It is concerned with decisions relating to current

assets and current liabilities

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Best Buy Co, NA’s largest consumer electronics

retailer, has performed extremely well over the

past decade. Its stock sold for $50 in late 2007 up

from $2 ten years earlier. Its excellent performance

stemmed from sound financial and operating

practices, especially in working capital

management.

WCM involves finding optimal levels for cash

marketable securities, accounts receivable and

inventory and then financing that working capital

for the least cost. Most of best buy’s customers use

credit cards, so neither in-store cash nor accounts

receivable is significant. Therefore Best buy’s

working capital focuses on inventories.

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To maintain sales, its stores must be well stocked

with the goods customers are seeking at the time

they are shopping. This involves determining what

new products are hot, determining where they can

be obtained at the lowest cost and delivering them

to stores in a timely manner.

Dramatic improvements in communications and

computer technology have transformed the way

Best Buy manages its inventories. It now collects

real-time data from each store on how each

products is selling and its computers place orders

automatically to keep the shelves full. Moreover, if

sales of an item are slipping, prices are lowered to

recue stocks of that item before the situation gets

so bad that drastic price cuts are necessary.

Working capital needs to be managed to maximize

profits and stock prices.

Inventories

Raw materials and

components

Work-in-progress

Trade debtors

Loans and advances

Bills Receivable

Marketable securities

Cash and bank balances

Sundry creditors

Bills payable

Outstanding expenses

Trade advances

Borrowings

Provisions

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Gross working capital is the total of all current

assets

Net working capital = current assets - current

liabilities

The working capital cycle can often be expressed

as a period of time (60 days)

Current ratio and Quick ratio

Cash budget is an estimate of future cash inflows

and outflows

Characteristics of current assets

Short life span

Swift transformation into other asset forms

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ROE = Profit margin x assets turnover x leverage

factor

The top line has the steepest slope which indicates

that the firm holds a great deal of cash,

marketable securities, receivables and inventories

relative to its sales. When receivables are high, the

firm has a liberal credit policy, which results in a

high level of accounts receivable. It results in a low

turnover, which in turn lowers ROE.

If the firm has a lean and mean investment policy,

holdings of current assets are minimized. This

results in a high ROE. Risks – material shortages can

lead to work stoppages, unhappy customers etc.

A moderate investment policy lies between the two

Relaxed current asset investment policy – under

conditions of uncertainty, there is requirement for

safety stock and tight credit policy to customers,

hence large current assets are carried

Restricted current asset investment policy – under

conditions of certainty, when sales, costs, lead

times, payment periods are all known for sure,

current assets are turned over more frequently

Moderate current asset investment policy

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Operating cycle is the time that elapses between

the purchase of raw materials and the collection of

cash for sales. It is divided into 4 stages: raw

materials, WIP, finished goods inventory and

debtors collection

= Inventory conversion period + accounts receivable

period

Cash conversion cycle is the time length between

the payment for raw material purchases and the

collection of cash for sales

Inventory conversion period + accounts receivable

period – accounts payable period

Jan: credit purchase of Raw Materials –

creates accounts payable

Feb: labor used in production – wages not paid

immediately – accrued wages

Mar: finished computers sold on credit –

creates accounts receivable

Apr: payment of accounts payable through

bank loan

May: collection of accounts receivable and

repayment of bank loan

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Inventory conversion period is time required to convert materials into finished goods and to sell those goods = average inventory/cost of goods sold per day

Accounts receivables period is time required to convert receivables into cash = average AR/sales per day

Accounts payable period is time between purchase of materials and payment of cash for them = average AP/cost of goods per day

Cash conversion cycle = inventory conversion period + Average receivables (collection) period – Accounts payable (deferral) period

General nature of business

Seasonality of operations

Production cycle

Business cycle

Credit policy

Growth and expansion

Production policy

Market conditions

Conditions of supply

Appropriation of profits

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Reported as cash and cash equivalents in the balance

sheet

Marketable securities - Very liquid securities that can

be converted into cash quickly at a reasonable price.

They tend to have maturities of less than one year.

Furthermore, the rate at which these securities can be

bought or sold has little effect on their prices.

Examples of marketable securities include commercial

paper, banker's acceptances, bank certificates,

Treasury bills and other money market instruments.

Case of Microsoft – one time dividend, stock repurchase

program, retiring debt, acquiring firms, financing major

expansions etc.

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Short term securities that can be bought and sold at short notice

Securities are held mostly for precautionary purposes but earn returns

Invest in securities when interest rates are high otherwise it is expensive and time consuming to convert them into cash Firm which have high growth rate Firms with volatile cash flow Small new firms which do not have exceptional credit

ratings

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Hold marketable securities rather than

demand deposits to provide liquidity

Borrow on short notice by establishing lines of

credit

Forecast payments and receipts better

Speed up receipts Lockboxes

Wire transfer

Use credit cards, debit cards and direct

deposits

Synchronize cash flows by using billing cycles

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Cash discounts on cash payment to suppliers

Maintain and improve its credit rating

Take advantage of favorable business opportunities

Meet emergencies

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An estimate of receipts, disbursements and cash

balances for a firm over a specified future period

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Goals of inventory management

To ensure that inventories needed to sustain operations are available

To hold the costs of ordering and carrying inventories to the lowest possible level

Types of costs Ordering & Receiving costs (cost of placing orders,

shipping and handling costs)

Carrying costs (warehouse rent, interest on capital locked up, insurance, property taxes, spoilage, depreciation and obsolescence, pilferage)

Shortage or stockout costs (loss of sales, customer, goodwill, disruption of production schedules)

Inventories are supplies, raw materials, work-in-progress and finished goods

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What should be the size of the order?

When should the order be placed?

Assumptions:

The forecast demand for a period is known

Orders can be replenished quickly

The only costs are ordering and carrying

The cost per order does not change with size

Cost of carrying is a percentage of inventory value

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Inventory is divided into 3 groups:

‘A’ group consists of items with the largest dollar

investment. This group consists of 20 percent of

the firm’s inventory items but 80 percent of the

investment in inventory

‘B’ group consists of items that account for the

next largest investment in inventory.

The ‘C’ group consist of a large number of items

that require a relatively small investment.

Typically ‘A’ group items are tracked on a

perpetual inventory system that allows daily

verification of each item’s inventory level.

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It implies that a firm should maintain a minimal level of inventory and rely on suppliers to provide parts and components just in time to meet its assembly requirements

It requires a strong and dependable relationship with suppliers who are

geographically not very remote from the mfg facility

a reliable transportation system

an easy physical access in the form of enough doors and conveniently located docks and storage areas to dovetail incoming supplies to the needs of assembly line

impeccable quality maintenance of component parts by the supplier

Lowers the ordering cost and also the safety stock by forging stronger long term relationship with the suppliers, average inventory level is lower

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Steady production vs seasonal production – average inventory higher for all round the year production than if production varies with change in sales

Outsourcing

Components purchased rather than made – in combination with JIT - lower inventory levels

Supply Chain Management

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A sole trader having $800 capital buys stock for $800. The next day he sells the stock on a 10 day credit for $1000 and takes an overdraft of $800 for stock purchase.

Accounts receivable is determined by Volume of credit sales Average time between sales and collection

Increase in receivables must be financed in some way

Entire amount of receivables need not be financed because of the profit component which does not involve any cash flow

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Credit period: 2 / 10, net 30; lengthening the credit period pushes sales up, lengthens cash conversion cycle, requires larger investment in debtors, leads to higher incidence of bad debts loss

Cash discount and trade discount Should attract new customers

Will increase cash flow

Credit standards: 5 C’s of credit are character, capacity, capital, collateral and conditions on which information is received from financial statements, bank references, firm experiences and stock market data

Collection policy: procedure that the firm follows to collect accounts receivable

Profit potential in granting credit through carrying charges levied on credit sales (nominal and effective interest rates) makes credit sales more profitable than cash sales

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Boston Lumber Company, wholesale distributor of

lumber products has credit sales of $1000 per day

and a collection period of 10 days. It must have

capital to carry $10,000 worth of receivables.

Accounts Receivables = sales/day x length of

collection period

What will be the impact if sales double or collection

period increases?

DSO = Receivables / Average sales per day

Receivables is $375 and Annual Sales turnover is

$3000 , Days Sales Outstanding = 46 days

The DSO can be compared to industry average (36

days) or to the firm’s own credit terms (30 days) 27

Accrued liabilities – outstanding rent Accounts payable or trade credit from suppliers Bank Finance Cash credits / overdrafts Loans Bill discounting: the seller draws a bill on the

purchaser, on acceptance it is discounted with the bank, who collects the full amount from the buyer on the due date

Letter of credit: an indirect form of financing whereby a bank undertakes the responsibility to honor the obligation of its customer, this helps the customer to obtain credit from its suppliers

Commercial paper Factoring

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Fixed or floating interest rate

Interest only vs amortized loans

Collateral Security in the form of hypothecation or

pledge

Maturity period – may or may not have maturity period

Restrictive covenants

Loan guarantees by stockholders

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A formal line of credit where the customer pays a

commitment fee and is then allowed to use the funds

when they are needed. It is usually used for operating

purposes, fluctuating each month depending on

customer's current cash flow needs.

FI considers several factors that determine a borrower's

ability to repay to decide on the maximum amount of

credit (credit limit)

Revolving credit borrowers are only required to pay

interest on the amount borrowed, plus commitment fees

on amount not borrowed

Interest is pegged to T-bill or market rate

Generally contains a clean-up clause for banks to extend

this type of credit in future

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It is unsecured short term promissory notes of large firms with high credit rating having an interest rate below the prime rate (a published interest rate charged by commercial banks to large, strong borrowers) Maturity period ranges from 90 to 180 days

Generally sold at a discount from its face value and redeemed at its face value, difference constitutes interest.

No well developed secondary market

The minimum size of commercial paper issue is Rs.2.5 and in denominations of half a million or more

Commercial paper is not backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.

The proceeds from this type of financing can only be used on current assets (inventories) and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement.

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A factor is a financial institution which offers services relating to management and financing of debts arising from credit sales, which ensures a definite pattern of cash inflows from credit sales of an organization and eliminates the need for credit and collection department

RBI authorized public sector banks that do factoring: SBI, Canbank, PNB, Bank of Allahabad

selects the accounts of the client and establishes the credit limits

factor assumes responsibility for collecting the debt

Advances money against not yet collected / not yet due accounts

Factoring is on a recourse basis

Besides interest on advances against debt the factor charges a commission which maybe 1 – 2% of the face value of the debt factored

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