Working Capital Management

2. Working Capital Management This chapter presents multiple strategies for managing the working capital of the firm. Cash Inventory Accounts Receivable

3. Account Receivables and Credit Policy Credit Management Steps • Establish terms of sale • What form of IOU will be required? • Perform a credit analysis • Create a credit policy • Develop a collection policy

4. 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

5. 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

6. Implicit Cost: Example On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?

7. Credit Agreements 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. 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

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: 2. Multiple Discriminant Analysis -

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? Yes, a score above 2.7 indicates good credit.

12. Credit Analysis: Discussion Credit analysis is only worthwhile if the expected savings exceed the cost. 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.

14. Payoff = Revenue - Cost Payoff = - Cost The Credit Decision and Probable Payoffs Customer pays = p Offer credit Customer defaults = 1-p Decision Refuse credit Payoff = 0

15. The Credit Decision Based on the probability of payoffs, the expected profit can be expressed as: Solving for p (probability), the break-even probability of collection is:

16. The Credit Decision:Some Final Thoughts • Maximize profit • Concentrate on the dangerous accounts • Look beyond the immediate order

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? * 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 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

20. Optimal Order Size: Minimize Costs

21. Optimal Inventory: Economic Order Quantity

22. 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.

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. Mail float Check received Processing float Check deposited Check clears Check clears Cash available to recipient Check charged to payer’s account Managing Float Availability float Payment float Check mailed

25. 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.

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? Yes, the firm is ahead $45 per day, plus any internal processing costs.

27. Other Payment Systems 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)

28. Investing Idle Cash: The Money Market Money Market – the market for short-term financial assets. • Treasury bills • Commercial paper • Certificates of deposit • Repurchase agreements

29. Appendix A: How Purchases are Paid

30. Appendix B: Methods Used to Make and Receive Electronic Payments

31. Appendix C: Use of Payment Systems in the United States, 2009 Source: www.federalreserve.gov, www.nacha.org, and www.chips.org