bad-debt experience. (The company does appear to have a bad-debt problem.)

1. What cash discount policy, if any, would you recommend?

In answering this question, the first step should be to examine the credit policies of competitors and the credit expectations of customers. There are probably standard credit terms that are commonly used in the industry. This firm may find that it is losing business from well-run companies that patronize its competitors in order to take advantage of cash discounts. Some reduction of revenue will occur as the company grants discounts to those already paying promptly. A careful estimate must be made of the degree to which payments can be accelerated and the extent to which new business can be obtained from well-managed customers. These benefits must be compared to the additional costs involved in such a policy change.

2. What other approaches might be used to improve cash flow from receivables?

Cash flow might be improved by factoring accounts receivable—funds would be obtained immediately and the factor would have to collect the receivables. Reducing bad debts through improved screening and/or collection practices would also improve cash flow.

Situation 3

1. Prepare a monthly cash budget for the three-month period ending in December.

|ASSUMPTIONS: | | | | | | |

|Collection Experience | | | | | | |

| Cash Sales % |25% | | | | | |

| 1 Month |35% | | | | | |

| 2 months |40% | | | | | |

|Purchases |75% |of sales | | | | |

|Utilities |3% |of sales | | | | |

|Short-term interest rate |10% | | | | | |

|Minimum cash balance |7,000 | | | | | |

|Cost of goods sold |75% | | | | | |

| | | | | | | |

| |Aug |Sept |Oct |Nov |Dec |Jan |

|Monthly sales |$150,000 |$175,000 |$200,000 |$220,000 |$180,000 |$200,000 |

|Cash receipts | | | | | | |

| Cash sales |25% | |$50,000 |$55,000 |$45,000 | |

| 1 month |35% | |61,250 |70,000 |77,000 | |

| 2 months |40% | |60,000 |70,000 |80,000 | |

| Total collections | | |$171,250 |$195,000 |$202,000 | |

| | | | | | | |

|Purchases |75% |$150,000 |$165,000 |$135,000 |$150,000 | |

|Cash disbursements | | | | | | |

| Payments on purchases | | |$150,000 |$165,000 |$135,000 | |

| Rent | | |5,000 |5,000 |5,000 | |

| Wages and salaries | | |25,000 |25,000 |25,000 | |

| Tax prepayment | | |10,000 | | | |

| Utilities |3% | |6,000 |6,600 |5,400 | |

| Interest long-term note | | | | |1,500 | |

| Total cash disbursements | |$196,000 |$201,600 |$171,900 | |

|Net change in cash | | |($24,750) |($6,600) |$30,100 | |

2. If the firm's beginning cash balance for the budget period is $7,000, and this is its minimum desired balance, determine when and how much the firm will need to borrow during the budget period. The firm has a $50,000 line of credit with its bank with interest (10 percent annual rate) paid monthly. For example, interest on a loan taken out at the end of September would be paid at the end of October and every month thereafter so long as the loan was outstanding.

|Beginning cash balance | | |$7,000 |$7,000 |$7,000 |

|Short-term interest | |0.833% | |-206 |-263 |

|Cash balance before borrowing | |-17,750 |194 |36,837 |

|Short-term borrowing (payments) | |24,750 |6,806 |-29,837 |

|Ending cash balance |$7,000 | |$7,000 |$7,000 |$7,000 |

| | | | | | |

|Cumulative short-term borrowing |0 |$24,750 |$31,556 |$1,719 |

|— |Answers to exploring the web exercises |

For each chapter, the instructor’s manual will include a short summary of suggested results students will have after completing the various Web exercises. Because the Web is a constantly changing medium, the answers may vary, and the links may change as well. Thus, answers are only suggested, and the URL for resources, where required, is provided.

Exercise 1

A cash flow statement clearly documents the movement of cash (working capital) in and out of your company during an accounting period.

Exercise 2

According to the text, cash flow statements are broken into three sections: operating activities, investing activities, and financing activities.

• Operating activities (all transactions and events that normally enter into the determination of operating income) include cash receipts, inventory, payroll, taxes, interest, utilities, rent, interest, and dividends.

• Investing activities include transactions and events involving the purchase and sale of securities (excluding cash equivalents), land, buildings, equipment, and other assets not generally held for resale.

• Financing activities deal with the flow of cash to or from the business owners (equity financing) and creditors (debt financing).

Exercise 3

There are generally two methods for calculating cash flow from operating activities: indirect and direct.

• Indirect: Because of its relative simplicity, the indirect method starts with a figure for net income (from your income statement). The net income is then adjusted to take into account changes during a specific accounting period. Adjustments are made to reflect depreciation and amortization, accounts receivable, inventory accounts payable, accrued wages payable, prepaid insurance, and income taxes payable.

• Direct: The direct method, although less popular, is favored by many financial managers because it reports the source of cash inflows and outflows directly, without the potentially confusing adjustments to net income. Instead of starting with a reported net income, the direct method analyzes the various types of operating activities and calculates the total cash flow created by each one. Before beginning the direct method, all accrual accounts must first be converted to a cash figure.

|— |SUGGESTED SOLUTION TO CASE 22: |

| |BARTON SALES AND SERVICE |

1. Evaluate the overall performance and financial structure of Barton Sales and Service.

The year’s performance, as recorded in Figure C23-1, is excellent. The net income after taxes of $54,540 represents a 55-percent return on the equity of $99,625. Moreover, this amount is the profit after allowance for officers’ salaries. In other words, salary compensation was realized by the owners in addition to the stated profit.

The current ratio of 2.1 to 1 indicates an apparently healthy current financial condition. The 1.0 to 1 acid-test ratio further confirms this assessment of current condition. The total debt is 57.8 percent of total assets—a percentage that might be viewed with some concern. However, the fact that a substantial part of the debt represents a note being paid off to the former owner over a period of several years makes this figure less disturbing.

2. What are the strengths and weaknesses in this firm’s management of accounts receivable and inventory?

The fact that the firm has experienced no significant losses from bad debts indicates that control of accounts receivable has been reasonably successful. However, management of receivables could be improved. The firm’s accountant should be directed to age the accounts so that the manager has a clear picture of the extent to which customers are using Barton’s money by delaying payments.

In the absence of a cash discount to encourage payment, the Bartons must be very aggressive in their collection procedures. The small interest charge on unpaid bills is not sufficient to provide a strong incentive for prompt payment. The practice of collecting payment for service calls at the time of service is to be commended. This practice, when successful, results in a cash sale and reduces bookkeeping and billing costs.

In summary, the Bartons have been managing accounts receivable successfully, but there is some question about the aggressiveness of their collection methods and the lack of aging of receivables.

They need to improve their management of inventory. The use of an annual physical inventory indicates that the firm does not know inventory levels at other times. This situation needs to be remedied as quickly as possible by introducing a perpetual inventory system. The recognition that there may be some slack in inventory suggests a need for more rigorous control. Excessive inventory involves heavy carrying charges and a drain on profits when interest costs are high. Some attempt should be made, therefore, probably through the firm’s CPA, to locate standards that can be used to evaluate the quality of their inventory management.

3. Should the firm reduce or expand its bank borrowing?

Bank borrowing is costly during periods of high interest rates. Profits can be improved by reducing borrowing, assuming that operations are not adversely affected. If Barton’s bank borrowing can be reduced by holding the cash balance at a lower level, by removing excess inventory, and by speeding up collection of receivables, the firm will benefit. Nonetheless, the firm should not pass up profitable opportunities merely for the sake of reducing borrowing.

4. Evaluate the Bartons’ management of trade accounts payable.

The Bartons are apparently taking advantage of all credit being offered by suppliers. However, their failure to take cash discounts is costly when calculated in terms of the annual rate of return on the cash involved. (The 2/10, net 30 terms are equivalent to an annual rate of 36 percent.) If cash is desperately needed or if the amount is trivial, this practice is permissible. Otherwise, they should begin taking cash discounts.

The suppliers offer quite different terms of payment. From the standpoint of financial management, the Bartons should order as much as possible under the floor-planning arrangement of Carrier. This involves no carrying cost. The next best terms are those offered by York—30 days to pay. The most severe terms are those offered by General Electric—payment soon after the receipt of the products.

5. Calculate Barton’s “cash conversion period.” Interpret your computation.

The cash conversion period equals the days in inventory plus the days in accounts receivable less the days in accounts payable. For Barton the cash conversion period is 68 days, computed as follows:

Days in inventories

[365 days ( (cost of goods sold/inventories)] 70 days

Days in accounts receivable

[365 days ( (sales/accounts receivable)] 28 days

Days in accounts payable

[365 days ( (cost of goods sold/accounts payable)] –30 days

Cash conversion period 68 days

6. How can Barton Sales and Service improve its working-capital situation?

To answer this question, we must summarize a number of points discussed above. The Bartons should reduce the cash balance to the minimum necessary for effective operation because idle cash is costly. They should adopt a more efficient form of inventory control that will reduce the inventory level and thereby reduce carrying costs. Accelerated collection of receivables would improve the working-capital situation. And, to the extent that buying could be concentrated with suppliers who offer the most generous financing terms, the firm could also minimize the costs associated with payables and inventory.

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