1. Chapter 20 Learning Objectives
1. Describe the usual steps in a firm’s credit management policy.
2. Measure the implicit interest rate on credit sales.
3. Describe how firms assess the probability that a customer will pay its bills.
4. Decide whether it makes sense to grant credit to customers.
5. Cite the costs and benefits of holding inventories and cash balances.
6. Compare the different techniques that firms use to make and receive payments.
7. Compare alternatives for investing excess funds over short horizons.

2. Working Capital Management
This chapter presents multiple strategies for managing the working capital of the firm.
Cash
Inventory
Chapter 20 Outline
Accounts Receivable and Credit Policy
Inventory Management
Cash Management
Investing Idle Cash: The Money Market
Accounts Receivable 2

3. Account Receivables and Credit Policy
Credit Management Steps
Establish terms of sale
What form of IOU will be required?
Perform a credit analysis
Create a credit policy
Develop a collection policy

4. A/R and Credit Policy Terminology
Trade Credit
Bills awaiting payment from one company to another
Consumer Credit
Bills awaiting payment from final customer to a
company
Terms of Sale
Credit, discount, and payment terms offered on a sale
Trade Credit: Bills awaiting payment from one company to another.
Consumer Credit: Bills awaiting payment from final customer to a company.
Terms of Sale: Credit, discount, and payment terms offered on a sale.

5. Terms of Sale: Example “5/10 net 60”
5 - percent discount for early payment
10 - number of days that the discount is available
net 60 - number of days before payment is due
Implicit Cost: A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier. 3

6. Implicit Cost: Example
On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given? 7

7. Credit Agreements Terminology
Open account – Agreement whereby sales are made with no formal debt contract
Commercial draft – An order to pay
Sight draft
Time draft
Trade acceptance
Banker’s acceptance – A time draft accepted (and therefore guaranteed) by the bank.
Open account – Agreement whereby sales are made with no formal debt contract
Commercial draft – An order to pay
Sight draft – A commercial draft where immediate payment is required
Time draft – A commercial draft where no immediate payment is required
Banker’s acceptance – A time draft accepted (and therefore guaranteed) by the bank. 8

8. Credit Analysis
Credit Analysis: Procedure to determine the likelihood a customer will pay his or her bills.
Credit agencies like Dun & Bradstreet provide reports on the credit-worthiness of a potential customer.
Financial ratios can be calculated to help determine a customer’s ability to pay his or her bills.
Credit Analysis - Procedure to determine the likelihood a customer will pay its bills. 9

9. Numerical Credit Scoring categories
The Five Cs of Credit
Numerical Credit Scoring categories
The customer’s character
The customer’s capacity to pay
The customer’s capital
The collateral provided by the customer
The condition of the customer’s business 10

10. Credit Analysis: Two Approaches
1. Beaver, McNichols and Rhie – Calculate the chance of failing during the next year relative to the odds of not failing based on the following equation:
2. Multiple Discriminant Analysis -
Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time.
Note: EBITDA is earnings before interest, taxes and depreciation/amortization. EBIT is earnings before interest and taxes. 12

11. Credit Analysis: Example
If the Altman Z-score cutoff for a credit-worthy business is 2.7 or higher, would we accept the following client?
Yes, a score above 2.7 indicates good credit. 14

12. Credit Analysis: Discussion
Credit analysis is only worthwhile if the expected savings exceed the cost.
When is this true?
Note: Don’t undertake a full credit analysis unless the order is big enough to justify it.
Note: Undertake a full credit analysis for the doubtful orders only. 16

13. The Credit Decision
Credit Policy: Standards set to determine the amount and nature of credit to extend to customers.
Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default.
Denying credit guarantees neither profit nor loss.
Credit Policy - Standards set to determine the amount and nature of credit to extend to customers. 17

14. The Credit Decision and Probable Payoffs
Payoff = Revenue - Cost
Payoff = - Cost
Customer pays = p
Offer credit
Customer defaults = 1-p
Decision
Refuse credit
Payoff = 0 20

15. The Credit Decision
Based on the probability of payoffs, the expected profit can be expressed as:
Solving for p (probability), the break-even probability of collection is: 23

16. The Credit Decision: Some Final Thoughts
Maximize profit
Concentrate on the dangerous accounts
Look beyond the immediate order 23

17. Collection Policy
Collection Policy: Procedures to collect and monitor receivables.
Aging Schedule: Classification of accounts receivable by time outstanding.
Collection Policy- Procedures to collect and monitor receivables.
Aging Schedule- Classification of accounts receivable by time outstanding. 24

18. Aging Schedule: Example
What is the goal of a good collection policy?
* The totals in the last row are based on the assumption that there are more than four customers. The others were omitted for brevity. 25

19. Primary Goal = Minimize amount of cash tied up in inventory
Inventory Management
Primary Goal = Minimize amount of cash tied up in inventory
Recall the Components of Inventory:
Raw materials
Work in process
Finished goods
Carrying Costs – The cost of storing goods plus the cost of capital tied up in inventory
Carrying Costs: The cost of storing goods plus the cost of capital tied up in inventory

20. Optimal Order Size: Minimize Costs24

21. Optimal Inventory: Economic Order Quantity
Economic Order Quantity - Order size that minimizes total inventory costs. 23

22. Cash Management Cash vs. Short-Term Securities Why not all cash?
Why not all short-term securities?
A sweep program is a program which helps firms invest idle cash. The firm’s bank automatically “sweeps” surplus funds into a higher-interest account.
Note: A sweep program is a program which helps firms invest idle cash. The firm’s bank automatically “sweeps” surplus funds into a higher-interest account.

23. Float
Float – The time between the moment a check is written and the moment the funds are deposited in the recipient’s account.
Payment Float – Checks written by a company that have not yet cleared.
Availability Float – Checks already deposited that have not yet cleared.
Float – The time between the moment a check is written and the moment the funds are deposited in the recipient’s account.
Payment Float - Checks written by a company that have not yet cleared.
Availability Float - Checks already deposited that have not yet cleared. 3

24. Managing Float Availability float Payment float Check mailed
Check received
Mail float
Check deposited
Processing float
Cash available
to recipient
Check charged to
payer’s account
Check
clears 20

25. Float and Check Handling
Concentration Banking
System whereby customers make payments to a regional collection center, which then transfers funds to a principal bank.
Lock-box System
System whereby customers send payments to a post office box, and a local bank collects and processes the checks.
Concentration Banking – System whereby customers make payments to a regional collection center, which then transfers funds to a principal bank.
Lock-box System – System whereby customers send payments to a post office box, and a local bank collects and processes checks. 13

26. Lock-Box System: Example
A lock box receives 180 payments per day, with an average amount of $1,000. The daily interest rate is .02% and the lock box saves 1.75 days in mailing time and 1.25 days in processing time. If the bank charges $0.35 per check, should the company use this system?
Yes, the firm is ahead $45 per day, plus any internal processing costs. 13

27. Electronic Funds Transfer (EFT), Three Methods
Other Payment Systems
Electronic Funds Transfer (EFT), Three Methods
1) Direct Payment
Automated Clearinghouse (ACH)
2) Direct Deposit
3) Wire Transfer
Fedwire
CHIPS (Clearing House Interbank Payments System)
Automated Clearinghouse (ACH) – An electronic network for cash transfers in the United States.
Note: Direct Payment  Automatic Debit; Direct Deposit  Automatic Credit

28. Investing Idle Cash: The Money Market
Money Market – the market for short-term financial assets.
Treasury bills
Commercial paper
Certificates of deposit
Repurchase agreements
Money Market - market for short term financial assets.
Note: The international market for short-term dollar investments is known as the eurodollar market. 26

29. Appendix A: How Purchases are Paid

30. Appendix B: Methods Used to Make and Receive Electronic Payments26

31. Appendix C: Use of Payment Systems in the United States, 2009
Source: and 26