Chapter 22:
Cash Conversion, Inventory,
and Receivables Management
Corporate Finance, 3e
Graham, Smart, and Megginson
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All Rights Reserved.
not be scanned,
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© 2010Learning.
South-Western,
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Cengage
Learning
The Cash Conversion Cycle
Operating
cycle
Cash
conversion
cycle
• Time from the beginning of the production to
the time when cash is collected from sale
• Equals the average age of inventory (AAI) plus
the average collection period (ACP)
• Financing the operating cycle is costly, so firms
have an incentive to shrink it.
• Operating cycle less the average payment
period on accounts payable
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Shortening the Cash Conversion
Cycle
CCC = OC – APP = AAI + ACP – APP
 To
shorten a firm’s operating cycle or
lengthen its payment period:
 Turn
over inventory as quickly as possible
 Collect accounts receivable as quickly as
possible
 Pay accounts as slowly as possible
 Reduce mail, processing, and clearing time
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Techniques for Controlling
Inventory

ABC System



Inventory segregated into three groups (A, B, and C) from most
costly to least costly investment
Control of the A items should be the most intensive.
Economic Order Quantity (EOQ) Model: EOQ 



S = inventory usage per period
O = order cost per order
C = carrying cost per unit per period
2SO
C
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Techniques for Controlling
Inventory


Reorder Points and Safety Stock:

Reorder point = Lead time in days × Daily usage

Safety Stock – Additional inventory held to allow for faster-thananticipated usage rates and delivery delays
Material Requirements Planning (MRP)



Uses a master schedule to ensure that the materials, labor, and
equipment needed for production are at the right places in the
right amounts at the right times
MRP II expands on MRP, using a complex computer system to
integrate data from many departments.
Just-in-Time (JIT) System

Materials should arrive exactly when they are needed for
production, rather than being stored on-site.
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Accounts Receivable Management
If a company decides
to offer trade credit,
it must:
Credit
standards
Credit selection
techniques
•
•
•
•
Determine its credit standards.
Set the credit terms.
Develop collection policy.
Monitor its A/R on both individual
and aggregate basis.
• 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.
Five C’s of
Credit
Credit
scoring
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Five C’s of Credit
Framework for in-depth credit analysis that is typically used
for high-dollar credit requests:
– 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
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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
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Changing Credit Standards
Credit standards
relaxed
• Increase in sales and profits (if positive
contribution margin), but higher costs
from additional A/R and additional bad
debt expense
Credit standards
tightened
• Reduced investment in A/R and lower
bad debt, but lower sales and profit
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Credit Terms
 Terms
of sale for customers
Net
30: Payment in full due in 30 days
Cash discounts
 Example:
 2%
2/10 net 30
discount if payment made within 10-day cash
discount period
 Otherwise,
full payment due within 30-day credit period
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Collection Policy
 Reminders,
form letters, telephone calls,
or personal visits may initiate customer
payment.
 At
a minimum, the company should
generally suspend further sales to the
customer until the delinquent account is
brought current.
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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
Average collection period: The average number of days
credit sales are outstanding
Accounts receivable
Average collection period 
Average sales per day
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.
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