Part 6
Understanding What the Numbers Mean
CHAPTER 22
Managing the
Firm’s Assets
Longenecker • Moore • Petty • Palich
© 2008 Cengage Learning.
All rights reserved.
PowerPoint Presentation by Charlie Cook
The University of West Alabama
Looking AHEAD
After you have read this chapter, you should be able to:
1. Describe the working-capital cycle of a small
business.
2. Identify the important issues in managing a firm’s
cash flows, including the preparation of a cash
budget.
3. Explain the key issues in managing accounts
receivable, inventory, and accounts payable.
4. Discuss the techniques commonly used in making
capital budgeting decisions.
5. Describe the capital budgeting practices of small
firms.
© 2008 Cengage Learning. All rights reserved.
22–2
The Working-Capital Cycle
• 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 working-
capital accounts
© 2008 Cengage Learning. All rights reserved.
22–3
Risk Management… (cont’d)
The Working Capital Cycle
1
Purchase or produce inventory for sale,
which increases accounts payable.
2
Sell inventory for cash; sell inventory for
credit (accounts receivable).
3
Pay the accounts payable (decreases cash
and accounts payable).
4
Collect the accounts receivable (decreases
accounts payable and increases cash).
5
Begin cycle again.
© 2008 Cengage Learning. All rights reserved.
22–4
22-1
Working-Capital Cycle
© 2008 Cengage Learning. All rights reserved.
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.
Cash conversion period—
the time required to convert
paid-for inventories and
accounts receivable into cash.
Day e. Accounts receivable are collected.
© 2008 Cengage Learning. All rights reserved.
22–6
22-3
Working-Capital Time Lines for Pokey, Inc., and Quick Turn Company
© 2008 Cengage Learning. All rights reserved.
22–7
Pokey, Inc.’s Beginning Balance Sheet
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
July
400
0
0
600
0
1,000
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
0
0
0
300
700
0
1,000
© 2008 Cengage Learning. All rights reserved.
22–8
Pokey, Inc.’s Monthly Balance Sheets
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
July
400
0
0
600
0
1,000
Aug.
400
0
500
600
0
1,500
Changes: August
Sept. to September
(100)
–500
0
500
600
0
1,000
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
0
0
0
300
700
0
1,000
500
0
0
300
700
0
1,500
0
0
0
300
700
0
1,000
© 2008 Cengage Learning. All rights reserved.
–500
22–9
Pokey, Inc.’s Monthly Balance Sheets
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
July
400
0
0
600
0
1,000
Aug.
400
0
500
600
0
1,500
Sept.
(100)
0
500
600
0
1,000
Oct.
(100)
900
0
600
(50)
1,350
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
0
0
0
300
700
0
1,000
500
0
0
300
700
0
1,500
0
0
0
300
700
0
1,000
0
250
25
300
700
75
1,350
© 2008 Cengage Learning. All rights reserved.
Changes:
September
to October
+900
–500
–50
+250
+25
+75
22–10
Changes in Pokey’s Balance Sheet
Change in the Balance Sheet
Effect on Income Statement
Increase accounts receivable of $900
 Sales
$900
Decrease inventories of $500
 Cost of goods sold
$500
Increase in accrued operating
expenses of $250
 Operating expenses
$250
Increase accumulated depreciation of $50  Depreciation expense
$50
Increase accrued taxes of $25
$25
© 2008 Cengage Learning. All rights reserved.
 Tax expense
22–11
Pokey, Inc.’s Monthly Balance Sheets
Changes:
October to
November
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
July
400
0
0
600
0
1,000
Aug.
400
0
500
600
0
1,500
Sept.
(100)
0
500
600
0
1,000
Oct.
(100)
900
0
600
(50)
1,350
Nov.
550 +650
0 –900
0
600
(50)
1,100
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
0
0
0
300
700
0
1,000
500
0
0
300
700
0
1,500
0
0
0
300
700
0
1,000
0
250
25
300
700
75
1,350
0
0
25
300
700
75
1,100
© 2008 Cengage Learning. All rights reserved.
–250
22–12
Pokey’s November Income Statement
Sales revenue
Cost of goods sold
Gross Profit
Operating expenses:
Cash
Depreciation
Total operating expenses
Operating income
Income tax (25%)
Net income
© 2008 Cengage Learning. All rights reserved.
900
500
400
250
50
300
100
25
75
22–13
Managing Cash Flows
• 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
© 2008 Cengage Learning. All rights reserved.
22–14
22-4
Flow of Cash Through a Business
© 2008 Cengage Learning. All rights reserved.
22–15
22-5
Three-Month Cash Budget for the Davies Corporation for July–September
© 2008 Cengage Learning. All rights reserved.
22–16
Managing Accounts Receivable
• 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.
© 2008 Cengage Learning. All rights reserved.
22–17
Credit Management Practices
• 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.
© 2008 Cengage Learning. All rights reserved.
22–18
Managing Accounts Receivable (cont’d)
• 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
© 2008 Cengage Learning. All rights reserved.
22–19
Managing Inventories
• Inventory is a “necessary evil.”
Product supply and consumer demand don’t always
match up.
• Reducing Inventory to Free Cash
Monitoring current inventory
 Determine
age and suitability for sale.
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.
© 2008 Cengage Learning. All rights reserved.
22–20
Managing Accounts Payable
• Negotiation
 Asks 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.
© 2008 Cengage Learning. All rights reserved.
22–21
22-6
An Accounts Payable Timetable for Terms of 3/10, Net 30
Annualized
interest rate =
Days in year
Net period - Cash discount period
x
Cash discount %
100 - Cash discount%
365
3
=
X
30 - 10 100 - 3
= 18.25 x 0.030928 = 0.564, or 56.4%
© 2008 Cengage Learning. All rights reserved.
22–22
Capital Budgeting
• Capital Budgeting Analysis
Helps managers make decisions about long-term
investments such as:
 Developing
new products
 Constructing
Replacing equipment
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.
© 2008 Cengage Learning. All rights reserved.
22–23
Three Rules of Capital Budgeting
• Investors judging the attractiveness of an
investment prefer:
More cash rather than less cash.
Cash sooner rather than later.
Less risk rather than more risk.
© 2008 Cengage Learning. All rights reserved.
22–24
Capital Budgeting Techniques
• 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?
© 2008 Cengage Learning. All rights reserved.
22–25
Capital Budgeting Techniques (cont’d)
• 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
2,000
3
2,500
4
3,000
Accounting return
on investment =
=
© 2008 Cengage Learning. All rights reserved.
1,000 + 2,000 + 2,500 + 3,000
4
10,000 + 0
2,125
5,000
2
= 0.425, or 42.5%
22–26
Capital Budgeting Techniques (cont’d)
• 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
Year
1–2
3–6
7–10
After-Tax
Profits
1,000
2,000
2,500
© 2008 Cengage Learning. All rights reserved.
After-Tax
Cash Flows
2,500
3,500
4,000
Investment Recovery
Year 1-2
Year 3-5
5,000
10,500
22–27
Discounted Cash Flows
• 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.
© 2008 Cengage Learning. All rights reserved.
22–28
A Firm’s Cost of Capital
• 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.
© 2008 Cengage Learning. All rights reserved.
22–29
Capital Budgeting Analysis in Small Firms
• 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
© 2008 Cengage Learning. All rights reserved.
22–30
Key TERMS
•
•
•
•
•
•
•
•
•
•
•
•
working-capital management
working-capital cycle
cash conversion period
cash budget
lock box
pledged accounts receivable
capital budgeting analysis
accounting return on investment technique
payback period technique
discounted cash flow (DCF) technique
net present value (NPV)
internal rate of return (IRR)
© 2008 Cengage Learning. All rights reserved.
22–31