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7/5/2003

Chapter 22. Model for managing and financing current assets

Chapter 22 deals with working capital management. Two useful tools for working capital management are (1) the
cash conversion cycle and (2) the cash budget. This spreadsheet model shows how these tools are used to help
manage current assets.
THE CASH CONVERSION CYCLE
The cash conversion cycle model 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, which is
the average time required to convert materials into finished goods and then to sell those goods. The inventory conversion period
is measured by dividing inventory by the average daily sales. (2) The receivables collection period, which is the length of time
required to convert the firm's receivables into cash, or how long it takes to collect cash from a sale. The receivables collection
period is measured by the days sales outstanding ratio (DSO), which is accounts receivable divided by average daily sales. (3)
The payables deferral period, which is the average length of time between the purchase of materials and labor and payment for
them. The payable deferral period is calculated by dividing average accounts payable by purchases per day (cost of goods sold
divided by 360 or 365 days). The cash conversion cycle is determined by the following formula:
Cash
conversion
cycle

Inventory
conversion
period

Receivables
collection
period

Payables
deferral
period

Problem
Calculate the cash conversion cycle for the Real Time Computer Company. Annual sales are $10 million, and the annual cost of
goods sold is $8 million. The average levels of inventory, receivables, and accounts payable are $2,000,000, $657,534, and
$657,534, respectively. RTCC uses a 365-day accounting year.
Sales
COGS
Inventories
AR
AP
Days/year

$10,000,000
$8,000,000
$2,000,000
$657,534
$657,534
365

Cash conversion cycle (CCC)

160000000 438356.164384
145000000 397260.273973
15000000
43000000
29000000
365
=
=
=
=

37.76

98.09375

135.85

62.85

Inventory conversion period

Inventory/COGSperday
Inventory/Sales per day
73.00
67.00

73

Receivables collection
period

Payables deferral
period

+
+

AR/Sales per day

24.00

AP/COGS per day

30.00

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It takes 73 days to make and then sell a computer, and another 24 days to collect cash after the sale, or a total of 97 days
between spending money and collecting cash. However, the company can delay payment for parts and labor for 30 days.
Therefore, the net days the firm must finance its labor and purchases is 97 - 30 = 67 days, which is the cash conversion cycle.
Companies like to shorten their cash conversion cycles as much as possible without adversely impacting operations. As noted in
the chapter, Amazon.com and Dell have been able to produce goods on demand, hence to reduce the inventory conversion
period to close to zero. In addition, since payments are made by credit card, the receivables collection period is also close to zero.
Then, if they pay suppliers after a 20 payables deferral period, they can end up with a NEGATIVE cash conversion cycle. In
that case, the faster the firms grow, the more cash they generate.
Improvement in the Cash Conversion Cycle
Suppose RTC can cut its inventory conversion period to 65 days and its receivables collection period to 23 days. Suppose it can
also increase its payables deferral period by 1 day. Assuming sales and costs remain unchanged, what impact will this have on
free cash flows?

Annual sales
Costs of goods sold (COGS)

Original
$10,000,000
8,000,000

Improved
10,000,000
8,000,000

73
24
30
67

65
23
31
57

Inventory conversion period (days)

Receivables collection period (days)
Payable deferral period (days)
Cash conversion cycle (days)

$2,000,000

$1,780,822

70

Inventorya
Receivablesb

657,534

630,137

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72
73
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75
76

Payablesc

657,534

679,452

Net operating working capital (NOWC)

$2,000,000
Improvement in FCF = Original NOWC - Improved NOWC

$1,731,507
$268,493

Notes: a Inventory = (Inventory conversion period)(Sales/365)

77

Receivables = (Receivables collection period)(Sales/365)

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Payables = (Payables deferral period)(Sales/365)

THE CASH BUDGET

The cash budget is a statement that shows cash flows over a specified period of time. Generally, firms use a monthly cash
budget for the coming year, plus a more detailed daily or weekly cash budget for the coming month. Monthly cash budgets are
used for long-range planning, and daily or weekly budgets for actual cash control. The following monthly cash budget
examines MicroDrive Inc. for the last 6 months of 2005.
Input Data
Collections during month of sale
Collections during 1st month after sale
Collections during 2nd month after sale
Discount on first month collections
Purchases as a % of next month's sales
Lease payments

20% Assumed constant. Don't change.

70% Formula. Don't change.
10% Allow this value to change to reflect slower collections.
2%
70%
$15

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Construction cost for new plant (Oct)
Target cash balance
Sales adjustment factor

100
$10
0.00

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THE CASH BUDGET

Collections and purchases worksheet

Sales (gross)
Collections
During month of sale
During first month after sale
During second month after sale
Total collections

May

June

July

August

September

October

$200

Purchases
70% of next months sales
Payments on last month's purchases

$250

$210

Cash gain or loss for month

Collections
Payments for purchases
Wages and salaries
Lease payments
Other expenses
Taxes
Payment for plant construction
Total payments
Net cash gain (loss) during month
Loan requirement or cash surplus
Cash at start of month if no borrowing
Cumulative cash
Target cash balance
Cumulative surplus cash or loans
outstanding to maintain $10 target cash balance
Max loan:

$300

$400

$500

$350

$250

$200

59
175
20
$254

78
210
25
$313

98
280
30
$408

69
350
40
$459

49
245
50
$344

39
175
35
$249

$280
$210

$350
$280

$245
$350

$175
$245

$140
$175

$140

$254
210
30
15
10

$313
280
40
15
15

$408
350
50
15
20
30

$459
245
40
15
15

$344
175
30
15
10

$249
140
30
15
10
20

$265
($11)

$350
($37)

$465
($57)

100
$415
$44

$230
$114

$215
$34

$ 15
$4
$10

$4
($33)
$10

($33)
($90)
$10

($90)
($46)
$10

($46)
$68
$10

$68
$102
$10

($6)

($43)

($100)

($56)

$58

$92

Question: If the percent of customers who pay in the 2nd month after the sale increased due to poor credit
management, how would this affect the maximum required loan?
Answer: Do a sensitivity analysis.
% paying Max Req'd Loan
late
$ 100
0%
$ 80
10%
$ 100
20%
$ 120
30%
$ 140
40%
$ 160
50%
$ 180
60%
$ 206
70%
$ 236
80%
$ 266

Effect of Late Payment % on Loan Requirements

$ 300
$ 200
$ 100
$0
0%

10%

20%

November December

$100

Loan Re qu i re m e n t

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30%

40%

50%

% Paying Late

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60%

70%

80%

$ 300
$ 200
$ 100
$0
0%

10%
E

20%

30%

40%

50%

% Paying
GLate

148

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60%
H

70%
I

80%

You could do all sorts of "What if" analyses. For example, what if sales declined by 50%. How would that affect the max loan
requirement?
Answer: Just change sales and observe the change in the max loan requirement. The max loan jumps from $100 to
$231. 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?
Here is a sensitivity analysis for the effect of changes in sales on the max loan requirement:
% Change
in Sales
-100%
-50%
0%
50%
100%

Max Loan
$ 100
$ 535
$ 231
$ 100
$ 32
-$ 34

Max Loan Re qu ire d

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Max Loan Vs. Change in Sales

$ 600
$ 500
$ 400
$ 300
$ 200
$ 100
$0
-$ 100
-100%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

% Change in S ales

Question:

If both sales and collections change, what will happen to the max loan requirement?

Answer:

Do a sensitivity analysis.
Change
in Sales
$100
-100%
-75%
-50%
-25%
0%
25%
50%
75%
100%

Maximum Loan Required

0%
$ 535
$ 377
$ 219
$ 121
$ 80
$ 41
$2
-$ 33
-$ 48

10%
$ 535
$ 378
$ 231
$ 143
$ 100
$ 66
$ 32
-$ 2
-$ 34

% Collections in 2nd month

20%
30%
40%
$ 535
$ 535
$ 535
$ 380
$ 381
$ 382
$ 246
$ 261
$ 276
$ 166
$ 188
$ 211
$ 120
$ 140
$ 160
$ 91
$ 116
$ 141
$ 62
$ 92
$ 122
$ 33
$ 68
$ 103
$5
$ 45
$ 85

50%
$ 535
$ 383
$ 291
$ 233
$ 180
$ 166
$ 152
$ 138
$ 125

You can see from the table that, from the base case (collections = 10%, change in sales = 0), an increase
in late payers increases the loan requirement, as does a decline in sales.

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60%
$ 535
$ 385
$ 306
$ 256
$ 206
$ 191
$ 182
$ 173
$ 165

70%
$ 535
$ 386
$ 321
$ 278
$ 236
$ 216
$ 212
$ 208
$ 205

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TRADE CREDIT
Accounts payable, or trade credit, is the largest single category of operating current liabilities on the balance sheet, representing
approximately 40 percent of the average nonfinancial corporation's current liabilities. Accounts payable, like accruals, is a
spontaneous liability because it generally experiences corresponding growth to a firm's productive assets. A firm's credit policy
tells us the terms by which they allow customers to purchase goods on credit. For example, Microchip Electronics' credit policy
is on terms of 2/10, net 30. This is interpreted as a 2% discount if paid within the first ten days, but the full invoice amount is
due within 30 days if the discount is not taken. If we are told that Microchip's annual purchases of $11,760,000, we can
calculate the firm's average daily A/P. (We will use a 365-day accounting year.)

Annual chip purchases

Days/year
Daily A/P

$11,760,000
365
$32,219

From the firm's trade terms, we also know the following:

% Discount
Discount period (in days)
Days until due

2%
10
30

If Microchip's customers decide to take advantage of the discount, the average accounts payable can be determined by
multiplying the daily accounts payable by the discount period.
Average A/P (w/discount)

$322,192

However, if the firm's customers decide to not take advantage of the discount, we assume that they will take the full term to pay
off the debt. We can determine the average accounts payable under this scenario, too.
Average A/P (w/o discount)

$966,575

The difference between these two average accounts payable figures tells the amount of credit Microchip offers to its customers.
Microchip's customers can use this trade credit to build up its cash account, to pay off debt, to expand inventories, or to extend
credit to its customers.
Trade Credit

$644,384

We have previously stated that Microchip's annual sales to its customers amounted to $11,760,000, and that they offer a 2%
discount for early payment. Dividing annual purchases by the percentage price paid (98%) gives us the total cost of goods. This
cost of goods is composed of an explicit cost ($11,760,000) and a finance charge (the 2%).
Total cost of goods
Finance charge

$12,000,000
$240,000

Dividing the trade finance charge by the trade credit gives us the nominal annual cost of the additional trade credit.
Nominal annual cost

37.24%

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The nominal annual cost can broken into two components: the cost per period of trade credit (discount percent divided by 100% - discount
percent) times the periods per year (365 divided by total days until required payment - the discount period). To check ourselves, we will
recalculate the nominal annual cost using this method.
Cost per period of trade credit
Periods per year
Nominal annual cost

2.04%
18.25
37.24%

We are not as concerned with the nominal cost as we are with the effective cost.
We can calculate the effective cost by using the formula: (1 + cost per period of trade credit) periods per year
Effective annual rate

44.59%

As always, we should not be solely concerned with the current situation. For example, suppose that Microchip extended its trade policy to
allow customers to take up to 60 days to make full payment. What would its new effective annual cost be? Notice, that this change in policy
has no effect on the cost per period of trade credit, but the periods per year does change.
If payment due after
New effective annual rate

60
15.89%

While we are considering how changes in trade policy changes the cost of credit, let us look at the following scenarios.

Credit terms
1/10, net 20
1/10, net 30
2/10, net 20
3/15, net 45

% discount
1%
1%
2%
3%

discount ends
10
10
10
15

payment due
20
30
20
45

Cost of additional credit if

the discount is not taken
Nominal
Effective
36.87%
44.32%
18.43%
20.13%
74.49%
109.05%
37.63%
44.86%

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