Short-Term Financial Management
Professor XXXXX
Course Name / Number
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
time = 0
Operating cycle
Purchase raw
materials on account
Sell finished goods
on account
Average Age of Inventory
Average payment
period
Collect accounts
receivable
Average Collection Period
Payment mailed
Cash Conversion Cycle
2
Time
Cost Tradeoffs in Working Capital
Accounts
Cost 1
(holding cost)
Cost 2 *
(cost of holding too little of
operating asset)
Cash and marketable
securities
Opportunity cost of funds
Illiquidity and solvency costs
Accounts receivable
Cost of investment in accounts
receivable and bad debts
Opportunity cost of lost sales due
to overly restrictive credit policy
and/or terms
Inventory
Carrying cost of inventory,
including financing, ware housing,
obsolescence costs, etc.
Order and setup costs associated
with replenishment and production
of finished goods
Cost of reduced liquidity caused
by increasing current liabilities
Financing costs resulting from the
use of less expensive short-term
financing rather than more
expensive long-term debt and
equity financing
Operating Assets
Short-Term Financing
Accounts payable, accruals,
and notes payable
3
Cost Trade-offs in Short-Term
Financial Management
Trade-off of Short-Term Financial Costs
Cost
Cost 1
Cost 2
Total Cost
Account Balance
4
Accounts Receivable
Management
If a company decides
to offer trade credit,
it must:
Credit
standards
Credit selection
5
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
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
6
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.
7
• 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
Credit Scoring of a Consumer
Credit Application by WEG Oil
8
Financial
and Credit
Characteristics
Score
(0 to 100)
(1)
Predetermine
d Weight
(2)
Weighted
Score
[(1) X (2)]
(3)
Credit references
80
0.15
12.00
Home ownership
100
0.15
15.00
Income range
75
0.25
18.75
Payment history
80
0.25
20.00
Years at address
90
0.10
9.00
Years on job
85
0.10
8.50
1.00
83.25
Changing Credit Standards
Credit standards
relaxed
Credit standards
tightened
• Increase in sales and profits (if positive
contribution margin), but higher costs
from additional A/R and additional bad
debt expense.
• Reduced investment in A/R and lower
bad debt, but lower sales and profit.
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
Additional profit contribution from sales
Marginal profit from   Sales  Contributi on Margin   Sales  Price - Variable Cost 
increased sales
 7000 un  ($12/un - $8/un)  $28,000
Cost of the marginal investment in accounts receivables
Cost of marginal
investment in A/R
 additional investment  required return
To compute additional investment, use the following
equations:
Average investment in
accounts receivable (AIAR)
10
total variable cost of annual sales

turnover of accounts receivable
Cost of the marginal investment in
accounts receivables
Total variable cost of
annual sales (TVC)
 annual unit sales  variable cost/unit
TVC CURRENT  140,000 un  $8/un  $1,120,000
TVC PROPOSED  147,000 un  $8/un  $1,176,000
Turnover of account
receivable (TOAR)

TOAR CURRENT 
365
average collection period (ACP)
365
365

 12.2 times/yea r
ACPCURRENT 30 days
365
365
TOAR PROPOSED 

 8.1 times/yea r
ACPPROPOSED 45 days
11
Cost of the marginal investment
in accounts receivables
AIAR CURRENT 
TVC CURRENT
$1,120,000

 $91,803.28
TOAR CURRENT
12.2
AIAR PROPOSED 
TVC PROPOSED
$1,176,000

 $145,185.18
TOAR PROPOSED
8.1
Compute additional investment and, assuming a required
return of 12%, compute cost of marginal investment in A/R.
Cost of marginal
investment in A/R
 additional investment  required return
 ( AIAR PPROPOSED - AIAR CURRENT )  required return  $6,406
12
Cost of Marginal Bad Debt
Expense
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).
BDE PROPOSED  (Sales PROPOSED)  bad debt expense rate  $1,764,000  0.02  $35,280
BDE CURRENT  (Sales CURRENT )  bad debt expense rate  $1,680,000  0.01  $16,800
Cost of marginal bad debt expense  $35,280 - $16,800  $18,480
4. Net profit for the credit decision
Net profit for the
credit decision
Marginal profit
Cost of marginal
= from increased investment in A/R
sales
= $28,000 - $6,406 - $18,480 = $3,114
13
Cost of
marginal
bad debts
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
14
Aging of accounts receivable: schedule that indicates the
portions of total A/R balance outstanding
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
15
• 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.
Cash Management
Cash management: the collection, concentration, and
disbursement of funds
Cash manager
responsible for
•
•
•
•
•
Cash management
Financial relationships with banks
Cash flow forecasting
Investing and borrowing
Development and maintenance of
information systems for cash management
Float: funds that have been sent by the payer but not yet
usable funds to the company
Time
Mail float
16
Processing
float
Availability
float
Clearing
float
Cash Position Management
Cash position management: collection, concentration,
and disbursement of funds on a daily basis
– Management of short-term investing if the company has a surplus of
funds and borrowing arrangements if company has a temporary
deficit of funds
Smaller companies set target cash balance for their
checking accounts.
Bank account
analysis
statement
17
• Bank provides report to its customers to
show recent activity in firms’ accounts.
• Banks cannot pay interest on corporate
checking account balances.
• Firms use earnings credit for balances to
offset charges.
Collections
Primary objective: speeding up collections
Collection systems: function of the nature of the business
Field-banking
system
18
• Collections are made over the counter
(retail) or at a collection office (utilities).
Mail-based
system
• Mail payments are processed at companies’
collection centers.
Electronic
payments
• Becoming increasingly popular because they
offer advantages to both parties.
Collections
Lockbox
system
• Speeds up collections because it affects all
components of float.
• Customers mail payments to a post office
box.
• Firm’s bank empties the box and processes
each payment and deposits the payments in
the firm’s account.
• Lockboxes reduce mail and clearing time.
Perform cost-benefit analysis to determine if lockbox system
worth using
Net benefit ( cos t)  (FVR  ra ) - LC , where
19
• FVR = float value reduction in dollars
• ra = cost of capital
• LC = annual operating cost of the lockbox system
Funds Transfer Mechanisms
20
Depository
transfer checks
• Unsigned check drawn on one of the firm’s
bank accounts and deposited in another of
the firm’s bank accounts
Automated
clearinghouse
debit transfers
• Preauthorized electronic withdrawal from
the payer’s account
• Settle accounts among participating banks.
Individual accounts are settled by respective
bank balance adjustments.
• Transfers clear in one day.
Wire transfers
• Electronic communication that, via
bookkeeping entries, removes funds from
the payer’s bank and deposits the funds in
the payee’s bank.
• Expensive: used only for high-dollar
payments
• Fedwire: primary wire transfer system in US
Accounts Payable Management
Management of time from purchase of raw materials until
payment is placed in the mail
Accounts
payable
functions
• Examine all incoming invoices and determine
the amount to be paid.
• Control function: cash manager verifies that
invoice information matches purchase order
and receiving information.
Decide between centralized or decentralized payables and
payments systems
21
If supplier offers cash discounts, analyze the best alternative
between paying at the end of credit period and taking the
discount.
Disbursements Products and
Methods
• Zero-balance accounts (ZBAs): disbursements accounts that
always have end-of-day balance of zero
– Allows the firm to maximize the use of float on each check,
without altering the float time of its suppliers
– Keeps all cash in interest-bearing accounts
• Controlled disbursement: Bank provides early notification of
checks presented against a company’s account every day.
– Federal Reserve Bank makes two presentments of checks to be
cleared each day for most large cash management banks.
• Positive pay: Company transmits to the bank a check-issued file to
the bank when checks are issued.
– Check-issued file includes check number and amount of each
item.
– Used for fraud prevention
22
Developments in Accounts
Payable and Disbursements
• Integrated (comprehensive) accounts payable: outsourcing of
accounts payable or disbursements operations
• Purchasing/procurement cards: increased use of credit cards
for low-dollar indirect purchases
• Imaging services: Both sides of the check, as well as remittance
information, is converted into digital images.
– Useful when incorporated with positive pay services
• Fraud prevention in disbursements: fraud prevention
measures:
– Written policies and procedures for creating and disbursing
checks; separating duties (approval, signing, reconciliation)
– Using safety features on checks; setting maximum dollar limits
and/or requiring multiple signatures
23
Short-Term Financial Management
Length of cash conversion cycle determines the amount
of resources the firm must invest in its operations.
Cost trade-offs apply to managing cash and marketable
securities, account receivable, inventory and account
payable.
Objective for account receivable: collect accounts as
quickly as possible without losing sales.
Objective for accounts payable: pay accounts as slowly
as possible without damaging firm’s credit.