Chapter 14

Working Capital
and Current
Assets
Management
Learning Goals

LG1 Understand working capital management, net

working capital, and the related trade-off
between profitability and risk.

LG2 Describe the cash conversion cycle, its funding

requirements, and the key strategies for
managing it.

LG3 Discuss inventory management: differing views,

common techniques, and international
concerns.

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Learning Goals

LG4 Explain the credit selection process and the

quantitative procedure for evaluating changes in
credit standards.

LG5 Review the procedures for quantitatively

considering cash discount changes, other
aspects of credit terms, and credit monitoring.

LG6 Understand the management of receipts and

disbursements, including float, speeding up
collections, slowing down payments, cash
concentration, zero-balance accounts, and
investing in marketable securities.

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Net Working Capital Fundamentals:
Working Capital Management

Working capital (or short-term financial)

management is the management of current assets
and current liabilities.
– Current assets include inventory, accounts receivable,
marketable securities, and cash.
– Current liabilities include notes payable, accruals, and
accounts payable.
– Firms are able to reduce financing costs or increase the
funds available for expansion by minimizing the amount of
funds tied up in working capital.

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Matter of Fact

CFOs Value Working Capital Management

– A survey of CFOs from firms around the world suggests
that working capital management is at the top of the list of
most valued finance functions.
– Among 19 different finance functions, CFOs surveyed
viewed working capital management as equally important
as capital structure, debt issuance and management, bank
relationships, and tax management.
– CFOs viewed the performance of working capital
management as only being better than the performance of
pension management.
– Consistent with their view that working capital
management is a high value but low satisfaction activity, it
was identified as the finance function second most in need
of additional resources.

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Net Working Capital Fundamentals:
Net Working Capital

• Working capital refers to current assets, which

represent the portion of investment that circulates
from one form to another in the ordinary conduct of
business.
• Net working capital is the difference between the
firm’s current assets and its current liabilities; can
be positive or negative.

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Net Working Capital Fundamentals:
Trade-off between Profitability and Risk

• Profitability is the relationship between revenues

and costs generated by using the firm’s assets—
both current and fixed—in productive activities.
– A firm can increase its profits by (1) increasing revenues
or (2) decreasing costs.
• Risk (of insolvency) is the probability that a firm
will be unable to pay its bills as they come due.
– A firm that is insolvent is unable to pay its bills as they
come due.

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Table 14.1 Effects of Changing Ratios on
Profits and Risk

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Figure 14.1 Yearly Medians for All U.S.-
Listed Manufacturing Companies

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Cash Conversion Cycle

The cash conversion cycle (CCC) is the

length of time required for a company to
convert cash invested in its operations to cash
received as a result of its operations.

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Cash Conversion Cycle:
Calculating the Cash Conversion Cycle

• A firm’s operating cycle (OC) is the time from the

beginning of the production process to collection of
cash from the sale of the finished product.
• It is measured in elapsed time by summing the
average age of inventory (AAI) and the average
collection period (ACP).

OC = AAI + ACP

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Cash Conversion Cycle:
Calculating the Cash Conversion Cycle

• 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.
• The time it takes to pay the accounts payable,
measured in days, is the average payment period
(APP). The operating cycle less the average
payment period yields the cash conversion cycle.
The formula for the cash conversion cycle is:

CCC = OC – APP

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Cash Conversion Cycle:
Calculating the Cash Conversion Cycle

Substituting for OC, we can see that the cash

conversion cycle has three main components, as
shown in the following equation: (1) average age of
the inventory, (2) average collection period, and (3)
average payment period.

CCC = AAI + ACP – APP

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Figure 14.2 Timeline for Whirlpool’s Cash
Conversion Cycle
In its 2012 annual report, Whirlpool Corporation
reported that it had revenues of $18.1 billion, cost of
goods sold of $15.2 billion, accounts receivable of $2.0
billion, and inventory of $2.4 billion.

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Cash Conversion Cycle: Calculating the
Cash Conversion Cycle

The resources Whirlpool had invested in this cash conversion

cycle (assuming a 365-day year) were:
Inventory = $15.2 billion x (58/365) = $2.4
+ Accounts receivable = 18.1 billion x (40/365) =
2.0
- Accounts payable = 15.2 billion x (89/365) =
3.7
= Resources invested =
$0.7

With roughly $700 million committed to working capital,

Whirlpool was surely motivated to make improvements.

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Matter of Fact

Increasing speed lowers working capital

– A firm can lower its working capital if it can
speed up its operating cycle.
– For example, if a firm accepts bank credit (like a
Visa card), it will receive cash sooner after the
sale is transacted than if it has to wait until the
customer pays its accounts receivable.

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Cash Conversion Cycle: Funding
Requirements of the Cash Conversion Cycle

• A permanent funding requirement is a constant

investment in operating assets resulting from
constant sales over time.
• A seasonal funding requirement is an
investment in operating assets that varies over time
as a result of cyclic sales.

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Cash Conversion Cycle: Funding Requirements of
the Cash Conversion Cycle

Nicholson Company holds, on average, $50,000 in

cash and marketable securities, $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 permanent. 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 + $1,250,000 + $750,000 -
$425,000). That amount would also equal its
permanent funding requirement.

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Cash Conversion Cycle: Funding Requirements of
the Cash Conversion Cycle

Semper Pump Company has seasonal funding needs.

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. Accounts
payable remain at $50,000.
Permanent fundingmin = $25,000 + $100,000 + $60,000 - $50,000
= $135,000
Seasonal fundingmax = ($25,000 + $750,000 + $400,000 -
$50,000) - $135,000 = $990,000.
Total funding varies from $135,000 to $1,125,000
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Figure 14.3 Semper Pump Company’s
Total Funding Requirements

Semper Pump Company has seasonal funding needs. Semper

has seasonal sales, with its peak sales being driven by the
summertime purchases of bicycle pumps.

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Cash Conversion Cycle: Aggressive versus
Conservative Seasonal Funding Strategies

An aggressive funding strategy is a funding

strategy under which the firm funds its seasonal
requirements with short-term debt and its permanent
requirements with long-term debt.
A conservative funding strategy is a funding
strategy under which the firm funds both its seasonal
and its permanent requirements with long-term debt.

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 Cash Conversion Cycle: Aggressive versus
Conservative Seasonal Funding Strategies

Semper Pump Company has a permanent funding requirement

of $135,000 in 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 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 balances = 0.0500  0 = 0
Total cost of aggressive strategy = $17,128.13

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Cash Conversion Cycle: Aggressive versus
Conservative Seasonal Funding Strategies

Alternatively, Semper can choose a conservative strategy,

under which surplus cash balances are fully invested. (In Figure
14.3, this surplus will be the difference 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 balances = 0.0500  888,750 = 44,437.50
Total cost of conservative = $45,562.50
strategy

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Cash Conversion Cycle: Strategies for
Managing the Cash Conversion Cycle

The goal is to minimize the length of the cash

conversion cycle, which minimizes negotiated
liabilities. This goal can be realized through use 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.

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Inventory Management

Differing viewpoints about appropriate inventory

levels commonly exist among a firm’s finance,
marketing, manufacturing, and purchasing managers.
– 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 marketing manager, on the other hand, would like to
have large inventories of the firm’s finished products.
– The manufacturing manager’s major responsibility is to
implement the production plan so that it results in the
desired amount of finished goods of acceptable quality
available on time at a low cost.
– The purchasing manager is concerned solely with the raw
materials inventories.

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Inventory Management: Common
Techniques for Managing Inventory

The ABC inventory system is an inventory

management technique that divides inventory into
three groups—A, B, and C, in descending order of
importance and level of monitoring, on the basis of
the dollar investment in each.
– The A group includes those items with the largest dollar
investment. Typically, this group consists of 20 percent of
the firm’s inventory items but 80 percent of its investment
in inventory.
– The B group consists of items that account for the next
largest investment in inventory.
– The C group consists of a large number of items that
require a relatively small investment.

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Inventory Management: Common
Techniques for Managing Inventory

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 that
allows daily verification of each item’s inventory level.
– B group items are frequently controlled through periodic,
perhaps weekly, checking of their levels.
– C group items are monitored with unsophisticated
techniques, such as the two-bin method; an
unsophisticated inventory-monitoring technique that
involves reordering inventory when one of two bins is
empty.

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Inventory Management: Common
Techniques for Managing Inventory

The large dollar investment in A and B group items

suggests the need for a better method of inventory
management than the ABC system.

The Economic Order Quantity (EOQ) Model is an

inventory management technique for determining an
item’s optimal order size, which is the size that
minimizes the total of its order costs and carrying
costs.
– The EOQ model is an appropriate model for the
management of A and B group items.

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Inventory Management: Common
Techniques for Managing Inventory

EOQ assumes that the relevant costs of inventory can

be divided into order costs and carrying costs.
– Order costs are the fixed clerical costs of placing and
receiving an inventory order.
– Carrying costs are the variable costs per unit of holding
an item in inventory for a specific period of time.
The EOQ model analyzes the tradeoff between order
costs and carrying costs to determine the order
quantity that minimizes the total inventory cost.

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Inventory Management: Common
Techniques for Managing Inventory

A formula can be developed for determining 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 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
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Inventory Management: Common
Techniques for Managing Inventory

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
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
The firm’s total cost of inventory is found by summing
the order cost and the carrying cost. Thus the total
cost function is
Total cost = (O  S/Q) + (C  Q/2)

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Inventory Management: Common
Techniques for Managing Inventory

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. EOQ occurs where
order cost = carrying cost. The resulting equation is

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Inventory Management: Common
Techniques for Managing Inventory

The reorder point is the point at which to reorder

inventory, expressed as days of lead time  daily
usage.

Because lead times and usage rates are not precise,

most firms hold safety stock—extra inventory that is
held to prevent stockouts of important items.

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Inventory Management: Common
Techniques for Managing Inventory

MAX Company, a producer of dinnerware, has an A group

inventory item that is vital to the production 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
– Thus,

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Inventory Management: Common
Techniques for Managing Inventory

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.

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Inventory Management: Common
Techniques for Managing Inventory

A just-in-time (JIT) system is an inventory

management technique that minimizes inventory
investment by having materials arrive at exactly the
time they are needed for production.
– Because its objective is to minimize inventory investment,
a JIT system uses no (or very little) safety stock.
– Extensive coordination among the firm’s employees, its
suppliers, 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.

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Focus on Practice

RFID: The Wave of the Future

– Wal-Mart began to use radio frequency identification
(RFID) technology to improve its inventory management in
2004, but the high cost of the tags has slowed its
implementation.
– Wal-Mart will then share the benefits and best practices
with its suppliers, which might want to achieve the same
benefits from the technology.

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Inventory Management: Computerized
Systems for Resource Control

A materials requirement planning (MRP) system

is an inventory management technique that applies
EOQ concepts and a computer to compare production
needs to available inventory balances and determine
when orders should be placed for various items on a
product’s bill of materials.
Manufacturing resource planning II (MRP II) is a
sophisticated computerized system that integrates
data from numerous areas such as finance,
accounting, marketing, engineering, and
manufacturing and generates production plans as well
as numerous financial and management reports.

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Inventory Management: Computerized
Systems for Resource Control

Enterprise resource planning (ERP) is a

computerized system that electronically integrates
external information about the firm’s suppliers and
customers with the firm’s departmental data so that
information on all available resources—human and
material—can be instantly obtained in a fashion that
eliminates production delays and controls costs.

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Accounts Receivable Management

The second component of the cash conversion cycle is the

average collection period. The average collection period
has two parts:
1. The time from the sale until the customer mails the
payment.
2. The time from when the payment is mailed until the firm
has the collected funds in its bank account.
The objective for managing accounts receivable is to collect
accounts receivable as quickly as possible without losing
sales from high-pressure collection techniques.
Accomplishing this goal encompasses three topics:
3. credit selection and standards
4. credit terms
5. credit monitoring.

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Accounts Receivable Management:
Credit Selection and Standards

Credit standards are a firm’s minimum requirements

for extending credit to a customer.
The five C’s of credit are as follows:
1. Character: The applicant’s record of meeting past
obligations.
2. Capacity: The applicant’s ability to repay the requested
credit.
3. Capital: The applicant’s debt relative to equity.
4. Collateral: The amount of assets the applicant has
available for use in securing the credit.
5. Conditions: Current general and industry-specific
economic conditions, and any unique conditions
surrounding a specific transaction.

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Accounts Receivable Management:
Credit Selection and Standards

Credit scoring is a credit selection method

commonly used with high-volume/small-dollar credit
requests; relies on a credit score determined by
applying statistically derived weights to a credit
applicant’s scores on key financial and credit
characteristics.

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Accounts Receivable Management:
Credit Selection and Standards

The firm sometimes will contemplate changing its

credit standards in an effort to improve its returns
and create greater value for its owners. To
demonstrate, consider the following changes and
effects on profits expected to result from the
relaxation of credit standards.

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Accounts Receivable Management:
Credit Selection and Standards
Dodd Tool is currently selling a product for $10 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,[Link] 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
(the 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%.
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Accounts Receivable Management:
Credit Selection and Standards

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).

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Accounts Receivable Management:
Credit Selection and Standards

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:

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Accounts Receivable Management:
Credit Selection and Standards

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 365 (the number of
days assumed in a year).

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Accounts Receivable Management:
Credit Selection and Standards
Turnover of accounts receivable

– Under present plan: (365/30) = 12.2

– Under proposed plan: (365/45) = 8.1
By substituting the cost and turnover data just
calculated into the average investment in accounts
receivable equation for each case, we get the
following average investments in accounts receivable:

– Under present plan: ($360,000/12.2) = $29,508

– Under proposed plan: ($378,000/8.1) = $46,667

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Accounts Receivable Management:
Credit Selection and Standards

Cost of marginal investment in accounts receivable

Average investment under proposed plan $46,667

– Average investment under present plan 29,508
Marginal investment in accounts receivable $17,159
 Required return on investment 0.15
Cost of marginal investment in A/R $ 2,574

The resulting value of $2,574 is considered a cost because it

represents the maximum amount that could have been earned
on the $17,159 had it been placed in the best equal-risk
investment alternative available at the firm’s required return on
investment of 15%.

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Accounts Receivable Management:
Credit Selection and Standards

Cost of marginal bad debts

Proposed plan: (0.02  $10/unit  63,000 units) = $12,600

Present plan: (0.01  $10/unit  60,000 units) =

6,000
Cost of marginal bad debts $ 6,600

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Table 14.2 Effects on Dodd Tool of a
Relaxation in Credit Standards
The net addition to total profits resulting from relaxing credit
standards would be $2,826 per year. Therefore, Dodd Tool
should relax its credit standards.

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Accounts Receivable Management:
Credit Selection and Standards

Credit management is difficult enough for managers

of purely domestic companies, and these tasks
become much more complex for companies that
operate internationally.
– This is partly because international operations typically
expose a firm to exchange rate risk.
– It is also due to the dangers and delays involved in
shipping goods long distances and in having to cross at
least two international borders.

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Accounts Receivable Management:
Credit Terms

Credit terms are the terms of sale for customers

who have been extended credit by the firm.
A cash discount is a percentage deduction from the
purchase price; available to the credit customer who
pays its account within a specified time.
– For example, terms of 2/10 net 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.

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Accounts Receivable Management:
Credit Terms
MAX Company has annual sales of $10 million and an average
collection period of 40 days (turnover = 365/40 = 9.1). 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 payments 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 = 365/25 = 14.6).
Should MAX institute the change?

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Table 14.3 Analysis of Initiating a Cash
Discount for MAX Company

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Accounts Receivable Management:
Credit Terms
A cash discount period is the number of days after
the beginning of the credit period during which the
cash discount is available.
The net effect of changes in this period is difficult to
analyze because of the nature of the forces involved.

– For example, if a firm were to 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.

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Accounts Receivable Management:
Credit Terms

The credit period is the number of days after the

beginning of the credit period until full payment of the
account is due.
Changes in the credit period, the number of days
after the beginning of the credit period until full
payment of the account is due, also affect a firm’s
profitability.
– For example, increasing a firm’s credit period from net 30
days to net 45 days should increase sales, positively
affecting profit. But both the investment in accounts
receivable and bad-debt expenses would also increase,
negatively affecting profit.

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Accounts Receivable Management:
Credit Terms

Credit monitoring is the ongoing review of a firm’s

accounts receivable to determine whether customers
are paying according to the stated credit terms.
– If they are not paying in a timely manner, credit
monitoring will alert the firm to the problem.
– Slow payments are costly to a firm because they lengthen
the average collection period and thus increase the firm’s
investment in accounts receivable.
– Two frequently used techniques for credit monitoring are
average collection period and aging of accounts receivable.

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Accounts Receivable Management:
Credit Terms
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:

Assuming receipt, processing, and collection time is

constant, the average collection period tells the firm,
on average, when its customers pay their accounts.

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Accounts Receivable Management:
Credit Terms
An aging schedule is a credit-monitoring technique
that breaks down accounts receivable into groups on
the basis of their time of origin; it indicates the
percentages of the total accounts receivable balance
that have been outstanding for specified periods of
time.

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Accounts Receivable Management:
Credit Terms

To gain insight into the firm’s relatively lengthy—51.3-

day—average collection period, Dodd prepared the
following aging schedule.

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Table 14.4
Popular Collection Techniques

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Management of Receipts and
Disbursements
The third component of the cash conversion cycle is
the average payment period. The average payment
period has two parts:
1. The time from purchase of goods on account until the firm
mails its payment.
2. The receipt, processing, and collection time required by
the firm’s suppliers.

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Management of Receipts and
Disbursements: Float

Float refers to funds that have been sent by the

payer but are not yet usable funds to the payee. Float
has three component parts:
1. Mail float is the time delay between when payment is
placed in the mail and when it is received.
2. Processing float is the time between receipt of a
payment and its deposit into the firm’s account.
3. Clearing float is the time between deposit of a payment
and when spendable funds become available to the firm.

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Management of Receipts and
Disbursements: 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.
• A popular technique for speeding up collections is a
lockbox system, which is a collection procedure
in which customers mail payments to a post office
box that is emptied regularly by the firm’s bank,
which processes the payments and deposits them
in the firm’s account. This system speeds up
collection time by reducing processing time as well
as mail and clearing time.

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Management of Receipts and
Disbursements: Slowing Down Payments

• Float is also a component of the firm’s average

payment period.
• Controlled disbursing is the strategic use of
mailing points and bank accounts to lengthen mail
float and clearing float, respectively.

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Matter of fact

• U.S.P.S. Problems Create Opportunities for Banks

– For decades, the United States Postal Service has been
struggling financially.
– In 2012, the USPS announced that to cut costs it would
dramatically reduce the number of mail processing facilities
that it operated.
– For companies, this meant an increase in mail float.
– For Fifth Third Bank, it was an opportunity. The bank
announced a new remote lockbox capture program in
which business-to-business payments would be retrieved
at local post offices around the country.
– Next, Fifth Third would make electronic images of those
payments, and the images would be processed at the
bank’s Cincinnati processing hub.
– Fifth Third promised customers that it would reduce mail
float and speed up the collection process for its clients.

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Management of Receipts and
Disbursements: Cash Concentration
Cash concentration is the process used by the firm to
bring lockbox and other deposits together into one bank,
often called the concentration bank. Cash concentration
has three main advantages.
1. First, it creates a large pool of funds for use in making short-term
cash investments. Because there is a fixed-cost component 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.
2. Second, concentrating the firm’s cash in one account improves the
tracking and internal control of the firm’s cash.
3. Third, having one concentration bank enables the firm to implement
payment strategies that reduce idle cash balances.

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Management of Receipts and Disbursements:
Cash Concentration

• A depository transfer check (DTC) is an

unsigned check drawn on one of a firm’s bank
accounts and deposited in another.
• An ACH (automated clearinghouse) transfer is
a preauthorized electronic withdrawal from the
payer’s account and deposit into the payee’s
account via a settlement among banks by the
automated clearinghouse, or ACH.
• A wire transfer is an electronic communication
that, via bookkeeping entries, removes funds from
the payer’s bank and deposits them in the payee’s
bank.

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Management of Receipts and
Disbursements: Zero-Balance Accounts

A zero-balance account (ZBA) is a disbursement

account that always has an end-of-day balance of
zero because the firm deposits money to cover checks
drawn on the account only as they are presented for
payment each day.

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Personal Finance Example

Megan Laurie, a 25-year-old nurse, works at a

hospital that pays her every 2 weeks by direct deposit
into her checking account, which pays no interest and
has no minimum balance requirement. She takes
home about $1,800 every 2 weeks—or about $3,600
per month. She maintains a checking account balance
of around $1,500. Whenever it exceeds that amount
she transfers the excess into her savings account,
which currently pays 1.5% annual interest. She
currently has a savings account balance of $17,000
and estimates that she transfers about $600 per
month from her checking account into her savings
account.

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Personal Finance Example

Megan pays her bills immediately when she receives

them. Her monthly bills average about $1,900, and
her monthly cash outlays for food and gas total about
$900. An analysis of Megan’s bill payments indicates
that on average she pays her bills 8 days early. Most
marketable securities are currently yielding about
4.2% annual interest. Megan is interested in learning
how she might better manage her cash balances.

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Personal Finance Example

Megan talks with her sister, who has had a finance

course, and they come up with three ways for Megan
to better manage her cash balance:
1. Invest current balances.
2. Invest monthly surpluses.

3. Slow down payments.

Based on these three recommendations, Megan would
increase her annual earnings by a total of about $673
($460 + $192 + $21). Clearly, Megan can grow her
earnings by better managing her cash balances.

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Table 14.5a Features of Popular
Marketable Securities

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Table 14.5b Features of Popular
Marketable Securities

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Review of Learning Goals

LG1 Understand working capital management, net

working capital, and the related trade-off
between profitability and risk.
Working capital management focuses on managing each of
the firm’s current assets and current liabilities in a manner
that positively contributes to the firm’s value. Net working
capital is the difference between current assets and current
liabilities. Risk, in the context of short-term financial
decisions, is the probability that a firm will be unable to pay
its bills as they come due. Assuming a constant level of total
assets, the higher a firm’s ratio of current assets to total
assets, the less profitable the firm, and the less risky it is.
The converse is also true. With constant total assets, the
higher a firm’s ratio of current liabilities to total assets, the
more profitable and the more risky the firm is. The converse
of this statement is also true.

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Review of Learning Goals
LG2 Describe the cash conversion cycle, its funding
requirements, and the key strategies for
managing it.
The cash conversion cycle has three components: (1)
average age of inventory, (2) average collection period, and
(3) average payment period. The length of the cash
conversion cycle determines the amount of time resources
are tied up in the firm’s day-to-day operations. The firm’s
funding decision for its cash conversion cycle ultimately
depends on management’s disposition toward risk and the
strength of the firm’s banking relationships. To minimize its
reliance on negotiated liabilities, the financial manager seeks
to (1) turn over inventory as quickly as possible, (2) collect
accounts receivable as quickly as possible, (3) manage mail,
processing, and clearing time, and (4) pay accounts payable
as slowly as possible. Use of these strategies should
minimize the length of the cash conversion cycle.

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Review of Learning Goals

LG3 Discuss inventory management: differing views,

common techniques, and international
concerns.
The viewpoints of marketing, manufacturing, and purchasing
managers about the appropriate levels of inventory tend to
cause higher inventories than those deemed appropriate by
the financial manager. Four commonly used techniques for
effectively managing inventory to keep its level low are (1)
the ABC system, (2) the economic order quantity (EOQ)
model, (3) the just-in-time (JIT) system, and (4)
computerized systems for resource control—MRP, MRP II, and
ERP. International inventory managers place greater
emphasis on making sure that sufficient quantities of
inventory are delivered where and when needed, and in the
right condition, than on ordering the economically optimal
quantities.

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Review of Learning Goals

LG4 Explain the credit selection process and the

quantitative procedure for evaluating changes in
credit standards.
Credit selection techniques determine which
customers’ creditworthiness is consistent with the
firm’s credit standards. Two popular credit selection
techniques are the five C’s of credit and credit scoring.
Changes in credit standards can be evaluated
mathematically by assessing the effects of a proposed
change on profits from sales, the cost of accounts
receivable investment, and bad-debt costs.

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Review of Learning Goals

LG5 Review the procedures for quantitatively

considering cash discount changes, other
aspects of credit terms, and credit monitoring.
Changes in credit terms—the cash discount, the cash
discount period, and the credit period—can be
quantified similarly to changes in credit standards.
Credit monitoring, the ongoing review of accounts
receivable, frequently involves use of the average
collection period and an aging schedule. Firms use a
number of popular collection techniques.

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Review of Learning Goals
LG6 Understand the management of receipts and
disbursements, including float, speeding up
collections, slowing down payments, cash
concentration, zero-balance accounts, and
investing in marketable securities.
Float refers to funds that have been sent by the payer but are not
yet usable funds to the payee. The components of float are mail
time, processing time, and clearing time. Float occurs in both the
average collection period and the average payment period. One
technique for speeding up collections is a lockbox system. A popular
technique for slowing payments is controlled disbursing.
The goal for managing operating cash is to balance the opportunity
cost of nonearning balances against the transaction cost of
temporary investments. Firms commonly use depository transfer
checks (DTCs), ACH transfers, and wire transfers to transfer lock box
receipts to their concentration banks quickly. Zero-balance accounts
(ZBAs) can be used to eliminate nonearning cash balances in
corporate checking accounts. Marketable securities are short-term,
interest-earning, money market instruments used by the firm to
earn a return on temporarily idle funds. They may be government or
nongovernment issues.

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Working Capital and Current Assets
Management

• Questions?

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