Chapter 15 Working-Capital Management Learning Objectives • Describe the risk-return tradeoff involved in managing working capital. • Describe the determinants of net working capital. • Compute the firm’s cash conversion cycle. • Estimate the cost of short-term credit. • Identify the primary sources of short-term credit. 15-2 © 2017 Pearson Education, Inc. All rights reserved. Working Capital • Gross working capital - The firm’s total investment in current assets. • Net working capital - The difference between the firm’s current assets and its current liabilities. • This chapter focuses on net working capital. 15-3 © 2017 Pearson Education, Inc. All rights reserved. Short-Term Sources of Financing • Include current liabilities, i.e., all forms of financing that have maturities of 1 year or less. • Two issues to consider: – How much short-term financing should the firm use? – What specific sources of short-term financing should the firm select? 15-4 © 2017 Pearson Education, Inc. All rights reserved. How Much Short-Term Financing Should a Firm Use? • This question is addressed by hedging principle of working-capital management. 15-5 © 2017 Pearson Education, Inc. All rights reserved. What Specific Sources of Short-Term Financing Should the Firm Select? • Three basic factors influence the decision: • The effective cost of credit • The availability of credit in the amount needed and for the period that financing is required • The influence of a particular credit source on the cost and availability of other sources of financing 15-6 © 2017 Pearson Education, Inc. All rights reserved. MANAGING CURRENT ASSETS AND LIABILITIES 15-7 © 2017 Pearson Education, Inc. All rights reserved. Current Assets • A firm’s current assets are assets that are expected to be converted to cash within 1 year, such as cash and marketable securities, accounts receivable, inventories. 15-8 © 2017 Pearson Education, Inc. All rights reserved. The Risk-Return Trade-Off • Holding more current assets will reduce the risk of illiquidity. • However, liquid assets like cash and marketable securities earn relatively less compared to other assets. Thus, larger amounts of liquid investments will reduce overall rate of return. • The trade-off: Increased liquidity must be traded off against the firm’s reduction in return on investment. 15-9 © 2017 Pearson Education, Inc. All rights reserved. Use of Current versus Long-Term Debt • Other things remaining the same, the greater the firm’s reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity. • The trade-off: A firm can reduce its risk of illiquidity through the use of long-term debt at the expense of a reduction in its return on invested funds. This trade-off involves an increased risk of illiquidity versus increased profitability. 15-10 © 2017 Pearson Education, Inc. All rights reserved. The Advantages of Current Liabilities: Return • Flexibility – Current liabilities can be used to match the timing of a firm’s needs for short-term financing. Example: Obtaining seasonal financing versus long-term financing for short-term needs. • Interest Cost – Interest rates on short-term debt are lower than on long-term debt. 15-11 © 2017 Pearson Education, Inc. All rights reserved. The Disadvantages of Current Liabilities: Risk • Risk of illiquidity increases due to: – Short-term debt must be repaid or rolled over more often – Uncertainty of interest costs from year to year 15-12 © 2017 Pearson Education, Inc. All rights reserved. DETERMINING THE APPROPRIATE LEVEL OF WORKING CAPITAL 15-13 © 2017 Pearson Education, Inc. All rights reserved. The Appropriate Level of Working Capital • Managing working capital involves interrelated decisions regarding investments in current assets and use of current liabilities. • Hedging principle or principle of selfliquidating debt provides a guide to the maintenance of appropriate level of liquidity. 15-14 © 2017 Pearson Education, Inc. All rights reserved. The Hedging Principle • The hedging principle involves matching the cash-flow-generating characteristics of an asset with the maturity of the source of financing used to finance its acquisition. • Thus, a seasonal need for inventories should be financed with a short-term loan or current liability. • On the other hand, investment in equipment that is expected to last for a long time should be financed with long-term debt. 15-15 © 2017 Pearson Education, Inc. All rights reserved. 15-16 © 2017 Pearson Education, Inc. All rights reserved. Permanent and Temporary Assets Permanent investments – Investments that the firm expects to hold for a period longer than one year Temporary investments – Current assets that will be liquidated and not replaced within the current year 15-17 © 2017 Pearson Education, Inc. All rights reserved. Sources of Financing • Total assets will be equal to sum of temporary, permanent, and spontaneous sources of financing. 15-18 © 2017 Pearson Education, Inc. All rights reserved. Temporary and Permanent Sources • Temporary sources of financing consist of current liabilities such as short-term secured and unsecured notes payable. • Permanent sources of financing include intermediate-term loans, long-term debt, preferred stock, and common equity. 15-19 © 2017 Pearson Education, Inc. All rights reserved. Spontaneous Sources of Financing • Spontaneous sources of financing arise spontaneously in the firm’s day-to-day operations. – Trade credit is often made available spontaneously or on demand from the firm’s suppliers when the firm orders its supplies or more inventory of products to sell. Trade credit appears on balance sheet as accounts payable. – Wages and salaries payable, accrued interest, and accrued taxes also provide valuable sources of spontaneous financing. 15-20 © 2017 Pearson Education, Inc. All rights reserved. 15-21 © 2017 Pearson Education, Inc. All rights reserved. THE CASH CONVERSION CYCLE 15-22 © 2017 Pearson Education, Inc. All rights reserved. The Cash Conversion Cycle • A firm can minimize its working capital by speeding up collection on sales, increasing inventory turns, and slowing down the disbursement of cash. This is captured by the cash conversion cycle (CCC). 15-23 © 2017 Pearson Education, Inc. All rights reserved. 15-24 © 2017 Pearson Education, Inc. All rights reserved. ESTIMATING THE COST OF SHORTTERM CREDIT USING THE APPROXIMATE COST-OF-CREDIT FORMULA 15-25 © 2017 Pearson Education, Inc. All rights reserved. Cost of Short-Term Credit 15-26 © 2017 Pearson Education, Inc. All rights reserved. APR example • A company plans to borrow $1,000 for 90 days. At maturity, the company will repay the $1,000 principal amount plus $30 interest. What is the APR? 15-27 © 2017 Pearson Education, Inc. All rights reserved. Annual Percentage Yield (APY) • APR does not consider compound interest. To account for the influence of compounding, we must calculate APY or annual percentage yield. Where: i is the nominal rate of interest per year m is number of compounding periods within a year 15-28 © 2017 Pearson Education, Inc. All rights reserved. APY example • In the previous example, # of compounding periods 360/90 = 4 Rate = 12% 15-29 © 2017 Pearson Education, Inc. All rights reserved. APR or APY ? • Because the differences between APR and APY are usually small, we can use the simple interest values of APR to compute the cost of short-term credit. 15-30 © 2017 Pearson Education, Inc. All rights reserved. SOURCES OF SHORT-TERM CREDIT 15-31 © 2017 Pearson Education, Inc. All rights reserved. Sources of Short-Term Credit Short-term credit sources can be classified into two basic groups: • Unsecured sources • Secured sources 15-32 © 2017 Pearson Education, Inc. All rights reserved. Unsecured Loans • Unsecured loans include all of those sources that have as their security only the lender’s faith in the ability of the borrower to repay the funds when due. • Major sources: – accrued wages and taxes, trade credit, unsecured bank loans, and commercial paper 15-33 © 2017 Pearson Education, Inc. All rights reserved. Secured Loans • Involve the pledge of specific assets as collateral in the event the borrower defaults in payment of principal or interest • Primary suppliers: – Commercial banks, finance companies, and factors • Principal sources of collateral: – Accounts receivable and inventories 15-34 © 2017 Pearson Education, Inc. All rights reserved. Unsecured Sources: Accrued Wages and Taxes • Since employees are paid periodically (biweekly or monthly), firms accrue a wagepayable account that is, in essence, a loan from their employees. • Similarly, if taxes are deferred or paid periodically, the firm has the use of the tax money. 15-35 © 2017 Pearson Education, Inc. All rights reserved. Unsecured Sources: Trade Credit • Trade credit arises spontaneously with the firm’s purchases. Often, the credit terms offered with trade credit involve a cash discount for early payment. • For example, the terms “2/10 net 30” means a 2% discount is offered for payment within 10 days, or the full amount is due in 30 days. • In this case, a 2% penalty is involved for not paying within 10 days. 15-36 © 2017 Pearson Education, Inc. All rights reserved. 15-37 © 2017 Pearson Education, Inc. All rights reserved. Effective Cost of Passing Up a Discount • Ex.: Terms 2/10 net 30 • The equivalent APR of this discount is: • The effective cost of delaying payment for 20 days is 36.73%. 15-38 © 2017 Pearson Education, Inc. All rights reserved. Unsecured Sources: Bank Credit • Commercial banks provide unsecured shortterm credit in two forms: – Lines of credit – Transaction loans (notes payable) 15-39 © 2017 Pearson Education, Inc. All rights reserved. Line of Credit – Informal agreement between a borrower and a bank about the maximum amount of credit the bank will provide the borrower at any one time. – There is no legal commitment on the part of the bank to provide the stated credit. – Banks usually require that the borrower maintain a minimum balance in the bank throughout the loan period (known as compensating balance). – Interest rate on a line of credit tends to be floating. 15-40 © 2017 Pearson Education, Inc. All rights reserved. Revolving Credit – Revolving credit is a variant of the line of credit form of financing. – A legal obligation is involved. 15-41 © 2017 Pearson Education, Inc. All rights reserved. Transaction Loans • A transaction loan is made for a specific purpose. This is the type of loan that most individuals associate with bank credit and is obtained by signing a promissory note. 15-42 © 2017 Pearson Education, Inc. All rights reserved. Unsecured Sources: Commercial Paper • The largest and most credit-worthy companies are able to use commercial paper—a short-term promise to pay that is sold in the market for short-term debt securities. • Maturity: Usually 6 months or less. • Interest Rate: Slightly lower (1/2 to 1%) than the prime rate on commercial loans. • New issues of commercial paper are placed directly or dealer placed. 15-43 © 2017 Pearson Education, Inc. All rights reserved. Commercial Paper: Advantages • Interest rates – Rates are generally lower than rates on bank loans • Compensating-balance requirement – No minimum balance requirements are associated with commercial paper • Amount of credit – Offers the firm with very large credit needs a single source for all its short-term financing • Prestige – Signifies credit status 15-44 © 2017 Pearson Education, Inc. All rights reserved. Secured Sources of Loans • Secured loans have assets of the firm pledged as collateral. If there is a default, the lender has first claim to the pledged assets. Because of its liquidity, accounts receivable is regarded as the prime source for collateral. • Accounts Receivable Loans – Pledging Accounts Receivable – Factoring Accounts Receivable • Inventory Loans 15-45 © 2017 Pearson Education, Inc. All rights reserved. Pledging Accounts Receivable • Borrower pledges accounts receivable as collateral for a loan obtained from either a commercial bank or a finance company. • The amount of the loan is stated as a percentage of the face value of the receivables pledged. • If the firm pledges a general line, then all of the accounts are pledged as security (simple and inexpensive). 15-46 © 2017 Pearson Education, Inc. All rights reserved. Pledging Accounts Receivable • If the firm pledges specific invoices, each invoice must be evaluated for creditworthiness (more expensive). • Credit Terms: Interest rate is 2–5% higher than the bank’s prime rate. In addition, handling fee of 1– 2% of the face value of receivables is charged. • While pledging has the attraction of offering considerable flexibility to the borrower and providing financing on a continuous basis, the cost of using pledging as a source of short-term financing is relatively higher compared to other sources. 15-47 © 2017 Pearson Education, Inc. All rights reserved. Factoring Accounts Receivable • Factoring accounts receivable involves the outright sale of a firm’s accounts to a financial institution called a factor. • A factor is a firm (such as commercial financing firm or a commercial bank) that acquires the receivables of other firms. The factor bears the risk of collection in exchange for a fee of 1–3% of the value of all receivables factored. 15-48 © 2017 Pearson Education, Inc. All rights reserved. Secured Sources: Inventory Loans • These are loans secured by inventories. • The amount of the loan that can be obtained depends on the marketability and perishability of the inventory. 15-49 © 2017 Pearson Education, Inc. All rights reserved. Types of Inventory Loans Floating or Blanket Lien Agreement – The borrower gives the lender a lien against all its inventories. Chattel Mortgage Agreement – The inventory is identified and the borrower retains title to the inventory but cannot sell the items without the lender’s consent. 15-50 © 2017 Pearson Education, Inc. All rights reserved. Types of Inventory Loans Field Warehouse-Financing Agreement – Inventories used as collateral are physically separated from the firm’s other inventories and are placed under the control of a third-party field-warehousing firm. Terminal Warehouse Agreement – Inventories pledged as collateral are transported to a public warehouse that is physically removed from the borrower’s premises. 15-51 © 2017 Pearson Education, Inc. All rights reserved. Key Terms • • • • • • • • • • • • 15-52 Chattel mortgage agreement Commercial paper Compensating balance Factor Factoring accounts receivable Field-warehouse agreement Floating lien agreement Gross working capital Hedging principle Inventory loans Line of credit Net working capital © 2017 Pearson Education, Inc. All rights reserved. • Operating net working capital • Permanent investments • Pledging accounts receivable • Revolving credit agreement • Secured loans • Temporary investments • Terminal-warehouse agreement • Trade credit • Transaction loan • Unsecured loans Chapter 17 Cash, Receivables, and Inventory Management Learning Objectives • Understand the problems inherent in managing the firm’s cash balances. • Evaluate the costs and benefits associated with managing a firm’s credit policies. • Understand the financial costs and benefits of managing firm’s investment in inventory. 17-2 © 2017 Pearson Education, Inc. All rights reserved. MANAGING THE FIRM’S INVESTMENT IN CASH AND MARKETABLE SECURITIES 17-3 © 2017 Pearson Education, Inc. All rights reserved. Cash and Marketable Securities • Cash refers to currency and coins plus demand deposit accounts. • Marketable securities includes security investments the firm can quickly convert to cash balances. 17-4 © 2017 Pearson Education, Inc. All rights reserved. Why a Company Holds Cash Cash Flow Process • Two typical sources of cash: external and internal • Irregular increases or decreases in the firm’s cash holdings can come from several sources such as: – – – – 17-5 Sale of securities (stocks and bonds) Nonmarketable-debt contracts Payment of dividend, interest, tax bills Share repurchases © 2017 Pearson Education, Inc. All rights reserved. 17-6 © 2017 Pearson Education, Inc. All rights reserved. Three Motives for Holding Cash • Transactions Motive – Balances held to meet cash needs that arise in the ordinary course of doing business. • Precautionary Motive – Precautionary balance serves as a buffer – Maintain balances to satisfy possible, but as yet unknown, needs • Speculative Motive – Cash held to take advantage of potential profitmaking situations 17-7 © 2017 Pearson Education, Inc. All rights reserved. Cash Management Objectives and Decisions • Cash management program must minimize the firm’s risk of insolvency. • Insolvency—The situation in which the firm is unable to meet its maturing liabilities on time. • A company is technically insolvent in that it lacks the necessary liquidity to make prompt payment on its current debt obligations. 17-8 © 2017 Pearson Education, Inc. All rights reserved. The Trade-Off • A large cash balance will help minimize the chance of insolvency, but it penalizes the company’s profitability. • A smaller cash balance will increase the chance of insolvency, but it will free up excess cash for investment and enhance profitability. 17-9 © 2017 Pearson Education, Inc. All rights reserved. Cash Management Objectives Two prime objectives: • Enough cash must be on hand to meet disbursal needs in the course of doing business. • Investment in idle cash balances must be reduced to a minimum. 17-10 © 2017 Pearson Education, Inc. All rights reserved. Cash Management Objectives • Two conditions would allow the firm to operate for extended periods with cash balances near or at zero: – Completely accurate forecast of net cash flows over the planning horizon. – Perfect synchronization of cash receipts and disbursements. 17-11 © 2017 Pearson Education, Inc. All rights reserved. Cash Management Decisions • What can be done to speed up cash collections and slow down or better control cash outflows? • What should be the composition of a marketable securities portfolio? 17-12 © 2017 Pearson Education, Inc. All rights reserved. Collection and Disbursement Procedures • The efficiency of firm’s cash management program can be improved by: – accelerating cash receipts – improving the methods used to disburse cash 17-13 © 2017 Pearson Education, Inc. All rights reserved. Speeding up Collection • What can be done to accelerate collection procedures? – Reduce float – Lockbox system 17-14 © 2017 Pearson Education, Inc. All rights reserved. 17-15 © 2017 Pearson Education, Inc. All rights reserved. Float and Managing Cash Inflow • Float—The time from when a check is written until the actual recipient can draw upon or use the funds: – – – – 17-16 Mail float Processing float Transit float Disbursing float © 2017 Pearson Education, Inc. All rights reserved. Float and Managing Cash Inflow • Mail Float – Time lapse from the moment a customer mails a remittance check until the firm begins to process it. • Processing Float – The time required for the firm to process remittance checks before they can be deposited in the bank. 17-17 © 2017 Pearson Education, Inc. All rights reserved. Float and Managing Cash Inflow • Transit Float – The time necessary for a deposited check to clear through the commercial banking system and become usable funds to the company. • Disbursing Float – Availability of funds in the company’s bank account during the time the payment check is clearing through the banking system. 17-18 © 2017 Pearson Education, Inc. All rights reserved. Lockbox Arrangement • Commercial banking service where customers mail checks to a post office box (rather than company) to expedite cash collection – The bank providing the lock box service is authorized to open the box, collect the mail, process the checks, and deposit the checks directly into the company’s account. – See Figure 17-3 17-19 © 2017 Pearson Education, Inc. All rights reserved. 17-20 © 2017 Pearson Education, Inc. All rights reserved. Benefits of Lockbox Arrangement • Reduces mail and processing float and can reduce transit float • Funds deposited in this manner are usually available for company use in one business day or less • Elimination of clerical functions • Early knowledge of dishonored checks 17-21 © 2017 Pearson Education, Inc. All rights reserved. Benefit of Float Reduction • The financial benefit of float reduction can be calculated as follows: – Sales per day × days of float reduction × assumed yield – Where: – Sales per day = Annual revenues / days in year 17-22 © 2017 Pearson Education, Inc. All rights reserved. Example • If a company with daily sales of $69,594,521 could invest in marketable securities to yield 6 percent annually and could eliminate 4 days of float, what would be the annual savings? = $69,594,521 * 4 * 0.06 = $16,702,685 17-23 © 2017 Pearson Education, Inc. All rights reserved. Managing the Cash Outflow • Goal: To increase company’s float by slowing down the disbursement and collection process through: – Zero balance accounts (ZBA) – Payable-through drafts (PTD) 17-24 © 2017 Pearson Education, Inc. All rights reserved. Zero Balance Accounts (ZBA) • Permit centralized control over the cash outflows while maintaining divisional disbursing authority. • Process: Establish zero balance accounts for all of the firm’s disbursing units. These accounts are all in the same concentration bank. Checks are drawn against these accounts, with the balance in each account never exceeding $0. Divisional disbursing authority is thereby maintained at the local level of managers. 17-25 © 2017 Pearson Education, Inc. All rights reserved. Benefits of Zero Balance Accounts • Achieves better control over its cash payments • Reduces excess cash balances held in regional banks for disbursing purposes • Increases disbursing float 17-26 © 2017 Pearson Education, Inc. All rights reserved. Payable-Through Drafts (PTD’s) • Legal instruments that have the physical appearance of ordinary checks but are not drawn on a bank. Instead, PTDs are drawn on and payment is authorized by the issuing firm against its demand deposit account. • Process: Field office issues drafts rather than checks to settle up payables. • Benefit: Achieves effective “control-office” control over field-authorized payments. 17-27 © 2017 Pearson Education, Inc. All rights reserved. 17-28 © 2017 Pearson Education, Inc. All rights reserved. Evaluating the Costs of Cash Management Services P = (D)(S)(i) P = per check processing cost if the system is adopted D = days saved in the collection process or float reduction S = average check size in dollars i = daily, before-tax opportunity cost or rate of return of carrying cash 17-29 © 2017 Pearson Education, Inc. All rights reserved. The Composition of a Marketable-Securities Portfolio • The general selection criteria for proper marketable-securities mix include: – – – – – 17-30 Financial risk Interest rate risk Liquidity Taxability Yields © 2017 Pearson Education, Inc. All rights reserved. Financial Risk • Refers to the uncertainty of expected returns from a security attributable to possible changes in the financial capacity of the security issuer to make future payments to the security owner. • If the chance of default on the terms of the instrument is high, then the financial risk is said to be high. 17-31 © 2017 Pearson Education, Inc. All rights reserved. Interest Rate Risk • Interest rate risk refers to the uncertainty of expected return from a financial instrument attributable to changes in interest rates. 17-32 © 2017 Pearson Education, Inc. All rights reserved. 17-33 © 2017 Pearson Education, Inc. All rights reserved. Liquidity • Liquidity refers to the ability to convert a security into cash. • Should an unforeseen event require that a significant amount of cash be immediately available, then a sizable portion of the portfolio might have to be sold. Manager should prefer securities that can be sold at or near its prevailing market price. 17-34 © 2017 Pearson Education, Inc. All rights reserved. Taxability • The tax treatment of the income a firm receives from its security investments does not affect the ultimate mix of the marketable-securities portfolio as much as the criteria mentioned earlier since interest income from most instruments is taxable at the federal level. 17-35 © 2017 Pearson Education, Inc. All rights reserved. 17-36 © 2017 Pearson Education, Inc. All rights reserved. Yields • Yield is affected by previous factors of financial risk, interest rates, liquidity and taxability. • The yield criterion involves an evaluation of the risks and benefits inherent in all of these factors. For example, if a given risk is assumed, such as lack of liquidity, a higher yield may be expected on the non-liquid instrument. 17-37 © 2017 Pearson Education, Inc. All rights reserved. 17-38 © 2017 Pearson Education, Inc. All rights reserved. Marketable Security Alternatives • Money market securities generally have short-term maturity and are highly marketable. • Characteristics of Marketable Securities in terms of five key attributes are: – – – – – 17-39 Denominations in which securities are available, Maturities that are offered, Basis used, Liquidity of the instrument, and Taxability of the investment returns © 2017 Pearson Education, Inc. All rights reserved. Examples of Marketable Securities • U.S. Treasury Bills – Direct obligations of the U.S. government sold by the U.S. Treasury on a regular basis. • Federal Agency Securities – Debt obligations of corporations and agencies that have been created to effect various lending programs of the U.S. government. 17-40 © 2017 Pearson Education, Inc. All rights reserved. Examples of Marketable Securities • Banker’s Acceptances – Draft (order to pay) drawn on a specific bank by an exporter in order to obtain payment for goods shipped to a customer who maintains an account with that specific bank. • Negotiable Certificates of Deposit – Marketable receipt for funds that have been deposited in a bank for a fixed period. 17-41 © 2017 Pearson Education, Inc. All rights reserved. Examples of Marketable Securities • Commercial paper – Short-term unsecured promissory notes sold by large businesses. • Repurchase agreements – Legal contracts that involve the actual sale of securities by a borrower to the lender, with a commitment on the part of the borrower to repurchase the securities at the contract price plus a stated interest charge. • Money market mutual funds – Pooling of the funds of large number of small savers. 17-42 © 2017 Pearson Education, Inc. All rights reserved. 17-43 © 2017 Pearson Education, Inc. All rights reserved. 17-44 © 2017 Pearson Education, Inc. All rights reserved. MANAGING THE FIRM’S INVESTMENT IN ACCOUNTS RECEIVABLE 17-45 © 2017 Pearson Education, Inc. All rights reserved. Accounts Receivable Management • Accounts receivable is less liquid compared to cash and marketable securities. Account receivables typically comprise 25% of a firm’s assets. • Size of investment in accounts receivable is determined by: – The percentage of credit sales to total sales – The level of sales – Credit and collection policies 17-46 © 2017 Pearson Education, Inc. All rights reserved. 17-47 © 2017 Pearson Education, Inc. All rights reserved. Terms of Sale— A Decision Variable • Identify the possible discount for early payment, the discount period, and the total credit period. – They are stated in the form a/b, net c – Thus a customer can deduct a% if paid within b days, otherwise it must be paid within c days. • Example 1/10, net 45 ==> Discount of 2% if paid within 10 days; otherwise due in 45 days. 17-48 © 2017 Pearson Education, Inc. All rights reserved. The Type of Customer— A Decision Variable • This involves determining the type of customer who qualifies for trade credit. • Need to consider the costs of credit investigation, collection costs, default costs. • May use credit scoring or a numerical evaluation of each applicant to determine their short-run financial well-being. 17-49 © 2017 Pearson Education, Inc. All rights reserved. Collection Effort— A Decision Variable • The probability of default increases with the age of the account. Thus, eliminating pastdue receivables is key. One common way of evaluating the situation is with ratio analysis – average collection period, ratio of receivables to assets, ratio of credit sales to receivables, ratio of bad debt to sales. • A direct tradeoff exists between collection expenses and lost goodwill on one hand and noncollection of accounts on the other. 17-50 © 2017 Pearson Education, Inc. All rights reserved. MANAGING THE FIRM’S INVESTMENT IN INVENTORY 17-51 © 2017 Pearson Education, Inc. All rights reserved. Inventory Management • Inventory management involves the control of the assets that are produced to be sold in the normal course of the firm’s operations. • The purpose of carrying inventory is to make each function of the business independent of each other function—so that delays or shutdowns in one area do not affect the production and sale of the final product. 17-52 © 2017 Pearson Education, Inc. All rights reserved. The Trade-Off • Risk: If inventory level is low, it is possible that there will be delays in production and customer delivery. • Return: Low inventory will reduce storage and handling costs and release funds tied up in inventory. Thus it will increase returns. • Similarly, high levels of inventory will reduce delays but increase costs. 17-53 © 2017 Pearson Education, Inc. All rights reserved. Types of Inventory • Raw materials inventory – Basic materials purchased to be used in the firm’s production operations • Work in process inventory – Partially finished goods requiring additional work before they become finished goods • Finished goods inventory – Goods on which production has been completed but are not yet sold 17-54 © 2017 Pearson Education, Inc. All rights reserved. Inventory Management Techniques • Effective inventory management is directly related to the size of the investment in inventory. • Effective management is essential to the goal of maximization of shareholder wealth. • To control the investment in inventory, management must solve two problems: – The order quantity problem – The order point problem 17-55 © 2017 Pearson Education, Inc. All rights reserved. The Order Quantity Problem • Involves determining the optimal order size for an inventory item given its expected usage, carrying costs, and ordering costs. 17-56 © 2017 Pearson Education, Inc. All rights reserved. Total Inventory Costs 17-57 © 2017 Pearson Education, Inc. All rights reserved. Total Inventory Costs • Economic order quantity (EOQ) attempts to determine the order size that will minimize total inventory costs. 17-58 © 2017 Pearson Education, Inc. All rights reserved. 17-59 © 2017 Pearson Education, Inc. All rights reserved. 17-60 © 2017 Pearson Education, Inc. All rights reserved. Assumptions of the EOQ Model • • • • • • 17-61 Constant or uniform demand A constant unit price Constant carrying costs Constant ordering costs Instantaneous delivery Independent orders © 2017 Pearson Education, Inc. All rights reserved. The Order Point Problem • The two most limiting assumptions in EOQ— constant demand and instantaneous delivery—are dealt with through the inclusion of safety stock. 17-62 © 2017 Pearson Education, Inc. All rights reserved. The Order Point Problem • Safety stock – Inventory held to accommodate any unusually large and unexpected usage during delivery time • Order point problem – The decision about how much safety stock to hold or how low the inventory should be depleted before it is ordered 17-63 © 2017 Pearson Education, Inc. All rights reserved. The Order Point Problem • Delivery-time stock—Inventory needed between the order date and the receipt of the inventory ordered. • The order point is reached when inventory falls to a level equal to the delivery-time stock plus the safety stock. See Figure 17-8. 17-64 © 2017 Pearson Education, Inc. All rights reserved. 17-65 © 2017 Pearson Education, Inc. All rights reserved. Just-in-Time Inventory System • The goal is to operate with the lowest average level of inventory possible. • Within the EOQ model, the basics are to: – Reduce ordering costs – Reduce safety stocks • This is achieved by attempts to receive continuous flow of deliveries of component parts. • The result is to actually have about 2 to 4 hours’ worth of inventory on hand. 17-66 © 2017 Pearson Education, Inc. All rights reserved. Inflation and EOQ • Inflation affects the EOQ model in two ways: – Anticipatory buying—buying in anticipation of a price increase to secure the goods at a lower cost. – Increased carrying costs—as inflation pushes up interest rates, the costs of carrying inventory increases. As “C” increases, the optimal EOQ declines in the EOQ model. 17-67 © 2017 Pearson Education, Inc. All rights reserved. Key Terms • • • • • • • • • 17-68 Anticipatory buying Cash Credit scoring Delivery-time stock Finished-goods inventory Float Insolvency Inventory management Just-in-time inventory control system © 2017 Pearson Education, Inc. All rights reserved. • • • • • • • • • Marketable securities Order point problem Order quantity problem Payable-through draft (PTD) Raw-materials inventory Safety stock Terms of sale Work-in-process inventory Zero balance accounts (ZBA)
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