1. Identify three current asset investment policies and describe how effective each is at matching a firm’s working capital needs.
a) Which approach is most effective varies from firm to firm. The cost of short-term debt is generally lower than that of long-term debt. But short-term debt is riskier for the borrowing firm. One plus side of short-term loans is that they can usually be negotiated much faster than long-term loans. Short-term debt generally offers greater flexibility as well.
b) Companies can choose a relaxed policy where it holds a lot of cash, receivables, and inventories (relative to sales); A restricted policy where holdings of current assets are minimized; or a more moderate policy, which is a mixture of the two previously listed.
1. Maturity Matching Approach: also called the self-liquidating approach, is characterized for its matching asset and liability maturities. All fixed assets and permanent assets are financed with long-term capital, while temporary current assets are financed with short-term debt. Uncertain asset lives, and equity financing prevent exact maturity matching.
2. Aggressive Approach: where a firm finances some of its permanent assets with short-term debt. The benefit of using short-term debt is overall lower interest rates since most of the time the yield curve is upward sloping. However, financing long-term assets with short-term debt can be quite risky.
3. Conservative Approach: Long-term capital is used to finance all permanent assets and also to meet some seasonal needs. The firm uses a small amount of short-term credit to meet peak requirements, but also meets part of its seasonal needs by storing liquidity in the form of marketable securities.
2. Describe the cash conversion cycle (CCC) and all the parts of its equation.
a) The cash conversion cycle is the process referring to the time in which they purchase/produce inventory, hold it for a time, and then sell it and receive cash.
b) Cash Conversion Cycle = Inventory Conversion Period + Average Collection Period – Payables Deferral Period
• Inventory Conversion Period (ICP): The length of time between purchasing material or merchandise from suppliers and recording a sale to customers.
• Average Collection Period (ACP): The length of time customers are given to pay for goods following a sale.
• Payables Deferral Period (PDP): The length of time the firm takes to pay its suppliers.
1. In general, what should a firm’s goal be with CCC? One could assume that a firm’s goal should be to have a low CCC, as it can signify a well-managed company.
2. What can a firm do to achieve that goal? Ways to lower a firms CCCA can include increasing its inventory turnover, decreasing the average collection period, and increasing the payment deferral period.
2. Explain the aging schedule.
a) An aging schedule breaks down a firms receivables by the age of account. They usually break down and categorize accounts as current (under 30 days), 1-30 days past due, 30-60 days past due, 60-90 days past due and more than 90 days past due.
2. What a manager can pull from it? Companies can use aging schedules to help predict cash flow by identifying pending liabilities by due date from earliest to latest and by classifying the anticipated income by the number of days since the invoices were sent out.
3. How do sales fluctuations impact it? Rising credit sales will result in the aging schedule exhibiting increased values in the younger categories, creating a misleading perception of an increased collection efficiency for the older categories.
3. Compare and contrast the benefits and drawbacks of Free Cash Flows vs. an Income Statement.
1. In an income statement, the main focus is on sales. It indicates whether or not the firm has made money during the period reported. It considers all the expenses and income received in that period and breaks it down until only net income remains. It can be used to find information on risk, financial flexibility, return on investment, and other operating capabilities.
a) Advantages: Provides detailed information on revenues. It provides all the data from sales, profits, operational efficiency and more to investors who want to get a clear picture of how the business is preforming. Since it is based on the matching principal and shows the expenses incurred in order to earn the revenues.
b) Disadvantages: includes not only current revenues gained from sales but also the money due from accounts receivable which the business has not paid yet, just as it includes liabilities as expenses that have not actually been paid yet. It helps gauge the earnings per share and other past financial data, but it does not provide data on expected growth. It also does not give any indication on how the revenue generation happens.
2. Free cash flow is the cash flow actually available for distribution to all investors after the company has made all investments in fixed assets and working capital necessary to sustain ongoing operations. It can be a measurement of a company’s financial performance and health.
a) Advantages: gives a close, intrinsic stock value. It is a trustworthy measurement that eliminates the guesswork because the reported earnings can be evaluated with more accuracy. It can be analyzed to find the real value of a company and determine if the stock price of that company is over or under valued.
b) Disadvantages: Free cash flow metrics will only work when a company is operating with 100% transparency.
4. You are consulting for Tiger Corp., and were surprised to find they sell on credit terms of net 90 days while industry-wide credit terms have recently been lowered to net 30 days. On annual credit sales of $1.98 million, Tiger currently averages 95 days of sales in accounts receivable. You estimate that tightening the credit terms to 30 days would reduce annual sales to $1,855,000, but accounts receivable would drop to 35 days of sales and the savings on investment in them should more than overcome any loss in profit. Tiger’s variable cost ratio is 60%, taxes are 40%, and the interest rate on funds invested in receivables is 21%. Assuming a 365-day year, calculate the cost of carrying receivables under the current policy and the new policy.
1. Current policy: $108,221.91
2. New policy: $37,354.12
3. Is this a better policy for Tiger Corp.? Why? The net income is positive so yes, the change in credit terms should be made.
5. Is the concept of zero working capital:
a) Realistic? It’s not possible for most businesses to achieve absolute zero working capital and perfectly efficient production. But a focus on minimizing cash, receivables, and inventories while maximizing payables will help a firm lower its investments in working capital and achieve financial and production economies.
b) Beneficial? Yes. Every dollar freed up by reducing inventories or receivables, or by increasing payables, results in a contribution to cash flow. Additionally, moving towards zero working capital can permanently rais a company’s free cash flow.
c) Why? Zero working capital target is a managerial objective to set inventories + receivables – payables = 0. It is meant to free up cash, speed up production, and help businesses operate more efficiently.
6. How is the Baumol model best used and how should it benefit a company? The Baumol model enables companies to determine their optimal cash balance. Its widely used for the purpose of cash management. It trades off between the opportunity cost/carrying cost and the transaction cost. Many businesses attempt to minimize the sum of holding cash and the cost of converting marketable securities to cash.
7. Explain the relationship between total ordering costs and total carrying costs. Total carrying cost can be found by multiplying the percent carrying cost by the price per unit and by the average number of units. We can assume that the carrying cost is variable dependent on the amount we order while the ordering cost is often fixed. The total ordering cost can be found by multiplying the fixed cost associated with ordering inventories by the number of orders placed per year. Using the total carrying cost and the total ordering costs we can find the total inventory cost (which is just the sum of the two). If the EOQ is ordered each time, then TCC and TOC should be equal to one another.
8. What are the purposes of having safety stock? Safety stock is inventory held to guard against larger-than-normal sales and/or shipping delays. Safety stock protects against unforeseen variation in supply and/or demand, compensate forecast inaccuracies in the case that demand is larger than predicted, prevent disruptions in manufacturing/deliveries, and avoid stock outs to keep customer service and satisfaction levels high.
9. What impact does increasing or decreasing safety stock have on EOQ? EOQ is the number of units that a company should add to inventory with each order to minimize the total costs of inventory such as holding costs, ordering costs, and shortage costs. Safety stock adds an additional carrying cost. Once you solve for Q you can use it to solve for TIC and then add the additional cost of your safety stock. Increasing or decreasing your quantity impacts your total carrying costs and ordering costs. High quantity raises carrying costs but may lower ordering costs, while a lower quantity will decrease carrying costs but may increase ordering costs.