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Part 7 Short-Term Financial Decisions Chapters in this Part Chapter 15 Working Capital and Current Assets Management Chapter 16 Current Liabilities Management Integrative Case 7: Casa de Diseño © 2012 Pearson Education, Inc. Publishing as Prentice Hall Chapter 15 Working Capital and Current Assets Management  Instructor’s Resources Overview This chapter introduces the fundamentals and describes the interrelationship of net working capital, profitability, a
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  © 2012 Pearson Education, Inc. Publishing as Prentice Hall   Part 7 Short-Term Financial Decisions   Chapters in this Part Chapter 15  Working Capital and Current Assets Management Chapter 16  Current Liabilities Management   Integrative Case 7: Casa de Diseño  © 2012 Pearson Education, Inc. Publishing as Prentice Hall   Chapter 15 Working Capital and Current Assets Management Instructor’s Resources Overview This chapter introduces the fundamentals and describes the interrelationship of net working capital, profitability, and risk in managing the firm’s current asset accounts. The chapter then focuses on the management of three major current asset accounts    cash, accounts receivable, and inventory. Also discussed are general inventory management policies, international inventory management, and several specific inventory management techniques: ABC, economic order quantity (EOQ), reorder point, materials requirement planning (MRP), and just-in-time (JIT). The key aspects of accounts receivable management are discussed: credit policy, credit terms, and collection policy. The chapter also discusses the additional risk factors involved in managing international accounts receivable. Examples demonstrate the effect of changes in credit policy. Also discussed are the impacts of changes in cash discounts. The chapter describes how managers and individuals often have to make choices that involve tradeoffs between quantity and price. Suggested Answer to Opener in Review   Question How does improved working capital management affect Cytec Industries’ firm value? According to the writeup, internal analysis showed that working capital could be reduced by $200 million. According to financial statements filed with the Securities & Exchange Commission, Cytec’s cost of capital is 12 percent. (Almost all companies these days report cost of capitals in documents that can be downloaded through EDGAR, the SEC’s Electronic Data Gathering, Analysis, and Retrieval system.) Therefore, on an annual basis the company is saving $24 million dollars. Beyond the directly measurable improvements in working capital, however, Cytec Industries’ employees became motivated and committed to the process. It would be hard to put a monetary value on this effort, but it surely enhanced firm value. Answers to Review Questions 1. Working capital management  , the management of the firm’s current assets and liabilities, is one of the financial manager’s most important functions. Managing these accounts wisely results in a balance between profitability and risk that has a positive impact on the firm’s value. With one-third of financial management time spent on current assets and one-fourth spent on current liabilities, over half of the time spent by financial managers is consumed in working capital management. Therefore, managing these current balance sheet accounts to achieve an appropriate balance between profitability and risk takes a large amount of a financial manager’s time. Despite all the time and effort dedicated to working capital management, this finance function was second in terms of being most in need of additional financial resources by CFOs.  322 Gitman ã  Principles of Managerial Finance,  Thirteenth   Edition © 2012 Pearson Education, Inc. Publishing as Prentice Hall   The basic definition of net working capital  is the difference between current assets and current liabilities. An alternative definition is that portion of current assets financed by long-term funding (when current assets exceed current liabilities—  positive working capital ) or that portion of the firm’s fixed assets financed with current liabilities (when current assets are less than current liabilities- negative working capital ). 2. The more predictable a firm’s cash inflows, the lower the level of net working capital with which it can safely operate. This is true since the more predictable or certain the receipt of cash inflow, the less cushion (i.e., net working capital) needed to absorb unexpected funds requirements. The higher a firm’s net working capital, the higher its liquidity may be, since more current assets are available to provide for payment of short-term obligations. However, if current assets are predominantly illiquid inventories or prepaid expenses, liquidity may not be improved with higher net working capital. Also, positive net working capital is financed with long-term funds, which are usually more costly and can place more constraints on the firm’s operations. Technical insolvency  occurs if a firm is unable to meet its payments when due. Generally, the higher the firm’s net working capital, the lower the risk, or chance, of technical insolvency. Increasing net working capital indicates increased liquidity and therefore a decreased risk of technical insolvency, and vice versa. 3. If a firm increases the ratio of current-to-total assets, it will have a larger proportion of current assets. Because current assets are less profitable, overall profitability will decrease. The firm will have more net working capital (due to increased current assets), lower risk of technical insolvency, and also may have greater liquidity. It is also important to consider the composition of current assets. The “nearer” a current asset is to cash, the greater its liquidity may be and the lower its risk. For example, an investment in accounts receivable is less risky than inventory. The higher the ratio of current liabilities to total assets, the more current liabilities in relation to long-term funds held by the firm. Since in most economic conditions, current liabilities are a cheaper form of financing than long-term funds, the reduced financing costs should increase the firm’s profits. At the same time, the firm has less net working capital, thereby reducing liquidity and increasing the risk of technical insolvency. A decrease in the ratio would increase both profits and risk. 4. A firm’s operating cycle  is the period when a firm has its money tied up in inventory and accounts receivable until cash is collected from the sale of the finished product. It is calculated by adding the average age of inventory (AAI) to the average collection period (ACP). The cash conversion cycle  (CCC) is the number of days in the firm’s operating cycle (OC) minus the average payment period (APP) for inputs to production. The CCC takes into account the time at which payment is made for material; this spontaneous form of financing partially or fully offsets the need for negotiated financing while resources are tied up in the OC. 5.   If a firm does not face a seasonal cycle, then they will face only a permanent funding requirement. With seasonal needs the firm must also make a decision as to how it wishes to meet the short-term nature of its seasonal cash demands. The firm may choose either an aggressive or a conservative policy toward this cyclical need. 6. An aggressive strategy  finances a firm’s seasonal needs, and possibly some of its permanent needs, with short-term funds, including trade credit as well as bank lines of credit or commercial paper. This approach seeks to increase profit by using as much of the less expensive short-term financing as possible, but increases risk since the firm operates with minimum net working capital, which could become negative. Another factor contributing to risk is the potential need to quickly arrange for long-term funding, which is generally more difficult to negotiate, to cover shortfalls in seasonal needs.  Chapter 15 Working Capital and Current Assets Management 323 © 2012 Pearson Education, Inc. Publishing as Prentice Hall   The conservative strategy  finances all expected fund requirements with long-term funds, while short-term funds are reserved for use in the event of an emergency. This strategy results in relatively lower profits, since the firm uses more of the expensive long-term financing and may pay interest on unneeded funds. The conservative approach has less risk because of the high level of net working capital (i.e., liquidity) that is maintained; the firm has reserved short-term borrowing power for meeting unexpected fund demands. 7. The longer the CCC the greater the amount of investment tied up in low return assets. Any extension of the cycle can result in higher costs and lower profits. 8. Financial managers will tend to want to keep inventory levels low to reduce financing costs. Marketing managers will tend to want large finished goods inventories. Manufacturing managers will tend to want high raw materials and finished goods inventories. The purchasing manager may favor high raw materials inventories if quantity discounts are available for large purchases. Inventory is an investment because managers must purchase the raw materials and make expenditures for the production of the product such as paying labor costs. Until cash is received through the sale of the finished goods, the cash expended for creation of the inventory, in any of its forms, is an investment by the firm. 9. The  ABC system  divides inventory into three categories of descending importance based on certain criteria established by the firm, such as total dollar investment and cost per item. Control of the A items is the most sophisticated due to the high investment involved, while B and C items would be subject to less strict controls. The  EOQ looks at all of the various costs of inventory and determines what order size minimizes total inventory cost. The model analyzes the tradeoff between order cost and carrying cost and determines the order quantity that minimizes the total inventory cost. The  JIT   system is a form of inventory control that attempts to reduce (at least theoretically) raw materials and finished goods inventory to zero. Ideally, the firm has only work-in-process inventory. JIT relies on timely receipt of high quality materials and workmanship; this system requires extensive cooperation among all parties. With modern technology there have developed a number of techniques for controlling inventory using computers. As a group these systems are referred to as computerized systems for resource control .   MRP  is a computerized system that breaks down the bill of materials for each product in order to determine what to order, when to order it, and what priorities to assign to ordering. MRP relies on EOQ and reorder point concepts to determine how much to order. This system simulates each product’s bill of materials, inventory status, and manufacturing process. By monitoring the production process, order and delivery process, and inventory levels the system determines when orders should be placed for each inventory part.  MRP II   is a computerized system that expands on the MRP system by incorporating other segments of the business, such as finance, accounting, marketing, engineering, and manufacturing into the model. In addition to inventory needs, the MRP II generates additional reports and coordinates the interaction of all areas impacted by inventory and production.  Enterprise resource planning (  ERP )   expands on both MRP systems by extending the information in the model to include data concerning suppliers and customers. By including both internal and external information, this system is designed to eliminate production delays.
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