Question

Working capital management

a) Your CFO tells you as finance manager that he feels much safer to have a smaller inventory and cash level than before. What are trade-offs involved in the decision of how much inventory or cash the firm should carry. Answer for both inventory level and cash level separately.

b) Receivables are for many companies a very important asset on the balance sheet – and the final step before receiving cash. Please explain what elements a credit policy of companies should contain in order to have high assurance for the collection of the receivables. Provide at least 3 elements.

Payout Policy

Artesia Ltd is making good profits, even though growth is slowing down a bit. So far the company has not paid out cash to its shareholders, however the CFO wants to start paying dividend or start the repurchase program. What questions should the CFO address in order to decide on a possible pay out?

Answer 1

A) INVENTORY LEVEL

Accounting for vendor delivery times

The inventory must incorporate the vendor’s lead time on delivery. Let’s assume Company A has a vendor with a standard transit time of 10 business days. These 10 days would be the time it takes the vendor to deliver product. In this case, Company A would need to account for the 10 business days when calculating their safety stock.

daily customer consumption

For example, Company A currently sells an average 440 units a month. However, it’s wrong to assume that it’s 440 units divided by 30 or 31 days. Instead, Company A must define the number of actual buying days in the month in order to forecast demand. While most software programs will account for this, it’s possible some businesses may have to do this manually. In this case, we’ll assume there are 4 full weeks plus 2 remaining days at the end of the month. Hence, the number of buying days is 22 and the average daily consumption is 440 units divided by 22 buying days, or 20 units sold each day.

Applying the 50% rule of safety stock

There is no silver bullet when it comes to determining safety stock, but there are formulas that you can use to help you figure out the right amount to keep on hand. To help you get started on determining your safety stock levels, the 50% rule is a generally accepted starting point that businesses use. To continue our example, the vendor’s delivery time averages 10 business days and Company A’s daily sales average 20 units.

Therefore, if Company A was to cover its entire transit time, it would set its safety stock at 200 units. However, Company A also knows that its inventory carrying costs would be somewhat high at this quantity. Therefore, applying the 50% rule of safety stock means Company A could set its safety stock at 100 units. This should allow it to meet the average customer demand for 5 business days.

Determine reorder points

Up to this point we’ve only determined Company A’s safety stock level. With this final step we’ll determine Company A’s reorder point. Going back to our vendor’s delivery time of 10 days, it makes sense to set Company A’s reorder point to cover this delivery time.

Therefore, we would set the reorder point at around 200 units. Once their inventory approaches 200 units, Company A would place another order with its vendor. Those 200 units that remain should cover consumption for the duration of the next shipment.

By considering the above factors we can make the decision.

CASH LEVEL

The basic object of cash management is to minimize the level of cash balance with the organisation. This can be achieved by preparing the Cash Budget. Once the cash budget is prepared the should see that there should not be a gap between actual cash inflows and its outflows. Due importance must be given to cash collection techniques. The techniques of fast collection and slow disbursements will helpful in controlling outflows of cash. The cash collection should be with an accelerated, while its disbursement must be slow as much as possible. The outflows can be controlled if the centralized system for cash disbursement is exercised. The payment must be made on due date i.e., not before the due date and not after the due date. The excess cash represents the surplus cash available with finance manager after meeting all outflows. The surplus cash is the excess cash available over minimum cash balance such excess should be invested in the purchase of temporary (short period) investments. The excess cash should be invested in securities where funds are safe, the liquidity: the fund should be available whenever required.

b) RECEIVABLES PAYOUT POLICY

While no company intends to adopt weak accounts receivable policies, lack of planning, poor enforcement or a failure
to focus on the function can result in unintended consequences. These often arise when companies:
• Fail to follow up with customers in a timely manner when payments are past due
• Allow sales reps to override credit limits – and end up suffering losses from bad credit risks
• Neglect to provide staff with appropriate training on how to deal with late paying customers
• Don’t pay sufficient attention to the accuracy of their bills, invoices or credit terms
• Allocate cash payments incorrectly, making it harder to figure out which payments are outstanding

Customer credit approval
First off, you need a process – clear and concise policies for issuing credit and recovering debt in a timely fashion.
To do this, you need to:
• Set responsibilities. Solicit input from the sales team when setting policies to ensure market realities are reflected. For instance, you need to understand when to grant credit, circumstances that may merit overriding credit limits and situations that would justify placing
accounts on hold. Once those policies are established, however, the finance team must enforce them and sales should not be authorized to issue credit or change terms without pre-approval. The aim is not to have finance
interrupt the sales process, but to acknowledge as an organization that not all customers are good customers.
• Determine when to assess credit limits. If a new customer is buying low volume items on short terms, a simple internal scorecard may be sufficient to assess their creditworthiness. Conversely, if a new customer is
interested in purchasing large volumes on a regular basis, you may need a more stringent process, such as full background and credit history checks.

2. Customer master data
Once you assign credit limits, payment terms, discounts, tax rates and return policies, and any other relevant terms (i.e. delivery address,e-mail address etc.) to specific customers, those terms must be accurately reflected in your billing and collection systems. Customer master data
should indicate what the customer is allowed to, purchase any dollar limits that apply, payment terms, whether they get volume discounts or advertising credits, and any other relevant terms.
Getting this wrong is more than a data entry glitch. For instance, if you enter an incorrect address, invoices go to the wrong place and receivables slow down. Likewise, if your master data indicates payment terms of 60 days
when it should be 30, you won’t be paid on time.
Recognize, too, that the master data must be updated if a customer’s credit profile changes. For instance, if you grant additional credit to a customer, this should be reflected in the system. Companies have a habit of assuming the
master system trumps all, but that’s only true if data accuracy is being maintained.

3.Collection process
While every business enjoys collecting revenues, not all organizations take a proactive approach to ensure receivables are collected on a timely basis. This is often due to weak processes. For instance, a lack of reporting can make it difficult – or impossible – to determine which
amounts are collectible and which may be in danger of default. Similarly, failure to adhere to the company’s credit or collection policies makes it harder to determine which payments are late and which will never arrive. Of course, before they can follow up on late payments,
your staff members also need assurance that the accounts receivable reports are accurate as of today and that there aren’t days, or even weeks, worth of cash receipts that have not yet been applied to customer accounts. This
requires a robust accounting process

c) Dividend payout

The personal aspirations are prioritized over objectives of the company and expectations of shareholders. In professional organizations, the distinct categorization between ownership and Control is followed. The shareholder’s are the owners of the firm and the professional managers are ( which may include the executive directors of the firm) appointed to run the organization in accordance with, the objectives of the firm. Ideally the objectives of the firm like, wealth maximization or value of the firm should also be the objective of the said employee hired by the owner. Typically , owners are called as principals and the employees are called as the Agents. As ownership and Control differs, the conflict between the agents and principals may take place. The individual goals of the agent, when differs that from the principal , which is explained by the agency cost theory. The short term objectives of the managers may be prioritized against the long term goals of the organization. This may have implication on the composition of the capital of the Firm.