Foundations of Financial Management: An Analysis (part 16)

“You cannot escape the responsibility of tomorrow by evading it today.”

~Abraham Lincoln~

Working Capital and the Financing Decision

(part B)

by

Charles Lamson

Controlling Assets---Matching Sales and Production

In most firms fixed assets grow slowly as productive capacity is increased and old equipment is replaced, but current assets fluctuate in the short run, depending on the level of production versus the level of sales. When the firm produces more than it sells, inventory rises. When sales rise faster than production, inventory declines and receivables rise.

Some firms employ level production (producing at a constant rate regardless of the demand level) methods to smooth production schedules and use manpower and equipment efficiently at a lower cost. One consequence of level production is that current assets go up and down when sales and production are not equal. Other firms may try to match sales and production as closely as possible in the short run. This allows current assets to increase or decrease with the level of sales and eliminates the large seasonal bulges or sharp reductions in current assets that occur under level production.

Publishing companies are good examples of companies with seasonal sales and inventory problems. By the nature of the textbook market, heavy sales are made in the third quarter of each year for fall semester sales. Most sales occur in July, August, September, and again in December for the second semester. The actual printing and binding of a book have fixed costs that make printing many copies more efficient. Since publishing companies reproduce books on demand, they contract with the printing company to print a fixed number of copies, depending on expected sales over at least one year and sometimes based on sales over several years. If the books sell better than expected, the publishing company will order a second or third printing. Orders may have to be placed as much as nine months before the books will actually be needed, And reorders will be placed as much as three or four months ahead of actual sales. If the book declines in popularity, the publisher could get stuck with a large inventory of obsolete books.

As mentioned above, most textbooks are sold to bookstores in August, September, and December. The smallest sales are in the first quarter and second quarters of the year and the heavy fixed costs of publishing cause very low earnings per share in these two quarters.

Because of the seasonal nature of the textbook publishing business, lenders as well as financial managers need to understand the need for inventory financing and inventory management. If management has not planned inventory correctly, lost sales due to stock outs could be a serious problem.

Retail firms, also have seasonal sales patterns. These companies do not stock a year or more of inventory at one time as do publishers. They are selling products that are either manufactured for them by others or manufactured by their subsidiaries. Most retail stores are not involved in deciding on level versus seasonal production but rather in matching sales and inventory. Their suppliers must make the decision to produce on either a level or a seasonal basis. Since the selling seasons are very much affected by the weather and holiday periods, the suppliers and retailers cannot avoid the inventory risk. The fourth quarter for retailers which begins in November and ends in January, is the biggest quarter and accounts for as much as one half of their earnings. You can be sure that inventory not sold during the Christmas season will be put on sale during January.

We shall see as we go through the next couple of posts that seasonal sales can cause asset management problems. A financial manager must be aware of these problems to avoid getting caught short of cash or unprepared to borrow when necessary.

Many retail-oriented firms have been more successful in matching sales and orders in recent years because of new, computerized inventory control systems linked to online point-of-sales terminals. These point-of-sale terminals allow either digital input or use of optical scanners to record the inventory code numbers and the amount of each item sold. At the end of the day, managers can examine sales and inventory levels item-by-item and, if need be, adjust orders or production schedules. The predictability of the market will influence the speed with which the manager reacts to this information, while the length and complexity of the production process will dictate just how fast production levels can be changed. 

Temporary Assets under Level Production---An Example

To get a better understanding of how current assets fluctuate, let us use the example of the Yawakuzi Motorcycle Company, which manufactures and sells in the snowy U.S. Midwest. Not too many people will be buying motorcycles during October through March, but sales will pick up in early spring and summer and will again trail off during the fall. Because of the fixed assets and the skilled labor involved in the production process, Yawakuzi decides that level production is the least expensive and the most efficient production method. The marketing department provides a 12-month sales forecast for October through September (Table 1).

Table 1 Yawakuzi sales forecast (in units)

After reviewing the sales forecast, Yawakuzi decides to produce 800 motorcycles per month, or one year's production of 9,600 divided by 12. A look at Table 2 shows how level production and seasonal sales combine to create fluctuating inventory. Assume that October's beginning inventory is one month's production of 800 units. The ending inventory level is computed for each month and then multiplied by the production cost per unit of $2,000.

Table 2 Yawakuzi's Production Schedule and Inventory

The inventory level at cost fluctuates from a high of $9 million dollars in March, the last consecutive month in which production is greater than sales, to a low of $1 million in August, the last month in which sales are greater than production. Table 3 combines sales forecast, a cash receipts schedule, a cash payment schedule, and a brief cash budget in order to examine the build-up and accounts receivable and cash.

Table 3 Sales forecast, cash receipts and payments, and cash budget

In Table 3 the sales forecast is based on assumptions in Table 1. The unit volume of sales is multiplied by a sales price of $3,000 to get sales dollars in millions. Next, cash receipts represent 50 percent collected in cash during the month of sale and 50 percent from the prior month's sales. For example, in October this would represent point 45 million dollars from the current month plus 75 million dollars from the prior month's sales.

Cash payments in Table 3 are based on an assumption of level production of 800 units per month at a cost of $2,000 per unit, or 1.6 million dollars, plus payments for overhead, dividends, interest, and taxes.

Finally, the cash budget in Table 3 represents a comparison of the cash receipts and cash payments schedules to determine cash flow. We further assume the firm desires a minimum cash balance of 25 million dollars plus in October, a negative cash flow of $1.1 million brings the cumulative cash balance to a negative $0.85 million and $1.1 million must be borrowed to provide an ending cash balance of $0.25 million. Similar negative cash flows in subsequent months necessitate expanding the bank loan. For example, in November there is a negative cash flow of $1.325 million. This brings the cumulative cash balance to -$1.075 million, requiring additional borrowings of $1.325 million to ensure a minimum cash balance of $0.25 million. The cumulative loan through November, October, and November borrowings now adds up to $2.425 million. Our cumulative bank loan is highest in the month of March.

We now wish to ascertain our total current asset build-up as a result of level production and fluctuating sales for October through September. The analysis is presented in Table 4. The cash figures come directly from the last line of table 3. The accounts receivable balance is based on the assumption that accounts receivable represent 50 percent of sales in a given month, as the other percent is paid for in cash. Thus the accounts receivable figure in Table 4 represents 50 percent of the sales figure from the second numerical line in Table 3. Finally, the inventory figure in Table 4 is taken directly from the last column of Table 2, which presented the production schedule and inventory data.

Table 4 Total current assets, first year ($ millions)

Total current assets (last column in Table 4) start at $3.3 million in October and rise to $10.35 million in the peak month of April. From April through August, sales are larger than production, and inventory falls to its low of $1 million in August, but accounts receivable peak at $3 million in the highest sales months of May, June, and July. The cash budget in Table 3 explains the cash flows and external funds borrowed to finance asset accumulation. From October to March, Yawakuzi borrows more and more money to finance the inventory build-up, but from April forward it eliminates all borrowing as inventory is liquidated and cash balances rise to complete the cycle. In October the cycle starts over again; but now the firm has accumulated cash it can use to finance next year's asset accumulation, pay a larger dividend, replace old equipment, or if growth in sales is anticipated invest in new equipment to increase productive capacity. Table 5 represents the cash budget and total current assets for the second year. Under a simplified no growth assumption, the monthly cash flow is the same as that of the first year, but beginning cash in October is much higher from the first year's ending cash balance and this lowers the borrowing requirement and increases the ending cash balance and total current assets at year-end. Higher current assets are present despite the fact that accounts receivable and inventory do not change.

Table 5 Cash budget and assets for second year with no growth in sales ($millions)

Figure 1 is a graphic presentation of the current asset cycle. It includes the two years covered in Tables 4 and 5 assuming level production and no sales growth. 

Figure 1     

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, PP. 146-153*

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