Managing the Firms Assets PART 5 Managing Growth

Managing the Firm’s Assets PART 5 Managing Growth in the Small Business Power. Point Presentation by Charlie Cook, The University of West Alabama © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Looking Ahead After studying this chapter, you should be able to: 1. Describe the working-capital cycle of a small business. 2. Identify the important issues in managing a firm’s cash flows 3. Explain the key issues in managing accounts receivable, inventory, and accounts payable. 4. Calculate and interpret a company’s conversion period. 5. Discuss the techniques commonly used in making capital budgeting decisions. 6. Describe the capital budgeting practices of small firms. 2 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The Working-Capital Cycle • Working-Capital Management Ø The management of current assets and current liabilities • Net Working Capital Ø 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 Ø The daily flow of resources through a firm’s working- capital accounts 3 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

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. 4 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Exhibit 22. 1 Working-Capital Cycle 5 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Exhibit 22. 2 Working-Capital Time Line Day a. Inventory is ordered in anticipation of future sales. Day b. Inventory is received. Day c. Inventory is sold on credit. Day d. Accounts payable come due and are paid. Cash conversion period— the time required to convert paid-for inventories and accounts receivable into cash. Day e. Accounts receivable are collected. 6 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Exhibit 22. 3 Working-Capital Time Lines for Pokey, Inc. , and Quick Turn Company 7 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Pokey, Inc. ’s Beginning Balance Sheet 8 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

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 0 300 700 0 1, 000 – 500 9 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

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 0 300 700 0 1, 000 0 25 300 75 1, 350 Changes: September to October +900 – 50 +25 +75 10 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Changes in Pokey’s Balance Sheet Change in the Balance Sheet Effect on Income Statement Increase accounts receivable of $900 Sales $900 Decrease inventories of $500 Cost of goods sold $500 Increase in accrued operating expenses of $250 Operating expenses $250 Increase accumulated depreciation of $50 Depreciation expense $50 Increase accrued taxes of $25 Tax expense 11 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

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 0 300 700 0 1, 000 0 25 300 75 1, 350 0 0 25 300 75 1, 100 – 250 12 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Pokey’s November Income Statement Sales revenue Cost of goods sold Gross Profit Operating expenses: Cash Depreciation Total operating expenses Operating income Income tax (25%) Net income 900 500 400 250 50 300 100 25 75 13 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Managing Cash Flows • The Nature of Cash Flows Revisited Ø The flow of actual cash through a firm determines whether or not the firm can meet its current obligations. • Net Cash Flow Ø The difference between inflow and outflows • Net Profit Ø The difference between revenue and expenses • The Growth Trap Ø A cash shortage (cash crunch) resulting from rapid growth 14 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Exhibit 22. 4 Flow of Cash through a Business 15 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Managing Accounts Receivable • How Accounts Receivable Affect Cash Ø 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 Ø Firm makes credit sale to customer. Ø Invoice is prepared and sent to customer. Ø Customer pays firm. 16 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Managing Accounts Receivable (cont’d) • Days Sales Outstanding Ø 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, 000 700, 000 1, 918 48, 000 63, 300 Slow Co. ’s Days Sales = Outstanding 63, 300 700, 000 ÷ 365 = 33 days 17 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

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. 18 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Managing Accounts Receivable (cont’d) • Accounts Receivable Financing Ø Pledged accounts receivable Accounts receivable used as collateral for a loan. Ø 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 19 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Managing Inventories • Inventory is a “necessary evil. ” Ø Product supply and consumer demand don’t always match up. • Monitoring Inventory Ø Determine age and suitability for sale. Ø Slowing moving inventory can create cash flow problems. Ø Days in inventory—number of days, on average, that a company is holding inventory. Days in inventory = Inventory Cost of goods sold ÷ 365 days 20 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Managing Inventories • Reducing Inventory to Free Cash Ø 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. 21 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Managing Accounts Payable • Negotiation Ø Asks creditors for adjustments or additional time. • Timing Ø Creditors’ funds can supply short-term cash needs until payment is demanded. Ø Accounts with cash discounts for early payment should be examined for their savings potential. Ø “Buy now, pay later”—pay early enough to get cash discounts and timely enough to avoid late-payment fees. 22 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Exhibit 22. 5 An Accounts Payable Timetable for Terms of 3/10, Net 30 Annualized interest rate = Days in year Net period - Cash discount period x Cash discount % 100 - Cash discount% = 18. 25 x 0. 030928 = 0. 564, or 56. 4% 23 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Capital Budgeting • Capital Budgeting Analysis Ø Helps managers make decisions about long-term investments such as: Developing new products Replacing equipment Constructing new facilities Expanding sales territories Ø Seeks to answer the question: “Do future benefits from the investment exceed the cost of making the investment? ” Ø Good decisions can add value to the firm; bad decisions can put the firm out of business. 24 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Capital Budgeting Techniques • Capital Budgeting Decisions Involve: Ø Accounting return on investment How many dollars in average profits are generated per dollar of average investment? Ø Payback period How long to recover the original profit outlay? Ø 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? 25 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Three Rules of Capital Budgeting • Investors judging the attractiveness of an investment prefer: Ø More cash rather than less cash. Ø Cash sooner rather than later. Ø Less risk rather than more risk. 26 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Capital Budgeting Techniques (cont’d) • Accounting Return on Investment Ø The average annual Initial investment = $10, 000 Year After-Tax Profits 1 1, 000 2 2, 000 3 2, 500 4 3, 000 after-tax profits relative to the average book value of an investment. Accounting return on investment = = 1, 000 + 2, 500 + 3, 000 4 10, 000 + 0 2, 125 5, 000 2 = 0. 425, or 42. 5% 27 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Capital Budgeting Techniques (cont’d) • Payback Period ØMeasuring 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, 500 After-Tax Cash Flows 2, 500 3, 500 4, 000 Investment Recovery Year 1 -2 Year 3 -5 5, 000 10, 500 28 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Discounted Cash Flows • Discounted Cash Flows (DCF) Ø 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. Ø Net present value (NPV) The current value of cash that will flow from a project over time less the initial investment outlay. Ø 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. 29 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

A Firm’s Cost of Capital • Cost of Capital Ø The rate of return required to satisfy a firm’s debt holders and investors. • Opportunity Cost Ø The rate of return that could be earned on another investment of similar risk. 30 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Capital Budgeting Analysis in Small Firms • Factors Affecting the Capital Budgeting Analysis Process: Ø Nonfinancial (personal) variables Ø Undercapitalization and liquidity problems Ø Uncertainty of cash flows within the firm Ø Lack of established market value for the firm Ø Small size, scope, and length of firm’s projects Ø Lack of managerial experience and talent in firm 31 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Key Terms • • working-capital management working-capital cycle cash conversion period days sales outstanding (average collection period) lock box pledged accounts receivable days in inventory days in payables • • • capital budgeting analysis accounting return on investment technique payback period technique discounted cash flow (DCF) techniques net present value (NPV) internal rate of return (IRR) 32 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.