Cash Management:
x
Cash is held for three reasonsx Medium of exchange to conduct business x For emergencies.
x In deflationary periods, cash goes up in value.
x
Recognize the importance of synchronizing cash inflows and outflows.Greater synchronizing means less idle cash. Growing business is good but puts strain on cash due to need to spend more before cash comes in from revenues.
Long-term assets generate greater return so the less a company has tied up in working capital, the better.
x Use zero balance account—checking account where bank will automatically transfer into the account the amount of charges for each day on the same day.
x
Discounts for receivables and payables--Always pay within discount period and seek favorable credit terms for purchases. Payments should be made at the end of the discount periods if the return is more than the firm's cost of capital. The return on taking the discount is calculated using the following formula: (MEMORIZE)
) discount 100
(
discount periodx
discount period
pay total
360
The return on taking the discount is also the cost of not taking the discount. Credit terms of 2/10 n/30 means the purchaser gets a 2% discount if paid within 10 days. If not paid by the 10th day, the full amount must be paid on or before the 30th day. Therefore, it costs 2% to use the seller’s money for 20 days.
(30-10) Example:
The high cost of short term financing has recently caused Loy Ltd. to re-evaluate the terms of credit it extends to its customers. The current policy is 1/10, net 30. If Loy's customers can borrow at the prime rate, at what prime rate must Loy change its terms of credit to avoid an undesirable extension in its collection of receivables?
a. 12.5%
b. 16.0%
c. 14.5%
d. 10.0%
e. 19.0%
*
Answer is on next page.*
Answer: (e) is correct.
First, we must calculate the cost of not taking the discount.
Using the formula to calculate the cost of not taking a discount, we have the following:
1 100 x 1 ) 10 30 (
360
18 x .010101 = .1818 = 18.18%
Thus, the prime rate where Loy must change its terms to avoid having customers not pay within the discount period would have to be greater than 18.18%. Thus, 19% is the only correct answer.
In other words, what interest rate must Loy’s customers be charged by banks to borrow money? Would Loy’s customers prefer to just borrow from Loy by not paying within the discount period. If Loy charges less than banks, then Loy’s customers will not pay within the discount period.
Lockbox accounts are frequently used by large, multilocation companies to make collections in cities within areas of heaviest customer billing. The company rents a local post office box and authorizes a local bank to pick up the remittances mailed to that box number. The bank empties the box at least once a day and immediately credits the company's account for collections. The greatest advantage of a lockbox is that it accelerates the availability of collected cash. Generally, in a lockbox arrangement the bank microfilms the checks for record purposes and provides the company with a deposit slip, a list of collections, and any customer correspondence. If the control over cash is improved and if the income generated from accelerating the receipt of funds exceeds the cost of the lockbox system, then it is considered a worthwhile undertaking.
Intermediate Accounting, Keiso & Weygandt, Ninth Edition, Wiley.
Wire transfers are the fastest and most expensive way to transfer funds from lockboxes to a firm’s main bank. A slower, but less expensive way, is to use a depository transfer check (official bank check). This is a bank check drawn on the local bank and payable to the concentration bank.
Inventory Management How much to order, and when
The objective is to minimize three costs:
x Ordering costs
Varies with number of purchases Includes receiving costs
x Carrying (holding) costs
Storage (opportunity cost – lost space rental)
Interest on money tied up (opportunity cost – of capital) Spoilage, damage
Obsolescence Property taxes Insurance
9-2
x Stockout costs
Lost contribution margins Customer bad will Factory shutdowns
Economic Order Quantity (EOQ) EOQ Model Assumptions
x
Constant, known demand x Same order size each time x No quantity discounts x Entire order received at one time x No limit on order sizeEOQ Computations (how much to order):
Where a = cost per purchase D = Annual demand K
EOQ 2aD
K = Fixed cost of purchasing
Example: Moss Converters Inc. uses 100,000 pounds of raw material annually in its production process. Material cost is $12 per pound. The cost to process a purchase order is $45, which includes variable costs of $35 and allocated fixed costs of $10. Out-of-pocket handling and storage costs amount to 20 percent of the per pound cost. The company’s cost of capital is 15 percent. The formula to determine the economic order quantity is
EOQ = SQRT (2 AD/K) A = the annual unit demand.
D = the cost per order.
K = the cost of carrying one unit per year.
Moss’ economic order quantity is a. 1,291 units.
b. 1,464 units.
c. 1,708 units.
d. 1,936 units.
e. 1,972 units.
Answer: (a) is correct.
The annual demand is given as 100,000 pounds. The cost per order is given as $35. (Only the variable cost should be considered for this, not any allocated fixed cost which will not change in total if we process more or fewer purchase orders.) Carrying costs must be computed as the handling and storage costs plus the cost of capital, or 20% + 15%, multiplied by $12 (the cost per pound). Thus K= 35% times $12, or $4.20. Consequently, EOQ equals the square root of 2 * 100,000 * $35 / $4.20, or the square root of 1,666,667, or 1,291.
Example: Companies that adopt just-in-time purchasing systems often experience a. an increase in carrying costs.
b. a reduction in the number of suppliers.
c. fewer deliveries from suppliers.
d. a greater need for inspection of goods as the goods arrive.
e. less need for linkage with a vendor’s computerized order entry system.
ANSWER: (b) is correct.
JIT purchasing often involves a reduction in the number of suppliers, as the company uses only the most dependable suppliers, and works closely with them to teach them exactly what specifications are required, including prompt deliveries and near-zero defects. An increase in carrying costs (choice a) would not result, since the goal is to reduce the amount of inventory carried. Fewer deliveries (choice c) would not result, since JIT often increases the number of deliveries, with each one containing a smaller number of units than previously. A greater need for inspection (choice d) would not result since JIT includes teaching the suppliers exactly what specifications are required, including near-zero defects. Less need for linkage with the vendor (choice e) would not result, since JIT involves greater linkage so that orders may be placed and received as quickly as possible.
Just-In-Time (JIT) seeks to minimize inventories with frequent, smaller purchases.
x Long-term relationships with fewer suppliers x Suppliers are selected for quality and reliability x Demand-pull – order inventory when needed