2. Working Capital Management
This chapter
presents multiple
strategies for
managing the
working capital of
the firm.
Cash Inventory
20-2
Accounts
Receivable
3. Account Receivables and
20-3
Credit Policy
Credit Management Steps
1. Establish terms of sale
2. What form of IOU will be required?
3. Perform a credit analysis
4. Create a credit policy
5. Develop a collection policy
4. A/R and Credit Policy
20-4
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
5. Terms of Sale: Example
20-5
“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
6. Implicit Cost: Example
On a $100 sale, with terms 5/10 net 60, what is the
implied interest rate on the credit given?
Effective annual rate
1+ -1
1+ -1=.454, or 45.4%
20-6
( )
( )
365/extra days credit
discount
discounted price
5 365/50
95
=
=
7. Credit Agreements
20-7
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.
8. 20-8
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.
9. 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
20-9
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:
Log(relative chance of failure) = - 6.445 - 1.192 ´ ROA + 2.307 ´ Liabilities - .346 ´
EBITDA
Assets Liabilities
= + + + +
1.2 NetWorkingCapital
20-10
2. Multiple Discriminant Analysis -
Altman Z Score Formula
Z 3.3 EBIT 1.0 Sales .6 MarketValueof Equity 1.4 Retained Earnings
Total Assets Total Assets Total Book Debt Total Asse
ts Total Assets
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?
EBIT = .24 sales = 1.2 market equity =
1.0
total assets total assets book debt
retained earnings = .4 working capital =
.20
total assets total assets
Z-Score = 3.3´.24+1.0´1.2 +.6´1.0 +1.4´.4 +1.2´0.2 =3.39
Yes, a score above 2.7 indicates good credit.
20-11
12. Credit Analysis: Discussion
Credit analysis is only worthwhile if the
expected savings exceed the cost.
20-12
When is this true?
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.
20-13
14. The Credit Decision and
20-14
Probable Payoffs
Offer credit
Refuse credit
Payoff = Revenue - Cost
Payoff = - Cost
Customer pays = p
Customer defaults = 1-p
Payoff = 0
Decision
15. The Credit Decision
Based on the probability of payoffs, the expected profit can be expressed as:
PV(Offer Credit) = PV(Refuse Credit)
20-15
PV(Revenue p ´ -Cost) -(1- p) ´ PV(Cost) =0
Solving for p (probability), the break-even probability of collection is:
PV(Cost)
PV(Rev)
p =
16. The Credit Decision:
Some Final Thoughts
20-16
1. Maximize profit
2. Concentrate on the dangerous accounts
3. Look beyond the immediate order
17. 20-17
Collection Policy
Collection Policy: Procedures to collect and monitor
receivables.
Aging Schedule: Classification of accounts receivable
by time outstanding.
18. Aging Schedule: Example
· · · · · ·
· · · · · ·
· · · · · ·
What is the goal of a good collection policy?
20-18
Customer's Less than More than
1-2 months 2-3 months Total Owed
Name 1 month 3 months
Able $10,000 $5,000 $2,500 0 $17,500
Baker 8,000 3,000 0 0 11,000
Charlie 5,000 0 0 0 5,000
Zebra 5,000 0 6,000 15,000 26,000
Tot
al* $200,000 $100,000 $25,000 $15,000 $340,000
* The totals in the last row are based on the assumption that there are more than four customers. The others were omitted for brevity.
19. Inventory Management
Primary Goal = Minimize amount of cash tied up in inventory
20-19
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
21. Optimal Inventory:
Economic Order Quantity
Economic Order Size = Q = 2 ´ sales ´ cost per order
carrying cost
20-21
22. Cash Management
Cash vs. Short-Term Securities
20-22
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.
23. 20-23
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.
24. Check
clears
20-24
Managing Float
Check mailed
Cash available
to recipient
Check charged to
payer’s account
Check
clears
Check received
Mail float
Check deposited
Processing float
Availability
float
Payment
float
25. Float and Check Handling
20-25
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.
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?
A lock box reduces the collection float by:
180´$1,000´(1.75 +1.25) = $540,000
20-26
Daily return
$540,000 per day´.0002 = $108 per day
Daily Cost
$.35 per check ´180 checks = $63 per day
Yes, the firm is ahead $45 per day, plus any internal processing costs.
27. Other Payment Systems
Electronic Funds Transfer (EFT), Three Methods
20-27
1) Direct Payment
Automated Clearinghouse (ACH)
2) Direct Deposit
3) Wire Transfer
Fedwire
CHIPS (Clearing House Interbank Payments System)
28. Investing Idle Cash:
The Money Market
Money Market – the market for short-term financial assets.
20-28
Treasury bills
Commercial paper
Certificates of deposit
Repurchase agreements
31. Appendix C: Use of Payment Systems
in the United States, 2009
20-31
Source: www.federalreserve.gov, www.nacha.org, and www.chips.org
Notas do Editor
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.
Chapter 20 Outline
Accounts Receivable and Credit Policy
Inventory Management
Cash Management
Investing Idle Cash: The Money Market
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.
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.
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.
Credit Analysis - Procedure to determine the likelihood a customer will pay its bills.
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.
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.
Credit Policy - Standards set to determine the amount and nature of credit to extend to customers.
Collection Policy- Procedures to collect and monitor receivables.
Aging Schedule- Classification of accounts receivable by time outstanding.
Carrying Costs – The cost of storing goods plus the cost of capital tied up in inventory
Economic Order Quantity - Order size that minimizes total inventory costs.
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.
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.
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.
Automated Clearinghouse (ACH) – An electronic network for cash transfers in the United States.
Note: Direct Payment Automatic Debit; Direct Deposit Automatic Credit
Money Market - market for short term financial assets.
Note: The international market for short-term dollar investments is known as the eurodollar market.