<<

. 36
( 100 .)



>>

materials and ultimate payments from customers is the sum of the inventory and ac-

FIGURE 2.1
Simple cycle of operations.
Cash




Raw materials
Receivables
inventory



Finished goods
inventory
Working Capital Management and Short-Term Planning 169


FIGURE 2.2
Cash conversion cycle

Accounts
receivable
Inventory period
period




Accounts payable Cash conversion cycle
period



Raw materials Payment for Sale of Cash collected
purchased raw materials finished goods on sales




counts receivable periods: first the raw materials must be purchased, processed, and
sold, and then the bills must be collected. However, the net time that the company is out
of cash is reduced by the time it takes to pay its own bills. The length of time between
the firm™s payment for its raw materials and the collection of payment from the cus-
tomer is known as the firm™s cash conversion cycle. To summarize,
CASH CONVERSION
CYCLE Period between
Cash conversion cycle = (inventory period + receivables period)
firm™s payment for materials
“ accounts payable period
and collection on its sales.

The longer the production process, the more cash the firm must keep tied up
in inventories. Similarly, the longer it takes customers to pay their bills, the
higher the value of accounts receivable. On the other hand, if a firm can delay
paying for its own materials, it may reduce the amount of cash it needs. In
other words, accounts payable reduce net working capital.

In the Appendix we showed you how the firm™s financial statements can be used to
estimate the inventory period, also called days™ sales in inventory:
average inventory
Inventory period =
annual costs of goods sold/365
The denominator in this equation is the firm™s daily output. The ratio of inventory to
daily output measures the average number of days from the purchase of the inventories
to the final sale.
We can estimate the accounts receivable period and the accounts payable period in a
similar way:1
average accounts receivable
Accounts receivable period =
annual sales/365
average accounts payable
Accounts payable period =
annual cost of goods sold/365
1 Because inventories are valued at cost, we divide inventory levels by cost of goods sold rather than sales rev-
enue to obtain the inventory period. This way, both numerator and denominator are measured by cost. The
same reasoning applies to the accounts payable period. On the other hand, because accounts receivable are
valued at product price, we divide average receivables by daily sales revenue to find the receivables period.
170 SECTION TWO



Cash Conversion Cycle
EXAMPLE .1
Table 2.2 provides the information necessary to compute the cash conversion cycle for
manufacturing firms in the United States in 1999. We can use the table to answer four
questions. How long on average does it take United States manufacturing firms to pro-
duce and sell their product? How long does it take to collect bills? How long does it take
to pay bills? And what is the cash conversion cycle?
The delays in collecting cash are given by the inventory and receivables period. The
delay in paying bills is given by the payables period. The net delay in collecting pay-
ments is the cash conversion cycle. We calculate these periods as follows:
average inventory
Inventory period =
annual cost of goods sold/365
(470 + 468)/2
= = 48.7 days
3,518/365
average accounts receivable
Receivables period =
annual sales/365
(471 + 481)/2
= = 43.8 days
3,968/365
average accounts payable
Payables period =
annual cost of goods sold/365
= (304 + 303)/2
= 31.5 days
3,518/365
The cash conversion cycle is

Inventory period + receivables period “ accounts payable period
= 48.7 + 43.8 “ 31.5 = 61.0 days
It is therefore taking United States manufacturing companies an average of 2 months
from the time they lay out money on inventories to collect payment from their cus-
tomers.




TABLE 2.2
These data can be used to calculate the cash conversion cycle for U.S. manufacturing
firms (figures in billions)

Income Statement Data Balance Sheet Data
Year Ending, First End of First Quarter End of First Quarter
Quarter 1999 1998 1999
Sales $3,968 Inventory $470 $468
Cost of goods sold 3,518 Accounts receivable 471 481
Accounts payable 304 303



Source: U.S. Department of Commerce, Quarterly Financial Report for Manufacturing, Mining and Trade Corporations, First Quarter, 1999, Tables
1.0 and 1.1.
Working Capital Management and Short-Term Planning 171



a. Suppose United States manufacturers are able to reduce inventory levels to a year-
Self-Test 1
average value of $250 billion and average accounts receivable to $300 billion. By
how many days will this reduce the cash conversion cycle?
b. Suppose that with the same level of inventories, accounts receivable, and accounts
payable, United States manufacturers can increase production and sales by 10 per-
cent. What will be the effect on the cash conversion cycle?



THE WORKING CAPITAL TRADE-OFF
Of course the cash conversion cycle is not cast in stone. To a large extent it is within
management™s control. Working capital can be managed. For example, accounts receiv-
able are affected by the terms of credit the firm offers to its customers. You can cut the
amount of money tied up in receivables by getting tough with customers who are slow
in paying their bills. (You may find, however, that in the future they take their business
elsewhere.) Similarly, the firm can reduce its investment in inventories of raw materi-
als. (Here the risk is that it may one day run out of inventories and production will grind
to a halt.)
These considerations show that investment in working capital has both costs and
benefits. For example, the cost of the firm™s investment in receivables is the interest that
could have been earned if customers had paid their bills earlier. The firm also forgoes
interest income when it holds idle cash balances rather than putting the money to work
in marketable securities. The cost of holding inventory includes not only the opportu-
nity cost of capital but also storage and insurance costs and the risk of spoilage or
obsolescence. All of these carrying costs encourage firms to hold current assets to a
CARRYING COSTS
minimum.
Costs of maintaining current
While carrying costs discourage large investments in current assets, too low a level
assets, including opportunity
of current assets makes it more likely that the firm will face shortage costs. For exam-
cost of capital.
ple, if the firm runs out of inventory of raw materials, it may have to shut down pro-
duction. Similarly, a producer holding a small finished goods inventory is more likely
SHORTAGE COSTS
to be caught short, unable to fill orders promptly. There are also disadvantages to hold-
Costs incurred from
ing small “inventories” of cash. If the firm runs out of cash, it may have to sell securi-
shortages in current assets.
ties and incur unnecessary trading costs. The firm may also maintain too low a level of
accounts receivable. If the firm tries to minimize accounts receivable by restricting
credit sales, it may lose customers.

An important job of the financial manager is to strike a balance between the
costs and benefits of current assets, that is, to find the level of current assets
that minimizes the sum of carrying costs and shortage costs.

In the Appendix we pointed out that in recent years many managers have tried to
make their staff more aware of the cost of the capital that is used in the business. So,
when they review the performance of each part of their business, they deduct the cost
of the capital employed from its profits. This measure is known as residual income or
economic value added (EVA), which is the term coined by the consulting firm Stern
Stewart. Firms that employ EVA to measure performance have often discovered that
they can make large savings on working capital. Herman Miller Corporation, the furni-
ture manufacturer, found that after it introduced EVA, employees became much more
conscious of the cash tied up in inventories. One sewing machine operator commented:
172 SECTION TWO


We used to have these stacks of fabric sitting here on the tables until we needed them . . . We
were going to use the fabric anyway, so who cares that we™re buying it and stacking it up
there? Now no one has excess fabric. They only have stuff we™re working on today. And it™s
changed the way we connect with suppliers, and we™re having [them] deliver fabric more
often.2

The company also started to look at how rapidly customers paid their bills. It found
that, any time an item was missing from an order, the customer would delay payment
until all the pieces had been delivered. When the company cleared up the problem of
missing items, it made its customers happier and it collected the cash faster.3
We will look more carefully at the costs and benefits of working capital later in this
material.


How will the following affect the size of the firm™s optimal investment in current
Self-Test 2
assets?
a. The interest rate rises from 6 percent to 8 percent.
b. A just-in-time inventory system is introduced that reduces the risk of inventory
shortages.
c. Customers pressure the firm for a more lenient credit sales policy.




Links between Long-Term and
Short-Term Financing
Businesses require capital”that is, money invested in plant, machinery, inventories,
accounts receivable, and all the other assets it takes to run a company efficiently.
Typically, these assets are not purchased all at once but are obtained gradually over time
as the firm grows. The total cost of these assets is called the firm™s total capital
requirement.
When we discussed long-term planning, we showed how the firm needs to develop
a sensible strategy that allows it to finance its long-term goals and weather possible set-
backs. But the firm™s total capital requirement does not grow smoothly and the company
must be able to meet temporary demands for cash. This is the focus of short-term fi-
nancial planning.
Figure 2.3 illustrates the growth in the firm™s total capital requirements. The
upward-sloping line shows that as the business grows, it is likely to need additional
fixed assets and current assets. You can think of this trendline as showing the base level
of capital that is required. In addition to this base capital requirement, there may be sea-
sonal fluctuations in the business that require an additional investment in current assets.
Thus the wavy line in the illustration shows that the total capital requirement peaks late
in each year. In practice, there would also be week-to-week and month-to-month fluc-
tuations in the capital requirement, but these are not shown in Figure 2.3.
Working Capital Management and Short-Term Planning 173


FIGURE 2.3
The firm™s total capital
Seasonal component
requirement grows over time.
of required assets
It also exhibits seasonal




Total capital requirement
variation around the trend.



The base level
of fixed assets
and current assets


<<

. 36
( 100 .)



>>