Chapter 20 Learning Objectives 1. Describe the usual steps in a firm’s credit management policy. 2. Measure the implicit interest rate on credit sales. 3. Describe how firms assess the probability that a customer will pay its bills. 4. Decide whether it makes sense to grant credit to customers. 5. Cite the costs and benefits of holding inventories and cash balances. 6. Compare the different techniques that firms use to make and receive payments. 7. Compare alternatives for investing excess funds over short horizons.

Working Capital Management This chapter presents multiple strategies for managing the working capital of the firm. Cash Inventory Chapter 20 Outline Accounts Receivable and Credit Policy Inventory Management Cash Management Investing Idle Cash: The Money Market Accounts Receivable 2

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

A/R and Credit Policy Terminology 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 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.

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 Implicit Cost: A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier. 3

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. Open account – Agreement whereby sales are made with no formal debt contract Commercial draft – An order to pay Sight draft – A commercial draft where immediate payment is required Time draft – A commercial draft where no immediate payment is required 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. Credit Analysis - Procedure to determine the likelihood a customer will pay its bills. 9

Numerical Credit Scoring categories 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 - Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time. Note: EBITDA is earnings before interest, taxes and depreciation/amortization. EBIT is earnings before interest and taxes. 12

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. 14

Credit Analysis: Discussion Credit analysis is only worthwhile if the expected savings exceed the cost. When is this true? Note: Don’t undertake a full credit analysis unless the order is big enough to justify it. Note: Undertake a full credit analysis for the doubtful orders only. 16

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. Credit Policy - Standards set to determine the amount and nature of credit to extend to customers. 17

The Credit Decision and Probable Payoffs Payoff = Revenue - Cost Payoff = - Cost Customer pays = p Offer credit Customer defaults = 1-p Decision Refuse credit Payoff = 0 20

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: 23

The Credit Decision: Some Final Thoughts Maximize profit Concentrate on the dangerous accounts Look beyond the immediate order 23

Collection Policy Collection Policy: Procedures to collect and monitor receivables. Aging Schedule: Classification of accounts receivable by time outstanding. Collection Policy- Procedures to collect and monitor receivables. Aging Schedule- Classification of accounts receivable by time outstanding. 24

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. 25

Primary Goal = Minimize amount of cash tied up in inventory 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 Carrying Costs: The cost of storing goods plus the cost of capital tied up in inventory

Optimal Order Size: Minimize Costs 24

Optimal Inventory: Economic Order Quantity Economic Order Quantity - Order size that minimizes total inventory costs. 23

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. Note: 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.

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. 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. 3

Managing Float Availability float Payment float Check mailed Check received Mail float Check deposited Processing float Cash available to recipient Check charged to payer’s account Check clears 20

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. 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 checks. 13

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. 13

Electronic Funds Transfer (EFT), Three Methods 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) Automated Clearinghouse (ACH) – An electronic network for cash transfers in the United States. Note: Direct Payment  Automatic Debit; Direct Deposit  Automatic Credit

Investing Idle Cash: The Money Market Money Market – the market for short-term financial assets. Treasury bills Commercial paper Certificates of deposit Repurchase agreements Money Market - market for short term financial assets. Note: The international market for short-term dollar investments is known as the eurodollar market. 26

Appendix A: How Purchases are Paid

Appendix B: Methods Used to Make and Receive Electronic Payments 26

Appendix C: Use of Payment Systems in the United States, 2009 Source: www.federalreserve.gov, www.nacha.org, and www.chips.org 26