Small Business Management Chapter 22 PowerPoint

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CHAPTER
22
Managing the
Firm’s Assets

LEARNING OBJECTIVES
By studying this chapter, you should be able to…
22-1 Describe the working capital cycle of a small business.
22-2 Identify the important issues in managing a firm’s cash flows.
22-3 Explain the critical issues in managing accounts receivable.
22-4 Discuss the key financial issues in managing inventory.
22-5 Describe the important issues in managing accounts payable.
22-6 Calculate and interpret a company’s cash conversion period.
22-7 Discuss the techniques commonly used in making capital
budgeting decisions.
22-8 Describe the capital budgeting practices of small firms.

22-1 THE WORKING
CAPITAL CYCLE (slide 1 of 3)
• Working capital is a firm’s current assets
(primarily cash, accounts receivable, and
inventory).
Net working capital Current assets Current (short-term) liabilities
 
• Working capital management – The
management of current assets and current
liabilities.
• Working capital cycle – The daily flow of
resources through a firm’s working capital
accounts.

22-1 THE WORKING
• The steps in a firm’s working capital cycle are as follows:
1. Purchase or produce inventory for sale, which increases
inventory on hand and (a) decreases cash if cash is used to
pay for the inventory or (b) increases accounts payable if the
inventory is purchased on credit.
2. (a) Sell the inventory for cash, which increases cash, or (b)
sell the inventory on credit, which increases accounts
receivable.
3. (a) Pay the accounts payable, which decreases accounts
payable and decreases cash, or (b) pay operating expenses
and taxes, which decreases cash.
4. Collect the accounts receivable when due, which decreases
accounts receivable and increases cash.
5. Begin the cycle again.

22.1 Working Capital Cycle

22-1 THE WORKING
• The only current liability included in the working capital cycle is
accounts payable, which affects the timing of payments for
inventory.
• Little can be done to “manage” accruals, so they are ignored as
part of the working capital cycle.
• A short-term bank note is not part of the working capital cycle.
• In this context, working capital should be thought of as the liquid
assets (cash and those soon to be converted into cash) that are
required to run and grow the business less any credit provided by
suppliers in the form of accounts payable.
• Depending on the industry, the working capital cycle may be long
or short.
• Whatever the industry, however, management should be working
continuously to shorten the cycle.

22-1a Timing and Size of Working
Capital Investments (slide 1 of 2)
• The working capital cycle begins with the
purchase or production of inventory and ends
with the collection of accounts receivable.

22.2 Working Capital Time Line (slide 1 of 2)
• The key dates are as follows:
• Day a: Inventory is ordered in anticipation of future sales.
• Day b: Inventory is received, and the supplier extends credit in the form of
accounts payable.
• Day c: Inventory is sold on credit.
• Day d: Accounts payable for purchases of inventory come due and are paid.
• Day e: Accounts receivable are collected.

22.2 Working Capital Time Line (slide 2 of 2)
• The investing and financing implications of the working capital cycle
are as follows:
• Money is invested in inventory from day b to day c.
• The supplier provides financing for the inventory from day b to day d.
• Money is invested in accounts receivable from day c to day e.
• Financing of the firm’s investment in accounts receivable must be
provided from day d to day e.

22-1a Timing and Size of Working
Capital Investments (slide 2 of 2)
• Cash conversion period – The time required
to convert paid-for inventory and accounts
receivable into cash.
• During this period, the firm no longer has the benefit
of supplier financing (accounts payable).
• The longer this period lasts, the greater the
potential cash flow problems for the firm.

22.3 Working Capital Time Line for Pokey, Inc.
• On August 15, Pokey, Inc., ordered inventory that it received on
August 31.
• Pokey, Inc., must pay its supplier for the inventory on September 30,
before eventually reselling it on October 15.
• It collects from the customers on November 30.
• Thus, the cash conversion period is 60 days, and the firm’s managers
must find a way to finance this investment in inventory and accounts
receivable or else the company will experience cash flow problems.

22.3 Working Capital Time Line for Quick Turn Company
• On August 15, Quick Turn Company ordered inventory that it received
on August 31.
• Quick Turn Company must pay its supplier for the inventory on
October 31.
• However, Quick Turn Company sells its product on September 30
and collects from its customers on October 31.
• Thus, there is no cash conversion period because the supplier is
essentially financing Quick Turn Company’s working capital needs.

22-1b Examples of Working
Capital Management (slide 1 of 8)
• To gain an even better understanding of the
working capital cycle, the next seven slides
show what happens to Pokey, Inc.’s, balance
sheet and income statement.

• July: Pokey, Inc., starts operations in July with $1,000,
financed by $300 in long-term debt and $700 in
common stock. At the outset, the owner purchased
$600 worth of fixed assets, leaving the remaining $400
in cash. At this point, the balance sheet would appear
as follows:
Cash $ 400
Fixed assets 600
TOTAL ASSETS $1,000
Long-term debt $ 300
Common stock 700
TOTAL DEBT AND EQUITY $1,000

• August: On August 15, the firm’s managers ordered $500 worth of
inventory, which was received on August 31. The supplier allowed Pokey,
Inc., 30 days from the time the inventory was received to pay for the
purchase. Thus, inventory and accounts payable both increased by $500
when the inventory was received. As a result of these transactions, the
balance sheet would appear as follows:

• September: On September 30, the firm paid for the
inventory. Both cash and accounts payable decreased
by $500, shown as follows:

• October: On October 15, merchandise was sold on credit for $900. The
firm incurred operating expenses in the amount of $250, to be paid in
early November. An additional $25 in accrued expenses resulted from
accruing taxes that will be owed on the firm’s earnings. Finally, in
October, the firm’s accountants recorded $50 in depreciation expenses,
resulting in accumulated depreciation of $50. The results are as follows:

• The relationship between Pokey, Inc.’s, balance sheet and income
statement is as follows:
Change in the Balance Sheet Effect on the Income Statement
Increase in accounts receivable of
$900
= Sales of $900
Decrease in inventory of $500 = Cost of goods sold of $500
Increase in accrued operating
expenses of $250
= Operating expenses of $250
Increase in accumulated
depreciation of $50
= Depreciation expense of $50
Increase in accrued taxes of $25 = Tax expense of $25

• November: In November, the accrued expenses were paid, which
resulted in a $250 decrease in accrued expenses. At the end of
November, the accounts receivable were collected, yielding a $900
increase in cash and a $900 decrease in accounts receivable. The final
series of balance sheets is as follows:

• The income statement for the period ending November 30 is as follows:
Sales revenue $ 900
Cost of goods sold (500)
Gross profit $ 400
Operating expenses:
Cash expense $(250)
Depreciation expense (50)
Total operating expenses $(300)
Operating income $ 100
Income tax (25%) (25)
Net income $ 75
• The $75 in profits is reflected as retained earnings on the balance sheet
to make the numbers match.

22-2 MANAGING CASH FLOWS
(slide 1 of 2)
• A firm’s cash flows consist of cash flowing into
a business (through sales revenue, borrowing,
etc.) and cash flowing out of the business
(through purchases, operating expenses, etc.).

22.4 Flow of Cash Through a Business

22-2 MANAGING CASH FLOWS
(slide 2 of 2)
• Calculating cash flows requires that a small business owner
distinguish between sales revenue and cash receipts.
• Revenue is recorded at the time a sale is made but do not affect cash
flows at that time unless the sale is a cash sale.
• Cash receipts are recorded when money actually flows into the firm,
often a month or two after the sale.
• Calculating cash flows also requires that a small business owner
distinguish between expenses and disbursements.
• Expenses occur when materials, labor, or other items are used.
• Payments (disbursements) for these expense items may be made
later, when checks are issued.
• To anticipate when cash will enter and leave a business, an
owner must develop a cash budget.

22-3 MANAGING ACCOUNTS
RECEIVABLE
• The most important factor in managing cash
well within a small firm is the ability to collect
accounts receivable quickly.

22-3a How Accounts
Receivable Affect Cash
• Granting credit to customers, although primarily a
marketing decision, directly affects a firm’s cash
account.
• By selling on credit and thus allowing customers to delay
payment, the selling firm delays the inflow of cash.
• The total amount of customers’ credit balances is
carried on the balance sheet as accounts receivable.
• Of all noncash assets, accounts receivable are close to
becoming cash.
• Sometimes called near cash, or receivables, accounts
receivable typically are collected and become cash within 30
to 60 days following a sale.

22-3b The Life Cycle of
Accounts Receivable (slide 1 of 3)
• The receivables cycle contains the following stages:
1. A credit sale is made.
2. In most businesses, an invoice is then prepared and mailed to the
purchaser.
3. When the invoice is received, the purchaser processes it, prepares a
check, and mails the check in payment to the seller.
• Under ideal circumstances, each of these steps is taken in a
timely manner.
• However, delays can occur at any stage of this process.
• A key goal of every business should be to minimize the average
time it takes customers to pay their bills.
• By streamlining administrative procedures, a firm can facilitate the
task of sending out bills, thereby generating cash more quickly.

• Days sales outstanding (average collection period) – The
number of days, on average, that a firm extends credit to its
customers.
• It is calculated as follows:
Accounts receivable
Days sales outstanding
Annual credit sales 365 days


• The following are some tips for 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.

• The following credit management practices can have a
positive effect on a firm’s cash flows:
• 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 by granting cash
discounts or charging interest on delinquent accounts.
• Age accounts receivable on a monthly or even a weekly basis
in order to identify delinquent accounts as quickly as possible.
• Use the most effective methods for collecting overdue accounts.
• Use a lock box.
• Lock box – A post office box for receiving remittances from
customers.

22-3c Accounts Receivable
Financing (slide 1 of 2)
• Some small businesses speed up the cash flow from
accounts receivable by borrowing against them.
• By financing receivables, these firms can often secure the use
of their money 30 to 60 days earlier than would be possible
otherwise.
• Two types of accounts receivable financing are
available:
1. Pledged accounts receivable – Accounts receivable used
as collateral for a loan.
2. Factoring – A business sells its accounts receivable to a
finance company.
• The finance company thereby assumes the bad-debt risk
associated with the receivables it buys.

22-3c Accounts Receivable
Financing (slide 2 of 2)
• Advantages of accounts receivable financing:
• It provides immediate cash flows for firms that have limited
working capital.
• The volume of borrowing can be quickly expanded
proportionally in order to match a firm’s growth in sales and
accounts receivable.
• Disadvantages of accounts receivable financing:
• The cost is high.
• Rates typically run several points above the prime interest rate.
• Factors charge a fee to compensate them for their credit
investigation activities and for the risk that customers may default
in payment.
• Pledging receivables may limit a firm’s ability to borrow from a
bank by removing a prime asset from its available collateral.

22-4 MANAGING INVENTORY
• Inventory is a “necessary evil” in a financial
management system.
• It is “necessary” because supply and demand
cannot be managed to coincide precisely with day-
to-day operations.
• It is an “evil” because it ties up funds that are not
actively productive.

22-4a Reducing Inventory
to Free Cash
• A concerted effort to manage inventory can
trim excess inventory and free cash for other
uses.

22-4b Monitoring Inventory
• When it comes to managing inventory, small business
owners tend to overstock.
• One of the first steps in managing inventory is to
discover what is in inventory and how long it has been
there.
• A yearly inventory for accounting purposes is inadequate for
proper inventory control.
• Days in inventory – The number of days, on average,
that a company holds inventory.
Inventory
Days in inventory
Cost of goods sold 365 days



22-4c Controlling Stockpiles
• Small business managers tend to overbuy inventory for
several reasons:
• Enthusiasm may lead the manager to forecast greater demand
than is realistic.
• The personalization of the business–customer relationship
may motivate a manager to stock everything customers want.
• A price-conscious manager may be overly susceptible to a
vendor’s appeal to “buy now, because prices are going up.”
• Improperly managed and uncontrolled stockpiling may
greatly increase inventory carrying costs and place a
heavy drain on the funds of a small business.

PAYABLE (slide 1 of 2)
• Accounts payable, a primary source of financing for
small firms, directly affects a firm’s cash flow situation.
• As long as a payable is outstanding, the buying firm can keep
cash equal to that amount in its checking account.
• When payment is made, however, the firm’s cash account is
reduced accordingly.
• Financial management of accounts payable hinges on
paying at various times and renegotiating in some cases.
• By buying on credit, a small business is using
creditors’ funds to supply short-term cash needs.
• The longer creditors’ funds can be borrowed, the better.
• Payment, therefore, should be delayed as long as acceptable
under the agreement.

PAYABLE (slide 2 of 2)
• Days in payables – The number of days, on average,
that a business takes to pay its accounts payable.
Accounts payable
Days in payables
Cost of goods sold 365 days


• Typically, accounts payable (trade credit) involve
payment terms that include a cash discount.
• Example: Terms of 3/10, net 30 offer a 3 percent potential
discount.
• By failing to take a discount, a business typically pays a higher
rate for use of a supplier’s money.

22.5 An Accounts Payable Timetable for Terms of 3/10, Net 30
Timetable (days after invoice
date)
Settlement Costs for a $20,000
Purchase
Days 1 through 10 $19,400
Days 11 through 30 $20,000
Days 31 and thereafter $20,000 + possible late penalty and
deterioration in credit rating

22-6 CASH CONVERSION
PERIOD REVISITED
• The cash conversion period is the time span
during which a firm’s investment in accounts
receivable and inventory must be financed.
• The cash conversion period is computed as
follows:
Cash conversion
period
Days in inventory Days sales outstanding Days in payables
  

22-7 CAPITAL BUDGETING
TECHNIQUES (slide 1 of 2)
• Capital budgeting is the management of long-term
assets—equipment and plant.
• Some capital budgeting decisions that might be made by a
small firm include the following:
• Developing a new product that shows promise but requires
additional study and improvement.
• Replacing a firm’s delivery truck with newer models.
• Expanding sales activity into a new territory.
• Constructing a new building.
• Hiring additional salespeople to intensify selling in the existing
market.
• Capital budgeting analysis – An analytical method
that helps managers make decisions about long-term
investments.

TECHNIQUES (slide 2 of 2)
• The three major techniques for making capital
budgeting decisions are the:
1. Accounting return on investment technique.
2. Payback period technique.
3. Discounted cash flow technique.
• They all attempt to address whether future benefits
from an investment will exceed the cost of making the
investment.
• Three simple rules are used in judging the merits of an
investment:
1. The investor prefers more cash rather than less cash.
2. The investor prefers cash sooner rather than later.
3. The investor prefers less risk rather than more risk.

22-7a Accounting Return
on Investment
• Accounting return on investment technique – A
capital budgeting technique that compares expected
average annual after-tax profits to the average book
value of an investment.
• The accounting return on a proposed investment is
calculated as follows:
Average annual after-tax profits
Accounting return on investment
Average book value of the investment

• The accounting return on investment technique has
two significant shortcomings:
1. It is based on accounting profits rather than actual cash flows
received.
2. It ignores the time value of money.

22-7b Payback Period
• Payback period technique – A capital budgeting
technique that measures the amount of time it will take
to recover the initial cash outlay of an investment.
• The merits of a project are judged on whether the initial
investment outlay can be recovered in less time than some
maximum acceptable payback period.
• Example: An owner may not want to invest in any project that will
require more than five years to recoup the original investment.
• This technique has two major weaknesses:
1. It ignores the time value of money.
2. It doesn’t consider cash flows received after the payback
period.

22-7c Discounted Cash Flows
(slide 1 of 2)
• Discounted cash flow (DCF) techniques –
Capital budgeting techniques that compare the
present value of future cash flows with the cost
of the initial investment.
• DCF techniques take into consideration the fact that
cash received today is more valuable than cash
received one year from now (the time value of
money).

22-7c Discounted Cash Flows
(slide 2 of 2)
• Two DCF techniques are:
1. Net present value (NPV) – The present value of expected
future cash flows less the initial investment outlay.
• If the NPV of the investment is positive—that is, if the present
value of future cash flows discounted at the rate of return
required to satisfy the firm’s investors exceeds the initial outlay—
the project is acceptable.
2. Internal rate of return (IRR) – The rate of return a firm
expects to earn on a project.
• For the investment outlay to be attractive, the IRR must exceed
the firm’s cost of capital—the rate of return required to satisfy the
firm’s investors.
• DCF techniques provide the best basis for decision
making in capital budgeting analysis.

PRACTICES IN SMALL FIRMS (slide 1 of 2)
• Increasing numbers of small business owners
are using some type of quantitative measure to
assess a capital investment, along with
judgment based on their experience.
• Still, only a small number of owners rely on DCF
techniques.
• The short-term mindset of small firms may explain, to
some degree, why they seldom use the conceptually richer
techniques for evaluating long-term investments.

PRACTICES IN SMALL FIRMS (slide 2 of 2)
• Many factors affect decision making in a small company:
• Nonfinancial variables.
• Attempts to just survive.
• Survival often becomes the top priority when the
undercapitalization and liquidity problems directly affect the
decision-making process.
• The uncertainty of cash flows.
• The uncertainty of cash flows makes long-term forecasting and
planning seem unappealing and even a waste of time.
• Difficulty in estimating the cost of capital.
• Estimating the cost of capital is more difficult for a small company
than for a large firm.
• The limited size of its projects.
• An owner’s lack of a financial management background.

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

Small Business Management Chapter 22 PowerPoint

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