17-1
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
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
17-2
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
17-3
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
17-4
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
17-5
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
17-6
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
17-7
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?
17-8
Cash Collection
Payment
Mailed
Payment
Received
Mailing Time
Payment
Deposited
Processing Delay
Cash
Available
Availability Delay
Collection Delay
Float management goal = reduce collection delay
17-9
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
17-10
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
17-11
Overview of Lockbox Processing
Figure 17.1
17-12
Lockboxes and Cash
Concentration
17-13
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
17-14
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
17-15
Zero-balance Accounts
Figure 17.3
17-16
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
17-17
Seasonal Cash Demands
Figure 17.4
17-18
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
17-19
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
17-20
Cash Flows from Granting Credit
Credit Sale
Check Mailed
Check Deposited
Cash Available
Cash Collection
Accounts Receivable
17-21
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
17-22
Credit Period Determinants
Factor
Effect on Credit Period
1. Perishable goods with low
collateral value
2. Low consumer demand
credit period
credit period
3. Low cost, low profitability, and credit period
high standardization
4. High credit risk
credit period
5. Small account size
credit period
6. Competition
credit period
7. Customer type
Varied
17-23
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
17-24
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
–
–
–
–
$10 interest (= .02*500)
Period rate = 10 / 490 = 2.0408%
Period = (45 – 10) = 35 days
365 / 35 = 10.4286 periods per year
• EAR = (1.020408)10.4286 – 1 = 23.45%
• The company benefits when customers choose
to forgo discounts
17-25
Credit Instruments
• Basic evidence of indebtedness
• Open account
– Most basic form
– Invoice only
• Promissory Note
– Basic IOU
– Not common
– Signed after goods delivered
17-26
Credit Instruments
Commercial Draft
• Sight draft = immediate payment required
• Time draft = not immediate
• When draft presented, buyer “accepts” it
– Indicates promise to pay
– “Trade acceptance”
• Seller may keep or sell acceptance
• Banker’s acceptance = bank guarantees
payment
17-27
Optimal Credit Policy
• Carrying costs
– Required return on receivables
– Losses from bad debts
– Cost of managing credit & collections
• If restrictive credit policy:
– Carrying costs low
– Credit shortage = opportunity costs
• More liberal credit policy likely if:
– Excess capacity
– Low variable operating costs
– Repeat customers
17-28
Optimal Credit Policy
Figure 17.5
Cost
($)
Optimal
amount of
credit
Carrying Cost
Opportunity costs
Amount of credit
extended ($)
17-29
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
17-30
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
17-31
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
17-32
Inventory Management
• Inventory = large percentage of firm assets
• Inventory costs:
– Cost of carrying too much inventory
– Cost of not carrying enough inventory
• Inventory management objective = find the
optimal trade-off between carrying too
much inventory versus not enough
17-33
Types of Inventory
• Manufacturing firm
– Raw material – production starting point
– Work-in-progress
– Finished goods – ready to ship or sell
• One firm’s “raw material” = another’s
“finished good”
• Derived vs. Independent demand
• Different types of inventory vary
dramatically in terms of liquidity
17-34
Inventory Costs
• Carrying costs = 20–40% of inventory
value per year
– Storage and tracking
– Insurance and taxes
– Losses due to obsolescence,
deterioration, or theft
– Opportunity cost of capital
• Shortage costs
– Restocking costs
– Lost sales or lost customers
Return to
Quick Quiz
17-35
Inventory Management
• Classify inventory by cost, demand,
and need
– Maintain larger quantities of items that
have substantial shortage costs
– Maintain smaller quantities of
expensive items
– Maintain a substantial supply of less
expensive basic materials
17-36
EOQ Model
• EOQ = Economic Order Quantity
• EOQ minimizes total inventory cost
• Q = inventory quantity in each order
Q/2 = Average inventory
• T = firm’s total unit sales per year
T/Q = number of orders per year
• CC = Inventory carrying cost per unit
• F = Fixed cost per order
Return to
Quick Quiz
17-37
EOQ Model
• Total carrying cost
= (Average inventory) x (Carrying cost per unit)
= (Q/2)(CC)
• Total restocking cost
= (Fixed cost per order) x (Number of orders)
= F(T/Q)
• Total Cost
= Total carrying cost + Total restocking cost
= (Q/2)(CC) + F(T/Q)
17-38
EOQ Model
• Total Cost
= Total carrying cost + Total restocking cost
= (Q/2)(CC) + F(T/Q)
• Q* Carrying costs = Restocking costs
(Q*/2)(CC) = F(T/Q*)
Q
*

2TF
CC
17-39
Example: EOQ
• Consider an inventory item that has
carrying cost = $1.50 per unit. The fixed
order cost is $50 per order and the firm
sells 100,000 units per year.
– What is the economic order quantity?
2(100,000)(50)
Q 
 2,582
1.50
*
17-40
Extensions to EOQ
• Safety stocks
– Minimum level of inventory kept on
hand
– Increases carrying costs
• Reorder points
– Inventory level at which you place an
order to account for delivery time
17-41
Derived-Demand Inventories
• Materials Requirements Planning (MRP)
– Computer-based ordering/scheduling
– Works backwards from set finished goods
level to establish levels of work-in-progress
required
• Just-in-Time Inventory
– Reorder and restock frequently
– Japanese system
• Keiretsu = industrial group
• Kanban = card signaling reorder time
17-42
Quick Quiz
1. What is the difference between
disbursement float and collection float?
(Slide 17.5)
2. What is credit analysis and why is it
important? (Slide 17.30)
3. What are the two main categories of
inventory costs? (Slide 17.35)
4. What components are required to
determine the economic order quantity?
(Slide 17.37)
17-43
Chapter 17
END