Short-Term Financial Management

TVU Reading College

MBA Managerial Finance
Lecture 3

Basics
Working Capital Basics

The assets/liabilities that are required

to operate a business on a day-to-day
basis
Cash
Accounts Receivable
Inventory
Accounts Payable
Accruals

These assets/liabilities are short-term

in nature and turn over regularly
2

Working Capital, Funding Requirements,

and the Current Accounts
Gross Working Capital (GWC)
represents the investment in assets
Working Capital Requires Funds

Maintaining a working capital balance

requires a permanent commitment of
funds
Example: Your firm will always have a

minimum level of Inventory, Accounts

Receivable, and Cashthis requires
funding

Working Capital, Funding Requirements,

and the Current Accounts
Spontaneous Financing

Your firm will also always have a

minimum level of Accounts Payable
in effect, money you have borrowed
Accounts Payable (and Accruals) are

generated spontaneously
Offset the funding required to support
assets

Net working capital is Gross Working Capital

Current Liabilities (or spontaneous financing)
Reflects the net amount of funds needed
to support routine operations
4

Objective of Working Capital

Management
To run the firm efficiently with as
little money as possible tied up in
Working Capital

Involves trade-offs between easier

operation and the cost of carrying
short-term assets
Benefit of low working capital

Able to funnel money into accounts that

generate a higher payoff

Cost of low working capital

Risky
5

The Cash Conversion Cycle

Operating
cycle
Cash
conversion
cycle

Time from the beginning of the

production to the time when cash is
collected from sale
Financing the operating cycle is costly,
so firms have an incentive to shrink it.
Operating cycle less the average
payment period on accounts payable

time = 0
Operating cycle
Purchase raw
materials on account

Sell finished goods

on account

Average Age of Inventory

Average payment
period

Collect accounts
receivable

Average Collection Period

Payment mailed
Cash Conversion Cycle
Time

Cost Tradeoffs in Working Capital

Accounts
Cost 1
(holding cost)

Cost 2 * Shortage Costs

(cost of holding too little of
operating asset)

Cash and marketable

securities

Opportunity cost of funds

Illiquidity and solvency costs

Accounts receivable

Cost of investment in accounts

receivable and bad debts

Opportunity cost of lost sales due

to overly restrictive credit policy
and/or terms

Inventory

Carrying cost of inventory,

including financing, warehousing,
obsolescence costs, etc.

Order and setup costs associated

with replenishment and production
of finished goods

Cost of reduced liquidity caused

by increasing current liabilities

Financing costs resulting from the

use of less expensive short-term
financing rather than more
expensive long-term debt and
equity financing

Operating Assets

Short-Term Financing
Accounts payable, accruals,
and notes payable

Cost Trade-offs in Short-Term Financial

Management
Trade-off of Short-Term Financial Costs

Cost

Cost 1
Cost 2
Total Cost

Account Balance
8

Inventory Management

Inventory Management
Mismanagement of inventory has the
potential to ruin a company
Inventory is not the direct
responsibility of the finance
department

Usually managed by a functional area

such as manufacturing or operations
However, finance department has an
oversight responsibility for inventory
management
Monitor level of lost of obsolete inventory
Supervise periodic physical inventories
10

Benefits and Costs of Carrying Adequate

Inventory
Benefits

Reduces stockouts and backorders

Makes operations run more smoothly, improves
customer relations and increases sales

Costs

Interest on funds used to acquire inventory

Storage and security
Insurance
Taxes
Shrinkage
Spoilage
Breakage
Obsolescence
11

Inventory Control and Management

Inventory management refers to
the overall way a firm controls
inventory and its cost

Define an acceptable level of

operating efficiency with regard to
inventory
Try to achieve that level with the
minimum inventory cost

12

Economic Order Quantity (EOQ) Model

EOQ model recognizes trade-offs
between carrying costs and
ordering costs

Carrying costs increase with the

amount of inventory held
Ordering costs increase with the
number of orders placed

EOQ minimizes the sum of ordering

and carrying costs
13

EOQ (Q*)
Total costs = Ordering costs + Carrying costs
Total costs = (number of orders per year Cost
per order) + (Avg. INV Annual carrying cost per
unit)

Total costs = (D/Q S) + (Q/2 C)

EOQ

Q
*

2SD
C

Optimal length of one inventory cycle

*
Q
*
T
D 365

or

365 Q
D

14

Safety Stocks, Reorder Points and Lead

Times
Safety stock provides a buffer against
unexpectedly rapid use or delayed
delivery

An additional supply of inventory that is

carried at all times to be used when normal
working stocks run out
Rarely advisable to carry so much safety
stock that stockouts never happen
Carrying costs would be excessive

Ordering lead time is the advance notice

needed so that an order placed will arrive
at the needed time

Usually estimated by the items supplier

15

Tracking InventoriesThe ABC System

Some inventory items warrant a great
deal of attention

Are very expensive

Are critical to the firms processes or to
those of customers

Some inventory items do not warrant a

great deal of attention

Commonplace, easy to obtain

An ABC system segregates items by

value and places tighter control on
higher cost (value) pieces
16

Just In Time (JIT) Inventory Systems

Suppliers deliver goods to manufacturers
just in time (JIT)
Theoretically eliminates the need for
factory inventory
A late delivery can stop a factorys entire
production line
JIT works best with large manufacturers
who are powerful with respect to the
supplier

Supplier is willing to do almost anything to

keep the manufacturers business
17

Management of Accounts Receivable

Accounts Receivable Management

If a company
decides to offer
trade credit, it
must:

Credit
standards

Credit
selection
techniques

Determine its credit

standards.
Set the credit terms.
Develop collection policy.
Monitor its A/R on both
individual and aggregate
Apply techniques
basis.
to determine which
customers should receive credit.
Use internal and external sources to
gather information relevant to the
decision to extend credit to specific
customers.
Take into account variable costs of the
products sold on credit.

Five Cs of
Credit

Credit
scoring

19

Five Cs of Credit
Framework for in-depth credit analysis that is
typically used for high-value credit requests:
Character: The applicants record of meeting past
obligations; desire to repay debt if able to do so
Capacity: The applicants ability to repay the requested
credit
Capital: The financial strength of the applicant as
reflected by its ownership position
Collateral: The amount of assets the applicant has
available for use in securing the credit
Conditions: Refers to current general and industryspecific economic conditions
20

Credit Scoring
Uses statistically-derived weights for key credit
characteristics to predict whether a credit applicant
will pay the requested credit in a timely fashion.

Used with high volume/small dollar credit requests

Most commonly used by large credit card operations, such as
banks, oil companies, and department stores.
An example
ABC Co Ltd uses credit scoring to make credit decisions.
Decision rule is:
Credit Score > 75: extend standard credit terms
65 < Credit Score < 75: extend limited credit (convert
to standard credit terms after 1 year if account is
properly maintained)
21
Credit Score < 65: reject application

Credit Scoring of a Consumer Credit

Application by ABC Co

Financial
and Credit
Characteristics

Score
(0 to 100)
(1)

Predetermined
Weight
(2)

Weighted
Score
[(1) X (2)]
(3)

Credit references

80

0.15

12.00

Home ownership

100

0.15

15.00

Income range

75

0.25

18.75

Payment history

80

0.25

20.00

Years at address

90

0.10

9.00

Years on job

85

0.10

8.50

1.00

83.25

22

Changing Credit Standards

Increase in sales and profits (if
Credit standards
positive contribution margin), but
higher costs from additional A/R
relaxed
and additional bad debt expense.
Reduced investment in A/R and
Credit standards
lower bad debt, but lower sales
tightened
and profit.
An exampleYMCc wants to evaluate the effects of a
relaxation of its credit standards:
YMCo sells CD organizers for 12/unit. All sales are on
credit. YMC expects to sell 140,000 units next year.
Variable costs are 8/unit and fixed costs are 200,000 per
year.
The change in credit standards will result in:
5% increase in sales; average collection period will
increase from 30 to 45 days; increase in bad debt
23
from 1% to 2%.

Effects of Changes in Credit Standards for

YMCo
Additional profit contribution from sales
Marginal profit from
Sales Contribution Margin Sales Price - Variable Cost
increased sales
7000 un (12/un- 8/un) 28,000

Cost of the marginal investment in accounts

receivables

Cost of marginal additional investment required return

investment in A/R

To compute additional investment, use the

following equations:
Average investment in
accounts receivable
(AIAR)

total variable cost of annual sales

turnover of accounts receivable

24

Cost of the marginal investment in accounts

receivables
Total variable cost of
annual unit sales variable cost/unit
annual sales (TVC)

TVCCURRENT 140,000un 8/un 1,120,000

TVCPROPOSED 147,000un 8/un 1,176,000
Turnover of account
receivable (TOAR)

365
average collection period (ACP)

TOAR CURRENT

TOAR PROPOSED

365
365

12.2 times/year
ACPCURRENT 30 days

365
365

8.1 times/year
ACPPROPOSED 45 days
25

Cost of the marginal investment in

accounts receivables
AIARCURRENT

TVCCURRENT 1,120,000

91,803.28
TOARCURRENT
12.2

AIARPROPOSED

TVCPROPOSED 1,176,000

145,185.1
8
TOARPROPOSED
8.1

Compute additional investment and, assuming a

required return of 12%, compute cost of marginal
investment in A/R.
Cost of marginal additional investment required return
investment in
A/R
( AIARPPROPOSED- AIARCURRENT) requiredreturn 6,406
26

Cost of Marginal Bad Debt Expense

3. Cost of marginal bad debt expense
Subtract the current level of bad debt expense (BDE CURRENT)
from the expected level of bad debt expense (BDE PROPOSED).
BDEPROPOSED (SalesPROPOSED) bad debt expenserate 1,764,000
0.02 35,280
BDECURRENT (SalesCURRENT) bad debt expenserate 1,680,000
0.01 16,800

Cost of marginal bad debt expense 35,280- 16,800 18,480

4. Net profit for the credit decision

Marginal profit
Net profit for the
Cost of marginal
= from increased credit decision
investment in A/R
sales

Cost of
marginal
bad debts

= 28,000 - 6,406 - 18,480 = 3,114

27

Credit Monitoring
Credit
monitoring
Techniques
for credit
monitoring

The ongoing review of a firms

accounts receivable to determine if
customers are paying according to
stated credit terms
Average collection period
Ageing of accounts receivable
Payment pattern monitoring

Average collection period: the average number of

days credit sales are outstanding
accounts receivable
Average collection period
average sales per day
Ageing of accounts receivable: schedule that
indicates the portions of total A/R balance
28
outstanding

Credit Monitoring
Payment pattern: the normal timing within which a
firms customers pay their accounts
Percentage of monthly sales collected the following
month
Should be constant over time; if payment pattern
changes, the firm should review its credit policies
An example
DJM Manufacturing determined that:
20% of sales collected in the month of sales, 50% in the
next month and 30% two months after the sale.
Can use payment pattern to construct cash receipts from
the cash budget:
If January sales are 400,000, DJM expects to collect
80,000 in January, 200,000 in February, and
29
120,000 in March.

Management of Cash

Cash Management
Cash management: the collection, concentration,
and disbursement of funds

Cash
manager
responsible
for

Cash management
Financial relationships with banks
Cash flow forecasting
Investing and borrowing
Development and maintenance of
information systems for cash
management

Float: funds that have been sent by the payer but

not yet usable funds to the company
Time

Mail float

Processin
g float

Availabilit
y float

Clearing
float
31

Costs of Holding Cash

Costs of holding
cash

Trading costs increase when the firm

must sell securities to meet cash needs.
Total cost of holding cash
Opportunity
Costs
The investment income
foregone when holding cash.
Trading costs
C*

Size of cash balance

32

33

34

The Baumol Model

C
T
Total cost K F
2
C

C
K
Opportunity Costs
2

Trading costs

T
F
C

C*
Size of cash balance
The optimal cash balance is found where the opportunity
costs equals the trading costs
C
*

2T
F
K

35

The Baumol Model

The optimal cash balance is found where the opportunity
costs equals the trading costs
Opportunity Costs = Trading Costs

C
T
K F
2
C
Multiply both sides by C

T F
C 2
K

C
K T F
2

2TF
C
K
*

36

37

38

Implications of the Miller-Orr Model

To use the Miller-Orr model, the
manager must do four things:
1.

2.

3.
4.

Set the lower control limit for the cash

balance.
Estimate the standard deviation of daily
cash flows.
Determine the interest rate.
Estimate the trading costs of buying and
selling securities.
39

Implications of the Miller-Orr Model

The model clarifies the issues of cash
management:

The best return point, Z, is positively

related to trading costs, F, and negatively
related to the interest rate K.
Z and the average cash balance are
positively related to the variability of cash
flows.

40

Cash Position Management

Cash position management: collection,
concentration, and disbursement of funds on a daily
basis

Management of short-term investing if the company has a

surplus of funds and borrowing arrangements if company has a
temporary deficit of funds

Smaller companies set target cash balance for

their current (Checking) accounts.
Bank account
analysis
statement

Bank provides report to its customers

to show recent activity in firms
accounts.
Banks cannot pay interest on
corporate Current (checking) account
balances.
41
Firms use earnings credit for balances

Collections
Primary objective: speeding up collections
Collection systems: function of the nature of the
business
Field-banking
system
Mail-based
system
Electronic
payments

Collections are made over the counter

(retail) or at a collection office
(utilities).
Mail payments are processed at
companies collection centers.

Becoming increasingly popular

because they offer advantages to
both
42
parties.

Collections

Lockbox
system
(USA)

Speeds up collections because it

affects all components of float.
Customers mail payments to a post
office box.
Firms bank empties the box and
processes each payment and deposits
the payments in the firms account.
Lockboxes reduce mail and clearing
time.

Perform cost-benefit analysis to determine if lockbox

system worth using

Net benefit ( cos t) (FVR ra ) - LC , where

FVR = float value reduction in dollars
ra = cost of capital

LC = annual operating cost of the lockbox system 43

Funds Transfer Mechanisms

Depository
transfer
checks
(USA)
Automated
direct debit
transfers

BACS /
Chaps/ Swift
transfers

Unsigned check drawn on one of the

firms bank accounts and deposited in
another of the firms bank accounts
Preauthorized electronic withdrawal
from the payers account
Settle accounts among participating
banks. Individual accounts are settled
by respective bank balance
adjustments.
Transfers clear in one day.

Electronic communication that, via

bookkeeping entries, removes funds from
the payers bank and deposits the funds in
the payees bank.
Bacs bankers automated clearing system
(4 days)
Chaps Clearing Houses Automated
44
payment system (Same day transfers)

Managing Accounts Payable

Accounts Payable Management

Management of time from purchase of raw materials
until payment is placed in the mail
Accounts
payable
functions

Examine all incoming invoices and

determine the amount to be paid.
Control function: cash manager verifies
that invoice information matches
purchase order and receiving
information.

Decide between centralized or decentralized

payables and payments systems
If supplier offers cash discounts, analyze the best
alternative between paying at the end of credit
period and taking the discount.
46

Disbursements Products and Methods

Zero-balance accounts (ZBAs):
disbursements accounts that always have
end-of-day balance of zero
Allows the firm to maximize the use of float on each

cheque, without altering the float time of its suppliers

Keeps all cash in interest-bearing accounts

Controlled disbursement:
Bank provides early notification of cheque presented

against a companys account every day.

Positive pay: Company transmits to the bank

a cheque-issued file to the bank when
cheques are issued.
Cheque-issued file includes cheque number and amount

of each item.
Used for fraud prevention

47

Developments in Accounts Payable and

Disbursements
Integrated (comprehensive) accounts
payable:

outsourcing of accounts payable or

disbursements operations

Purchasing/procurement cards:

increased use of credit cards for low-dollar

indirect purchases

Imaging services:

Both sides of the cheque, as well as

remittance information, is converted into
digital images.
Useful when incorporated with positive pay
services
48

Financing Working Capital

Sources of Short-term Financing

Spontaneous financing

Accounts payable and accruals

Unsecured bank loans

Commercial paper
Secured loans

50

Spontaneous Financing
Accruals

Money you owe employees, for example, for

work performed but for which they have not
yet been paid
Tend to be very short-term

Accounts payable (AKA trade credit)

Money you owe suppliers for goods you

bought on credit
Credit Terms: Terms of trade specify when you

are to repay the debt

Example of terms of trade: 2/10, net/30

You must pay the entire amount by 30 days
If you pay within 10 days, you will receive a 2%
discount
51

Spontaneous Financing
The prompt payment discount

Passing up prompt payment discounts

is generally a very expensive source
of financing

52

Spontaneous Financing
Abuses of Trade Credit Terms

Trade credit, while originally a service

to a firms customers, has become so
commonplace it is now expected
Companies offer it because they have to

Stretching payables is a common

abuse of trade credit
Paying payables beyond the due date

(AKA: leaning on the table)

Slow paying companies receive poor
credit ratings in credit reports issued by
credit agencies
53

Unsecured Bank Loan

Represent the primary source of
short-term loans for most
companies
Promissory note (AKA Notes
Payable)

Note signed promising to repay the

amount borrowed plus interest
Bank usually credits the amount to

borrowers checking account

54

Unsecured Bank Loans

Line of credit

Informal, non-binding agreement between

bank and firm that specifies the maximum
amount firm can borrow over a specific time
frame (usually a year)
Borrower pays interest only on the amount borrowed

Revolving credit agreement

Similar to a line of credit except bank

guarantees the availability of funds up to a
maximum amount (effectively a binding
agreement)
Borrower pays a commitment fee on the unborrowed

funds (whether they are used or not)

55

Unsecured Bank Loans

Compensating balances

A minimum amount by which the

borrowers bank account cannot drop
below (therefore it is unavailable for
use)

Increases the effective interest rate on a loan

Typically between 10% and 20% of

amounts loaned

56

Unsecured Bank Loans

Clean-Up Requirements

Theoretically a firm can constantly

roll-over its short-term debt
Borrow on a new note to pay off an old

note

Risky for both the firm and the bank

Banks require that borrowers clean up

short-term loans once a year
Remain out of short-term debt for a

certain time period

57

Commercial Paper
Notes issued by large, financially-strong
firms and sold to investors

Basically a short-term corporate bond

Unsecured (usually)
Buyers are usually other institutions (insurance

companies, mutual funds, banks, pension funds)

Maturity is less than 270 days
Considered a very safe investment, therefore
pays a relatively low interest rate
Rather than paying a coupon rate, interest is
discounted
Commercial paper market is rigid and formalno
flexibility in repayment terms
58

Short-Term Credit Secured by Current

Assets
Debt is secured by the current
asset being financed
More popular in some industries
than in others

Common in seasonal businesses

59

Short-Term Credit Secured by Current

Assets
Receivables Financing:

Accounts receivable represent money that is

to be collected in the near future
Banks recognize that this money will be
collected soon are are willing to lend money
based on this soon-to-be-collected money
Invoice discounting: firm sells AR to lender but

retains control of control of the accounts

AR are now paid directly to lender to a specified

account

Factoring AR: firm sells AR to lender (at a) and the

lending firm (factor) takes control of the accounts

AR are now paid directly to lender

Lender assumes responsibility for credit control &
collection

60

Short-Term Credit Secured by Current

Assets

Pledging Accounts Receivable (US Variant of

Invoice Discounting)

Firm promises to use the money paid from the

collected accounts to pay off bank loan
Accounts Receivable still belong to firm which still
collects the accounts
If firm doesnt repay, lender has recourse to borrower

Lender can provide

General line of credit tied to all receivables
Lender likely to advance at most 75% of the balance of
accounts
Specific line of credit tied to individual accounts

receivable

Evaluates based on creditworthiness of account

Lender likely to advance as much as 90% of the
balance of accepted accounts

61

Short-Term Credit Secured by Current

Assets
Factoring Accounts Receivable

Firm sells Accounts Receivable to lender (at a

severe discount) and the lending firm (factor)
takes control of the accounts
Accounts Receivable are now paid directly to lender

Factor usually reviews accounts and only

accepts accounts it deems creditworthy
Factors offer a wide range of services
Perform credit checks on potential customers
Advance cash on accounts it accepts or remit cash

after collection
Collect cash from customers
Assume the bad-debt risk when customers dont
pay

62

Short-Term Credit Secured by Current

Assets
Inventory Financing (Common in USA)

Use a firms inventory as collateral for a short-term

loan
Popular but subject to a number of problems
Lenders arent usually equipped to sell inventory
Specialized inventories and perishable goods are difficult to

market

Types of methods used

Blanket lienslender has a lien (claim) against all inventories

of the borrower but borrower remains in physical control of

inventory
Chattel mortgage agreementcollateralized inventory is
identified by serial number and cant be sold without lenders
permission (but borrower remains in physical control of
inventory)
Warehousingcollateralized inventory is removed from
borrowers premises and placed in a warehouse (borrowers
access controlled by third party)

63

Short-Term Financial Management

Length of cash conversion cycle determines the
amount of resources the firm must invest in its
operations.
Cost trade-offs apply to managing cash and
marketable securities, accounts receivable,
inventory and accounts payable.
Objective for account receivable:

collect accounts as quickly as possible without losing

sales.

Objective for accounts payable:

pay accounts as slowly as possible without damaging

firms credit.

Working Capital Finance Principle is to Match

Length of Finance with Asset
64