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Part

5
Short-Term
Financial
Decisions

Chapter 13
Working Capital and
Current Assets Management

Chapter 14
Current Liabilities Management
Chapter Across the Disciplines


13
Why This Chapter Matters To You
Accounting: In order to record and report
the firm’s transactions, you need to under-
stand the cash conversion cycle and the
management of inventory, accounts
receivable, and receipts and disburse-

Working Capital ments of cash.
Information systems: You need to under-
stand the cash conversion cycle, inven-
and tory, accounts receivable, and receipts
and disbursements of cash in order to
design financial information systems that

Current Assets enhance effective short-term financial
management.
Management: You need to understand
Management management of working capital and cur-
rent assets so that you can decide
whether to finance the firm’s funds
requirements aggressively or
conservatively.
LEARNING GOALS
Marketing: You need to understand credit
Understand short-term financial selection and monitoring because sales
LG1
management, net working capital, will be affected by the availability of credit
and the related tradeoff between to purchasers; sales will also be affected
profitability and risk. by inventory management.
Describe the cash conversion cycle, Operations: You need to understand the
LG2
its funding requirements, and the key
cash conversion cycle because you will
strategies for managing it.
be responsible for reducing the cycle
Discuss inventory management: through the efficient management of
LG3
differing views, common techniques, inventory levels and costs.
and international concerns.
Explain the credit selection process
LG4
and the quantitative procedure for
evaluating changes in credit
standards.
Review the procedures for
LG5
quantitatively considering cash
discount changes, other aspects of
credit terms, and credit monitoring.
Understand the management of
LG6
receipts and disbursements, including
float, speeding collections, slowing
payments, cash concentration, zero-
balance accounts, and investing in
492 marketable securities.
493
CHAPTER 13 Working Capital and Current Assets Management



A n important consideration for all firms is the ability to finance the transition
from cash to inventories to receivables and back to cash. Various strategies
exist for managing current assets in order to reduce the amount of financing
needed to support this cycle. In addition to managing cash, firms also must man-
age the accounts that typically represent the firm’s largest investment in current
assets—inventories and accounts receivable. This chapter looks at the manage-
ment of these various aspects of the firm’s current assets.




Net Working Capital Fundamentals
LG1

The firm’s balance sheet provides information about the structure of a firm’s
investments on the one hand and the structure of its financing sources on the
other. The structures chosen should consistently lead to the maximization of the
value of the owners’ investment in the firm.
Important components of the firm’s financial structure include the level of
investment in current assets and the extent of current liability financing. In U.S.
manufacturing firms, current assets account for about 40 percent of total assets;
current liabilities represent about 26 percent of total financing. Therefore, it
should not be surprising to learn that short-term financial management—manag-
short-term financial management
Management of current assets ing current assets and current liabilities—is one of the financial manager’s most
and current liabilities. important and time-consuming activities. A study of Fortune 1000 firms found
that more than one-third of financial management time is spent managing current
assets and about one-fourth of financial management time is spent managing cur-
rent liabilities.
The goal of short-term financial management is to manage each of the firm’s
current assets (inventory, accounts receivable, cash, and marketable securities)
and current liabilities (accounts payable, accruals, and notes payable) to achieve
a balance between profitability and risk that contributes positively to the firm’s
value. This chapter does not discuss the optimal level of current assets and cur-
rent liabilities that a firm should have. That issue is unresolved in the financial lit-
erature. Here we first use net working capital to consider the basic relationship
between current assets and current liabilities and then use the cash conversion
cycle to consider the key aspects of current asset management. In the following
chapter, we consider current liability management.



Net Working Capital
Current assets, commonly called working capital, represent the portion of invest-
working capital
Current assets, which represent ment that circulates from one form to another in the ordinary conduct of busi-
the portion of investment that
ness. This idea embraces the recurring transition from cash to inventories to
circulates from one form to
receivables and back to cash. As cash substitutes, marketable securities are con-
another in the ordinary conduct
sidered part of working capital.
of business.
Current liabilities represent the firm’s short-term financing, because they
include all debts of the firm that come due (must be paid) in 1 year or less. These
debts usually include amounts owed to suppliers (accounts payable), employees
and governments (accruals), and banks (notes payable), among others.
494 PART 5 Short-Term Financial Decisions


As noted in Chapter 8, net working capital is commonly defined as the differ-
net working capital
The difference between the ence between the firm’s current assets and its current liabilities. When the current
firm’s current assets and its assets exceed the current liabilities, the firm has positive net working capital.
current liabilities; can be
When current assets are less than current liabilities, the firm has negative net
positive or negative.
working capital.
The conversion of current assets from inventory to receivables to cash pro-
vides the source of cash used to pay the current liabilities. The cash outlays for
current liabilities are relatively predictable. When an obligation is incurred, the
firm generally knows when the corresponding payment will be due. What is diffi-
cult to predict are the cash inflows—the conversion of the current assets to more
liquid forms. The more predictable its cash inflows, the less net working capital a
firm needs. Because most firms are unable to match cash inflows to outflows with
certainty, current assets that more than cover outflows for current liabilities are
usually necessary. In general, the greater the margin by which a firm’s current
assets cover its current liabilities, the better able it will be to pay its bills as they
come due.


The Tradeoff Between Profitability and Risk
A tradeoff exists between a firm’s profitability and its risk. Profitability, in this
profitability
The relationship between context, is the relationship between revenues and costs generated by using the
revenues and costs generated by
firm’s assets—both current and fixed—in productive activities. A firm’s profits
using the firm’s assets—both
can be increased by (1) increasing revenues or (2) decreasing costs. Risk, in the
current and fixed—in productive
context of short-term financial management, is the probability that a firm will be
activities.
unable to pay its bills as they come due. A firm that cannot pay its bills as they
risk (of technical insolvency)
come due is said to be technically insolvent. It is generally assumed that the
The probability that a firm will be
greater the firm’s net working capital, the lower its risk. In other words, the more
unable to pay its bills as they
net working capital, the more liquid the firm and therefore the lower its risk of
come due.
becoming technically insolvent. Using these definitions of profitability and risk,
technically insolvent
we can demonstrate the tradeoff between them by considering changes in current
Describes a firm that is unable to
assets and current liabilities separately.
pay its bills as they come due.


Changes in Current Assets
How changing the level of the firm’s current assets affects its profitability–risk
tradeoff can be demonstrated using the ratio of current assets to total assets. This
ratio indicates the percentage of total assets that is current. For purposes of illus-
tration, we will assume that the level of total assets remains unchanged.1 The
effects on both profitability and risk of an increase or decrease in this ratio are
summarized in the upper portion of Table 13.1. When the ratio increases—that
is, when current assets increase—profitability decreases. Why? Because current
assets are less profitable than fixed assets. Fixed assets are more profitable
because they add more value to the product than that provided by current assets.
Without fixed assets, the firm could not produce the product.
The risk effect, however, decreases as the ratio of current assets to total assets
increases. The increase in current assets increases net working capital, thereby


1. In order to isolate the effect of changing asset and financing mixes on the firm’s profitability and risk, we assume
the level of total assets to be constant in this and the following discussion.
495
CHAPTER 13 Working Capital and Current Assets Management


TABLE 13.1 Effects of Changing Ratios
on Profits and Risk

Change Effect Effect
Ratio in ratio on profit on risk

Increase Decrease Decrease
Current assets
Total assets Decrease Increase Increase

Increase Increase Increase
Current liabilities
Total assets Decrease Decrease Decrease




reducing the risk of technical insolvency. In addition, as you go down the asset
side of the balance sheet, the risk associated with the assets increases: Investment
in cash and marketable securities is less risky than investment in accounts receiv-
able, inventories, and fixed assets. Accounts receivable investment is less risky
than investment in inventories and fixed assets. Investment in inventories is less
risky than investment in fixed assets. The nearer an asset is to cash, the less risky
it is. The opposite effects on profit and risk result from a decrease in the ratio of
current assets to total assets.

Changes in Current Liabilities
How changing the level of the firm’s current liabilities affects its profitability–risk
tradeoff can be demonstrated by using the ratio of current liabilities to total
assets. This ratio indicates the percentage of total assets that has been financed
with current liabilities. Again, assuming that total assets remain unchanged, the
effects on both profitability and risk of an increase or decrease in the ratio are
summarized in the lower portion of Table 13.1. When the ratio increases, prof-
itability increases. Why? Because the firm uses more of the less expensive current
liabilities financing and less long-term financing. Current liabilities are less expen-
sive because only notes payable, which represent about 20 percent of the typical
manufacturer’s current liabilities, have a cost. The other current liabilities are
basically debts on which the firm pays no charge or interest. However, when the
ratio of current liabilities to total assets increases, the risk of technical insolvency
also increases, because the increase in current liabilities in turn decreases net
working capital. The opposite effects on profit and risk result from a decrease in
the ratio of current liabilities to total assets.


Review Questions

13–1 Why is short-term financial management one of the most important and
time-consuming activities of the financial manager? What is net working
capital?
13–2 What is the relationship between the predictability of a firm’s cash inflows
and its required level of net working capital? How are net working capi-
tal, liquidity, and risk of technical insolvency related?
496 PART 5 Short-Term Financial Decisions


13–3 Why does an increase in the ratio of current to total assets decrease both
profits and risk as measured by net working capital? How do changes in
the ratio of current liabilities to total assets affect profitability and risk?




The Cash Conversion Cycle
LG2


Central to short-term financial management is an understanding of the firm’s
cash conversion cycle.2 This cycle frames discussion of the management of the
firm’s current assets in this chapter and that of the management of current liabili-
ties in Chapter 14. Here, we begin by demonstrating the calculation and applica-
tion of the cash conversion cycle.


Calculating the Cash Conversion Cycle
A firm’s operating cycle (OC) is the time from the beginning of the production
operating cycle (OC)
The time from the beginning of process to collection of cash from the sale of the finished product. The operating
the production process to the
cycle encompasses two major short-term asset categories: inventory and accounts
collection of cash from the sale
receivable. It is measured in elapsed time by summing the average age of inven-
of the finished product.
tory (AAI) and the average collection period (ACP).
OC AAI ACP (13.1)
However, the process of producing and selling a product also includes the
purchase of production inputs (raw materials) on account, which results in
accounts payable. Accounts payable reduce the number of days a firm’s resources
cash conversion cycle (CCC) are tied up in the operating cycle. The time it takes to pay the accounts payable,
The amount of time a firm’s
measured in days, is the average payment period (APP). The operating cycle less
resources are tied up; calculated
the average payment period is referred to as the cash conversion cycle (CCC). It
by subtracting the average
represents the amount of time the firm’s resources are tied up. The formula for
payment period from the operat-
the cash conversion cycle is
ing cycle.

CCC OC APP (13.2)
Substituting the relationship in Equation 13.1 into Equation 13.2, we can see
that the cash conversion cycle has three main components, as shown in Equation
13.3: (1) average age of the inventory, (2) average collection period, and (3) aver-
age payment period.

CCC AAI ACP APP (13.3)

Clearly, if a firm changes any of these time periods, it changes the amount of
resources tied up in the day-to-day operation of the firm.



2. The conceptual model that is used in this section to demonstrate basic short-term financial management strategies
was developed by Lawrence J. Gitman in “Estimating Corporate Liquidity Requirements: A Simplified Approach,”
The Financial Review (1974), pp. 79–88, and refined and operationalized by Lawrence J. Gitman and Kanwal S.
Sachdeva in “A Framework for Estimating and Analyzing the Required Working Capital Investment,” Review of
Business and Economic Research (Spring 1982), pp 35–44.
497
CHAPTER 13 Working Capital and Current Assets Management


FIGURE 13.1
Time = 0 100 days
Operating Cycle (OC)
Time Line for MAX
Company’s Cash
Conversion Cycle
Purchase Raw Sell Finished Collect
MAX Company’s operating
Materials on Goods on Accounts
cycle is 100 days, and its
Account Account Receivable
cash conversion cycle is 65
Average Age of Inventory (AAI) Average Collection Period (ACP)
days
60 days 40 days
Cash
Pay
Average Inflow
Accounts
Payment Payable
Period (APP) Cash Conversion Cycle (CCC)
65 days
35 days
Cash
Outflow
Time




MAX Company, a producer of paper dinnerware, has annual sales of $10 mil-
EXAMPLE
lion, a cost of goods sold of 75% of sales, and purchases that are 65% of cost of
goods sold. MAX has an average age of inventory (AAI) of 60 days, an average
collection period (ACP) of 40 days, and an average payment period (APP) of 35
days. Thus the cash conversion cycle for MAX is 65 days (60 40 35). Figure
13.1 presents MAX Company’s cash conversion cycle as a time line.
The resources MAX has invested in this cash conversion cycle (assuming a
360-day year) are
Inventory ($10,000,000 0.75) (60/360) $1,250,000
Accounts receivable ( 10,000,000 40/360) 1,111,111
Accounts payable ( 10,000,000 0.75 0.65) (35/360) 473,958
Resources invested $1,887,153

Changes in any of the time periods will change the resources tied up in opera-
tions. For example, if MAX could reduce the average collection period on its
accounts receivable by 5 days, it would shorten the cash conversion time line and
thus reduce the amount of resources MAX has invested in operations. For MAX,
a 5-day reduction in the average collection period would reduce the resources
invested in the cash conversion cycle by $138,889 [$10,000,000 (5/360)].


Funding Requirements
of the Cash Conversion Cycle
We can use the cash conversion cycle as a basis for discussing how the firm funds
its required investment in operating assets. We first differentiate between perma-
nent and seasonal funding needs and then describe aggressive and conservative
seasonal funding strategies.
498 PART 5 Short-Term Financial Decisions


Permanent versus Seasonal Funding Needs
permanent funding requirement
A constant investment in operat-
If the firm’s sales are constant, then its investment in operating assets should also
ing assets resulting from
be constant, and the firm will have only a permanent funding requirement. If the
constant sales over time.
firm’s sales are cyclic, then its investment in operating assets will vary over time
seasonal funding requirement
with its sales cycles, and the firm will have seasonal funding requirements in
An investment in operating
addition to the permanent funding required for its minimum investment in oper-
assets that varies over time as a
ating assets.
result of cyclic sales.

Nicholson Company holds, on average, $50,000 in cash and marketable securi-
EXAMPLE
ties, $1,250,000 in inventory, and $750,000 in accounts receivable. Nicholson’s
business is very stable over time, so its operating assets can be viewed as perma-
nent. In addition, Nicholson’s accounts payable of $425,000 are stable over time.
Thus Nicholson has a permanent investment in operating assets of $1,625,000
($50,000 $1,250,0000 $750,000 $425,000). That amount would also
equal its permanent funding requirement.
In contrast, Semper Pump Company, which produces bicycle pumps, has sea-
sonal funding needs. Semper has seasonal sales, with its peak sales driven by the
summertime purchases of bicycle pumps. Semper holds, at minimum, $25,000 in
cash and marketable securities, $100,000 in inventory, and $60,000 in accounts
receivable. At peak times, Semper’s inventory increases to $750,000, and its
accounts receivable increase to $400,000. To capture production efficiencies,
Semper produces pumps at a constant rate throughout the year. Thus accounts
payable remain at $50,000 throughout the year. Accordingly, Semper has a per-
manent funding requirement for its minimum level of operating assets of
$135,000 ($25,000 $100,000 $60,000 $50,000) and peak seasonal fund-
ing requirements (in excess of its permanent need) of $990,000 [($25,000
$750,000 $400,000 $50,000) $135,000]. Semper’s total funding require-
ments for operating assets vary from a minimum of $135,000 (permanent) to a
seasonal peak of $1,125,000 ($135,000 $990,000). Figure 13.2 depicts these
needs over time.


Aggressive versus Conservative
Seasonal Funding Strategies
Short-term funds are typically less expensive than long-term funds. (The yield
aggressive funding strategy
A funding strategy under which curve is typically upward-sloping.) However, long-term funds allow the firm to
the firm funds its seasonal lock in its cost of funds over a period of time and thus avoid the risk of increases
requirements with short-term
in short-term interest rates. Also, long-term funding ensures that the required
debt and its permanent require-
funds are available to the firm when needed. Short-term funding exposes the firm
ments with long-term debt.
to the risk that it may not be able to obtain the funds needed to cover its seasonal
conservative funding strategy
peaks. Under an aggressive funding strategy, the firm funds its seasonal require-
A funding strategy under which
ments with short-term debt and its permanent requirements with long-term debt.
the firm funds both its seasonal
Under a conservative funding strategy, the firm funds both its seasonal and its
and its permanent requirements
permanent requirements with long-term debt.
with long-term debt.


Semper Pump Company has a permanent funding requirement of $135,000 in
EXAMPLE
operating assets and seasonal funding requirements that vary between $0 and
$990,000 and average $101,250. If Semper can borrow short-term funds at
6.25% and long-term funds at 8%, and if it can earn 5% on the investment of
499
CHAPTER 13 Working Capital and Current Assets Management


FIGURE 13.2 Semper Pump Company’s Total Funding Requirements
Semper Pump Company’s peak funds need is $1,125,000, and its minimum need is $135,000



Peak
Need
Funding Requirements for



1,125,000
Operating Assets ($)




1,000,000
Seasonal Need
($0 to $990,000,
average = $101,250)
Total Need
(between
$135,000 to
$1,125,000)
500,000
Total
Need


135,000 Permanent Need
Minimum ($135,000)
Need
0
1 year

Time




any surplus balances, then the annual cost of an aggressive strategy for seasonal
funding will be

Cost of short-term financing 0.0625 $101,250 $ 6,328.13
Cost of long-term financing 0.0800 135,000 10,800.00
Earnings on surplus balances3 0.0500 0 0
Total cost of aggressive strategy $17,128.13

Alternatively, Semper can choose a conservative strategy, under which sur-
plus cash balances are fully invested. (In Figure 13.2, this surplus will be the dif-
ference between the peak need of $1,125,000 and the total need, which varies
between $135,000 and $1,125,000 during the year.) The cost of the conservative
strategy will be

Cost of short-term financing 0.0625 $ 0 $ 0
Cost of long-term financing 0.0800 1,125,000 90,000.00
Earnings on surplus balances4 0.0500 888,750 44,437.50
Total cost of conservative strategy $45,562.50

It is clear from these calculations that for Semper, the aggressive strategy is
far less expensive than the conservative strategy. However, it is equally clear


3. Because under this strategy the amount of financing exactly equals the estimated funding need, no surplus bal-
ances exist.
4. The average surplus balance would be calculated by subtracting the sum of the permanent need ($135,000) and
the average seasonal need ($101,250) from the seasonal peak need ($1,125,000) to get $888,750
($1,125,000 $135,000 $101,250). This represents the surplus amount of financing that on average could be
invested in short-term vehicles that earn a 5% annual return.
500 PART 5 Short-Term Financial Decisions


that Semper has substantial peak-season operating-asset needs and that it must
have adequate funding available to meet the peak needs and ensure ongoing
operations.

Clearly, the aggressive strategy’s heavy reliance on short-term financing
makes it riskier than the conservative strategy because of interest rate swings and
possible difficulties in obtaining needed short-term financing quickly when sea-
sonal peaks occur. The conservative strategy avoids these risks through the
locked-in interest rate and long-term financing, but it is more costly because of the
negative spread between the earnings rate on surplus funds (5% in the example)
and the cost of the long-term funds that create the surplus (8% in the example).
Where the firm operates, between the extremes of the aggressive and conservative
seasonal funding strategies, depends on management’s disposition toward risk
and the strength of its banking relationships.


Strategies for Managing
the Cash Conversion Cycle
A positive cash conversion cycle, as we saw for MAX Company in the earlier
example, means the firm must use negotiated liabilities (such as bank loans) to sup-
port its operating assets. Negotiated liabilities carry an explicit cost, so the firm
benefits by minimizing their use in supporting operating assets. Minimum negoti-
ated liabilities can be realized through application of the following strategies:
1. Turn over inventory as quickly as possible without stockouts that result in
lost sales.
2. Collect accounts receivable as quickly as possible without losing sales from
high-pressure collection techniques.
3. Manage mail, processing, and clearing time to reduce them when collecting
from customers and to increase them when paying suppliers.
4. Pay accounts payable as slowly as possible without damaging the firm’s
credit rating.
Techniques for implementing these four strategies are the focus of the remainder
of this chapter and the following chapter.


Review Questions

13–4 What is the difference between the firm’s operating cycle and its cash con-
version cycle?
13–5 Why is it helpful to divide the funding needs of a seasonal business into its
permanent and seasonal funding requirements when developing a funding
strategy?
13–6 What are the benefits, costs, and risks of an aggressive funding strategy
and of a conservative funding strategy? Under which strategy is the bor-
rowing often in excess of the actual need?
13–7 Why is it important for a firm to minimize the length of its cash conver-
sion cycle?
501
CHAPTER 13 Working Capital and Current Assets Management


Inventory Management
LG3

The first component of the cash conversion cycle is the average age of inventory.
The objective for managing inventory, as noted above, is to turn over inventory
as quickly as possible without losing sales from stockouts. The financial manager
tends to act as an advisor or “watchdog” in matters concerning inventory; he or
she does not have direct control over inventory but does provide input to the
inventory management process.


Differing Viewpoints About Inventory Level
Differing viewpoints about appropriate inventory levels commonly exist among a
firm’s finance, marketing, manufacturing, and purchasing managers. Each views
inventory levels in light of his or her own objectives. The financial manager’s
general disposition toward inventory levels is to keep them low, to ensure that
the firm’s money is not being unwisely invested in excess resources. The market-
ing manager, on the other hand, would like to have large inventories of the firm’s
finished products. This would ensure that all orders could be filled quickly, elim-
inating the need for backorders due to stockouts.
The manufacturing manager’s major responsibility is to implement the pro-
duction plan so that it results in the desired amount of finished goods of acceptable
quality at a low cost. In fulfilling this role, the manufacturing manager would keep
raw materials inventories high to avoid production delays. He or she also would
favor large production runs for the sake of lower unit production costs, which
would result in high finished goods inventories.
The purchasing manager is concerned solely with the raw materials invento-
ries. He or she must have on hand, in the correct quantities at the desired times
and at a favorable price, whatever raw materials are required by production.
Without proper control, in order to get quantity discounts or in anticipation of
rising prices or a shortage of certain materials, the purchasing manager may pur-
chase larger quantities of resources than are actually needed at the time.


Common Techniques for Managing Inventory
Numerous techniques are available for effectively managing the firm’s inventory.
Here we briefly consider four commonly used techniques.

The ABC System
A firm using the ABC inventory system divides its inventory into three groups: A,
ABC inventory system
Inventory management technique B, and C. The A group includes those items with the largest dollar investment.
that divides inventory into three
Typically, this group consists of 20 percent of the firm’s inventory items but 80
groups—A, B, and C, in descend-
percent of its investment in inventory. The B group consists of items that account
ing order of importance and level
for the next largest investment in inventory. The C group consists of a large num-
of monitoring, on the basis of the
ber of items that require a relatively small investment.
dollar investment in each.
The inventory group of each item determines the item’s level of monitoring.
The A group items receive the most intense monitoring because of the high dollar
investment. Typically, A group items are tracked on a perpetual inventory system
502 PART 5 Short-Term Financial Decisions


that allows daily verification of each item’s inventory level. B group items are fre-
quently controlled through periodic, perhaps weekly, checking of their levels. C
group items are monitored with unsophisticated techniques, such as the two-bin
method. With the two-bin method, the item is stored in two bins. As an item is
two-bin method
Unsophisticated inventory- needed, inventory is removed from the first bin. When that bin is empty, an order
monitoring technique that is
is placed to refill the first bin while inventory is drawn from the second bin. The
typically applied to C group items
second bin is used until empty, and so on.
and involves reordering
The large dollar investment in A and B group items suggests the need for a bet-
inventory when one of two bins
ter method of inventory management than the ABC system. The EOQ model, dis-
is empty.
cussed next, is an appropriate model for the management of A and B group items.

The Economic Order Quantity (EOQ) Model
One of the most common techniques for determining the optimal order size for
inventory items is the economic order quantity (EOQ) model. The EOQ model
economic order
quantity (EOQ) model considers various costs of inventory and then determines what order size mini-
Inventory management technique mizes total inventory cost. EOQ assumes that the relevant costs of inventory can be
for determining an item’s optimal
divided into order costs and carrying costs. (The model excludes the actual cost of
order size, which is the size that
the inventory item.) Each of them has certain key components and characteristics.
minimizes the total of its order
Order costs include the fixed clerical costs of placing and receiving orders: the
costs and carrying costs.
cost of writing a purchase order, of processing the resulting paperwork, and of
order costs
receiving an order and checking it against the invoice. Order costs are stated in
The fixed clerical costs of
dollars per order.
placing and receiving an
Carrying costs are the variable costs per unit of holding an item of inventory
inventory order.
for a specific period of time. Carrying costs include storage costs, insurance costs,
carrying costs
the costs of deterioration and obsolescence, and the opportunity or financial cost
The variable costs per unit of
of having funds invested in inventory. These costs are stated in dollars per unit per
holding an item in inventory for a
specific period of time. period.
Order costs decrease as the size of the order increases. Carrying costs, how-
ever, increase with increases in the order size. The EOQ model analyzes the trade-
off between order costs and carrying costs to determine the order quantity that
minimizes the total inventory cost.

Mathematical Development of EOQ A formula can be developed for deter-
mining the firm’s EOQ for a given inventory item, where

S usage in units per period
O order cost per order
C carrying cost per unit per period
Q order quantity in units

The first step is to derive the cost functions for order cost and carrying cost. The
order cost can be expressed as the product of the cost per order and the number
of orders. Because the number of orders equals the usage during the period
divided by the order quantity (S/Q), the order cost can be expressed as follows:

Order cost O S/Q (13.4)

The carrying cost is defined as the cost of carrying a unit of inventory per period
multiplied by the firm’s average inventory. The average inventory is the order
503
CHAPTER 13 Working Capital and Current Assets Management


quantity divided by 2 (Q/2), because inventory is assumed to be depleted at a
constant rate. Thus carrying cost can be expressed as follows:

Carrying cost C Q/2 (13.5)
The firm’s total cost of inventory is found by summing the order cost and the
total cost of inventory
The sum of order costs and carrying cost. Thus the total cost function is
carrying costs of inventory.
Total cost (O S/Q) (C Q/2) (13.6)

Because the EOQ is defined as the order quantity that minimizes the total cost
function, we must solve the total cost function for the EOQ. The resulting equa-
tion is

2 SO
EOQ (13.7)
C

Although the EOQ model has weaknesses, it is certainly better than subjec-
tive decision making. Despite the fact that the use of the EOQ model is outside
the control of the financial manager, the financial manager must be aware of its
utility and must provide certain inputs, specifically with respect to inventory car-
rying costs.

Reorder Point Once the firm has determined its economic order quantity, it
must determine when to place an order. The reorder point reflects the firm’s daily
reorder point
The point at which to reorder usage of the inventory item and the number of days needed to place and receive
inventory, expressed as days of an order. Assuming that inventory is used at a constant rate, the formula for the
lead time daily usage.
reorder point is
Reorder point Days of lead time Daily usage (13.8)

For example, if a firm knows it takes 3 days to place and receive an order, and if
it uses 15 units per day of the inventory item, then the reorder point is 45 units of
inventory (3 days 15 units/day). Thus, as soon as the item’s inventory level falls
to the reorder point (45 units, in this case) an order will be placed at the item’s
EOQ. If the estimates of lead time and usage are correct, then the order will
safety stock
arrive exactly as the inventory level reaches zero. However, lead times and usage
Extra inventory that is held to
rates are not precise, so most firms hold safety stock (extra inventory) to prevent
prevent stockouts of important
stockouts of important items.
items.


MAX Company has an A group inventory item that is vital to the production
EXAMPLE
process. This item costs $1,500, and MAX uses 1,100 units of the item per year.
MAX wants to determine its optimal order strategy for the item. To calculate the
EOQ, we need the following inputs:

Order cost per order $150
Carrying cost per unit per year $200

Substituting into Equation 13.7, we get

2 1,100 $150
EOQ 41 units
$200
504 PART 5 Short-Term Financial Decisions


The reorder point for MAX depends on the number of days MAX operates
per year. Assuming that MAX operates 250 days per year and uses 1,100 units of
this item, its daily usage is 4.4 units (1,100 250). If its lead time is 2 days and
MAX wants to maintain a safety stock of 4 units, the reorder point for this item
is 12.8 units [(2 4.4) 4]. However, orders are made only in whole units, so the
order is placed when the inventory falls to 13 units.

The firm’s goal for inventory is to turn it over as quickly as possible without
stockouts. Inventory turnover is best calculated by dividing cost of goods sold by
average inventory. The EOQ model determines the optimal order size and, indi-
rectly, through the assumption of constant usage, the average inventory. Thus the
EOQ model determines the firm’s optimal inventory turnover rate, given the
firm’s specific costs of inventory.


Just-in-Time (JIT) System
The just-in-time (JIT) system is used to minimize inventory investment. The phi-
just-in-time (JIT) system
Inventory management technique losophy is that materials should arrive at exactly the time they are needed for pro-
that minimizes inventory invest- duction. Ideally, the firm would have only work-in-process inventory. Because its
ment by having materials arrive
objective is to minimize inventory investment, a JIT system uses no (or very little)
at exactly the time they are
safety stock. Extensive coordination among the firm’s employees, its suppliers,
needed for production.
and shipping companies must exist to ensure that material inputs arrive on time.
Failure of materials to arrive on time results in a shutdown of the production line
until the materials arrive. Likewise, a JIT system requires high-quality parts from
suppliers. When quality problems arise, production must be stopped until the
problems are resolved.
The goal of the JIT system is manufacturing efficiency. It uses inventory as a
tool for attaining efficiency by emphasizing quality of the materials used and
their timely delivery. When JIT is working properly, it forces process inefficien-
cies to surface.


Materials Requirement Planning
(MRP) System
Many companies use a materials requirement planning (MRP) system to deter-
materials requirement
planning (MRP) system mine what materials to order and when to order them. MRP applies EOQ con-
Inventory management technique cepts to determine how much to order. By means of a computer, it simulates each
that applies EOQ concepts and a
product’s bill of materials, inventory status, and manufacturing process. The bill
computer to compare production
of materials is simply a list of all the parts and materials that go into making the
needs to available inventory
finished product. For a given production plan, the computer simulates materials
balances and determine when
orders should be placed for requirements by comparing production needs to available inventory balances. On
various items on a product’s bill the basis of the time it takes for a product that is in process to move through the
of materials.
various production stages and the lead time required to get materials, the MRP
system determines when orders should be placed for the various items on the bill
of materials.
The advantage of the MRP system is that it forces the firm to consider its
inventory needs more carefully. The objective is to lower the firm’s inventory
investment without impairing production. If the firm’s opportunity cost of capital
505
CHAPTER 13 Working Capital and Current Assets Management


for investments of equal risk is 15 percent, every dollar of investment released
from inventory increases before-tax profits by $0.15.



International Inventory Management
International inventory management is typically much more complicated for
exporters in general, and for multinational companies in particular, than for
purely domestic firms. The production and manufacturing economies of scale
that might be expected from selling products globally may prove elusive if prod-
ucts must be tailored for individual local markets, as very frequently happens, or
if actual production takes place in factories around the world. When raw materi-
als, intermediate goods, or finished products must be transported long dis-
tances—particularly by ocean shipping—there will inevitably be more delays,
confusion, damage, theft, and other difficulties than occur in a one-country oper-
ation. The international inventory manager therefore puts a premium on flexibil-
ity. He or she is usually less concerned about ordering the economically optimal
quantity of inventory than about making sure that sufficient quantities of inven-
tory are delivered where they are needed, when they are needed, and in a condi-
tion to be used as planned.


Review Questions

13–8 What are likely to be the viewpoints of each of the following managers
about the levels of the various types of inventory: finance, marketing,
manufacturing, and purchasing? Why is inventory an investment?
13–9 Briefly describe each of the following techniques for managing inventory:
ABC system, economic order quantity (EOQ) model, just-in-time (JIT)
system, and materials requirement planning (MRP) system.
13–10 What factors make managing inventory more difficult for exporters and
multinational companies?




Accounts Receivable Management
LG4

The second component of the cash conversion cycle is the average collection
period. This period is the average length of time from a sale on credit until the
payment becomes usable funds for the firm. The average collection period has
two parts. The first part is the time from the sale until the customer mails the pay-
ment. The second part is the time from when the payment is mailed until the firm
has the collected funds in its bank account. The first part of the average collection
period involves managing the credit available to the firm’s customers, and the
second part involves collecting and processing payments. This section of the
chapter discusses the firm’s accounts receivable credit management.
The objective for managing accounts receivable is to collect accounts receiv-
able as quickly as possible without losing sales from high-pressure collection
506 PART 5 Short-Term Financial Decisions


techniques. Accomplishing this goal encompasses three topics: (1) credit selection
and standards, (2) credit terms, and (3) credit monitoring.


Credit Selection and Standards
Credit selection involves application of techniques for determining which cus-
credit standards
tomers should receive credit. This process involves evaluating the customer’s
The firm’s minimum requirements
creditworthiness and comparing it to the firm’s credit standards, its minimum
for extending credit to a
requirements for extending credit to a customer.
customer.



Five C’s of Credit
One popular credit selection technique is the five C’s of credit, which provides a
five C’s of credit
framework for in-depth credit analysis. Because of the time and expense
The five key dimensions—
character, capacity, capital, involved, this credit selection method is used for large-dollar credit requests. The
collateral, and conditions—used
five C’s are
by credit analysts to provide a
framework for in-depth credit
1. Character: The applicant’s record of meeting past obligations.
analysis.
2. Capacity: The applicant’s ability to repay the requested credit, as judged in
terms of financial statement analysis focused on cash flows available to repay
debt obligations.
3. Capital: The applicant’s debt relative to equity.
4. Collateral: The amount of assets the applicant has available for use in secur-
ing the credit. The larger the amount of available assets, the greater the
chance that a firm will recover funds if the applicant defaults.
5. Conditions: Current general and industry-specific economic conditions, and
any unique conditions surrounding a specific transaction.

Analysis via the five C’s of credit does not yield a specific accept/reject deci-
sion, so its use requires an analyst experienced in reviewing and granting credit
requests. Application of this framework tends to ensure that the firm’s credit cus-
tomers will pay, without being pressured, within the stated credit terms.


Credit Scoring
Credit scoring is a method of credit selection that is commonly used with high-
volume/small-dollar credit requests. Credit scoring applies statistically derived
credit scoring
A credit selection method weights for key financial and credit characteristics to predict whether a credit
commonly used with high-
applicant will pay the requested credit in a timely fashion. Simply stated, the pro-
volume/small-dollar credit
cedure results in a score that measures the applicant’s overall credit strength, and
requests; relies on a credit score
the score is used to make the accept/reject decision for granting the applicant
determined by applying statisti-
credit. Credit scoring is most commonly used by large credit card operations,
cally derived weights to a credit
applicant’s scores on key such as those of banks, oil companies, and department stores. The purpose of
financial and credit
credit scoring is to make a relatively informed credit decision quickly and inex-
characteristics.
pensively, recognizing that the cost of a single bad scoring decision is small. How-
ever, if bad debts from scoring decisions increase, then the scoring system must be
WW re-evaluated. For a demonstration of credit scoring, including use of a spread-
W
sheet for that purpose, see the book’s Web site at www.aw.com/gitman.
507
CHAPTER 13 Working Capital and Current Assets Management


Changing Credit Standards
The firm sometimes will contemplate changing its credit standards in order to
improve its returns and create greater value for its owners. To demonstrate, con-
sider the following changes and effects on profits expected to result from the
relaxation of credit standards.


Effects of Relaxation of Credit Standards
Variable Direction of change Effect on profits

Sales volume Increase Positive
Investment in accounts receivable Increase Negative
Bad-debt expenses Increase Negative



If credit standards were tightened, the opposite effects would be expected.


Dodd Tool, a manufacturer of lathe tools, is currently selling a product for $10
EXAMPLE
per unit. Sales (all on credit) for last year were 60,000 units. The variable cost per
unit is $6. The firm’s total fixed costs are $120,000.
The firm is currently contemplating a relaxation of credit standards that is
expected to result in the following: a 5% increase in unit sales to 63,000 units; an
increase in the average collection period from 30 days (its current level) to 45
days; an increase in bad-debt expenses from 1% of sales (the current level) to 2%.
The firm’s required return on equal-risk investments, which is the opportunity
cost of tying up funds in accounts receivable, is 15%.
To determine whether to relax its credit standards, Dodd Tool must calculate
its effect on the firm’s additional profit contribution from sales, the cost of the
marginal investment in accounts receivable, and the cost of marginal bad debts.

Additional Profit Contribution from Sales Because fixed costs are “sunk” and
therefore are unaffected by a change in the sales level, the only cost relevant to a
change in sales is variable costs. Sales are expected to increase by 5%, or 3,000
units. The profit contribution per unit will equal the difference between the sale
price per unit ($10) and the variable cost per unit ($6). The profit contribution
per unit therefore will be $4. The total additional profit contribution from sales
will be $12,000 (3,000 units $4 per unit).

Cost of the Marginal Investment in Accounts Receivable To determine the cost
of the marginal investment in accounts receivable, Dodd must find the difference
between the cost of carrying receivables under the two credit standards. Because
its concern is only with the out-of-pocket costs, the relevant cost is the variable
cost. The average investment in accounts receivable can be calculated by using
the following formula:

Average investment Total variable cost of annual sales
(13.9)
in accounts receivable Turnover of accounts receivable
508 PART 5 Short-Term Financial Decisions


where
360
Turnover of accounts receivable
Average collection period
The total variable cost of annual sales under the present and proposed plans can
be found as follows, using the variable cost per unit of $6.

Total variable cost of annual sales
Under present plan: ($6 60,000 units) $360,000
Under proposed plan: ($6 63,000 units) $378,000
The turnover of accounts receivable is the number of times each year that the
firm’s accounts receivable are actually turned into cash. It is found by dividing the
average collection period into 360 (the number of days assumed in a year).
Turnover of accounts receivable
360
Under present plan: 12
30
360
Under present plan: 8
45
By substituting the cost and turnover data just calculated into Equation 13.9
for each case, we get the following average investments in accounts receivable:

Average investment in accounts receivable
$360,000
Under present plan: $30,000
12
$378,000
Under proposed plan: $47,250
8
The marginal investment in accounts receivable and its cost are calculated as
follows:
Cost of marginal investment in accounts receivable
Average investment under proposed plan $47,250
Average investment under present plan 30,000
Marginal investment in accounts receivable $17,250
Required return on investment 0.15
Cost of marginal investment in A/R $ 2,588

The resulting value of $2,588 is considered a cost because it represents the maxi-
mum amount that could have been earned on the $17,250 had it been placed in
the best equal-risk investment alternative available at the firm’s required return
on investment of 15%.

Cost of Marginal Bad Debts The cost of marginal bad debts is found by taking
the difference between the levels of bad debts before and after the proposed
relaxation of credit standards.
509
CHAPTER 13 Working Capital and Current Assets Management


Cost of marginal bad debts
Under proposed plan: (0.02 $10/unit 63,000 units) $12,600
Under present plan: (0.01 $10/unit 60,000 units) 6,000
Cost of marginal bad debts $ 6,600

Note that the bad-debt costs are calculated by using the sale price per unit ($10)
to deduct not just the true loss of variable cost ($6) that results when a customer
fails to pay its account, but also the profit contribution per unit (in this case $4)
that is included in the “additional profit contribution from sales.” Thus the
resulting cost of marginal bad debts is $6,600.


Making the Credit Standard Decision To decide whether to relax its credit
standards, the firm must compare the additional profit contribution from sales to
the added costs of the marginal investment in accounts receivable and marginal
bad debts. If the additional profit contribution is greater than marginal costs,
credit standards should be relaxed.

The results and key calculations related to Dodd Tool’s decision whether to relax
EXAMPLE
its credit standards are summarized in Table 13.2. The net addition to total prof-
its resulting from such an action will be $2,812 per year. Therefore, the firm
should relax its credits standards as proposed.



TABLE 13.2 The Effects on Dodd Tool of a Relaxation
of Credit Standards

Additional profit contribution from sales
[3,000 units ($10 $6)] $12,000
Cost of marginal investment in A/Ra
Average investment under proposed plan:
$6 63,000 $378,000
$47,250
8 8
Average investment under present plan:
$6 60,000 $360,000
30,000
12 12
Marginal investment in A/R $17,250
Cost of marginal investment in A/R (0.15 $17,250) ($ 2,588)
Cost of marginal bad debts
Bad debts under proposed plan (0.02 $10 63,000) $12,600
Bad debts under present plan (0.01 $10 60,000) 6,000
Cost of marginal bad debts ($ 6,600)
Net profit from implementation of proposed plan $ 2,812
aThe denominators 8 and 12 in the calculation of the average investment in accounts receivable
under the proposed and present plans are the accounts receivable turnovers for each of these plans
(360/45 8 and 360/30 12).
510 PART 5 Short-Term Financial Decisions


The procedure described here for evaluating a proposed change in credit
standards is also commonly used to evaluate other changes in the management of
accounts receivable. If Dodd Tool had been contemplating tightening its credit
standards, for example, the cost would have been a reduction in the profit contri-
bution from sales, and the return would have been from reductions in the cost of
the investment in accounts receivable and in the cost of bad debts. Another appli-
cation of this procedure is demonstrated later in the chapter.



Managing International Credit
Credit management is difficult enough for managers of purely domestic compa-
nies, and these tasks become much more complex for companies that operate
internationally. This is partly because (as we have seen before) international
operations typically expose a firm to exchange rate risk. It is also due to the dan-
gers and delays involved in shipping goods long distances and in having to cross
at least two international borders.
Exports of finished goods are usually priced in the currency of the importer’s
local market; most commodities, on the other hand, are priced in dollars. There-
fore, a U.S. company that sells a product in Japan, for example, would have to
price that product in Japanese yen and extend credit to a Japanese wholesaler in
the local currency (yen). If the yen depreciates against the dollar before the U.S.
exporter collects on its account receivable, the U.S. company experiences an
exchange rate loss; the yen collected are worth fewer dollars than expected at the
time the sale was made. Of course, the dollar could just as easily depreciate
against the yen, yielding an exchange rate gain to the U.S. exporter. Most compa-
nies fear the loss more than they welcome the gain.
For a major currency such as the Japanese yen, the exporter can hedge
against this risk by using the currency futures, forward, or options markets, but it
is costly to do so, particularly for relatively small amounts. If the exporter is sell-
ing to a customer in a developing country—where 40 percent of U.S. exports are
now sold—there will probably be no effective instrument available for protecting
against exchange rate risk at any price. This risk may be further magnified
because credit standards may be much lower (and acceptable collection tech-
niques much different) in developing countries than in the United States.
Although it may seem tempting just “not to bother” with exporting, U.S. compa-
nies no longer can concede foreign markets to international rivals. These export
sales, if carefully monitored and (where possible) effectively hedged against
exchange rate risk, often prove to be very profitable.


credit terms
The terms of sale for customers
Credit Terms
who have been extended credit
by the firm.
Credit terms are the terms of sale for customers who have been extended credit
cash discount
by the firm. Terms of net 30 mean the customer has 30 days from the beginning
A percentage deduction from the
of the credit period (typically end of month or date of invoice) to pay the full
purchase price; available to the
invoice amount. Some firms offer cash discounts, percentage deductions from the
credit customer who pays its
purchase price for paying within a specified time. For example, terms of 2/10 net
account within a specified time.
511
CHAPTER 13 Working Capital and Current Assets Management


30 mean the customer can take a 2 percent discount from the invoice amount if
the payment is made within 10 days of the beginning of the credit period or can
pay the full amount of the invoice within 30 days.
A firm’s regular credit terms are strongly influenced by the firm’s business.
For example, a firm selling perishable items will have very short credit terms,
because its items have little long-term collateral value; a firm in a seasonal busi-
ness may tailor its terms to fit the industry cycles. A firm wants its regular credit
terms to conform to its industry’s standards. If its terms are more restrictive than
its competitors’, it will lose business; if its terms are less restrictive than its com-
petitors’, it will attract poor-quality customers that probably could not pay
under the standard industry terms. The bottom line is that a firm should com-
pete on the basis of quality and price of its product and service offerings, not its
credit terms. Accordingly, the firm’s regular credit terms should match the
industry standards, but individual customer terms should reflect the riskiness of
the customer.



Cash Discount
Including a cash discount in the credit terms is a popular way to achieve the goal
of speeding up collections without putting pressure on customers. The cash dis-
count provides an incentive for customers to pay sooner. By speeding collections,
the discount decreases the firm’s investment in accounts receivable (which is the
objective), but it also decreases the per-unit profit. Additionally, initiating a cash
discount should reduce bad debts because customers will pay sooner, and it
should increase sales volume because customers who take the discount pay a
lower price for the product. Accordingly, firms that consider offering a cash dis-
count must perform a benefit–cost analysis to determine whether extending a
cash discount is profitable.


MAX Company has an average collection period of 40 days (turnover
EXAMPLE
360/40 9). In accordance with the firm’s credit terms of net 30, this period is
divided into 32 days until the customers place their payments in the mail (not
everyone pays within 30 days) and 8 days to receive, process, and collect pay-
ments once they are mailed. MAX is considering initiating a cash discount by
changing its credit terms from net 30 to 2/10 net 30. The firm expects this change
to reduce the amount of time until the payments are placed in the mail, resulting
in an average collection period of 25 days (turnover 360/25 14.4).
As noted earlier in the EOQ example (page 503), MAX has a raw material
with current annual usage of 1,100 units. Each finished product produced requires
1 unit of this raw material at a variable cost of $1,500 per unit, incurs another
$800 of variable cost in the production process, and sells for $3,000 on terms of
net 30. MAX estimates that 80% of its customers will take the 2% discount and
that offering the discount will increase sales of the finished product by 50 units
(from 1,100 to 1,150 units) per year but will not alter its bad-debt percentage.
MAX’s opportunity cost of funds invested in accounts receivable is 14%. Should
MAX offer the proposed cash discount? An analysis similar to that demonstrated
earlier for the credit standard decision, presented in Table 13.3, shows a net loss
512 PART 5 Short-Term Financial Decisions


TABLE 13.3 Analysis of Initiating a Cash Discount
for MAX Company

Additional profit contribution from sales

[50 units ($3,000 $2,300)] $35,000

Cost of marginal investment in A/Ra
Average investment presently (w/o discount):

$2,300 1,100 units $2,530,000
$281,111
9 9

Average investment with proposed cash discount:b

$2,300 1,150 units $2,645,000
183,681
14.4 14.4

Reduction in accounts receivable investment $ 97,430
Cost savings from reduced investments in
accounts receivable (0.14 $97,430)c $13,640
Cost of cash discount (0.02 0.80 1,150 $3,000) ($55,200)
Net profit from initiation of proposed cash discount ($ 6,560)
aIn analyzing the investment in accounts receivable, we use the variable cost of the product sold
($1,500 raw materials cost $800 production cost $2,300 unit variable cost) instead of the
sale price, because the variable cost is a better indicator of the firm’s investment.
bThe average investment in accounts receivable with the proposed cash discount is estimated to
be tied up for an average of 25 days instead of the 40 days under the original terms.
cMAX’s opportunity cost of funds is 14%.




from the cash discount of $6,560. Thus MAX should not initiate the proposed
cash discount. However, other discounts may be advantageous.

Cash Discount Period
The cash discount period, the number of days after the beginning of the credit
cash discount period
period during which the cash discount is available, can be changed by the finan-
The number of days after the
beginning of the credit period cial manager. The net effect of changes in this period is difficult to analyze
during which the cash discount
because of the nature of the forces involved. For example, if a firm were to
is available.
increase its cash discount period by 10 days (for example, changing its credit
terms from 2/10 net 30 to 2/20 net 30), the following changes would be expected
to occur: (1) Sales would increase, positively affecting profit. (2) Bad-debt
expenses would decrease, positively affecting profit. (3) The profit per unit would
decrease as a result of more people taking the discount, negatively affecting
profit. The difficulty for the financial manager lies in assessing what impact an
increase in the cash discount period would have on the firm’s investment in
accounts receivable. This investment will decrease because of non–discount tak-
ers now paying earlier. However, the investment in accounts receivable will
increase for two reasons: (1) Discount takers will still get the discount but will
pay later, and (2) new customers attracted by the new policy will result in new
accounts receivable. If the firm were to decrease the cash discount period, the
effects would be the opposite of those just described.
513
CHAPTER 13 Working Capital and Current Assets Management


Credit Period
Changes in the credit period, the number of days after the beginning of the credit
credit period
period until full payment of the account is due, also affect a firm’s profitability.
The number of days after the
beginning of the credit period For example, increasing a firm’s credit period from net 30 days to net 45 days
until full payment of the account
should increase sales, positively affecting profit. But both the investment in
is due.
accounts receivable and bad-debt expenses would also increase, negatively affect-
ing profit. The increased investment in accounts receivable would result from
both more sales and generally slower pay, on average, as a result of the longer
credit period. The increase in bad-debt expenses results from the fact that the
longer the credit period, the more time available for a firm to fail, making it
unable to pay its accounts payable. A decrease in the length of the credit period is
likely to have the opposite effects. Note that the variables affected by an increase
in the credit period behave in the same way they would have if the credit stan-
dards had been relaxed, as demonstrated earlier in Table 13.2.



Credit Monitoring
The final issue a firm should consider in its accounts receivable management is
credit monitoring. Credit monitoring is an ongoing review of the firm’s accounts
credit monitoring
The ongoing review of a firm’s receivable to determine whether customers are paying according to the stated
accounts receivable to
credit terms. If they are not paying in a timely manner, credit monitoring will
determine whether customers
alert the firm to the problem. Slow payments are costly to a firm because they
are paying according to the
lengthen the average collection period and thus increase the firm’s investment in
stated credit terms.
accounts receivable. Two frequently cited techniques for credit monitoring are
average collection period and aging of accounts receivable. In addition, a number
of popular collection techniques are used by firms.

Average Collection Period
The average collection period is the second component of the cash conversion
cycle. As noted in Chapter 2, it is the average number of days that credit sales are
outstanding. The average collection period has two components: (1) the time
from sale until the customer places the payment in the mail and (2) the time to
receive, process, and collect the payment once it has been mailed by the customer.
The formula for finding the average collection period is

Accounts receivable
Average collection period (13.10)
Average sales per day

Assuming receipt, processing, and collection time is constant, the average collec-
tion period tells the firm, on average, when its customers pay their accounts.
Knowing its average collection period enables the firm to determine whether
there is a general problem with accounts receivable. For example, a firm that has
credit terms of net 30 would expect its average collection period (minus receipt,
processing, and collection time) to equal about 30 days. If the actual collection
period is significantly greater than 30 days, the firm has reason to review its
credit operations. If the firm’s average collection period is increasing over time, it
has cause for concern about its accounts receivable management. A first step in
analyzing an accounts receivable problem is to “age” the accounts receivable. By
514 PART 5 Short-Term Financial Decisions


this process the firm can determine whether the problem exists in its accounts
receivable in general or is attributable to a few specific accounts.


Aging of Accounts Receivable
The aging of accounts receivable requires the firm’s accounts receivable to be
aging of accounts receivable
A credit-monitoring technique broken down into groups on the basis of the time of origin. The breakdown is
that uses a schedule that typically made on a month-by-month basis, going back 3 or 4 months. The result
indicates the percentages of the
is a schedule that indicates the percentages of the total accounts receivable bal-
total accounts receivable
ance that have been outstanding for specified periods of time. Its purpose is to
balance that have been outstand-
enable the firm to pinpoint problems.
ing for specified periods of time.
If a firm with terms of net 30 has an average collection period (minus receipt,
processing, and collection time) of 50 days, the firm will want to age its accounts
receivable. If the majority of accounts are 2 months old, then the firm has a gen-
eral problem and should review its accounts receivable operations. If the aging
shows that most accounts are collected in about 35 days and a few accounts are
way past due, then the firm should analyze and pursue collection of those specific
past-due accounts.


Popular Collection Techniques
A number of collection techniques, ranging from letters to legal action, are
employed. As an account becomes more and more overdue, the collection effort
becomes more personal and more intense. In Table 13.4 the popular collection



TABLE 13.4 Popular Collection Techniques

Techniquea Brief description

Letters After a certain number of days, the firm sends a polite letter remind-
ing the customer of the overdue account. If the account is not paid

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