1. Short-Term Financial Management
Dr. Del Hawley
MBA 622

2. Quarterly Sales for Hershey Foods (1992 – 2002)
1,400
1,200
1,000
800
600
400
200
Year
Quarterly Sales ($ in millions)
Quarterly Sales

3. Financing Strategies Available to Hershey
1,400
1,200
1,000
800
600
400
200
Quarters ( )
1,600
1,800
Total Assets($ in millions)
Hershey’s Current Assets Matching Strategy Conservative Strategy Aggressive Strategy

4. Short-Term Financing Strategies
Companies can adopt the following strategies to fund long-term needs and seasonal fluctuations of sales:
Conservative strategy
Use long-term financing to cover both permanent assets and temporary assets.
Aggressive strategy
Use short-term financing to fund both seasonal peaks and part of long-term growth in sales and assets.
Matching strategy
Finance permanent assets with long-term funding sources and temporary asset requirement with short-term financing.

5. The Cash Conversion Cycle
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
time = 0
Purchase raw materials on account
Operating cycle
Sell finished goods on account
Collect accounts receivable
Average Collection Period
Average Age of Inventory
Average payment period
Cash Conversion Cycle
Time
Payment mailed

6. 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 costs
Opportunity cost of funds
Cash and marketable securities
Operating Assets
Cost 2 *
(cost of holding too little of operating asset)
Cost 1
(holding cost)

7. Cost Trade-offs in Short-Term Financial Management

8. 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

9. Five C’s of Credit
Framework for in-depth credit analysis that is typically used for high-dollar credit requests:
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

10. 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

11. Credit Scoring of a Consumer Credit Application by WEG Oil
83.25
1.00
8.50
0.10 85
Years on job
9.00 90
Years at address
20.00
0.25 80
Payment history
18.75 75
Income range
15.00
0.15
100
Home ownership
12.00
Credit references
Weighted Score [(1) X (2)] (3)
Predetermined Weight (2)
Score (0 to 100) (1)
Financial and Credit Characteristics

12. 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%.

13. Effects of Changes in Credit Standards for YMC
Additional profit contribution from sales
Marginal profit from
increased sales
Cost of the marginal investment in accounts receivables
Cost of marginal
investment in A/R
To compute additional investment, use the following equations:
Average investment in accounts receivable (AIAR)

14. Cost of the marginal investment in accounts receivables
Total variable cost of annual sales (TVC)
Turnover of account receivable (TOAR)

15. Cost of the marginal investment in accounts receivables
Compute additional investment and, assuming a required return of 12%, compute cost of marginal investment in A/R.
Cost of marginal investment in A/R

16. Cost of Marginal Bad Debt Expense
Subtract the current level of bad debt expense (BDECURRENT) from the expected level of bad debt expense (BDEPROPOSED).
Cost of marginal bad debt expense
4. Net profit for the credit decision
Net profit for the credit decision
Marginal profit from increased sales
Cost of marginal investment in A/R
Cost of marginal bad debts = -
= $28,000 - $6,406 - $18,480 = $3,114

17. Techniques for 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

18. 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.

19. Cash manager responsible for
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

20. Cash Position Management
Cash position management: collection, concentration, and disbursement of funds on a daily basis
Management of short-term investing if the company has a surplus of funds and borrowing arrangements if company has a temporary deficit of funds
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.

21. 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.

22. 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
FVR = float value reduction in dollars
ra = cost of capital
LC = annual operating cost of the lockbox system

23. 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 clearinghouse 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

24. Accounts Payable Management
Management 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.

25. 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

26. 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

27. Short-Term Financial Management
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.