1. Short-Term Financial Management Professor XXXXX Course Name / Number

2. 2 The Cash Conversion Cycle 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 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

3. 3 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 costsOpportunity cost of fundsCash and marketable securities Operating Assets Cost 2 * (cost of holding too little of operating asset) Cost 1 (holding cost)

4. 4 Cost Trade-offs in Short-Term Financial Management

5. 5 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

6. 6 Five C’s of Credit –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:

7. 7 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

8. 8 Credit Scoring of a Consumer Credit Application by WEG Oil 83.251.00 8.500.1085Years on job 9.000.1090Years at address 20.000.2580Payment history 18.750.2575Income range 15.000.15100Home ownership 12.000.1580Credit references Weighted Score [(1) X (2)] (3) Predetermine d Weight (2) Score (0 to 100) (1) Financial and Credit Characteristics

9. 9 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%.

10. 10 Effects of Changes in Credit Standards for YMC Marginal profit from increased sales Cost of marginal investment in A/R Average investment in accounts receivable (AIAR ) Additional profit contribution from sales Cost of the marginal investment in accounts receivables To compute additional investment, use the following equations:

11. 11 Cost of the marginal investment in accounts receivables Total variable cost of annual sales (TVC) Turnover of account receivable (TOAR)

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

13. 13 Cost of Marginal Bad Debt Expense Cost of marginal bad debt expense 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 3. Cost of marginal bad debt expense Subtract the current level of bad debt expense (BDE CURRENT ) from the expected level of bad debt expense (BDE PROPOSED ). 4. Net profit for the credit decision

14. 14 Credit Monitoring 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

15. 15 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.

16. 16 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

17. 17 Cash Position Management Cash position management: collection, concentration, and disbursement of funds on a daily basis 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. –Management of short-term investing if the company has a surplus of funds and borrowing arrangements if company has a temporary deficit of funds

18. 18 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.

19. 19 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 r a = cost of capital LC = annual operating cost of the lockbox system

20. 20 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

21. 21 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.

22. 22 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

23. 23 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

24. 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. Short-Term Financial Management