International_Corporate_Finance_Fin_Gm571_Week_3

Lawrence Sports Simulation Team International Corporate Finance/FIN GM571 Alternative Working Capital Policies to Consider The short-term financing strategy Lawrence Sports (LS) is not efficacious. It is in need of improvement and is a problem that LS must consider an alternative working capital policy. The current policy places LS in an overly dependent financial position on the company’s primary customer, Mayo Stores. When Mayo Stores, who composed 95% of annual sales, does not make a payment to the credit terms of 20% upon purchase and 80% the following week, this produces a negative domino effect on LS. The situation leaves them incapable of paying its own suppliers and operating costs, and resorting to a costly line of credit from bank and potentially leading LS into bankruptcy (University of Phoenix, 2010). Such a method indicates that Lawrence Sports has an imbalance between working capital inflows and outflows. Therefore, LS must create and maintain a cash budget to manage assets more efficiently, allowing a resource minimally to pay bills, granting themselves a buffer in which to receive late payments, and thus reducing reliance upon short-term financing. A second working capital alternative for LS to consider is negotiating an increase of trade credit with the company’s primary supplier Murray Leather Works to who earn 75% of sales from LS in terms of allowed credit amount, collection policy, and discount periods. The current credit terms dictates 15% upon purchase and 85% the following week (Emery, Finnerty, & Stowe, 2007). As valuable a customer who LS is to Murray, LS can negotiate extensions of 30 or 60 days credit from Murray. In addition, Lawrence Sports can also discuss such terms with Gartner, who sources 75% of the business’ raw material. However, because LS does not have excessive bargaining power with Gartner’s 37% market control, the company may find it beneficial to seek out another alternate supplier who controls the remaining 63% pool of the market (University of Phoenix, 2010). A third working capital policy LS should consider is slightly to increase prices charged to Mayo Stores or revise the credit terms to a cash on delivery basis rather than the current terms of the following week. One or both of these changes would reduce the financial adverse effect and vulnerability incurred to LS resulting from the intermittent late or lack of payment from Mayo and defrays the cost of LS resorting to a line of credit to cover operating and inventory expenses. However, Mayo Store may reject such increase in supplier cost terms in which case LS should strategize gradually to expand the business’ customer base to others who will value the high-level quality that LS builds into the branded equipment and protective gear (University of Phoenix, 2010). Working capital policy recommendation for Lawrence Sports The recommended working capital policy for LS is to create and maintain a cash budget that manages assets more effectively. This policy favors the conservative approach to financing working capital. According to Corporate Financial Management, "The goal of working capital management is shareholder wealth maximization, avoiding negative-NPV decisions and seeking positive-NPV decisions"(Emery, Finnerty, & Stowe, 2007, p. 639). In other words, LS’s priority is to exercise tight control and oversight of its cash management operations. Almost always, this action will ultimately result in shareholder satisfaction. The responsibility of handling domestic or international transactions, with respect to cash management, should be assigned to one person. This will help to maintain an efficient cash budget that results in enough cash on hand to pay current bills and to allow for unforeseen emergencies. The basic idea of the conservative working capital policy is to have low risk and excess cash for future investments. "If general economic conditions worsen or if the firm's own circumstances deteriorate, the firm might have trouble getting the money it needs. To guard against the risk of a credit shutoff or a cost increase, the conservative approach uses more long-term and less short-term financing than the maturity-matching approach"(Emery, Finnerty, & Stowe, 2007, p. 642). The contingencies for the recommendation include aggressively seeking other vendors from either a domestic or international platform in lieu of firms Gartner or Murray filing for bankruptcy. Another contingency is to maintain business relationships with industry cash managers, in the event of an inadvertent firing that occurs within the cash management department of Lawrence Sports. Performance measures that are used to evaluate the recommendation include industry metrics used by competitors, critical evaluation of industry best practices, review of inventory impacts, and cash budgeting lessons learned. Almost always, these performance measures will help drive LS leadership into making the best decision that will result in profitability and business success. The implementation plan for the recommendation includes LS executive leaders communicating the plan effectively to the employees. The implementation plan should include a solicitation of employee feedback to ensure unity of command. The aim is to move forward and make the necessary adjustments as necessary. The growth, survivability and success of LS include the development of proper short term and long term working capital management. "In its day-to-day operations, a firm must maintain adequate liquidity. Cash Conversion Cycle and Importance to Working Capital Management The cash conversion cycle is the length of time between the payment of accounts payable and the receipt of cash from accounts receivable (Emery, 2007). To minimize the loan burden from the bank minimal, Lawrence Sports has to negotiate short-term payment and collection arrangements with the company’s business partners. The cash conversion cycle measures working capital efficiency and may help determine the health of a business. If the business had no credit, they would not have any cash from the moment they purchased the materials until Lawrence Sports sold the product. If Lawrence Sports granted the company’s customers credit but did not use that credit to buy raw materials, the company’s cash conversion cycle would be longer. On the other end, using credit to buy raw materials would shorten the firm’s cash conversion cycle (Emery, 2007). The cash conversion cycle is equal to the inventory conversion period plus the receivables collection period minus the payables deferral period (Emery, 2007). LS needs to maintain good relationships with the company’s business partners but they must also convert its products into cash through sales quickly. The shorter the cycle, better it is for the company. Additional Working Capital Management Policies As with any business, it is imperative that financial and accounting reports are adhered to for proper executive decision making. Most organizations should be using several types of budget reports. Some of the more commonly used are sales reports, actual-versus budgeted reports as well as actual-versus budgeted advertising expenses (Horngren, Sundem, Stratton, Burgstahler, and Schatzberg 2008). Quite often decision-making is based on these types of budgets and accounting reports. Additionally, many organizations manage their working capital policies through the use of reserve cash balances as well as capital in the form of currency denominations dealings. The figure below as provided by Zireb international details the reasons for holding cash as it relates to their risk. [pic] Additionally, all organizations should maintain a balance between liquidity and profitability while conducting is day-to-day operations both nationally and internationally. As described by Padachi (2006), an organization must also be able to meet its short-term obligations. Thus it should allow them a guaranteed profitable venture. This obligation also coincides with organizations hedging the negative results against the positive results in hopes that the positives outweigh the negatives. This can be further detailed in the description by Michalski (2009), where he discusses, “If the level of liquid assets is not adequate, it enhances the companies operating risk – loss of liquidity. Thus by maintaining cash balances in a particular currency, the Multi-National Corporations are speculating (or hedging') in that currency. As discussed by Eun and Resnick, most multi-nationals use a central depository as a means to have a cash pool as well as the mobilization or funds (currency). This concept has the MNC depositing their monies in the central bank who them pays out the currency in the host country. This is often done to increase profits margins based on the currency fluctuations. Benefits of Efficient Cash Management Technique Many of the required skills for effective cash management are the same regardless of whether a firm operates domestically or internationally. When there is a temporary cash shortage, good cash management involves investing excess funds at a positive rate and borrowing at the lowest rate possible. However, firms with multinational operations require the firm to decide on whether the cash management function should be centralized or decentralized. It is recommended that Lawrence Sport’s focuses on centralized cash management, where its corporate headquarters will be based in the United States (Eun & Resnick, 2007). The cornerstone of any capital management system is in its cash budget. According to Eun and Resnick (2007), the cash budget is a plan that lays out the time and size of expected cash receipts and disbursements. It is recommended LS prepare a cash budget in advance for the fiscal year and implement a weekly time interval as the planning frequency. The organization can also reduce transaction costs through multilateral netting. A multilateral netting system will help the organization in reducing the expenses associated with inter-affiliate foreign exchange transactions. Furthermore, LS will benefit from implementing a centralized cash depository. Through a centralized cash depository excess capital is transmitted to the central cash pool. Thereafter, a central cash manager arranges to cover shortages of cash. As a result, there is less of a chance for funds being denominated in the wrong currency. A central cash manager is advantageous because he or she has a global view of the most favorable borrowing rates and the most advantageous investment rates. Ultimately, a centralized cash management system with a cash pool can reduce the investment Lawrence Sports has in contingency cash balances, thus saving the organization money (Eun & Resnick, 2007). References Emery, Finnerty, & Stowe. (2007). Corporate Financial Management (3rd ed.). New Jersey: Pearson-Prentice Hall. Eun & Resnick. (2007). International Financial Management (4th ed.). New York: McGraw- Hill. Horngren, C. T., Sundem, G. L., Stratton, W.O., Burgstahler, D., and Schatzberg, J . (2008). Introduction to Management Accounting (14th ed.). Pearson Education Inc. (page 12). Michalski, G., (2009). Target Liquid Balances and Value of the Firm Zireb International, (2009). Zireb Zagreb International Review of Economics & Business, Vol 12 University of Phoenix. (2010). Finance for Managerial Decision Making. Retrieved from University of Phoenix, FINGM571 website.