Chapter 6: Introduction to Working Capital Management Outline: The Working Capital Cash Conversion Cycle (CCC) How Changes in Current Accounts Impact External

Chapter 6: Introduction to Working Capital ManagementOutline: The Working Capital Cash Conversion

Cycle (CCC) How Changes in Current Accounts Impact

External Financing Working Capital Investment and

Financing Strategies Management of Credit and A/R Management of Inventory Management of A/P

v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 4: Module 3, Chapter 6 - 1


The Cash Conversion of a Business

Discussion Question

What is a company’s CCC and cash turnover given the following? Days’ inventory = 45 days Days’ receivables = 35 days Days’ payables = 30 days


CCC = Days' Inventory + Days' Receiveables Days' PayablesCCC = 45 + 35 30 = 50 days

365 365Cash Turnover = = = 7.3 TimesCCC 50

Answer:

Discussion Question

Why should caution be exercised when reducing the receivables and inventory conversion periods or extending the payables deferral period?Answer: Lost sales from overly strict credit and collection Production stoppages from inadequate materials or

parts Payables stretched beyond the due date Foregone cost-saving trade discounts Higher prices assessed by vendors due to smaller

orders or slower payment Refusal to sell to customers that are good credit

risks but occasionally slow in paying Excessive reliance on A/P in lieu of a stable base of

short-term bank creditv3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 4: Module 3, Chapter 6 - 4

Discussion Question

Which two accounts vary spontaneously as sales levels change, and how do they change?

Answer: Current assets—As sales increase, credit sales

also increase, resulting in larger dollar amounts invested in A/R.

Current liabilities—Decrease in A/P results in a decrease in cash or an increase in debt because decreases in current liabilities must be offset by decreases in an asset account or increases in other liability accounts.


Discussion Question

What are some of the characteristics of a restrictive current asset investment strategy?

Answer: Company maintains low levels of current

assets relative to sales. Raw materials investment is tightly

managed using JIT. A/R balances are kept low.


Discussion Question

What are some of the characteristics of a relaxed current asset investment strategy?

Answer: A company maintains high levels of current

assets relative to sales: High levels of cash High levels of A/R

A large investment in current assets is likely to lower investment returns, but the firm operates with less risk because of its larger liquid asset balances.


Alternative Current Asset Financing Policies


Relationship Between Treasury and Credit Management Credit management

Treasury and credit management are typically separated (must maintain good relations).

Credit is a sales tool, so credit manager works with sales manager.

Establish credit standards, define credit extension terms, approve customers for credit sales and set individual/aggregate credit limits.

A/R management Typically a credit manager responsibility. Bill and process payments, monitor payment

patterns and collect delinquent accounts.v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 4: Module 3, Chapter 6 - 9

Trade Credit Policies

Policies and procedures should clearly define: Credit standards Credit terms Discount terms Collection

policies


Discussion Question

What are the ramifications of overly strict or overly lenient credit standards?

Answer: Too strict: A company may decline trade

credit to customers who represent an acceptable credit risk and limit their sales opportunities.

Too lenient: A company may grant trade credit to customers who represent an unacceptable credit risk and increase the risk of late payments and bad debt expenses.


The Five C’s of Credit

Character An intent or willingness to pay, as evidenced by payment history

CapacityCurrent and future financial resources that can be committed to pay obligations

CapitalShort- and long-term financial resources to supplement insufficient cash flow for payments

CollateralAssets or guarantees used to secure an obligation if payment terms are not met

ConditionsGeneral, existing economic environment impacting a customer’s ability to pay or willingness of a company to grant credit



Credit Terms and Customer Discounts

Credit limits

The aggregate amount of credit granted each customer; new customers generally receive the lowest limit; companies continuously review customer payment history and adjust limits as needed.

Penalty fees

Assessed for payments received after the due date; usually a percentage of the amount past due; must be stated clearly at the time of sale and disclosed on the invoice.

Eligibility for discount

A benchmark eligibility date established for discounts; may be the postmark date of remittance or the date funds are received.

Forms of Credit Extension

Open account

Installment credit

Revolving credit

Letter of credit (L/C)


Common Terms of Sale

Cash before delivery (CBD) Cash on delivery (COD) Cash terms Net terms Discount terms Monthly billing Draft/bill of lading Seasonal dating Consignment


Sales Discounting

Records gross revenues on the income statement and in receivables

Records discounts as an expense

Records net revenues on the income statement and in receivables

Shows any discounts not taken as income


Gross MethodGross method Net method

Financing Accounts Receivable

Unsecured borrowing Secured borrowing Securitization Captive finance

subsidiary Third-party financing B2B credit cards Factoring Private-label financing


Cross-Border Trade Management

Other methods: Banker’s acceptance (BA) Trade acceptance Barter, countertrade, trading

companies


Discussion Question

In a documentary collection, what roles do the banks involved in the transaction play?

Answer:Act only as collecting and paying agents and assume no direct obligation for ensuring that payment is made: Remitting bank, the bank of the seller/exporter,

receives collection documents from the seller and remits (forwards) them to the buyer’s bank with instructions for payment.

Collecting bank is the bank that presents the documents to the buyer. In exchange for these documents, the bank collects cash or a promise to pay.


Documentary Collection


(5) (6)

(7)

(4)

(2)

(1)

(3) (8)

Buyer(Importer)

Seller (Exporter)

ForeignCollecting

Bank

RemittingBank

Letter of Credit (L/C)

Commercial L/C Issued by a bank as the

intended mechanism of payment

Involves the domestic or international shipment of merchandise

Typically requires presentment of a draft, commercial invoice and related shipping documents

Standby L/C Issued primarily by

U.S. banks Serves as a vehicle to

ensure the financial performance of a bank’s customer to a third-party beneficiary

Typically requires the presentation of a sight draft and documentation


Accepted

Banker’s Acceptance (BA) Created when one person

signs an unconditional written order directing a bank to pay a certain sum of money on demand or at a definite time to another person.

By accepting, the bank agrees to pay the face value if the buyer fails to make payment.

Bank may hold to maturity or sell at discount as short-term negotiable instrument.

Acceptance financing cost: Discount rate (rate

earned by investor) Commission


Consumer Credit Legislation

Truth in Lending Act (1968) Fair Credit Reporting Act (1971) Fair Credit Billing Act (1975) Equal Credit Opportunity Act (1975) Fair Debt Collection Practices Act

(1978) Credit Card Accountability

Responsibility and Disclosure Act (2009)


Elements of Basic Inventory Policy

Why companies hold inventory Provide goods for expected sales Precautionary, speculative or to meet supplier

requirements Types of inventory

Raw materials, WIP, finished goods, scrap or obsolete items, and stores and supplies

Levels of inventory Benefits and costs of inventory Inventory financing


Just-In-Time (JIT) Inventory Management

Minimizes inventory by reducing costs or uncertainties underlying motives for holding inventory.

Often paired with MPS. Retailers link to POS

equipment. Goals:

Eliminate waste. Standardize the

production process. Continuously improve

quality.

Benefits: Improved supplier relationships, lower transaction costs, better planning. Supplier-managed

replenishment programs

Paid-on-production processes

Accounting methods and purchase timing may need changes.


Discussion Question

What is the primary responsibility of accounts payable (A/P), and what are the elements of this process?

Answer:Vouchering Verify incoming invoices and authorize

payments. Traditional three-way match: Invoice

matched to both an approved purchase order and receiving (possibly shipping) information.


Disbursement System ConsiderationsCentralized vs. decentralized A/P and disbursements? Information access Fraud prevention

Written policies and internal controls Prompt bank reconciliation Quality check stock Banking services (e.g., positive pay)

Relationship maintenance with payees


$ $ $ $ $ $ $ $

Discussion Question

What are some disadvantages of centralized disbursement systems?

Answer: Potential negative impact on payee

relations Delayed payments to vendors and/or

lost discount opportunities Must coordinate between central A/P

and field offices to resolve payment disputes


Chapter 7: Working Capital Tools

Outline:

Treasury Management Timelines Cash Discount

Calculations Cash Conversion

Cycle (CCC) A/R Monitoring and

Control Considerations for

Global Management of Working Capital

E-Commercev3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 4: Module 3, Chapter 7 - 29

Operating Cash Flows


Cash outflows(disbursements)

Cash outflows(disbursements)

Cash inflows(various sources)

Cash inflows(various sources)

$ $

$

Concentration/ funding flowsConcentration/ funding flows

Liquidity management

flows

Liquidity management

flows

Surplus Suitable

investments Pay down debt

Shortage Sell investments Draw on debt

Cash Flow Timeline and Float


Discussion Question

Discuss the differences between collection and disbursement float from the perspective of the seller/payee and buyer/payor.

Answer: From seller/payee’s perspective, collection float (i.e.,

mail, processing and availability float) represents delay between time check is mailed and time seller/payee’s account is credited with available funds.

From buyer/payor’s perspective, disbursement float (i.e., mail, processing and clearing float) represents delay between time check is mailed and time buyer/payor’s account is debited.


Benefits of Float Reduction: Negotiating Shared Benefits

Payment timing changes

The seller adjusts the timing (i.e., value date) of the payment.

Price changes (discount offer)

The seller offers the buyer a cash discount to compensate for earlier payment.


Float Neutral Calculation Discount approach depends on cost of funds (i.e.,

opportunity cost) for buyer and timing difference in days.

Example: r = 12% and TD = 3 days.


+

+

1Discount = 1

r1 TD

3651

= 1 12%

1 3365

1= 1 = 1 0.99901467

1.0009863= 0.00098533 = 0.001 (Rounded) or 0.10%

Where:

TD = Total days difference between check and electronic payments

r = Opportunity cost as an annual rate

Discussion Question

What is the primary cost associated with collection float, and why? What are some methods used to reduce or eliminate collection float, and what considerations do these decisions require?Answer: Opportunity cost, because uncollected

funds cannot be invested or used to pay down debt.

Methods used to reduce or eliminate collection float should be weighed against the cost of achieving those improvements:

Remote deposit capture (RDC) Lockbox services


Collection and Disbursement Float For Check-Based Payments


Depositorreceivescollected

funds

Check clearsback to

drawee bankaccount

Checkprocessed

and deposited

Check drawn andmailed out

Lockboxreceives

check

Field officereceives

check

Check encodedand processed

through clearingsystem

Disbursement FloatMail Float Processing Float Clearing Float

Sending Party

Collection FloatReceiving Party

Mail Float Processing Float Availability Float

Cost for a Buyer of Not Taking the Cash Discount Should a discount be taken if the cost

of short-term funds is 8%?


D 365Discount Cost = 100 D N T

2 365= 100 2 30 10

2 365= = 0.0204 18.25 =.3723 or 37.23%98 20Where:

D = Discount percentage—2%N = Net period—30 daysT = Discount period—10 days

Discussion Question

Describe three situations when a buyer should forgo an offered cash discount.Answer: If the firm can earn a rate of return exceeding the

discount rate by investing the funds in the short term instead of paying early and earning the discount

If the firm does not have cash available to take the discount but has a short-term credit facility that carries an interest rate higher than the approximate cost of not taking the discount

If the firm has the ability to effectively change the discount terms by stretching out its A/P terms


Benefit for a Seller of Offering a Cash Discount Sellers induce early payment or offer discount to be

competitive. Calculate seller’s net benefit due to reduction in revenue per $1 of sales. Terms below are 2/10, net 30.


Receive on Day 10

Receive on Day 30

TAFP 1 D $100,000 1 .02PV = = =$97,598.91

CC .151 + T 1 + 10 365 365

$100,000TAFPPV = = CC .151 + N 1 + 30 365 365

Day 10 Day 30

=$98,782.13

NPV = PV PV = $97,598.91 $98,782.13 = $1,183.22

Where TAFP = total amount of full payment; CC = annual opportunity cost of capital (in this example, 15%); D = discount rate; T = days in discount period; N = days in net period

Cash Conversion Cycle (CCC)

Elements in the CCC:


Days’ inventory

Days’ receivables

Days’ payables

Inventory365

Cost of Goods Sold

Accounts Receivable 365Revenues

Accounts Payable365

Cost of Goods Sold

Calculation of the Cash Conversion Cycle (CCC)

Calculates the time required to convert a cash outflow (a payment to a supplier) into a cash inflow (a collection from the customer for the goods sold)


Cash Conversion Cycle = Days' Inventory + Days' Receivables Days' Payables

= 103.15 Days + 41.36 Days 63.48 Days = 81.03 Days

Discussion Question

If a company has a cash conversion cycle of 81.03 days, how many cash conversion cycles does the company go through in a year (cash turnover ratio)?

Answer:


365 DaysCash Turnover =

Cash Conversion Cycle

365= 81.03

= 4.5 Times

Discussion Question

What can a treasury professional discover by monitoring individual accounts receivable?

Answer: Errors or delays in the invoicing or payment

process that are slowing collections Customers who may delay payment

intentionally until follow-up is initiated A change in financial condition that

may alter a customer’s ability to maketimely payments and require the curtailment of future credit sales


Days’ Sales Outstanding (DSO)

Assume that a company has outstanding receivables of $285,000 at the end of the first quarter and credit sales of $310,000 for the quarter. Using a 90-day averaging period, the DSO for this company can be computed as follows:


Sales During Period $310,000Avg. Daily Credit Sales = = = $3,444.44Number of Days in Period 90

Outstanding A/R $285,000.00DSO = = = 82.74 DaysAvg. Daily Credit Sales $3,444.44

Average Past Due = DSO Avg. Days of Credit Terms

= 82.74 Days 60 Days = 22.74 Days

If the company’s credit terms are net 60, the average past due is computed as follows:

Aging Schedule CTP

Separates A/R into current and past-due receivables in 30-day increments (on a customer or aggregate basis) and can determine the percent past due


Age of A/R Amount of A/R % of Total A/R

Current $1,750,000 70%

1-30 days past due 375,000 15%

31-60 days past due 250,000 10%

Over 60 days past due 125,000 5%

Total $2,500,000 100%


A/R Balance Pattern for March

=+$ 25,000=+$160,000

=+$105,000

=+$ 50,000

Discussion Question

All of the following are true of the stipulations generally specified in a multicurrency account EXCEPTa) the base currency in which the account is

denominated.b) the currencies not accepted (all others are accepted).c) the spread or margin over the spot rate to use in

exchanging each currency back to the base currency.

d) the value date to apply to debits and credits for each transaction type and currency.

Answer: b. The correct stipulation is “The portfolio of currencies accepted.”


Types of Netting

Purchases between two subsidiaries are periodically netted against each other.

Payments netted in different currencies are converted to a common currency.

Similar to a bilateral system, but multiple subsidiaries participate.

Payments are converted to a common currency.

Payments are combined. Central treasury

management center makes the necessary FX conversions.


Only the net difference is transferred.

Subsidiaries either pay or receive the net amount in their own currency.

Bilateral Multilateral

Before Netting


With Multilateral Netting


Discussion Question

Describe lead and lag payments used in netting systems. Leading Executing cross-border payments between

subsidiaries before the scheduled payment date Used when a subsidiary country’s currency is

expected to depreciate relative to the parent company’s currency

Lagging Executing cross-border payments between

subsidiaries after the scheduled payment date Used when a subsidiary country’s currency is

expected to appreciate relative to the parent company’s currency


Re-Invoicing


Buys goods from exporting subsidiary

Sells goods to importing subsidiary

Company-owned

subsidiary

Actual shipment

Title and funds in subsidiary’s currency

Before Re-Invoicing


With Re-Invoicing


Export Financing: Long-Term Export Financing through an ECA

Advantages Interest rate generally

fixed at a lower rate and for a longer term than otherwise available.

Indirect government involvement can provide some protection from government appropriation or interference.

Disadvantages Time required to

obtain the necessary approvals

Currency exposure if loan’s currency differs from the project/subsidiary’s cash flows


Ex-Im Bank is the official export credit agency (ECA) of the U.S.

Electronic Commerce (E-Commerce)

Different types of e-commerce

Electronic data interchange (EDI)

Use of the Internet for e-commerce and EDI

Key issues in the development of e-commerce


Discussion Question

Identify the different types of e-commerce.

1. Applications include logistics and supply chain management as well as billing and payment.

2. It allowed businesses easier access to customers and vice versa.

3. Early applications were sales to customers and purchasing from suppliers via EDI/EFT.

4. It involves alternative payment approaches to facilitate the many, small-value payments occurring between consumers.


Answers: B2B

B2C

B2B

C2C

Electronic Data Interchange (EDI)


Structured electronic transactions

Secure messages, no data reentry

Buy side Sell side Purchasing Order placement Receiving A/P

Sales Order processing Shipping A/R

Exclusive use of trading partners Retail, transportation, automotive

ASC X12 UN/EDIFACT

Proprietary EDI Cross-industry EDI

Use of the Internet for E-Commerce and EDI

Internet-based e-commerce Uses the Internet and

Internet technology to link business applications between trading partners

Data transfer is often in a non-EDI format: Proprietary between

two users Industry standard or a

general standard

Internet-enabled EDI Often used to

encourage smaller trading partners to begin using EDI

Useful for low transaction volumes within limited trading communities


Discussion Question

How have UNCITRAL, the UCC and the E-SIGN Act affected the development of e-commerce?

Answer: UNCITRAL formulated a framework stating that

information should not be denied legal effect based solely on format.

For signatures, UNCITRAL trusts public key cryptography (public/private keys).

U.S. still uses UCC (paper-based transactions), but in 2000 E-SIGN Act gave digital signatures same authority as ink signatures (used as model elsewhere).



B2B E-Commerce Implementation

Evaluated receipts settlement (ERS) Eliminates need for supplier to send invoice to a customer

(customer pays by preestablished date) Quantity received agreed-upon price

Traditional Approach ERS Approach Send purchase order (PO) for

shipment. Receive delivery at some later

date. Receive invoice for shipment

from supplier. Match the PO, receiving dock

and invoice. Pay for the goods if everything

matched properly.

Supplier and manufacturer enter long-term supply chain agreement:

Prices Quantities Delivery schedules Product specifications

Supplier has access to manufacturer’s production schedules.

Barcode scanning transmitted to A/P, no invoicing.

B2B E-Commerce Implementation

Paid-on-production In retail, title transfers at shipping dock;

in manufacturing, paid-on-production can be used due to multiple legal concerns:

Liability Bankruptcy Use of inventory assets for supporting loans

Title transfers when item is used.

Electronic presentment of invoices and bills


Discussion Question

A manufacturer has a long CCC and a strategic partnership with a single supplier, cannot adjust raw materials turnover due to the nature of the process, and must use JIT. Which of the following e-commerce processes fits best?a) Evaluated receipts settlement (ERS)b) Paid-on-productionc) Electronic bill presentment and payment

(EBPP)d) Electronic invoice presentment and

payment (EIPP)

Answer: b


Documents

Chapter 6: Introduction to Working Capital Management Outline: The Working Capital Cash Conversion Cycle (CCC) How Changes in Current Accounts Impact External