Small Business Discussion Board 13 & 14

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Chapter_22_Managing_Assets.pdf

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Small Business Management, 18e

Longenecker/Petty/Palich/Hoy

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Managing the Firm’s Assets

Chapter 22

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Learning Goals:

 Describe the working capital cycle of a small

business.

 Identify the important issues in managing a firm’s

cash flows.

 Explain the key issues in managing accounts

receivable.

 Discuss the key financial issues in managing

inventory.

 Describe the key issues in managing account

payable.

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Learning Goals (cont.):

 Calculate and interpret a company’s cash

conversion period.

 Discuss the techniques commonly used in making

capital budgeting decisions.

 Describe the capital budgeting practices of small

firms.

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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)

22–5

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The Working-Capital Cycle

(cont.)  Working-Capital Cycle

The daily flow of resources through a firm’s

working-capital accounts

22–6

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Collect the accounts receivable (decreases

accounts payable and increases cash).

Sell inventory for cash; sell inventory for

credit (accounts receivable).

The Working Capital Cycle

Purchase or produce inventory for sale,

which increases accounts payable.

Pay the accounts payable (decreases cash

and accounts payable).

Begin cycle again.5

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© 2017 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

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Working

Capital

Cycle

22.1

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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.

Day e. Accounts receivable are collected.

22.2

Cash conversion period— the time required to convert paid-

for inventories and accounts

receivable into cash.

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Working Capital Time Lines for Pokey, Inc., and Quick Turn Company22.3

Pokey, Inc.’s Beginning Balance

Sheet

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July

Cash 400

Accounts receivable 0

Inventory 0

Fixed assets 600

Accumulated depreciation 0

TOTAL ASSETS 1,000

Accounts payable 0

Accrued operating expenses 0

Income tax payable 0

Long-term debt 300

Common debt 700

Retained earnings 0

TOTAL DEBT AND EQUITY 1,000

Pokey, Inc.’s Monthly Balance Sheets

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July Aug. Sept.

Cash 400 400 (100)

Accounts receivable 0 0 0

Inventory 0 500 500

Fixed assets 600 600 600

Accumulated depreciation 0 0 0

TOTAL ASSETS 1,000 1,500 1,000

Accounts payable 0 500 0

Accrued operating expenses 0 0 0

Income tax payable 0 0 0

Long-term debt 300 300 300

Common debt 700 700 700

Retained earnings 0 0 0

TOTAL DEBT AND EQUITY 1,000 1,500 1,000

Changes: August

to September

–500

Pokey, Inc.’s Monthly Balance Sheets

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July Aug. Sept. Oct.

Cash 400 400 (100) (100)

Accounts receivable 0 0 0 900

Inventory 0 500 500 0

Fixed assets 600 600 600 600

Accumulated depreciation 0 0 0 (50)

TOTAL ASSETS 1,000 1,500 1,000 1,350

Accounts payable 0 500 0 0

Accrued operating expenses 0 0 0 250

Income tax payable 0 0 0 25

Long-term debt 300 300 300 300

Common debt 700 700 700 700

Retained earnings 0 0 0 75

TOTAL DEBT AND EQUITY 1,000 1,500 1,000 1,350

Changes:

September

to October

+900

–500

–50

+250

+25

+75

Changes in Pokey’s Balance Sheet

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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  Operating expenses of $250

expenses of $250

Increase accumulated depreciation of $50  Depreciation expense of $50

Increase accrued taxes of $25  Tax expense of $25

Pokey, Inc.’s Monthly Balance Sheets

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Changes:

October to

November

+650

–900

–250

July Aug. Sept. Oct. Nov.

Cash 400 400 (100) (100) 550

Accounts receivable 0 0 0 900 0

Inventory 0 500 500 0 0

Fixed assets 600 600 600 600 600

Accumulated depreciation 0 0 0 (50) (50)

TOTAL ASSETS 1,000 1,500 1,000 1,350 1,100

Accounts payable 0 500 0 0 0

Accrued operating expenses 0 0 0 250 0

Income tax payable 0 0 0 25 25

Long-term debt 300 300 300 300 300

Common debt 700 700 700 700 700

Retained earnings 0 0 0 75 75

TOTAL DEBT AND EQUITY 1,000 1,500 1,000 1,350 1,100

Pokey’s November Income

Statement

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Sales revenue 900

Cost of goods sold (500)

Gross profit 400

Operating expenses:

Cash (250)

Depreciation expense (50)

Total operating expenses (300)

Operating income 100

Income tax (25%) (25)

Net income 75

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

22–17

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Managing Cash Flows (cont.)

 Net Profit

The difference between revenue and expenses

 The Growth Trap

A cash shortage (cash crunch) resulting from rapid

growth

22–18

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Flow of Cash Through a Business22.4

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.

22–20

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Managing Accounts Receivable

(cont.)

 Days Sales Outstanding

◦ Average collection period—number of days, on average, a firm is extending credit to its customers.

22–21

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Days sales outstanding =

Accounts receivable

Annual credit sales ÷ 365 daysExample: Fast Co. Slow Co.

Total sales $1,000,000 $1,000,000

Credit sales 700,000 700,000

Average credit sales per day 1,918 1,918

Accounts receivable 48,000 63,300

Fast Co.’s

Days Sales

Outstanding

48,000

= 25 days 700,000 ÷

365

Slow Co.’s

Days Sales

Outstanding

63,300

= 33 days700,000 ÷ 365

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.

22–22

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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

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Managing Accounts Receivable

(cont.)

 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.

22–24

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Managing Accounts Receivable

(cont.)

 Accounts Receivable Financing (cont.)

Factoring

Advantage

 Immediate cash flow

Disadvantages

 High interest costs for loans funds and discounts for

factored receivables

 Loss of receivables as collateral in borrowing

22–25

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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.

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Days in inventory =

Inventory

Cost of goods sold ÷ 365 days

Managing Inventory (cont.)

 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.

22–27

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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.

22–28

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Managing Accounts Payable

(cont.)

 Timing

“Buy now, pay later”—pay early enough to

get cash discounts and timely enough to avoid

late-payment fees.

22–29

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An Accounts Payable Timetable for Terms of 3/10, Net 30

Annualized

interest rate discount%Cash-100

%discount Cash x

perioddiscount Cash-periodNet

yearinDays =

3-100

3 X

10-30

365 =

56.4%or0.564,0.030928x18.25 ==

22.5

Capital Budgeting

 Capital Budgeting Analysis

Helps managers make decisions about

long-term investments such as:

Developing new products

Constructing new facilities

Replacing equipment

Expanding sales territories

22–31

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Capital Budgeting (cont.)

 Capital Budgeting Analysis (cont.)

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.

22–32

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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?

22–33

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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.

22–34

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Capital Budgeting Techniques

(cont.)  Accounting Return on

Investment

The average annual

after-tax profits relative

to the average book

value of an investment.

22–35

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Year After-Tax Profits

1 1,000

2 2,000

3 2,500

4 3,000

000010

0003500200020001

+++

= ,

,,,, Accounting return

on investment

42.5%or0.425, 5,000

2,125 ==

Initial investment = $10,000

Capital Budgeting Techniques

(cont.)  Payback Period

◦ Measuring the amount of time it will take to recover the cash outlay of an investment.

22–36

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After-Tax

Year Profits

1–2 1,000

3–6 2,000

7–10 2,500

After-Tax

Cash Flows

2,500

3,500

4,000

Investment Recovery

Year 1-2 Year 3-5

5,000

10,500

Original Investment = $15,000

Acceptable payback period= 5 years

Payback period = 4.86 years

Annual Depreciation = $1,500

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.

22–37

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Discounted Cash Flows (cont.)

 Discounted Cash Flows (DCF)

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.

22–38

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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

22–39

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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

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