ShortTerm Financial Management Professor XXXXX Course Name Number

Short-Term Financial Management Professor XXXXX Course Name / Number

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 Operating cycle Purchase raw materials on account Sell finished goods on account Average Age of Inventory Average payment period Collect accounts receivable Average Collection Period Payment mailed Cash Conversion Cycle 2 Time

Cost Tradeoffs in Working Capital Accounts Cost 1 (holding cost) Cost 2 * (cost of holding too little of operating asset) Cash and marketable securities Opportunity cost of funds Illiquidity and solvency costs Accounts receivable Cost of investment in accounts receivable and bad debts Opportunity cost of lost sales due to overly restrictive credit policy and/or terms Inventory Carrying cost of inventory, including financing, ware housing, obsolescence costs, etc. Order and setup costs associated with replenishment and production of finished goods Cost of reduced liquidity caused by increasing current liabilities Financing costs resulting from the use of less expensive short-term financing rather than more expensive long-term debt and equity financing Operating Assets Short-Term Financing Accounts payable, accruals, and notes payable 3

Cost Trade-offs in Short-Term Financial Management 4

Accounts Receivable Management If a company decides to offer trade credit, it must: Credit standards Credit selection 5 techniques • • Determine its credit standards. Set the credit terms. Develop collection policy. Monitor its A/R on both individual and aggregate basis. • 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. Five C’s of Credit scoring

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 6

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. 7 • 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

Credit Scoring of a Consumer Credit Application by WEG Oil 8 Financial and Credit Characteristics Score (0 to 100) (1) Predetermine d Weight (2) Weighted Score [(1) X (2)] (3) Credit references 80 0. 15 12. 00 Home ownership 100 0. 15 15. 00 Income range 75 0. 25 18. 75 Payment history 80 0. 25 20. 00 Years at address 90 0. 10 9. 00 Years on job 85 0. 10 8. 50 1. 00 83. 25

Changing Credit Standards Credit standards relaxed Credit standards tightened • Increase in sales and profits (if positive contribution margin), but higher costs from additional A/R and additional bad debt expense. • Reduced investment in A/R and lower bad debt, but lower sales and profit. 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%. 9

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) 10

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

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 12

Cost of Marginal Bad Debt Expense 3. 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 Marginal profit Cost of marginal = from increased investment in A/R sales = $28, 000 - $6, 406 - $18, 480 = $3, 114 13 Cost of marginal bad debts

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 14 Aging of accounts receivable: schedule that indicates the portions of total A/R balance outstanding

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 15 • 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.

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 Time 16 Mail float Processing float Availability float Clearing float

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 17 • 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.

Collections Primary objective: speeding up collections Collection systems: function of the nature of the business Field-banking system 18 • 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.

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

Funds Transfer Mechanisms 20 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

Accounts Payable 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 21 If supplier offers cash discounts, analyze the best alternative between paying at the end of credit period and taking the discount.

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 22

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 23

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.