Financial Analysis, Planning and Forecasting Theory and Application Chapter 20 Credit, Cash, Marketable Securities, and Inventory Management By Cheng F. Lee Rutgers University, USA John Lee Center for PBBEF Research, USA

Outline 20.1 Introduction 20.2 Trade credit 20.3 The cost of trade credit 20.4 Financial ratios and credit analysis 20.5 Credit decision and collection policies 20.6 The Baumol and Miller-Orr model 20.7 Cash management systems 20.8 Credit lines and bank relations 20.9 Marketable securities management 20.10 Inventory Management 20.11 Summary Appendix 20.A

20.1 Introduction

20.2 Trade credit （20-1） Table 20.1 Aging of Accounts Receivable January February Accounts Receivable ﹪ of Total 0-30 days ＄ 250,000 25.0﹪ 22.7﹪ 31-60 days 500,000 50.0﹪ 525,000 47.8﹪ 61-90 days 200,000 20.0﹪ 250,000 Over 90 days 50,000 5.0﹪ 75,000 6.8﹪ Total accounts receivable ＄1,000,000 100.0﹪ ＄1,100,000

20.3 The cost of trade credit The seller’s perspective The buyer’s perspective

20.3 The cost of trade credit = Current sales =＄1 million per year. S = Incremental sales =＄250,000. V = Variable costs as a percentage of sales = 70 percent. includes the cost of administering the credit department and all other costs except bad-debt losses and financing costs (interest charges) associated with carrying the investment in receivables. Costs of carrying inventories are included in . 1-V = Contribution margin = 30 percent or equivalently, the percentage of each sales dollar that goes toward covering overhead and increasing profits. k = The cost of financing the investment in receivables = 12 percents. k is the firm’s cost of new capital when the capital is used to finance receivables. = Average collection period prior to a change in credit policy = 20 days. = New average collection period after the credit policy change = 30 days. In this example, we assume that customers pay on time, thus ACP = specified collection period).

20.3 The cost of trade credit (20.2)

20.3 The cost of trade credit （20.3） （20.4）

20.4 Financial ratios and credit analysis Financial ratio analysis Numerical credit scoring Benefits of credit-scoring models Outside sources of credit information

20.4 Financial ratios and credit analysis (20.5) Table 20.2 Status and Index Values of the Accounts Account Number Account Status 7 Bad .81 10 .89 2 1.30 3 1.45 6 1.64 12 Good 1.77 11 1.83 4 1.96 1 2.25 8 2.50 5 2.61 9 2.80

20.4 Financial ratios and credit analysis Figure 20.1 Distributions of Good and Bad Accounts 1.83 12 Discriminate Function Value Probability of Occurrence 1.64 1.77 1.96 Bad Good

20.4 Financial ratios and credit analysis (20.6) Credit Score from Scoring Model Cumulative Frequencies “Goods” “Bads” －.200 0 ﹪ .208 35 .226 2 36 .245 3 40 .356 6 58 .543 16 76 .577 17 82 .596 20 85 .699 34 97 .763 49 99 .898 75 100 1.200

20.4 Financial ratios and credit analysis Figure 19-2 Key to Dun and Bradstreet Ratings

20.5 Credit decision and collection policies Collection policy Factoring and credit insurance

20.6 The Baumol and Miller-Orr model Baumol’s EOQ model Miller-Orr model

20.6 The Baumol and Miller-Orr model （20.7） Figure 20.3

20.6 The Baumol and Miller-Orr model Figure 20.4

20.6 The Baumol and Miller-Orr model

20.6 The Baumol and Miller-Orr model Figure 20.5

20.6 The Baumol and Miller-Orr model （20.8） （20.9） （20.10） （20.11）

20.6 The Baumol and Miller-Orr model upper limit = lower limit + spread = ＄20,000＋＄22,293 = ＄42,293

20.7 Cash management systems Float Cash collection and transference systems Cash transference mechanism and scheduling

20.7 Cash management systems Figure 20.6

20.7 Cash management systems Figure 20.7 Source: Stone and Hill, 1980.

20.7 Cash management systems Figure 20.8 Source: Stone and Hill, 1980.

20.8 Credit lines and bank relations

20.8 Credit lines and bank relations

20.9 Marketable securities management Investment criteria for surplus cash balances Types of marketable securities Hedging considerations

20.9 Marketable securities management

20.9 Marketable securities management (20.12)

20.10 Inventory Management Inventory Loans Economic order quantity

20.10 Inventory Management （20.13）

20.11 Summary The subject of Chapter 20 is the management of trade credit for both buyer and seller. For the buyer, the essential issue is to determine the cost of using trade credit as a form of financing, then compare this cost with the cost of alternative sources of capital. While some argue that accounts payable have no cost, we support the arguments against this view. That is, for the buyer, trade credit involves opportunity costs in the form of foregone discounts, implicit bankruptcy costs for taking on too much accounts payable, and costs associated with the timing of taxes and the accounting procedure used. The grantor of trade credit, the seller, has a large array of decisions to make. The first of these we discussed was determining the cost of granting trade credit. Next, we examined a numerical credit-scoring method via linear discriminant analysis to make the credit-granting decision more effective in terms of risk and related collection and bad-debt costs. Finally, we discussed the other aspects of the firm’s credit policy, including the decision of how much credit to grant, on what terms, and the collection policy procedures to be pursued for delinquent accounts. We noted that the evaluation of various collection policies can be viewed and even carried out in the framework of a capital budgeting problem. Earlier we discussed a number of methods to deal with the capital budgeting problem with uncertainty, including（1）the risk-adjusted discount rate method,（2）the certainty equivalent method,（3）the statistical distribution method, and（4）various simulation methods.

20.11 Summary We also discussed the various aspects of cash and marketable security management. Two techniques that can assist in the estimation of an optimal level or range for cash balance were Baumol’s model and the Miller-Orr model. To make the cash collection system more efficient, the firm can choose from various methods for collecting or transferring cash and deciding when to transfer it. Such cost minimization is ideal for linear programming applications.

20.7 Summary The credit line offers the firm a means of handling cash variations caused by seasonal effects or unanticipated events. Establishing good bank relations is an important feature for any cash management system. However, bank services do take on a cost, typically in the form of compensating balances. While credit lines can be a good investment for a bank, they can have detrimental effects on the bank’s liquidity that could intensify any maturity gap problems. Efficient cash management ensures that surplus balances are invested in marketable securities that meet minimum standards for certainty of principal, maturity, liquidity, and yield. In Chapter 20, we considered the hedge decision from the cash manager’s perspective and gave various examples of hedging applications. Optimal inventory management was also briefly discussed.

Appendix 20.A. Derivation of Equation 20-1