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Lecture 10: Working Capital Management

Cash Inventory

Accounts Receivable

This chapter presents multiple

strategies for managing the

working capital of the firm.

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Account Receivables and Credit Policy

Credit Management Steps1. 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

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A/R and Credit PolicyTerminology

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

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Terms of Sale: Example“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

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Implicit Cost: Example

On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?

365/extra days creditdiscount

discounted price

365/50595

Effective annual rate

1+ -1

1+ -1=.454, or 45.4%

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Credit AgreementsTerminology

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.

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Credit AnalysisCredit 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.

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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

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Credit Analysis: Two Approaches

2. Multiple Discriminant Analysis -

Altman Z Score Formula

3.3 1.0 .6 1.4EBIT Sales MarketValueof Equity Retained Earnings

ZTotal Assets Total Assets Total Book Debt Total Asse

1.2NetWorking Capital

ts Total Assets

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:

(relative chance of failure) 6.445 1.192 2.307 .346Liabilities EBITDA

Log ROAAssets Liabilities

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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 sales market equity

.24 1.2 1.0total assets total assets book debt

retained earnings working capital.4 .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.

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Credit Analysis: Discussion

Credit analysis is only worthwhile if the expected savings exceed the cost.

When is this true?

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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.

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The Credit Decision and Probable Payoffs

Refuse credit

Offer credit

Payoff = Revenue - Cost

Payoff = - Cost

Customer pays = p

Customer defaults = 1-p

Payoff = 0

Decision

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The Credit DecisionBased on the probability of payoffs, the expected profit can be expressed as:

PV(Offer Credit) = PV(Refuse Credit)

PV(Revenue Cost) (1 ) (Cost) 0p p PV

Solving for p (probability), the break-even probability of collection is:

PV(Cost)

PV(Rev)p

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The Credit Decision:Some Final Thoughts

1. Maximize profit

2. Concentrate on the dangerous accounts

3. Look beyond the immediate order

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Collection Policy

Collection Policy: Procedures to collect and monitor receivables.

Aging Schedule: Classification of accounts receivable by time outstanding.

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Aging Schedule: ExampleCustomer's Less than More than

1-2 months 2-3 months Total OwedName 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.

What is the goal of a good collection policy?

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Inventory Management

Primary Goal = Minimize amount of cash tied up in inventory

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

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Optimal Order Size: Minimize Costs

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Optimal Inventory: Economic Order Quantity

cost carrying

orderper cost sales 2= Q SizeOrder Economic

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Cash Management

Cash vs. Short-Term Securities

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.

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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.

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Managing Float

Check mailed

Cash availableto recipient

Check charged topayer’s account

Check clears

Check clears

Check received

Mail float

Check deposited

Processing float

Availability float

Payment float

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Float and Check Handling

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.

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Lock-Box System: ExampleA 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

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.

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Electronic Funds Transfer (EFT), Three Methods

1) Direct Payment Automated Clearinghouse (ACH)

2) Direct Deposit

3) Wire Transfer Fedwire CHIPS (Clearing House Interbank Payments System)

Other Payment Systems

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Investing Idle Cash: The Money Market

Money Market – the market for short-term financial assets.

Treasury bills Commercial paper Certificates of deposit Repurchase agreements

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Appendix A: How Purchases are Paid

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Appendix B: Methods Used to Make and Receive Electronic Payments

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Appendix C: Use of Payment Systems in the United States, 2009

Source: www.federalreserve.gov, www.nacha.org, and www.chips.org