MANAGING WORKING CAPITAL
Cash Budgets and Current Assets
Upon reading this chapter, students should:
• Be able to compare and contrast working and fixed capital • Understand the impact of the operating cycle on the size of investment in accounts receivable and inventories • Know the differences between the three motives • Be able to differentiate between float, collection float, and disbursement float • Know how to appraise a firm’s credit worthiness • Be able to appraise the effectiveness of a firm’s inventory management policies
A firm can invest in both working capital and fixed capital. Working capital is a firm’s current assets and includes cash, marketable securities, inventory, and accounts receivable. Fixed capital is a firm’s fixed assets and includes plant, equipment and property. Firms that cannot obtain short-term financing become candidates for bankruptcy. Management of working capital is particularly important to the entrepreneurial or venture firm because there is such a pull on resources.
Two important concepts in managing working capital are the operating cycle and the cash conversion cycle: • The operating cycle measures the time between receiving raw materials and collecting the cash from credit sales posted to accounts receivable • The cash conversion cycle measures the time it takes to collect money from the company’s customers and use those funds to pay its suppliers
Calculating three ratios will reveal the average length of these cycles: 1. Inventory days = 365 / (Cost of goods sold / Inventories) 2. Accounts receivable period (average collection period) = Accounts receivable / (Net sales / 365) 3. Average payment period = Accounts payable / (Cost of goods sold / 365)
The operating cycle is the inventory conversion period plus the average collection period. The cash conversion cycle is the operating cycle minus the average payment period.
In order to determine average investment in accounts receivable, multiply net sales per day by the average collection period. With this number, a manager can now estimate what the investment in accounts receivable will be fore ht following year given sales increases and average collection period. In order to determine investment required in inventories, multiply average cost of goods sold per day by inventory conversion period. The required amount of accounts payable can be found by multiplying the cost of goods sold per day by average payment period. Armed with these numbers, a manager can tweak the business practices and use these numbers as metrics for improvement. If savings can be wrung out of the operating cycle and conversion cycle, this means less money will have to be raised in financing.
A cash budget details the cash inflows and outflows of a firm over a specific time frame. Small firms may prepare annual or monthly cash budgets while larger firms will forecast cash flows weekly or daily. Most firms have a minimum desired cash balance that depends on the firm’s ability to acquire financing on short notice, management preferences, and the predictability of cash inflows and outflows.
Estimates of cash inflows are driven by two main factors:
1. Sales forecast (may exhibit seasonality)
2. Customer payment patterns
Cash outflows will go to suppliers, payroll, taxes, operating expenses, and purchases of plant and equipment.
In order to construct the cash budget, list all expected cash inflows and then all expected cash outflows for the particular period, generating a net cash flow amount.
As a general rule of thumb, the average firm has 1/3 or more of its assets in the form of current assets (cash, accounts receivable and inventory).
Seasonal production and forecasting can lead to idle plant capacity and laid-off workers during...
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