The Inventory Conversion Period (ICP): the average time required to convert
materials into finished goods and then sell them
The Receivables Collection Period, also known as the Days Sales Outstanding
(DSO): the average time required to convert A/R into cash.
The Payables Deferral Period (PDP): the average time period between the
purchase of materials and the cash payment for them.
Beginning
Item End of year Average
of year
Accounts $515,068 $800,000 $657,534
receivable
Inventory $1,500,000 $2,500,000 $2,000,000
Accounts $415,068 $910,000 $662,534
payable
Sales (all credit) were $10 million and cost of goods sold were $8 million
Determine the CCC.
ICP= Inventory Conversion Period = Inventory / Sales
2,000,000/(10,000,000/365) = 73 days using SALES (as the text does)
If we use COGS, ICP = 2,000,000 /( 8,000,000 / 365) and get ICP=91 days
DSO= Days Sales Outstanding = Accounts Receivable / Credit Sales per day
657,534/(10,000,000/365) = 24 days
PDP= Payables Deferral Period = Accounts Payable / COGS per day
662,534/(8,000,000/365) =30 days
CCC= cash conversion cycle 73+24-30.2=66.8 days On average, 2 months
FMGT 3510 Chapter 17 Page 5
If the ICP (using sales) is cut to 65 days and the DSO to 23 days and the PDP
increases to 31 days what is the new CCC? By how much is free cash flow
increased in the year of these changes? In the next year if sales increase by
10%?
New CCC=65+23-31=57 days
Inventory drops by 8 days:(10,000,000/365) x 8 = $219,178
A/R drops by 1 day: 10,000,000/365 X 1= $27,397
A/P increase by 1 day: (8,000,000/365) x 1 = $21,918
$268,493
improvement in FCF in
year of change
FMGT 3510 Chapter 17 Page 6
CONSERVATIVE
Jan Feb Mar Apr
Temp NOWC - 30,000 20,000 -
Perm NOWC 50,000 50,000 50,000 50,000
50,000 80,000 70,000 50,000
Short Term Debt - - - -
Long Term Debt 80,000 80,000 80,000 80,000
AGGRESSIVE
Jan Feb Mar Apr
Temp NOWC - 30,000 20,000 -
Perm NOWC 50,000 50,000 50,000 50,000
50,000 80,000 70,000 50,000
Cash Surplus/(Deficit) - - - -
Assumptions
Collections during month of sale 20% The 2% discount is taken by customers on these sales
Collections during 1st month after sale 70%
Collections during 2nd month after sale 10%
Discount on first month collections 2% The company's credit policy is 2/10, net 40
Purchases as a % of next month's sales 70% Materials are purchased based on the expected sales next month
Lease payments $15
Construction cost for new plant (Oct) $100
Target cash balance $10 The company does not want to go below this amount
Payments during month after purchases 100%
Short-Term Financing
Advantages of short term financing
o Faster/easier to obtain.
o Appropriate for temporary NOWC needs caused by seasonality.
o Not locked in to an amount or an interest rate for a long time.
o Fewer covenants than for long term debt.
o D/E= debt to equity
o D/E =<.5, (debt to equity) restrictive covenant
o TIE times interest earned
o Usually cheaper.
The Effective Annual Rate (EAR) takes into account the compounding
periods:
Actual, real percent cost given the frequency of compounding
If Frequency of compounding periods = 1,that is 1 cycle per year
then it is an annual cycle and APR= EAR
If the terms are 2/10, net 30 then
365
Discount Days credit - discountperiod
EAR 1 1
1 - Discount
= ( + ) -1 = 44.6%==> Effective cost of missed
opportunity of not taking the discount offered on your AP invoice.
APR = 37.2%
EAR = 44.6%
2ndf ICONV
NOM 37.2 ENTER
DWN ARROW
DWN ARROW
C/Y 18.25 ENTER no of compounding periods per year
DWN
DWN
EFF CPT 44.52168843 ACTUAL PERCENT COST OF MISSING THE AP DISCOUNT
EAR = 44.52%
Enter what is given
Compute (CPT) what is wanted
CPT NOM (APR)
NOM NOMINAL
Example 1:
You purchase goods on terms of 2/10, net 30.
Cost of financing if you pay on day 35?
Calculator
2nd ICONV
C/Y = N = 14.6 Enter
NOM = APR = 29.8 Enter
EFF [CPT] = 34.31
Example 2
Cost of financing if you pay on day 45?
N = 365 /(45 10) = 10.43 = Cycles Per Year
APR = [2/ (100 2)] * [365 / 35] = 21.28
EFF = (1+2/98)(365/35) -1 =23.45%
Calculator
2nd ICONV
C/Y = N = 10.43 Enter
NOM = APR = 21.28 Enter
EFF [CPT] = 23.45
FMGT 3510 Chapter 17 Page 19
Example 3:
A company has credit terms of 2/12, net 28.
What is the annual cost of trade credit (APR)? What is the effective cost (EAR)?
365
Discount Days credit - discountperiod
EAR 1 1
1 - Discount
= ( + ) = 58.5%
Calculator
Annual Percent Rate Effective Annual Rate
N=1 N = 16/365 = 0.0438
PV = 100 2 = 98 PV = 98
PMT = 0 PMT = 0
FV = -100 FV = -100
CPT I/Y = 2.04 ( 1Cycle) CPT I/Y = 58.6%
APR = 2.04 * ( 365 / 16) = 46.53%
FMGT 3510 Chapter 17 Page 20
The typical loan is a one-year line of credit. The loan will state a maximum
amount that can be borrowed and the business can borrow any amount up to
this amount during the term of the loan.
o A revolving line of credit is similar but has a longer term.
o Credit lines can be committed vs. noncommitted
Money market financing
Large firms with excellent credit records can obtain financing directly from the
money markets by issuing short-term debt securities.
o Commercial paper: short-term notes with maturities ranging from 30 to
365 days, offered in denominations of $100 thousand and up. Usually
backed by a bank line of credit. Commercial paper is usually less costly
than bank loans.
o Bankers acceptances: variant of commercial paper where for a fee, a bank
guarantees the papers principal and interest.
Disadvantage of money market financing: the risk that the market may
temporarily dry up (as during the 2008 credit crisis) when it comes time to roll
over the paper.
FMGT 3510 Chapter 17 Page 22
Example 5
What if APR is 12%, paid quarterly? Lets assume that each quarter is the
same length.
Example 6
What if interest rate is APR= 12% but paid on a discount basis? This
means that the interest amount is paid at the beginning of the loan period.
0 0.25 0.50 0.75 1.0
Example 7
Sometimes a compensating balance (CP) is required. This provision means
that the borrower must keep a minimum amount on deposit at the bank,
stated as a percentage of the loan amount e.g. 20%. If this amount exceeds
what the borrower would normally have on deposit then we must take it into
account when calculating the loan cost. The loan is still a 12% discount loan.
0 0.25 0.50 0.75 1.0
10,000 -10,000
-1,200 discount amount 2,000
-2,000 compensating balance kept at the bank as security
6,800 Net proceeds to Company ` -8,000
N=1 PV=6,800 PMT= 0 FV= -8,000 I/Y=17.65%
Effective cost of borrowing given the discount + compensating balance
FMGT 3510 Chapter 17 Page 26
The seller may realize cost savings by transferring the credit and
collection functions to the factor.
Example 8
The factor charges a fee of 2.5% of A/R sold to it, plus interest of 9% APR
and a deposit equal to 5% of A/R. What is the EAR of factoring a 1 month
A/R of $10,000?
0 1 month
2nd ICONV
NOM 42.50681199 ent ENTER NOMINAL, ANNUAL PERCENT RATE
C/Y 12 ent
EFF CPT = 51.85% = EAR = EFFECTIVE ANNUAL RATE
FMGT 3510 Chapter 17 Page 29
o Inventory financing
Inventory is assigned to lender as security based on a predetermined
margin percentage (usually a lower percentage than the one used for
receivable).
Form of charge:
o Blanket lien (covering all inventory)
o Trust receipts (covering specific, high value items such as
automobiles)
o Warehouse receipt financing: goods are held in either a third
party public warehouse or at a field warehouse at the
borrowers premises but segregated.