Chapter 12 – Working Capital Chapter 12 – Working Capital ManagementManagement

Learning ObjectivesLearning Objectives Illustrate how to manage accounts receivable Illustrate how to manage accounts receivable Explain the components of credit policyExplain the components of credit policy Explains how toExplains how to

Speed up receivablesSpeed up receivables Slow down payablesSlow down payables

Diagram the floatDiagram the float Explain inventory management and EOQExplain inventory management and EOQ Account for working capital in capital Account for working capital in capital

budgetingbudgeting

Managing Accounts ReceivableManaging Accounts Receivable

Objective in accounts receivable Objective in accounts receivable management: speed up receivablesmanagement: speed up receivables Want payment from customers as soon as Want payment from customers as soon as

practicalpractical Must be aware of standard business practicesMust be aware of standard business practices

Collecting AccountsCollecting Accounts How do customers pay (cash or credit)How do customers pay (cash or credit) When do customers pay (cash now…but When do customers pay (cash now…but

credit?)credit?) Credit sales over extended period of timeCredit sales over extended period of time

Managing Accounts ReceivableManaging Accounts Receivable

Aging receivablesAging receivables Identifies chronic late payersIdentifies chronic late payers Assigns late fees to proper accountsAssigns late fees to proper accounts Follow-up with late paying customersFollow-up with late paying customers

Example 12.2, page 352Example 12.2, page 352 Age customer accountAge customer account Follow-up invoice with late feesFollow-up invoice with late fees Late fees billed by individual invoicesLate fees billed by individual invoices

CreditCredit

Granting of credit to customersGranting of credit to customers Policy on qualifying customers for creditPolicy on qualifying customers for credit Policy on payment planPolicy on payment plan Policy on follow-up for late paymentsPolicy on follow-up for late payments

Qualifying for creditQualifying for credit Credit screeningCredit screening

Self scoring – credit card or gasoline company cardSelf scoring – credit card or gasoline company card Some verification of information and ability – car loanSome verification of information and ability – car loan Substantial verification of ability to repay – home loanSubstantial verification of ability to repay – home loan Increasing cost usually match the increase in the size of the Increasing cost usually match the increase in the size of the

creditcredit Example 12.3 – Inflatable boats – How much to spend Example 12.3 – Inflatable boats – How much to spend

on screening activities (NPV decision)on screening activities (NPV decision)

CreditCredit Payment PolicyPayment Policy

Methods to speed up receivablesMethods to speed up receivables Discount for speedy payment (implicit cost?)Discount for speedy payment (implicit cost?) Lock boxes for faster processing of paymentsLock boxes for faster processing of payments Wire transfersWire transfers

Collecting Overdue DebtCollecting Overdue Debt Cost and Benefits of each stageCost and Benefits of each stage

Collection agent, court, write of as bad debtCollection agent, court, write of as bad debt

Methods to slow down payablesMethods to slow down payables Check payment Check payment Playing the float with remote disbursementsPlaying the float with remote disbursements

Inventory ManagementInventory Management

Keeping track of inventoryKeeping track of inventory ABC MethodABC Method

A goods are critical goods, or high priced goodsA goods are critical goods, or high priced goods B goods are moderately priced or essential goodsB goods are moderately priced or essential goods C goods are low priced or non-essential goodsC goods are low priced or non-essential goods

Most effort is spent on A goodsMost effort is spent on A goods Little effort is spent on C goodsLittle effort is spent on C goods Redundant Inventory ItemsRedundant Inventory Items

Economic Order Quantity – how much inventory Economic Order Quantity – how much inventory to keep on handto keep on hand

Inventory ManagementInventory Management

Cost components of inventoryCost components of inventory Ordering CostsOrdering Costs

The cost paid to ship inventory from supplier to companyThe cost paid to ship inventory from supplier to company Does not include the cost of the itemDoes not include the cost of the item

Carrying CostsCarrying Costs The storage and handling costs while inventory is in “store” The storage and handling costs while inventory is in “store”

or “manufacturing facility”or “manufacturing facility” Costs include space and utilitiesCosts include space and utilities Smooth inventory consumption (big assumption of model)Smooth inventory consumption (big assumption of model)

EOQ finds optimal trade-off between carrying EOQ finds optimal trade-off between carrying costs and ordering costs costs and ordering costs

Inventory ManagementInventory Management

Carrying Costs (cc), per unit carrying costs times Carrying Costs (cc), per unit carrying costs times average inventoryaverage inventory

Ordering Costs (oc) number of orders times cost per Ordering Costs (oc) number of orders times cost per orderorder

Total Inventory Costs = CC + OCTotal Inventory Costs = CC + OC EOQ is optimal order quantity that minimizes total EOQ is optimal order quantity that minimizes total

inventory costs with S being annual salesinventory costs with S being annual sales

Inventory ManagementInventory Management

Additional Issues with EOQAdditional Issues with EOQ Reorder PointReorder Point

Placement of order quantity before inventory hits zero due to Placement of order quantity before inventory hits zero due to shipping timeshipping time

Does not alter the actual order quantity or average inventory Does not alter the actual order quantity or average inventory on handon hand

Safety StockSafety Stock Placement of order quantity before inventory hits zero and Placement of order quantity before inventory hits zero and

with additional days in case order is delayedwith additional days in case order is delayed Does not alter quantity but does increase average inventory Does not alter quantity but does increase average inventory

on handon hand

JIT – Just in Time, system that sets safety stock JIT – Just in Time, system that sets safety stock to zero to zero

Effect of Working Capital on Capital Effect of Working Capital on Capital BudgetingBudgeting

Working Capital usually a necessary component Working Capital usually a necessary component of a projectof a project Build up current assets and current liabilities at start Build up current assets and current liabilities at start

of a projectof a project Necessary components for making productsNecessary components for making products Expensed as products are soldExpensed as products are sold

Maintained inventory levels during the project Maintained inventory levels during the project but could build as production increasesbut could build as production increases

Recover working capital at end of projectRecover working capital at end of project Draw down of inventory items supporting productionDraw down of inventory items supporting production Because items are expensed in COGS must show Because items are expensed in COGS must show

recovery of current assets and current liabilities recovery of current assets and current liabilities

HomeworkHomework

Problem 4 – Aging of Accounts ReceivableProblem 4 – Aging of Accounts Receivable Problem 8 – Credit TermsProblem 8 – Credit Terms Problem 9 – EOQProblem 9 – EOQ Problem 12 – Working Capital Impact Problem 12 – Working Capital Impact