Entrepreneurial Finance, 5th Edition Adelman and Marks 5-1 Entrepreneurial Finance, 5th Edition Adelman and Marks PRENTICE HALL ©2010 by Pearson Education,

Entrepreneurial Finance, 5th EditionAdelman and Marks

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PRENTICE HALL©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458

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Chapter 7

WORKING CAPITAL MANAGEMENT


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Learning Objectives• Understand the general concept of

working capital management.• Describe the asset categories that are

included in working capital management.• Determine the methods of managing

disbursement and collection of cash to increase business profitability.

• Understand how a business balances extending credit and its ability to manage increased accounts receivable.


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Learning Objectives (continued)• Explain how accounts receivable are

analyzed.• Understand the role that proper inventory

management plays in the profitability of a business enterprise.

• Understand how a business’s current liabilities are managed.

• Understand the relationship of between accrued liabilities management and obligations to federal and local government agencies.

• Understand the relationship of trade and cash discounts to the minimization of accounts payable.


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Working Capital• Working capital consists of the current

assets and the current liabilities of a business.

• Current assets are gross working capital.– Cash, marketable securities, accounts

receivable, and inventory

• Net working capital is the difference between a business’s total current assets and its total current liabilities.


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Working Capital Management • Working capital management is our

ability to effectively and efficiently control current assets and current liabilities in a manner that will provide our firm with maximum return on its assets and will minimize payments for its liabilities.


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Current Asset Management• Cash management• Marketable securities management• Accounts receivable management• Inventory management


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Cash Management• The goal of cash management is to obtain

the highest return possible on cash. Cash consists of:– Petty cash– Cash on hand– Cash in bank, checking– Cash in bank, savings


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Cash Management (continued)

• Float

– The disbursement float is the time that elapses between payment by check and the check’s actually clearing the bank, at which point funds are removed from our checking account.

– Collections float is the amount of time that elapses between your depositing a debtor’s check in your account and the check’s clearing, at which point the funds are actually placed in your account.


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Cash Management (continued)• Float (continued)

– Managing collection float:• A lockbox is a post office box that is opened by an

agent of the bank, and checks received there are immediately deposited in our account.

• Electronic funds transfer (EFT) is accomplished when funds are immediately transferred from one bank account to another via computer.


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Marketable Securities Management• Marketable securities normally are

those investment vehicles that include U.S. treasury bills, government and corporate bonds, and stocks.

• Excess cash should be placed in the above vehicles because they increase in value more than cash itself.


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Accounts Receivable Management• The goal of accounts receivable

management is to increase sales by offering credit to customers. – Options to offering credit include:

• The business issuing its own credit card or line of credit.

• Factoring—selling accounts receivable to another firm at a discount off of the original sales price.


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Accounts Receivable Management • The 3 C’s of credit:

– A customer’s character is favorable if that customer has paid his or her bills on time in the past and has favorable credit references from other creditors.

– Capacity to pay refers to whether the customer has enough cash flow or disposable income to pay back a loan or pay off a bill.

– Collateral is the ability to satisfy a debt or pay a creditor by selling assets for cash.

– Capital is your investment in the business– Conditions are the economic conditions that

may effect a loan process


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Accounts Receivable Management (continued)

• Credit terms are the requirements that our business establishes for payment of a loan (the use of credit by a customer). – To speed up collections, cash discounts are

often offered to a business customer. An example would be 2/10 net 30. If the customer pays the bill within 10 days of the invoice a 2 percent discount is given. Otherwise the entire net is due 20 days later or at the 30th day.


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Accounts Receivable Management (continued)

• Analyzing accounts receivable:– Accounts receivable turnover:

– Example:

– Collection days is 365 days in a year divided by accounts receivable turnover:

receivable accounts Average

SalesCredit turnover recievable Accounts

6$50,000

$300,000 turnover recievable Accounts

daysdays 61833.60 6

365 days Collection


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Accounts Receivable Management (continued)• Use of collection days:

– If collection days exceed our credit terms, then we have to speed up collections.

• Example: If we give terms of 30 days and we collect in 61 days as previously shown, then we have to speed up collections in order to better manage accounts receivable. We may also have to re-evaluate our credit policies.

– If collection days are less then our terms, then we have increased our liquidity. May also consider loosening credit policy.


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Accounts Receivable Management (continued)• Aging of accounts receivable is

accomplished by determining the amounts of accounts receivable, the various lengths of time for which these accounts have been due, and the percentage of accounts that falls within each time frame.


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Table 7-1 Aging of Accounts Receivable

Customer Outstanding

Balance Days

Outstanding1 5,000$ 302 7,000 453 15,000 304 12,000 705 8,000 906 15,000 607 6,000 1208 10,000 1009 13,000 45

10 9,000 90

Total 100,000$

Customer 0–30 31–60 61–90 90+

1 5,000$ 2 7,000$ 3 15,000 4 12,000$ 5 8,0006 15,0007 6,000$ 8 10,0009 13,00010 9,000

Totals 20,000$ 35,000$ 29,000$ 16,000$

PercentageOutstanding 20% 35.00% 29.00% 16.00%

Aging Schedule

Days Outstanding


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Inventory Management• The overall goal of inventory

management is to minimize total inventory costs while maximizing customer satisfaction.

• Two primary decisions must be made:– Establish the reorder quantity (the number

of items to order) – Establish the reorder point (that level of

inventory at which a new order will be placed).


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Inventory Management (continued)– Determining EOQ with quantity discounts

requires the following procedures:• Compute EOQ for each discounted price.• If the computed EOQ falls within the discounted

quantity area, then order the EOQ.• If the EOQ does not fall within the discounted

quantity area, then compute total inventory costs.• Order the minimum quantity that provides the

lowest overall total inventory costs.


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Inventory Management

• Reorder Point Calculations – The reorder point (ROP) has three factors

that are used in determining the quantity of an item that exists when we actually place an order:

• Lead-time (L) is the time that lapses from order placement to order receipt.

• Daily demand (d) is the quantity of a product that is used per day.

• Safety Stock (ss) the quantity of stock you keep for variations in demand. ssLdROP


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Inventory Management• Just-in-time (JIT) is an inventory system

where orders are delivered to satisfy daily, and in some cases hourly, demand. It is primarily used in manufacturing.– If daily demand can be accurately predicted– If vendor delivery reliability is outstanding– If vendors will deliver on an hourly or daily

basis, then JIT inventory can be used


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Inventory Management• Types of inventories

– Raw materials are the items that a company uses in producing its final product.

– Work-in-process inventories are made up of those items that are being produced.

– Finished goods inventories are made up of those items that are actually sold by the business.

– Maintenance, repair, and operating (MRO) inventories are made up of those items that are used by the firm in normal operations, but are not manufactured or sold by the firm.


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Inventory Management• ABC inventory analysis is based on the

80-20 rule or Pareto’s Law– A items: 5 to 10 percent of the inventory

items (i.e., individual stock numbers or stock keeping units) that make up approximately 75 percent of total costs

– B items: 10 to 15 percent of the inventory stock numbers that make up 10 to 15 percent of the total costs

– C items: The remaining 75 to 80 percent of the stock numbers account for only 10 to 15 percent of total costs (C items)


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Table 7-3 Hannah’s Donut Shop Inventory List

Item Number

Item DescriptionAnnual

Demand Unit Cost

Total Cost

1 Bavarian cream filling 100.0 15.00$ 1,500.00$ 2 Bleach 104.0 0.60 62.40 3 Blueberry filling 15.6 20.10 313.56 4 Bread flour for raised donuts 990.0 6.10 6,039.00 5 White frosting base 15.6 29.90 466.44 6 Buttermilk mix 35.0 23.30 815.50 7 Cake donut mix 625.0 30.50 19,062.50 8 Raised mix 990.0 21.50 21,285.00 9 Cherry fruit bits 26.0 13.80 358.80

10 Chocolate fudge base 26.0 37.60 977.60 11 Chocolate donut mix 52.0 25.10 1,305.20 12 Chunky apple 20.8 16.95 352.56 13 Comet 26.0 0.40 10.40 14 Degreaser 10.4 6.40 66.56 15 Dish washing lotion 52.0 3.99 207.48 16 H&R all-purpose flour 52.0 6.99 363.48 17 Lemon mist filling 10.4 13.20 137.28 18 Oat bran 26.0 25.95 674.70 19 Old-fashioned donuts 26.0 22.55 586.30 20 Raspberry filling 50.0 14.44 722.00 21 SAF instant yeast 45.0 33.15 1,491.75 22 Shortening 950.0 22.80 21,660.00 23 Stirrers, coffee 10.4 2.49 25.90 24 Straws, wrapped 5.2 4.00 20.80 25 Sugar packets 5.2 8.99 46.75 26 Sweet N Low 2.6 8.39 21.81 27 Trash bags 10.4 8.70 90.48 28 Urn coffee 45.0 46.50 2,092.50 29 #1 Donut trays 60.0 22.00 1,320.00 30 #2 Donut trays 52.0 21.50 1,118.00

Total inventory cost 83,194.75$


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Current Liabilities Management

• Current liabilities management consists of minimizing our obligations and payments for short-term debt, accrued liabilities, and accounts payable. It consists of:– Short-term debt management– Accrued liabilities management– Accounts payable management


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Current Liabilities Management (continued)

• Short-term debt management– Short-term debt consists of business

obligations that will be paid within the current accounting period. They consist of the following:

• Current payments on long-term debt• Bank lines of credit• Notes payable • Accounts payable • Short-term loan for one year or less


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Current Liabilities Management (continued)• Lines of credit:

– A line of credit is similar to a credit card. • With it, we obtain a credit limit, but we are not

obligated to make payments unless we actually borrow the money.

• A line of credit is normally obtained from our primary bank.

• A line of credit is used when our cash outflow exceeds our cash inflow.


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Accrued Liabilities Management (continued)• Accrued liabilities are those obligations

of the firm that are accumulated during the normal course of business and are primarily payroll taxes and benefits, property taxes, and sales taxes.


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Accounts Payable Management• Accounts payable are the debts of a

business which are owed to vendors. Vendors offer several types of discounts. They are: – Trade discounts– Cash discounts– Quantity discounts


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Accounts Payable Management (continued)

• Trade discounts are amounts deducted from list prices of items when specific services are performed by the trade customer. – Trade discounts may be expressed as a single

amount, such as 30 percent, or in a series, such as 30/20/10.


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• Calculation of trade discounts:– Calculation of trade discounts can be

accomplished by moving backward from the list price.

– If list price is $300 and trade discounts are 30/20/10 then:

$210($300x0.3)-$300

Price Discounted discount trade - price List

$168$42-$210($210x0.2) -$210 $151.20$16.80-$168($168x0.1) -$168


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Accounts Payable Management (continued)• Calculation of trade discounts (continued)

– The net cost rate factor is the actual percentage of the list price paid after taking all successive trade discounts—50.4 percent in this case.

– One minus the net cost rate factor is the single equivalent discount.


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– A second simpler way of determining the net cost rate factor and the invoice price is to multiply the complements of the trade discounts as shown below:

0.504(0.9)(0.7)(0.8) factor rate cost Net

0.90.1-1 complement Third

0.80.2-1 complement Second

0.7.03-1 complement First


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– The invoice price (the price that you actually pay the vendor) can be simply calculated by the following formula:

20.151$)504.0)(300($ price Invoice

factor ratecost net x priceList price Invoice


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• Cash discounts are offered to credit customers to entice them to pay promptly. – The seller views a cash discount as a sales

discount. – The customer views it as a purchase

discount. – The terms of a cash discount play an

important role in determining how the invoice will be paid.


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Accounts Payable Management (continued)• Cash discounts will normally appear on an

invoice in terms such as 2/10 n30. – This means that the customer may deduct 2

percent off of the invoice price if he or she pays within 10 days.

– If the customer does not pay within 10 days, he has the use of 98% of the money owed for the next 20 days.

– If the customer pays within 30 days, the net, or total amount, of the invoice is due.

– If he or she pays after 30 days, the credit agreement with the seller normally stipulates that a monthly interest charge be added to the unpaid balance.


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Accounts Payable Management

• Calculations used in cash discounts:– A $10,000 invoice with terms of 2/10 n30– Option 1: Pay off the $10,000 with a

payment of $9,800 within 10 days of the invoice date.

• This is computed by multiplying the invoice price by 1 minus the discount (1 - 0.02 = 0.98, and $10,000 x 0.98 = $9,800).

• Or by taking the invoice price times the discount and subtracting it from the invoice price ($10,000 x 0.02 = $200, and $10,000 - $200 = $9,800).


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• Calculations used in cash discounts (continued):– A $10,000 invoice with terms of 2/10 n30– Option 2: Pay the invoice price of $10,000

on the 30th day after the invoice date. If this option is chosen, he will pay the equivalent of 37.23 percent annual interest because of his delaying payment. The logic is shown on the following page.


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• Calculations used in cash discounts (continued):– $200 is the cost paid on $9,800 for 20 days,

or an interest rate of 2.04 percent ([$200 $9,800] x 100).

– This will result in an effective annual interest rate of 37.23 percent (2.04 x [365 20days]).

– The effective annual interest rate is obtained by multiplying the time period interest rate by the number of time periods in an accounting year (365 20).


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• Quantity discounts are offered by vendors to increase their own cash flow when they offer discounts to customers who purchase items in large quantities.

Item Number Quantity Unit Cost10010 1–99 15.00$

100–499 14.50 500–999 14.00

Table 7-5 Quantity Discounts


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Accounts Payable Management (continued)• Cumulative discounts are normally

discounts that are offered on total purchases of an item during the vendor’s fiscal year.

Documents

Entrepreneurial Finance, 5th Edition Adelman and Marks 5-1 Entrepreneurial Finance, 5th Edition Adelman and Marks PRENTICE HALL ©2010 by Pearson Education,