17-1

McGraw-Hill/Irwin Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

Understand
How firms manage cash and various collection, concentration, and disbursement techniques How to manage receivables, and the basic components of credit policy Various inventory types, different inventory management systems, and what determines the optimal inventory level
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Chapter Outline
17.1 Float and Cash Management 17.2 Cash Management: Collection, Disbursement, and Investment 17.3 Credit and Receivables 17.4 Inventory Management 17.5 Inventory Management Techniques

17-3

Reasons for Holding Cash

John Maynard Keynes
Speculative motive = take advantage of unexpected opportunities Precautionary motive = in case of emergencies Transaction motive = to pay day-to-day bills
Trade-off: opportunity cost of holding cash vs. transaction cost of converting marketable securities to cash
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Understanding Float
Float = difference between cash balance recorded in the cash account and the cash balance recorded at the bank Disbursement float
Generated when a firm writes checks Available balance at bank book balance > 0

Collection float
Checks received increase book balance before the bank credits the account Available balance at bank book balance < 0

Net float = disbursement float + collection float

Return to Quick Quiz
17-5

Managing Float
Management concern = net float and available balance Collections and disbursement times

1. Mailing time
2. Processing delay 3. Availability delay

To speed collections, decrease one or more

To slow disbursements, increase one or more

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Float Issues
Kiting
Systematic overdrafting Writing checks for no economic reason other than to exploit float

Electronic Data Interchange & Check 21

EDI = direct, electronic information exchange Check 21 = bank receiving a customer check may transmit an electronic image and receive immediate payment
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Example: Types of Float

You have $3,000 in your checking account. You just deposited $2,000 and wrote a check for $2,500.
What is the disbursement float? What is the collection float? What is the net float? What is your book balance? What is your available balance?

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Cash Collection
Payment Mailed Payment Received Payment Deposited Cash Available

Mailing Time

Processing Delay Collection Delay

Availability Delay

Float management goal = reduce collection delay

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Cash Collection
Over-the-counter-collection
Point of sale collection

Preauthorized payment system

Payment amount and dates fixed in advance Payments automatically transferred

Payments via mailed checks

One mailing address Various collection points
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Lockboxes & Cash Concentration

Customer checks mailed to a P.O box Local bank picks up checks several times each day
Lockbox maintained by local bank Checks deposited to firms account

Firms may have many lockbox arrangements around the country

Funds end up in multiple accounts

Cash concentration = procedure to gather funds into firms main accounts Reduces mailing and processing times
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Overview of Lockbox Processing

Figure 17.1

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Lockboxes and Cash Concentration

17-13

Cash Disbursements
Disbursement float = desirable Slowing down payments can increase disbursement float
Mail checks from distant bank or post office May not be ethical or optimal

Controlling disbursements
Zero-balance account Controlled disbursement account
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Zero-balance Accounts
Firm maintains
A master bank account Several subaccounts

Bank automatically transfers funds from main account to subaccount as checks presented for payment Requires safety stock buffer in main account only
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Zero-balance Accounts Figure 17.3

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Investing Idle Cash

Money market = financial instruments with original maturity one year Temporary Cash Surpluses
Seasonal or cyclical activities
Buy marketable securities with seasonal surpluses Convert back to cash when deficits occur

Planned or possible expenditures

Accumulate marketable securities in anticipation of upcoming expenses
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Seasonal Cash Demands

Figure 17.4

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Characteristics of Short-Term Securities

Maturity firms often limit the maturity of short-term investments to 90 days to avoid loss of principal due to changing interest rates Default risk avoid investing in marketable securities with significant default risk Marketability ease of converting to cash Taxability consider different tax characteristics when making a decision
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Credit Management: Key Issues

Granting credit increases sales Costs of granting credit
Chance that customers wont pay Financing receivables

Credit management = trade-off between increased sales and the costs of granting credit

17-20

Cash Flows from Granting Credit

Credit Sale

Check Mailed

Check Deposited

Cash Available

Cash Collection
Accounts Receivable

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Components of Credit Policy

Terms of sale
Credit period (usually 30-120 days) Cash discount and discount period Type of credit instrument

Credit analysis
Distinguishing between good customers that will pay and bad customers that will default

Collection policy
Effort expended on collecting receivables
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Credit Period Determinants

Factor
1. Perishable goods with low collateral value 2. Low consumer demand Effect on Credit Period credit period credit period

3. Low cost, low profitability, and credit period high standardization 4. High credit risk credit period 5. Small account size credit period

6. Competition
7. Customer type

credit period
Varied
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Terms of Sale
Basic Form: 2/10 net 45
2% discount if paid in 10 days Total amount due in 45 days if discount is not taken

Buy $500 worth of merchandise with the credit terms given above
Pay $500(1 - .02) = $490 if you pay in 10 days Pay $500 if you pay in 45 days

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Example: Cash Discounts

Finding the implied interest rate when customers do not take the discount Credit terms of 2/10 net 45 and $500 loan
$10 interest (= .02*500) Period rate = 10 / 490 = 2.0408% Period = (45 10) = 35 days 365 / 35 = 10.4286 periods per year

EAR = (1.020408)10.4286 1 = 23.45% The company benefits when customers choose to forgo discounts
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Credit Instruments
Basic evidence of indebtedness Open account
Most basic form Invoice only

Promissory Note
Basic IOU Not common Signed after goods delivered
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Credit Instruments
Commercial Draft Sight draft = immediate payment required Time draft = not immediate When draft presented, buyer accepts it
Indicates promise to pay Trade acceptance

Seller may keep or sell acceptance Bankers acceptance = bank guarantees payment
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Optimal Credit Policy

Carrying costs
Required return on receivables Losses from bad debts Cost of managing credit & collections

If restrictive credit policy:

Carrying costs low Credit shortage = opportunity costs

More liberal credit policy likely if:

Excess capacity Low variable operating costs Repeat customers
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Optimal Credit Policy

Figure 17.5
Cost ($) Optimal amount of credit

Carrying Cost

Opportunity costs

Amount of credit extended ($)

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Credit Analysis
Process of deciding which customers receive credit Credit information
Financial statements Credit reports/past payment history Banks Payment history with the firm

Determining creditworthiness
5 Cs of Credit Credit Scoring
Return to Quick Quiz

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Five Cs of Credit
Character = willingness to meet financial obligations Capacity = ability to meet financial obligations out of operating cash flows Capital = financial reserves Collateral = assets pledged as security Conditions = general economic conditions related to customers business
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Collection Policy
Monitoring receivables
Watch average collection period relative to firms credit terms Use aging schedule to monitor percentage of overdue payments

Collection policy
Delinquency letter Telephone call Collection agency Legal action
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Inventory Management
Inventory = large percentage of firm assets Inventory costs:
Cost of carrying too much inventory Cost of not carrying enough inventory

Inventory management objective = find the optimal trade-off between carrying too much inventory versus not enough

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Types of Inventory
Manufacturing firm
Raw material production starting point Work-in-progress Finished goods ready to ship or sell

One firms raw material = anothers finished good Derived vs. Independent demand Different types of inventory vary dramatically in terms of liquidity
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Inventory Costs
Carrying costs = 2040% of inventory value per year
Storage and tracking Insurance and taxes Losses due to obsolescence, deterioration, or theft Opportunity cost of capital

Shortage costs
Restocking costs Lost sales or lost customers
Return to Quick Quiz
17-35

Inventory Management
Classify inventory by cost, demand, and need
Maintain larger quantities of items that have substantial shortage costs Maintain smaller quantities of expensive items Maintain a substantial supply of less expensive basic materials
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EOQ Model
EOQ = Economic Order Quantity EOQ minimizes total inventory cost Q = inventory quantity in each order
Q/2 = Average inventory

T = firms total unit sales per year

T/Q = number of orders per year

CC = Inventory carrying cost per unit F = Fixed cost per order

Return to Quick Quiz
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EOQ Model
Total carrying cost
= (Average inventory) x (Carrying cost per unit) = (Q/2)(CC)

Total restocking cost

= (Fixed cost per order) x (Number of orders) = F(T/Q)

Total Cost
= Total carrying cost + Total restocking cost = (Q/2)(CC) + F(T/Q)
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EOQ Model
Total Cost
= Total carrying cost + Total restocking cost = (Q/2)(CC) + F(T/Q)

Q* Carrying costs = Restocking costs

(Q*/2)(CC) = F(T/Q*)

2TF CC

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Example: EOQ
Consider an inventory item that has carrying cost = $1.50 per unit. The fixed order cost is $50 per order and the firm sells 100,000 units per year.
What is the economic order quantity?

2(100 ,000 )(50 ) Q 2,582 1.50

*
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Extensions to EOQ
Safety stocks
Minimum level of inventory kept on hand Increases carrying costs

Reorder points
Inventory level at which you place an order to account for delivery time
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Derived-Demand Inventories
Materials Requirements Planning (MRP)
Computer-based ordering/scheduling Works backwards from set finished goods level to establish levels of work-in-progress required

Just-in-Time Inventory
Reorder and restock frequently Japanese system
Keiretsu = industrial group Kanban = card signaling reorder time
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Quick Quiz
1. What is the difference between disbursement float and collection float?
(Slide 17.5)

2. What is credit analysis and why is it important? (Slide 17.30) 3. What are the two main categories of inventory costs? (Slide 17.35) 4. What components are required to determine the economic order quantity?
(Slide 17.37)
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Chapter 17
END