Short Term Financing and

Working Capital
Management
Trade Credit
Inventory Management
Cash Management

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Why study trade credit and inventory
management
• ON MARCH 11, 2011, a devastating tsunami hit Japan.
• While business problems in the immediate area were to be expected,
they actually extended much further.
• For example, on March 17, General Motors announced that it would
shut down its plant in Shreveport, Louisiana, because of a parts
shortage caused by the tsunami.

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• Other carmakers experienced similar problems. Nissan announced that
it would shut down four plants in North America for several weeks
because of parts shortages, and Honda announced that it would cut
shifts at its seven North American plants from eight hours to four
hours to conserve parts.
• As these examples show, inventory shortages of things like key parts
can cause major problems for businesses, but companies also dislike
carrying excessive inventory levels for a variety of reasons.

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Why do firms grant credit?
• Offering credit is a way of stimulating sales.
• The costs associated with granting credit are significant.
• First, there is the chance that the customer will not pay.
• Second, the firm has to bear the costs of carrying the receivables.
• The credit policy decision thus involves a trade-off between the
benefits of increased sales and the costs of granting credit.

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• From an accounting perspective, when credit is granted, an account
receivable is created.
• Such receivables include credit to other firms, called trade credit, and
credit granted to consumers, called consumer credit.

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Components of Credit Policy
1. Terms of sale: If the firm does grant credit to a customer, the terms
of sale will specify (perhaps implicitly) the credit period, the cash
discount and discount period, and the type of credit instrument.
2. Credit analysis: In granting credit, a firm determines how much
effort it needs to expend, trying to distinguish between customers
who will pay and those who will not.
3. Collection policy: After credit has been granted, the firm has the
potential problem of collecting the cash, for which it must establish
a collection policy.

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Timeline of Cash Flows from Granting Credit

7
The Investment in Receivables
• Any firm's investment in accounts receivable depends on the amount
of credit sales and the average collection period.
• For example, if a firm’s average collection period, ACP, is 30 days,
then, at any given time, there will be 30 days’ worth of sales
outstanding.
• If credit sales run $1,000 per day, the firm’s accounts receivable will
then be equal to 30 days * $1,000 per day = $30,000, on average.

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Terms of the Sale
• The terms of a sale are made up of three distinct elements:
1. The period for which credit is granted (the credit period).
2. The cash discount and the discount period.
3. The type of credit instrument.

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The Basic Form
• The easiest way to understand the terms of sale is to consider the
below example.
2/10, net 60.

• This means that customers have 60 days from the invoice date to pay
the full amount; however, if payment is made within 10 days, a 2
percent cash discount can be taken.

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• Consider a buyer who places an order for $1,000 and assume that the
terms of the sale are 2/10, net 60.
• What is the amount the buyer will pay in the first 10 days?
• The buyer can pay $1,000 * (1 - .02) = $980 in 10 days or $1,000 in
60 days.
• If the terms are stated as just net 30, the customer has 30 days from the
invoice date to pay the entire $1,000, and no discount is offered for
early payment.

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The Credit Period
• The credit period is the basic length of time for which credit is
granted.
• For example, with 2/10, net 30, the net credit period is 30 days, and
the cash discount period is 10 days.

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The Invoice
• The invoice date is the beginning of the credit period.
• An invoice is a written account of merchandise shipped to the buyer.
• For individual items, by convention, the invoice date is usually the
shipping or billing date, not the date on which the buyer receives the
goods or the bill.
• Many other arrangements exist. For example, the terms of sale might
be ROG (Receipt of Goods). In this case, the credit period starts
when the customer receives the order. This might be used when the
customer is in a remote location.

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• With EOM dating, all sales made during a particular month are
assumed to be made at the end of that month. This is useful when a
buyer makes purchases throughout the month but the seller bills only
once a month.
• For example, 2/10th, EOM tells the buyer to take a 2 percent discount
if payment is made by the 10th of the month; otherwise, the full
amount is due.
• MOM, for middle of month, is another variation.

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Cost of the Credit
• Suppose the order is for $1,000. The buyer can pay $980 in 10 days or
wait another 20 days and pay $1,000. It’s obvious that the buyer is
effectively borrowing $980 for 20 days and that the buyer pays $20 in
interest on the “loan.”
• What’s the interest rate? In other words, what is the effective rate?

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• 44.59%

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The Cash Discount and the ACP
• Cash discount encourages customers to pay early,
• shorten the receivables period
• reduce the firm’s investment in receivables.
• For example, suppose a firm currently has terms of net 30 and an
average collection period (ACP) of 30 days.
• If it offers terms of 2/10, net 30, then 50 percent of its customers (in
terms of volume of purchases) pay in 10 days. The remaining
customers take an average of 30 days to pay. What will the new ACP
be? If the firm’s annual sales are $15 million (before discounts), what
will happen to the investment in receivables?
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• If half of the customers take 10 days to pay and half take 30, then the
new average collection period will be:

• New ACP = .50 * 10 days + .50 * 30 days = 20 days

• The ACP thus falls from 30 days to 20 days. Average daily sales are
$15 million/365 = $41,096 per day.
• Receivables will thus fall by $41,096 * 10 = $410,960.

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Credit Policy Effects
• Revenue Effects
• Delay in receiving cash from sales
• May be able to increase the price
• May increase total sales
• Cost Effects
• The cost of the sale is still incurred even though the cash from the sale
has not been received
• Cost of debt – must finance receivables
• Probability of nonpayment – some percentage of customers will not
pay for products purchased
• Cash discount – some customers will pay early and pay less than the
full sales price
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Total Cost of Granting Credit
• Carrying costs
• Required return on receivables
• Losses from bad debts
• Costs of managing credit and collections
• Shortage costs
• Lost sales due to a restrictive credit policy
• Total cost curve
• Sum of carrying costs and shortage costs
• Optimal credit policy is where the total cost curve is minimized

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The Costs of
Granting
Credit

21
Inventory Management

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• Inventory can be a large percentage of a firm’s assets
• There can be significant costs associated with carrying too much
inventory
• There can also be significant costs associated with not carrying
enough inventory
• Inventory management tries to find the optimal trade-off between
carrying too much inventory versus not enough

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Inventory Costs
• Carrying costs – range from 20 – 40% of inventory value per year
• Storage and tracking
• Insurance and taxes
• Losses due to obsolescence, deterioration, or theft
• The opportunity cost of capital
• Shortage costs
• Restocking costs
• Lost sales or lost customers
• Consider both types of costs and minimize the total cost

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Inventory Management Techniques
• The ABC approach
• The Economic Order Quantity model

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ABC approach
• The ABC approach is a simple approach to inventory management in
which the basic idea is to divide inventory into three (or more) groups.
• Most to least important.
• Classify inventory by cost, demand, and need
• Those items that have substantial shortage costs should be maintained
in larger quantities than those with lower shortage costs
• Generally, maintain smaller quantities of expensive items
• Maintain a substantial supply of less expensive basic materials

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27
The Economic Order Quantity Model
• The EOQ model minimizes the total inventory cost

• Total carrying cost =

(average inventory) x (carrying cost per unit) = (Q/2)(CC)

• Total restocking cost = (fixed cost per order) x (number of orders)

= F(T/Q)
• T is the total sales
• Q is the quantity ordered
• CC is carrying cost per unit
• F is fixed cost per order
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• Total Cost = Total carrying
cost + total restocking cost
= (Q/2)(CC) + F(T/Q)
• T is the total sales
• Q is the quantity ordered
• CC is carrying cost per unit
• F is the fixed cost per order
• At EOQ, total carrying cost
and total restocking cost are
equal

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 2TF
• The minimum quantity to order, Q*: Q 
*

• T is the total sales CC

• Q is the quantity ordered
• CC is carrying cost per unit
• F is the fixed cost per order

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Question
• Thiewes Shoes begins each period with 100 pairs of hiking boots in
stock. This stock is depleted each period and reordered. The carrying
cost per pair of boots per year is $3. Thiewes sells a total of 600 pairs of
boots in a year. The restocking cost is $20 per order.
• Calculate
• The total carrying costs for the hiking boots
• The number of times per year does Thiewes restock
• The total restocking costs?
• What size orders should Thiewes place to minimize costs? Then, find
out how often Thiewes will restock. What are the total carrying and
restocking costs? The total costs?
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• Inventories always start at 100 items and end up at zero, so average
inventory is 50 items. At an annual cost of $3 per item, total carrying
costs are $150.
• Total carrying cost =
(average inventory) x (carrying cost per unit) = (Q/2)(CC)
• (100/2)*(3) = $150

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• Thiewes orders 100 items each time. Total sales are 600 items per
year, so Thiewes restocks six times per year or about once every two
months. The restocking costs would be 6 orders * $20 per order =
$120.
• Total restocking cost = (fixed cost per order) x (number of orders)
= F*(T/Q)
• 20*(600/100)=$120

• Total Cost = Total carrying cost + total restocking cost

• 150+120=$270
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• The total number of pairs of boots ordered for the year (T) is 600. The
restocking cost (F) is $20 per order, and the carrying cost (CC) is $3.
We can calculate the EOQ for Thiewes as follows:

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• Because Thiewes sells 600 pairs per year, it will restock 600/89.44 =
6.71 times. The total restocking costs will be $20 * 6.71 = $134.16.
Average inventory will be 89.44/2 = 44.72. The carrying costs will be
$3 * 44.72 = $134.16, the same as the restocking costs.

• Total Cost = Total carrying cost + total restocking cost

• The total costs are thus $268.33.

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Cash Management

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Cash Management
• Cash management is concerned with the management of:
1. cash flows into and out of the firm,
2. cash flows within the firm, and
3. cash balances held by the firm at a point in time by financing
deficit or investing surplus cash.

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Cash management cycle

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• The firm should evolve strategies regarding the following four facets
of cash management:
1. Cash planning: By meticulously planning cash inflows and
outflows, the firm can confidently project cash surplus or deficit for
each period. This is where a cash budget comes into play, providing
a clear roadmap for effective cash management.
2. Managing the cash flows: The firm can exercise its financial
control by accelerating cash inflows and strategically decelerating
cash outflows.

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3. Optimum cash level: The firm's financial security lies in its ability
to decide on the appropriate level of cash balances. By carefully
weighing the cost of excess cash against the danger of cash
deficiency, the firm can determine the optimum level of cash
balances, ensuring a stable financial position.
4. Investing surplus cash: The surplus cash balances should be
invested to earn profits
• The ideal cash management system will depend on the firm’s products,
organisation structure, competition, culture, and available options.

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