1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Working Capital Management
This chapter
presents multiple
strategies for
managing the
working capital of
the firm.
Cash Inventory
20-2
Accounts
Receivable

3. Account Receivables and
20-3
Credit Policy
Credit Management Steps
1. Establish terms of sale
2. What form of IOU will be required?
3. Perform a credit analysis
4. Create a credit policy
5. Develop a collection policy

4. A/R and Credit Policy
20-4
Terminology
Trade Credit
• Bills awaiting payment from one company to another
Consumer Credit
• Bills awaiting payment from final customer to a
company
Terms of Sale
• Credit, discount, and payment terms offered on a sale

5. Terms of Sale: Example
20-5
“5/10 net 60”
5 - percent discount for early payment
10 - number of days that the discount is available
net 60 - number of days before payment is due

6. Implicit Cost: Example
On a $100 sale, with terms 5/10 net 60, what is the
implied interest rate on the credit given?
Effective annual rate
1+ -1
1+ -1=.454, or 45.4%
20-6
( )
( )
365/extra days credit
discount
discounted price
5 365/50
95
=
=

7. Credit Agreements
20-7
Terminology
Open account – Agreement whereby sales are made with
no formal debt contract
Commercial draft – An order to pay
Sight draft
Time draft
Trade acceptance
Banker’s acceptance – A time draft accepted (and
therefore guaranteed) by the bank.

8. 20-8
Credit Analysis
Credit Analysis: Procedure to determine the likelihood
a customer will pay his or her bills.
 Credit agencies like Dun & Bradstreet provide
reports on the credit-worthiness of a potential
customer.
 Financial ratios can be calculated to help determine
a customer’s ability to pay his or her bills.

9. The Five Cs of Credit
Numerical Credit Scoring categories
 The customer’s character
 The customer’s capacity to pay
 The customer’s capital
 The collateral provided by the customer
 The condition of the customer’s business
20-9

10. Credit Analysis: Two Approaches
1. Beaver, McNichols and Rhie – Calculate the chance of failing during the next
year relative to the odds of not failing based on the following equation:
Log(relative chance of failure) = - 6.445 - 1.192 ´ ROA + 2.307 ´ Liabilities - .346 ´
EBITDA
Assets Liabilities
= + + + +
1.2 NetWorkingCapital
20-10
2. Multiple Discriminant Analysis -
Altman Z Score Formula
Z 3.3 EBIT 1.0 Sales .6 MarketValueof Equity 1.4 Retained Earnings
Total Assets Total Assets Total Book Debt Total Asse
ts Total Assets

11. Credit Analysis: Example
If the Altman Z-score cutoff for a credit-worthy business is 2.7
or higher, would we accept the following client?
EBIT = .24 sales = 1.2 market equity =
1.0
total assets total assets book debt
retained earnings = .4 working capital =
.20
total assets total assets
Z-Score = 3.3´.24+1.0´1.2 +.6´1.0 +1.4´.4 +1.2´0.2 =3.39
Yes, a score above 2.7 indicates good credit.
20-11

12. Credit Analysis: Discussion
Credit analysis is only worthwhile if the
expected savings exceed the cost.
20-12
When is this true?

13. The Credit Decision
Credit Policy: Standards set to determine the amount
and nature of credit to extend to customers.
 Extending credit gives you the probability of making
a profit, not the guarantee. There is still a chance of
default.
 Denying credit guarantees neither profit nor loss.
20-13

14. The Credit Decision and
20-14
Probable Payoffs
Offer credit
Refuse credit
Payoff = Revenue - Cost
Payoff = - Cost
Customer pays = p
Customer defaults = 1-p
Payoff = 0
Decision

15. The Credit Decision
Based on the probability of payoffs, the expected profit can be expressed as:
PV(Offer Credit) = PV(Refuse Credit)
20-15
PV(Revenue p ´ -Cost) -(1- p) ´ PV(Cost) =0
Solving for p (probability), the break-even probability of collection is:
PV(Cost)
PV(Rev)
p =

16. The Credit Decision:
Some Final Thoughts
20-16
1. Maximize profit
2. Concentrate on the dangerous accounts
3. Look beyond the immediate order

17. 20-17
Collection Policy
Collection Policy: Procedures to collect and monitor
receivables.
Aging Schedule: Classification of accounts receivable
by time outstanding.

18. Aging Schedule: Example
· · · · · ·
· · · · · ·
· · · · · ·
What is the goal of a good collection policy?
20-18
Customer's Less than More than
1-2 months 2-3 months Total Owed
Name 1 month 3 months
Able $10,000 $5,000 $2,500 0 $17,500
Baker 8,000 3,000 0 0 11,000
Charlie 5,000 0 0 0 5,000
Zebra 5,000 0 6,000 15,000 26,000
Tot
al* $200,000 $100,000 $25,000 $15,000 $340,000
* The totals in the last row are based on the assumption that there are more than four customers. The others were omitted for brevity.

19. Inventory Management
Primary Goal = Minimize amount of cash tied up in inventory
20-19
Recall the Components of Inventory:
 Raw materials
Work in process
 Finished goods
Carrying Costs: The cost of storing goods plus the cost
of capital tied up in inventory

20. Optimal Order Size:
Minimize Costs
20-20

21. Optimal Inventory:
Economic Order Quantity
Economic Order Size = Q = 2 ´ sales ´ cost per order
carrying cost
20-21

22. Cash Management
Cash vs. Short-Term Securities
20-22
Why not all cash?
Why not all short-term securities?
A sweep program is a program which helps firms invest idle
cash. The firm’s bank automatically “sweeps” surplus funds
into a higher-interest account.

23. 20-23
Float
Float – The time between the moment a check is
written and the moment the funds are deposited in
the recipient’s account.
Payment Float – Checks written by a company that
have not yet cleared.
Availability Float – Checks already deposited that
have not yet cleared.

24. Check
clears
20-24
Managing Float
Check mailed
Cash available
to recipient
Check charged to
payer’s account
Check
clears
Check received
Mail float
Check deposited
Processing float
Availability
float
Payment
float

25. Float and Check Handling
20-25
Concentration Banking
•System whereby customers make payments to a regional
collection center, which then transfers funds to a
principal bank.
Lock-box System
•System whereby customers send payments to a post
office box, and a local bank collects and processes the
checks.

26. Lock-Box System: Example
A lock box receives 180 payments per day, with an average amount
of $1,000. The daily interest rate is .02% and the lock box saves
1.75 days in mailing time and 1.25 days in processing time. If the
bank charges $0.35 per check, should the company use this system?
A lock box reduces the collection float by:
180´$1,000´(1.75 +1.25) = $540,000
20-26
Daily return
$540,000 per day´.0002 = $108 per day
Daily Cost
$.35 per check ´180 checks = $63 per day
Yes, the firm is ahead $45 per day, plus any internal processing costs.

27. Other Payment Systems
Electronic Funds Transfer (EFT), Three Methods
20-27
1) Direct Payment
 Automated Clearinghouse (ACH)
2) Direct Deposit
3) Wire Transfer
 Fedwire
 CHIPS (Clearing House Interbank Payments System)

28. Investing Idle Cash:
The Money Market
Money Market – the market for short-term financial assets.
20-28
 Treasury bills
 Commercial paper
 Certificates of deposit
 Repurchase agreements

29. Appendix A: How Purchases are Paid
20-29

30. Appendix B: Methods Used to Make
and Receive Electronic Payments
20-30

31. Appendix C: Use of Payment Systems
in the United States, 2009
20-31
Source: www.federalreserve.gov, www.nacha.org, and www.chips.org