How can management speed up cash inflows?

LectL~i-e

Introduction to Working Capital

Content Author: Louise August, CPA, PhD

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Our topic this week is Working Capital: how to manage it and how to finance it …and yes, Cash Flow. It’s still all about cash flow.

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The term Working Capital (WC) refers to the short term accounts that keep daily operations going —Current Assets (i.e., Cash, Receivables, Inventory) and Current Liabilities (i.e., Payables and Accruals). Remember that the definition of current is an account that will be settled (collected or paid) in cash within one year. No matter what kind of business we operate, we’ll have them, though not every business will necessarily have each one: For example, a service business such as a CPA firm isn’t likely to have inventory and a Cash & Carry, as the name implies, isn’t likely to have receivables.

Of course there are other balance sheet accounts that are classified as current — assets such as prepaid expenses and marketable securities, and liabilities such as short-term debt and notes payable. They are properly classified as current but are usually excluded from the calculations of Net Operating Working Capital (NOWC) because they are not directly related to operations. Whether they are considered operating ornon-operating, all of these current asset and liability accounts need to be managed and financed.

For calculations of NOWC we include only those current accounts that are directly operations-related —only the Operating Current Assets and Operating Current Liabilities. To further complicate things, sources will differ as to how they title various components of Working Capital. Notice in the graphic below the term Working Capital can be used to refer to just the asset accounts or to the net of assets —liabilities. Very confusing.

SNorking Capital Gross working capita[

Gash EquivaEents are high q uality, I~~~r risk se~~rities th e are readily converted intca c~-ash, such ~s bank cert~Fscates of deposit:, commercial paper and treasu ry bills.

Cash and Cash Equivalents can be a problem area. This balance sheet line item includes actual coin and currency, checking account balances and near cash items collectively referred to as Cash Equivalents. Obviously, some amount of cash is needed to run the business but companies often have cash balances far in excess of the amount needed to meet liquidity needs, particularly in times of economic uncertainty. The problem is that in reported financial data companies rarely disclose the level necessary for operations vs. the additional portion. Ideally we’d analyze the make-up of this account and exclude to excess portion. An even more conservative approach would be to exclude cash balances entirely. While you should be aware of this issue, for this course, we’ll overlook the nuances surrounding cash to keep the NOWC computations simple and

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include cash and cash equivalents along with Receivables and Inventory as Operating Current Assets.

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Lecture

Managing Current Assets &Liabilities

Content Author: Louise August, CPA, PhD.

The overall objective of managing Working Capital (WC) accounts is to run the firm efficiently and effectively. This means that we’ll need to find a balance between two competing goals: maintaining appropriate levels in each of these accounts while at the same time minimizing the amount of capital tied up in them.

Setting Target Levels: Remember that regardless of whether a WC account is included or excluded from various calculations such as NOWC and intrinsic value, all these accounts need the attention of management to see that they are analyzed, controlled and financed appropriately.

CURRENT ASSETS

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Cash: Whether its checking account balances or actual currency in cash registers, cash is non-interest bearing, so the firm will want to minimize these amounts. However, a certain amount of cash will be necessary to meet the needs of daily operations —paying invoices, covering payroll, etc.

Cash Equivalents and Marketable Securities: These two captions refer to various types of instruments that can be readily bought or sold. They tend to be high-quality and have maturities of less than one year, and therefore have low-risk (that also means they’ll be low-yielding). Examples of marketable securities include commercial paper, bankers’ acceptances, treasury bills, and other money market instruments.

Receivables: If the firm extends trade credit to its customers there will be capital tied up in Accounts Receivable (AR). The level of AR is the result of several factors: credit terms offered, credit granting standards, payment incentives offered, and collection practices.

Inventory: Most firms have inventories and, depending on the type of business, it may be the largest asset on the balance sheet after Property, Plant &Equipment. Having too much inventory will obviously tie up a lot of capital, but having too little can be a disaster. Consider the consequences of empty shelves and poor selection, or worse shutting down a production line.

CURRENT LIABILITIES

On the other side of WC management are the Current Liabilities —Accounts Payable and Accruals. They are often referred to as spontaneous liabilities, because they arise in normal course of business without much overt action on the

part of the firm. These balances represent a deferral of payments to be made, so the higher the balances are, the less cash that needs to be paid out — at least for a short period of time. The amounts owed will need to be paid on a timely

basis, so the balances in these accounts really aren’t entirely within managements control. However, they are free sources of financing in the sense that there is no interest due on these unpaid balances.

PAYABLES: Just as the firm extends credit to its customer, so do the firm’s vendors and suppliers. While we don’t want

to pay any sooner than we have to, we also don’t want to develop a reputation as a slow payer… its a small world.

ACCRUALS: These accounts are typically the result of taxes and wages that are owed but haven’t yet been paid.

Determining WC Practice

This is a matter of how much time and effort will be devoted to the management of WC accounts on a regular, ongoing basis. Its a classic trade-off between effort and cost.

For example, its certainly easier to just keep a lot of inventory on hand so you’ll never have to worry about running low. On

the other hand, having more capital tied up is obviously more costly. It will be more challenging in terms of time and effort to

maintain minimal inventory amounts while also keeping shelves looking well-stocked or the production lines running smoothly.

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Monitoring &Controlling Activity

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Once the decisions have been made about target levels and management practice, managers will need ways to keep track of in the WC accounts and assess the success of their efforts. We’ll look at the various tools and techniques available shortly.

Financing the Capital Invested

The firm will also need to consider how the capital invested in WC accounts is to be financed. Some of the capital needed in WC Asset accounts will be covered by the spontaneous liabilities of Payables and Accruals. But if those sources are not enough, and often they are not, then the firm will likely turn to short term bank debt. We’ll consider this topic separately.

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Managing Cash

Content Author: Louise August, CPA, PhD

Cash is the first of the current assets that we II be discussing. It is necessary for firms to hold cash. However, since cash is anon-earning asset, it is important that the level of cash balances held be minimal. However, the firm does need to have enough cash to meet its obligations on a timely basis. Cash balances are determined by the cash flow cycle, and the cash budget is the tool used to track those cash flows. Having enough cash to pay bills is very important for firms. Many companies have problems because they aren’t able to generate enough cash.

_… Financial managers attempt to minimize cash balances, while optimizing the use of the cash by speeding up the cash inflows and slowing down cash outflows.

! ~ Managing Cash

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OUTLINE ~ ~ 29 00:00 / 14:15

How can management speed up cash inflows?

Click here for answer

How can management slow down cash outflows?

Click here for answer

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Pale 1 of 2

Managing Cash

Content Author: Louise August, CPA, PhD

Cash is the first of the current assets that we’ll be discussing. It is necessary for firms to

hold cash. However, since cash is anon-earning asset, it is important that the level of cash

balances held be minimal. However, the firm does need to have enough cash to meet its

obligations on a timely basis. Cash balances are determined by the cash flow cycle, and

the cash budget is the tool used to track those cash flows. Having enough cash to pay bills

is very important for firms. Many companies have problems because they aren’t able to

generate enough cash.

Financial managers attempt to minimize cash balances, while optimizing the use of the

cash by speeding up the cash inflows and slowing down cash outflows.

~ ~ Managing Cash

Click Q to begin presentation. Content Author: Louise August, CPA, PhD is. Walsh College, A1J riyAtS ~Y52NCd

1 /29 00:00/14:15 OUTLINE

How can management speed up cash inflows?

Speeding up collections:

1. Decentralized collection centers may speed up the collection of accounts receivable by reducing mailing time. The collection centers are often located in areas with large numbers of customers.

2. Wire transfer of funds is used to transfer from collection points to a centralized banking location.

3. Lock-box systems can be used to collect customers’ payments. With alock-box system, customers mail payment to a post office box serviced by a local bank in their geographical area.

4. Streamlining in-house processes can help to eliminate wasted time in getting checks deposited.

How can management slow down cash outflows?

Slowing disbursements:

Firms may attempt to extended disbursement time by sending checks from distant locations. This method, however, is not as effective as it once was. Management can also carefully look at paying bills towards the end of the credit period offered rather than paying as soon as a bill is received.However, it is important to evaluate any discounts provided by paying early.

Keep in mind that paying late is rarely a good idea. We will not endear ourselves to our vendors and suppliers by making them wait.

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Printable Presentation

Managing Cash

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Monitoring and Controlling

Working Capital

Cash ~’~ 3rketable ;

I Securities i

Accounts ~~~ventory Receivable

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Cash

o Checking account balances

o Actual coin and currency

• Type of business is a determinant

• Examples: • K-Mart ~A

• Doctor’s office .’~~y

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~ Cash: The Goal

o To maintain sufficient but not excessive cash balance

o Corporate checking account balance does nol earn interest

• Opportunity cost because losing out on interest that could be earned elsewhere

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Reasons Firms Hold Cash Balances

1 . Transaction motive Payments in regular course of business

2. Precautionary motive Take care of the unexpected

3. Offset compensating balance requirements Bank requirement in lieu of fees and charges

~ Cash Management

Antjcipate the cash flows

• Know your firm’s patterns of inflows and outflows

• Use of the cash budget

_. r~ inflow

Cash

outflow,… _ _ ;

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Zero Balance Accounts

o Cash management at the bank • Also known as Sweep Accounts

o Maintain two accounts at the bank 1. Interest bearing account 2, Checking account

o Checks paid as they clear Balance swept to interest bearing account

~ Cash Management

2. Managing Float The time that a check spends in “limbo”

• Receipt of check —interval between when check is received and $$ is available to us

• Payment with check —interval between when check is written and $$ is withdrawn from our account

~ Types of Float

1. Mail float ~

• US Postal Service

2. Processing floai • Within the firm -accounting a

department

3. Transit floai • Banking system ~

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Printable Presentation

( Managing Float

o Time period to collecting cash

o Minimizing “collections fioaY’

a Accelerate collections

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Managing Float ~~o~~~~

o Exert control over things that happen within the firm

o Streamlining in-firm processes

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