. 2
( 2)

within a certain period after this letter has been sent, a second, more
demanding letter is sent.
Telephone calls If letters prove unsuccessful, a telephone call may be made to the
customer to request immediate payment. If the customer has a rea-
sonable excuse, arrangements may be made to extend the payment
period. A call from the seller™s attorney may be used.
Personal visits This technique is much more common at the consumer credit level,
but it may also be effectively employed by industrial suppliers. Send-
ing a local salesperson or a collection person to confront the cus-
tomer can be very effective. Payment may be made on the spot.
Collection agencies A firm can turn uncollectible accounts over to a collection agency or
an attorney for collection. The fees for this service are typically quite
high; the firm may receive less than 50 cents on the dollar from
accounts collected in this way.
Legal action Legal action is the most stringent step, an alternative to the use of a
collection agency. Not only is direct legal action expensive, but it
may force the debtor into bankruptcy without guaranteeing the ulti-
mate receipt of the overdue amount.
aThe techniques are listed in the order in which they are typically followed in the collection process.
CHAPTER 13 Working Capital and Current Assets Management

techniques are listed, and briefly described, in the order typically followed in the
collection process.

Review Questions

13“11 What is the role of the five C™s of credit in the credit selection activity?
13“12 Explain why credit scoring is typically applied to consumer credit deci-
sions rather than to mercantile credit decisions.
13“13 What are the basic tradeoffs in a tightening of credit standards?
13“14 Why are the risks involved in international credit management more
complex than those associated with purely domestic credit sales?
13“15 Why do a firm™s regular credit terms typically conform to those of its
13“16 Why should a firm actively monitor the accounts receivable of its credit
customers? How do the techniques of average collection period and
aging of accounts receivable work?

Management of Receipts and Disbursements

As discussed in the previous section, the average collection period (the second
component of the cash conversion cycle) has two parts: (1) the time from sale
until the customer mails the payment and (2) the receipt, processing, and collec-
tion time. The third component of the cash conversion cycle, the average pay-
ment period, also has two parts: (1) the time from purchase of goods on account
until the firm mails its payment and (2) the receipt, processing, and collection
time required by the firm™s suppliers. The receipt, processing, and collection time
for the firm, both from its customers and to its suppliers, is the focus of receipts
and disbursements management.

Funds that have been sent by the
Float refers to funds that have been sent by the payer but are not yet usable funds
payer but are not yet usable
to the payee. Float is important in the cash conversion cycle because its presence
funds to the payee.
lengthens both the firm™s average collection period and its average payment
mail float
period. However, the goal of the firm should be to shorten its average collection
The time delay between when
period and lengthen its average payment period. Both can be accomplished by
payment is placed in the mail and
managing float.
when it is received.
Float has three component parts:
processing float
The time between receipt of a
1. Mail float is the time delay between when payment is placed in the mail and
payment and its deposit into the
when it is received.
firm™s account.
2. Processing float is the time between receipt of the payment and its deposit
clearing float into the firm™s account.
The time between deposit of a
3. Clearing float is the time between deposit of the payment and when spend-
payment and when spendable
able funds become available to the firm. This component of float is attribut-
funds become available to the
able to the time required for a check to clear the banking system.
516 PART 5 Short-Term Financial Decisions

Check Issued Check Received Bookkeeping Check Clears
Float Time Line and Mailed by by the Payee Entries Made
the Payer Company and Check
Float resulting from a check
Company Deposited
issued and mailed by the
payer company to the payee
Mail Processing Clearing
Float Float Float
(3 days) (2 days) (4 days)

0 3 5 9

Total Float (9 days)

Figure 13.3 illustrates the key components of float resulting from the issuance
and mailing of a check by the payer company to the payee company on day zero.
The entire process required a total of 9 days: 3 days™ mail float, 2 days™ processing
float, and 4 days™ clearing float. To the payer company, the delay is disbursement
float; to the payee company, the delay is collection float.
Some popular techniques for managing the component parts of float to speed
up collections and slow down payments are described here.

Speeding Up Collections
Speeding up collections reduces customer collection float time and thus reduces
the firm™s average collection period, which reduces the investment the firm must
make in its cash conversion cycle. In our earlier examples, MAX Company had
annual sales of $10 million and 8 days of total collection float (receipt, process-
ing, and collection time). If MAX can reduce its float time to 5 days, it will reduce
its investment in the cash conversion cycle by $83,333 ([$10,000,000/360
days] 3 days).
A popular technique for speeding up collections is a lockbox system. A lock-
box system works as follows: Instead of mailing payments to the company, cus-
lockbox system
A collection procedure in which tomers mail payments to a post office box. The firm™s bank empties the post
customers mail payments to a
office box regularly, processes each payment, and deposits the payments in the
post office box that is emptied
firm™s account. Deposit slips, along with payment enclosures, are sent (or trans-
regularly by the firm™s bank, who
mitted electronically) to the firm by the bank so that the firm can properly credit
processes the payments and
customers™ accounts. Lockboxes are geographically dispersed to match the loca-
deposits them in the firm™s
account. This system speeds up tions of the firm™s customers. A lockbox system affects all three components of
collection time by reducing
float. Lockboxes reduce mail time and often clearing time by being near the firm™s
processing time as well as mail
customers. Lockboxes reduce processing time to nearly zero because the bank
and clearing time.
deposits payments before the firm processes them. Obviously a lockbox system
reduces collection float time, but not without a cost; therefore, a firm must per-
form an economic analysis to determine whether to implement a lockbox system.
Lockbox systems are commonly used by large firms whose customers are
geographically dispersed. However, a firm does not have to be large to benefit
CHAPTER 13 Working Capital and Current Assets Management

In Practice
FOCUS ON ETHICS What Does It Do for You?
Lake Lillian, Minnesota, gained a courage the practice. Cash man- sional association to which many
mention in a Chicago-area media agers overlooked the fact that cash managers and treasurers
outlet, but not for being a hot fish- putting money in one™s own pocket belong implemented an ethical
ing spot in this state of 10,000 took it out of someone else™s. code. Anyone who is designated a
lakes. An eagle-eyed Chicago con- E.F. Hutton, at the time one of “Certified Cash Manager” by the
sumer wondered why his 25-cent the most prominent stock brokers Association for Financial Profes-
rebate check from Illinois Bell in the United States, took advan- sionals must agree to maintain the
was drawn on a bank in Lake Lil- tage of banks™ inability to track highest standards of conduct,
lian. He was told by a media inves- deposits and transfers and gained including the standard to “refrain
tigator that many large corpora- interest-free use of multiple mil- from intentional abuses of finan-
tions issued rebate checks drawn lions of dollars each day. Though cial systems and markets.”
on a bank there in order to get many saw this as just “aggressive Remote disbursing has largely
more “float””the time between cash management,” a 1985 U.S. disappeared. However, the fact
when checks were issued and Justice Department ruling saw it that many cash managers still see
when the funds were deducted as fraud (because Hutton was nothing wrong with sending checks
from their accounts. In reply, the using money that its banks had not to the wrong address or changing
particular bank justifiably insisted yet collected from the check writer disbursement banks to add a little
there was more to the story, noting and without the bank™s knowl- more float shows that ethical codes
its expertise in processing many edge). Attorneys writing in do not guarantee ethical behavior.
small-dollar checks. Bankers Magazine urged cash The odd locations of some “con-
The cash management prac- managers not to use any type of trolled disbursement accounts”
tice of “remote disbursing””writ- remote disbursement in which the today indicate that financial man-
ing checks on banks located in sole purpose is to increase check agers need one more reminder: The
geographically isolated locations collection delays, thereby creating mere fact that something is legal
to take advantage of the difficulty float. That float causes a “hold” to does not necessarily make it moral
of presenting checks to them in a be placed on the funds so that the or ethical. The Golden Rule”do to
timely manner was common depositor cannot use them. others as you would have them do
before the Federal Reserve issued In response to E.F. Hutton™s to you”shows the inadvisability of
a policy statement in 1979 to dis- aggressive practices, the profes- remote disbursing.

from a lockbox. Smaller firms can also benefit from a lockbox system. The bene-
fit to small firms often comes primarily from transferring the processing of pay-
ments to the bank.

Slowing Down Payments
Float is also a component of the firm™s average payment period. In this case, the
float is in the favor of the firm. The firm may benefit by increasing all three of the
components of its payment float. One popular technique for increasing payment
float is controlled disbursing, which involves the strategic use of mailing points
controlled disbursing
The strategic use of mailing and bank accounts to lengthen mail float and clearing float, respectively. This
points and bank accounts to
approach should be used carefully, though, because longer payment periods may
lengthen mail float and clearing
strain supplier relations.
float, respectively.

In summary, a reasonable overall policy for float management is (1) to collect
payments as quickly as possible, because once the payment is in the mail, the
518 PART 5 Short-Term Financial Decisions

funds belong to the firm, and (2) to delay making payment to suppliers, because
once the payment is mailed, the funds belong to the supplier.

Cash Concentration
Cash concentration is the process used by the firm to bring lockbox and other
cash concentration
The process used by the firm to deposits together into one bank, often called the concentration bank. Cash con-
bring lockbox and other deposits
centration has three main advantages. First, it creates a large pool of funds for
together into one bank, often
use in making short-term cash investments. Because there is a fixed-cost compo-
called the concentration bank.
nent in the transaction cost associated with such investments, investing a single
pool of funds reduces the firm™s transaction costs. The larger investment pool
also allows the firm to choose from a greater variety of short-term investment
vehicles. Second, concentrating the firm™s cash in one account improves the
tracking and internal control of the firm™s cash. Third, having one concentra-
tion bank enables the firm to implement payment strategies that reduce idle
cash balances.
There are a variety of mechanisms for transferring cash from the lockbox
bank and other collecting banks to the concentration bank. One mechanism is a
depository transfer check (DTC), which is an unsigned check drawn on one of
depository transfer check (DTC)
An unsigned check drawn on one the firm™s bank accounts and deposited in another. For cash concentration, a
of a firm™s bank accounts and DTC is drawn on each lockbox or other collecting bank account and deposited in
deposited in another.
the concentration bank account. Once the DTC has cleared the bank on which it
is drawn (which may take several days), the transfer of funds is completed. Most
firms currently provide deposit information by telephone to the concentration
bank, which then prepares and deposits into its account the DTC drawn on the
lockbox or other collecting bank account.
A second mechanism is an ACH (automated clearinghouse) transfer, which is
ACH (automated clearinghouse)
transfer a preauthorized electronic withdrawal from the payer™s account. A computerized
Preauthorized electronic clearing facility (called the automated clearinghouse, or ACH) makes a paperless
withdrawal from the payer™s
transfer of funds between the payer and payee banks. An ACH settles accounts
account and deposit into the
among participating banks. Individual accounts are settled by respective bank
payee™s account via a settlement
balance adjustments. ACH transfers clear in one day. For cash concentration, an
among banks by the automated
clearinghouse, or ACH. ACH transfer is made from each lockbox bank or other collecting bank to the
concentration bank. An ACH transfer can be thought of as an electronic DTC,
but because the ACH transfer clears in one day, it provides benefits over a DTC;
however, both banks in the ACH transfer must be members of the clearinghouse.
A third cash concentration mechanism is a wire transfer. A wire transfer is an
wire transfer
An electronic communication electronic communication that, via bookkeeping entries, removes funds from the
that, via bookkeeping entries, payer™s bank and deposits them in the payee™s bank. Wire transfers can eliminate
removes funds from the payer™s
mail and clearing float and may reduce processing float as well. For cash concen-
bank and deposits them in the
tration, the firm moves funds using a wire transfer from each lockbox or other
payee™s bank.
collecting account to its concentration account. Wire transfers are a substitute for
DTC and ACH transfers, but they are more expensive.
It is clear that the firm must balance the costs and benefits of concentrating
cash to determine the type and timing of transfers from its lockbox and other col-
lecting accounts to its concentration account. The transfer mechanism selected
should be the one that is most profitable. (The profit per period of any transfer
mechanism equals earnings on the increased availability of funds minus the cost
of the transfer system.)
CHAPTER 13 Working Capital and Current Assets Management

Zero-Balance Accounts
Zero-balance accounts (ZBAs) are disbursement accounts that always have an
zero-balance account (ZBA)
A disbursement account that end-of-day balance of zero. The purpose is to eliminate nonearning cash balances
always has an end-of-day
in corporate checking accounts. A ZBA works well as a disbursement account
balance of zero because the firm
under a cash concentration system.
deposits money to cover checks
ZBAs work as follows: Once all of a given day™s checks are presented for pay-
drawn on the account only as
ment from the firm™s ZBA, the bank notifies the firm of the total amount of checks,
they are presented for payment
each day. and the firm transfers funds into the account to cover the amount of that day™s
checks. This leaves an end-of-day balance of $0 (zero dollars). The ZBA enables
the firm to keep all of its operating cash in an interest-earning account, thereby
eliminating idle cash balances. Thus a firm that used a ZBA in conjunction with a
cash concentration system would need two accounts. The firm would concentrate
its cash from the lockboxes and other collecting banks into an interest-earning
account and would write checks against its ZBA. The firm would cover the exact
dollar amount of checks presented against the ZBA with transfers from the
interest-earning account, leaving the end-of-day balance in the ZBA at $0.
A ZBA is a disbursement management tool. As we discussed earlier, the firm
would prefer to maximize its payment float. However, some cash managers feel
that actively attempting to increase float time on payments is unethical. A ZBA
enables the firm to maximize the use of float on each check without altering the
float time of payments to its suppliers. Keeping all the firm™s cash in an interest-
earning account enables the firm to maximize earnings on its cash balances by
capturing the full float time on each check it writes.

Investing in Marketable Securities
Marketable securities are short-term, interest-earning, money market instruments
that can easily be converted into cash.5 Marketable securities are classified as part
of the firm™s liquid assets. The firm uses them to earn a return on temporarily idle
funds. To be truly marketable, a security must have (1) a ready market in order to
minimize the amount of time required to convert it into cash, and (2) safety of
principal, which means that it experiences little or no loss in value over time.
The securities that are most commonly held as part of the firm™s marketable-
securities portfolio are divided into two groups: (1) government issues, which
have relatively low yields as a consequence of their low risk, and (2) nongovern-
ment issues, which have slightly higher yields than government issues with similar
maturities because of the slightly higher risk associated with them. Table 13.5
summarizes the key features and recent (May 1, 2002) yields for popular mar-
ketable securities.

Review Questions

13“17 What is float and what are its three components?

5. As explained in Chapter 1, the money market results from a financial relationship between the suppliers and
demanders of short-term funds, that is, marketable securities.
520 PART 5 Short-Term Financial Decisions

Features and Recent Yields on Popular Marketable Securitiesa
TABLE 13.5

Yield on
Initial May 1,
Security Issuer Description maturity Risk and return

Government Issues
Treasury bills U.S. Treasury Issued weekly at auction; sold at a 91 and 182 days Lowest, virtually 1.73%
discount; strong secondary market risk-free
Treasury notes U.S. Treasury Stated interest rate; interest paid 1 to 10 years Low, but slightly 1.79%
semiannually; strong secondary higher than U.S.
market Treasury bills
Federal agency Agencies of fed- Not an obligation of U.S. Treasury; 9 months to Slightly higher than
issues eral government strong secondary market 30 years U.S. Treasury issues

Nongovernment Issues

Negotiable Commercial Represent specific cash deposits in 1 month to Higher than U.S. 1.83%
certificates banks commercial banks; amounts and 3 years Treasury issues and
of deposit (CDs) maturities tailored to investor comparable to
needs; large denominations; good commercial paper
secondary market
Commercial Corporation Unsecured note of issuer; large 3 to 270 days Higher than U.S. 1.80%
paper with a high denominations Treasury issues
credit standing and comparable
to negotiable CDs
Banker™s Banks Results from a bank guarantee of 30 to About the same as 1.86%
acceptances a business transaction; sold at 180 days negotiable CDs and
discount from maturity value commercial paper
but higher than U.S.
Treasury issues
Eurodollar Foreign Deposits of currency not native to 1 day to Highest, due to 1.91%
deposits banks the country in which the bank 3 years less regulation of
is located; large denominations; depository banks
active secondary market and some foreign
exchange risk
Money market Professional Professionally managed portfolios None”depends Vary, but generally
mutual funds portfolio of marketable securities; provide on wishes of higher than U.S.
management instant liquidity investor Treasury issues and
companies comparable to
negotiable CDs and
commercial paper
Repurchase Bank or Bank or security dealer sells Customized to Generally slightly ”
agreements security specific securities to firm and purchaser™s below that associated
dealer agrees to repurchase them at a needs with the outright
specific price and time purchase of the
aThe prime rate of interest at this time was 4.75%.
bYields obtained for 3-month maturities of each security.
cFederal National Mortgage Association (Fannie Mae) constant maturity debt index is used here.
dThe Dryfus Money Market Fund with an average maturity of 64 days is used here in the absence of any average-yield data. Comparatively low
money market mutual fund yields occur when interest rates are historically low, as was the case in early 2002.
Source: Wall Street Journal, May 2, 2002, pp. C9, C10, and C14.
CHAPTER 13 Working Capital and Current Assets Management

13“18 What are the firm™s objectives with regard to collection float and to pay-
ment float?
13“19 What are the three main advantages of cash concentration?
13“20 What are three mechanisms of cash concentration? What is the objective
of using a zero-balance account (ZBA) in a cash concentration system?
13“21 What two characteristics make a security marketable? Why are the yields
on nongovernment marketable securities generally higher than the yields
on government issues with similar maturities?

It is important for a firm to maintain a reasonable level of net working capital. To do this, it
must balance the high profit and high risk associated with low levels of current assets and
high levels of current liabilities against the low profit and low risk that result from high levels
of current assets and low levels of current liabilities. A strategy that achieves a reasonable
balance between profits and liquidity should positively contribute to the firm™s value.
Similarly, the firm should manage its cash conversion cycle by turning inventory
quickly; collecting accounts receivable quickly; managing mail, processing, and clearing
time; and paying accounts payable slowly. These strategies should enable the firm to man-
age its current accounts efficiently and to minimize the amount of required investment in
operating assets.
The financial manager can use various techniques to manage inventory, accounts
receivable, and cash receipts to reduce the amount of resources needed to support the busi-
ness. Employing these strategies, and using various techniques to manage accounts payable
and cash disbursements to shorten the cash conversion cycle, should minimize the firm™s
cash requirements, thereby positively contributing to its value. Clearly, active management
of the firm™s working capital and current assets should positively contribute to the firm™s
goal of maximizing its stock price.

current assets and current liabilities. Profitability is
Understand short-term financial management,
the relationship between revenues and costs. Risk,
net working capital, and the related tradeoff
in the context of short-term financial decisions, is
between profitability and risk. Short-term financial
the probability that a firm will become technically
management is focused on managing each of the
insolvent”unable to pay its bills as they come due.
firm™s current assets (inventory, accounts receivable,
Assuming a constant level of total assets, the higher
cash, and marketable securities) and current liabili-
a firm™s ratio of current assets to total assets, the
ties (accounts payable, accruals, and notes payable)
less profitable the firm, and the less risky it is. The
in a manner that positively contributes to the firm™s
converse is also true. With constant total assets, the
value. Net working capital is the difference between
522 PART 5 Short-Term Financial Decisions

higher a firm™s ratio of current liabilities to total are concerned with applying techniques for deter-
assets, the more profitable and the more risky the mining which customers™ creditworthiness is consis-
firm is. The converse of this statement is also true. tent with the firm™s credit standards. Two popular
credit selection techniques are the five C™s of credit
Describe the cash conversion cycle, its funding and credit scoring. Changes in credit standards can
requirements, and the key strategies for manag- be evaluated mathematically by assessing the effects
ing it. The cash conversion cycle represents the of a proposed change in profits on sales, the cost of
amount of time a firm™s resources are tied up. It has accounts receivable investment, and bad-debt costs.
three components: (1) average age of inventory, (2)
average collection period, and (3) average payment Review the procedures for quantitatively con-
period. The length of the cash conversion cycle sidering cash discount changes, other aspects of
determines the amount of time resources are tied up credit terms, and credit monitoring. Changes in
in the firm™s day-to-day operations. The firm™s credit terms (particularly the initiation of, or a
investment in short-term assets often consists of change in, the cash discount) can be quantified in a
both permanent and seasonal funding requirements. way similar to that for changes in credit standards.
The seasonal requirements can be financed using Changes in the cash discount period can also be
either a low-cost, high-risk, aggressive financing evaluated using similar methods. Credit monitoring,
strategy or a high-cost, low-risk, conservative the ongoing review of customer payment of
financing strategy. The firm™s funding decision for accounts receivable, frequently involves use of the
its cash conversion cycle ultimately depends on average collection period and the aging of accounts
management™s disposition toward risk and the receivable. A number of popular collection tech-
strength of the firm™s banking relationships. To niques are used by firms.
minimize its reliance on negotiated liabilities, the
financial manager seeks to (1) turn over inventory Understand the management of receipts and
as quickly as possible, (2) collect accounts receiv- disbursements, including float, speeding col-
able as quickly as possible, (3) manage mail, pro- lections, slowing payments, cash concentration,
cessing, and clearing time, and (4) pay accounts zero-balance accounts, and investing in marketable
payable as slowly as possible. Use of these strategies securities. Float refers to funds that have been sent
should minimize the cash conversion cycle. by the payer but are not yet usable funds to the
payee. The components of float are mail time, proc-
Discuss inventory management: differing views, essing time, and clearing time. Float occurs in both
common techniques, and international con- the average collection period and the average pay-
cerns. The viewpoints of marketing, manufacturing, ment period. One technique for speeding up collec-
and purchasing managers about the appropriate lev- tions to reduce collection float is a lockbox system.
els of inventory tend to cause higher inventories than A popular technique for slowing payments to
those deemed appropriate by the financial manager. increase payment float is controlled disbursing,
Four commonly used techniques for effectively man- which involves strategic use of mailing points and
aging inventory to keep its level low are (1) the ABC bank accounts. The goal for managing operating
system, (2) the economic order quantity (EOQ) cash is to balance the opportunity cost of nonearning
model, (3) the just-in-time (JIT) system, and (4) the balances against the transaction cost of temporary
materials requirement planning (MRP) system. investments. Firms commonly use depository trans-
International inventory managers place greater fer checks (DTCs), ACH transfers, and wire trans-
emphasis on making sure that sufficient quantities of fers to transfer lockbox receipts to their concentra-
inventory are delivered where they are needed, when tion banks quickly. Zero-balance accounts (ZBAs)
they are needed, and in the right condition, than on can be used to eliminate nonearning cash balances in
ordering the economically optimal quantities. corporate checking accounts. Marketable securities
are short-term, interest-earning, money market
Explain the credit selection process and the instruments used by the firm to earn a return on
quantitative procedure for evaluating changes temporarily idle funds. They may be government or
in credit standards. Credit selection and standards nongovernment issues.
CHAPTER 13 Working Capital and Current Assets Management

SELF-TEST PROBLEMS (Solutions in Appendix B)
ST 13“1 Cash conversion cycle Hurkin Manufacturing Company pays accounts payable
on the tenth day after purchase. The average collection period is 30 days, and
the average age of inventory is 40 days. The firm currently spends about $18
million on operating-cycle investments. The firm is considering a plan that
would stretch its accounts payable by 20 days. If the firm pays 12% per year for
its resource investment, what annual savings can it realize by this plan? Assume
no discount for early payment of accounts payable and a 360-day year.

ST 13“2 EOQ analysis Thompson Paint Company uses 60,000 gallons of pigment per
year. The cost of ordering pigment is $200 per order, and the cost of carrying
the pigment in inventory is $1 per gallon per year. The firm uses pigment at a
constant rate every day throughout the year.
a. Calculate the EOQ.
b. Assuming that it takes 20 days to receive an order once it has been placed,
determine the reorder point in terms of gallons of pigment. (Note: Use a 360-
day year.)

ST 13“3 Relaxing credit standards Regency Rug Repair Company is trying to decide
whether it should relax its credit standards. The firm repairs 72,000 rugs per
year at an average price of $32 each. Bad-debt expenses are 1% of sales, the
average collection period is 40 days, and the variable cost per unit is $28.
Regency expects that if it does relax its credit standards, the average collection
period will increase to 48 days and that bad debts will increase to 11„2% of sales.
Sales will increase by 4,000 repairs per year. If the firm has a required rate of
return on equal-risk investments of 14%, what recommendation would you give
the firm? Use your analysis to justify your answer.

13“1 Cash conversion cycle American Products is concerned about managing cash
efficiently. On the average, inventories have an age of 90 days, and accounts
receivable are collected in 60 days. Accounts payable are paid approximately 30
days after they arise. The firm spends $30 million on operating-cycle investments
each year, at a constant rate. Assume a 360-day year.
a. Calculate the firm™s operating cycle.
b. Calculate the firm™s cash conversion cycle.
c. Calculate the amount of resources needed to support the firm™s cash conver-
sion cycle.
d. Discuss how management might be able to reduce the cash conversion cycle.

13“2 Changing cash conversion cycle Camp Manufacturing turns over its inventory
8 times each year, has an average payment period of 35 days, and has an average
collection period of 60 days. The firm™s total annual outlays for operating-cycle
investments are $3.5 million. Assume a 360-day year.
a. Calculate the firm™s operating and cash conversion cycles.
b. Calculate the firm™s daily cash operating expenditure. How much in
resources must be invested to support its cash conversion cycle?
524 PART 5 Short-Term Financial Decisions

c. If the firm pays 14% for these resources, by how much would it increase its
annual profits by favorably changing its current cash conversion cycle by 20

13“3 Multiple changes in cash conversion cycle Garrett Industries turns over its
inventory 6 times each year; it has an average collection period of 45 days and
an average payment period of 30 days. The firm™s annual operating-cycle invest-
ment is $3 million. Assume a 360-day year.
a. Calculate the firm™s cash conversion cycle, its daily cash operating expendi-
ture, and the amount of resources needed to support its cash conversion
b. Find the firm™s cash conversion cycle and resource investment requirement if
it makes the following changes simultaneously.
(1) Shortens the average age of inventory by 5 days.
(2) Speeds the collection of accounts receivable by an average of 10 days.
(3) Extends the average payment period by 10 days.
c. If the firm pays 13% for its resource investment, by how much, if anything,
could it increase its annual profit as a result of the changes in part b?
d. If the annual cost of achieving the profit in part c is $35,000, what action
would you recommend to the firm? Why?

13“4 Aggressive versus conservative seasonal funding strategy Dynabase Tool has
forecast its total funds requirements for the coming year as shown in the following

Month Amount Month Amount

January $2,000,000 July $12,000,000
February 2,000,000 August 14,000,000
March 2,000,000 September 9,000,000
April 4,000,000 October 5,000,000
May 6,000,000 November 4,000,000
June 9,000,000 December 3,000,000

a. Divide the firm™s monthly funds requirement into (1) a permanent compo-
nent and (2) a seasonal component, and find the monthly average for each of
these components.
b. Describe the amount of long-term and short-term financing used to meet the
total funds requirement under (1) an aggressive funding strategy and (2) a
conservative funding strategy. Assume that under the aggressive strategy,
long-term funds finance permanent needs and short-term funds are used to
finance seasonal needs.
c. Assuming that short-term funds cost 12% annually and that the cost of long-
term funds is 17% annually, use the averages found in part a to calculate the
total cost of each of the strategies described in part b.
d. Discuss the profitability“risk tradeoffs associated with the aggressive strategy
and those associated with the conservative strategy.
13“5 EOQ analysis Tiger Corporation purchases 1,200,000 units per year of one
component. The fixed cost per order is $25. The annual carrying cost of the item
is 27% of its $2 cost.
CHAPTER 13 Working Capital and Current Assets Management

a. Determine the EOQ under the following conditions: (1) no changes, (2) order
cost of zero, and (3) carrying cost of zero.
b. What do your answers illustrate about the EOQ model? Explain.

13“6 EOQ, reorder point, and safety stock Alexis Company uses 800 units of a
product per year on a continuous basis. The product has a fixed cost of $50 per
order, and its carrying cost is $2 per unit per year. It takes 5 days to receive a
shipment after an order is placed, and the firm wishes to hold 10 days™ usage in
inventory as a safety stock.
a. Calculate the EOQ.
b. Determine the average level of inventory. (Note: Use a 360-day year to calcu-
late daily usage.)
c. Determine the reorder point.
d. Indicate which of the following variables change if the firm does not hold the
safety stock: (1) order cost, (2) carrying cost, (3) total inventory cost, (4)
reorder point, (5) economic order quantity. Explain.

13“7 Accounts receivable changes without bad debts Tara™s Textiles currently has
credit sales of $360 million per year and an average collection period of 60 days.
Assume that the price of Tara™s products is $60 per unit and that the variable
costs are $55 per unit. The firm is considering an accounts receivable change
that will result in a 20% increase in sales and a 20% increase in the average col-
lection period. No change in bad debts is expected. The firm™s equal-risk oppor-
tunity cost on its investment in accounts receivable is 14%.
a. Calculate the additional profit contribution from new sales that the firm will
realize if it makes the proposed change.
b. What marginal investment in accounts receivable will result?
c. Calculate the cost of the marginal investment in accounts receivable.
d. Should the firm implement the proposed change? What other information
would be helpful in your analysis?

13“8 Accounts receivable changes with bad debts A firm is evaluating an accounts
receivable change that would increase bad debts from 2% to 4% of sales. Sales
are currently 50,000 units, the selling price is $20 per unit, and the variable cost
per unit is $15. As a result of the proposed change, sales are forecast to increase
to 60,000 units.
a. What are bad debts in dollars currently and under the proposed change?
b. Calculate the cost of the marginal bad debts to the firm.
c. Ignoring the additional profit contribution from increased sales, if the pro-
posed change saves $3,500 and causes no change in the average investment in
accounts receivable, would you recommend it? Explain.
d. Considering all changes in costs and benefits, would you recommend the pro-
posed change? Explain.
e. Compare and discuss your answers in parts c and d.

13“9 Relaxation of credit standards Lewis Enterprises is considering relaxing its
credit standards to increase its currently sagging sales. As a result of the pro-
posed relaxation, sales are expected to increase by 10% from 10,000 to 11,000
units during the coming year; the average collection period is expected to
increase from 45 to 60 days; and bad debts are expected to increase from 1% to
3% of sales. The sale price per unit is $40, and the variable cost per unit is $31.
526 PART 5 Short-Term Financial Decisions

The firm™s required return on equal-risk investments is 25%. Evaluate the pro-
posed relaxation, and make a recommendation to the firm.

13“10 Initiating a cash discount Gardner Company currently makes all sales on credit
and offers no cash discount. The firm is considering offering a 2% cash discount
for payment within 15 days. The firm™s current average collection period is 60
days, sales are 40,000 units, selling price is $45 per unit, and variable cost per
unit is $36. The firm expects that the change in credit terms will result in an
increase in sales to 42,000 units, that 70% of the sales will take the discount,
and that the average collection period will fall to 30 days. If the firm™s required
rate of return on equal-risk investments is 25%, should the proposed discount be

13“11 Shortening the credit period A firm is contemplating shortening its credit
period from 40 to 30 days and believes that as a result of this change, its average
collection period will decline from 45 to 36 days. Bad-debt expenses are
expected to decrease from 1.5% to 1% of sales. The firm is currently selling
12,000 units but believes that as a result of the proposed change, sales will
decline to 10,000 units. The sale price per unit is $56, and the variable cost per
unit is $45. The firm has a required return on equal-risk investments of 25%.
Evaluate this decision, and make a recommendation to the firm.

13“12 Lengthening the credit period Parker Tool is considering lengthening its credit
period from 30 to 60 days. All customers will continue to pay on the net date.
The firm currently bills $450,000 for sales and has $345,000 in variable costs.
The change in credit terms is expected to increase sales to $510,000. Bad-debt
expenses will increase from 1% to 1.5% of sales. The firm has a required rate of
return on equal-risk investments of 20%.
a. What additional profit contribution from sales will be realized from the pro-
posed change?
b. What is the cost of the marginal investment in accounts receivable?
c. What is the cost of the marginal bad debts?
d. Do you recommend this change in credit terms? Why or why not?

13“13 Float Simon Corporation has daily cash receipts of $65,000. A recent analysis
of its collections indicated that customers™ payments were in the mail an average
of 2.5 days. Once received, the payments are processed in 1.5 days. After pay-
ments are deposited, it takes an average of 3 days for these receipts to clear the
banking system.
a. How much collection float (in days) does the firm currently have?
b. If the firm™s opportunity cost is 11%, would it be economically advisable for
the firm to pay an annual fee of $16,500 to reduce collection float by 3 days?
Explain why or why not.

13“14 Lockbox system Eagle Industries feels that a lockbox system can shorten its
accounts receivable collection period by 3 days. Credit sales are $3,240,000 per
year, billed on a continuous basis. The firm has other equally risky investments
with a return of 15%. The cost of the lockbox system is $9,000 per year.
a. What amount of cash will be made available for other uses under the lockbox
CHAPTER 13 Working Capital and Current Assets Management

b. What net benefit (cost) will the firm realize if it adopts the lockbox system?
Should it adopt the proposed lockbox system?

13“15 Zero-balance account Union Company is considering establishment of a zero-
balance account. The firm currently maintains an average balance of $420,000 in
its disbursement account. As compensation to the bank for maintaining the zero-
balance account, the firm will have to pay a monthly fee of $1,000 and maintain a
$300,000 non-interest-earning deposit in the bank. The firm currently has no
other deposits in the bank. Evaluate the proposed zero-balance account, and make
a recommendation to the firm, assuming that it has a 12% opportunity cost.

CHAPTER 13 CASE Assessing Roche Publishing Company™s
Cash Management Efficiency

L isa Pinto, vice president of finance at Roche Publishing Company, a rapidly
growing publisher of college texts, is concerned about the firm™s high level
of short-term resource investment. She believes that the firm can improve the
management of its cash and, as a result, reduce this investment. In this regard,
she charged Arlene Bessenoff, the treasurer, with assessing the firm™s cash man-
agement efficiency. Arlene decided to begin her investigation by studying the
firm™s operating and cash conversion cycles.
Arlene found that Roche™s average payment period was 25 days. She con-
sulted industry data, which showed that the average payment period for the
industry was 40 days. Investigation of three similar publishing companies
revealed that their average payment period was also 40 days. She estimated the
annual cost of achieving a 40-day payment period to be $53,000.
Next, Arlene studied the production cycle and inventory policies. The aver-
age age of inventory was 120 days. She determined that the industry standard as
reported in a survey done by Publishing World, the trade association journal,
was 85 days. She estimated the annual cost of achieving an 85-day average age
of inventory to be $150,000.
Further analysis showed Arlene that the firm™s average collection period was
60 days. The industry average, derived from the trade association data and infor-
mation on three similar publishing companies, was found to be 42 days”30%
lower than Roche™s. Arlene estimated that if Roche initiated a 2% cash discount
for payment within 10 days of the beginning of the credit period, the firm™s aver-
age collection period would drop from 60 days to the 42-day industry average.
She also expected the following to occur as a result of the discount: Annual sales
would increase from $13,750,000 to $15,000,000; bad debts would remain un-
changed; and the 2% cash discount would be applied to 75% of the firm™s sales.
The firm™s variable costs equal 80% of sales.
Roche Publishing Company is currently spending $12,000,000 per year on its
operating-cycle investment, but it expects that initiating a cash discount will
increase its operating-cycle investment to $13,100,000 per year. Arlene™s concern
was whether the firm™s cash management was as efficient as it could be. Arlene
knew that the company paid 12% annual interest for its resource investment and
therefore viewed this value as the firm™s required return. For this reason, she was
concerned about the resource investment cost resulting from any inefficiencies in
the management of Roche™s cash conversion cycle.
528 PART 5 Short-Term Financial Decisions

a. Assuming a constant rate for purchases, production, and sales throughout the
year, what are Roche™s existing operating cycle (OC), cash conversion cycle
(CCC), and resource investment need?
b. If Roche can optimize operations according to industry standards, what
would its operating cycle (OC), cash conversion cycle (CCC), and resource
investment need be under these more efficient conditions?
c. In terms of resource investment requirements, what is the annual cost of
Roche Publishing Company™s operational inefficiency?
d. Evaluate whether Roche™s strategy for speeding its collection of accounts
receivable would be acceptable. What annual net profit or loss would result
from implementation of the cash discount?
e. Use your finding in part d, along with the payables and inventory costs given,
to determine the total annual cost the firm would incur to achieve the indus-
try level of operational efficiency.
f. Judging on the basis of your findings in parts c and e, should the firm incur
the annual cost to achieve the industry level of operational efficiency?
Explain why or why not.

WEB EXERCISE Go to the Web site www.bankone.com. Click on Commercial in the left column.
WW 1. What are the general categories of business services that Bank One offers?
(They are listed in the left column.)
Click on Manage Cash.
2. What cash management services does the bank offer? What are Merchant
Services and Stored-Value Cards, and how do they help businesses manage
Click on Treasury Management Services and then on Products and Services to
get a list of seven different areas. Click on the appropriate area to answer the fol-
lowing questions.
3. Describe the services for the following areas and explain how they increase a
firm™s efficiency in managing its cash: (a) Collections and Deposits, (b) Dis-
bursements and Payments, and (c) E-Commerce.
In one of the above areas, click on ACH Services and then on What is ACH.
4. Discuss the role of the ACH network, the process by which payments are
made, and describe two types of electronic payment options.
5. Navigate the International Banking page and click on Products and Services
and then on Treasury. What services does Bank One offer for Collection, Dis-
bursements, and Electronic Banking? How do these offerings differ from its
domestic services, and why?

Remember to check the book™s Web site at
for additional resources, including additional Web exercises.


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