Working Capital and Current Assets Management

working capital (or short-term financial) management

Management of current assets and current liabilities.

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 viewed working capital management as equally important as capital structure, debt issuance and management, bank relationships, and tax management. Their satisfaction with the performance of working capital management was quite the opposite, however. CFOs viewed the performance of working capital management as being better only 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.¹

working capital

Current assets, which represent the portion of investment that circulates from one form to another in the ordinary conduct of business.

net working capital

The difference between the firm’s current assets and its current liabilities.

profitability

The relationship between revenues and costs generated by using the firm’s assets—both current and fixed—in productive activities.

risk (of insolvency)

The probability that a firm will be unable to pay its bills as they come due.

insolvent

Describes a firm that is unable to pay its bills as they come due.

Changes in Current Assets

We can demonstrate how changing the level of the firm’s current assets affects its profitability–risk trade-off by using the ratio of current assets to total assets. This ratio indicates the percentage of total assets that is current. For purposes of illustration, we will assume that the level of total assets remains unchanged. The effects on both profitability and risk of an increase or decrease in this ratio are summarized in the upper portion of Table 15.1. When the ratio increases—that is, when current assets increase—profitability decreases. Why? The answer is because current assets are less profitable than fixed assets. Fixed assets are more profitable because they add more value to the product than that provided by current assets.

The risk effect, however, decreases as the ratio of current assets to total assets increases. The increase in current assets increases net working capital, thereby reducing the risk of insolvency. In addition, as you go down the asset side of the balance sheet, the risk associated with the assets increases: Investment in cash and marketable securities is less risky than investment in accounts receivable, inventories, and fixed assets. Accounts receivable investment is less risky than investment in inventories and fixed assets. Investment in inventories is less risky than investment in fixed assets. The nearer an asset is to cash, the less risky it is. The opposite effects on profit and risk result from a decrease in the ratio of current assets to total assets.

In an effort to manage the risk effect, firms have been steadily moving away from riskier current asset components, such as inventory. Figure 15.1 shows that over time current assets consistently account for about 60 percent of total assets in U.S. manufacturing firms, but inventory levels are dropping dramatically. That current assets relative to total assets remains fairly constant while inventory investment is shrinking indicates that U.S. manufacturing firms are substituting less risky current assets for inventory, the riskiest current asset. Indeed, Figure 15.1 shows that cash levels are increasing relative to total assets.

Changes in Current Liabilities

We also can demonstrate how changing the level of the firm’s current liabilities affects its profitability–risk trade-off by using the ratio of current liabilities to total assets. This ratio indicates the percentage of total assets that has been financed with current liabilities. Again, assuming that total assets remain unchanged, the effects on both profitability and risk of an increase or decrease in the ratio are summarized in the lower portion of Table 15.1. When the ratio increases, profitability increases. Why? Here it is because the firm uses more of the less-expensive current liabilities financing and less long-term financing. Current liabilities are less expensive because only notes payable, which represent about 20 percent of the typical manufacturer’s current liabilities, have a cost. The other current liabilities are basically debts on which the firm pays no charge or interest. However, when the ratio of current liabilities to total assets increases, the risk of insolvency also increases because the increase in current liabilities in turn decreases net working capital. The opposite effects on profit and risk result from a decrease in the ratio of current liabilities to total assets.

operating cycle (OC)

The time from the beginning of the production process to collection of cash from the sale of the finished product.

OC = AAI + ACP

(15.1)

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.

CCC = OC − APP

(15.2)

CCC = AAI + ACP − APP

(15.3)

Example 15.1

My Finance Lab Solution Video

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. From this information (and assuming for simplicity that cost of goods sold equals purchases), we can determine that the company’s average age of inventory was 58 days, its average collection period was 40 days, and its average payment period was 89 days. Thus, the cash conversion cycle for Whirlpool was just 9 days (58 + 40 − 89). Figure 15.2 presents Whirlpool’s cash conversion cycle as a time line.

The resources Whirlpool had invested in this cash conversion cycle (assuming a 365-day year) were

With roughly $700 million committed to working capital, Whirlpool was surely motivated to make improvements. Changes in any of the component cycles will change the resources tied up in Whirlpool’s operations. For example, if Whirlpool could reduce its collection period from 40 days to 30 days, holding all else equal, its working capital requirement would fall by more than $500 million. It is clear why companies pay close attention to working capital management.

FIGURE 15.2 Time Line for Whirlpool’s Cash Conversion Cycle

Permanent versus Seasonal Funding Needs

If the firm’s sales are constant, its investment in operating assets should also be constant, and the firm will have only a permanent funding requirement. If the firm’s sales are cyclic, its investment in operating assets will vary over time with its sales cycles, and the firm will have seasonal funding requirements in addition to the permanent funding required for its minimum investment in operating assets.

Aggressive versus Conservative Seasonal Funding Strategies

Short-term funds are typically less expensive than long-term funds. That is, interest rates on short-term loans are typically lower than rates on long-term loans because the yield curve is typically upward sloping. However, long-term funds allow the firm to lock in its cost of funds over a period of time and thus avoid the risk of increases in short-term interest rates. Also, long-term funding ensures that the required funds are available to the firm when needed. Short-term funding exposes the firm to the risk that it may not be able to obtain the funds needed to cover its seasonal peaks. Under an aggressive funding strategy, the firm funds its seasonal requirements with short-term debt and its permanent requirements with long-term debt. Under a conservative funding strategy, the firm funds both its seasonal and its permanent requirements with long-term debt.

Clearly, the aggressive strategy’s heavy reliance on short-term financing makes it riskier than the conservative strategy because of interest rate swings and possible difficulties in obtaining needed short-term financing quickly when seasonal peaks occur. The conservative strategy avoids these risks through the locked-in interest rate and long-term financing, but it is more costly because of the negative spread between the earnings rate on surplus funds (5 percent in the example) and the cost of the long-term funds that create the surplus (8 percent in the example). Where the firm operates, between the extremes of the aggressive and conservative seasonal funding strategies, depends on management’s disposition toward risk and the strength of its banking relationships.

REVIEW QUESTIONS

ABC System

A firm using the ABC inventory system divides its inventory into three groups: A, B, and C. 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.

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. With the two-bin method, the item is stored in two bins. As an item is needed, inventory is removed from the first bin. When that bin is empty, an order is placed to refill the first bin while inventory is drawn from the second bin. The second bin is used until empty, and so on.

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 EOQ model, discussed next, is an appropriate model for the management of A and B group items.

Economic Order Quantity (EOQ) Model

One of the most common techniques for determining the optimal order size for inventory items is the economic order quantity (EOQ) model. The EOQ model considers various costs of inventory and then determines what order size minimizes total inventory cost.

EOQ assumes that the relevant costs of inventory can be divided into order costs and carrying costs. (The model excludes the actual cost of the inventory item.) Each of them has certain key components and characteristics. Order costs include the fixed clerical costs of placing and receiving orders: the cost of writing a purchase order, of processing the resulting paperwork, and of receiving an order and checking it against the invoice. Order costs are stated in dollars per order. Carrying costs are the variable costs per unit of holding an item of inventory for a specific period of time. Carrying costs include storage costs, insurance costs, the costs of deterioration and obsolescence, and the opportunity or financial cost of having funds invested in inventory. These costs are stated in dollars per unit per period.

Order costs decrease as the size of the order increases. Carrying costs, however, increase with increases in the order size. The EOQ model analyzes the tradeoff between order costs and carrying costs to determine the order quantity that minimizes the total inventory cost.

Mathematical Development of EOQ A formula can be developed for determining the firm’s EOQ for a given inventory item, where

The first step is to derive the cost functions for order cost and carrying cost. 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:

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

The firm’s total cost of inventory is found by summing the order cost and the carrying cost. Thus, the total cost function is

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.² The resulting equation is

Although the EOQ model has weaknesses, it is certainly better than subjective decision making. Even though the use of the EOQ model is outside the control of the financial manager, the financial manager must be aware of its utility and must provide certain inputs, specifically with respect to inventory carrying costs.

2. In this simple model, the EOQ occurs at the point where the order cost [O × (S ÷ Q)] just equals the carrying cost [C × (Q ÷ 2)]. To demonstrate, we set the two costs equal and solve for Q:

[O × (S ÷ Q)] = [C × (Q ÷ 2)]

Then cross-multiplying, we get

2 × O × S = C × Q²

Dividing both sides by C, we get

Q² = (2 × O × S) ÷ C

so

Reorder Point Once the firm has determined its economic order quantity, it must determine when to place an order. The reorder point reflects the number of days of lead time the firm needs to place and receive an order and the firm’s daily usage of the inventory item. Assuming that inventory is used at a constant rate, the formula for the reorder point is

For example, if a firm knows it takes 3 days to place and receive an order and if it uses 15 units per day of the inventory item, the reorder point is 45 units of inventory (3 days × 15 units/day). Thus, as soon as the item’s inventory level falls to the reorder point (45 units, in this case), an order will be placed at the item’s EOQ. If the estimates of lead time and usage are correct, the order will arrive exactly as the inventory level reaches zero. However, lead times and usage rates are not precise, so most firms hold safety stock (extra inventory) to prevent stockouts of important items.

The firm’s goal for inventory is to turn it over as quickly as possible without stockouts. Inventory turnover is best calculated by dividing cost of goods sold by average inventory. The EOQ model determines the optimal order size and, indirectly, through the assumption of constant usage, the average inventory. Thus, the EOQ model determines the firm’s optimal inventory turnover rate, given the firm’s specific costs of inventory.

Just-in-Time (JIT) System

The just-in-time (JIT) system is used to minimize inventory investment. The philosophy is that materials should arrive at exactly the time they are needed for production. Ideally, the firm would have only work-in-process inventory. 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. When quality problems arise, production must be stopped until the problems are resolved.

The goal of the JIT system is manufacturing efficiency. It uses inventory as a tool for attaining efficiency by emphasizing quality of the materials used and their timely delivery. When JIT is working properly, it forces process inefficiencies to surface.

Knowing the level of inventory is, of course, an important part of any inventory management system. As described in the Focus on Practice box, radio frequency identification technology may be the “next new thing” in improving inventory and supply chain management.

Computerized Systems for Resource Control

Today, a number of systems are available for controlling inventory and other resources. One of the most basic is the materials requirement planning (MRP) system. It is used to determine what materials to order and when to order them. MRP applies EOQ concepts to determine how much to order. Using a computer, MRP simulates each product’s bill of materials, inventory status, and manufacturing process. The bill of materials is simply a list of all parts and materials that go into making the finished product. For a given production plan, the computer simulates material requirements by comparing production needs to available inventory balances. On the basis of the time it takes for a product that is in process to move through the various production stages and the lead time to get materials, the MRP system determines when orders should be placed for various items on the bill of materials. The objective of this system is to lower the firm’s inventory investment without impairing production. If the firm’s pretax opportunity cost of capital for investments of equal risk is 20 percent, every dollar of investment released from inventory will increase before-tax profits by $0.20.

A popular extension of MRP is manufacturing resource planning II (MRP II), which integrates data from numerous areas such as finance, accounting, marketing, engineering, and manufacturing using a sophisticated computer system. This system generates production plans as well as numerous financial and management reports. In essence, it models the firm’s processes so that the effects of changes in one area of operations on other areas can be assessed and monitored. For example, the MRP II system would allow the firm to assess the effect of an increase in labor costs on sales and profits.

Whereas MRP and MRP II tend to focus on internal operations, enterprise resource planning (ERP) systems expand the focus to the external environment by including information about suppliers and customers. ERP electronically integrates all a firm’s departments so that, for example, production can call up sales information and immediately know how much must be produced to fill customer orders. Because all available resources—human and material—are known, the system can eliminate production delays and control costs. ERP systems automatically note changes, such as a supplier’s inability to meet a scheduled delivery date, so that necessary adjustments can be made.

REVIEW QUESTIONS

credit standards

The firm’s minimum requirements for extending credit to a customer.

Five C’s of Credit

One popular credit selection technique is the five C’s of credit, which provides a framework for in-depth credit analysis. Because of the time and expense involved, this credit selection method is used for large-dollar credit requests. The five C’s are as follows:

• 1. Character: The applicant’s record of meeting past obligations.
• 2. Capacity: The applicant’s ability to repay the requested credit, as judged in terms of financial statement analysis focused on cash flows available to repay debt obligations.
• 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. The larger the amount of available assets, the greater the chance that a firm will recover funds if the applicant defaults.
• 5. Conditions: Current general and industry-specific economic conditions and any unique conditions surrounding a specific transaction.

Analysis via the five C’s of credit does not yield a specific accept/reject decision, so its use requires an analyst experienced in reviewing and granting credit requests. Application of this framework tends to ensure that the firm’s credit customers will pay, without being pressured, within the stated credit terms.

Credit Scoring

Credit scoring is a method of credit selection that firms commonly use with high-volume/small-dollar credit requests. Credit scoring applies statistically derived weights to a credit applicant’s scores on key financial and credit characteristics to predict whether he or she will pay the requested credit in a timely fashion. Simply stated, the procedure results in a score that measures the applicant’s overall credit strength, and the score is used to make the accept/reject decision for granting the applicant credit. Credit scoring is most commonly used by large credit card operations, such as those of banks, oil companies, and department stores. The purpose of credit scoring is to make a relatively informed credit decision quickly and inexpensively, recognizing that the cost of a single bad scoring decision is small. However, if bad debts from scoring decisions increase, the scoring system must be reevaluated.

Changing Credit 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.

If credit standards were tightened, the opposite effects would be expected.

Making the Credit Standard Decision To decide whether to relax its credit standards, the firm must compare the additional profit contribution from sales to the added costs of the marginal investment in accounts receivable and marginal bad debts. If the additional profit contribution is greater than marginal costs, credit standards should be relaxed.

The procedure described here for evaluating a proposed change in credit standards is also commonly used to evaluate other changes in the management of accounts receivable. If Dodd Tool had been contemplating tightening its credit standards, for example, the cost would have been a reduction in the profit contribution from sales, and the return would have been from reductions in the cost of the investment in accounts receivable and in the cost of bad debts. Another application of this procedure is demonstrated later in this chapter.

Managing International Credit

Credit management is difficult enough for managers of purely domestic companies, and these tasks become much more complex for companies that operate internationally. It is partly because (as we have seen before) 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 international borders.

Exports of finished goods are usually priced in the currency of the importer’s local market; most commodities, on the other hand, are priced in dollars. Therefore, a U.S. company that sells a product in Japan, for example, would have to price that product in Japanese yen and extend credit to a Japanese wholesaler in the local currency (yen). If the yen depreciates against the dollar before the U.S. exporter collects on its account receivable, the U.S. company experiences an exchange rate loss; the yen collected are worth fewer dollars than expected at the time the sale was made. Of course, the yen could just as easily appreciate against the dollar, yielding an exchange rate gain to the U.S. exporter. Most companies fear the loss more than they welcome the gain.

For a major currency such as the Japanese yen, the exporter can hedge against this risk by using the currency futures, forward, or options markets, but it is costly to do so, particularly for relatively small amounts. If the exporter is selling to a customer in a developing country, there will probably be no effective instrument available for protecting against exchange rate risk at any price. This risk may be further magnified because credit standards may be much lower (and acceptable collection techniques much different) in developing countries than in the United States. Although it may seem tempting to just “not bother” with exporting, U.S. companies no longer can concede foreign markets to international rivals. These export sales, if carefully monitored and (where possible) effectively hedged against exchange rate risk, often prove to be very profitable.

credit terms

The terms of sale for customers who have been extended credit by the firm.

cash discount

A percentage deduction from the purchase price; available to the credit customer who pays its account within a specified time.

Cash Discount

Including a cash discount in the credit terms is a popular way to speed up collections without putting pressure on customers. The cash discount provides an incentive for customers to pay sooner. By speeding collections, the discount decreases the firm’s investment in accounts receivable, but it also decreases the per-unit profit. Additionally, initiating a cash discount should reduce bad debts because customers will pay sooner, and it should increase sales volume because customers who take the discount pay a lower price for the product. Accordingly, firms that consider offering a cash discount must perform a benefit–cost analysis to determine whether extending a cash discount is profitable.

Cash Discount Period

The financial manager can change the cash discount period, 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; and (3) the profit per unit would decrease as a result of more people taking the discount, negatively affecting profit.

The difficulty for the financial manager lies in assessing what impact an increase in the cash discount period would have on the firm’s investment in accounts receivable. This investment will decrease because of non–discount takers now paying earlier. However, the investment in accounts receivable will increase for two reasons: (1) Discount takers will still get the discount but will pay later, and (2) new customers attracted by the new policy will result in new accounts receivable. If the firm were to decrease the cash discount period, the effects would be the opposite of those just described.

Credit Period

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. The increased investment in accounts receivable would result from both more sales and generally slower pay, on average, as a result of the longer credit period. The increase in bad-debt expenses is because the longer the credit period, the more time available for a firm to fail, making it unable to pay its accounts payable. A decrease in the length of the credit period is likely to have the opposite effects. Note that the variables affected by an increase in the credit period behave in the same way they would have if the credit standards had been relaxed, as demonstrated earlier in Table 15.2.

credit monitoring

The ongoing review of a firm’s accounts receivable to determine whether customers are paying according to the stated credit terms.

Average Collection Period

The average collection period is the second component of the cash conversion cycle. As noted in Chapter 3, it is the average number of days that credit sales are outstanding. 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.

Knowing its average collection period enables the firm to determine whether there is a general problem with accounts receivable. For example, a firm that has credit terms of net 30 would expect its average collection period (minus receipt, processing, and collection time) to equal about 30 days. If the actual collection period is significantly greater than 30 days, the firm has reason to review its credit operations. If the firm’s average collection period is increasing over time, it has cause for concern about its accounts receivable management. A first step in analyzing an accounts receivable problem is to “age” the accounts receivable. By this process, the firm can determine whether the problem exists in its accounts receivable in general or is attributable to a few specific accounts.

Aging of Accounts Receivable

An aging schedule breaks down accounts receivable into groups on the basis of their time of origin. The breakdown is typically made on a month-by-month basis, going back 3 or 4 months. The resulting schedule indicates the percentages of the total accounts receivable balance that have been outstanding for specified periods of time. The purpose of the aging schedule is to enable the firm to pinpoint problems. A simple example will illustrate the form and evaluation of an aging schedule.

Popular Collection Techniques

A number of collection techniques, ranging from letters to legal action, are employed. As an account becomes more and more overdue, the collection effort becomes more personal and more intense. In Table 15.4, the popular collection techniques are listed and briefly described in the order typically followed in the collection process.

float

Funds that have been sent by the payer but are not yet usable funds to the payee.

lockbox system

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.

Matter of fact

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

For decades, the United State 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 change 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.

controlled disbursing

The strategic use of mailing points and bank accounts to lengthen mail float and clearing float, respectively.

in practice focus on ETHICS: Stretching Accounts Payable: Is It a Good Policy?

Stretching payables has often been considered good cash management. By delaying bill payments as long as possible without damaging the firm’s credit, companies get interest-free loans from suppliers. Some businesses deliberately increase their accounts payable lag to cover temporary cash shortages.

There are two negative ramifications of stretching accounts payables (A/P). First, the stretching out of payables can be pushed too far, and a business can get tagged as a slow payer. Vendors will eventually put increasing pressure on the company to make more timely payments.

Stretching accounts payables also raises ethical issues. First, it may cause the firm to violate the agreement it entered with its supplier when it purchased the merchandise. More important to investors, the firm may stretch A/P to artificially boost reported operating cash flow during a reporting period. In other words, firms can improve reported operating cash flows due solely to a decision to slow the payment rate to vendors. Unfortunately for investors, the improvement in operating cash flows may be unsustainable if vendors force the company to improve its payment record; at a minimum, any year-over-year improvement in operating cash flow may be unsustainable.

The extension of payables can be identified by monitoring days sales payables (DSP), calculated as the end-of-period accounts payable balance divided by the cost of goods sold and multiplied by the number of days in the period. As DSP grows, operating cash flows are boosted.

A more complicated version of stretching payables is the financing of payables, which occurs when a company uses a third-party financial institution to pay the vendor in the current period and pays back the bank in a subsequent period. This approach reclassifies the amount from accounts payable to short-term loans. The reclassification results in a decrease to operating cash flow in that quarter and an increase in financing cash flow. Normally, cash expenditures for accounts payable are included in operating activities. Because the timing and extent of vendor financing is at the discretion of company management, the temptation to manipulate operating cash flows may prove too great for some.

Setting aside the ethical ramifications of stretching accounts payable, there may be financial incentives for avoiding the practice. Companies that can move to an automated A/P system may be able to take advantage of beneficial early payment discounts that provide a far better risk-free rate of return than stretching out accounts payable. For example, a 2/10 net 30 discount equates to about a 36 percent annualized return. Viewed this way, an A/P balance may be the most expensive debt on the balance sheet.

Although vendor discounts for early payment are very rewarding, what are some of the difficulties that may arise to keep a firm from taking advantage of those discounts?

cash concentration

The process used by the firm to bring lockbox and other deposits together into one bank, often called the concentration bank.

depository transfer check (DTC)

An unsigned check drawn on one of a firm’s bank accounts and deposited in another.

ACH (automated clearinghouse) transfer

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.

wire transfer

An electronic communication that, via bookkeeping entries, removes funds from the payer’s bank and deposits them in the payee’s bank.

zero-balance account (ZBA)

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.

Personal Finance Example 15.10

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.

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.

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. Megan can transfer her current savings account balances into a liquid marketable security, thereby increasing the rate of interest earned from 1.5% to about 4.2%. On her current $17,000 balance, she will immediately increase her annual interest earnings by about $460 [(0.042 − 0.015) × $17,000].
• 2. Invest monthly surpluses. Megan can transfer monthly the $600 from her checking account to the liquid marketable security, thereby increasing the annual earnings on each monthly transfer by about $16 [(0.042 − 0.015) × $600], which for the 12 transfers would generate additional annual earnings of about $192 (12 months × $16).
• 3. Slow down payments. Rather than paying her bills immediately on receipt, Megan can pay her bills nearer their due date. By doing so, she can gain 8 days of disbursement float each month, or 96 days per year (8 days per month × 12 months), on an average of $1,900 of bills. Assuming that she can earn 4.2% annual interest on the $1,900, slowing down her payments would save about $21 annually [(96 ÷ 365) × 0.042 × $1,900].

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.

TABLE 15.5 Features of Popular Marketable Securities

Security	Issuer	Description	Initial maturity	Risk and return
Government issues
Treasury bills	U.S. Treasury	Issued weekly at auction; sold at a discount; strong secondary market	4, 13, and 26 weeks	Lowest, virtually risk-free
Treasury notes	U.S. Treasury	Stated interest rate; interest paid semiannually; strong secondary market	1 to 10 years	Low, but higher than U.S. Treasury bills
Treasury bonds	U.S. Treasury	Stated interest rate; interest paid semiannually; strong secondary market	11 to 30 years	Less than corporate bonds, but higher than U.S. Treasury bills and notes
Federal agency issues	Agencies of federal goverment	Not an obligation of U.S. Treasury; strong secondary market	9 months to 30 years	Slightly higher than U.S. Treasury issues
Nongovernment issues
Negotiable certificates of deposit (CDs)	Commercial banks	Represent specific cash deposits in commercial banks; amounts and maturities tailored to investor needs; large denominations; good secondary market	1 month to 3 years	Higher than U.S. Treasury issues and comparable to commercial paper
Commercial paper	Corporation with a high credit standing	Unsecured note of issuer; large denominations	3 to 270 days	Higher than U.S. Treasury issues and comparable to negotiable CDs
Banker’s acceptances	Banks	Results from a bank guarantee of a business transaction; sold at discount from maturity value	30 to 180 days	About the same as negotiable CDs and commercial paper but higher than U.S. Treasury issues
Eurodollar deposits	Foreign banks	Deposits of currency not native to the country in which the bank is located; large denominations; active secondary market	1 day to 3 years	High, due to less regulation of despository banks and some foreign exchange risk
Money market mutual funds	Professional portfolio management companies	Professionally managed portfolios of marketable securities; provide instant liquidity	None—depends on wishes of investor	Vary, but generally higher than U.S. Treasury issues and comparable to negotiable CDs and commercial paper
Repurchase agreements	Bank or securities dealer	Bank or securities dealer sells specific securities to firm and agrees to repurchase them at a specific price and time	Customized to purchaser’s needs	Generally slightly below that associated with the outright purchase of the security

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