Financial Decision-Making

Short-Term Financial Management—Discussion Guide

Slide # 1 THINK ABOUT IT

There are a lot of moving parts when it comes to finance and business. Before it is reasonable to make decisions about investing or raising capital, a business must have stable operations.

KEY CONCEPTS

Slide #2 The main objective in short-term financial management is ensuring that a business is maintaining a positive net cash flow that enables it to pay its bills on time and make short-term investments that increase profitability.

These short-term investments can only be achieved if the business is first able to consistently pay its bills.

• • To achieve this necessary baseline in liquidity, however, short-term financial management must start with monitoring and adjusting working capital and cash flows.
  • This involves not only keeping cash inflows sufficient and steady, but also involves managing operating costs and cash outflows appropriately.

Slide #3 Short-term financial management is largely comprised of managing cash flow and working capital.

Cash flow is the movement of money into and out of a business.

Working capital is the difference between current assets and current liabilities.

• • Put another way, working capital is the remaining amount of short-term assets after the amount of short-term liabilities has been subtracted.
  • If this is a negative number, it means that the business owes more in short-term debts than it owns in things of short-term value, thereby making it difficult to pay bills on time.

Although related, working capital and cash flow are not the same thing.

• • Cash is just one type of current asset that affects working capital.
  • If, for example, a business buys inventory with cash, this amounts to a decrease in net cash flow because cash leaves the business without a corresponding cash inflow.
    • However, the amount of working capital does not decrease in this situation because the exchange of a current asset (cash) for a current asset (inventory) balances out—there is no net change in current assets in relation to the amount of current liabilities.

• • If, however, the business purchases a new building, working capital and cash flow both decrease because cash is paid for the building (even if only a down payment), but there is not a corresponding current asset to balance out the cash payment because buildings are noncurrent, fixed assets.
    • Since a current asset was exchanged for a fixed asset, the result is a decrease in both net cash flow and net working capital.

Slide #4 Working capital and cash flow management can be further divided into three interconnected sets of responsibilities. They are the areas of accounts receivable management, accounts payable management, and inventory management.

Accounts receivable management and accounts payable management are important aspects of both working capital management and cash flow management.

• • Receivables are current assets that make up a significant part of cash inflows, while payables are current liabilities that impact cash outflows.
  • In general, these tasks involve ensuring an appropriate balance and schedule for collecting receivables and paying payables in a way that doesn’t leave the business without the appropriate amount of cash required to pay bills and maintain smooth operations.
  • The next two lessons will focus more on how these areas are managed.

Inventory management involves the procurement, storage, and selling of a business’s products.

• • Depending on the type of business, this could include managing a range of activities from ordering finished goods, storing them, and stocking them for resale to overseeing all aspects of ordering raw materials, adjusting the rate of product assembly or manufacturing, inventory storage/stocking, and the logistics of providing the product to the customer.

Inventory management is a critically important aspect of working capital management since inventory is one of a business’s most important and valuable assets.

• • It is also a current asset in that it is owned by a business and intended to be sold (converted into cash) in the short term.
  • If managed poorly, however, inventory can cause major problems for a business’s working capital calculations.
    • This occurs when too much inventory is held and ties up large portions of a company’s working capital until the inventory is sold and converted into cash.
    • Any inventory that is not sold within the expected time frame can disrupt the working capital cycle, which is the amount of time it takes a business to convert all of its working capital into cash.

The best way to maximize the working capital cycle is to shorten the amount of time taken to sell inventory (inventory management) and collect revenue (account receivable management) and to lengthen the amount of time taken to pay debts and bills while still paying them on time (accounts payable management).

• • In this way, accounts receivable management and accounts payable management depend on inventory management to turn materials and products into cash from customers.

Slide #5 A number of measurements aid in assessing a business’s working capital and cash flow management, and which areas of responsibility can be adjusted to reach better outcomes. They include:

Cash conversion cycle, the number of days required to convert investments in inventory into cash from the sale of that inventory.

• • This includes the amount of time to produce and sell a product in addition to the amount of time to collect cash from the sale and pay any bills associated with purchasing the product’s raw materials.

Current ratio (sometimes called the working capital ratio) is a measure of a business’s ability to pay all of its short-term debts.

• • It is essentially net working capital expressed in ratio form.

Inventory turnover is a measure of how long it takes a business to sell its entire inventory and replace it with new inventory.

• • This number is often expressed as a ratio and is used to compare different businesses within the same industry.
  • For more information on calculating inventory turnover, click here: https://www.investopedia.com/terms/i/inventoryturnover.asp.

Slide #6 Beyond working capital and cash flow management, short-term financial management also involves decision-making about how to use the cash that an organization has on hand.

If cash inflows are consistently higher than outflows, the remaining cash should be invested and used to generate additional profits.

Cash management involves all aspects of collecting cash and selecting the short-term investments intended to generate further profits.

• • In addition to managing accounts receivable and payable (which will be covered in the next lessons), cash management involves managing short-term investments while maintaining sufficient liquidity.
  • If liquidity becomes an issue, financial managers must make decisions about whether to issue additional stock or take on debt to bring in enough capital to operate.

To anticipate when to make investments or raise capital, financial managers use a cash budget, which lists expected cash inflows and outflows for an upcoming accounting period.

Cash management is a complicated, but important, aspect of growing a business.

• • Advances in technology have made these responsibilities easier to manage for smaller businesses.

Accounts Receivable—Discussion Guide

Slide #1 THINK ABOUT IT

Working capital management can be broken down into four major components: inventory, cash, accounts payable, and accounts receivable. Because many businesses offer the sale of their products on credit, keeping good records of the credit extended, when it is due, and which customers pay on time helps maintain efficient operations and steady cash flow.

KEY CONCEPTS

Slide #2 One of the central aspects of short-term financial management involves accounts receivable.

• • Often, this money is owed for products that have been sold to customers on credit but has not yet been paid.

Sometimes, an individual line of unpaid credit is called a receivable.

• • Receivables are considered current assets in that they are expected to be converted into cash in the short term.

The conversion of credit or receivables into cash is called collection, and a business’s cash flow can really depend on effective collection policies.

Even though it means they will not receive the cash immediately, businesses sell products on credit for a number of reasons.

• • Issuing credit can help build strong relationships with customers, improve sales numbers, and help ensure consistent inventory turnover.
  • However, there is some risk involved in selling on credit.

• • It is rare that a business is able to collect payment for all its receivables.

Whatever the reason for the nonpayment, receivables that are not able to be collected are referred to as bad debts.

• • Bad debts are usually written off after a certain period of time, but until they are, these uncollected receivables will influence the calculations of working capital and net cash flow.
  • Businesses typically anticipate some amount of credit becoming bad debts, but limiting them is a major aspect of accounts receivable management.

Slide #2 Much like inventory that sits too long, receivables that are not collected in a timely manner can cause problems with working capital management.

Receivables that are not collected on time are still calculated as current assets.

• • Because of this, past-due receivables can tie up working capital and delay cash inflows.
  • Therefore, keeping a close eye on the routine collection of receivables is a major aspect of accounts receivable management.

One measure of the efficiency of accounts receivable collection is the average collection period, which is the average number of days that pass between the sale of a product on credit and when the cash for that sale is received.

• • It can also be expressed in a ratio known as the collection ratio.
  • Knowing this information will better allow management to anticipate when cash inflows and outflows might be out of balance.
  • Typically, smaller average collection periods are best.
  • Once this average number of days gets too high, the business could be at risk of not having enough cash on hand to pay its bills.
    • In this case, the business may need to adjust its collection policies to shorten its average collection period.
    • One way to do this is to offer an early payment discount to incentivize customers to pay sooner.

Slide #4 One tool used to aid in accounts receivable management is an aging schedule.

An accounts receivable aging schedule charts each customer’s unpaid credit and groups these receivables based on how long they have remained unpaid.

Accounts receivable aging schedules are utilized by internal users to:

• • Predict cash flow and when inflows and outflows might be out of balance.
  • Calculate bad debts that will need to be accounted for in the books.
  • Adjust credit limits to customers who frequently pay late.

Aging schedules are sometimes provided to external users as well.

• • For example, an auditor may use an aging schedule to verify any bad debts that are reported on financial statements.
  • Businesses may also provide aging schedules to creditors or lenders to show that they can pay bills on time.

Aging schedules can be made for both accounts receivable and accounts payable.

• • For more information, and an example of an accounts receivable aging schedule, click here: https://www.accountingtools.com/articles/what-is-accounts-receivable-aging.html.

Accounts Payable—Discussion Guide

Slide # 1 THINK ABOUT IT

Just as working capital involves both current assets and current liabilities, working capital management involves more than just managing the current assets of inventory, cash, and accounts receivable. It also involves the careful maintenance of current liabilities, including accounts payable.

KEY CONCEPTS

Slide #2 Accounts payable is the running total of the amount of money that a business owes and for which payment is planned in the short term.

This money is often owed for purchases the business makes on credit that is extended from its suppliers.

Individual lines of unpaid debt are called payables, and they are considered current liabilities.

• • The amount of payables directly influences calculations for both working capital and cash flow.

Even if there is enough cash to cover the cost of their purchases, businesses tend to prefer to buy on credit because it allows them to make purchases on a consistent basis, regardless of available cash or disruptions in cash inflows.

• • This keeps operations stable, routine, and predictable.

Slide 3 A major aspect of accounts payable management is making certain that payments are made on time. Regularly making payments on time leads to strong relationships with suppliers.

This could mean greater flexibility in payment dates, discounted prices, and special offers.

On the other hand, late payments or defaults can lead to significant problems for the entire organization.

• • These problems can include worsening credit ratings and having to pay higher interest rates, weakened relationships and less flexibility with suppliers, not being extended credit in the future, difficulty in finding new suppliers to work with, and even bankruptcy.

Accounts payable management involves managing a wide array of different schedules.

In general, the rule of thumb for managing accounts receivable and accounts payable is to collect receivables as quickly as possible and pay debts as late as possible without being past due.

• • Sometimes, however, it benefits the business to pay bills early.
    • In some cases, suppliers might offer discounts for early payment.
    • Suppliers have their own accounts receivables they need to manage, after all, and early collection may be worth the discounts they offer for paying early.

Slide #4 Accounts payable managers must read invoices carefully because this may be the only place that some suppliers provide information on early-payment discounts.

There are a couple of ways that these discounts might appear on an invoice, but they are rarely written out in sentence form.

More often, the invoice might show a credit term or cash discount term of “2/10

net 30."

• • • This means that a 2% discount applies if the bill is paid within 10 days of the invoice date, but that the full amount will be due in 30 days from the invoice date.
    • These discount notations tend to follow the formula:
      1. X/Y net Z
      2. X = percent discount
      3. Y = number of days to pay the discounted rate
      4. Z = number of days to pay the full amount

Although early payments can further complicate accounts payable management and schedules, these discounts can help increase profitability and improve relationships with suppliers.

Slide #5 Keeping clean and organized records is crucial for maintaining all of the information related to different payables.

It is important to make sure that every payable is both recorded in the correct amount and listed with the appropriate due date to ensure that no debt becomes overdue and that all discounts are realized.

• • To organize all of this information, some managers prepare accounts payable aging schedules.

Similar to the accounts receivable aging schedule, accounts payable aging schedules help keep payment dates and totals available for quick reference.

• • Accounts payable aging schedules are less common, however, because payables can vary widely in their payment terms, and the simple 30-day categorization might not work well for these more-varied terms and due dates.
  • Accounting software may offer specific reports that are better suited for use in accounts payable management.