Quiz 4 – Financial Management

1. This is an open book and open note quiz.
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CHAPTER
© Adalberto Rios Szalay/Sexto Sol/Getty Images
W
16
Supply Chains and
Working Capital
Management
hat do Southwest Airlines, Apple, Qualcomm, and Family Dollar Stores
have in common? Each led its industry in the latest CFO Magazine
annual survey of working capital management, which covered the 1,000
largest U.S. publicly traded firms. Each company is rated on its “days of working capital,”
which is the amount of net operating working capital required per dollar of daily sales:
Days of
¼
working capital ðDWCÞ
Receivables þ Inventory − Payables
Average daily sales
The median industry ratio varies significantly. For example, the median in
the computer and peripherals industry is 43, but the median in machinery is 82.
The median airline holds zero days of working capital—its payables are as large
as its combined receivables and inventory. But even within an industry, there is
considerable variation. For example, Family Dollar has 16 days but Nordstrom
has 79.
After being burned in the recent recession, many companies are holding
record amounts of cash and have been accused by analysts of losing their focus
on working capital. Not so with Thomson Reuters, a world leader in the news and
data businesses, however. Thomson Reuters doesn’t have much inventory and is
hampered in reducing its receivables because it operates in so many different
countries, so instead it focused on standardizing its global accounts payable
policies and improved its DSO (days sales outstanding) by 3 days. When asked
about the cash that other companies could possibly wring out of their working
capital, Thomson Reuters’s CFO Bob Daleo said, “Instead of giving it to their
vendors and customers, why don’t they give it back to their shareholders?” Keep
this in mind as you read this chapter.
Sources: See David Katz, “Easing the Squeeze: The 2011 Working Capital Scorecard,” CFO,
July/August 2011, at the Web site www.cfo.com/article.cfm/14586631/c_2984340/?f=archives;
for the rankings, see www.cfo.com/media/pdf/1107WCcharts.pdf.
631
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Corporate Valuation and Working
Capital Management
© Rob Webb/Getty Images
which can lead, in turn, to larger free cash flows and
greater firm value.
Superior working capital management can dramatically
reduce required investments in operating capital,
Sales revenues
–
Operating costs and taxes
–
Required investments in operating capital
Free cash flow
(FCF)
Value =
FCF1
(1 + WACC)1
+
=
FCF2
(1 + WACC)
2
+…+
FCF∞
(1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion
Cost of debt
Cost of equity
Firm’s debt/equity mix
Firm’s business risk
© Cengage Learning 2014
resource
The textbook’s Web site
contains an Excel file that
will guide you through the
chapter’s calculations. The
file for this chapter is
Ch16 Tool Kit.xls, and we
encourage you to open the
file and follow along as you
read the chapter.
Working capital management involves two basic questions: (1) What is the
appropriate amount of working capital, both in total and for each specific
account, and (2) how should working capital be financed? Note that sound
working capital management goes beyond finance. Indeed, improving the firm’s
working capital position generally comes from improvements in the operating
divisions. For example, experts in logistics, operations management, and information technology often work with engineers and production specialists to
develop ways to speed up the manufacturing process and thus reduce the
goods-in-process inventory. Similarly, marketing managers and logistics experts
cooperate to develop better ways to deliver the firm’s products to customers.
Finance comes into play in evaluating how effective the firm’s operating departments are relative to other firms in its industry and also in evaluating the
profitability of alternative proposals for improving working capital management.
In addition, financial managers decide how much cash their companies should
keep on hand and how much short-term financing should be used to finance
their working capital.
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Chapter 16
Supply Chains and Working Capital Management
633
16-1 Overview of Working Capital
Management
Consider some of the activities involved in a company’s supply chain. The company places
an order with a supplier. The supplier ships the order and bills the company. The company
either pays immediately or waits, in which case the unpaid amount is called an account
payable. The newly arrived shipment goes into inventory until it is needed. If the supplier
shipped finished products, the company will distribute the goods to its warehouses or retail
facilities. If instead the supplier shipped components or raw materials, the company will use
the shipment in a manufacturing or assembly process, putting the final product into its
finished goods inventory. Items from the finished goods inventory will be shipped either
directly to customers or to warehouses for later shipments. When a customer purchases the
product, the company bills the customer and often offers the customer credit. If the customer
doesn’t pay immediately, the unpaid balance is called an account receivable. During this
process, the company has been accruing unpaid wages (because the company doesn’t pay its
employees daily) and unpaid taxes (because the company doesn’t pay the IRS daily).
Several current assets and current liabilities are involved in this process—cash is spent
(when paying suppliers, employees, taxes, etc.) and collected (when customers pay),
accounts receivable are created and collected, inventory ebbs and flows, accounts payable
are generated and paid, and accruals accumulate until paid. Notice that these are the same
operating current assets (cash, accounts receivable, and inventories) and operating current
liabilities (accounts payable and accruals) that are used in calculating net operating
working capital (NOWC), which is defined as operating current assets minus operating
current liabilities.
In addition to operating current assets and operating current liabilities, there are two
other current accounts related to working capital management: short-term investments
and short-term debt. We discuss each current asset and liability later in the chapter, but it
will be helpful if we first distinguish between cash and short-term investments because
this can be a source of confusion.
Many dictionaries define cash as currency (coins and bills) and demand deposit
accounts (such as a checking account at a bank). Most companies have very little currency
on hand, and most have relatively small checking accounts. However, most companies
own a wide variety of short-term financial assets. For example, Apple and Microsoft own:
(1) checking accounts, (2) U.S. Treasury and agency securities, (3) certificates of deposits
and time deposits, (4) commercial paper, (5) money market funds and other mutual funds
(with low price volatility), (6) short-term or floating-rate corporate and municipal notes
and bonds, and (7) and floating-rate preferred stock. Most of these holdings can be
converted into cash very quickly at prices identical or very close to their book values, so
sometimes they are called cash equivalents.
Some of these financial assets are held to support current ongoing operations and some
are held for future purposes, and this is the distinction we make when defining cash and
short-term investments. In particular, we define cash as the total value of the short-term
financial assets that are held to support ongoing operations because this is the definition
of cash that is required to be consistent with the definition of cash used to calculate
NOWC (which is used, in turn, to calculate free cash flow and the intrinsic value of the
company). We define short-term investments as the total value of short-term financial
assets held for future purposes. Keep these distinctions in mind when we discuss cash
management and short-term investments later in the chapter.
We normally use the term NOWC, but the term working capital is also used for slightly
different purposes, so be aware of this when you see it in the financial press. For example,
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the financial press defines working capital, sometimes called gross working capital, as
current assets used in operations.1 The press also defines net working capital as all
current assets minus all current liabilities.
16-2 Using and Financing Operating
Current Assets
Operating current assets (CA) are used to support sales. Having too much invested in
operating CA is inefficient, but having too little might constrain sales. Many companies
have seasonal, growing sales, so they have seasonal growing operating CA, which has an
implication for the pattern of financing that companies choose. The next sections address
these issues.
16-2a Efficient Use of Operating Current Assets
Most companies can influence their ratios of operating current assets to sales. Some
companies choose a relaxed policy and hold a lot of cash, receivables, and inventories
relative to sales. This is a relaxed policy. On the other hand, if a firm has a restricted
policy, holdings of current assets are minimized and we say that the firm’s policy is tight
or “lean-and-mean.” A moderate policy lies between the two extremes.
We can use the Du Pont equation to demonstrate how working capital management
affects the return on equity:
ROE ¼ Profit margin % Total assets turnover % Equity multiplier
Net income
Sales
Assets
%
%
¼
Sales
Assets Equity
A relaxed policy means a high level of assets and hence a low total assets turnover
ratio; this results in a low ROE, other things held constant. Conversely, a restricted
policy results in low current assets, a high turnover, and hence a relatively high ROE.
However, the restricted policy exposes the firm to risk, because shortages can lead to
work stoppages, unhappy customers, and serious long-run problems. The moderate
policy falls between the two extremes. The optimal strategy is the one that management believes will maximize the firm’s long-run free cash flow and thus the stock’s
intrinsic value.
Note that changing technologies can lead to changes in the optimal policy. For
example, if a new technology makes it possible for a manufacturer to produce a given
product in 5 rather than 10 days, then work-in-progress inventories can be cut in half.
Similarly, many retailers have inventory management systems that use bar codes on all
merchandise. These codes are read at the cash register; this information is transmitted
electronically to a computer that adjusts the remaining stock of the item; and the
computer automatically places an order with the supplier’s computer when the stock
falls to a specified level. This process lowers the “safety stocks” that would otherwise be
necessary to avoid running out of stock. Such systems have dramatically lowered
inventories and thus boosted profits.
1
The term “working capital” originated with the old Yankee peddler, who would load his wagon with pots and
pans and then take off to peddle his wares. His horse and wagon were his fixed assets, while his merchandise was
sold, or turned over at a profit, and thus was called his working capital.
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Chapter 16
Supply Chains and Working Capital Management
635
16-2b Financing Operating Current Assets
Investments in operating current assets must be financed, and the primary sources of
funds include bank loans, credit from suppliers (accounts payable), accrued liabilities,
long-term debt, and common equity. Each of those sources has advantages and disadvantages, so a firm must decide which sources are best for it.
To begin, note that most businesses experience seasonal and/or cyclical fluctuations. For
example, construction firms tend to peak in the summer, retailers peak around Christmas,
and the manufacturers who supply both construction companies and retailers follow related
patterns. Similarly, the sales of virtually all businesses increase when the economy is strong,
so they increase operating current assets during booms but let inventories and receivables
fall during recessions. However, current assets rarely drop to zero—companies maintain
some permanent operating current assets, which are the operating current assets needed
even at the low point of the business cycle. For a growing firm in a growing economy,
permanent current assets tend to increase over time. Also, as sales increase during a cyclical
upswing, current assets are increased; these extra current assets are defined as temporary
operating current assets as opposed to permanent current assets. The way permanent and
temporary current assets are financed is called the firm’s operating current assets financing
policy. Three alternative policies are discussed next.
MATURITY MATCHING,
OR
“SELF-LIQUIDATING,” APPROACH
The maturity matching, or “self-liquidating,” approach calls for matching asset and
liability maturities as shown in Panel a of Figure 16-1. All of the fixed assets plus the
permanent current assets are financed with long-term capital, but temporary current assets
are financed with short-term debt. Inventory expected to be sold in 30 days would be
financed with a 30-day bank loan; a machine expected to last for 5 years would be financed
with a 5-year loan; a 20-year building would be financed with a 20-year mortgage bond; and
so on. Actually, two factors prevent exact maturity matching, uncertain asset lives and
equity financing. For example, a firm might finance inventories with a 30-day bank loan,
expecting to sell the inventories and use the cash to retire the loan. But if sales are slow, then
the “life” of the inventories would exceed the original 30-day estimate and the cash from
sales would not be forthcoming, perhaps causing the firm problems in paying off the
loan when it comes due. In addition, some common equity financing must be used, and
common equity has no maturity. Still, if a firm attempts to match or come close to
matching asset and liability maturities, this is defined as a moderate current asset
financing policy.
AGGRESSIVE APPROACH
Panel b of Figure 16-1 illustrates the situation for a more aggressive firm that finances
some of its permanent assets with short-term debt. Note that we used the term “relatively”
in the title for Panel b because there can be different degrees of aggressiveness. For
example, the dashed line in Panel b could have been drawn below the line designating
fixed assets, indicating that all of the current assets—both permanent and temporary—
and part of the fixed assets were financed with short-term credit. This policy would be a
highly aggressive and the firm would be subject to dangers from loan renewal as well as
rising interest rate problems. However, short-term interest rates are generally lower than
long-term rates, and some firms are willing to gamble by using a large amount of lowcost, short-term debt in hopes of earning higher profits.
A possible reason for adopting the aggressive policy is to take advantage of an upward
sloping yield curve, for which short-term rates are lower than long-term rates. However,
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FIGURE 16-1
Alternative Operating Current Assets Financing Policies
a. Moderate Approach (Maturity Matching)
Dollars
Temporary
Current Assets
Temporary
Current Assets
Short-Term
Debt
Permanent Level
of Current Assets
Total
Permanent
Assets
Long-Term
Nonspontaneous Debt
Financing plus Equity
plus Spontaneous
Current Liabilities
Fixed Assets
1
2
3
4
5
6
7
8
Time Period
b. Relatively Aggressive Approach
Dollars
Temporary
Current Assets
Short-Term
Debt
Permanent Level
of Current Assets
Long-Term
Nonspontaneous Debt
Financing plus Equity
plus Spontaneous
Current Liabilities
Fixed Assets
1
2
3
4
5
6
7
8
Time Period
c. Conservative Approach
Dollars
Short-Term Financing
Requirements
Marketable
Securities
Permanent Level
of Current Assets
Fixed Assets
1
2
3
4
5
Long-Term
Nonspontaneous Debt
Financing plus Equity
plus Spontaneous
Current Liabilities
6 7 8
Time Period
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Chapter 16
Supply Chains and Working Capital Management
637
as many firms learned during the financial crisis of 2009, a strategy of financing long-term
assets with short-term debt is really quite risky. As an illustration, suppose a company
borrowed $1 million on a 1-year basis and used the funds to buy machinery that would
lower labor costs by $200,000 per year for 10 years.2 Cash flows from the equipment
would not be sufficient to pay off the loan at the end of only one year, so the loan would
have to be renewed. If the economy were in a recession like that of 2009, the lender might
refuse to renew the loan, and that could lead to bankruptcy. Had the firm matched
maturities and financed the equipment with a 10-year loan, then the annual loan
payments would have been lower and better matched with the cash flows, and the loan
renewal problem would not have arisen.
Under some circumstances, even maturity matching can be risky, as many firms that
thought they were conservatively financed learned in 2009. If a firm borrowed on a 30-day
bank loan to finance inventories that it expected to sell within 30 days but then sales
dropped, as they did for many firms in 2009, the funds needed to pay off the maturing
bank loan might not be available. Then the bank might not extend the loan, and if it did
not, then the firm could be forced into bankruptcy. This happened to many firms in 2009,
and it was exacerbated by the banks’own problems. The banks lost billions on mortgages,
mortgage-backed bonds, and other bad investments, which led them to restrict credit to
their normal business customers in order to conserve their own cash.
CONSERVATIVE APPROACH
Panel c of the figure shows the dashed line above the line designating permanent current
assets, indicating that long-term capital is used to finance all permanent assets and also
to meet some seasonal needs. In this situation, the firm uses a small amount of shortterm credit to meet its peak requirements, but it also meets a part of its seasonal needs
by “storing liquidity” in the form of marketable securities. The humps above the dashed
line represent short-term financings, while the troughs below the dashed line represent
short-term security holdings. This conservative financing policy is fairly safe, and the
wisdom of using it was demonstrated in 2009—when credit dried up, firms with adequate
cash holdings were able to operate more effectively than those that were forced to cut back
their operations because they couldn’t order new inventories or pay their normal workforce.
CHOOSING
AMONG THE
APPROACHES
Because the yield curve is normally upward sloping, the cost of short-term debt is generally
lower than that of long-term debt. However, short-term debt is riskier for the borrowing
firm for two reasons: (1) If a firm borrows on a long-term basis then its interest costs will
be relatively stable over time, but if it uses short-term credit, then its interest expense can
fluctuate widely—perhaps reaching such high levels that profits are extinguished.3 (2) If a
firm borrows heavily on a short-term basis, then a temporary recession may adversely
affect its financial ratios and render it unable to repay its debt. Recognizing this fact, the
lender may not renew the loan if the borrower’s financial position is weak, which could
force the borrower into bankruptcy.
2
We are oversimplifying here. Few lenders would explicitly lend money for 1 year to finance a 10-year asset.
What would actually happen is that the firm would borrow on a 1-year basis for “general corporate purposes”
and then actually use the money to purchase the 10-year machinery.
3
The prime interest rate—the rate banks charge very good customers—hit 21% in the early 1980s. This produced
a level of business bankruptcies that was not seen again until 2009. The primary reason for the very high interest
rate was that the inflation rate was up to 13%, and high inflation must be compensated by high interest rates.
Also, the Federal Reserve was tightening credit in order to hold down inflation, and it was encouraging banks to
restrict their lending.
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Note also that short-term loans can generally be negotiated much faster than long-term
loans. Lenders need to make a thorough financial examination before extending longterm credit, and the loan agreement must be spelled out in great detail because a lot can
happen during the life of a 10- to 20-year loan.
Finally, short-term debt generally offers greater flexibility. If the firm thinks that interest
rates are abnormally high and due for a decline, it may prefer short-term credit because
prepayment penalties are often attached to long-term debt. Also, if its needs for funds are
seasonal or cyclical, then the firm may not want to commit itself to long-term debt
because of its underwriting costs and possible prepayment penalties. Finally, long-term
loan agreements generally contain provisions, or covenants, that constrain the firm’s
future actions in order to protect the lender, whereas short-term credit agreements
generally have fewer restrictions.
All things considered, it is not possible to state that either long-term or short-term
financing is generally better. The firm’s specific conditions will affect its decision, as will
the risk preferences of managers. Optimistic and/or aggressive managers will lean more
toward short-term credit to gain an interest cost advantage, whereas more conservative
managers will lean toward long-term financing to avoid potential renewal problems. The
factors discussed here should be considered, but the final decision will reflect managers’
personal preferences and subjective judgments.
SELF-TEST
Identify and explain three alternative current asset investment policies.
Use the Du Pont equation to show how working capital policy can affect a firm’s
expected ROE.
What are the reasons for not wanting to hold too little working capital? For not
wanting to hold too much?
Differentiate between permanent operating current assets and temporary operating
current assets.
What does maturity matching mean, and what is the logic behind this policy?
What are some advantages and disadvantages of short-term versus long-term debt?
16-3 The Cash Conversion Cycle
All firms follow a “working capital cycle” in which they purchase or produce inventory,
hold it for a time, and then sell it and receive cash. This process is known as the cash
conversion cycle (CCC).
16-3a Calculating the Target CCC
Assume that Great Basin Medical Equipment (GBM), a start-up business, buys orthopedic
devices from a manufacturer in China and sells them through distributors in the United
States, Canada, and Mexico. Its business plan calls for it to purchase $10,000,000 of
merchandise at the start of each month and sell it within 50 days. The company will have
40 days to pay its suppliers, and it will give its customers 60 days to pay for their purchases.
GBM expects to just break even during its first few years and so its monthly sales will be
$10,000,000, the same as its purchases (or cost of goods sold). For simplicity, assume that
there are no administrative costs. Also, any funds required to support operations will be
obtained from the bank, and those loans must be repaid as soon as cash becomes available.
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Chapter 16
Supply Chains and Working Capital Management
639
This information can be used to calculate GBM’s target, or theoretical, cash conversion
cycle, which “nets out” the three time periods described below.
1. Inventory conversion period. For GBM, this is the 50 days it expects to take to sell
the equipment, converting it from equipment to accounts receivable.4
2. Average collection period (ACP). This is the length of time customers are given to
pay for goods following a sale. The ACP is also called the days sales outstanding
(DSO). GBM’s business plan calls for an ACP of 60 days based on its 60-day credit
terms. This is also called the receivables conversion period, as it is supposed to take 60
days to collect and thus convert receivables to cash.
3. Payables deferral period. This is the length of time GBM’s suppliers give it to pay for
its purchases, which in our example is 40 days.
On Day 1, GBM expects to buy merchandise, and it expects to sell the goods and thus
convert them to accounts receivable within 50 days. It should then take 60 days to collect
the receivables, making a total of 110 days between receiving merchandise and collecting
cash. However, GBM is able to defer its own payments for only 40 days.
We can combine these three periods to find the theoretical, or target, cash conversion
cycle, shown below as an equation and diagrammed in Figure 16-2.
Inventory
Average
Payables
Cash
conversion þ collection & deferral ¼ conversion
period
period
period
cycle
50
(16-NaN)
þ
60
&
40
¼
(16-1)
70 days
FIGURE 16-2
The Cash Conversion Cycle
Inventory
Conversion
Period (50 Days)
Payables
Deferral
Period (40 Days)
Receive
Materials
Pay Cash for
Purchased
Materials
Finish Goods
and Sell Them
Average
Collection
Period (60 Days)
Cash
Conversion
Period
(70 Days)
Days
Collect Cash
for Accounts
Receivable
4
If GBM were a manufacturer, the inventory conversion period would be the time required to convert raw
materials into finished goods and then to sell those goods.
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Although GBM is supposed to pay its suppliers $10,000,000 after 40 days, it does
not expect to receive any cash until 50 + 60 = 110 days into the cycle. Therefore,
it will have to borrow the $10,000,000 cost of the merchandise from its bank on Day 40,
and it does not expect to be able to repay the loan until it collects on Day 110. Thus, for
110 − 40 = 70 days—which is the theoretical cash conversion cycle (CCC)—it will owe
the bank $10,000,000 and it will be paying interest on this debt. The shorter the cash
conversion cycle the better, because a shorter CCC means lower interest charges.
Observe that if GBM could sell goods faster, collect receivables faster, or defer its
payables longer without hurting sales or increasing operating costs, then its CCC would
decline, its expected interest charges would be reduced, and its expected profits and stock
price would increase.
16-3b Calculating the Actual CCC from
Financial Statements
So far we have illustrated the CCC from a theoretical standpoint. However, in practice we
would generally calculate the CCC based on the firm’s financial statements, and the
actual CCC would almost certainly differ from the theoretical value because of real-world
complexities such as shipping delays, sales slowdowns, and slow-paying customers.
Moreover, a firm such as GBM would be continually starting new cycles before the
earlier ones ended, and this too would muddy the waters.
To see how the CCC is calculated in practice, assume that GBM has been in business
for several years and is in a stable position, placing orders, making sales, receiving
payments, and making its own payments on a recurring basis. The following data were
taken from its latest financial statements:
Selected Items from GBM’s Financial Statements (Millions of Dollars)
Annual sales
Cost of goods sold
$1,216.7
1,013.9
Inventories
Accounts receivable
140.0
445.0
Accounts payable
115.0
Thus, GBM’s net operating working capital due to inventory, receivables, and payables is
$140 + $445 − $115 = $470 million, and that amount must be financed—in GBM’s case,
through bank loans at a 10% interest rate. Therefore, its interest expense is $47 million per year.
We can analyze the situation more closely. First, consider the inventory conversion
period:
Inventory conversion period ¼
¼
Inventory
Cost of goods sold per day
(16-2)
$140:0
¼ 50:4 days
$1;013:9=365
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Chapter 16
Supply Chains and Working Capital Management
641
Thus, it takes GBM an average of 50.4 days to sell its merchandise, which is very close to
the 50 days called for in the business plan. Note also that inventory is carried at cost,
which explains why the denominator in Equation 16-2 is the cost of goods sold per day,
not daily sales.
The average collection period (or days sales outstanding) is calculated next:
Average collection period ¼ ACPðor DSOÞ ¼
¼
Receivables
Sales=365
(16-3)
$445:0
¼ 133:5 days
$1;216:7=365
Thus, it takes GBM 133.5 days after a sale to receive cash, not the 60 days called for in its
business plan. Because receivables are recorded at the sales price, we use daily sales (rather
than the cost of goods sold per day) in the denominator for the ACP.
The payables deferral period is found as follows, again using daily cost of goods sold in
the denominator because payables are recorded at cost:
Payables
Payables
Payables
¼
¼
deferral period
Purchases per day
Cost of goods sold=365
¼
(16-4)
$115:0
¼ 41:4 days
$1;013:9=365
GBM is supposed to pay its suppliers after 40 days, but it actually pays on average just
after Day 41. This slight delay is normal, because mail delays and time for checks to be
cashed generally slow payments down a bit.
We can now combine the three periods to calculate GBM’s actual cash conversion
cycle:
Cash conversion cycleðCCCÞ ¼ 50:4 days þ 133:5 days − 41:4 days ¼ 142:5 days
resource
See Ch16 Tool Kit.xls on
the textbook’s Web site for
details.
Figure 16-3 summarizes all of these calculations and then analyzes why the actual
CCC exceeds the theoretical CCC by such a large amount. It is clear from the figure that
the firm’s inventory control is working as expected in that sales match the inflow of new
inventory items quite well. Also, its own payments match reasonably well the terms
under which it buys. However, its accounts receivable are much higher than they should
be, indicating that customers are not paying on time. In fact, they are paying 73.5 days
late, which is increasing GBM’s working capital. Because working capital must be
financed, the collections delay is lowering the firm’s profits and presumably hurting
its stock price.
When the CFO reviewed the situation, she discovered that GBM’s customers—doctors,
hospitals, and clinics—were themselves reimbursed by insurance companies and government units, and those organizations were paying late. The credit manager was doing
everything he could to collect faster, but the customers said that they just could not make
their own payments until they themselves were paid. If GBM wanted to keep making
sales, it seemed that it would have to accept late-paying customers. However, the CFO
wondered if collections might come in faster if GBM offered substantial discounts for
early payments. We will take up this issue later in the chapter.
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FIGURE 16-3
Summary of the Cash Conversion Cycle (Millions of Dollars)
Note:
GBM’s inventories are in line with its plans, and it is paying its suppliers nearly on time. However, some of its customers are paying quite late,
so its average collection period (or DSO) is 133.5 days even though all customers are supposed to pay by Day 60.
16-3c Benefits of Reducing the CCC
As we have seen, GBM currently has a CCC of 142.5 days, which results in $470 million
being tied up in net operating working capital. Assuming that its cost of debt to carry
working capital is 10%, this means that the firm is incurring interest charges of
$47 million per year to carry its working capital. Now suppose the company can speed
up its sales enough to reduce the inventory conversion period from 50.4 to 35.0 days. In
addition, it begins to offer discounts for early payment and thereby reduces its average
collection period to 40 days. Finally, assume that it could negotiate a change in its own
payment terms from 40 to 50 days. The “New” column of Figure 16-4 shows the net
effects of these improvements: a 117.5-day reduction in the cash conversion cycle and a
reduction in net operating working capital from $470.0 to $91.7 million, which saves
$37.8 million of interest.
Recall also that free cash flow (FCF) is equal to NOPAT minus the net new investment in operating capital. Therefore, if working capital decreases by a given amount
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Chapter 16
Supply Chains and Working Capital Management
643
FIGURE 16-4
Benefits from Reducing the Cash Conversion Cycle (Millions of Dollars)
while other things remain constant, then FCF increases by that same amount—$378.3
million in the GBM example. If sales remained constant in the following years, then this
reduction in working capital would simply be a one-time cash inflow. However, suppose
sales grow in future years. When a company improves its working capital management,
the components (inventory conversion period, collection period, and payments period)
usually remain at their improved levels, which means the NOWC-to-Sales ratio remains
at its new level. With an improved NOWC-to-Sales ratio, less working capital will be
required to support future sales, leading to higher annual FCFs than would have otherwise
existed.
Thus, an improvement in working capital management creates a large one-time increase
in FCF at the time of the improvement as well as higher FCF in future years. Therefore,
an improvement in working capital management is a gift that keeps on giving.
These benefits can add substantial value to the company. Professors Hyun-Han Shin and
Luc Soenen studied more than 2,900 companies over a 20-year period, finding a strong
relationship between a company’s cash conversion cycle and its stock performance.5 For
an average company, a 10-day improvement in its CCC was associated with an increase
in pre-tax operating profit margin from 12.76% to 13.02%. Moreover, companies with
cash conversion cycles 10 days shorter than the average for their industry had annual
stock returns that were 1.7 percentage points higher than the average company. Given
results like these, it’s no wonder firms place so much emphasis on working capital
management! 6
5
Hyun-Han Shin and Luc Soenen, “Efficiency of Working Capital Management and Corporate Profitability,”
Financial Practice and Education, Fall/Winter 1998, pp. 37–45.
6
For more on the CCC, see James A. Gentry, R. Vaidyanathan, and Hei Wai Lee, “A Weighted Cash Conversion
Cycle,” Financial Management, Spring 1990, pp. 90–99.
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Some Firms Operate with Negative
Working Capital!
Some firms are able to operate with zero or even negative net working capital. Dell Computer and Amazon are
examples. When customers order computers from
Dell’s Web site or books from Amazon, they must provide a credit card number. Dell and Amazon then receive
next-day cash, even before the product is shipped and
even before they have paid their own suppliers. This
results in a negative CCC, which means that working
capital provides cash rather than uses it.
© Rob Webb/Getty Images
In order to grow, companies normally need cash
for working capital. However, if the CCC is negative
then growth in sales provides cash rather than uses it.
This cash can be invested in plant and equipment,
research and development, or for any other corporate
purpose. Analysts recognize this point when they value
Dell and Amazon, and it certainly helps their stock
prices.
SELF-TEST
Define the following terms: inventory conversion period, average collection period,
and payables deferral period. Give the equation for each term.
What is the cash conversion cycle? What is its equation?
What should a firm’s goal be regarding the cash conversion cycle, holding other
things constant? Explain your answer.
What are some actions a firm can take to shorten its cash conversion cycle?
A company has $20 million of inventory, $5 million of receivables, and $4 million
of payables. Its annual sales revenue is $80 million, and its cost of goods sold is
$60 million. What is its CCC? (120.15)
16-4 The Cash Budget
resource
See Ch16 Tool Kit.xls on
the textbook’s Web site for
details.
Firms must forecast their cash flows. If they are likely to need additional cash, then they
should line up funds well in advance. Yet if they are likely to generate surplus cash, then
they should plan for its productive use. The primary forecasting tool is the cash budget,
illustrated in Figure 16-5, which is taken from the chapter’s Excel Tool Kit model. The
illustrative company is Educational Products Corporation (EPC), which supplies educational materials to schools and retailers in the Midwest. Sales are cyclical, peaking in
September and then declining for the balance of the year.
16-4a Monthly Cash Budgets
Cash budgets can be of any length, but EPC and most companies use a monthly cash
budget, such as the one in Figure 16-5, but set up for 12 months. We used only 6
months for the purpose of illustration. The monthly budget is used for longer-range
planning, but a daily cash budget is also prepared at the start of each month to provide a
more precise picture of the daily cash flows for use in scheduling actual payments on a
day-by-day basis.
The cash budget focuses on cash flows, but it also includes information on forecasted
sales, credit policy, and inventory management. Because the statement is a forecast and
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Chapter 16
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645
FIGURE 16-5
EPC’s Cash Budget, July–December 2014 (Millions of Dollars)
Notes:
1. Although the budget period is July through December, sales and purchases data for May and June are needed to determine collections and payments
during July and August.
2. Firms can both borrow and pay off commercial loans on a daily basis, so the $26.2 million loan needed for July would likely be gradually borrowed as
needed on a daily basis, and during October the $234.8 million loan that presumably existed at the beginning of the month would be reduced daily to the
$86.2 million ending balance—which, in turn, would be completely paid off sometime during November.
3. The data in the figure are for EPC’s base-case forecast. Data for alternative scenarios are shown in the chapter’s Excel Tool Kit model.
not a report on historical results, actual results could vary from the figures given. Therefore,
the cash budget is generally set up as an expected, or base-case, forecast, but it is created
with a model that makes it easy to generate alternative forecasts to see what would happen
under different conditions.
Figure 16-5 begins with a forecast of sales for each month on Row 145. Then, on Row
146, it shows possible percentage deviations from the forecasted sales. Because we are
showing the base-case forecast, no adjustments are made, but the model is set up to show
the effects if sales increase or decrease and so result in “adjusted sales” that are above or
below the forecasted levels.
The company sells on terms of “2/10, net 60.” This means that a 2% discount is given if
payment is made within 10 days; otherwise, the full amount is due in 60 days. However,
like most companies, EPC finds that some customers pay late. Experience shows that 20%
of customers pay during the month of the sale and take the discount. Another 70% pay
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during the month immediately following the sale, and 10% are late, paying in the second
month after the sale.7
The statement (Line 154) next shows forecasted materials purchases, which equal 60%
of the following month’s sales. EPC buys on terms of net 30, meaning that it receives no
discounts and is required to pay for its purchases within 30 days of the purchase date. The
purchases information is followed by forecasted payments for materials, labor, leases,
other payments such as dividends and interest on long-term bonds, taxes (due in
September and December), and a payment of $150 million in September for a new plant
that is being constructed.
When the total forecasted payments are subtracted from the forecasted collections, the
result is the expected net cash gain or loss for each month. This gain or loss is added to or
subtracted from the excess cash on hand at the start of the forecast (which we assume was
zero), and the result—the cumulative net cash flow—is the amount of cash the firm would
have on hand at the end of the month if it neither borrowed nor invested.
EPC’s target cash balance is $10 million, and it plans either to borrow to meet this
target or to invest surplus funds if it generates more cash than it needs. How the target
cash balance is determined is discussed later in the chapter, but EPC believes that it needs
$10 million.
By subtracting the target cash balance from the cumulative cash flow, we calculate the
loan needed or surplus cash, as shown on Row 169. A negative number indicates that we
need a loan, whereas a positive number indicates that we forecast surplus cash that is
available for investment or other uses.
We total the net cash flows on Row 165 and show the cumulative total on Row 166.
Cell M166 shows that the cumulative for the forecast period is $37 million. Because this
number is positive, it indicates that EPC’s cumulative cash flow is positive. Also, note that
EPC borrows on a basis that allows it to borrow or repay loans on a daily basis. Thus, it
would borrow a total of $26.2 million in July, increasing the loan daily, and would
continue to build up the loan through September. Then, when its cash flows turn positive
in October, it would start repaying the loan on a daily basis and completely pay it off
sometime in November, assuming that everything works out as forecasted.
Note that our cash budget is incomplete in that it shows neither interest paid on the
working capital loans nor interest earned on the positive cash balances. These amounts
could be added to the budget simply by adding rows and including them. Similarly, if the
firm makes quarterly dividend payments, principal payments on its long-term bonds, or
any other payments, or if it has investment income, then those cash flows also could be
added to the statement. In our simplified statement, we just lumped all such payments
into “other payments.”
Under the base-case forecast, the CFO will need to arrange a line of credit so that the
firm can borrow up to $234.8 million, increasing the loan over time as funds are needed
and repaying it later when cash flows become positive. The treasurer would show the cash
budget to the bankers when negotiating for the line of credit. Lenders would want to know
how much the firm expects to need, when the funds will be needed, and when the loan
will be repaid. The lenders—and EPC’s top executives—would question the treasurer
7
Because we are using a monthly forecast instead of a daily forecast, we assume that all purchases are made on
the first day of the month. Thus, discounted payments are received in the month of the sale, regular payments are
received in the month after the sale, and late payments are received two months after the sale. Obviously, a daily
budget would be more accurate. Also, a negligible percentage of sales results in bad debts. The low bad-debt
losses evident here result from EPC’s careful screening of customers and its generally tight credit policies.
However, the cash budget model is able to show the effects of bad debts, so EPC’s CFO could show top
management how cash flows would be affected if the firm relaxed its credit policy in order to stimulate sales or if
the recession worsened and more customers were forced to delay payments.
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Chapter 16
resource
See Ch16 Tool Kit.xls on
the textbook’s Web site for
details.
Supply Chains and Working Capital Management
647
about the budget, and they would want to know how the forecasts would be affected if
sales were higher or lower than those projected, how changes in customers’payment times
would affect the forecasts, and the like. The focus would be on these two questions: How
accurate is the forecast likely to be? What would be the effects of significant errors? The first
question could best be answered by examining historical forecasts, and the second by
running different scenarios as we do in the Excel Tool Kit model.
No matter how hard we try, no forecast will ever be exactly correct, and this includes
cash budgets. You can imagine the bank’s reaction if the company negotiated a loan of
$235 million and then came back a few months later saying that it had underestimated
its requirements and needed to boost the loan to say $260 million. The banker might
refuse, thinking the company was not well managed. Therefore, EPC’s treasurer would
undoubtedly want to build a cushion into the line of credit—say, a maximum commitment of $260 million rather than the forecasted requirement of $234.8 million. However, as we discuss later in the chapter, banks charge commitment fees for guaranteed
lines of credit; thus, the higher the cushion built into the line of credit, the more costly
the credit will be. This is another reason why it is important to develop accurate
forecasts.
16-4b Cash Budgets versus Income Statements and
Free Cash Flows
If you look at the cash budget, it looks similar to an income statement. However, the two
statements are quite different. Here are some key differences: (1) In an income statement,
the focus would be on sales, not collections. (2) An income statement would show accrued
taxes, wages, and so forth, not the actual payments. (3) An income statement would show
depreciation as an expense, but it would not show expenditures on new fixed assets. (4)
An income statement would show a cost for goods purchased when those goods were
sold, not for when they were ordered or paid.
These are obviously large differences, so it would be a big mistake to confuse a cash
budget with an income statement. Also, the cash flows shown on the cash budget are
different from the firm’s free cash flows, because FCF reflects after-tax operating income
and the investments required to maintain future operations whereas the cash budget
reflects only the actual cash inflows and outflows during a particular period.
The bottom line is that cash budgets, income statements, and free cash flows are all
important and are related to one another, but they are also quite different. Each is
designed for a specific purpose, and the main purpose of the cash budget is to forecast
the firm’s liquidity position, not its profitability.
16-4c Daily Cash Budgets
resource
See Ch16 Tool Kit.xls on
the textbook’s Web site for
details.
Note that if cash inflows and outflows do not occur uniformly during each month, then
the actual funds needed might be quite different from the indicated amounts. The data in
Figure 16-5 show the situation on the last day of each month, and we see that the
maximum projected loan during the forecast period is $234.8 million. Yet if all payments
had to be made on the 1st of the month but most collections came on the 30th, then EPC
would have to make $270 million of payments in July before it received the $253.8 million
from collections. In that case, the firm would need to borrow about $270 million in July,
not the $26.2 million shown in Figure 16-5. This would make the bank unhappy—perhaps
so unhappy that it would not extend the requested credit. A daily cash budget would have
revealed this situation.
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Figure 16-5 was prepared using Excel, which makes it easy to change the assumptions.
In the Tool Kit model we examine the cash flow effects of changes in sales, in customers’
payment patterns, and so forth. Also, the effects of changes in credit policy and inventory
management could be examined through the cash budget.
SELF-TEST
How could the cash budget be used when negotiating the terms of a bank loan?
How would a shift from a tight credit policy to a relaxed policy be likely to affect
a firm’s cash budget?
How would the cash budget be affected if our firm’s suppliers offered us terms
of “2/10, net 30,” rather than “net 30,” and we decided to take the discount?
Suppose a firm’s cash flows do not occur uniformly throughout the month.
What effect would this have on the accuracy of the forecasted borrowing
requirements based on a monthly cash budget? How could the firm deal with
this problem?
16-5 Cash Management and the Target
Cash Balance
Companies need cash to pay for expenses related to daily ongoing operations, including
labor, raw materials, utility bills, and taxes. Companies also need cash for several other
predictable purposes, including major purchases and payments to investors (interest
payments, principal payments, and dividend payments). Following are the issues that
companies consider when deciding how much cash to hold in support of ongoing
operations. We discuss major purchases and payments to investors in Section 16-10.
16-5a Routine (but Uncertain) Operating Transactions
Cash balances are necessary in business operations. Payments must be made in cash,
and receipts are deposited in the cash account. Cash balances associated with routine
payments and collections are known as transactions balances. Cash inflows and outflows are unpredictable, and the degree of predictability varies among firms and industries.
Therefore, firms need to hold some cash to meet random, unforeseen fluctuations in
inflows and outflows. These “safety stocks” are called precautionary balances, and the
less predictable the firm’s cash flows, the larger such balances should be. Research
confirms this and shows that companies with volatile cash flows do in fact hold higher
cash balances.8
In addition to holding cash for transactions and precautionary reasons, it is essential
that the firm have sufficient cash to take trade discounts. Suppliers frequently offer
customers discounts for early payment of bills. As we will see later in this chapter, the
cost of not taking discounts is sometimes very high, so firms should have enough cash to
permit payment of bills in time to take advantage of discounts.
Many companies have a line of credit to cover unexpected cash needs; we discuss lines
of credit in Section 16-12.
8
See Tim Opler, Lee Pinkowitz, René Stulz, and Rohan Williamson, “The Determinants and Implications of
Corporate Cash Holdings,” Journal of Financial Economics, 1999, pp. 3–46.
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Chapter 16
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649
16-5b Compensating Balances
A bank makes money by lending out funds that have been deposited with it, so the larger its
deposits, the better the bank’s profit position. If a bank is providing services to a
customer, then it may require that customer to leave a minimum balance on deposit
to help offset the costs of providing those services. Also, banks may require borrowers to
hold their transactions deposits at the bank. Both types of deposits are called compensating balances. In a 1979 survey, 84.7% of responding companies reported they were
required to maintain compensating balances to help pay for bank services; only 13.3%
reported paying direct fees for banking services.9 By 1996, those findings were reversed:
Only 28% paid for bank services with compensating balances, while 83% paid direct
fees.10 Although the use of compensating balances to pay for services has declined, these
balances improve a firm’s relationship with its bank and are still a reason why some
companies hold additional cash.
SELF-TEST
Why is cash management important?
What are the primary motives for holding cash?
16-6 Cash Management Techniques
In terms of dollar volume, most business is conducted by large firms, many of which
operate nationally or globally. They collect cash from many sources and make payments
from a number of different cities or even countries. For example, companies such as IBM,
General Electric, and Hewlett-Packard have manufacturing plants all around the world,
even more sales offices, and bank accounts in virtually every city in which they do business.
Their collection centers follow sales patterns. However, while some disbursements are made
from local offices, most are made in the cities where manufacturing occurs or from the
home office. Thus, a major corporation might have hundreds or even thousands of bank
accounts located in cities all over the globe, but there is no reason to think that inflows and
outflows will balance in each account. Therefore, a system must be in place to transfer funds
from where they come in to where they are needed, to arrange loans to cover net corporate
shortfalls, and to invest net corporate surpluses without delay. Some commonly used
techniques for accomplishing these tasks are discussed next.11
16-6a Synchronizing Cash Flow
If you as an individual were to receive income once a year, then you would probably put it
in the bank, draw down your account periodically, and have an average balance for the
year equal to about half of your annual income. If instead you received income weekly and
paid rent, tuition, and other charges on a daily basis, then your average bank balance
9
See Lawrence J. Gitman, E. A. Moses, and I. T. White, “An Assessment of Corporate Cash Management
Practices,” Financial Management, Spring 1979, pp. 32–41.
10
See Charles E. Maxwell, Lawrence J. Gitman, and Stephanie A. M. Smith, “Working Capital Management and
Financial-Service Consumption Preferences of US and Foreign Firms: A Comparison of 1979 and 1996
Preferences,” Financial Practice and Education, Fall/Winter 1998, pp. 46–52.
11
For more information on cash management, see Bruce J. Summers, “Clearing and Payment Systems: The Role
of the Central Bank,” Federal Reserve Bulletin, February 1991, pp. 81–91.
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would still be about half of your periodic receipts and thus only 1/52 as large as if you
received income only once annually.
Exactly the same situation holds for businesses: By timing their cash receipts to
coincide with their cash outlays, firms can hold their transactions balances to a minimum.
Recognizing this fact, firms such as utilities, oil companies, and credit card companies
arrange to bill customers—and to pay their own bills—on regular “billing cycles” throughout the month. This synchronization of cash flows provides cash when it is needed and
thus enables firms to reduce their average cash balances.
16-6b Speeding Up the Check-Clearing Process
When a customer writes and mails a check, the funds are not available to the receiving
firm until the check-clearing process has been completed. First, the check must be
delivered through the mail. Checks received from customers in distant cities are especially
subject to mail delays.
When a customer’s check is written on one bank and a company deposits the check in
another bank, the company’s bank must verify that the check is valid before the payee can
use those funds. Checks are generally cleared through the Federal Reserve System or
through a clearinghouse set up by the banks in a particular city.12 Before 2004, this
process sometimes took 2 to 5 days. But with the passage of a federal law in 2004 known
as “Check 21,” banks can exchange digital images of checks. This means that most checks
now clear in a single day.
16-6c Using Float
Float is defined as the difference between the balance shown in a firm’s (or individual’s)
checkbook and the balance on the bank’s records. Suppose a firm writes, on average,
checks in the amount of $5,000 each day, and suppose it takes 6 days for these checks to
clear and be deducted from the firm’s bank account. This will cause the firm’s own
checkbook to show a balance that is $30,000 smaller than the balance on the bank’s
records; this difference is called disbursement float. Now suppose the firm also receives
checks in the amount of $5,000 daily but that it loses 4 days while those checks are being
deposited and cleared. This will result in $20,000 of collections float. In total, the firm’s
net float—the difference between the $30,000 positive disbursement float and the $20,000
negative collections float—will be $10,000. In sum, collections float is bad, disbursement
float is good, and positive net float is even better.
Delays that cause float will occur because it takes time for checks to (1) travel through
the mail (mail float), (2) be processed by the receiving firm (processing float), and (3)
clear through the banking system (clearing, or availability, float). Basically, the size of a
firm’s net float is a function of its ability to speed up collections on checks it receives and
to slow down collections on checks it writes. Efficient firms go to great lengths to speed up
the processing of incoming checks, thus putting the funds to work faster, and they try to
stretch their own payments out as long as possible, sometimes by disbursing checks from
banks in remote locations.
12
For example, suppose a check for $100 is written on Bank A and deposited at Bank B. Bank B will usually
contact either the Federal Reserve System or a clearinghouse to which both banks belong. The Fed or the
clearinghouse will then verify with Bank A that the check is valid and that the account has sufficient funds to
cover the check. Bank A’s account with the Fed or the clearinghouse is then reduced by $100, and Bank B’s
account is increased by $100. Of course, if the check is deposited in the same bank on which it was drawn, that
bank merely transfers funds by bookkeeping entries from one depositor to another.
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651
Your Check Isn’t in the Mail
© Rob Webb/Getty Images
Issuing payroll checks to thousands of employees is
expensive—in both the time and resources it takes the
company to print, process, and deliver the checks, and
in the time it takes the employee to deposit or cash the
check. Paper checks cost a company between $1 and $2
each, and multiply that by thousands of employees,
some of whom are paid weekly or biweekly, it adds up
to a lot of money every year. Direct deposit of payroll
checks into the employee’s checking account reduces
these costs, but there are still many employees, especially seasonal, temporary, part-time, or young employees, who don’t have a checking account.
A growing solution to high check costs and the
needs of these “unbanked” employees is the payroll
debit card. Companies, in partnership with a bank, issue
the employee a debit card that is automatically filled
each payday. The employee either uses the debit card
to make purchases or withdraws cash at an ATM. The
cost to load a debit card is around $0.20, and so saves
the companies 80% to 90% of the cost to print a check,
and saves the unbanked employee from paying the frequently usurious check-cashing fees that can be 10% or
more. In fact, because debit card transactions that are
processed as a credit card result in fees to the merchant,
there is a small amount of money available to provide a
rebate to the employer. For example, Premier Pay Cards
offers a 0.1% rebate to the employer on certain purchases the employee makes with the debit card.
Although the use of a debit card for payroll eliminates the float that would occur with check-based pay,
for many companies the reduced processing costs and
increased employee satisfaction more than outweigh
the reduction in float.
Sources: “The End of the Paycheck,” Fortune Small Business
Magazine, December 5, 2006, and www.premierpaycards.com.
16-6d Speeding Up Collections
Two major techniques are used to speed collections and to get funds where they are
needed: lockboxes and electronic transfers.
LOCKBOXES
A lockbox system is one of the oldest cash management tools. In a lockbox system,
incoming checks are sent to post office boxes rather than to the firm’s corporate headquarters. For example, a firm headquartered in New York City might have its West Coast
customers send their payments to a post office box in San Francisco, its customers in the
Southwest send their checks to Dallas, and so on, rather than having all checks sent to
New York City. Several times a day, a local bank will empty the lockbox and deposit the
checks into the company’s local account. The bank then provides the firm with a daily
record of the receipts collected, usually via an electronic data transmission system in a
format that permits online updating of the firm’s accounts receivable records.
A lockbox system reduces the time required to receive incoming checks, to deposit them,
and to get them cleared through the banking system and available for use. Lockbox services
can make funds available as many as 2 to 5 days faster than via the “regular” system.
PAYMENT
BY
WIRE
OR
AUTOMATIC DEBIT
Firms are increasingly demanding payments of larger bills by wire or by automatic electronic debits. Under an electronic debit system, funds are automatically deducted from one
account and added to another. This is, of course, the ultimate in speeding up a collection
process, and computer technology is making such a process increasingly feasible and
efficient, even for retail transactions.
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SELF-TEST
What is float? How do firms use float to increase cash management efficiency?
What are some methods firms can use to accelerate receipts?
16-7 Inventory Management
Inventory management techniques are covered in depth in production management
courses. Still, financial managers have a responsibility for raising the capital needed to
carry inventory and for overseeing the firm’s overall profitability, so it is appropriate that
we cover the financial aspects of inventory management here.
The twin goals of inventory management are (1) ensuring that the inventories
needed to sustain operations are available, while (2) holding the costs of ordering
and carrying inventories to the lowest possible level. In analyzing improvements in
the cash conversion cycle, we identified some of the cash flows associated with a
reduction in inventory. In addition to the points made earlier, lower inventory levels
reduce costs due to storage and handling, insurance, property taxes, spoilage, and
obsolescence.
Before the computer age, companies used simple inventory control techniques such as
the “red line” system, where a red line was drawn around the inside of a bin holding
inventory items; when the actual stock declined to the level where the red line showed,
inventory would be reordered. Now computers have taken over, and supply chains have
been established that provide inventory items just before they are needed—the just-intime system. For example, consider Trane Corporation, which makes air conditioners and
currently uses just-in-time procedures. In the past, Trane produced parts on a steady
basis, stored them as inventory, and had them ready whenever the company received an
order for a batch of air conditioners. However, the company’s inventory eventually
covered an area equal to three football fields, and it still could take as long as 15 days
to fill an order. To make matters worse, occasionally some of the necessary components
simply could not be located; in other instances, the components were located but found to
have been damaged from long storage.
Then Trane adopted a new inventory policy—it began producing components only
after receiving an order and then sending the parts directly from the machines that make
them to the final assembly line. The net effect: Inventories fell nearly 40% even as sales
were increasing by 30%.
Such improvements in inventory management can free up considerable amounts of
cash. For example, suppose a company has sales of $120 million and an inventory
turnover ratio of 3. This means the company has an inventory level of
Inventory ¼ Sales=ðInventory turnover ratioÞ
¼ $120=3 ¼ $40 million
If the company can improve its inventory turnover ratio to 4, then its inventory
will fall to
Inventory ¼ $120=4 ¼ $30 million
This $10 million reduction in inventory boosts free cash flow by $10 million.
However, there are costs associated with holding too little inventory, and these costs
can be severe. If a business lowers its inventories, then it must reorder frequently, which
increases ordering costs. Even worse, if stocks become depleted then firms can miss out on
profitable sales and also suffer lost goodwill, which may lead to lower future sales.
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Chapter 16
Supply Chains and Working Capital Management
653
Supply Chain Management
© Rob Webb/Getty Images
Herman Miller Inc. manufactures a wide variety of
office furniture, and a typical order from a single customer might require work at five different plants. Each
plant uses components from different suppliers, and
each plant works on orders for many customers. Imagine all the coordination this requires. The sales force
generates the order, the purchasing department orders
components from suppliers, and the suppliers must
order materials from their own suppliers. The suppliers
make and then ship the components to Herman Miller,
the factory builds the products, the different products
are gathered together to complete the order, and then
the order is shipped to the customer. If one part of that
process malfunctions, then the order will be delayed,
inventory will pile up, extra costs to expedite the order
will be incurred, and the customer’s goodwill will be
damaged, hurting future growth.
To prevent such consequences, many companies
employ supply chain management (SCM). The key element in SCM is sharing information all the way back
from the retailer where the product is sold, to the company’s own plant, then back to the firm’s suppliers, and
even back to the suppliers’ suppliers. SCM requires
special computer software, but even more important,
it requires cooperation among the different companies
and departments in the supply chain. This culture of
open communication is often difficult for companies,
because they are reluctant to divulge operating information. For example, EMC Corp., a manufacturer of
data storage systems, has become deeply involved in
the design processes and financial controls of its key
suppliers. Many of EMC’s suppliers were initially wary
of these new relationships. However, SCM has been a
win–win proposition, resulting in higher profits for both
EMC and its suppliers.
The same is true at many other companies. After
implementing SCM, Herman Miller was able to reduce
its days of inventory on hand by a week and to cut 2
weeks off delivery times to customers. It was also able
to operate its plants at a 20% higher volume without
additional capital expenditures, because downtime due
to inventory shortages was virtually eliminated. As
another example, Heineken USA can now get beer
from its Dutch breweries to its customers’ shelves in
less than 6 weeks, compared with 10 to 12 weeks
before implementing SCM. As these and other companies have found, SCM increases free cash flows, and
that leads to more profits and higher stock prices.
Sources: Elaine L. Appleton, “Supply Chain Brain,” CFO, July
1997, pp. 51–54; and Kris Frieswick, “Up Close and Virtual,”
CFO, April 1998, pp. 87–91.
Therefore, it is important to have enough inventory on hand to meet customer demands
but not so much as to incur the costs we discussed previously. Inventory optimization
models have been developed, but the best approach—and the one most firms today are
following—is to use supply chain management and monitor the system closely.13
SELF-TEST
What are some costs associated with high inventories? With low inventories?
What is a “supply chain,” and how are supply chains related to just-in-time
inventory procedures?
A company has $20 million in sales and an inventory turnover ratio of 2.0. If it can
reduce its inventory and improve its inventory turnover ratio to 2.5 with no loss in
sales, by how much will FCF increase? ($2 million)
13
For additional insights into the problems of inventory management, see Richard A. Followill, Michael
Schellenger, and Patrick H. Marchard, “Economic Order Quantities, Volume Discounts, and Wealth Maximization,” The Financial Review, February 1990, pp. 143–152.
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16-8 Receivables Management
Firms would, in general, rather sell for cash than on credit, but competitive pressures force
most firms to offer credit for substantial purchases, especially to other businesses. Thus,
goods are shipped, inventories are reduced, and an account receivable is created.14
Eventually, the customer will pay the account, at which time (1) the firm will receive
cash and (2) its receivables will decline. Carrying receivables has both direct and indirect
costs, but selling on credit also has an important benefit: increased sales.
Receivables management begins with the firm’s credit policy, but a monitoring system is
also important to keep tabs on whether the terms of credit are being observed. Corrective
action is often needed, and the only way to know whether the situation is getting out of
hand is with a good receivables control system.15
16-8a Credit Policy
The success or failure of a business depends primarily on the demand for its products—
as a rule, high sales lead to larger profits and a higher stock price. Sales, in turn, depend
on a number of factors: Some, like the state of the economy, are exogenous, but others
are under the firm’s control. The major controllable factors are sales prices, product
quality, advertising, and the firm’s credit policy. Credit policy, in turn, consists of the
following four variables.
1. Credit period. A firm might sell on terms of “net 30,” which means that the customer
must pay within 30 days.
2. Discounts. If the credit terms are stated as “2/10, net 30,” then buyers may deduct 2%
of the purchase price if payment is made within 10 days; otherwise, the full amount
must be paid within 30 days. Thus, these terms allow a discount to be taken.
3. Credit standards. How much financial strength must a customer show to qualify for
credit? Lower credit standards boost sales, but they also increase bad debts.
4. Collection policy. How tough or lax is a company in attempting to collect slow-paying
accounts? A tough policy may speed up collections, but it might also anger customers
and cause them to take their business elsewhere.
The credit manager is responsible for administering the firm’s credit policy. However,
because of the pervasive importance of credit, the credit policy itself is normally established by the executive committee, which usually consists of the president plus the vice
presidents of finance, marketing, and production.
16-8b The Accumulation of Receivables
The total amount of accounts receivable outstanding at any given time is determined by
two factors: (1) the credit sales per day and (2) the average length of time it takes to collect
cash on accounts receivable:
14
Whenever goods are sold on credit, two accounts are created—an asset item entitled accounts receivable appears on
the books of the selling firm, and a liability item called accounts payable appears on the books of the purchaser. At this
point, we are analyzing the transaction from the viewpoint of the seller, so we are concentrating on the variables
under its control (i.e., the receivables). We examine the transaction from the viewpoint of the purchaser later in this
chapter, where we discuss accounts payable as a source of funds and consider their cost.
15
For more on credit policy and receivables management, see Shehzad L. Mian and Clifford W. Smith,
“Extending Trade Credit and Financing Receivables,” Journal of Applied Corporate Finance, Spring 1994, pp.
75–84; and Paul D. Adams, Steve B. Wyatt, and Yong H. Kim, “A Contingent Claims Analysis of Trade Credit,”
Financial Management, Autumn 1992, pp. 104–112.
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Chapter 16
Supply Chains and Working Capital Management
Accounts
¼
receivable
655
Credit sales
Length of
%
per day
collection period
(16-5)
For example, suppose Boston Lumber Company (BLC), a wholesale distributor of
lumber products, opens a warehouse on January 1 and, starting the first day, makes sales
of $1,000 each day. For simplicity, we assume that all sales are on credit and that
customers are given 10 days to pay. At the end of the first day, accounts receivable will
be $1,000; they will rise to $2,000 by the end of the second day; and by January 10, they
will have risen to 10($1,000) = $10,000. On January 11, another $1,000 will be added to
receivables, but payments for sales made on January 1 will be collected and thus will
reduce receivables by $1,000, so total accounts receivable will remain constant at $10,000.
Once the firm’s operations have stabilized, the following situation will exist:
Accounts
Credit sales
Length of
¼
%
receivable
per day
collection period
¼
$1;000
%
10 days
¼ $10;000
If either credit sales or the collection period changes, these changes will be reflected in the
accounts receivable balance.
16-8c Monitoring the Receivables Position
Both investors and bank loan officers should pay close attention to accounts receivable,
because what you see on a financial statement is not necessarily what you end up getting.
To see why, consider how the accounting system operates. When a credit sale is made, these
events occur: (1) inventories are reduced by the cost of goods sold, (2) accounts receivable are
increased by the sales price, and (3) the difference is reported as a profit, which is adjusted for
taxes and then added to the previous retained earnings balance. If the sale is for cash, then the
cash from the sale has actually been received by the firm and the scenario just described is
completely valid. If the sale is on credit, however, then the firm will not receive the cash from
the sale unless and until the account is collected. Firms have been known to encourage “sales”
to weak customers in order to report high current profits. This could boost the firm’s stock
price—but only for a short time. Eventually, credit losses will lower earnings, at which time the
stock price will fall. This is another example of how differences between a firm’s stock price
and its intrinsic value can arise, and it is something that security analysts must keep in mind.
An analysis along the lines suggested in the following sections will detect any such
questionable practice, and it will also help a firm’s management learn of problems that
might be arising. Such early detection helps both investors and bankers avoid losses, and it
also helps a firm’s management maximize intrinsic values.
DAYS SALES OUTSTANDING (DSO)
Suppose Super Sets Inc., a television manufacturer, sells 200,000 television sets a year at a
price of $198 each. Assume that all sales are on credit under the terms 2/10, net 30. Finally,
assume that 70% of the customers take the discount and pay on Day 10 and that the other
30% pay on Day 30.16
16
Unless otherwise noted, we assume throughout that payments are made either on the last day for taking
discounts or on the last day of the credit period. It would be foolish to pay on (say) the 5th day or on the 20th
day if the credit terms were 2/10, net 30.
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Supply Chain Finance
© Rob Webb/Getty Images
In our global economy, companies purchase parts and
materials from suppliers located all over the world. For
small and mid-size suppliers, especially those in less
developed economies, selling to international customers
can lead to cash flow problems. First, many suppliers
have no way of knowing when their invoices have been
approved by their customers. Second, they have no way
of knowing when they will actually receive payment from
their customers. With a 4–5-month lag between the time
an order is received and the time the payment occurs,
many suppliers resort to expensive local financing that
can add as much as 4% to their costs. Even worse, some
suppliers go out of business, which reduces competition
and ultimately leads to higher prices.
Although most companies work very hard with their
suppliers to improve their supply chain operations—
which is at the heart of supply management—a recent
poll shows that only 13% actively use supply chain
finance (SCF) techniques. However, that figure is likely
to rise in the near future. For example, Big Lots joined a
Web-based service operated by PrimeRevenue that
works like this: First, invoices received by Big Lots are
posted to the system as soon as they are approved. The
supplier doesn’t need specialized software but can check
its invoices using a Web browser. Second, the supplier
has the option of selling the approved invoices at a discount to financial institutions and banks that have access
to the PrimeRevenue network. A further advantage to the
supplier is that it receives cash within a day of the
invoices’ approval. In addition, the effective interest rate
built into the discounted price is based on the credit
rating of Big Lots, not that of the supplier.
As Big Lots treasurer Jared Poff puts it, this allows
vendors to “compete on their ability to make the product
and not on their ability to access financing.”
Source: Kate O’Sullivan, “Financing the Chain,” CFO,
February 2007, pp. 46–53.
Super Sets’s days sales outstanding (DSO), sometimes called the average collection
period (ACP), is 16 days:
DSO ¼ ACP ¼ 0:7ð10 daysÞ þ 0:3ð30 daysÞ ¼ 16 days
Super Sets’s average daily sales (ADS) is $108,493:
ADS ¼
¼
Annual sales
ðUnits soldÞðSales priceÞ
¼
365
365
(16-6)
200;000ð$198Þ
$39;600;000
¼
¼ $108;493
365
365
Super Sets’s accounts receivable—assuming a constant, uniform rate of sales throughout
the year—will at any point in time be $1,735,888:
Receivables ¼ ðDSOÞ ðADSÞ
(16-7)
¼ ð$108;493Þð16Þ ¼ $1;735;888
Note that DSO, or average collection period, is a measure of the average length of time it
takes the firm’s customers to pay off their credit purchases. Super Sets’s DSO is 16 days
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Chapter 16
Supply Chains and Working Capital Management
657
versus an industry average of 25 days, so either Super Sets has a higher percentage of
discount customers or else its credit department is exceptionally good at ensuring prompt
payment.
Finally, note that you can derive both the annual sales and the receivables balance from
the firm’s financial statements, so you can calculate DSO as follows:
DSO ¼
Receivables
$1;735;888
¼
¼ 16 days
Sales per day
$108;493
The DSO can also be compared with the firm’s own credit terms. For example, suppose
Super Sets’s DSO had been averaging 35 days. With a 35-day DSO, some customers
obviously are taking more than 30 days to pay their bills. In fact, if many customers are
paying by Day 10 to take advantage of the discount, then the others must be taking, on
average, much longer than 35 days. A way to check this possibility is to use an aging schedule,
as described next.
AGING SCHEDULES
An aging schedule breaks down a firm’s receivables by age of account. Table 16-1 shows the
December 31, 2013, aging schedules of two television manufacturers, Super Sets and Wonder
Vision. Both firms offer the same credit terms, and they have the same total receivables. Super
Sets’s aging schedule indicates that all of its customers pay on time: 70% pay by Day 10 and
30% pay by Day 30. In contrast, Wonder Vision’s schedule, which is more typical, shows that
many of its customers are not paying on time: 27% of its receivables are more than 30 days
old, even though Wonder Vision’s credit terms call for full payment by Day 30.
Aging schedules cannot be constructed from the type of summary data reported in
financial statements; rather, they must be developed from the firm’s accounts receivable
ledger. However, well-run firms have computerized accounts receivable records, so it is
easy to determine the age of each invoice, to sort electronically by age categories, and thus
to generate an aging schedule.
Management should constantly monitor both the DSO and the aging schedule to
detect any trends, to see how the firm’s collections experience compares with its credit
terms, and to see how effectively the credit department is operating in comparison with
other firms in the industry. If the DSO starts to lengthen or the aging schedule begins to
TABLE 16-1
Aging Schedules
Super Sets
Age of Account
(Days)
0–10
Wonder Vision
Value of
Account
Percentage of
Total Value
Value of
Account
Percentage of
Total Value
$1,215,122
70%
$ 815,867
47%
11–30
520,766
30
451,331
26
31–45
0
0
260,383
15
46–60
0
0
173,589
10
Over 60
0
0
34,718
2
Total receivables
$1,735,888
100%
$1,735,888
100%
© Cengage Learning 2014
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show an increasing percentage of past-due accounts, then the credit manager should
examine why these changes are occurring.
Although increases in the DSO and the aging schedule are warning signs, this does not
necessarily indicate the firm’s credit policy has weakened. If a firm experiences sharp
seasonal variations or if it is growing rapidly, then both the aging schedule and the DSO
may be distorted. To see this point, note that the DSO is calculated as follows:
DSO ¼
Accounts receivable
Annual sales=365
Receivables at any point in time reflect sales in the past 1 or 2 months, but sales as shown
in the denominator are for the past 12 months. Therefore, a seasonal increase in sales will
increase the numerator more than the denominator and hence will raise the DSO, even if
customers continue to pay just as quickly as before. Similar problems arise with the aging
schedule, because if sales are rising then the percentage in the 0–10-day category will be
high, and the reverse will occur if sales are falling. Therefore, a change in either the DSO
or the aging schedule should be taken as a signal to investigate further; it is not necessarily
a sign that the firm’s credit policy has weakened.
SELF-TEST
Explain how a new firm’s receivables balance is built up over time.
Define days sales outstanding (DSO). What can be learned from it? How is it
affected by sales fluctuations?
What is an aging schedule? What can be learned from it? How is it affected by sales
fluctuations?
A company has annual sales of $730 million. If its DSO is 35, what is its average
accounts receivables balance? ($70 million)
16-9 Accruals and Accounts Payable
(Trade Credit)
Recall that net operating working capital is equal to operating current assets minus operating current liabilities. The previous sections discussed the management of operating current
assets (cash, inventory, and accounts receivable), and the following sections discuss the
two major types of operating current liabilities: accruals and accounts payable.17
16-9a Accruals
Firms generally pay employees on a weekly, biweekly, or monthly basis, so the balance
sheet will typically show some accrued wages. Similarly, the firm’s own estimated income
taxes, employment and income taxes withheld from employees, and sales taxes collected
are generally paid on a weekly, monthly, or quarterly basis. Therefore, the balance sheet
will typically show some accrued taxes along with accrued wages.
These accruals can be thought of as short-term, interest-free loans from employees and
taxing authorities, and they increase automatically (that is, spontaneously) as a firm’s
17
For more on accounts payable management, see James A. Gentry and Jesus M. De La Garza, “Monitoring
Accounts Payables,” Financial Review, November 1990, pp. 559–576.
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Chapter 16
Supply Chains and Working Capital Management
A Wag of the Finger or Tip of the
Hat? The Colbert Report and Small
Business Payment Terms
On February 17, 2011, The Colbert Report featured an interview with Jeffrey Leonard. During a spirited exchange with
Stephen Colbert, Leonard accused many large businesses
of imposing onerous payment terms on their small suppliers. According to Leonard, when Cisco Systems sells to the
U.S. government, Cisco receives its payment in 30 days, the
standard credit terms used by the federal government. Yet
Cisco changed its own credit policy in 2010 to “net 60,”
meaning that Cisco’s suppliers don’t get paid for 60 days. In
other words, many small companies essentially are helping
Cisco finance its working capital, even though Cisco has
over $39 billion in cash. Cisco isn’t alone in delaying its
payments: Dell, Walmart, and AB InBev (the owner of
Anheuser-Busch) also pay slower than 30 days.
Colbert and Leonard agreed on the facts but
interpreted them differently. Leonard suggested that
659
© Rob Webb/Getty Images
the government should help small businesses by
requiring its own supplier companies to offer their
vendors the same terms as the government does.
Colbert, however, suggested (perhaps with tonguein-cheek) that this was just the natural result of free
markets and that no government interference was
warranted.
You be the judge. When big companies legally
take what they can from smaller companies, should
they receive a wag of the finger or a tip of the hat?
Sources: www.washingtonmonthly.com/features/2011/
1101.leonard.html; www.colbertnation.com/the-colbertreport-videos/374633/february-17-2011/jeffrey-leonard;
and www.allbusiness.com/company-activities-management/
management- benchmarking/15472247-1.html.
operations expand. However, a firm cannot ordinarily control its accruals: The timing of
wage payments is set by economic forces and industry norms, and tax payment dates are
established by law. Thus, firms generally use all the accruals they can, but they have little
control over the levels of these accounts.
16-9b Accounts Payable (Trade Credit)
Firms generally make purchases from other firms on credit, recording the debt as an
account payable. Accounts payable, or trade credit, is the largest single operating current
liability, representing about 40% of the current liabilities for an average nonfinancial
corporation. The percentage is somewhat larger for smaller firms: Because small companies often have difficulty obtaining financing from other sources, they rely especially
heavily on trade credit.
Trade credit is a spontaneous source of financing in the sense that it arises from
ordinary business transactions. For example, suppose a firm makes average purchases
of $2,000 a day on terms of net 30, meaning that it must pay for goods 30 days after the
invoice date. On average, it will owe 30 times $2,000, or $60,000, to its suppliers. If its
sales, and consequently its purchases, were to double, then its…