CHAPTER 17
WORKING CAPITAL MANAGEMENT
CHAPTER 17 QUIZ
CHAPTER ORGANIZATION
The basic objective in cash management is to keep the investment in cash as low as possible while still operating the
firm's activities efficiently and effectively. This goal usually reduces to the dictum “Collect early and pay late.”
Accordingly, we discuss ways of accelerating collections and managing disbursements.
In addition, firms must invest temporarily idle cash in short-term marketable securities. These securities can be bought
and sold in the financial markets. As a group, they have very little default risk, and most are highly liquid.
17.1

Float and Cash Management
Reasons for Holding Cash
Speculative motive - The need to hold cash in order to be able to take advantage of, for example, bargain
purchase opportunities that might arise, attractive interest rates, and (in the case of international firms) favorable
exchange rate fluctuations.
Precautionary motive - The need to hold cash as a safety margin to act as a financial reserve. is the need for a
safety supply to act as a financial reserve.
Transaction motive - The need to have cash on hand to pay bills. Transaction-related needs come from the
normal disbursement and collection activities of the firm.
The opportunity cost of holding cash is the return that could be earned by investing the cash in other assets.
However, there is also a cost to convert between cash and other assets. The optimal cash balance will balance
these costs to minimize the overall cost of holding cash.

Understanding Float - The difference between the available balance and the ledger balance is called the float,
and it represents the net effect of checks in the process of clearing (moving through the banking system).
Book balance – the amount of cash recorded in the accounting records of the firm
Available balance – the amount of cash the bank says is available to be withdrawn from the account (may
not be the same as the amount of checks deposited minus amount of checks paid, because deposits are not
normally available immediately)
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Float = Available balance – book balance
Negative float implies that checks have been deposited that are not yet available. The firm needs to be
careful that it does not write checks over the available balance, or the checks may bounce.
Positive float implies that checks have been written that have not yet cleared. The company needs to make
be sure to adjust the available balance so it does not think that there is more money to spend than there
actually is.
Disbursement float – generated by checks the firm has written that have not yet cleared the bank;
arrangements can be made so that this money is invested in marketable securities until needed.
Collection float – generated by checks that have been received by the firm but are not yet included in the
available balance at the bank
Have you ever written a check a day or two before receiving your paycheck, even though on the day you mailed the
check, your checking account had insufficient funds to cover it? This is an example of using disbursement float. We
recognize that the time for the check to travel through the mail and then be processed and cleared, should allow enough
time for the paycheck to clear our bank. We do need to be careful about this process, however. The check we wrote
may go through the system faster than anticipated and it may take the paycheck longer to become available than
anticipated. In this case, our check may bounce or at the very least our credit line will be tapped and we end up paying
some unexpected interest charges.
Float management involves controlling the collection and disbursement of cash. The objective in cash
collection is to speed up collections and reduce the lag between the time customers pay their bills and the time
the cash becomes available. The objective in cash disbursement is to control payments and minimize the firm's
costs associated with making payments. Managers need to be more concerned with net float and available
balances than with the book balance.
Total collection or disbursement times can be broken down into three parts: mailing time, processing delay, and
availability delay:
o Mailing time is the part of the collection and disbursement process during which checks are trapped in
the postal system.
o Processing delay is the time it takes the receiver of a check to process the payment and deposit it in a
bank for collection.
o Availability delay refers to the time required to clear a check through the banking system.
The Institutional Investor (September 1985) provides a lengthy discussion of legal and ethical questions surrounding
cash management. The article, “Cash management: Where do you draw the line,” by Barbara Donnelly, focuses on the
E.F. Hutton check kiting scandal. In retrospect, it is clear that the value of lost reputation far exceeded the savings
gained via the company’s cash management strategies.
The Expedited Funds Availability Act (EFAA) governs the availability of funds deposited by firms. The following
rules apply (based on US Code: Title 12 Section 4002 as of January 23, 2000):

Cash or electronic payment and government checks are available the day after deposit.

Local checks are available two days after deposit.

Non-local checks are available five days after deposit.
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Note that these rules indicate the maximum time for availability. A bank may make funds available sooner. Also,
deposits made at ATMs can have a different schedule due to the processing time required.
Electronic Data Interchange and Check 21: The End of Float?
17.2

Cash Management: Collection, Disbursement, and Investment
Cash Collection and Concentration
Collection Time = mailing time + processing delay + availability delay
Cash collection policies depend on the nature of the business. Firms can choose to have checks mailed to
one location, or many locations (reduces mailing time), or allow preauthorized payments. Many firms
also accept online payments either with a credit card or with authorization to request the funds directly
from your bank.
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Lockboxes are special post office boxes that allow banks to process the incoming checks and then send
the information on account payment to the firm; that reduces processing time and often reduces mail
time because several regional lockboxes can be used.
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Cash concentration is the practice of moving cash from multiple banks into the firm’s main accounts.
This is a common practice that is used in conjunction with lockboxes.

Managing Cash Disbursements
Increasing disbursement float – slowing payments by increasing mail delay, processing time, or collection
time. May not want to do this from both an ethical standpoint and a valuation standpoint. Slowing payment
could cause a company to forgo discounts on its accounts payable. As we will see later in the chapter, the cost
of forgoing discounts can be extremely high.
We make a point to emphasize the importance of ethical behavior in this area of cash management. Because
transactions occur frequently and in large amounts, unscrupulous financial managers tend to “cut corners” in this area
more often than in some others. Some corporations routinely pay late, or take discounts that have not been offered. This
hurts the suppliers that the company does business with and may ultimately hurt the company through a loss of
reputation or credit.
Controlling disbursements – minimize liquidity needs by keeping a tight rein on disbursements through any
ethical means possible.
Zero-balance accounts – maintain several sub-accounts at regional banks and one master account. Funds are
transferred from the master account when checks are presented for payment at one of the regional accounts.
This reduces the firm’s liquidity needs.
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Controlled disbursement accounts – the firm is notified on a daily basis how much cash is required to meet
that day’s disbursements and the firm wires the necessary funds.

Investing Idle Cash
If a firm has a temporary cash surplus, it can invest in short-term securities. As we have mentioned at various
times, the market for short-term financial assets is called the money market. The maturity of short-term
financial assets that trade in the money market is one year or less. Firms have temporary cash surpluses for
various reasons. Two of the most important are the financing of seasonal or cyclical activities of the firm and
the financing of planned or possible expenditures.
Characteristics of Short-Term Securities - Given that a firm has some temporarily idle cash, there are a variety
of short-term securities available for investing. The most important characteristics of these short-term
marketable securities are their maturity, default risk, marketability, and taxability.
o Maturity refers to the time period over which interest and principal payments are made. We know that
for a given change in the level of interest rates, the prices of longer-maturity securities will change more
than those of shorter-maturity securities. As a consequence, firms often limit their investments in
marketable securities to those maturing in less than 90 days to avoid the risk of losses in value from
changing interest rates.
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o Default risk refers to the probability that interest and principal will not be paid in the promised amounts
on the due dates (or not paid at all). Of course, some securities have negligible default risk, such as U.S.
Treasury bills. Given the purposes of investing idle corporate cash, firms typically avoid investing in
marketable securities with significant default risk.
o Marketability refers to how easy it is to convert an asset to cash; so, marketability and liquidity mean
much the same thing. Some money market instruments are much more marketable than others. At the
top of the list are U.S. Treasury bills, which can be bought and sold very cheaply and very quickly.
“Marketability” suggests that large amounts of an asset can be bought or sold
quickly with little effect on the current market price. This characteristic is usually
associated with financial markets that are “broad” and “deep.” Broad markets have
a large number of participants; deep markets have participants that are willing and
able to engage in large transactions. The market for U.S. T-bills epitomizes these
characteristics. There are millions of potential buyers and sellers world-wide and
multi-million dollar transactions are common.
o Taxability - Interest earned on money market securities that are not some kind of government obligation
(either federal or state) is taxable at the local, state, and federal levels. U.S. Treasury obligations such as
T-bills are exempt from state taxation, but other government-backed debt is not. Municipal securities are
exempt from federal taxes, but they may be taxed at the state level.
17.3

Credit and Receivables - When credit is granted, an account receivable is created. These receivables include
credit to other firms, called trade credit, and credit granted consumers, called consumer credit, and they
represent a major investment of financial resources by U.S. businesses. Furthermore, trade credit is a very
important source of financing for corporations.
Components of Credit Policy - If a firm decides to grant credit to its customers, then it must establish
procedures for extending credit and collecting. In particular, the firm will have to deal with the following
components of credit policy:
1. Terms of sale. The terms of sale establish how the firm proposes to sell its goods and services. If the
firm grants credit to a customer, the terms of sale will specify (perhaps implicitly) the credit period, the
cash discount and discount period, and the type of credit instrument.
2. Credit analysis. In granting credit, a firm determines how much effort to expend trying to distinguish
between customers who will pay and customers who will not pay. Firms use a number of devices and
procedures to determine the probability that customers will not pay, and, put together, these are called
credit analysis.
3. Collection policy. After credit has been granted, the firm has the potential problem of collecting the
cash when it becomes due, for which it must establish a collection policy.

Terms of the Sale
Credit period – amount of time allowed for payment; Cash discount and discount period – percent of
discount allowed if payment is made during the discount period; Type of credit instrument
Basic form: 2/10 net 60 means 2% discount if paid in 10 days; total amount is due in 60 days if the discount
is not taken. In this example, the 60 days is the net credit period, the 10 days is the discount period and the
2% is the cash discount amount.
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The invoice date is the date for which the credit period starts. This is normally the shipping date, but some
companies may post-date the invoice to encourage customers to order early.
Length of the credit period depends on:
-Buyer’s inventory and credit cycle
-Perishability and collateral value
-Consumer demand
-Cost, profitability, and standardization
-Credit risk
-Size of the account
-Competition
-Customer type
Cash discounts – offered by sellers to induce early payment. Not taking the discount involves a cost of credit
for the purchaser.
Cost of credit – the cost of not taking discounts offered (this is a benefit to the company granting credit)
Periodic rate = (discount %) / (100% – discount %)
Number of periods per year = m = 365 / (net credit period – discount period)
APR = m x (periodic rate)
EAR = (1 + periodic rate)m – 1
Example: Consider terms of 1/15, net 45 (assume payment is made on time in 45 days when the discount is forgone)
Periodic rate = 1 / (100 – 1) = 1 / 99 = .0101
Number of periods per year = m = 365 / (45 – 15) = 12.166667
APR = 12.166667(.0101) = 12.288%
EAR = (1 + .0101)12.166667 – 1 = (1.0101)12.166667 – 1 = .130055 = 13.01%
Offering discounts generally reduces the average collection period and thus the cash cycle. This reduces
the amount of financing required, but the company loses sales in the amount of the discount taken.
Consequently, the firm needs to look at the size and timing of the expected cash flows to determine
what, if any, discount should be offered.
Credit instruments – the basic evidence of indebtedness
o Open account – invoice only
o Promissory note – basic IOU, may be used when the order is large or the purchasing firm has a history
of late payments
o Commercial draft – request for funds sent directly to the purchaser’s bank
o Sight draft – payable immediately
o Time draft – payment required by some future date
o Trade acceptance – buyer accepts draft with agreement to pay in the future
o Bankers’ acceptance – bank accepts draft and guarantees payment
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Various investments have been developed to shift the risk of non-payment of receivables in international transactions
from the seller to a financial institution. For example, a banker’s acceptance is an irrevocable letter of credit issued by a
bank guaranteeing payment of the face amount. A letter of credit is simply a promise from the buyer’s bank to make
payment upon receipt of the goods by the buyer. While these guarantee arrangements add to the cost of doing business,
their existence greatly facilitates international trade.

Optimal Credit Policy - An optimal credit policy is one in which the incremental cash flows from sales are
equal to the incremental costs of carrying the increased investment in accounts receivable. The cost of granting
credit is described by the total credit cost curve, which depicts the trade-off between two kinds of costs:
Carrying costs – required return on receivables, losses from bad debts, costs of managing credit and collections
Opportunity costs – potential profit from credit sales that is lost

Credit Analysis - Once a firm decides to grant credit to its customers, it must then establish guidelines for
determining who will and who will not be allowed to buy on credit. Credit analysis refers to the process of
deciding whether or not to extend credit to a particular customer. It usually involves two steps: gathering
relevant information and determining creditworthiness.
Information sources commonly used to assess creditworthiness include the following:
1. Financial statements. A firm can ask a customer to supply financial statements such as balance sheets and
income statements. Minimum standards and rules of thumb based on financial ratios can then be used as a
basis for extending or refusing credit.
2. Credit reports on the customer's payment history with other firms. Quite a few organizations sell
information on the credit strength and credit history of business firms. The best-known and largest firm of
this type is Dun & Bradstreet, which provides subscribers with a credit reference book and credit reports on
individual firms. Experian (formerly TRW) is another well-known credit-reporting firm. Ratings and
information are available for a huge number of firms, including very small ones. Equifax, Trans Union, and
Experian are the major suppliers of consumer credit information.
3. Banks. Banks will generally provide some assistance to their business customers in acquiring information
on the creditworthiness of other firms.
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4. The customer's payment history with the firm. The most obvious way to obtain information about the
likelihood of a customer's not paying is to examine whether they have settled past obligations and how
quickly they have met these obligations.
There are no magical formulas for assessing the probability that a customer will not pay. In very general terms,
the classic five C’s of credit are the basic factors to be evaluated:
1.
2.
3.
4.
5.
Character. The customer's willingness to meet credit obligations.
Capacity. The customer's ability to meet credit obligations out of operating cash flows.
Capital. The customer's financial reserves.
Collateral. Assets pledged by the customer for security in case of default.
Conditions. General economic conditions in the customer's line of business.
Credit scoring – assigning a numerical rating to customers based on credit history.
Credit scoring models were initially introduced in the 1940s and became widespread in the 1960s. Companies that use
scoring models need to use great care to make sure that the factors that determine the credit score do not depend on
race, gender, geographic location, or any other criteria that could be considered discriminatory. Failure to take the
proper precautions is not only unethical; it can lead to substantial legal problems, customer ill will, and lost sales.

Collection Policy - Collection policy involves monitoring receivables to spot trouble and obtaining payment on
past-due accounts.
Monitoring Receivables
To keep track of payments by customers, most firms will monitor outstanding accounts. First, a firm will
normally keep track of its average collection period, ACP, through time. If a firm is in a seasonal business, the
ACP will fluctuate during the year, but unexpected increases in the ACP are a cause for concern. Either
customers in general are taking longer to pay, or some percentage of accounts receivable is seriously overdue.
The aging schedule is a second basic tool for monitoring receivables. To prepare one, the credit department
classifies accounts by age. Suppose a firm has $100,000 in receivables. Some of these accounts are only a few
days old, but others have been outstanding for quite some time. The following is an example of an aging
schedule:
Collection Effort
A firm usually goes through the following sequence of procedures for customers whose payments are overdue:
1. It sends out a delinquency letter informing the customer of the past-due status of the account.
2. It makes a telephone call to the customer.
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3. It employs a collection agency.
4. It takes legal action against the customer.
17.4

Inventory Management
The Financial Manager and Inventory Policy
Despite the size of a typical firm's investment in inventories, the financial manager of a firm will not normally
have primary control over inventory management. Instead, other functional areas such as purchasing,
production, and marketing will usually share decision-making authority. Inventory management has become an
increasingly important specialty in its own right, and financial management will often only have input into the
decision. Financial managers see the results of inventory decisions in many places – ROA, inventory turnover,
and Days’ Sales in Inventory ratios, to name a few.

Inventory Types
For a manufacturer, inventory is classified into one of three categories:
- Raw materials
- Work-in-progress
- Finished goods
Classification into one of these categories depends on the firm’s business; raw materials for one firm may be
finished goods for another. Inventory types have different levels of liquidity. Demand for raw materials and
work-in-progress depends on the demand for finished goods

Inventory Costs
There are two basic types of costs associated with current assets in general and with inventory in particular. The
first of these are carrying costs. Here, carrying costs represent all of the direct and opportunity costs of keeping
inventory on hand. These include:
- Storage and tracking costs.
- Insurance and taxes.
- Losses due to obsolescence, deterioration, or theft.
- The opportunity cost of capital for the invested amount.
The sum of these costs can be substantial, roughly ranging from 20 to 40 percent of inventory value per year.
The other types of costs associated with inventory are shortage costs. These are costs associated with having
inadequate inventory on hand. The two components of shortage costs are restocking costs and costs related to
safety reserves. Depending on the firm's business, order or restocking costs are either the costs of placing an
order with suppliers or the cost of setting up a production run. The costs related to safety reserves are
opportunity losses such as lost sales and loss of customer goodwill that result from having inadequate inventory.
A basic trade-off in inventory management exists because carrying costs increase with inventory levels while
shortage or restocking costs decline with inventory levels. The basic goal of inventory management is thus to
minimize the sum of these two costs.
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17.5
Inventory Management Techniques

The ABC Approach is a simple approach to inventory management where the basic idea is to divide inventory
into three (or more) groups. The underlying rationale is that a small portion of inventory in terms of quantity
might represent a large portion in terms of inventory value, and this group would be monitored closely.

The Economic Order Quantity Model
EOQ – the restocking quantity that minimizes total inventory costs based on the assumption that inventory is
depleted at a steady pace.
Total carrying costs = (average inventory)(carrying cost per unit) = (Q/2)(CC)
Total restocking costs = (fixed cost per order)(number of orders) = F(T/Q)
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Total costs = carrying costs + restocking costs = (Q/2)(CC) + F(T/Q)
EOQ 
2TF
CC
The EOQ is the point where the total carrying costs equal the total restocking costs. This is the quantity that
minimizes the cost function and can be found by taking the first derivative, setting it equal to zero, and
solving for Q.
The Trektronics store begins each month with 900 phasers in stock. This stock is depleted each month and reordered. If
the carrying cost per phaser is $38 per year and the fixed order cost is $530, what is the total carrying cost? What is the
restocking cost? Should the company increase or decrease its order size? Describe an optimal inventory policy for the
company in terms of order size and order frequency.
The carrying costs are the average inventory times the cost of carrying an individual unit, so:
Carrying costs = (900/2)($38) = (450)($38) = $17,100
The economic order quantity is:
EOQ = [(2T × F)/CC]1/2
EOQ = [2(12)(900)($530)/$38]1/2
EOQ = 548.87 phasers
The order costs are the number of orders times the cost of an order, so:
Restocking costs = 12($530) = $6,360
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The optimal number of orders per year will be the total units sold per year divided by the EOQ, so:
Number of orders per year = 12(900) / 548.87 = 10,800 / 548.87 = 19.68
The firm’s policy is not optimal, since the carrying costs and the order costs are not equal. The company should
decrease the order size and increase the number of orders.

Extensions to the EOQ Model
Up to this point we have assumed that a company will let its inventory run down to zero and then reorder. In
reality, a company will wish to reorder before its inventory goes to zero for two reasons. First, by always having
at least some inventory on hand, the firm minimizes the risk of a stockout and the resulting losses of sales and
customers. Second, when a firm does reorder, there will be some time lag before the inventory arrives.
Safety stocks – minimum level of inventory that must be kept on hand. If a firm carries safety stock, then
inventory won’t actually reach zero and the carrying cost component will be higher than what is predicted by
the EOQ model.
Reorder points – place orders before inventory reaches a critical level. Designed to account for delivery time.
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
Managing Derived-Demand Inventories - Demand for some inventory types is derived from, or dependent on,
other inventory needs. Materials requirements planning (MRP) and just-in-time inventory (JIT)
management are two methods for managing demand-dependent inventories.
Summary and Conclusions
This chapter has covered cash, receivables, and inventory management. Along the way, we have touched on a large
number of subjects. Some of the more important issues we examined are:
1. Firms seek to manage their cash by keeping no more than is needed on hand. The reason is that holding cash has
an opportunity cost, namely, the returns that could be earned by investing the money.
2. Float is an important consideration in cash management, and firms seek to manage collections and
disbursements in ways designed to optimize the firm's net float.
3. A firm's credit policy includes the terms of sale, credit analysis, and collection policy. The terms of sale cover
three related subjects: the credit period, cash discount, and credit instrument.
4. The optimal credit policy for a firm depends on many specific factors, but generally involves trading off the
costs of granting credit, such as the carrying costs of receivables and the possibility of nonpayment, against the
benefits in terms of increased sales.
5. There are different types of inventories that differ greatly in their liquidity and management. The basic trade-off
in inventory management is the cost of carrying inventory versus the cost of restocking. We developed the
famous EOQ model, which explicitly balances these costs.
6. Firms use different inventory management techniques; we described a few of the better known, including the
ABC approach and just-in-time, or JIT, inventory management.
Link to Sample Exam questions: https://www.eztestonline.com/190704/13524091042391100.tp4
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