FIN 2004 Finance Tutorial 10 :

Working Capital Management

Key Concepts
Working capital management decides the level of each type of current asset to hold and how to finance them. Operating cycle : time between acquiring the inventory and collecting the cash.
Operating cycle = inventory period + accounts receivable period

Inventory period : time required to acquire and sell the inventory. Accounts receivable period (DSO or ACP) : time required to collect on credit sales. Cash Conversion Cycle : time between firms payment for inventory and collection on its sales.
cash conversion cycle or cash cycle = operating cycle accounts payable period = inventory period + account receivable period accounts payable period
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Inventory Inventory or Sales/365 COGS/365 365 = inventory turnover

The Operating Cycle

Receivable s Sales/365 365 = receivable s turnover

Key Concepts
A cash budget is a weekly, monthly, or quarterly forecast of cash inflows and outflows. The budget indicates deficient or excessive cash balances, and financing plans are formulated based on it. Float is difference between cash balance in the bank and the cash balance recorded in the books
Float = Bank balance Book balance

Disbursement float is generated when a firm writes cheques

Collection float occurs when the firm receives cheque

Key Concepts
Net float = Disbursement float + Collection float The net float at a point in time is simply the overall difference between the firms bank balance and its book balance If the firm is efficient, it will have positive net float. Firm can make use of float. This will save on financing cost. The disbursement float = the average dollar amount of cheques written x the average number of days for the cheques to clear The collection float is the average dollar amount of cheques received x the average number of days for the cheques to clear
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Key Concepts
Credit term includes (1) credit period and (2) discount given for early payment. For example : 5/10 net 30 5 - percent discount for early payment 10 - number of days that the discount is available net 30 - number of days before payment is due DSO or ACP = percentage of accounts taking the discount x the discount period + the percentage of accounts not taking the discount x the days until full payment is required. The interest rate for the term of the discount can be calculated as : Periodic interest rate = discount (%)/discount price (%) = 5/95 = 0.0526 for (30 -10) days The effective annual rate = [ ( 1 + (discount/discount price) 365/extra day credit 1 ]

RWJ Chap 18 Q6 Consider the following financial statement information for the Mediate Corporation:
Item Inventory Accounts receivable Accounts payable Credit sales Cost of goods sold Beginning $9,780 4,108 7,636 $89,804 56,384 Ending $11,380 4,938 7,927

Calculate the operating and cash cycles. How do you interpret your answer?

The operating cycle is the inventory period plus the receivables period. The inventory turnover and inventory period are: Inventory turnover = COGS/Average inventory Inventory turnover = $56,384/[($9,780 + 11,380)/2] = 5.3293 times Inventory period = 365 days/Inventory turnover Inventory period = 365 days/5.3293 = 68.49 days And the receivables turnover and receivables period are: Receivables turnover = Credit sales/Average receivables Receivables turnover = $89,804/[($4,108 + 4,938)/2] = 19.8550 times Receivables period = 365 days/Receivables turnover Receivables period = 365 days/19.8550 = 18.38 days So, the operating cycle is: Operating cycle = 68.49 days + 18.38 days = 86.87 days

The cash cycle is the operating cycle minus the payables period. The payables turnover and payables period are: Payables turnover = COGS/Average payables Payables turnover = $56,384/[($7,636 + 7,927)/2] = 7.2459 times Payables period = 365 days/Payables turnover Payables period = 365 days/7.2459 = 50.37 days So, the cash cycle is: Cash cycle = 86.87 days 50.37 days = 36.50 days The firm is receiving cash on average 36.50 days after it pays its bills.

RWJ Chap 18 Q11 Here are some important figures from the budget of Nashville Nougats, Inc., for the second quarter of 2009: April Credit sales Credit purchases Cash disbursements Wages, taxes, and expenses Interest Equipment purchases 53,800 13,100 87,000 51,000 13,100 147,000 78,300 13,100 0 $390,000 147,800 May $364,000 176,300 June $438,000 208,500

The company predicts that 5 percent of its credit sales will never be collected, 35 percent of its sales will be collected in the month of the sale, and the remaining 60 percent will be collected in the following month. Credit purchases will be paid in the month following the purchase. Sales collections = In March 2009, credit sales were $245,000, and credit purchases were $168,000. Using this information, complete the following cash budget:

0.35(current month sales) + 0.60(previous month sales)

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April Beginning cash balance Cash receipts Cash collections from credit sales Total cash available Cash disbursements $140,000

May

June

Explanation: The sales collections each month will be: Sales collections = 0.35(current month sales) + 0.60(previous month sales)

April Beginning cash balance Cash receipts Cash collections from credit sales Total cash available Cash disbursements Purchases Wages, taxes, and expenses Interest Equipment purchases Total cash disbursements Ending cash balance $168,000 53,800 13,100 87,000 $321,900 $101,600 283,500 $423,500 $140,000

May $101,600

June $104,100

361,400 463,000 $147,800 51,000 13,100 147,000 $358,900 $104,100

371,700 475,800 $176,300 78,300 13,100 0 $267,700 $208,100

RWJ Chap 18 Q13 Youve worked out a line of credit arrangement that allows you to borrow up to $50 million at any time. The interest rate is 0.64% per month. In addition, 5% of the amount that you borrow must be deposited in a non-interest-bearing account. Assume that your bank uses compound interest on its line of credit loans. a. b. What is the effective annual interest rate on this lending arrangement? Suppose you need $15million today and you repay it in six months. How much interest will you pay?

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a.

If you borrow $50,000,000 for one month, you will pay interest of: Interest = $50,000,000(0.0064) = $320,000 However, with the compensating balance, you will only get the use of: Amount received = $50,000,000 50,000,000(0.05)= $47,500,000 This means the periodic interest rate is: Periodic interest = $320,000/$47,500,000 = 0.006737 or 0.674%

So, the EAR is: EAR = [1 + ($320,000/$47,500,000)]12 1= 0.0839 or 8.39% b. To end up with $15,000,000, you must borrow: Amount to borrow = $15,000,000/(1 0.05) = $15,789,473.68 The total interest you will pay on the loan is: Total interest paid = $15,789,473.68(1.0064)6 15,789,473.68= 616,100.02
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RWJ Chap 19 Q2 Each business day, on average, a company writes checks totaling $14,000 to pay its suppliers. The usual clearing time for the checks is four days. Meanwhile, the company is receiving payments from its customers each day, in the form of checks, totaling $26,000. The cash from the payments is available to the firm after two days. (Do not include the dollar signs ($). Negative amounts should be indicated by a minus sign.) a. Calculate the companys disbursement float, collection float, and net float. b. How would your answer to part (a) change if the collected funds were available in one day instead of two?

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(a) The disbursement float is the average monthly checks written times the average number of days for the checks to clear, so: Disbursement float = 4($14,000) = $56,000 The collection float is the average monthly checks received times the average number of days for the checks to clear, so: Collection float = 2($26,000) = $52,000 The net float is the disbursement float plus the collection float, so: Net float = $56,000 52,000 = $4,000 (b) The new collection float will be: Collection float = 1($26,000) = $26,000 And the new net float will be: Net float = $56,000 26,000 = $30,000
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RWJ Chap 20 Q3 Kyoto Joe, Inc., sells earnings forecasts for Japanese securities. Its credit terms are 2/10, net 30. Based on experience, 65 percent of all customers will take the discount a. What is the average collection period for Kyoto Joe? b. If Kyoto Joe sells 1,300 forecasts every month at a price of $1,700 each, what is its average balance sheet amount in accounts receivable?
(a) The average collection period is the percentage of accounts taking the discount times the discount period, plus the percentage of accounts not taking the discount times the days until full payment is required, so: Average collection period = 0.65(10 days) + 0.35(30 days) Average collection period = 17 days (b) And the average daily balance is: Average balance = 1,300($1,700)(17)(12/365) Average balance = $1,235,178.08
We multiply by 12 to calculate the average yearly AR. To calculate average daily we divide by 365

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RWJ Chap 20 Q5 A Firm offers terms of 1/10, net 35. What effective annual interest rate does the firm earn when a customer does not take the discount? Without doing any calculations, explain what will happen to this effective rate if: a. This discount is changed to 2%. b. The credit period is increased to 60 days. c. The discount period is increased to 15 days.
The interest rate for the term of the discount is: Interest rate = 0.01/0.99 Interest rate = 0.0101 or 1.01% And the interest is for: 35 10 = 25 days m=365/25 So, using the EAR equation, the effective annual interest rate is: EAR = (1 + Periodic rate)m 1 EAR = (1.0101)365/25 1 EAR = 0.1580 or 15.80%

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(a) This discount is changed to 2%.

The effective annual rate = [ ( 1 + (discount/discount price)

365/extra day credit

1]

From the equation, it can be seen that EAR will increase

(b) The credit period is increased to 60 days From the equation, extra day credit will increase, EAR will decrease

(c) The discount period is increased to 15 days. From the equation, extra day credit will decrease, EAR will increase

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