Chapter 22

Report
1. Describe the working-capital cycle of a small firm.
2. Identify the important issues in managing a firm’s
cash flows
3. Explain the key issues in managing accounts receivable.
4. Discuss the key issues in managing inventory.
5. Explain the key issues in managing accounts payable.
6. Calculate and interpret a firm’s cash conversion period.
7. Discuss the techniques commonly used in making capital
budgeting decisions.
8. Describe the capital budgeting practices of small firms.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–2
The Working-Capital Cycle
• Working-Capital Management
 The management of current assets and current
liabilities
• Net Working Capital
 The sum of a firm’s current assets (cash, account
receivable, and inventories) less current liabilities
(short-term notes, accounts payable, and accruals)
• Working-Capital Cycle
 The daily flow of resources through a firm’s working-
capital accounts
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–3
The Working Capital Cycle
1
Purchase or produce inventory for sale,
which increases accounts payable.
2
Sell inventory for cash; sell inventory for
credit (accounts receivable).
3
Pay the accounts payable (decreases cash
and accounts payable).
4
Collect the accounts receivable (decreases
accounts payable and increases cash).
5
Begin cycle again.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–4
22.1
Working
Capital
Cycle
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–5
22.2
Working Capital Time Line
Day a. Inventory is ordered in anticipation of future sales.
Cash conversion period—
Day b. Inventory is received.
the time required to convert paidfor inventories and accounts
receivable into cash.
Day c. Inventory is sold on credit.
Day d. Accounts payable come due and are paid.
Day e. Accounts receivable are collected.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–6
22.3
Working Capital Time Lines for Pokey, Inc., and Quick Turn Company
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–7
Pokey, Inc.’s Beginning Balance Sheet
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
July
400
0
0
600
0
1,000
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
0
0
0
300
700
0
1,000
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–8
Pokey, Inc.’s Monthly Balance Sheets
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
July
400
0
0
600
0
1,000
Aug.
400
0
500
600
0
1,500
Changes: August
Sept. to September
(100)
–500
0
500
600
0
1,000
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
0
0
0
300
700
0
1,000
500
0
0
300
700
0
1,500
0
0
0
300
700
0
1,000
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
–500
22–9
Pokey, Inc.’s Monthly Balance Sheets
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
July
400
0
0
600
0
1,000
Aug.
400
0
500
600
0
1,500
Sept.
(100)
0
500
600
0
1,000
Oct.
(100)
900
0
600
(50)
1,350
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
0
0
0
300
700
0
1,000
500
0
0
300
700
0
1,500
0
0
0
300
700
0
1,000
0
250
25
300
700
75
1,350
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Changes:
September
to October
+900
–500
–50
+250
+25
+75
22–10
Changes in Pokey’s Balance Sheet
Change in the Balance Sheet
Effect on Income Statement
Increase accounts receivable of $900
 Sales of
$900
Decrease inventories of $500
 Cost of goods sold of
$500
Increase in accrued operating
expenses of $250
 Operating expenses of
$250
Increase accumulated depreciation of $50  Depreciation expense of
$50
Increase accrued taxes of $25
$25
 Tax expense of
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–11
Pokey, Inc.’s Monthly Balance Sheets
Changes:
October to
November
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
TOTAL ASSETS
July
400
0
0
600
0
1,000
Aug.
400
0
500
600
0
1,500
Sept.
(100)
0
500
600
0
1,000
Oct.
(100)
900
0
600
(50)
1,350
Nov.
550 +650
0 –900
0
600
(50)
1,100
Accounts payable
Accrued operating expenses
Income tax payable
Long-term debt
Common debt
Retained earnings
TOTAL DEBT AND EQUITY
0
0
0
300
700
0
1,000
500
0
0
300
700
0
1,500
0
0
0
300
700
0
1,000
0
250
25
300
700
75
1,350
0
0
25
300
700
75
1,100
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
–250
22–12
Pokey’s November Income Statement
Sales revenue
Cost of goods sold
Gross profit
Operating expenses:
Cash
Depreciation expense
Total operating expenses
Operating income
Income tax (25%)
Net income
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
900
(500)
400
(250)
(50)
(300)
100
(25)
75
22–13
Managing Cash Flows
• The Nature of Cash Flows Revisited
 The flow of actual cash through a firm determines
whether or not the firm can meet its current obligations.
• Net Cash Flow
 The difference between inflow and outflows
• Net Profit
 The difference between revenue and expenses
• The Growth Trap
 A cash shortage (cash crunch) resulting from rapid
growth
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–14
22.4
Flow of Cash Through a Business
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–15
Managing Accounts Receivable
• How Accounts Receivable Affect Cash
 Accounts receivable represent the firm’s decision to
delay the inflow of cash from customers who have
been extended credit.
• Life Cycle of Accounts Receivable
 Firm makes credit sale to customer.
 Invoice is prepared and sent to customer.
 Customer pays firm.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–16
Managing Accounts Receivable (cont’d)
• Days Sales Outstanding
 Average collection period—number of days, on
average, a firm is extending credit to its customers.
Days sales outstanding =
Accounts receivable
Annual credit sales ÷ 365 days
Example:
Total sales
Credit sales
Average credit sales per day
Accounts receivable
Fast Co.’s
Days Sales
Outstanding
=
48,000
700,000 ÷ 365
= 25 days
Fast Co.
Slow Co.
$1,000,000
$1,000,000
700,000
700,000
1,918
1,918
48,000
63,300
Slow Co.’s
Days Sales
Outstanding
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
63,300
=
700,000 ÷ 365
= 33 days
22–17
Managing Collections on Accounts
• Hire someone else to handle
collections one day per week.
• Accept credit cards.
• Sell the receivables to a third party.
• Where possible, require prepayment.
• For a service business, write a
detailed work plan and payment
schedule and have it signed by the
customer.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–18
Credit Management Practices
• Minimize the time between shipping, invoicing, and
sending notices on billings.
• Review previous credit experiences to determine
impediments to cash flows.
• Provide incentives for prompt payment.
• Age accounts receivable on a monthly or even a weekly
basis to identify delinquent accounts.
• Use the most effective methods for collecting overdue
accounts.
• Use a lock box—a post office box for receiving
remittances.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–19
Managing Accounts Receivable (cont’d)
• Accounts Receivable Financing
 Pledged accounts receivable

Accounts receivable used as collateral for a loan.
 Factoring
Obtaining cash by selling accounts receivable at a discount to
another firm.
 Advantage
– Immediate cash flow
 Disadvantages
– High interest costs for loans funds and discounts for
factored receivables
– Loss of receivables as collateral in borrowing

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–20
Managing Inventory
• Inventory is a “necessary evil.”
 Product supply and consumer demand don’t always
match up.
• Monitoring Inventory
 Determine age and suitability for sale.
 Slowing moving inventory can create cash flow
problems.
 Days in inventory—number of days, on average, that
a company is holding inventory.
Days in inventory =
Inventory
Cost of goods sold ÷ 365 days
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–21
Managing Inventory
• Reducing Inventory to Free Cash
 Controlling stockpiles

Match on-hand inventory with demand.

Avoid personalizing the business-customer relationship.

Avoid forward purchasing of inventory; carrying cost for
excess inventory may exceed any savings.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–22
Managing Accounts Payable
• Negotiation
 Ask creditors for adjustments or additional time.
• Timing
 Creditors’ funds can supply short-term cash needs
until payment is demanded.
 Accounts with cash discounts for early payment
should be examined for their savings potential.
 “Buy now, pay later”—pay early enough to get cash
discounts and timely enough to avoid late-payment
fees.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–23
22.5
An Accounts Payable Timetable for Terms of 3/10, Net 30
Annualized
interest rate =
=
Days in year
Net period - Cash discount period
365
30 - 10
X
x
Cash discount %
100 - Cash discount%
3
100 - 3
= 18.25 x 0.030928 = 0.564, or 56.4%
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–24
Capital Budgeting
• Capital Budgeting Analysis
 Helps managers make decisions about
long-term investments such as:

Developing new products

Replacing equipment

Constructing new facilities

Expanding sales territories
 Seeks to answer the question:

“Do future benefits from the investment exceed
the cost of making the investment?”
 Good decisions can add value to the firm; bad
decisions can put the firm out of business.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–25
Capital Budgeting Techniques
• Capital Budgeting Decisions Involve:
 Accounting return on investment

How many dollars in average profits are generated per dollar
of average investment?
 Payback period

How long to recover the original profit outlay?
 Discounted cash flows (net present value or internal
rate of return)

How does the present value of future benefits from the
investment compare to the investment outlay?
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–26
Three Rules of Capital Budgeting
• Investors judging the attractiveness
of an investment prefer:
1. More cash rather than less cash.
2. Cash sooner rather than later.
3. Less risk rather than more risk.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–27
Capital Budgeting Techniques (cont’d)
• Accounting Return on Investment
 The average annual
after-tax profits relative
to the average book
value of an investment.
Initial investment = $10,000
Year After-Tax Profits
1
1,000
2
2,000
3
2,500
4
3,000
Accounting return
on investment =
=
1,000 + 2,000 + 2,500 + 3,000
4
10,000 + 0
2,125
5,000
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2
= 0.425, or 42.5%
22–28
Capital Budgeting Techniques (cont’d)
• Payback Period
 Measuring the amount of time it will take to recover
the cash outlay of an investment.
Original Investment = $15,000
Annual Depreciation = $1,500
Acceptable payback period= 5 years
Payback period = 4.86 years
Year
1–2
3–6
7–10
After-Tax
Profits
1,000
2,000
2,500
After-Tax
Cash Flows
2,500
3,500
4,000
Investment Recovery
Year 1-2
Year 3-5
5,000
10,500
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–29
Discounted Cash Flows
• Discounted Cash Flows (DCF)
 Comparing the present value of future cash flows with
the cost of the initial investment.

Cash received today is more valuable than cash to be
received in the future—the time value of money.
 Net present value (NPV)

The current value of cash that will flow from a project over
time less the initial investment outlay.
 Internal rate of return (IRR)

The rate of return that a firm expects to earn on a project;
return rate must exceed cost of capital.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–30
A Firm’s Cost of Capital
• Cost of Capital
 The rate of return required to satisfy
a firm’s debt holders and investors.
• Opportunity Cost
 The rate of return that could be
earned on another investment
of similar risk.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–31
Capital Budgeting Analysis in Small Firms
• Factors Affecting the Capital Budgeting Analysis
Process:
 Nonfinancial (personal) variables
 Undercapitalization and liquidity problems
 Uncertainty of cash flows within the firm
 Lack of established market value for the firm
 Small size, scope, and length of firm’s projects
 Lack of managerial experience and talent in firm
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–32
Key Terms
accounting return on
investment technique
capital budgeting analysis
cash conversion period
days in inventory
days in payables
days sales outstanding
(average collection
period)
discounted cash flow (DCF)
techniques
internal rate of return (IRR)
lock box
net present value (NPV)
payback period technique
pledged accounts receivable
working capital cycle
working capital management
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22–33

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