1. 17-1 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

2. 17-2 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

3. 17-3 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

4. 17-4 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

5. 17-5 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

6. 17-6 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

7. 17-7 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

8. 17-8 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?

9. 17-9 Cash Collection Payment PaymentPayment Cash Mailed ReceivedDeposited Available Mailing TimeProcessing DelayAvailability Delay Collection Delay Float management goal = reduce collection delay

10. 17-10 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

11. 17-11 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 firm’s account Firms may have many lockbox arrangements around the country –Funds end up in multiple accounts Cash concentration = procedure to gather funds into firm’s main accounts Reduces mailing and processing times

12. 17-12 Overview of Lockbox Processing Figure 17.1

13. 17-13 Lockboxes and Cash Concentration

14. 17-14 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

15. 17-15 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

16. 17-16 Zero-balance Accounts Figure 17.3

17. 17-17 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

18. 17-18 Seasonal Cash Demands Figure 17.4

19. 17-19 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

20. 17-20 Credit Management: Key Issues Granting credit increases sales Costs of granting credit –Chance that customers won’t pay –Financing receivables Credit management = trade-off between increased sales and the costs of granting credit

21. 17-21 Cash Flows from Granting Credit Credit SaleCheck MailedCheck Deposited Cash Available Cash Collection Accounts Receivable

22. 17-22 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

23. 17-23 Credit Period Determinants Factor Effect on Credit Period 1. Perishable goods with low collateral value  credit period 2. Low consumer demand  credit period 3. Low cost, low profitability, and high standardization  credit period 4. High credit risk  credit period 5. Small account size  credit period 6. Competition  credit period 7. Customer typeVaried

24. 17-24 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

25. 17-25 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

26. 17-26 Credit Instruments Basic evidence of indebtedness Open account –Most basic form –Invoice only Promissory Note –Basic IOU –Not common –Signed after goods delivered

27. 17-27 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 Banker’s acceptance = bank guarantees payment

28. 17-28 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

29. 17-29 Optimal Credit Policy Figure 17.5 Amount of credit extended ($) Cost ($) Carrying Cost Opportunity costs Optimal amount of credit

30. 17-30 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

31. 17-31 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 customer’s business

32. 17-32 Collection Policy Monitoring receivables –Watch average collection period relative to firm’s credit terms –Use aging schedule to monitor percentage of overdue payments Collection policy –Delinquency letter –Telephone call –Collection agency –Legal action