1.
Describe the working-capital cycle of a small firm.
2.
Identify the important issues in managing a firm’s cash flows
3.
Explain the key issues in managing accounts receivable.
4.
Discuss the key issues in managing inventory.
5.
Explain the key issues in managing accounts payable.
6.
Calculate and interpret a firm’s cash conversion period.
7.
Discuss the techniques commonly used in making capital budgeting decisions.
8.
Describe the capital budgeting practices of small firms.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –2

• Working-Capital Management
 The management of current assets and current liabilities
• Net Working Capital
 The sum of a firm’s current assets (cash, account receivable, and inventories) less current liabilities
(short-term notes, accounts payable, and accruals)
• Working-Capital Cycle
 The daily flow of resources through a firm’s workingcapital accounts
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –3

The Working Capital Cycle
1
2
3
4
5
Purchase or produce inventory for sale, which increases accounts payable.
Sell inventory for cash; sell inventory for credit (accounts receivable).
Pay the accounts payable (decreases cash and accounts payable).
Collect the accounts receivable (decreases accounts payable and increases cash).
Begin cycle again.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –4

22.1
Working
Capital
Cycle
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22 –5

22.2
Working Capital Time Line
Day a. Inventory is ordered in anticipation of future sales.
Day b. Inventory is received.
Day c. Inventory is sold on credit.
Day d. Accounts payable come due and are paid.
Day e. Accounts receivable are collected.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cash conversion period — the time required to convert paidfor inventories and accounts receivable into cash.
22 –6

22.3
Working Capital Time Lines for Pokey, Inc., and Quick Turn Company
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22 –7

Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
July
400
0
0
600
0
1,000
0
0
0
300
700
0
1,000
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –8

Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
July
400
0
0
600
0
1,000
0
300
0
0
700
0
1,000
Aug.
400
0
500
600
0
1,500
500
0
0
300
700
0
1,500
Sept.
Changes: August to September
–500 (100)
0
500
600
0
1,000
–500
0
300
0
0
700
0
1,000
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –9

Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
July
400
0
0
600
0
1,000
0
0
0
300
700
0
1,000
Aug.
400
0
500
600
0
1,500
500
0
0
300
700
0
1,500
Sept.
(100)
0
500
600
0
1,000
0
0
0
300
700
0
1,000
Oct.
(100)
900
0
600
(50)
1,350
Changes:
September to October
+900
–500
–50
0
250
25
300
700
75
1,350
+250
+25
+75
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –10

Change in the Balance Sheet
Increase accounts receivable of $900
Decrease inventories of $500


Effect on Income Statement
Sales of
Cost of goods sold of
$900
$500
Increase in accrued operating expenses of $250
 Operating expenses of $250
Increase accumulated depreciation of $50  Depreciation expense of $50
Increase accrued taxes of $25  Tax expense of $25
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –11

Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
July
400
600
0
0
0
1,000
0
300
700
0
0
0
1,000
Aug.
400
0
500
600
0
1,500
500
0
0
300
700
0
1,500
Sept.
(100)
0
500
600
0
1,000
0
300
700
0
0
0
1,000
Oct.
(100)
900
0
600
(50)
1,350
0
250
25
300
700
75
1,350
Changes:
October to
November
Nov.
550
600
(50)
0
0
1,100
+650
–900
25
300
700
75
0
0
1,100
–250
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –12

Sales revenue
Cost of goods sold
Gross profit
Operating expenses:
Cash
Depreciation expense
Total operating expenses
Operating income
Income tax (25%)
Net income
900
(500)
400
(250)
(50)
(300)
100
(25)
75
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –13

• The Nature of Cash Flows Revisited
 The flow of actual cash through a firm determines whether or not the firm can meet its current obligations.
• Net Cash Flow
 The difference between inflow and outflows
• Net Profit
 The difference between revenue and expenses
• The Growth Trap
 A cash shortage (cash crunch) resulting from rapid growth
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –14

22.4
Flow of Cash Through a Business
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –15

• How Accounts Receivable Affect Cash
 Accounts receivable represent the firm’s decision to delay the inflow of cash from customers who have been extended credit.
• Life Cycle of Accounts Receivable
 Firm makes credit sale to customer.
 Invoice is prepared and sent to customer.
 Customer pays firm.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –16

• Days Sales Outstanding
 Average collection period —number of days, on average, a firm is extending credit to its customers.
Days sales outstanding =
Accounts receivable
Annual credit sales ÷ 365 days
Fast Co.’s
Days Sales
Outstanding
=
Example:
Total sales
Credit sales
Average credit sales per day
Accounts receivable
Fast Co. Slow Co.
$1,000,000 $1,000,000
700,000
1,918
48,000
700,000
1,918
63,300
48,000
700,000 ÷ 365
= 25 days
Slow Co.’s
Days Sales
Outstanding
=
63,300
700,000 ÷ 365
= 33 days
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –17

• Hire someone else to handle collections one day per week.
• Accept credit cards.
• Sell the receivables to a third party.
• Where possible, require prepayment.
• For a service business, write a detailed work plan and payment schedule and have it signed by the customer.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –18

• Minimize the time between shipping, invoicing, and sending notices on billings.
• Review previous credit experiences to determine impediments to cash flows.
• Provide incentives for prompt payment.
• Age accounts receivable on a monthly or even a weekly basis to identify delinquent accounts.
• Use the most effective methods for collecting overdue accounts.
• Use a lock box—a post office box for receiving remittances.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –19

• Accounts Receivable Financing
 Pledged accounts receivable
 Accounts receivable used as collateral for a loan.
 Factoring
 Obtaining cash by selling accounts receivable at a discount to another firm.
 Advantage
– Immediate cash flow
 Disadvantages
– High interest costs for loans funds and discounts for factored receivables
– Loss of receivables as collateral in borrowing
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –20

• Inventory is a “necessary evil.”
 Product supply and consumer demand don’t always match up.
• Monitoring Inventory
 Determine age and suitability for sale.
 Slowing moving inventory can create cash flow problems.
 Days in inventory —number of days, on average, that a company is holding inventory.
Days in inventory =
Inventory
Cost of goods sold ÷ 365 days
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –21

• Reducing Inventory to Free Cash
 Controlling stockpiles
 Match on-hand inventory with demand.
 Avoid personalizing the business-customer relationship.
 Avoid forward purchasing of inventory; carrying cost for excess inventory may exceed any savings.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –22

• Negotiation
 Ask creditors for adjustments or additional time.
• Timing
 Creditors’ funds can supply short-term cash needs until payment is demanded.
 Accounts with cash discounts for early payment should be examined for their savings potential.
 “Buy now, pay later”—pay early enough to get cash discounts and timely enough to avoid late-payment fees.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –23

22.5
An Accounts Payable Timetable for Terms of 3/10, Net 30
Annualized interest rate
=
Days in year
Net period Cash discount period
Cash discount % x
100 Cash discount%
=
365
30 10
X
3
100 3
=
18.25
x 0.030928
=
0.564, or 56.4%
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –24

• Capital Budgeting Analysis
 Helps managers make decisions about long-term investments such as:
 Developing new products  Replacing equipment
 Constructing new facilities  Expanding sales territories
 Seeks to answer the question:

“Do future benefits from the investment exceed the cost of making the investment?”
 Good decisions can add value to the firm; bad decisions can put the firm out of business.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –25

• Capital Budgeting Decisions Involve:
 Accounting return on investment
 How many dollars in average profits are generated per dollar of average investment?
 Payback period
 How long to recover the original profit outlay?
 Discounted cash flows (net present value or internal rate of return)
 How does the present value of future benefits from the investment compare to the investment outlay?
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –26

• Investors judging the attractiveness of an investment prefer:
1.
More cash rather than less cash.
2.
Cash sooner rather than later.
3.
Less risk rather than more risk.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –27

• Accounting Return on Investment
 The average annual after-tax profits relative to the average book value of an investment.
Initial investment = $10,000
Year After-Tax Profits
1 1,000
2
3
4
2,000
2,500
3,000
Accounting return on investment =
=
1 , 000 + 2 , 000 + 2 , 500 + 3 , 000
4
2,125
5,000
10 , 000 + 0
2
= 0.425, or 42.5%
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –28

• Payback Period
 Measuring the amount of time it will take to recover the cash outlay of an investment.
Original Investment = $15,000
Annual Depreciation = $1,500
Acceptable payback period= 5 years
Payback period = 4.86 years
After-Tax
Year Profits
1 –2 1,000
3 –6 2,000
7 –10 2,500
After-Tax
Cash Flows
2,500
3,500
4,000
Investment Recovery
Year 1-2 Year 3-5
5,000
10,500
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –29

• Discounted Cash Flows (DCF)
 Comparing the present value of future cash flows with the cost of the initial investment.
 Cash received today is more valuable than cash to be received in the future —the time value of money.
 Net present value (NPV)
 The current value of cash that will flow from a project over time less the initial investment outlay.
 Internal rate of return (IRR)
 The rate of return that a firm expects to earn on a project; return rate must exceed cost of capital.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –30

• Cost of Capital
 The rate of return required to satisfy a firm’s debt holders and investors.
• Opportunity Cost
 The rate of return that could be earned on another investment of similar risk.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –31

• Factors Affecting the Capital Budgeting Analysis
Process:
 Nonfinancial (personal) variables
 Undercapitalization and liquidity problems
 Uncertainty of cash flows within the firm
 Lack of established market value for the firm
 Small size, scope, and length of firm’s projects
 Lack of managerial experience and talent in firm
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –32

accounting return on investment technique capital budgeting analysis cash conversion period days in inventory days in payables days sales outstanding
(average collection period) discounted cash flow (DCF) techniques internal rate of return (IRR) lock box net present value (NPV) payback period technique pledged accounts receivable working capital cycle working capital management
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22 –33