Financial Management (Fin-man) De La Salle Lipa

Module 5
WORKING CAPITAL MANAGEMENT

The Operating Cycle and the Cash Cycle

The operating cycle is the length of time between purchasing the inventory and collecting the cash from
sale of the inventory. The inventory period (also called inventory conversion period or days’ sales in
inventories) is the length of time required to purchase and sell the inventory. The accounts receivable
period (also called average collection period, days’ sales in receivables or days sales outstanding)
is the length of time required to collect on credit sales. The formula for the operating cycle is as follows:

Operating cycle = Inventory period + Accounts receivable period

The cash conversion cycle is the length of time between the firm’s payment for its inventory and the
collection of payment from the customer. The accounts payable period (also called payables deferral
period or days payables outstanding) is the length of time between purchase of inventory and
payment for the inventory, which is computed by dividing 365 days by the ratio of cost of goods sold to
average accounts payable. The formula for the cash conversion cycle is as follows:

Cash conversion cycle = Inventory period + Accounts receivable period – Accounts payable period

Figure 1.
Cash Flow Time Line and the Short-Term Operating Activities of a Typical Manufacturing Firm

For example, the following data were taken from its latest financial statements of a firm: annual sales,
$1,216,666; cost of goods sold, $1,013,889; inventory, $250,000; accounts receivable, $300,000, and
accounts payable, $150,000.

Inventory period = 365 / ($1,013,889/$250,000) = 90 days

Accounts receivable period = 365 / ($1,216,666/$300,000) = 90 days

Accounts payable period = 365 / ($1,013,889/$150,000) = 54 days

Operating cycle = 90 days + 90 days = 180 days

Cash conversion cycle = 90 days + 90 days – 54 days = 126 days

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Receivables Management

Investment in accounts receivable. The investment in accounts receivable (or average accounts
receivable) for any firm depends on the amount of credit sales and the average collection period. The
formula to compute the investment in accounts receivable is as follows:

Investment in accounts receivable = Average daily sales x Accounts receivable period

If a firm generated credit sales of $365,000 during the year and the average collection period is 21 days,
its average accounts receivable is as follows:

Investment in accounts receivable = $365,000 / 365 days x 21 days = $21,000

Cost of carrying receivables. When computing the cost of carrying receivables, only variable costs
enter the calculation because this is the only cost element in receivables that must be financed. As such,
the formula to compute the cost of carrying receivables is as follows:

Cost of carrying receivables = Average daily sales x Accounts receivable period x Variable cost x Cost of
funds

For example, a firm’s annual sales is $400 million. Under its current credit policy, 50 percent of those
customers who pay do so on day 10 and take the discount, 40 percent pay on day 30, and 10 percent
pay late, on day 40. Its variable cost ratio is 70 percent, and its pre-tax cost of capital invested in
receivables is 20 percent. Thus, its annual cost of carrying receivables is:

Cost of carrying receivables = $400,000,000/365 x ((50% x 10 days) + (40% x 30 days) + (10% x 40

days) x 70% cost ratio x 20% = $3,221,917.81

Incremental after-tax profit. To compute for the incremental profit, the formula is as follows:

Incremental profit = Incremental sales – Variable cost – Incremental cost of carrying receivables –
Incremental bad debts – Incremental sales discounts – Other incremental expenses – Income tax

For example, a company has annual credit sales of $1.6 million. Current expenses for the collection
department are $35,000, bad debt losses are 1.5 percent, and the days sales outstanding is 30 days.
The firm is considering easing its collection efforts such that collection expenses will be reduced to
$22,000 per year. The change is expected to increase bad debt losses to 2.5 percent and to increase the
days sales outstanding to 45 days. In addition, sales are expected to increase to $1,625,000 per year.
Should the firm relax collection efforts if the opportunity cost of funds is 16 percent, the variable cost ratio
is 75 percent, and taxes are 40 percent? Assume 360 days per year. The incremental after-tax profit is
as follows:

Cost of carrying receivables = ($1,625,000 / 360 x 45 days x 75% x 16%) – ($1,600,000 / 360 x 30 days
x 75% x 16%) = $8,375

Incremental after-tax profit = (($1,625,000 – $1,600,000) x (1 – 75%) – $8,375 – (($1,625,000 x 2.5%) –

($1,600,000 x 1.5%)) – ($35,000 $– $22,000) x (1 – 40%) = $(3,450)

Terms of credit. Firms that sell on credit have a credit policy that includes their terms of credit. An
example of a term of credit is “2/10, net 30.” A customer is entitled to a 2% discount if he pays within 10
days. In any event, he must pay within 30 days. The discount period is 10 days while the credit period is
30 days.

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The following equation can be used to calculate the annual percentage rate of not taking discounts:

Cost of discount forfeited = Discount percentage / (100% – Discount percentage) x 365 / (Credit period –
Discount period)

In the above example, the computation of the nominal cost of trade credit of the term of credit “2/10, net
30” is as follows:

Cost of discount forfeited = 2% / (100% – 2%) x 365 / (30 – 10) = 37.24%

Compensating balances. Banks sometimes require borrowers to maintain an average demand deposit
(checking account) balance of 10% to 20% of the loan’s face amount. This is called a compensating
balance, and such balances raise the effective interest rate on the loans. The effective annual rate is as
follows:

EAR = Net cost of borrowing / (Principal amount – Net cost of borrowing if discounted – Compensating
balance)) x 365 / Credit period = Cost of borrowing / (1 – % cost of borrowing if discounted – %
compensating balance)) x 365 / Credit period

For example, compute the effective rate of a 15% discounted loan for 90 days, $200,000, with 10%
compensating balance. Assume 360 days per year.

EAR = (15% x 90/360) / (1 – (15% x 90/360) – 10%) x 360/90 = 17.39%

Inventory Management

A firm typically waits until inventories of materials are about to be exhausted and then reorders a
constant quantity. This inventory rule is illustrated in the following graph.

Figure 2.
Reorder Point
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Reorder point. The reorder point or reorder level is a specific level at which the stock needs to be
replenished. The time required to receive the ordered quantity once an order is placed is called lead
time. In order to avoid a shortage in inventory due to an increase in demand or a delay in delivery, a
safety stock serve as insurance. The formula for reorder point is as follows:

Reorder point = Daily average usage x Lead time in days + Safety stock

In the example above, a firm periodically maintains a total of 3,400 bottles during a 12-day order cycle,
which includes a safety stock of 1,000 bottles. It sells 200 bottles a day. It would take 7 days from the
time the firm places an order to the time it receives them. The reorder point is computed as follows:

Reorder Point = 200 x 7 days + 1,000 = 2,400 bottles

By the end of the 12-day order cycle, the firm which has already sold 2,400 and maintains only the safety
stock of 1,000 bottles will receive its order of 2,400 to be sold during the next 12-day order cycle.

Inventory-related costs. Two types of inventory costs can be readily identified with inventory. Ordering
costs are the costs of placing and receiving an order. Examples include the costs of processing an order
(clerical costs and documents), insurance for shipment, and unloading costs. Carrying costs are the
costs of holding inventory. Examples include insurance, inventory taxes, obsolescence, the opportunity
cost of funds tied up in inventory, handling costs, and storage space. To compute for the total costs
associated with inventory, the formula is as follows:

Total costs = Ordering costs + Carrying costs = (Annual demand / Number of units ordered x Cost per
order) + (Number of units ordered / 2 x Carrying cost per unit)

For example, a retail clothing shop sells 25,000 shirts each year. It costs the company $2 per year to
hold a pair of jeans in inventory, and the fixed cost to place an order is $40. Assume that it orders 500
shirts each time it needs inventory, the total cost is computed as follows:

Total costs = (25,000 / 500 x $40) + (500/2 x $2) = $2,500

As the firm increases its order size, the number of orders falls and therefore the order costs decline.
However, an increase in order size also increases the average amount in inventory, so that the carrying
cost of inventory rises. The trick is to strike a balance between these two costs.

Economic order quantity. Economic order quantity determines the amount or order size that should be
ordered to minimize the total ordering costs and carrying costs. EOQ is computed as follows.

EOQ = √((2 x Annual demand x Cost per order) / (Carrying cost per order))

In the previous example, the economic order quantity is computed as follows:

EOQ = √((2 x 25,000 x $40) / $2) = 1,000 units

This means that ideally, the firm should have an order size of 1,000 units to be able to incur inventory-
related costs at a minimum. Likewise it will need to place 25,000/1,000 or 25 orders during the year. To
check if the firm has indeed estimated the least inventory-related costs, the total cost for the above
example is recomputed using the economic order quantity as order size:

Total cost = (25,000 / 1,000 x $40) + (1,000/2 x $2) = $2,000

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Cash Management

Float. The cash balance that a firm shows on its books is called the firm’s book, or ledger, balance. The
balance shown in its bank account as available to spend is called its available, or collected, balance. The
difference between the available balance and the ledger balance, called the float, represents the net
effect of checks in the process of clearing (moving through the banking system).

Float management involves controlling the collection and disbursement of cash. The objective in cash
collection is to speed up collections and reduce the lag between the time customers pay their bills and
the time the cash becomes available. The objective in cash disbursement is to control payments and
minimize the firm’s costs associated with making payments.

Total collection or disbursement times can be broken down into three parts:
1. Mailing time (or mail float) is the part of the collection and disbursement process during which
checks are trapped in the postal system.
2. Processing delay (or processing float) is the time it takes the receiver of a check to process the
payment and deposit it in a bank for collection.
3. Availability delay (or check-clearing float) refers to the time required to clear a check through the
banking system.

Figure 3.
Components of Collection or Disbursement Time

Lockboxes. When a firm receives its payments by mail, it must decide where the checks will be mailed
and how the checks will be picked up and deposited. Careful selection of the number and locations of
collection points can greatly reduce collection times. Many firms use special post office boxes called
lockboxes to intercept payments and speed cash collection. The formula for computing the net benefit of
using a lockbox is as follows:

Net benefits = Annual (pretax) earnings on released funds – Annual bank processing fee = (Average
daily collections x Reduction in collection time x Interest rate) – (Fixed cost + (Number of payments per
year x Variable cost per payment))

Suppose that a firm is considering establishing a bank lockbox collection system. The lockbox would
reduce average mailing time for customer payments from 3 days to 1 1/2 days, check-processing time
from 2 days to 1 day, and clearing time from 3 days to 1 1/2 days. Annual collections are $91.25 million,
and the average number of payments received total 550 per day (assume 365 days per year). A bank
has agreed to process the payments for an annual fee of $15,000 plus $0.10 per payment received. This
bank would not require a compensating balance. Assuming an 8 percent opportunity cost for released
funds, should the firm use the lockbox collection system?

Net benefits = ($91,250,000 / 365 x ((3 – 1 1/2) + (2 – 1) + (3 – 1 1/2)) x 8%) – ($15,000 + (550 x 365 x
$0.10)) = $44,925
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Target cash balance. A model for establishing the firm’s target cash balance that closely resembles the
economic ordering quantity model used for inventory. The firm typically incurs two types of cost. Holding
costs (or opportunity costs) for keeping the cash balance are the return foregone on the marketable
securities. Transaction costs (or trading costs) are those cost incurred whenever it converts its
marketable securities to cash. To compute for the total costs associated with the cash balance, the
formula is as follows:

Total costs = Transaction costs + Holding costs = (Total fund requirements x Cash balance x Cost per
transaction) + (Cash balance / 2 x Holding cost per unit)

The formula to compute the optimum cash balance is as follows:

Optimal cash balance = √((2 x Total fund requirements x Cost per transaction) / (Holding cost per order))

For example, a firm projects that cash outlays of $4.5 million will occur uniformly throughout the year. It
plans to meet its cash requirements by periodically selling marketable securities from its portfolio. The
firm’s marketable securities are invested to earn 12 percent, and the cost per transaction of converting
securities to cash is $27. The computation for the optimal cash balance is as follows:

Optimal cash balance = √((2 x $4,500,000 x $27) / (12%)) = $45,000

The total annual cost of maintaining cash balances is as follows:

Total costs = ($4,500,000 / $45,000 x $27) + ($45,000/2 x 12%) = $8,100

Exercises

1. In fiscal 2018 and 2018, The Adecco Group’s financial statements included the following items.
(In Millions)
2018 2019
Inventory $ 9,587 $14,544
Accounts receivable 16,899 18,149
Accounts payable 5,856 8,161
Sales 42,588 60,138
Cost of goods sold 28,779 40,831
What was The Adecco Group’s operating cycle and cash conversion cycle in 2019?

2. McKesson sells on terms 2/10, net 30. Total sales for the year are $912,500. Forty percent of the
customers pay on the tenth day and take discounts; the other 60 percent pay, on average, 45 days
after their purchases. What is the average amount of receivables?

3. Petrobras’s budgeted sales for the coming year are $40,500,000 of which 80% are expected to be
credit sales at terms of n/30. It estimates that a proposed relaxation of credit standards will increase
credit sales by 20% and increase the average collection period from 30 days to 40 days. Based on a
360-day year, compute the expected increase in the average accounts receivable balance based on
the proposed relaxation of credit to standards.

4. Uralkali sells fertilizers and pesticides to various retail hardware and nursery stores on terms of “2/10,
net 30.” The company currently does not grant credit to retailers with a 3 (fair) or 4 (limited) Dun &
Bradstreet Composite Credit Appraisal. An estimated $5,475,000 in additional sales per year could
be generated if Uralkali extended credit to retailers in the “fair” category. The estimated average

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collection period for these customers is 75 days, and the expected bad-debt loss ratio is 5 percent.
The company also estimates that an additional inventory investment of $800,000 is required for the
anticipated sales increase. Approximately 10 percent of these customers are expected to take the
cash discount. Uralkali’s variable cost ratio is 0.75, and its required pretax rate of return on
investments in current assets is 18 percent. Determine the net change in pretax profits.

5. Schuff Steel Company is considering changing its credit terms from 2/15, net 30 to 3/10, net 30 in
order to speed collections. At present, 40 percent of its customers take the 2 percent discount. Under
the new term, discount customers are expected to rise to 50 percent. Regardless of the credit terms,
half of the customers who do not take the discount are expected to pay on time, whereas the
remainder will pay 10 days late. The change does not involve a relaxation of credit standards;
therefore bad debt losses are not expected to rise above their present 2 percent level. However, the
more generous cash discount terms are expected to increase sales from $2 million to $2.6 million per
year. Its variable cost ratio is 75 percent, the interest rate on funds invested in accounts receivable is
9 percent, and the firm’s income tax rate is 40 percent. Using 360 days a year.
a. What are the days sales outstanding before and after the change of credit policy?
b. How much is the incremental carrying cost of receivable?
c. How much is the incremental after-tax profit from the change in credit terms?

6. Deutsche Bahn obtained a short-term bank loan for $1,000,000 at an annual interest rate 12%. As a
condition of the loan, it is required to maintain a compensating balance of $300,000 in its checking
account. The checking account earns interest at an annual rate of 3%. Deutsche Bahn would
otherwise maintain only $100,000 in its checking account for transactional purposes. Compute the
costs of the loan.

7. Philip Morris International offers terms of 2/10, net 35. What effective annual rate does the firm earn
when a customer does not take the discount?

8. Kuwahara makes bicycles. It produces 5,400 bicycles a year and therefore requires 10,800 tires per
year. It buys the tires for bicycles from a supplier at a cost of $20 per tire. The company’s inventory
carrying cost is estimated to be 15% of cost of a tire and the ordering is $50 per order. Assume 360
days per year. Determine the following:
a. Economic order quantity.
b. Total annual inventory costs of this policy.
c. Optimal ordering frequency.

9. Builders Circle, a hardware and building supplies company, processes all its customer credit card
payments at its Atlanta headquarters. A Boston bank has offered to process the payments from
Builders Circle customers located in the New England region for $50,000 per year plus $0.20 per
payment. No compensating balance will be required. Under this lockbox arrangement, the average
mailing time for payments would be reduced from 3 days to 1.5 days. Check processing and clearing
time would be reduced from 5 days to 2. Annual collections from the New England region are $292
million. The total number of payments received annually is 600,000 (an average of 50,000 credit card
holders x 12 payments per year). Assume that any funds released by this lockbox arrangement can
be invested by Builders Circle to earn 10 percent per year before taxes. The establishment of a
lockbox system for the New England region will reduce payment processing costs at its Atlanta
headquarters by $40,000 per year. Using this information, determine:
a. The annual (pretax) earnings on the released funds.
c. The annual fee that Builders Circle must pay the Boston bank for processing the payments.
d. The annual net (pretax) benefits Builders Circle will receive by establishing this lockbox
arrangement with the Boston bank.

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10. Colgate-Palmolive needs a total of $21,000 in cash during the year for transactions and other
purposes. The interest rate is 4 percent per year, and selling securities costs $25 per sale. Determine
the following:
a. Target cash balance
b. Total annual cost of maintaining cash balances

END