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Internal Financial Management
10 Internal Financial Management John Vinturella and Suzanne Erickson
Introduction A prerequisite to any external fund-raising should be a focus on the management of internal cash inflows and outflows. Unfortunately, in many business start-ups, this is an area that often takes a backseat to seemingly more pressing issues. Far too often, the chief financial officer (CFO) position is seen as a luxury to be added later, if at all. Focus is placed on accounting rather than on financial planning and cash flow management. As any experienced businessperson knows, profits and cash flow are not the same. Accounting statements alone most likely will not provide the information needed to successfully manage the business financially. Although working capital management is important for all companies, it is especially important for new and smaller companies. Start-up firms can choose to lease many of their fixed assets, but current assets must, by their nature, be owned. This means that current assets typically represent a larger portion of the total assets of the company for small or new businesses. On the liability side, a small business’s limited access to capital means that the small business is forced into a relatively higher reliance on short-term debt. Additionally, a small firm is much more likely to be unable to withstand a cash flow crisis than its larger, more established counterpart. In combination, these facts make working capital management critical for any small or new business. To ensure that internal cash management is optimal, noninterest-earning current asset balances should be kept to a minimum. Accounts receivable should be minimized by expediting collections from customers. Inventories at all levels should be minimized to reduce costs. On the liability side, accounts payable should be managed so that payments to suppliers take advantage of any free credit provided. Working capital management (the control of current asset and liability accounts) occupies the majority of all financial managers’ time. The importance of working capital management for the new business, besides survival, is that it can be a source of funds for the entrepreneurial venture. Likewise, a cash shortfall can turn into a death knell for a new company. Internal cash management is critical to both survival and growth for entrepreneurs.
Raising Entrepreneurial Capital. DOI: http://dx.doi.org/10.1016/B978-0-12-401666-8.00010-8 © 2013 Elsevier Inc. All rights reserved.
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The Cash Conversion Cycle The primary tool of working capital management is the cash conversion cycle (CCC), which calculates the time that money is tied up in the normal business cycle of the company. The CCC calculates the number of days that cash is tied up in inventory and accounts receivable, as well as the extent to which this cash investment is covered by the financing provided by a firm’s creditors through accounts payable. The CCC is calculated by adding the inventory conversion period, the number of days that work-in-process and finished goods sit in inventory, to the average collection period for accounts receivable. The sum of these two represents the total number of days that cash is tied up in nonearning assets.1 Experienced businesspeople know that sales do not equal cash. It is quite possible (even likely) that a business shows an accounting profit but has little or no cash due to sales waiting for collection in accounts receivable. Meanwhile, inventory needs to be purchased to continue the business cycle, which exacerbates the cash flow problem. As the firm purchases new inventory, financing is provided spontaneously through the use of accounts payable. As inventory purchases are made, trade credit is extended by suppliers and provides an automatic source of financing to the firm. There are two issues with accounts payable: the financing provided and the cost of that financing. The CCC focuses only on the former. We will discuss the cost of trade credit later in the chapter. The CCC is calculated as follows: CCC 5 ACP 1 ICP 2 DPO
ð10:1Þ
where ACP (average collection period) 5 accounts receivable/(sales/365). ICP (inventory conversion period) 5 inventory/(cost of goods sold/365). DPO (days payables outstanding) 5 accounts payable/(cost of goods sold/ 365).
Note that the ICP and the DPO calculations use cost of goods sold rather than sales in the denominator. This is because accounts receivable includes the profit markup and is correctly compared to sales per day. Both sales and accounts receivable are in “retail dollars,” if you will. Inventory and accounts payable, on the other hand, are recorded at cost and must therefore be compared to cost of goods sold per day, not sales per day. This distinction is not a technicality. The purpose of calculating the CCC is to provide management with guidance as to how to better control working capital. By using sales in the denominator of the ICP and DPO calculations, the denominator will be overstated and the days in inventory and payables may be severely
1
For some firms, especially banks and retail, accounts receivable is a major source of revenue due to the high interest rates charged. For most firms, however, interest earned on outstanding receivables is far less important than the cash tied up in those receivables.
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understated. The objective is to better manage the business with the help of good information. This requires that the CCC be calculated correctly. What does the CCC tell us? The CCC represents the number of days that cash is tied up in the overall business cycle of the firm. A CCC of 15, for example, would indicate that cash is tied up in current assets for 15 days longer than the financing provided from accounts payable. This represents a need for external financing— short-term loans—to cover the imbalance. Let us look at the accounts of two companies to illustrate the calculation of the CCC and to demonstrate a difference in policy between the two companies. Recent financial data for Dell Inc. and IBM are given in Table 10.1. The CCC for Dell is ACP 1 ICP 2 DPO 5 CCC 9803 1404 11; 656 1 2 ð62; 071=365Þ ð48; 260=365Þ ð48; 260=365Þ 5 57:65 1 10:62 2 88:16 5 2 19:89 days For IBM, the CCC is 29; 561 2595 8517 1 2 ð106; 916=365Þ ð56; 778=365Þ ð56; 778=365Þ 5 100:92 1 16:68 2 54:75 5 62:85 days Dell’s negative CCC is a result of the very low levels of inventory (the Dell model) and the rather long time (88 days) Dell takes to pay its creditors. The CCC indicates that Dell’s suppliers are, in effect, financing the company, covering the costs of receivables and inventory and providing nearly 20 days of financing over and above the current asset needs. Dell needs no external financing to cover its investment in current assets. IBM, on the other hand, needs over 62 days of external financing to get through its normal operating cycle.
Table 10.1 Comparison of Cash Conversion Cycles ($ Million)
Revenue Cost of goods sold Accounts receivable Inventory Accounts payable Source: 10K.
Dell, End of Fiscal Year February 3, 2012
IBM, End of Fiscal Year December 31, 2011
62,071 48,260 9803 1404 11,656
106,916 56,778 29,561 2595 8517
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The CCC provides an insight to operating and financial policy at the two companies, but it is also a guide to help with internal financial management. Dell’s DPO of 88.2 indicates that, on average, Dell takes 88 days to pay its trade creditors. Normally, such a long payables period would be associated with finance charges that could make this an expensive source of credit. The CCC (and the company’s balance sheet) provides no clue as to the actual cost of this credit, but the long DPO should prompt further investigation. The goal of working capital management is to get the CCC near zero. Accounts payable should just cover the firm’s investment in operating current assets. IBM with a CCC of 62.9 may be incurring interest charges on a regular basis to cover its regular operating cycle cash flow needs. How can IBM lower its CCC to reduce the reliance on external financing? If IBM could reduce its ACP to 30 days, it would be nearly to its goal. If IBM can reduce inventories, it may achieve a zero CCC without extending its payment period to creditors. The CCC is a tool used to highlight the flow of dollars into current assets and from current liabilities. The tool should be used to better manage those accounts to reduce the firm’s need for external financing. A reduction in the CCC leads to two distinct benefits. First, there is a one-time increase in cash as cash is converted from current assets. Second, there is an ongoing increase in efficiency as the firm speeds up collections and inventory conversion. An efficiency measure related to the CCC is working capital per dollar of sales (WC/sales). Working capital is defined as Current assets 2 Current liabilities Embracing the idea that virtually all current assets are nonearning assets, a company that generates sales with a smaller investment in working capital is managing its current assets and current liabilities more efficiently. On average, the Fortune 500 companies use $0.20 in working capital to generate $1.00 in sales, although the ratio differs substantially from industry to industry. Service or consulting companies need relatively little working capital to generate sales, whereas manufacturers like Dell and IBM need much more. Efficient companies use in the $0.070.17 range. Using the current asset and liability figures given in Table 10.2, we can calculate the working capital efficiency of Dell and IBM. The numbers in the table reflect the Table 10.2 Working Capital Efficiency ($ Million)
Current assets Current liabilities Working capital Sales Source: 10K.
Dell, End of Fiscal Year February 3, 2012
IBM, End of Fiscal Year December 31, 2011
29,448 22,001 7447 62,071
50,928 42,123 8805 106,916
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total value of current assets and liabilities for Dell and IBM, not just the three accounts focused on in the CCC. Dell’s efficiency can be calculated as Dell efficiency 5
$7447 5 0:12 $62; 071
IBM’s efficiency is even better and near the low end of the optimal efficiency range as well: IBM efficiency 5
$8805 5 0:08 $106; 916
Both companies use relatively low amounts of working capital to generate sales and are therefore managing their current assets and liabilities efficiently.
The Cost of Trade Credit The preceding section would seem to imply that maximizing the use of trade credit is one way to reduce the CCC and increase operating efficiency. This is true only if the trade credit can be had for a reasonable cost. Typically, trade credit comes in two varieties: free and costly. It is very important to distinguish between the two and calculate the true cost of any costly trade credit. The terms of trade credit determine its cost. Terms of net 30 mean that the invoice amount is due in 30 days. In this case, the supplier is offering free credit for 30 days. All firms should maximize their use of free credit; in other words, they should not pay before day 30! A common set of terms is 2/10 net 30. In this case the buyer will subtract 2% (the finance charge) from the invoice amount if the bill is paid by day 10, otherwise the full amount on the invoice is due on day 30. Here is an opportunity to obtain vendor financing for 20 days. What is the cost of foregoing the discount and paying on day 30? In this case, a finance charge of 2% is charged for 20 days of financing. We can calculate the effective cost of the trade credit using the following formulas: Periodic rate 5
Discount percentage ð1 2 Discount percentageÞ
Effective rate 5 ð11Periodic rateÞn 2 1
ð10:2Þ ð10:3Þ
where n 5 the number of compounding periods in a year and is calculated as 365/(payment date 2 discount date). The effective cost of foregoing the discount on terms of 2/10 net 30 is Periodic rate 5 2%ð1:0 2 2%Þ 5
0:02 5 0:0204 0:098
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n5
365 5 18:25 ð30 2 10Þ
Effective rate 5 ð1 1 0:0204Þ18:25 2 1 5 44:56% Foregoing the discount in this case provides very expensive credit indeed! If the company can cover its short-term cash flow needs by borrowing from a bank at less than 44.6%, it should use the bank loan to pay on day 10 and avoid the very costly trade credit. A company can lower the cost of trade credit by stretching its payment terms, for example, paying on day 40 rather than on day 30. Let us assume 2/10 net 30 are the terms of the credit Dell uses in this example but that they pay on day 72 (with no additional penalty other than the loss of the discount). What is the effective cost of the actual terms of the credit? n5
365 5 5:9 ð72 2 10Þ
Effective cost 5 ð110:0204Þ5:9 5 12:65% Although delaying payment obviously lowers the cost of the trade credit substantially, this is a risky strategy. It imposes a potential cash flow problem on the supplier, and the company risks losing its source of supply in the long run. Many authors advocate testing the supplier’s limits by delaying payment until the supplier complains. The idea is that some leeway is built into the collection period, and, by testing, the company can take advantage of slack in the collection policies of its suppliers. Delaying payment shifts the cash flow problem from you, the customer, to your supplier. In some cases, especially for small suppliers, this could impose a major burden on the supplier. It is usually better to work with your suppliers than foster an adversarial relationship to lower your costs.
The Cash Budget The CCC indicates how many days of financing are needed but does not indicate the amount of external financing needed. To predict the amount of external financing needed, the financial manager must prepare a cash budget. The cash budget is a forecast of cash inflows and outflows, monthly over the next year or daily over the next month. It is extremely important to prepare both monthly and daily cash budgets. This allows the financial manager to anticipate external financing needs and arrange for them in advance, from a position of strength, rather than a position of weakness when the cash crisis hits. The cash budget is based on a sales forecast and the payment history of the firm’s customers. For a start-up, the payment patterns must be estimated, just as the sales forecast is. In estimating payment patterns, you must recognize that a firm
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rarely collects 100% of its credit sales. Some allowance for bad debts must be built into the cash budget. A start-up can obtain industry data on bad debts to help build a more accurate budget.
Sample Cash Budget To illustrate the creation of a cash budget, we will use the case of Penny’s Pottery. Penny’s Pottery is a start-up and therefore has no outstanding accounts receivable in January of its first year of operations. Payment patterns for accounts receivable have been estimated based on industry data. Penny has created the following sales forecast for her first 7 months in operation:
Sales ($)
January
February
March
April
May
June
July
20,000
22000
30,000
35,000
35,000
40,000
50,000
Using estimates based on industry data, Penny has estimated that 20% of her customers will take the 2% discount she offers and pay on day 10, 65% will pay within 30 days of sales, and 13% will pay within 60 days of sales. Using estimates based on industry norms, Penny estimates that 2% of her accounts will prove uncollectible. Penny is a wholesale distributor of Italian pottery. She buys pottery from individual artisans in Italy and resells them to designers and retail stores. All of her sales are on credit. Her cost of goods is 70% of sales, and she typically buys the pottery and pays for it 1 month in advance of sales. Penny estimates that selling, general, and administrative expenses will total 15% of sales and be paid in the month of sale. Taxes are paid quarterly in April, June, September, and January and equal 15% of quarterly sales. Penny is anticipating a fixed asset purchase totaling $50,000 in March, and interest on a loan of $600 is due in June. If Penny experiences a cash shortfall, she can borrow from her bank on a line of credit (LOC) at a 12% annual rate. Interest is due the month following borrowing on all cumulative balances outstanding. The loan principal is repaid as excess cash is realized. Penny has $5000 cash on hand as she commences operations and would like to keep a target cash balance of $5000 on hand at all times. Table 10.3 illustrates the cash budget. The first part of the cash budget is the collection schedule; payment patterns are used to translate sales into cash inflows. Discount sales equal 20% of the same month sales, minus the 2% early payment discount. Sales in the month are equal to 65% of same month sales, and day 60 sales are 13% of the previous month’s sales. Collections represent the only cash inflows in this cash budget. Obviously, if Penny had interest earned, proceeds from asset sales, or any other type of cash inflow it would be incorporated in the cash inflow section of the budget. Payments are calculated according to the given percentages and information. Cost of goods sold is based on sales in the next month, and taxes are based on
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Table 10.3 Penny’s Pottery Collection Schedule ($)
Sales Discount sales Month of sale Day 60 Collections CASH INFLOWS Collections PAYMENTS COGS SG&A Taxes Fixed asset Interest—term loan Interest—line of credit Total payments Cash surplus or deficit Beginning cash Cash available Target balance Borrowing needed Repayment Cumulative borrowing Ending cash balance
January
February
March
April
May
20,000 3920 13,000
June
July
16,920
22,000 4312 14,300 2600 21,212
30,000 5880 19,500 2860 28,240
35,000 6860 22,750 3900 33,510
35,000 6860 22,750 4550 34,160
40,000 7840 26,000 4550 38,390
50,000
16,920
21,212
28,240
33,510
34,160
38,390
15,400 3000
21,000 3300
24,500 4500
24,500 5250 3600
28,000 5250
35,000 6000 5500
50,000 600 15
46
554
558
554
18,400 (1480)
24,315 (3103)
79,046 (50,806)
33,904 (394)
33,808 352
47,654 (9264)
5000 3520 5000 1480
5000 1897 5000 3103
5000 (45,806) 5000 50,806
5000 4606 5000 394
5000 5352 5000
5000 (4264) 5000 9264
1480
4583
55,389
55,783
352 55,430
64,695
5000
5000
5000
5000
5000
5000
Payments: 20% take 2% discount and pay on day 10; 65% pay on day 30; 13% pay on day 60; 2% never pay. Cost of goods sold (COGS) 5 70% of sales paid month prior to sales; SG&A 5 15% of sales; taxes 5 April and June 15% of quarterly sales; FA purchase 5 $50,000 in March; interest 5 $600 in June.
first- and second-quarter total sales, respectively. Interest on the LOC is based on cumulative borrowing from the prior month. The cash surplus or deficit is calculated as cash inflows less total payments. Beginning cash is then added to the cash surplus or deficit to determine cash available. Because Penny does not want to go below $5000 in cash on hand, $5000 is shown as the target cash balance. Each month, cash available is automatically compared to the target to determine whether external financing is needed. As can be seen in the cash budget, Penny needs to add to her loan balance in 5 of the 6 months. Interest is automatically
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calculated on the cumulative loan balance and added to the total payments. In May, Penny generates a slight surplus and uses the extra cash to repay part of the LOC. The cash budget for Penny’s Pottery, as it stands so far, would not be very appealing to a banker. Why? Penny is a net borrower in 5 of the 6 months of the budget with no indication that she will be able to pay off the LOC. Penny’s external financing needs are exacerbated by her desire to keep $5000 in cash on hand, and she needs to weigh the cash safety net against the cost of financing it. Penny’s problem is bigger than the target cash balance, however. What is going on here? Penny’s sales are growing nicely, more than doubling in the seventh-month forecast. Why does she keep going deeper and deeper into debt? Herein lies one of the great ironies of financial management. The faster you grow, the less money you will have. Always. Because Penny buys her inventory in advance of sales, when sales are rising, her costs go up faster than sales. Because her customers do not pay cash at the time of sales, collections lag behind sales, adding to the cash flow problems in a period of rising sales. In periods of rapid sales growth, all firms experience cash flow problems, just as Penny is. The importance of the cash budget as a planning tool is to see the cash shortfall in advance and to plan for it. If we had extended the cash budget further, Penny’s sales may have declined in some months, allowing her to catch up. Over the course of a year, a banker will demand to see a month or two in which the LOC can be paid down to zero. A LOC is short-term financing, and no banker wants to see it used as permanent capital. The monthly cash budget is an important planning tool, but crucial detail is obscured by focusing on only the month-end balances. To complete the cash planning process, a daily cash budget must be prepared for the following month. The daily budget is critical because cash inflows and outflows do not occur uniformly throughout the month. Although sales may or may not occur uniformly, expenses almost certainly will be congregated on certain days, throwing off the validity of the monthly cash budget on certain days. For example, the monthly budget shows a $1480 deficit from operations for the month of January. But what if Penny pays her employees on the fifth of the month and her suppliers on the tenth? Virtually all her expenses will be incurred by the tenth, when only a third of her sales have been made. This means that the within-month deficit on the tenth is likely to be considerably larger than the $1480 shown for the month. Because Penny must have the cash to pay her employees and suppliers, she must arrange for within-month cash shortfalls to be covered in order to remain solvent. The format of the daily cash budget is the same as the monthly budget except that cash flows are assigned to the actual days on which they occur. Creating the daily budget is an insignificant technical step but a very important management tool that should not be overlooked. Modifications to the structure of the cash budget are virtually endless. For a business that does not extend credit to its customers, sales would typically be for cash or cash and credit card. Cash sales are recorded in the month of sale at their face value. Credit card sales result in cash to the company with varying speeds, depending on the credit card company involved. All credit card companies deduct a fee, usually around 3% of sales, for the credit provided. Although some small
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businesses do not accept credit cards because of the fee charged, increasing the payment options for your customers potentially increases your sales. Accepting credit cards, rather than extending your own credit, eliminates the need for a credit department, reduces bad debts to zero except in rare cases, and, most importantly, allows cash to be realized sooner.
Sources of Short-Term Financing What are the company’s options for obtaining short-term financing? Before answering this question, we need to ask a more fundamental question. How should the external financing be split between short-term and long-term sources of financing? At first this may seem to be a surprising question. Perhaps you have heard of the old adage “Finance current assets with short-term loans and fixed assets with long-term sources of funds.” But this piece of folk wisdom ignores the fact that all firms carry some permanent levels of current assets. It is unlikely that a firm will ever carry zero receivables or zero inventory. This means then that there is a permanent level of current assets that may be more efficiently financed with longer term sources of funds, either equity or long-term debt. The company needs to analyze current asset and liability levels across the year. What are the minimum levels of assets carried during the slack business period? A true maturity-matching approach to financing would indicate financing the permanent levels of current assets with long-term sources of funds. Relying too heavily on short-term debt maximizes the company’s exposure to interest rate risk. If you must continually refinance or roll over a short-term note, you will be burdened with higher costs in a period of rising interest rates. By using long-term financing to finance permanent current assets, the firm locks in a cost of funds. In periods of rising interest rates, reliance on short-term loans can turn out to be very expensive.
Lines of Credit The best source of financing for cyclical current asset needs is a revolving LOC. A LOC is essentially a preapproved loan, available on demand in part or whole, up to the preapproved limit. For approval, the company must submit a cash budget to the bank, which must include months of positive cash flow and demonstrate an ability to repay the LOC. The budget should also demonstrate when and why external financing is needed. As cash deficits occur, a check can be written against the LOC, drawing on it to a predetermined maximum. The beauty of the LOC is that should you end up not needing the funds, there is no charge.2 Also, unlike a term loan, there are no scheduled repayments of principal. As in the Penny’s Pottery case, principal payments are made as cash flow 2
Sometimes there is a charge to establish a more formal LOC. This is typically the case for very large lines in which a commitment from the bank represents a substantial commitment of resources. An entrepreneurial venture is unlikely to need the formal LOC and would not be charged a commitment fee.
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allows. Interest is incurred monthly and must be paid on outstanding balances, but the deferment of principal payments buys the cash-strapped firm time and flexibility.
Asset-Backed Loans Term loans from banks, typically called notes payable on the firm’s balance sheet, are more structured than an LOC and therefore not as desirable. Unfortunately, in the early stages of a company’s life, the bank may not be willing to extend an unsecured LOC to the company, and a secured loan may be the only option for obtaining financing. What assets are appropriate for securing a short-term loan? Personal assets are always an option. If the firm has a marketable securities portfolio, it would be good security for a loan. More likely assets to use as collateral are the firm’s inventories or accounts receivable. Inventories as collateral do not work for all firms. To be acceptable collateral, the inventory items must be finished goods with a ready market for liquidation. Car and boat dealerships routinely finance their inventories by pledging the individual vehicles as collateral for the loans used to buy the vehicles from the manufacturers. Some raw materials, such as sheet steel, also work as collateral. The key is whether the bank would be able to find a ready buyer for the asset in its current state. Work-in-process would never be acceptable collateral to a bank. Accounts receivable may also be used as collateral, but, like inventory, not all accounts receivable are created equally. A bank is much more likely to accept your receivables as collateral if your customers are large corporate accounts. A business selling to individual consumers would not provide the type of receivables that a bank would typically accept. Assuming that you are selling to large corporate accounts, pledging accounts receivable essentially shifts the focus on creditworthiness from you, the start-up, to your customers. Pledging simply means offering your accounts receivable as collateral for a loan. In this case, your customer’s creditworthiness determines how likely the accounts are to be collected and thus how valuable they are. This is ideal for a new company without a credit history that is selling to established companies. To use receivables as collateral, the bank will examine your receivables and advance a loan only against the current receivables, 30 days old or less. Typically, the bank will lend 80% of the book value of current receivables. You retain possession of the receivables, remain responsible for collecting them, and suffer any losses of nonpayment by your customers.
Factoring Factoring, discussed in Chapter 2, is an alternative to pledging and provides another option to use accounts receivable in financing. When factoring, the firm actually sells its accounts receivable to a third party—the factor. The factor may be
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a bank or a specialized factoring company. Factoring is accepted practice in some industries, apparel manufacturing for one, and frowned upon in others. As with pledging, a factor will examine your receivables and accept only quality current receivables. The difference is that you sell the receivables to the factor, realizing cash from the sale immediately and removing the receivables from your balance sheet. Your customers send their payments to the factor, and the factor in effect becomes your credit department, handling collections and absorbing any losses from nonpayment. The high cost typical of most factoring arrangements is, in theory, justified by the value of the financing and accounts receivable function provided. The transaction involves more than lending, and costs are commensurately higher. Before you conclude that factoring is the solution to your cash flow needs, however, consider that the factor accepts only your current accounts. If you have past-due accounts receivable, you will have to maintain at least a partial credit department to deal with them. Also, the factor will advance anywhere from 70% to 95% of the face value of receivables, depending on their quality. Additionally, the factor withholds a reserve until all accounts are collected. When the accounts are paid in full, the factor will forward you the funds held in reserve. Many new firms use the factoring arrangement to get them through the early life stages characterized by substantial cash flow shortages, then switch to more conventional financing as soon as they are able. Factoring may be expensive, but if the alternative is out of cash (OOC), it can begin to look more attractive.
Customers Customers can be a source of financing for the new venture in at least 2 ways. If your business provides a new or customized product or service, it may be in the customer’s best interest to help get your firm up to scale through a direct investment. This works best when the business was started to address the needs of a particular customer or when a customer offloads work, previously done in-house, to your firm. Simply put, if there are no good substitutes for what you offer, the chance of direct investment by your customers rises substantially. Another option for customer financing is to demand full or partial payment in advance. This strategy works best when the service is ongoing (consulting) or the product takes some time to develop or is highly customized. In the previous cash conversion example, we noted that Dell carries very little inventory and has a negative CCC. The Dell model is to demand payment from customers in advance, at the time of the order for a computer or system. Dell buys inventory as orders come in, thus eliminating the need for a parts inventory, a very significant fact in an industry with such rapid obsolescence. As noted, Dell does not use the cash deposit to purchase inventory, instead buying on account and conserving the cash in the business. In consulting or service businesses, a deposit is often demanded up front when a contract is signed. This serves to improve cash flow, but it also bonds the customer as a serious buyer of your services. The same is true when the customer is buying a
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tangible product. A down payment or deposit increases the odds that the buyer is a serious customer. Even if the customer later withdraws the order, the deposit may allow you to break even on the lost sale.
Cash Management Banks provide cash management services that limit the firm’s need to carry idle cash balances. In addition, the firm can do several things on its own to expedite the flow of cash. Every attempt should be made to synchronize the cash flow between payables and receivables. A relevant example is provided by the situation of a private school on whose board one of the authors sat. Each year the school experienced a severe cash flow crunch because books and supplies had to be ordered in advance of the school year. Revenue came in the form of tuition, which was not collected until school started in September. The author suggested moving the tuition payment cycle up 1 month, with tuition starting in August. The change was implemented, the cash flow crisis was solved, and, although the parents were not thrilled with making a tuition payment during the summer, they did like the fact that payments ended a month earlier in the spring. Another simple technique to solve a cash flow problem is the management of payroll. By switching from a weekly or twice-a-month payroll system to an end-ofmonth payroll, all of the cash inflows from the month will be available to cover the payroll outflow. The firm has a lot of control over the timing of many of its cash flows, and synchronization is the key to managing cash flow efficiently. A basic goal of cash management is to get access to incoming funds as quickly as possible. Invoices should accompany goods out the door. Never wait until the end of the month (or even the week) to bill your customers. By waiting to invoice, you are providing free credit to your customers and incurring a cash shortfall for yourself. As discussed previously, discounts may provide enticement to customers to pay sooner. In exchange for a 2% discount, you will gain the use of your cash 2030 days sooner and perhaps negate a need for higher cost external financing. It should go without saying that all firms need a competent credit department, but here again the tendency to scrimp can interfere with best practices. Credit standards must be set and enforced before credit is extended. Payment patterns must be constantly monitored to spot changes in patterns that could lead to cash flow problems down the road. Collections must be timely and forceful to ensure payment. Occasionally, credit extensions to customers may need to be discontinued for nonpayment and no further credit extended. U.S. News’ Money section3 suggests six practical ways that firms can solve their collection problems: 3
http://money.usnews.com/money/business-economy/small-business/articles/2008/05/12/6-ways-firmscan-solve-collection-problems.
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1. Give out as little credit as possible. If customers balk, they may have been poor credit risks to begin with. When you know that a customer is serious about paying their bills, you could try some payment schedule that works for both of you. 2. If you are going to lend money, think like a banker. Make all customers fill out a credit application and update it every year. Many businesses get a credit report on the applicant to help them make the decision. 3. Time is of the essence. The value of your accounts receivable lessens with the age of its payments due. Make that “friendly but firm” phone call. 4. Make sure you have the facts in front of you. Before you pick up the phone, have all the information about the customer’s account in front of you and make sure you are familiar with it to avoid getting the run-around. 5. Be willing to negotiate if need be. Work with the customer or you may not get anything. Let them make partial payments over some period of time if need be. 6. If all else fails, do not try to be your own collector. There are collection agencies that know how to get the most that you can for a customer. The customer has a greater incentive to settle where they know that their credit rating is at risk.
Accuracy is crucial to a smoothly functioning credit operation. One financial manager observed that at least 95% of collection problems derive from the following: G
G
G
G
Incorrect or incomplete invoices sent to the customer. Invoices sent to the wrong address. The amount of the invoice exceeding the authority of the person receiving the invoice. A change in personnel at the customer company.
To ensure timely payment, know your customers and their procedures, keep the lines of communication open, and work with them. Increasingly, firms are moving to electronic invoicing and payments, eliminating the problem of mail and bank processing float. It also reduces the very timeconsuming task of processing checks.
Lockboxes If your customers are spread across the country or around the world, regional lockboxes can reduce mail float and improve your access to your cash. A lockbox is a regional post office box monitored and maintained by a local bank. Your customers mail payments to the closest lockbox, and the bank collects the payments and wires funds into your account daily. If your business is located on the East Coast, for example, you may be able to cut 23 days of mail float time out of the collection process by having your West Coast customers’ mail payments to a West Coast lockbox. If you are receiving thousands of dollars a day in payments, a reduction of 23 days in float adds up over the year. The lockbox allows you to realize your sales dollars sooner, alleviating the need for external financing for those days.
Bank Cash Management Services The use of preauthorized debits is an excellent way to control cash flow and reduce defaults. Preauthorized debits are monthly transfers from your customers’ checking accounts into your bank account. This alleviates the need for monthly paper billing,
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allows you to accurately forecast cash inflows, and reduces the chance of nonpayment by your customers. Banks also provide cash management services for small businesses. Essentially, this service is a sweep account that allows the firm to carry a zero balance in its noninterest-bearing checking account. The checking account is tied to an interestbearing money market fund. Each day, money is transferred from the money market fund to cover any checks written against the account that day, and surplus balances are transferred to the money market fund. The checking account will always show a zero balance, and cash will always be invested, albeit at currently very low money market rates. It is wise to think of all current assets as nonearning assets. A company should constantly monitor its level of cash and ensure that it is put to its best use. Even though a company may use a sweep account to keep the cash-earning interest, the interest earned is trivial compared to what the money could be earning if it were put to productive use in the firm’s fixed assets. Large stockpiles of cash are a red flag in attracting takeover suitors. More to the point, the owner’s wealth is not being maximized unless money is put to its most productive use, and that use is virtually never in current assets.
Summary This chapter explores the opportunities for finding capital through the internal management of cash flows. Cash flow management, distinct from the accounting function, is a financial function necessary for planning and for reducing the need for external sources of financing. Working capital management, the control of current assets and current liabilities, is more important for small firms than for large ones. This is due to the fact that small and new firms have relatively more capital invested in current assets and have less access to capital than their larger counterparts. The CCC is the basic tool of working capital management. It allows the firm to monitor and control the cash invested in accounts receivable and inventory and to maximize the use of free, or reasonably priced, credit from suppliers. Trade credit can be free or very expensive. It is critical to determine its cost and use it optimally. Ideally, the firm’s total investment in accounts receivable and inventory will be financed by free trade credit from its suppliers. An example was used to demonstrate the creation of the cash budget. The cash budget allows the firm to spot external financing needs and to arrange for them in advance. Additionally, the cash budget allows the firm to manage cash flows to reduce the firm’s need for external financing. Firms must produce both monthly and daily cash budgets to adequately control and plan for cash shortfalls. The relationship between rapid growth and negative cash flow was discussed. One solution to this problem is obviously to grow more slowly. Although this is
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the antithesis of what may seem obvious, it may be the most prudent way for most firms to proceed. The chapter also looked at various sources of short-term financing. Short-term financing options include LOCs, asset-backed loans, factoring, customers, and internal cash management techniques. Internal cash management techniques include coordinated cash flows, timely invoicing and collection, and adequate credit standards applied in the initial credit granting decision. The importance of accuracy and working with your customers was also emphasized. The overriding goal in working capital management is to minimize the investment in nonearning current assets, reduce the firm’s reliance on external financing, and redirect resources to their most productive use in the business—toward fixed assets.
Discussion Questions 1. Look up Starbuck’s most recent financial statements. Calculate the CCC for Starbucks. What advice would you offer Starbucks based on the CCC? 2. What is the cost of the following trade credit terms of 3/15 net 45? What options does the company have if it deems the cost of the credit too expensive? 3. Prepare a cash budget for March and April based on the following information:
Sales Wages Rent Other Taxes
January
February
March
April
$50,000
$50,000
$40,000 3000 1000 400
$60,000 4000 1000 600 8000
Experience shows that 20% of customers pay in the month of sale, 70% pay 1 month later, and the rest of paying customers pay 2 months after sale. Three percent of customers never pay. Inventory is purchased 1 month prior to sale, and cost of goods sold equals 70% of sales. Accounts payable are paid 30 days after purchase. Any financing is done through a 12% LOC. The company has $5000 cash on hand on March 1 and would like to retain a cash balance of $5000.
Case 10.1 New Tech (O): Monthly Cash Budget Using a spreadsheet, prepare a cash budget for New Tech for the next year (January through December) based on the following information.
October Sales revenue (previous year) Purchases PAYMENT SCHEDULE Cash sales 5 10% 30-day payment 5 70% 60-day payment 5 20% PURCHASE SCHEDULE Paid in first month 5 40% Paid during second 60 days 5 60%
Sales revenue Purchases
325.0
November 325.0
December 325.0 59.2
Jan.
Feb.
March
April
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
325 59.0
300 59.2
275 59.2
325 59.2
350 59.2
375 59.2
400 59.2
375 59.2
350 59.2
300 59.2
275 59.2
250 59.2
4.2 40.0 2.5
4.0 39.0 2.2
5.1 38.0 2.4
5.4 42.0 2.5
7.3 38.4 2.5
6.5 44.3 2.8
6.7 42.5 2.7
6.6 41.0 2.5
6.1 38.0 2.6
7.0 39.0 2.6
5.8 39.5 2.6
5.7 38.0 2.4
60.0 5.9 7.0 6.0 5.0
62.0 5.0 7.1 6.5 6.0
65.8 5.8 6.9 7.0 3.0
62.8 6.8 6.8 9.0 40.0
62.7 6.9 7.6 8.5 50.0
67.9 7.4 7.8 8.7 21.5
71.6 8.0 8.4 8.3 18.3
62.8 7.8 7.5 8.1 18.7
64.9 6.5 7.7 7.0 18.9
66.9 6.8 7.7 7.2 16.0
68.0 6.4 7.9 6.0 8.5
65.0 6.4 7.4 7.5 14.0
Disbursements Freight in Labor Utilities, insurance, etc. Salaries—selling Commissions Travel Advertising Other charges—
(Continued)
(Continued) Jan.
Feb.
March
April
35.0
35.0
34.0
33.0
5.8 8.3
5.8 10.3
5.8 15.6
9.3 40.0
9.3 45.0
9.3 33.0
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
36.0
36.0
38.0
39.0
35.0
33.0
32.0
34.0
5.8 7.5
5.8 8.3
5.8 7.7
5.8 7.9
5.8 6.2
5.8 6.7
5.8 6.9
5.8 6.3
5.8 8.3
9.3 350.0
9.3 500.0
9.3 16.8
9.3 23.8
9.3 23.0
9.3 18.0
9.3 20.0
9.3 20.0
9.3 10.0
Selling Salaries— administration Leasing Research and development Taxes Purchase of assets
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Sensitivity Analysis G
G
What would happen to New Tech’s need for external financing if sales varied plus or minus 10%, 20%, and 30% from the forecasted level? Prepare a sensitivity analysis. What would happen to New Tech’s financing needs if customers began to pay 15% in the month of sale, 60% the month after, and the rest in 2 months? Assume that at least 3% bad debts remain.
Bibliography Bandyk M: 6 Ways firms can solve collection problems. Retrieved at ,http://money. usnews.com/money/business-economy/small-business/articles/2008/05/12/6-ways-firmscan-solve-collection-problems.. Bowen, HK, Andrew RJ, Laurence EK, Kevin EK, and Baltej K: Cash Management Practices in Small Companies. Harvard Business School Background Note 699-047, December 1998. Cambridge MA. Brealey RA, Myers SC: Principles of corporate finance, ed 5, New York, NY, 1996, IrwinMcGraw Hill. Brigham EF, Daves PR: Intermediate financial management, ed 7, Mason, OH, 2001, SouthWestern. Copeland TE, Weston JF: Financial management, ed 9, Fort Worth, TX, 1992, Dryden Press. Jassy AR, Katz L, Kelly K, Kochar B: Cash management practices in small companies, Harvard Business School Note, 1998. Stancill JM: When is there cash in cash flow? Harv Bus Rev MarchApril:3849,1987.
Introduction A prerequisite to any external fund-raising should be a focus on the management of internal cash inflows and outflows. Unfortunately, in many business start-ups, this is an area that often takes a backseat to seemingly more pressing issues. Far too often, the chief financial officer (CFO) position is seen as a luxury to be added later, if at all. Focus is placed on accounting rather than on financial planning and cash flow management. As any experienced businessperson knows, profits and cash flow are not the same. Accounting statements alone most likely will not provide the information needed to successfully manage the business financially. Although working capital management is important for all companies, it is especially important for new and smaller companies. Start-up firms can choose to lease many of their fixed assets, but current assets must, by their nature, be owned. This means that current assets typically represent a larger portion of the total assets of the company for small or new businesses. On the liability side, a small business’s limited access to capital means that the small business is forced into a relatively higher reliance on short-term debt. Additionally, a small firm is much more likely to be unable to withstand a cash flow crisis than its larger, more established counterpart. In combination, these facts make working capital management critical for any small or new business. To ensure that internal cash management is optimal, noninterest-earning current asset balances should be kept to a minimum. Accounts receivable should be minimized by expediting collections from customers. Inventories at all levels should be minimized to reduce costs. On the liability side, accounts payable should be managed so that payments to suppliers take advantage of any free credit provided. Working capital management (the control of current asset and liability accounts) occupies the majority of all financial managers’ time. The importance of working capital management for the new business, besides survival, is that it can be a source of funds for the entrepreneurial venture. Likewise, a cash shortfall can turn into a death knell for a new company. Internal cash management is critical to both survival and growth for entrepreneurs.
Raising Entrepreneurial Capital. DOI: http://dx.doi.org/10.1016/B978-0-12-401666-8.00010-8 © 2013 Elsevier Inc. All rights reserved.
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The Cash Conversion Cycle The primary tool of working capital management is the cash conversion cycle (CCC), which calculates the time that money is tied up in the normal business cycle of the company. The CCC calculates the number of days that cash is tied up in inventory and accounts receivable, as well as the extent to which this cash investment is covered by the financing provided by a firm’s creditors through accounts payable. The CCC is calculated by adding the inventory conversion period, the number of days that work-in-process and finished goods sit in inventory, to the average collection period for accounts receivable. The sum of these two represents the total number of days that cash is tied up in nonearning assets.1 Experienced businesspeople know that sales do not equal cash. It is quite possible (even likely) that a business shows an accounting profit but has little or no cash due to sales waiting for collection in accounts receivable. Meanwhile, inventory needs to be purchased to continue the business cycle, which exacerbates the cash flow problem. As the firm purchases new inventory, financing is provided spontaneously through the use of accounts payable. As inventory purchases are made, trade credit is extended by suppliers and provides an automatic source of financing to the firm. There are two issues with accounts payable: the financing provided and the cost of that financing. The CCC focuses only on the former. We will discuss the cost of trade credit later in the chapter. The CCC is calculated as follows: CCC 5 ACP 1 ICP 2 DPO
ð10:1Þ
where ACP (average collection period) 5 accounts receivable/(sales/365). ICP (inventory conversion period) 5 inventory/(cost of goods sold/365). DPO (days payables outstanding) 5 accounts payable/(cost of goods sold/ 365).
Note that the ICP and the DPO calculations use cost of goods sold rather than sales in the denominator. This is because accounts receivable includes the profit markup and is correctly compared to sales per day. Both sales and accounts receivable are in “retail dollars,” if you will. Inventory and accounts payable, on the other hand, are recorded at cost and must therefore be compared to cost of goods sold per day, not sales per day. This distinction is not a technicality. The purpose of calculating the CCC is to provide management with guidance as to how to better control working capital. By using sales in the denominator of the ICP and DPO calculations, the denominator will be overstated and the days in inventory and payables may be severely
1
For some firms, especially banks and retail, accounts receivable is a major source of revenue due to the high interest rates charged. For most firms, however, interest earned on outstanding receivables is far less important than the cash tied up in those receivables.
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understated. The objective is to better manage the business with the help of good information. This requires that the CCC be calculated correctly. What does the CCC tell us? The CCC represents the number of days that cash is tied up in the overall business cycle of the firm. A CCC of 15, for example, would indicate that cash is tied up in current assets for 15 days longer than the financing provided from accounts payable. This represents a need for external financing— short-term loans—to cover the imbalance. Let us look at the accounts of two companies to illustrate the calculation of the CCC and to demonstrate a difference in policy between the two companies. Recent financial data for Dell Inc. and IBM are given in Table 10.1. The CCC for Dell is ACP 1 ICP 2 DPO 5 CCC 9803 1404 11; 656 1 2 ð62; 071=365Þ ð48; 260=365Þ ð48; 260=365Þ 5 57:65 1 10:62 2 88:16 5 2 19:89 days For IBM, the CCC is 29; 561 2595 8517 1 2 ð106; 916=365Þ ð56; 778=365Þ ð56; 778=365Þ 5 100:92 1 16:68 2 54:75 5 62:85 days Dell’s negative CCC is a result of the very low levels of inventory (the Dell model) and the rather long time (88 days) Dell takes to pay its creditors. The CCC indicates that Dell’s suppliers are, in effect, financing the company, covering the costs of receivables and inventory and providing nearly 20 days of financing over and above the current asset needs. Dell needs no external financing to cover its investment in current assets. IBM, on the other hand, needs over 62 days of external financing to get through its normal operating cycle.
Table 10.1 Comparison of Cash Conversion Cycles ($ Million)
Revenue Cost of goods sold Accounts receivable Inventory Accounts payable Source: 10K.
Dell, End of Fiscal Year February 3, 2012
IBM, End of Fiscal Year December 31, 2011
62,071 48,260 9803 1404 11,656
106,916 56,778 29,561 2595 8517
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The CCC provides an insight to operating and financial policy at the two companies, but it is also a guide to help with internal financial management. Dell’s DPO of 88.2 indicates that, on average, Dell takes 88 days to pay its trade creditors. Normally, such a long payables period would be associated with finance charges that could make this an expensive source of credit. The CCC (and the company’s balance sheet) provides no clue as to the actual cost of this credit, but the long DPO should prompt further investigation. The goal of working capital management is to get the CCC near zero. Accounts payable should just cover the firm’s investment in operating current assets. IBM with a CCC of 62.9 may be incurring interest charges on a regular basis to cover its regular operating cycle cash flow needs. How can IBM lower its CCC to reduce the reliance on external financing? If IBM could reduce its ACP to 30 days, it would be nearly to its goal. If IBM can reduce inventories, it may achieve a zero CCC without extending its payment period to creditors. The CCC is a tool used to highlight the flow of dollars into current assets and from current liabilities. The tool should be used to better manage those accounts to reduce the firm’s need for external financing. A reduction in the CCC leads to two distinct benefits. First, there is a one-time increase in cash as cash is converted from current assets. Second, there is an ongoing increase in efficiency as the firm speeds up collections and inventory conversion. An efficiency measure related to the CCC is working capital per dollar of sales (WC/sales). Working capital is defined as Current assets 2 Current liabilities Embracing the idea that virtually all current assets are nonearning assets, a company that generates sales with a smaller investment in working capital is managing its current assets and current liabilities more efficiently. On average, the Fortune 500 companies use $0.20 in working capital to generate $1.00 in sales, although the ratio differs substantially from industry to industry. Service or consulting companies need relatively little working capital to generate sales, whereas manufacturers like Dell and IBM need much more. Efficient companies use in the $0.070.17 range. Using the current asset and liability figures given in Table 10.2, we can calculate the working capital efficiency of Dell and IBM. The numbers in the table reflect the Table 10.2 Working Capital Efficiency ($ Million)
Current assets Current liabilities Working capital Sales Source: 10K.
Dell, End of Fiscal Year February 3, 2012
IBM, End of Fiscal Year December 31, 2011
29,448 22,001 7447 62,071
50,928 42,123 8805 106,916
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total value of current assets and liabilities for Dell and IBM, not just the three accounts focused on in the CCC. Dell’s efficiency can be calculated as Dell efficiency 5
$7447 5 0:12 $62; 071
IBM’s efficiency is even better and near the low end of the optimal efficiency range as well: IBM efficiency 5
$8805 5 0:08 $106; 916
Both companies use relatively low amounts of working capital to generate sales and are therefore managing their current assets and liabilities efficiently.
The Cost of Trade Credit The preceding section would seem to imply that maximizing the use of trade credit is one way to reduce the CCC and increase operating efficiency. This is true only if the trade credit can be had for a reasonable cost. Typically, trade credit comes in two varieties: free and costly. It is very important to distinguish between the two and calculate the true cost of any costly trade credit. The terms of trade credit determine its cost. Terms of net 30 mean that the invoice amount is due in 30 days. In this case, the supplier is offering free credit for 30 days. All firms should maximize their use of free credit; in other words, they should not pay before day 30! A common set of terms is 2/10 net 30. In this case the buyer will subtract 2% (the finance charge) from the invoice amount if the bill is paid by day 10, otherwise the full amount on the invoice is due on day 30. Here is an opportunity to obtain vendor financing for 20 days. What is the cost of foregoing the discount and paying on day 30? In this case, a finance charge of 2% is charged for 20 days of financing. We can calculate the effective cost of the trade credit using the following formulas: Periodic rate 5
Discount percentage ð1 2 Discount percentageÞ
Effective rate 5 ð11Periodic rateÞn 2 1
ð10:2Þ ð10:3Þ
where n 5 the number of compounding periods in a year and is calculated as 365/(payment date 2 discount date). The effective cost of foregoing the discount on terms of 2/10 net 30 is Periodic rate 5 2%ð1:0 2 2%Þ 5
0:02 5 0:0204 0:098
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n5
365 5 18:25 ð30 2 10Þ
Effective rate 5 ð1 1 0:0204Þ18:25 2 1 5 44:56% Foregoing the discount in this case provides very expensive credit indeed! If the company can cover its short-term cash flow needs by borrowing from a bank at less than 44.6%, it should use the bank loan to pay on day 10 and avoid the very costly trade credit. A company can lower the cost of trade credit by stretching its payment terms, for example, paying on day 40 rather than on day 30. Let us assume 2/10 net 30 are the terms of the credit Dell uses in this example but that they pay on day 72 (with no additional penalty other than the loss of the discount). What is the effective cost of the actual terms of the credit? n5
365 5 5:9 ð72 2 10Þ
Effective cost 5 ð110:0204Þ5:9 5 12:65% Although delaying payment obviously lowers the cost of the trade credit substantially, this is a risky strategy. It imposes a potential cash flow problem on the supplier, and the company risks losing its source of supply in the long run. Many authors advocate testing the supplier’s limits by delaying payment until the supplier complains. The idea is that some leeway is built into the collection period, and, by testing, the company can take advantage of slack in the collection policies of its suppliers. Delaying payment shifts the cash flow problem from you, the customer, to your supplier. In some cases, especially for small suppliers, this could impose a major burden on the supplier. It is usually better to work with your suppliers than foster an adversarial relationship to lower your costs.
The Cash Budget The CCC indicates how many days of financing are needed but does not indicate the amount of external financing needed. To predict the amount of external financing needed, the financial manager must prepare a cash budget. The cash budget is a forecast of cash inflows and outflows, monthly over the next year or daily over the next month. It is extremely important to prepare both monthly and daily cash budgets. This allows the financial manager to anticipate external financing needs and arrange for them in advance, from a position of strength, rather than a position of weakness when the cash crisis hits. The cash budget is based on a sales forecast and the payment history of the firm’s customers. For a start-up, the payment patterns must be estimated, just as the sales forecast is. In estimating payment patterns, you must recognize that a firm
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rarely collects 100% of its credit sales. Some allowance for bad debts must be built into the cash budget. A start-up can obtain industry data on bad debts to help build a more accurate budget.
Sample Cash Budget To illustrate the creation of a cash budget, we will use the case of Penny’s Pottery. Penny’s Pottery is a start-up and therefore has no outstanding accounts receivable in January of its first year of operations. Payment patterns for accounts receivable have been estimated based on industry data. Penny has created the following sales forecast for her first 7 months in operation:
Sales ($)
January
February
March
April
May
June
July
20,000
22000
30,000
35,000
35,000
40,000
50,000
Using estimates based on industry data, Penny has estimated that 20% of her customers will take the 2% discount she offers and pay on day 10, 65% will pay within 30 days of sales, and 13% will pay within 60 days of sales. Using estimates based on industry norms, Penny estimates that 2% of her accounts will prove uncollectible. Penny is a wholesale distributor of Italian pottery. She buys pottery from individual artisans in Italy and resells them to designers and retail stores. All of her sales are on credit. Her cost of goods is 70% of sales, and she typically buys the pottery and pays for it 1 month in advance of sales. Penny estimates that selling, general, and administrative expenses will total 15% of sales and be paid in the month of sale. Taxes are paid quarterly in April, June, September, and January and equal 15% of quarterly sales. Penny is anticipating a fixed asset purchase totaling $50,000 in March, and interest on a loan of $600 is due in June. If Penny experiences a cash shortfall, she can borrow from her bank on a line of credit (LOC) at a 12% annual rate. Interest is due the month following borrowing on all cumulative balances outstanding. The loan principal is repaid as excess cash is realized. Penny has $5000 cash on hand as she commences operations and would like to keep a target cash balance of $5000 on hand at all times. Table 10.3 illustrates the cash budget. The first part of the cash budget is the collection schedule; payment patterns are used to translate sales into cash inflows. Discount sales equal 20% of the same month sales, minus the 2% early payment discount. Sales in the month are equal to 65% of same month sales, and day 60 sales are 13% of the previous month’s sales. Collections represent the only cash inflows in this cash budget. Obviously, if Penny had interest earned, proceeds from asset sales, or any other type of cash inflow it would be incorporated in the cash inflow section of the budget. Payments are calculated according to the given percentages and information. Cost of goods sold is based on sales in the next month, and taxes are based on
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Table 10.3 Penny’s Pottery Collection Schedule ($)
Sales Discount sales Month of sale Day 60 Collections CASH INFLOWS Collections PAYMENTS COGS SG&A Taxes Fixed asset Interest—term loan Interest—line of credit Total payments Cash surplus or deficit Beginning cash Cash available Target balance Borrowing needed Repayment Cumulative borrowing Ending cash balance
January
February
March
April
May
20,000 3920 13,000
June
July
16,920
22,000 4312 14,300 2600 21,212
30,000 5880 19,500 2860 28,240
35,000 6860 22,750 3900 33,510
35,000 6860 22,750 4550 34,160
40,000 7840 26,000 4550 38,390
50,000
16,920
21,212
28,240
33,510
34,160
38,390
15,400 3000
21,000 3300
24,500 4500
24,500 5250 3600
28,000 5250
35,000 6000 5500
50,000 600 15
46
554
558
554
18,400 (1480)
24,315 (3103)
79,046 (50,806)
33,904 (394)
33,808 352
47,654 (9264)
5000 3520 5000 1480
5000 1897 5000 3103
5000 (45,806) 5000 50,806
5000 4606 5000 394
5000 5352 5000
5000 (4264) 5000 9264
1480
4583
55,389
55,783
352 55,430
64,695
5000
5000
5000
5000
5000
5000
Payments: 20% take 2% discount and pay on day 10; 65% pay on day 30; 13% pay on day 60; 2% never pay. Cost of goods sold (COGS) 5 70% of sales paid month prior to sales; SG&A 5 15% of sales; taxes 5 April and June 15% of quarterly sales; FA purchase 5 $50,000 in March; interest 5 $600 in June.
first- and second-quarter total sales, respectively. Interest on the LOC is based on cumulative borrowing from the prior month. The cash surplus or deficit is calculated as cash inflows less total payments. Beginning cash is then added to the cash surplus or deficit to determine cash available. Because Penny does not want to go below $5000 in cash on hand, $5000 is shown as the target cash balance. Each month, cash available is automatically compared to the target to determine whether external financing is needed. As can be seen in the cash budget, Penny needs to add to her loan balance in 5 of the 6 months. Interest is automatically
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calculated on the cumulative loan balance and added to the total payments. In May, Penny generates a slight surplus and uses the extra cash to repay part of the LOC. The cash budget for Penny’s Pottery, as it stands so far, would not be very appealing to a banker. Why? Penny is a net borrower in 5 of the 6 months of the budget with no indication that she will be able to pay off the LOC. Penny’s external financing needs are exacerbated by her desire to keep $5000 in cash on hand, and she needs to weigh the cash safety net against the cost of financing it. Penny’s problem is bigger than the target cash balance, however. What is going on here? Penny’s sales are growing nicely, more than doubling in the seventh-month forecast. Why does she keep going deeper and deeper into debt? Herein lies one of the great ironies of financial management. The faster you grow, the less money you will have. Always. Because Penny buys her inventory in advance of sales, when sales are rising, her costs go up faster than sales. Because her customers do not pay cash at the time of sales, collections lag behind sales, adding to the cash flow problems in a period of rising sales. In periods of rapid sales growth, all firms experience cash flow problems, just as Penny is. The importance of the cash budget as a planning tool is to see the cash shortfall in advance and to plan for it. If we had extended the cash budget further, Penny’s sales may have declined in some months, allowing her to catch up. Over the course of a year, a banker will demand to see a month or two in which the LOC can be paid down to zero. A LOC is short-term financing, and no banker wants to see it used as permanent capital. The monthly cash budget is an important planning tool, but crucial detail is obscured by focusing on only the month-end balances. To complete the cash planning process, a daily cash budget must be prepared for the following month. The daily budget is critical because cash inflows and outflows do not occur uniformly throughout the month. Although sales may or may not occur uniformly, expenses almost certainly will be congregated on certain days, throwing off the validity of the monthly cash budget on certain days. For example, the monthly budget shows a $1480 deficit from operations for the month of January. But what if Penny pays her employees on the fifth of the month and her suppliers on the tenth? Virtually all her expenses will be incurred by the tenth, when only a third of her sales have been made. This means that the within-month deficit on the tenth is likely to be considerably larger than the $1480 shown for the month. Because Penny must have the cash to pay her employees and suppliers, she must arrange for within-month cash shortfalls to be covered in order to remain solvent. The format of the daily cash budget is the same as the monthly budget except that cash flows are assigned to the actual days on which they occur. Creating the daily budget is an insignificant technical step but a very important management tool that should not be overlooked. Modifications to the structure of the cash budget are virtually endless. For a business that does not extend credit to its customers, sales would typically be for cash or cash and credit card. Cash sales are recorded in the month of sale at their face value. Credit card sales result in cash to the company with varying speeds, depending on the credit card company involved. All credit card companies deduct a fee, usually around 3% of sales, for the credit provided. Although some small
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businesses do not accept credit cards because of the fee charged, increasing the payment options for your customers potentially increases your sales. Accepting credit cards, rather than extending your own credit, eliminates the need for a credit department, reduces bad debts to zero except in rare cases, and, most importantly, allows cash to be realized sooner.
Sources of Short-Term Financing What are the company’s options for obtaining short-term financing? Before answering this question, we need to ask a more fundamental question. How should the external financing be split between short-term and long-term sources of financing? At first this may seem to be a surprising question. Perhaps you have heard of the old adage “Finance current assets with short-term loans and fixed assets with long-term sources of funds.” But this piece of folk wisdom ignores the fact that all firms carry some permanent levels of current assets. It is unlikely that a firm will ever carry zero receivables or zero inventory. This means then that there is a permanent level of current assets that may be more efficiently financed with longer term sources of funds, either equity or long-term debt. The company needs to analyze current asset and liability levels across the year. What are the minimum levels of assets carried during the slack business period? A true maturity-matching approach to financing would indicate financing the permanent levels of current assets with long-term sources of funds. Relying too heavily on short-term debt maximizes the company’s exposure to interest rate risk. If you must continually refinance or roll over a short-term note, you will be burdened with higher costs in a period of rising interest rates. By using long-term financing to finance permanent current assets, the firm locks in a cost of funds. In periods of rising interest rates, reliance on short-term loans can turn out to be very expensive.
Lines of Credit The best source of financing for cyclical current asset needs is a revolving LOC. A LOC is essentially a preapproved loan, available on demand in part or whole, up to the preapproved limit. For approval, the company must submit a cash budget to the bank, which must include months of positive cash flow and demonstrate an ability to repay the LOC. The budget should also demonstrate when and why external financing is needed. As cash deficits occur, a check can be written against the LOC, drawing on it to a predetermined maximum. The beauty of the LOC is that should you end up not needing the funds, there is no charge.2 Also, unlike a term loan, there are no scheduled repayments of principal. As in the Penny’s Pottery case, principal payments are made as cash flow 2
Sometimes there is a charge to establish a more formal LOC. This is typically the case for very large lines in which a commitment from the bank represents a substantial commitment of resources. An entrepreneurial venture is unlikely to need the formal LOC and would not be charged a commitment fee.
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allows. Interest is incurred monthly and must be paid on outstanding balances, but the deferment of principal payments buys the cash-strapped firm time and flexibility.
Asset-Backed Loans Term loans from banks, typically called notes payable on the firm’s balance sheet, are more structured than an LOC and therefore not as desirable. Unfortunately, in the early stages of a company’s life, the bank may not be willing to extend an unsecured LOC to the company, and a secured loan may be the only option for obtaining financing. What assets are appropriate for securing a short-term loan? Personal assets are always an option. If the firm has a marketable securities portfolio, it would be good security for a loan. More likely assets to use as collateral are the firm’s inventories or accounts receivable. Inventories as collateral do not work for all firms. To be acceptable collateral, the inventory items must be finished goods with a ready market for liquidation. Car and boat dealerships routinely finance their inventories by pledging the individual vehicles as collateral for the loans used to buy the vehicles from the manufacturers. Some raw materials, such as sheet steel, also work as collateral. The key is whether the bank would be able to find a ready buyer for the asset in its current state. Work-in-process would never be acceptable collateral to a bank. Accounts receivable may also be used as collateral, but, like inventory, not all accounts receivable are created equally. A bank is much more likely to accept your receivables as collateral if your customers are large corporate accounts. A business selling to individual consumers would not provide the type of receivables that a bank would typically accept. Assuming that you are selling to large corporate accounts, pledging accounts receivable essentially shifts the focus on creditworthiness from you, the start-up, to your customers. Pledging simply means offering your accounts receivable as collateral for a loan. In this case, your customer’s creditworthiness determines how likely the accounts are to be collected and thus how valuable they are. This is ideal for a new company without a credit history that is selling to established companies. To use receivables as collateral, the bank will examine your receivables and advance a loan only against the current receivables, 30 days old or less. Typically, the bank will lend 80% of the book value of current receivables. You retain possession of the receivables, remain responsible for collecting them, and suffer any losses of nonpayment by your customers.
Factoring Factoring, discussed in Chapter 2, is an alternative to pledging and provides another option to use accounts receivable in financing. When factoring, the firm actually sells its accounts receivable to a third party—the factor. The factor may be
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a bank or a specialized factoring company. Factoring is accepted practice in some industries, apparel manufacturing for one, and frowned upon in others. As with pledging, a factor will examine your receivables and accept only quality current receivables. The difference is that you sell the receivables to the factor, realizing cash from the sale immediately and removing the receivables from your balance sheet. Your customers send their payments to the factor, and the factor in effect becomes your credit department, handling collections and absorbing any losses from nonpayment. The high cost typical of most factoring arrangements is, in theory, justified by the value of the financing and accounts receivable function provided. The transaction involves more than lending, and costs are commensurately higher. Before you conclude that factoring is the solution to your cash flow needs, however, consider that the factor accepts only your current accounts. If you have past-due accounts receivable, you will have to maintain at least a partial credit department to deal with them. Also, the factor will advance anywhere from 70% to 95% of the face value of receivables, depending on their quality. Additionally, the factor withholds a reserve until all accounts are collected. When the accounts are paid in full, the factor will forward you the funds held in reserve. Many new firms use the factoring arrangement to get them through the early life stages characterized by substantial cash flow shortages, then switch to more conventional financing as soon as they are able. Factoring may be expensive, but if the alternative is out of cash (OOC), it can begin to look more attractive.
Customers Customers can be a source of financing for the new venture in at least 2 ways. If your business provides a new or customized product or service, it may be in the customer’s best interest to help get your firm up to scale through a direct investment. This works best when the business was started to address the needs of a particular customer or when a customer offloads work, previously done in-house, to your firm. Simply put, if there are no good substitutes for what you offer, the chance of direct investment by your customers rises substantially. Another option for customer financing is to demand full or partial payment in advance. This strategy works best when the service is ongoing (consulting) or the product takes some time to develop or is highly customized. In the previous cash conversion example, we noted that Dell carries very little inventory and has a negative CCC. The Dell model is to demand payment from customers in advance, at the time of the order for a computer or system. Dell buys inventory as orders come in, thus eliminating the need for a parts inventory, a very significant fact in an industry with such rapid obsolescence. As noted, Dell does not use the cash deposit to purchase inventory, instead buying on account and conserving the cash in the business. In consulting or service businesses, a deposit is often demanded up front when a contract is signed. This serves to improve cash flow, but it also bonds the customer as a serious buyer of your services. The same is true when the customer is buying a
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tangible product. A down payment or deposit increases the odds that the buyer is a serious customer. Even if the customer later withdraws the order, the deposit may allow you to break even on the lost sale.
Cash Management Banks provide cash management services that limit the firm’s need to carry idle cash balances. In addition, the firm can do several things on its own to expedite the flow of cash. Every attempt should be made to synchronize the cash flow between payables and receivables. A relevant example is provided by the situation of a private school on whose board one of the authors sat. Each year the school experienced a severe cash flow crunch because books and supplies had to be ordered in advance of the school year. Revenue came in the form of tuition, which was not collected until school started in September. The author suggested moving the tuition payment cycle up 1 month, with tuition starting in August. The change was implemented, the cash flow crisis was solved, and, although the parents were not thrilled with making a tuition payment during the summer, they did like the fact that payments ended a month earlier in the spring. Another simple technique to solve a cash flow problem is the management of payroll. By switching from a weekly or twice-a-month payroll system to an end-ofmonth payroll, all of the cash inflows from the month will be available to cover the payroll outflow. The firm has a lot of control over the timing of many of its cash flows, and synchronization is the key to managing cash flow efficiently. A basic goal of cash management is to get access to incoming funds as quickly as possible. Invoices should accompany goods out the door. Never wait until the end of the month (or even the week) to bill your customers. By waiting to invoice, you are providing free credit to your customers and incurring a cash shortfall for yourself. As discussed previously, discounts may provide enticement to customers to pay sooner. In exchange for a 2% discount, you will gain the use of your cash 2030 days sooner and perhaps negate a need for higher cost external financing. It should go without saying that all firms need a competent credit department, but here again the tendency to scrimp can interfere with best practices. Credit standards must be set and enforced before credit is extended. Payment patterns must be constantly monitored to spot changes in patterns that could lead to cash flow problems down the road. Collections must be timely and forceful to ensure payment. Occasionally, credit extensions to customers may need to be discontinued for nonpayment and no further credit extended. U.S. News’ Money section3 suggests six practical ways that firms can solve their collection problems: 3
http://money.usnews.com/money/business-economy/small-business/articles/2008/05/12/6-ways-firmscan-solve-collection-problems.
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1. Give out as little credit as possible. If customers balk, they may have been poor credit risks to begin with. When you know that a customer is serious about paying their bills, you could try some payment schedule that works for both of you. 2. If you are going to lend money, think like a banker. Make all customers fill out a credit application and update it every year. Many businesses get a credit report on the applicant to help them make the decision. 3. Time is of the essence. The value of your accounts receivable lessens with the age of its payments due. Make that “friendly but firm” phone call. 4. Make sure you have the facts in front of you. Before you pick up the phone, have all the information about the customer’s account in front of you and make sure you are familiar with it to avoid getting the run-around. 5. Be willing to negotiate if need be. Work with the customer or you may not get anything. Let them make partial payments over some period of time if need be. 6. If all else fails, do not try to be your own collector. There are collection agencies that know how to get the most that you can for a customer. The customer has a greater incentive to settle where they know that their credit rating is at risk.
Accuracy is crucial to a smoothly functioning credit operation. One financial manager observed that at least 95% of collection problems derive from the following: G
G
G
G
Incorrect or incomplete invoices sent to the customer. Invoices sent to the wrong address. The amount of the invoice exceeding the authority of the person receiving the invoice. A change in personnel at the customer company.
To ensure timely payment, know your customers and their procedures, keep the lines of communication open, and work with them. Increasingly, firms are moving to electronic invoicing and payments, eliminating the problem of mail and bank processing float. It also reduces the very timeconsuming task of processing checks.
Lockboxes If your customers are spread across the country or around the world, regional lockboxes can reduce mail float and improve your access to your cash. A lockbox is a regional post office box monitored and maintained by a local bank. Your customers mail payments to the closest lockbox, and the bank collects the payments and wires funds into your account daily. If your business is located on the East Coast, for example, you may be able to cut 23 days of mail float time out of the collection process by having your West Coast customers’ mail payments to a West Coast lockbox. If you are receiving thousands of dollars a day in payments, a reduction of 23 days in float adds up over the year. The lockbox allows you to realize your sales dollars sooner, alleviating the need for external financing for those days.
Bank Cash Management Services The use of preauthorized debits is an excellent way to control cash flow and reduce defaults. Preauthorized debits are monthly transfers from your customers’ checking accounts into your bank account. This alleviates the need for monthly paper billing,
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allows you to accurately forecast cash inflows, and reduces the chance of nonpayment by your customers. Banks also provide cash management services for small businesses. Essentially, this service is a sweep account that allows the firm to carry a zero balance in its noninterest-bearing checking account. The checking account is tied to an interestbearing money market fund. Each day, money is transferred from the money market fund to cover any checks written against the account that day, and surplus balances are transferred to the money market fund. The checking account will always show a zero balance, and cash will always be invested, albeit at currently very low money market rates. It is wise to think of all current assets as nonearning assets. A company should constantly monitor its level of cash and ensure that it is put to its best use. Even though a company may use a sweep account to keep the cash-earning interest, the interest earned is trivial compared to what the money could be earning if it were put to productive use in the firm’s fixed assets. Large stockpiles of cash are a red flag in attracting takeover suitors. More to the point, the owner’s wealth is not being maximized unless money is put to its most productive use, and that use is virtually never in current assets.
Summary This chapter explores the opportunities for finding capital through the internal management of cash flows. Cash flow management, distinct from the accounting function, is a financial function necessary for planning and for reducing the need for external sources of financing. Working capital management, the control of current assets and current liabilities, is more important for small firms than for large ones. This is due to the fact that small and new firms have relatively more capital invested in current assets and have less access to capital than their larger counterparts. The CCC is the basic tool of working capital management. It allows the firm to monitor and control the cash invested in accounts receivable and inventory and to maximize the use of free, or reasonably priced, credit from suppliers. Trade credit can be free or very expensive. It is critical to determine its cost and use it optimally. Ideally, the firm’s total investment in accounts receivable and inventory will be financed by free trade credit from its suppliers. An example was used to demonstrate the creation of the cash budget. The cash budget allows the firm to spot external financing needs and to arrange for them in advance. Additionally, the cash budget allows the firm to manage cash flows to reduce the firm’s need for external financing. Firms must produce both monthly and daily cash budgets to adequately control and plan for cash shortfalls. The relationship between rapid growth and negative cash flow was discussed. One solution to this problem is obviously to grow more slowly. Although this is
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the antithesis of what may seem obvious, it may be the most prudent way for most firms to proceed. The chapter also looked at various sources of short-term financing. Short-term financing options include LOCs, asset-backed loans, factoring, customers, and internal cash management techniques. Internal cash management techniques include coordinated cash flows, timely invoicing and collection, and adequate credit standards applied in the initial credit granting decision. The importance of accuracy and working with your customers was also emphasized. The overriding goal in working capital management is to minimize the investment in nonearning current assets, reduce the firm’s reliance on external financing, and redirect resources to their most productive use in the business—toward fixed assets.
Discussion Questions 1. Look up Starbuck’s most recent financial statements. Calculate the CCC for Starbucks. What advice would you offer Starbucks based on the CCC? 2. What is the cost of the following trade credit terms of 3/15 net 45? What options does the company have if it deems the cost of the credit too expensive? 3. Prepare a cash budget for March and April based on the following information:
Sales Wages Rent Other Taxes
January
February
March
April
$50,000
$50,000
$40,000 3000 1000 400
$60,000 4000 1000 600 8000
Experience shows that 20% of customers pay in the month of sale, 70% pay 1 month later, and the rest of paying customers pay 2 months after sale. Three percent of customers never pay. Inventory is purchased 1 month prior to sale, and cost of goods sold equals 70% of sales. Accounts payable are paid 30 days after purchase. Any financing is done through a 12% LOC. The company has $5000 cash on hand on March 1 and would like to retain a cash balance of $5000.
Case 10.1 New Tech (O): Monthly Cash Budget Using a spreadsheet, prepare a cash budget for New Tech for the next year (January through December) based on the following information.
October Sales revenue (previous year) Purchases PAYMENT SCHEDULE Cash sales 5 10% 30-day payment 5 70% 60-day payment 5 20% PURCHASE SCHEDULE Paid in first month 5 40% Paid during second 60 days 5 60%
Sales revenue Purchases
325.0
November 325.0
December 325.0 59.2
Jan.
Feb.
March
April
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
325 59.0
300 59.2
275 59.2
325 59.2
350 59.2
375 59.2
400 59.2
375 59.2
350 59.2
300 59.2
275 59.2
250 59.2
4.2 40.0 2.5
4.0 39.0 2.2
5.1 38.0 2.4
5.4 42.0 2.5
7.3 38.4 2.5
6.5 44.3 2.8
6.7 42.5 2.7
6.6 41.0 2.5
6.1 38.0 2.6
7.0 39.0 2.6
5.8 39.5 2.6
5.7 38.0 2.4
60.0 5.9 7.0 6.0 5.0
62.0 5.0 7.1 6.5 6.0
65.8 5.8 6.9 7.0 3.0
62.8 6.8 6.8 9.0 40.0
62.7 6.9 7.6 8.5 50.0
67.9 7.4 7.8 8.7 21.5
71.6 8.0 8.4 8.3 18.3
62.8 7.8 7.5 8.1 18.7
64.9 6.5 7.7 7.0 18.9
66.9 6.8 7.7 7.2 16.0
68.0 6.4 7.9 6.0 8.5
65.0 6.4 7.4 7.5 14.0
Disbursements Freight in Labor Utilities, insurance, etc. Salaries—selling Commissions Travel Advertising Other charges—
(Continued)
(Continued) Jan.
Feb.
March
April
35.0
35.0
34.0
33.0
5.8 8.3
5.8 10.3
5.8 15.6
9.3 40.0
9.3 45.0
9.3 33.0
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
36.0
36.0
38.0
39.0
35.0
33.0
32.0
34.0
5.8 7.5
5.8 8.3
5.8 7.7
5.8 7.9
5.8 6.2
5.8 6.7
5.8 6.9
5.8 6.3
5.8 8.3
9.3 350.0
9.3 500.0
9.3 16.8
9.3 23.8
9.3 23.0
9.3 18.0
9.3 20.0
9.3 20.0
9.3 10.0
Selling Salaries— administration Leasing Research and development Taxes Purchase of assets
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Sensitivity Analysis G
G
What would happen to New Tech’s need for external financing if sales varied plus or minus 10%, 20%, and 30% from the forecasted level? Prepare a sensitivity analysis. What would happen to New Tech’s financing needs if customers began to pay 15% in the month of sale, 60% the month after, and the rest in 2 months? Assume that at least 3% bad debts remain.
Bibliography Bandyk M: 6 Ways firms can solve collection problems. Retrieved at ,http://money. usnews.com/money/business-economy/small-business/articles/2008/05/12/6-ways-firmscan-solve-collection-problems.. Bowen, HK, Andrew RJ, Laurence EK, Kevin EK, and Baltej K: Cash Management Practices in Small Companies. Harvard Business School Background Note 699-047, December 1998. Cambridge MA. Brealey RA, Myers SC: Principles of corporate finance, ed 5, New York, NY, 1996, IrwinMcGraw Hill. Brigham EF, Daves PR: Intermediate financial management, ed 7, Mason, OH, 2001, SouthWestern. Copeland TE, Weston JF: Financial management, ed 9, Fort Worth, TX, 1992, Dryden Press. Jassy AR, Katz L, Kelly K, Kochar B: Cash management practices in small companies, Harvard Business School Note, 1998. Stancill JM: When is there cash in cash flow? Harv Bus Rev MarchApril:3849,1987.