© 2007 Thomson South-Western

Chapter 23Short-Term Financial

Management

Professor XXXXXCourse Name / Number

2

The Cash Conversion Cycle

Operating 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.

Cash conversion

cycle

• Operating cycle less the average payment period on accounts payable

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Time Line for the Operating and Cash Conversion Cycles for Reese Industries

4

Shortening the Cash Conversion Cycle

To shorten a firm’s operating cycle or lengthen its payment period:Turn over inventory as quickly as

possibleCollect accounts receivable as quickly

as possible Pay accounts as slowly as possibleReduce mail, processing, and clearing

time

5

Cost Trade-offs in Short-Term Financial Management

6

Cost Trade-offs in Short-Term Financial Management

7

Inventory Management

Controlling inventory: ABC System – inventory segregated into three groups,

A, B, and C, from most costly to least costly investment.

Economic Order Quantity (EOQ) Model –

Reorder Points – Reorder point = lead time in days x daily usage

Safety Stock – determined by analyzing the probabilities of both increased usage rates and delivery delays

Material Requirements Planning – uses a master schedule

MRP II – uses a complex computer system to integrate data from many departments

Just-In-Time System - materials should arrive exactly when they are needed for production, rather than being stored on-site.

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Accounts Receivable Management

• Determine its credit standards.

• Set the credit terms.• Develop collection policy.• Monitor its A/R on both

individual and aggregate basis.

If a company decides to offer trade credit, it

must:

Credit standards

• Apply techniques 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.

Credit selection

techniques

Five C’s of Credit

Credit scoring

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Five C’s of Credit

– Character: The applicant’s record of meeting past obligations; desire to repay debt if able to do so

– Capacity: The applicant’s 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 industry-specific economic conditions

Framework for in-depth credit analysis that is typically used for high-dollar credit requests:

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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…

WEG Oil uses credit scoring to make credit decisions. WEG Oil 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)

• Credit Score < 65: reject application

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Credit Scoring of a Consumer Credit Application by WEG Oil

83.251.00

8.500.1085Years on job

9.000.1090Years at address

20.000.2580Payment history

18.750.2575Income range

15.000.15100Home ownership

12.000.1580Credit references

Weighted Score

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

Predetermined Weight

(2)

Score(0 to 100)

(1)

Financialand Credit Characteristics

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WEG Oil’s Credit Standards

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Changing Credit Standards

• Increase in sales and profits (if positive contribution margin), but higher costs from additional A/R and additional bad debt expense.

Credit standards relaxed

• Reduced investment in A/R and lower bad debt, but lower sales and profit.

Credit standards tightened

An example…YMC wants to evaluate the effects of a relaxation of its credit standards:

• YMC 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 from 1% to 2%.

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Effects of Changes in Credit Standards for YMC

Cost Variable - Price Sales Margin on Contributi Sales Marginal profit fromincreased sales

28,000$ $8/un) -($12/un un 7000

return required investment additional Cost of marginalinvestment in A/R

receivable accounts ofturnover sales annual ofcost variabletotal

Average investment inaccounts receivable (AIAR)

Additional profit contribution from sales

Cost of the marginal investment in accounts receivables

To compute additional investment, use the following equations:

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Cost of the marginal investment in accounts receivables

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

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

$1,176,000 $8/un un 147,000TVCPROPOSED

(ACP) period collection average

365Turnover of account

receivable (TOAR)

r times/yea2.12days 30

365

ACP

365TOAR

CURRENTCURRENT

r times/yea1.8days 54

365

ACP

365TOAR

PROPOSEDPROPOSED

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Cost of the marginal investment in accounts receivables

$91,803.2812.2

$1,120,000

TOAR

TVCAIAR

CURRENT

CURRENTCURRENT

8$145,185.18.1

$1,176,000

TOAR

TVCAIAR

PROPOSED

PROPOSEDPROPOSED

return required investment additional Cost of marginalinvestment in A/R

$6,406 return required )AIAR - AIAR ( CURRENTPPROPOSED

Compute additional investment and, assuming a required return of 12%, compute cost of marginal

investment in A/R.

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Cost of Marginal Bad Debt Expense

$35,2800.02$1,764,000 rate expensedebt bad )Sales(BDE PROPOSEDPROPOSED

$16,8000.01$1,680,000 rate expense debt bad )Sales(BDE CURRENTCURRENT

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

Net profit for the credit decision

Marginal profit from increased

sales

Cost of marginalinvestment in A/R

Cost of marginal

bad debts= - -

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

3. Cost of marginal bad debt expense

Subtract the current level of bad debt expense (BDECURRENT) from the expected level of bad debt expense (BDEPROPOSED).

4. Net profit for the credit decision

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Credit Terms

Terms of sale for customers:Net 30End of monthDate of invoiceCash discounts

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Credit Monitoring

Credit monitoring

• The ongoing review of a firm’s accounts receivable to determine if customers are paying according to stated credit terms

Techniques for credit

monitoring

• Average collection period• Aging of accounts receivable• Payment pattern monitoring

dayper sales average

receivable accounts period collection Average

Average collection period: the average number of days credit sales are outstanding

Aging of accounts receivable: schedule that indicates the portions of total A/R balance

outstanding

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Credit Monitoring

Payment pattern: the normal timing within which a firm’s 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 $120,000 in March.