Chapter 17

Working Capital
Management

17-1
Accounts Receivable

 Funds due from a customer

Variables/Elements of Credit Policy

1. Credit Period
is the length of time buyers are given to pay
for their purchases

– How long to pay?

Shorter period reduces DSO and average
A/R, but it may discourage sales.

17-2
Elements of Credit Policy

2. Cash Discounts
Is the price reductions given for early payment
- Lowers price.
Attracts new customers and reduces DSO.

3. Credit Standards
The required financial strength of acceptable credit
customers
– Tighter standards tend to reduce sales, but
reduce bad debt expense.
Fewer bad debts reduce DSO.
17-3
Elements of Credit Policy

Credit Standards Factors:

 a. Customer debt and interest coverage
ratios
 b. Customer’s credit history
 c. Credit score
Credit Score is a numerical score from 0 to 10
that indicates the likelihood that a person or
business will pay on time
17-4
 Elements of Credit Policy

4. Collection Policy
refers to the procedures used to collect past due
accounts
- How tough?
Tougher policy will reduce DSO but may damage
customer relationships.
Importance:
 a. It has a major effect on sales
 b. It influences the amount of funds tied up in receivables
 c. It affects bad debt losses
17-5
 Elements of Credit Policy

Credit Terms is defined as a statement of their credit

period and discount policy like 2/10, net 30
Accounts Receivable = Sales on credit per day
x Length of collection period
Accounts Receivable Investment (tied up with capital)
= ADS x DSO
Average Daily Sales (ADS) = Annual Credit Sales / 365
Days Sales Outstanding (DSO) = Receivables / ADS

Note: DSO should be no greater than the credit period

17-6
Does company face any risk if it
tightens its credit policy?
 Yes, a tighter credit policy may discourage
sales.
 Some customers may choose to go elsewhere if
they are pressured to pay their bills sooner.
 Companies must balance the benefits of fewer
bad debts with the cost of possible lost sales.

17-7
If entity reduces its DSO without adversely
affecting sales, how would this affect its cash
position?

 Short run: If customers pay sooner, this

increases cash holdings.
 Long run: Over time, the company would
hopefully invest the cash in more productive
assets, or pay it out to shareholders. Both of
these actions would increase EVA

 EVA (economic value added) = is a measure of a

company's financial performance based on the residual wealth
calculated by deducting its cost of capital from its operating profit,
adjusted for taxes on a cash basis.

17-8
EXERCISE:

 Sales = $10,000,000;
A/R = $2,000,000;
DSO = ?
 DSO = 2,000,000/(10,000,000/365)
= 73 days.
 What if all customers paid on time (assuming that it
makes no sense for customers to pay earlier than 30
days), then the firm’s DSO = 30 days. If customers
paid on time, the firm’s A/R = 30  $10,000,000/365
= $821,917.81.
 Cash freed up = $2,000,000 – $821,917.81 =
$1,178,082.19.
17-9
EXERCISE 2:

 Sales = Php 20,000,000

DSO = 60 days

 Compute the ADS? (at 365 days)

 Ave. investment in AR?
 What if the customers pay within the 30 day credit
period? How much is the cash freed-up for investment?

17-10
EXERCISE 3:

 ADS = 2,500,000 (at 365 days)

DSO = 45 days

 Compute the annual credit sales?

 Ave. investment in AR?
 If the company planned to have a cash free of P
2,500,000 for investment, what credit period should they
implement?

17-11
Inventory

 Inventories include:
 Supplies
 Raw materials
 Work in process
 Finished good

17-12
Inventory Costs

 Types of inventory costs

 Carrying costs – storage and handling costs,
insurance, property taxes, depreciation, and
obsolescence.
 Ordering costs – cost of placing orders, shipping,
and handling costs.
 Costs of running short – loss of sales or
customer goodwill, and the disruption of
production schedules.

 Reducing inventory levels generally reduces

carrying costs, increases ordering costs, and may
increase the costs of running short.
17-13
Impact of holding too much inventory?

 If inventory turnover is considerably lower than

the industry average, the firm is carrying a lot
of inventory per dollar of sales.
 By holding excessive inventory, the firm is
increasing its costs, which reduces its ROE.
 Moreover, additional working capital must be
financed, so EVA is also lowered.

17-14
Task of Financial Manager on Inventory

 Install and maintain computer systems used to

track inventories
 Raise the capital needed to acquire additional
inventory holdings
 Identify area of weakness that affect firm’s
overall profitability

17-15
If a company reduces its inventory, without
adversely affecting sales, what effect will this have
on the cash position?

 Short run: Cash will increase as inventory

purchases decline.
 Long run: Company is likely to take steps to
reduce its cash holdings and increase its EVA.

17-16
What is AP/ trade credit?

 Is a debt arising from credit sales and recorded

as an accounts receivable by the seller and as an
account payable by the buyer
 Trade credit is credit furnished by a firm’s
suppliers.
 Trade credit is often the largest source of short-
term credit, especially for small firms.
 Spontaneous, easy to get, but cost can be high.

17-17
Illustration:
List Price = $100
Credit terms = 2/10, net 30
Units = 20 per day

 List Price = True Price (net of discount) + Finance Charge

(the trade discount)
= $ 98 ($100 x 98%) + $ 2 ($100 x 2%)

 Accounts Payable (within discount period)

= Discount period x No. of units x True price
= 10 days x 20 units x $ 98
= $ 19,600 17-18
Illustration:
List Price = $100
Credit terms = 2/10, net 30
Units = 20 per day

 Accounts Payable (beyond discount period)

= Credit period x No. of units x True price
= 30 days x 20 units x $ 98
= $ 58,800

Additional or Extra Credit = $ 58,800 - $ 19,600 = $ 39,200

Discount lost = $ 2 x 20 units x 365 = $ 14,600
17-19
Illustration:
Annual Purchases @discount
= 20 units x 98 x 365 days = P 715,400
Annual Purchases @no discount
= 20 units x 100 x 365 days = P 730,000

Additional Annual Cost of Extra Credit (Discount Lost)

= 730,000 – 715,400
= 14,600
Nominal Annual Cost of Trade Credit
= 14,600 = 37.24 %
39,200
17-20
Effective Cost of Trade Credit

 Periodic rate = 0.02/0.98 = 2.0408%

 Periods/year = 365/(30 – 10) = 18.25
 Effective cost of trade credit

EAR  (1  Periodic rate) N  1

 (1.020408)18.25  1  44.59%

17-21
Terms of Trade Credit

 A firm buys $3,000,000 net ($3,030,303

gross) on terms of 1/10, net 40 annually.
 The firm can forego discounts and pay on
Day 40, without penalty.

Net daily purchases  $3,000,000/365

 $8,219.18

17-22
Breaking Down Trade Credit

 Payables level, if the firm takes discounts

 Payables = $8,219.18(10) = $82,192
 Payables level, if the firm takes no discounts
 Payables = $8,219.18(40) = $328,767
 Credit breakdown
Total trade credit $328,767
Free trade credit - 82,192
Costly trade credit $246,575

17-23
Nominal Cost of Trade Credit

 The firm loses 0.01($3,030,303)

= $30,303 of discounts to obtain $246,575 in
extra trade credit:
rNOM = $30,303/$246,575
= 0.1229 = 12.29%
 The $30,303 is paid throughout the year, so
the effective cost of costly trade credit is
higher.

17-24
Nominal Cost of Trade Credit Formula

Discount % 365 days

rNO M  
1  Discount % Days taken  Disc. period
1 365
 
99 40  10
 0.1229
 12.29%

17-25
Effective Cost of Trade Credit

 Periodic rate = 0.01/0.99 = 1.01%

 Periods/year = 365/(40 – 10) = 12.1667
 Effective cost of trade credit

EAR  (1  Periodic rate) N  1

 (1.0101)12.1667  1  13.01%

17-26
 Exercises:
1. Deluter Cement, Inc. buys on terms of 2/10, net 30. It does not take
discounts, and it typically pays 30 days after the invoice date. Net
purchases amount to $720,000 per year. What is the nominal annual
percentage cost of its non-free trade credit, based on a 365-day year? Its
costly trade credit amount in dollar?

2. A company buys on terms of 10/15, net 30. It does not take the
discount, and it generally pays after 40 days. What is the nominal annual
percentage cost of its non-free trade credit, based on a 365-day year?

3. Suppose the credit terms offered to your firm by its suppliers are 3/10,
net 30 days. Your firm is not taking discounts, but is paying after 25 days
instead of waiting until Day 30. You point out that the nominal cost of not
taking the discount and paying on Day 30 is approximately 37%. But since
your firm is neither taking discounts nor paying on the due date, what is
the effective annual percentage cost of costly trade credit, using a 365-day
17-27
year?
 Suggested Answer:

1. a. 37.24
b. $ 38,663.01
* net daily purchases = 720,000
365 days
* discount lost = 720,000 x 2%

2. a. 162.22 %
3. a. 109.84%

17-28
Bank Loans

 The firm can borrow $100,000 for 1 year at

an 8% nominal rate.
 Interest may be set under one of the
following scenarios:
 Simple annual interest
 Installment loan, add-on, 12 months

17-29
Simple Annual Interest

 Simple interest means no discount or add-on.

Interest = 0.08($100,000) = $8,000
rNOM = EAR = $8,000/$100,000 = 8.0%
 For a 1-year simple interest loan, rNOM = EAR.

17-30
Add-on Interest

 Interest = 0.08 ($100,000) = $8,000

 Face amount = $100,000 + $8,000 = $108,000
 Monthly payment = $108,000/12 = $9,000
 Avg loan outstanding = $100,000/2 = $50,000
 Approximate annual rate or cost =
$8,000/$50,000 = 16.0%
 To find the appropriate effective rate, recognize
that the firm receives $100,000 and must make
monthly payments of $9,000 (like an annuity).17-31
Add-on Interest

From the calculator output below, we have:

rNOM = 12 (0.012043)
= 0.1445 = 14.45%
EAR = (1.012043)12 – 1 = 15.45%

INPUTS 12 100 -9 0

N I/YR PV PMT FV

OUTPUT 1.2043

17-32
EXERCISE:

Purchases = $8,000,000; terms = 3/5 net 60; currently

pays on Day 5 and takes discounts.
 Forgoes discounts; additional credit = ?
$8,000,000/365  55 days = $1,205,479.45.
 Nominal cost of trade credit = = 3.09%  6.6364 =
20.52%.
 Effective cost of trade credit = (1 + 3/97)365/55 – 1 =
1.2240 – 1 = 22.40%.
Bank loan: 10%, interest paid monthly
 EAR = (1 + 0.10/12)12 – 1 = 1.1047 – 1 = 10.47%.
 Because the effective cost of the bank loan is less than
half the effective cost of the trade credit, the bank loan
should be used. 17-33
Commercial Paper

 Unsecured, short-term promissory notes of

large firms, usually issued in denominations of
$ 100,000 or more with an interest rate below
the prime rate
 Generally unsecured but “asset-backed paper”,
and secured by short-term and long-term
loans.

17-34
Accruals (Accrued Liabilities)

 Continually recurring short-term liabilities

 A result of incurred cost of operations not yet
paid within a period
 A spontaneous funds generated as the firm
expands

17-35
Securities in Short-Term Financing

Secured Loan = a loan backed by collaterals

Types of Collaterals
 Accounts Receivable
 Inventories
 Stocks
 Bonds
 Equipment
 Land

17-36