1. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Chapter 22: Cash Conversion, Inventory, and Receivables Management © 2010 South-Western, a part of Cengage Learning Corporate Finance, 3e Graham, Smart, and Megginson

2. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. The Cash Conversion Cycle 2 Operating cycle Time from the beginning of the production to the time when cash is collected from sale Equals the average age of inventory (AAI) plus the average collection period (ACP) 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

3. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Shortening the Cash Conversion Cycle  To shorten a firm’s operating cycle or lengthen its payment period:  Turn over inventory as quickly as possible  Collect accounts receivable as quickly as possible  Pay accounts as slowly as possible  Reduce mail, processing, and clearing time 3 CCC = OC – APP = AAI + ACP – APP

4. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Techniques for Controlling Inventory  ABC System  Inventory segregated into three groups (A, B, and C) from most costly to least costly investment  Control of the A items should be the most intensive.  Economic Order Quantity (EOQ) Model:  S = inventory usage per period  O = order cost per order  C = carrying cost per unit per period 4

5. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Techniques for Controlling Inventory  Reorder Points and Safety Stock:  Reorder point = Lead time in days × Daily usage  Safety Stock – Additional inventory held to allow for faster-than- anticipated usage rates and delivery delays  Material Requirements Planning (MRP)  Uses a master schedule to ensure that the materials, labor, and equipment needed for production are at the right places in the right amounts at the right times  MRP II expands on MRP, using a complex computer system to integrate data from many departments.  Just-in-Time (JIT) System  Materials should arrive exactly when they are needed for production, rather than being stored on-site. 5

6. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Accounts Receivable Management 6 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

7. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Five C’s of Credit 7 –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:

8. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Credit Scoring  Used with high volume/small dollar credit requests  Most commonly used by large credit card operations, such as banks, oil companies, and department stores 8 Uses statistically-derived weights for key credit characteristics to predict whether a credit applicant will pay the requested credit in a timely fashion.

9. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Changing Credit Standards 9 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

10. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Credit Terms  Terms of sale for customers  Net 30: Payment in full due in 30 days  Cash discounts  Example: 2/10 net 30  2% discount if payment made within 10-day cash discount period  Otherwise, full payment due within 30-day credit period 10

11. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Collection Policy  Reminders, form letters, telephone calls, or personal visits may initiate customer payment.  At a minimum, the company should generally suspend further sales to the customer until the delinquent account is brought current.

12. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Credit Monitoring 12 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 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

13. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Credit Monitoring 13 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.