Short-Term Financial Management

Professor XXXXXCourse Name / Number

2

The Cash Conversion Cycle

time = 0

Purchase rawmaterials on account

Operating cycle

Sell finished goodson account

Collect accountsreceivable

Average Collection PeriodAverage Age of Inventory

Average paymentperiod

Cash Conversion Cycle

Time

Payment mailed

Operating cycle

• Time from the beginning of the production to the time when cash is collected from sale

• Financing the operating cycle is costly, so firms have an incentive to shrink it. Cash

conversion cycle

• Operating cycle less the average payment period on accounts payable

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Cost Tradeoffs in Working Capital Accounts

Financing costs resulting from the use of less expensive short-term financing rather than more expensive long-term debt and equity financing

Cost of reduced liquidity caused by increasing current liabilities

Accounts payable, accruals, and notes payable

Short-Term Financing

Order and setup costs associated with replenishment and production of finished goods

Carrying cost of inventory, including financing, ware housing, obsolescence costs, etc.

Inventory

Opportunity cost of lost sales due to overly restrictive credit policy and/or terms

Cost of investment in accounts receivable and bad debts

Accounts receivable

Illiquidity and solvency costsOpportunity cost of fundsCash and marketable securities

Operating Assets

Cost 2 * (cost of holding too little of operating asset)

Cost 1(holding cost)

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Cost Trade-offs in Short-Term Financial Management

Trade-off of Short-Term Financial Costs

Account Balance

Co

st

Cost 1

Cost 2

Total Cost

5

Accounts Receivable Management

• Determine its credit standards.

• Set the credit terms.• Develop collection policy.• Monitor its A/R on both

individual and aggregate basis.

If a company decides to offer trade credit, it

must:

Credit standards

• Apply techniques to determine which customers should receive credit.

• Use internal and external sources to gather information relevant to the decision to extend credit to specific customers.

• Take into account variable costs of the products sold on credit.

Credit selection

techniques

Five C’s of Credit

Credit scoring

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Five C’s of Credit

– Character: The applicant’s record of meeting past obligations; desire to repay debt if able to do so

– Capacity: The applicant’s ability to repay the requested credit

– Capital: The financial strength of the applicant as reflected by its ownership position

– Collateral: The amount of assets the applicant has available for use in securing the credit

– Conditions: Refers to current general and industry-specific economic conditions

Framework for in-depth credit analysis that is typically used for high-dollar credit requests:

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Credit Scoring

Uses statistically-derived weights for key credit characteristics to predict whether a credit applicant

will pay the requested credit in a timely fashion.

– Used with high volume/small dollar credit requests– Most commonly used by large credit card operations, such as

banks, oil companies, and department stores.

• An example…

WEG Oil uses credit scoring to make credit decisions. WEG Oil decision rule is:• Credit Score > 75: extend standard credit terms• 65 < Credit Score < 75: extend limited credit (convert

to standard credit terms after 1 year if account is properly maintained)

• Credit Score < 65: reject application

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Credit Scoring of a Consumer Credit Application by WEG Oil

83.251.00

8.500.1085Years on job

9.000.1090Years at address

20.000.2580Payment history

18.750.2575Income range

15.000.15100Home ownership

12.000.1580Credit references

Weighted Score

[(1) X (2)](3)

Predetermined Weight

(2)

Score(0 to 100)

(1)

Financialand Credit Characteristics

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Changing Credit Standards

• Increase in sales and profits (if positive contribution margin), but higher costs from additional A/R and additional bad debt expense.

Credit standards relaxed

• Reduced investment in A/R and lower bad debt, but lower sales and profit.

Credit standards tightened

An example…YMC wants to evaluate the effects of a relaxation of its credit standards:

• YMC sells CD organizers for $12/unit. All sales are on credit. YMC expects to sell 140,000 units next year.

• Variable costs are $8/unit and fixed costs are $200,000 per year.

• The change in credit standards will result in:• 5% increase in sales; average collection period will

increase from 30 to 45 days; increase in bad debt from 1% to 2%.

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Effects of Changes in Credit Standards for YMC

Cost Variable - Price Sales Margin on Contributi Sales Marginal profit fromincreased sales

28,000$ $8/un) -($12/un un 7000

return required investment additional Cost of marginalinvestment in A/R

receivable accounts ofturnover

sales annual ofcost variabletotalAverage investment in

accounts receivable (AIAR)

Additional profit contribution from sales

Cost of the marginal investment in accounts receivables

To compute additional investment, use the following equations:

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Cost of the marginal investment in accounts receivables

cost/unit variable salesunit annual Total variable cost of annual sales (TVC)

$1,120,000 $8/un un 140,000TVCCURRENT

$1,176,000 $8/un un 147,000TVCPROPOSED

(ACP) period collection average

365Turnover of account

receivable (TOAR)

r times/yea2.12days 30

365

ACP

365TOAR

CURRENTCURRENT

r times/yea1.8days 54

365

ACP

365TOAR

PROPOSEDPROPOSED

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Cost of the marginal investment in accounts receivables

$91,803.2812.2

$1,120,000

TOAR

TVCAIAR

CURRENT

CURRENTCURRENT

8$145,185.18.1

$1,176,000

TOAR

TVCAIAR

PROPOSED

PROPOSEDPROPOSED

return required investment additional Cost of marginalinvestment in A/R

$6,406 return required )AIAR - AIAR ( CURRENTPPROPOSED

Compute additional investment and, assuming a required return of 12%, compute cost of marginal

investment in A/R.

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Cost of Marginal Bad Debt Expense

$35,2800.02$1,764,000 rate expensedebt bad )Sales(BDE PROPOSEDPROPOSED

$16,8000.01$1,680,000 rate expense debt bad )Sales(BDE CURRENTCURRENT

$18,480$16,800-35,280$ Cost of marginal bad debt expense

Net profit for the credit decision

Marginal profit from increased

sales

Cost of marginalinvestment in A/R

Cost of marginal

bad debts= - -

= $28,000 - $6,406 - $18,480 = $3,114

3. Cost of marginal bad debt expense

Subtract the current level of bad debt expense (BDECURRENT) from the expected level of bad debt expense (BDEPROPOSED).

4. Net profit for the credit decision

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Credit Monitoring

Credit monitoring

• The ongoing review of a firm’s accounts receivable to determine if customers are paying according to stated credit terms

Techniques for credit

monitoring

• Average collection period• Aging of accounts receivable• Payment pattern monitoring

dayper sales average

receivable accounts period collection Average

Average collection period: the average number of days credit sales are outstanding

Aging of accounts receivable: schedule that indicates the portions of total A/R balance

outstanding

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Credit Monitoring

Payment pattern: the normal timing within which a firm’s customers pay their accounts

• Percentage of monthly sales collected the following month

• Should be constant over time; if payment pattern changes, the firm should review its credit policies

• An example…• DJM Manufacturing determined that:

• 20% of sales collected in the month of sales, 50% in the next month and 30% two months after the sale.

• Can use payment pattern to construct cash receipts from the cash budget:• If January sales are $400,000, DJM expects to collect

$80,000 in January, $200,000 in February, and $120,000 in March.

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Cash Management

Cash management: the collection, concentration, and disbursement of funds

Cash manager

responsible for

• Cash management• Financial relationships with banks• Cash flow forecasting• Investing and borrowing• Development and maintenance of

information systems for cash management

Float: funds that have been sent by the payer but not yet usable funds to the company

Mail float Processing float

Availability float

Clearing float

Time

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Cash Position Management

Cash position management: collection, concentration, and disbursement of funds on a daily

basis

Smaller companies set target cash balance for their checking accounts.

Bank account analysis

statement

• Bank provides report to its customers to show recent activity in firms’ accounts.

• Banks cannot pay interest on corporate checking account balances.

• Firms use earnings credit for balances to offset charges.

– Management of short-term investing if the company has a surplus of funds and borrowing arrangements if company has a temporary deficit of funds

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Collections

Primary objective: speeding up collections

Collection systems: function of the nature of the business

Field-banking system

• Collections are made over the counter (retail) or at a collection office (utilities).

Mail-based system

• Mail payments are processed at companies’ collection centers.

Electronic payments

• Becoming increasingly popular because they offer advantages to both parties.

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Collections

Lockbox system

• Speeds up collections because it affects all components of float.

• Customers mail payments to a post office box.

• Firm’s bank empties the box and processes each payment and deposits the payments in the firm’s account.

• Lockboxes reduce mail and clearing time.

Perform cost-benefit analysis to determine if lockbox system worth using

where,cos ) - LC r (FVR t) t (Net benefi a• FVR = float value reduction in dollars

• ra = cost of capital

• LC = annual operating cost of the lockbox system

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Funds Transfer Mechanisms

Depository transfer checks

• Unsigned check drawn on one of the firm’s bank accounts and deposited in another of the firm’s bank accounts

Automated clearinghous

e debit transfers

• Preauthorized electronic withdrawal from the payer’s account

• Settle accounts among participating banks. Individual accounts are settled by respective bank balance adjustments.

• Transfers clear in one day.

Wire transfers

• Electronic communication that, via bookkeeping entries, removes funds from the payer’s bank and deposits the funds in the payee’s bank.

• Expensive: used only for high-dollar payments

• Fedwire: primary wire transfer system in US

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Accounts Payable ManagementManagement of time from purchase of raw materials

until payment is placed in the mail

Accounts payable

functions

• Examine all incoming invoices and determine the amount to be paid.

• Control function: cash manager verifies that invoice information matches purchase order and receiving information.

Decide between centralized or decentralized payables and payments systems

If supplier offers cash discounts, analyze the best alternative between paying at the end of credit

period and taking the discount.

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Disbursements Products and Methods• Zero-balance accounts (ZBAs): disbursements accounts

that always have end-of-day balance of zero– Allows the firm to maximize the use of float on each check,

without altering the float time of its suppliers– Keeps all cash in interest-bearing accounts

• Controlled disbursement: Bank provides early notification of checks presented against a company’s account every day.– Federal Reserve Bank makes two presentments of checks

to be cleared each day for most large cash management banks.

• Positive pay: Company transmits to the bank a check-issued file to the bank when checks are issued.– Check-issued file includes check number and amount of

each item.– Used for fraud prevention

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Developments in Accounts Payable and Disbursements• Integrated (comprehensive) accounts payable:

outsourcing of accounts payable or disbursements operations

• Purchasing/procurement cards: increased use of credit cards for low-dollar indirect purchases

• Imaging services: Both sides of the check, as well as remittance information, is converted into digital images.– Useful when incorporated with positive pay services

• Fraud prevention in disbursements: fraud prevention measures:– Written policies and procedures for creating and

disbursing checks; separating duties (approval, signing, reconciliation)

– Using safety features on checks; setting maximum dollar limits and/or requiring multiple signatures

Length of cash conversion cycle determines the amount of resources the firm must invest in its

operations.

Cost trade-offs apply to managing cash and marketable securities, account receivable,

inventory and account payable.

Objective for account receivable: collect accounts as quickly as possible without losing sales.

Objective for accounts payable: pay accounts as slowly as possible without damaging firm’s

credit.

Short-Term Financial Management