Chapter 16 - Activities01

Working Capital
Management
Chapter 16
© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
CASH CONVERSION CYCLE
 The cash conversion cycle focuses on the length

of time between when the company must make
payments and when it receives cash inflows.
The cash conversion cycle is determined by
three factors
1) The inventory conversion period
2) The receivables collection period
3) The payables deferral period
1) The inventory conversion period
The average time required to convert materials

into finished goods and then to sell those goods.
2) The receivables collection period
The length of time required to convert the firm's

receivables into cash, or how long it takes to
collect cash from a sale.
3) The payables deferral period
The average length of time between the purchase

of materials and labor and payment for them.
The cash conversion cycle is determined by the
following formula:
 A Company has $12,000,000 of sales,

 $3000,000 of inventories,
 $3,250,000 of receivables, and
 $1,250,000 of payables.
 COGS is 75% of sales,
 and it finances working capital with bank loans
at an 8% rate.
 What is the cash conversion cycle (CCC)?
 CCC = Inventory conversion period + Average

collection period – Payables deferral period.
Inventory
 Inventory conversion period=
COGS Per day
Receivables
 Average collection period= Sales/365
Payables
 Payables deferral period =
COGS/365
 CCC = Inventory conversion period + Average collection period

– Payables deferral period.
 CCC =
 If the company could lower its inventories and

receivables by 10% each
 Increase its payables by 10%, all without
affecting sales or cost of goods sold,
 what would be the new CCC?
 how much cash would be freed up?
 how would that affect the before tax profits?
 Lower inventories and receivables by 10% each and increase

payables by 10%. Sales and COGS remain the same.
 Inventory = $3,000,000  0.9 = $2,700,000.
 A/R = $3,250,000  0.9 = $2,925,000.

 A/P = $1,250,000  1.1 = $1,375,000.
 Student Exercise Calculate new CCC?
 CCC = Inventory conversion period + Average

collection period – Payables deferral period.
Inventory
 Inventory conversion period=
COGS Per day
Receivables
 Average collection period= Sales/365
Payables
 Payables deferral period =
COGS/365
 Cash freed up:

  Inventory =
  Receivables =
  Payables =
 Cash freed up =
 4.Impact on pretax profits:

THE CASH BUDGET
 The cash budget is a statement that shows expected cash flows

over a specified period of time.
 Generally, firms use a monthly cash budget for the coming year,
plus a daily cash budget for the coming month.
 The monthly cash budgets are used for long-range planning,

and the daily budget for actual cash control.
 The following monthly cash budget examines a company for the

last 6 months of 2019.
THE CASH BUDGET
2019 Cash Budget (Dollars in Millions)

Input Data
Collections during month of sale 20% Assumed constant. Don't change.
Collections during 1st month after sale 70% Assumed constant. Don't change.
Collections during 2nd month after sale 10% Equal to 100% – (20% + 70%) – Bad debt %
Percent bad debts 0% Can change to see effects
Discount on first month collections 2% Can change to see effects
Purchases as a % of next month's sales 70% Can change to see effects
Lease payments $ 15 Can change to see effects
Construction cost for new plant (Oct) $ 100 Can change to see effects
Target cash balance $ 10 Can change to see effects
Sales adjustment factor (change from base) 0% % increase or decrease from base to see effects
May June July August Sept Oct Nov Dec
Sales (gross) $200 $250 $300 $400 $500 $350 $250 $200
Collections
During month of sale: 0.2(Sales)(0.98)
During 1st month after sale: 0.7(prior month's sales)
During 2nd month after sale: 0.1(sales 2 months ago)
Total collections
Purchases: 70% of next month's sales
Payments
Payment for materials: Last month's purchases
Wages and salaries 30 40 50 40 30 30
Lease payments 15 15 15 15 15 15
Other expenses 10 15 20 15 10 10
Taxes 30 20
Payment for plant construction 100
Total payments
Net cash flows:
Net cash flow (NCF) for month
Cumulative NCF: Prior month's cum. NCF plus this month's NCF
Cash surplus (or loan requirement)
Target cash balance $10 $10 $10 $10 $10 $10
Surplus cash (or loan needed):
Maximum required loan (shown as a negative)
Maximum available for investment
If the percent of customers who end up as bad debts increases, how
would this affect the maximum required loan?
Answer: Do a sensitivity analysis.

% bad Max Req'd Loan
debts $ 115
0.00% $ 115
1.00% $ 122
2.00% $ 130
3.00% $ 137
4.00% $ 145
5.00% $ 152
6.00% $ 160
7.00% $ 167
8.00% $ 175
9.00% $ 182
10.00% $ 190
Assume sales declined by 50%.
How would that affect the maximum loan requirement?
If sales declined by 50%, the maximum loan rises

from $115 to $246.
We would then have to ask, "Would our lenders
more than double our line of credit in the face of
a 50% drop in sales?
If not, would we go bankrupt?"
Assume sales declined by 50%.
How would that affect the maximum loan requirement?
% Change Max Loan

in Sales $ 115
-50% $ 246
-25% $ 158
0% $ 115
25% $ 81
50% $ 47
If both sales and collections change, what will happen to the
maximum loan requirement?
 Thru sensitivity analysis

Change Maximum Loan Required
in Sales Bad Debt %
$115 0% 1% 2% 3% 4% 5% 6% 7%
-100% $ 550 $ 550 $ 550 $ 550 $ 550 $ 550 $ 550 $ 550
-75% $ 393 $ 398 $ 403 $ 408 $ 413 $ 418 $ 423 $ 428
-50% $ 246 $ 251 $ 257 $ 267 $ 277 $ 287 $ 297 $ 307
-25% $ 158 $ 167 $ 176 $ 184 $ 193 $ 202 $ 210 $ 219
0% $ 115 $ 122 $ 130 $ 137 $ 145 $ 152 $ 160 $ 167
25% $ 81 $ 90 $ 100 $ 109 $ 119 $ 128 $ 137 $ 147
50% $ 47 $ 58 $ 70 $ 81 $ 92 $ 103 $ 115 $ 126
75% $ 13 $ 27 $ 40 $ 53 $ 66 $ 79 $ 92 $ 105
100% -$ 19 -$ 5 $ 10 $ 25 $ 40 $ 55 $ 70 $ 85
If both sales and collections change, what will happen to the
maximum loan requirement?
 You can see from the table that, from the base
case (Bad Debt % = 0, change in sales = 0), an
increase in late payers increases the loan
requirement, as does a decline in sales.
The model could be used to analyze the effects of other
variables,
 such as changing the discount allowed,

 changing the timing of payments for purchases
 Thus, all sorts of "what if" questions can be
answered with the Excel model.
 Remember that the most important requirement
of a good model is good inputs.
 Models don't provide inputs, but they do tell us
what variables are most important, hence they
help direct us to the areas that should be
studied most closely.
Calculation of APR and Effective Interest Rate on Add-on loan
 Suppose you borrow $10,000 on an add-on

basis at a nominal rate of 3.0% to purchase a
car, with the loan to be repaid in 12 monthly
installments.
 What are the approximate rate of interest, the
annual percentage rate, and the effective rate
on your loan?
Calculation of APR and Effective Interest Rate on Add-on loan
Amount received $10,000.00

Rate per year 3.000%
N Months 12
Annual interest $300.00
Total loan $10,300.00
Monthly pmt $858.33
Rate/month 0.45771%
Approximate rate
Annual interest/(Amount received/2) 6.00%
APR = Rate/month × 12 5.49%
EFF% = (1+Rate/Month)^N-1 5.63%
End of Chapter 16
© 2019 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
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 or school-approved learning management system for classroom use.
Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5

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Working Capital

 The cash conversion cycle focuses on the length

1) The inventory conversion period

The average time required to convert materials

2) The receivables collection period

The length of time required to convert the firm's

3) The payables deferral period

The average length of time between the purchase

 A Company has $12,000,000 of sales,

 CCC = Inventory conversion period + Average

 CCC = Inventory conversion period + Average collection period

 If the company could lower its inventories and

 Lower inventories and receivables by 10% each and increase

 Inventory = $3,000,000  0.9 = $2,700,000.

 A/R = $3,250,000  0.9 = $2,925,000.

 A/P = $1,250,000  1.1 = $1,375,000.

 Student Exercise Calculate new CCC?

 CCC = Inventory conversion period + Average

 Cash freed up:

 The cash budget is a statement that shows expected cash flows

 The monthly cash budgets are used for long-range planning,

 The following monthly cash budget examines a company for the

2019 Cash Budget (Dollars in Millions)

Collections during month of sale 20% Assumed constant. Don't change.

Percent bad debts 0% Can change to see effects

Discount on first month collections 2% Can change to see effects

Purchases as a % of next month's sales 70% Can change to see effects

Lease payments $ 15 Can change to see effects

Target cash balance $ 10 Can change to see effects

Answer: Do a sensitivity analysis.

If sales declined by 50%, the maximum loan rises

% Change Max Loan

 Thru sensitivity analysis

 such as changing the discount allowed,

 Suppose you borrow $10,000 on an add-on

Amount received $10,000.00

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