1. Cash and Working Capital Management

2. Working Capital Management
= current assets – current liabilities
Working capital management refers to choosing the levels and mix of:
cash, marketable securities, receivables and inventories.
different types of short-term financing.

3. Considerations in Working Capital Management
Sales impact
Liquidity
Relations with stakeholders
suppliers
customers
Short-term financing mix
profitability
risk considerations

4. Working Capital Management
Maturity matching approach
Conservative approach
Aggressive approach

5. Maturity Matching Approach
Hedge risk by matching the maturities of assets and liabilities.
Permanent current assets are financed with long-term financing, while temporary current assets are financed with short-term financing.
There are no excess funds.

6. Conservative Approach
Long-term funds are used to finance both permanent as well as some temporary short-term assets.
When there are excess funds, they are invested in marketable securities.

7. Aggressive Approach
Use less long-term and more short-term financing than the conservative approach.

8. Cash Conversion Cycle
The cash conversion cycle is the length of time between payment of accounts payable and the receipt of cash from accounts receivable.

9. Cash Conversion Cycle Purchase Inventory Sale on Credit
Collect Acct. Receivable
Inventory Conversion Period
Receivables Collection Period
Time
Payment of Accts. Payable
Cash Conversion Cycle
Payables Deferral Period

10. Cash Conversion Cycle

11. Inventory Conversion Period
The inventory conversion period is the length of time from the purchase of inventory to the time the sales are made on credit.

12. Receivables Collection Period
The receivables collection period is the average number of days it takes to collect on accounts receivable.
Equal to days sales outstanding (DSO)

13. Payables Deferral Period
The payables deferral period is the average length of time between the purchase of materials and labor and the payment of cash for the same.

14. Cash Conversion Cycle
Given the following information about Vision Opticals, compute the firm’s cash conversion cycle.
Inventory
Accounts Receivable
Accounts Payable
Wages, Benefits, Payroll Taxes
Sales
Cost of Sales
Selling & Other Expenses
$19,000
$21,000
$5,600
$9,000
$227,000
$93,000
$22,000

15. Inventory Conversion Period

16. Receivables Collection Period

17. Payables Deferral Period

18. Cash Conversion Cycle

19. Cash Management
How much liquidity (cash plus marketable securities) should the firm have?
What should be the relative proportions of cash and marketable securities?

20. Demands for Cash Transactions demand Precautionary demand
Speculative demand
Compensating balances

21. Short-Term Financing Trade Credit Secured and Unsecured Bank Loans
Commercial Paper

22. Corporate Financial Management 2e Emery Finnerty Stowe
Accounts Receivable and Inventory Management
Corporate Financial Management 2e
Emery Finnerty Stowe

23. Why Grant Credit? Financial intermediation Collateral
Information costs
Product quality information
Employee theft
Steps in the distribution process
Convenience, safety, and buyer psychology

24. The Basic Credit Granting Decision
Credit should be granted if the NPV of granting credit is positive.
The NPV depends on:
amount of the sale
investment in the sale
probability of payment
payment period
required return
collection efforts

25. The NPV of the Basic Credit Granting Decision
Let
R = amount of sale
p = probability of payment
C = the firm’s investment in the sale
r = the required return
t = time at which payment is expected

26. The Basic Credit Granting Decision
Mohawk Carpets is considering extending $5,000 of credit to a customer. Mohawk has invested $3,750 in the sale and it estimates that the customer has a 75% probability of making the payment. The payment is due in 2 months, and the required rate of return in 20% APY.
Should Mohawk grant credit to this customer?

27. The Basic Credit Granting Decision
What is the minimum probability of payment that Mohawk would require from this customer?

28. Credit Policy Decisions
Choice of credit terms
Setting evaluation methods and credit standards
Monitoring receivables
Taking actions for slow payments
Controlling & administering the firm’s credit functions

29. Sources of Credit Information
A credit application, including references
Applicant’s payment history
Information from sales representatives
Financial statements for recent years
Reports from credit rating agencies
Dun & Bradstreet Credit Services
Credit bureau reports
Industry association credit files

30. Judgmental Approach to Credit Decisions
The five C’s of credit:
Character
Capacity
Capital
Collateral
Conditions

31. Credit Scoring Models
These combine several financial variables to create a single score or index.
Credit is granted if the score is above a pre-specified cut-off value.
Advantages:
Easy to compute
Easy to change standards
Avoids bias or discrimination
Requires large samples to “calibrate.”

32. Monitoring Accounts Receivables
Aging schedules
Average age of receivables
Collection fractions and receivables balance fractions
Pursuing delinquent credit customers
Changing credit policy

33. Aging Schedule
An aging schedule shows the dollar amount and the percentage of receivables in several age classifications.
Age (days)
Amount
Percent
0 to 30
31 to 60
61 to 90
over 90
$23,200
$9,300
$3,500 $0
64.44%
25.83%
9.72%
0.00%
Total
$36,000
100.00%

34. Average Age
The average age is computed by using the mid-points of the age ranges:
Average Age =
(0.6444)(15) + (0.2583)(45) + (0.0972)(75)
= days

35. Collection & Receivables Fraction Balances
Collection fractions are the percentage of sales collected during various months after the sale.
Receivables Balance fractions are the percentage of a month’s sales that remain uncollected at the end of the month of the sale and at the end of successive months.

36. Pursuing Delinquent Accounts
Letters
Telephone calls
Personal visits
Collection agencies
Legal proceedings

37. Changing Credit Policy
Credit policy can be changed by changing:
credit terms
credit standards
collection policies
A change in the credit policy affects:
sales
cost of goods sold
bad debt expense
carrying costs of receivables
administrative costs

38. Changing Credit Policy
Sales of Mabry Fireplace Co. are currently $500,000 under credit terms of “net 30.” Bad debt losses amount to 1.50% and the balance is collected in 1.50 months on average.
Under the proposed policy of “2/10, net 30,” sales would increase by 12% and bad debts would decline to 0.75% of sales. About 65% of the customers are expected to take the discount. About 65% of sales would be collected within 0.5 months and the remainder within 1.5 months. Assume that Mabry’s investment in sales equals 60% and that the required rate of return is 1.50% per month.
Should Mabry change its credit policy to the proposed one?

39. Changing Credit Policy
Under the current policy, Mabry’s investment in sales is $300,000.
60%×$500,000 = $300,000.
Bad debts are $7,500.
$7,500 = 1.50%×$500,000
Sales collections are $492,500.
= $500,000 – $7,500 = $492,500
(in 1.50 months).

40. Changing Credit Policy
Under the new policy, sales = $560,000.
1.12×$500,000 = $560,000.
Mabry’s investment in sales = $336,000.
60%×$560,000 = $336,000.
Bad debt losses = $4,200.
0.75%×$560,000 = $4,200.
Discounts taken = 7,280.
65%×2%×($560,000) = $7,280.

41. Changing Credit Policy
Sales collected = $548,520.
$560,000 – $4,200 – $7,280 = $548,520.
Amount collected in 0.5 months: $356,720.
65%×0.98×$560,000 = $356,720.
Amount collected in 1.5 months =
(100% – 65% – 0.75%)×$560,000 =
$191,800.

42. Changing Credit Policy
NPV of current policy = $181,623 so switch.

43. Inventory Management Types of inventories: Raw materials
Work-in-process
Finished goods

44. Just-In-Time (JIT) Inventory Systems
Materials should arrive exactly as they are needed in the production process.
Reduces inventory holding costs
Important factors determining success of JIT systems:
Planning requirements
Supplier relations
Setup costs
Other cost factors
Impact on credit terms