BUSINESS AND FAITH INTEGRATION
BUSI 530
Chapter 20: Working Capital Management
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.
Inventory
Cash
Accounts Receivable
Chapter 20 Outline
· Accounts Receivable and Credit Policy
· Inventory Management
· Cash Management
· Investing Idle Cash: The Money Market
Account Receivables and Credit Policy
Credit Management Steps
1. Establish terms of sale
2. What form of IOU will be required?
3. Perform a credit analysis
4. Create a credit policy
5. 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.
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.
Implicit Cost: Example
On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?
Credit Agreements
Terminology
· 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.
Credit Analysis
Credit Analysis - Procedure to determine the likelihood a customer will pay its 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.
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
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.
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.
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.
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.
The Credit Decision and Probable Payoffs
Payoff = Revenue - Cost
Payoff = - Cost
Customer pays = p
Offer credit
Decision
Customer defaults = 1-p
Refuse credit
Payoff = 0
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:
The Credit Decision: Some Final Thoughts
1. Maximize profit
2. Concentrate on the dangerous accounts
3. Look beyond the immediate order
Collection Policy
Collection Policy- Procedures to collect and monitor receivables.
Aging Schedule- Classification of accounts receivable by time outstanding.
Aging Schedule: Example
What is the goal of a good collection policy?
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
Optimal Order Size: Minimize Costs
Optimal Inventory: Economic Order Quantity
Economic Order Quantity - Order size that minimizes total inventory costs.
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.
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.
Managing Float
Payment float
Availability float
Check mailed
Mail float
Check received
Processing float
Check deposited
Check
clears
Check
clears
Check charged to
payer’s account
Cash available
to recipient
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 checks.
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.
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 - market for short term financial assets.
· Treasury bills
· Commercial paper
· Certificates of deposit
· Repurchase agreements
Note: The international market for short-term dollar investments is known as the eurodollar market.
Appendix A: How Purchases are Paid
Appendix B: Methods Used to Make and Receive Electronic Payments
Appendix C: Use of payment Systems in the United States, 2009
Page 1 of 9
(relative chance of failure)6.4451.1922.
307.346
LiabilitiesEBITDA
LogROA
AssetsLiabilities
=--´+´-´
Altman
Z Score Formula
3.31.0.61.4
EBITSalesMarketValueofEquityRetainedEarn
ings
Z
TotalAssetsTotalAssetsTotalBookDebtTotal
Asse
=+++
1.2
NetWorkingCapital
tsTotalAssets
+
EBITsalesmarket equity
.241.21.0
total assetstotal assetsbook debt
===
retained earningsworking capital
.4.20
total assetstotal assets
==
Z-Score = 3.3.24+1.01.2.61.01.4.41.20.23
.39
´´+´+´+´=
PV(Offer Credit) = PV(Refuse Credit)
PV(RevenueCost)(1) (Cost)0
ppPV
´---´=
PV(Cost)
PV(Rev)
p
=
Customer'sLess thanMore than
1-2 months2-3 monthsTotal Owed
Name1 month3 months
Able$10,000$5,000$2,5000$17,500
Baker8,0003,0000011,000
Charlie5,0000005,000
Zebra5,00006,00015,00026,000
Tot
······
······
······
al*$200,000$100,000$25,000$15,000$340,00
0
cost
carrying
order
per
cost
sales
2
=
Q
Size
Order
Economic
´
´
=
A lock box reduces the collection float
by:
180$1,000(1.751.25)$540,000
´´+=
Daily Cost
$.35 per check180 checks = $63 per day
´
Daily return
$540,000 per day.0002$108 per day
´=
(
)
(
)
365/extra days credit
discount
discounted price
365/50
5
95
Effective annual rate
1+-1
1+-1=.454, or 45.4%
=
=