McGraw-Hill/IrwinCopyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.Working Capital ManagementCashInventoryAccounts ReceivableThis chapter presents multiple strategies for managing the working capital of the firm. 2 2Account Receivables and Credit PolicyCredit Management Steps1.Establish terms of sale2.What form of IOU will be required?3.Perform a credit analysis4.Create a credit policy5.Develop a collection policy3 3A/R and Credit Policy TerminologyTrade Credit Bills awaiting payment from one company to anotherConsumer Credit Bills awaiting payment from final customer to a companyTerms of Sale Credit, discount, and payment terms offered on a sale4 4Terms 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 due5 5Implicit Cost: ExampleOn a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?6 6Credit AgreementsTerminology Open account Agreement whereby sales are made with no formal debt contract Commercial draft An order to paySight draft Time draft Trade acceptance Bankers acceptance A time draft accepted (and therefore guaranteed) by the bank.7 7Credit AnalysisCredit Analysis: Procedure to determine the likelihood a customer will pay his or her bills.w Credit agencies like Dun & Bradstreet provide reports on the credit-worthiness of a potential customer.w Financial ratios can be calculated to help determine a customers ability to pay his or her bills.8 8The Five Cs of CreditNumerical Credit Scoring categoriesThe customers characterThe customers capacity to payThe customers capitalThe collateral provided by the customerThe condition of the customers business9 9Credit Analysis: Two Approaches2. Multiple Discriminant Analysis -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:1010Credit Analysis: ExampleIf the Altman Z-score cutoff for a credit-worthy business is 2.7 or higher, would we accept the following client?Yes, a score above 2.7 indicates good credit.1111Credit Analysis: DiscussionCredit analysis is only worthwhile if the expected savings exceed the cost.When is this true?1212The Credit DecisionCredit Policy: Standards set to determine the amount and nature of credit to extend to customers.w Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default. w Denying credit guarantees neither profit nor loss.1313The Credit Decision and Probable PayoffsRefuse creditOffer creditPayoff = Revenue - CostPayoff = - CostCustomer pays = pCustomer defaults = 1-pPayoff = 0Decision1414The Credit DecisionBased on the probability of payoffs, the expected profit can be expressed as:Solving for p (probability), the break-even probability of collection is:1515The Credit Decision: Some Final Thoughts1.Maximize profit2.Concentrate on the dangerous accounts3.Look beyond the immediate order1616Collection PolicyCollection Policy: Procedures to collect and monitor receivables. Aging Schedule: Classification of accounts receivable by time outstanding.1717Aging Schedule: Example* 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?1818Inventory ManagementPrimary Goal = Minimize amount of cash tied up in inventoryRecall the Components of Inventory:Raw materialsWork in processFinished goodsCarrying Costs: The cost of storing goods plus the cost of capital tied up in inventory1919Optimal Order Size: Minimize Costs2020Optimal Inventory: Economic Order Quantity2121Cash Management Cash vs. Short-Term SecuritiesWhy not all cash?Why not all short-term securities?A sweep program is a program which helps firms invest idle cash. The firms bank automatically “sweeps” surplus funds into a higher-interest account.2222FloatFloat The time between the moment a check is written and the moment the funds are deposited in the recipients account.Payment Float Checks written by a company that have not yet cleared.Availability Float Checks already deposited that have not yet cleared.2323Managing FloatCheck mailedCash available to recipientCheck charged to payers accountCheck clearsCheck clearsCheck receivedMail floatCheck depositedProcessing floatAvailability floatPayment float2424Float and Check HandlingConcentration 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.2525Lock-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