Most of this book is devoted to long-term financial decisions, including capital budgeting and debt policy. It is now time to look at the financial management of current assets and liabilities. “Current” or “short-term” mean that the asset or liability will mature or be replaced in 12 months or less.
Current assets and liabilities are collectively labeled working capital.Table 30.1 shows the composition of working capital of all U.S. manufacturing companies in 2017. The asset side of this working-capital balance sheet includes cash and short-term investments, inventories and accounts receivable (payments due from customers). The liability side includes accounts payable (payments the firm must make to suppliers), short-term borrowing, income taxes due, and the current part of long-term debt, that is, principal payments that come due in the next 12 months. There is also a large entry collecting various other current liabilities. Current assets are larger than current liabilities, so net working capital (current assets minus current liabilities) was positive.
TABLE 30.1 Current assets and liabilities for U.S. manufacturing corporations, 4th quarter 2017 ($ billions). Percentages show the size of each short-term asset or liability relative to total book assets.
Source: U.S. Census Bureau, Quarterly Financial Report for U.S. Manufacturing, Mining, and Trade Corporations, Table 1, www.census.gov/econ/qfr/index.html.
The percentages in Table 30.1 show that working capital is not small change. For example, accounts receivable and inventories each accounted for 7% or more of total book assets. The sum of all current assets was 24% of total book assets.
But don’t be too quick to take these average percentages as normal. There is wide variation across companies and industries, as we will see in a moment. The composition of your firm’s working capital will depend on the nature of its business and its relationships with customers and suppliers. It may also depend on your firm’s cumulative free cash flow. A company that generates more cash than it invests will often build up large holdings of cash and short-term investments. We will note the “cash mountains” accumulated by Apple, Facebook, and a few other highly profitable companies.
The components of working capital all have to be managed. We will focus mostly on inventories, accounts receivable, and cash. The management of inventories boils down to a trade-off, of the costs of holding inventories against the benefit of having buffer stocks to meet unexpected needs. The management of accounts receivable requires a credit policy for customers. The management of cash requires having cash on hand for day-to-day transactions, while at the same time sweeping up excess cash that would otherwise sit idle.
Excess cash is usually invested in short-term financial instruments, including Treasury bills, commercial paper, and repos (repurchase agreements). At the end of the chapter, we describe these money market securities and show how to compare their yields.
30-1The Composition of Working Capital
The financial manager cannot freely choose the amount of investment in inventories or accounts receivable or the size of accounts payable; the amounts will depend in large part on the nature of the firm’s operations and the industry it is in.
Figure 30.1 shows the relative importance of working capital in different industries. For example, current assets account for nearly 75% of total book assets of pharmaceutical companies but less than 10% of total book assets of railroads. For some industries, current assets means principally inventory; for others, it means accounts receivable or cash and securities. Retail firms hold large inventories. Receivables are relatively more important for auto producers. Cash and securities make up the bulk of current assets of computer and pharmaceutical companies.
FIGURE 30.1 Current assets as a percentage of total assets in different industries in fourth quarter 2017
Source: U.S. Census Bureau, Quarterly Financial Report for U.S. Manufacturing, Mining, and Trade Corporations, www.census.gov/econ/qfr/index.html.
Table 30.2 presents working-capital balance sheets for four U.S. corporations: Cummins, a manufacturer, mostly of diesel engines; Macy’s department stores; electric utility Entergy; and trucking company J. B. Hunt.
TABLE 30.2 Components of working capital for four U.S. corporations, third quarter 2017 ($ millions). Short-term debt includes principal amounts of long-term debt due within one year. Net working capital equals current assets minus current liabilities. Percentages show the size of each short-term asset or liability relative to total book assets.
The composition of Cummins’s working capital was not too different from the manufacturing aggregate in Table 30.1, although its net working capital was a larger fraction of net book assets. Cummins keeps extensive inventories of raw materials, work in progress, and finished goods awaiting sale. Its inventory of $3,146 million was 17.5% of total book assets. It carried about $3.5 billion in accounts receivable, but accounts payable were even larger at about $4.1 billion. Cummins was, in effect, financing its current assets partly with accounts payable because $4.1 billion due to its suppliers remained to be paid.
Macy’s current assets were dominated by inventory. Its shelves and warehouses were stocked with goods awaiting sale to retail customers. Other current assets were much less important. The most important current liability was accounts payable at about $5.3 billion. Like Cummins, Macy’s got short-term financing by deferring payments to suppliers.
Entergy’s current assets and liabilities were much smaller fractions of its total assets than for Cummins and Macy’s. Entergy’s inventories were small, which makes sense when you realize that its main product, electricity, cannot be stored and has to be produced at the instant it is consumed. Note also that Entergy’s current liabilities included about $2.2 billion of debt maturing in the coming year. Its current liabilities were larger than its current assets, so its net working capital was negative at slightly less than $1 billion. (There is nothing necessarily odd or dangerous about negative working capital. It happens frequently.)
J. B. Hunt, a much smaller company than the other three in Table 30.2, carried no inventories at all. It transports goods; it does not buy and hold them in inventory for resale. Hunt’s working capital was dominated by large positions in receivables (21.2% of total assets) and payables (16.8% of total assets). It used no short-term debt financing.
We provide Table 30.2 just to alert you to the diversity that can be found in firms’ working-capital accounts and to illustrate some industry patterns. We now turn to the management of working capital, starting with inventory.
30-2Inventories
Most firms keep inventories of raw materials, work in process, or finished goods awaiting sale and shipment. But they are not obliged to do so. For example, they could buy materials day by day, as needed. But then they would pay higher prices for ordering in small lots, and they would risk production delays if the materials were not delivered on time. They can avoid that risk by ordering more than the firm’s immediate needs. Similarly, firms could do away with inventories of finished goods by producing only what they expect to sell tomorrow. But this too could be a dangerous strategy. A small inventory of finished goods may mean shorter and more costly production runs, and it may not be sufficient to meet an unexpected increase in demand.
There are also costs to holding inventories that must be set against these benefits. Money tied up in inventories does not earn interest, storage and insurance must be paid for, and there may be risk of spoilage or obsolescence. Firms need to strike a sensible balance between the benefits of holding inventory and the costs.
EXAMPLE 30.1 
The Inventory Trade-Off
Akron Wire Products uses 255,000 tons a year of wire rod. Suppose that it orders Q tons at a time from the manufacturer. Just before delivery, Akron has effectively no inventories. Just after delivery it has an inventory of Q tons. Thus Akron’s inventory of wire rod roughly follows the sawtooth pattern in Figure 30.2.
FIGURE 30.2 A simple inventory rule. The company waits until inventories of materials are about to be exhausted and then reorders a constant quantity.
There are two costs to this inventory. First, each order that Akron places involves a handling and delivery cost. Second, there are carrying costs, such as the cost of storage and the opportunity cost of the capital that is invested in inventory. Akron can reduce the order costs by placing fewer and larger orders. On the other hand, a larger order size increases the average quantity held in inventory, so that the carrying costs rise. Good inventory management requires a trade-off between these two types of cost.
This is illustrated in Figure 30.3. We assume here that each order that Akron places involves a fixed order cost of $450, while the annual carrying cost of the inventory works out at about $55 a ton. You can see how a larger order size results in lower order costs but higher carrying costs. The sum of the two costs is minimized when the size of each order is Q = 2,043 tons. The optimal order size (2,043 tons in our example) is termed the economic order quantity, or EOQ.1
FIGURE 30.3 As the inventory order size is increased, order costs fall and inventory carrying costs rise. Total costs are minimized when the saving in order costs is equal to the increase in carrying costs.
BEYOND THE PAGE
Try It! Figure 30.3: Akron’s inventory costs
mhhe.com/brealey13e
Our example was not wholly realistic. For instance, most firms do not use up their inventory of raw material at a constant rate, and they would not wait until stocks had completely run out before they were replenished. But this simple model does capture some essential features of inventory management:
· Optimal inventory levels involve a trade-off between carrying costs and order costs.
· Carrying costs include the cost of storing goods as well as the cost of capital tied up in inventory.
· A firm can manage its inventories by waiting until they reach some minimum level and then replenish them by ordering a predetermined quantity.2
· When carrying costs are high and order costs are low, it makes sense to place more frequent orders and maintain lower levels of inventory.
· Inventory levels do not rise in direct proportion to sales. As sales increase, the optimal inventory level rises, but less than proportionately.
Manufacturers today typically get by with slimmer inventories than they used to. Some have adopted a just-in-time strategy in which inventories of parts and subassemblies are nearly zero. Just-in-time was pioneered by Toyota. Suppliers deliver parts and subassemblies to Toyota’s assembly plants only as needed on the production line. Deliveries are made throughout the day at intervals as short as one hour. Toyota can operate successfully with minimal inventories only because it and its suppliers make sure that traffic snarl-ups, strikes, and other hazards do not interrupt the flow of components and bring production to a standstill. Thus a just-in-time inventory system has its costs. The company and its suppliers have to maintain systems and procedures to ensure that parts and subassemblies really do arrive just in time.
Just-in-time inventory management works when the flow of production is steady and predictable, so that no significant buffer is needed for unexpected changes or requirements. But in most circumstances inventory buffers are needed. For example, a gas-fired power plant may hold a supply of fuel oil for use in case gas supplies are cut short. (Some power plants in New England switch from natural gas to fuel oil in severe cold snaps, when the demand for gas for residential heating soars.) Department stores hold extra merchandise in case consumer demand is higher than expected. It’s better to bear the cost of holding inventory than to bear the risk of disgruntled customers staring at empty shelves. As a rough and general rule, the greater the uncertainty, the larger the inventory buffer should be.
Sometimes it may be possible to reduce inventories of finished goods by producing the goods to order. For example, Dell Computer discovered that it did not need to keep a large stock of finished machines. Its customers are able to use the Internet to specify what features they want on their PCs. The computer is then assembled to order and shipped to the customer.3
30-3Credit Management
We continue our tour of current assets with the firm’s accounts receivable. When one company sells goods to another, it does not usually expect to be paid immediately. These unpaid bills, or trade credit, compose the bulk of accounts receivable. The remainder is made up of consumer credit, that is, bills that are awaiting payment by the final customer.
Management of trade credit requires answers to five sets of questions:
1. How long are you going to give customers to pay their bills? Are you prepared to offer a cash discount for prompt payment?
2. Do you require some formal IOU from the buyer or do you just ask him or her to sign a receipt?
3. How do you determine which customers are likely to pay their bills?
4. How much credit are you prepared to extend to each customer? Do you play it safe by turning down any doubtful prospects? Or do you accept the risk of a few bad debts as part of the cost of building a large regular clientele?
5. How do you collect the money when it becomes due? What do you do about reluctant payers or deadbeats?
We discuss each of these topics in turn.
Terms of Sale
Not all sales involve credit. For example, if you are supplying goods to a wide variety of irregular customers, you may demand cash on delivery (COD). And, if your product is custom-designed, it may be sensible to ask for cash before delivery (CBD) or to ask for progress payments as the work is carried out.
When we look at transactions that do involve credit, we find that each industry seems to have its own particular practices.4 These norms have a rough logic. For example, firms selling consumer durables may allow the buyer a month to pay, while those selling perishable goods, such as cheese or fresh fruit, typically demand payment in a week. Similarly, a seller may allow more extended payment if its customers are in a low-risk business, if their accounts are large, if they need time to check the quality of the goods, or if the goods are not quickly resold.
To encourage customers to pay before the final date, it is common to offer a cash discount for prompt settlement. For example, pharmaceutical companies commonly require payment within 30 days but may offer a 2% discount to customers who pay within 10 days. These terms are referred to as “2/10, net 30.”
If goods are bought on a recurrent basis, it may be inconvenient to require separate payment for each delivery. A common solution is to pretend that all sales during the month in fact occur at the end of the month (EOM). Thus goods may be sold on terms of 8/10 EOM, net 60. This arrangement allows the customer a cash discount of 8% if the bill is paid within 10 days of the end of the month; otherwise the full payment is due within 60 days of the invoice date.
Cash discounts are often very large. For example, a customer who buys on terms of 2/10, net 30 may decide to forgo the cash discount and pay on the thirtieth day. This means that the customer obtains an extra 20 days’ credit but pays about 2% more for the goods. This is equivalent to borrowing money at a rate of 44.6% per annum.5 Of course, any firm that delays payment beyond the due date gains a cheaper loan but damages its reputation.
The Promise to Pay
Repetitive sales to domestic customers are almost always made on open account. The only evidence of the customer’s debt is the record in the seller’s books and a receipt signed by the buyer.
If you want a clear commitment from the buyer before you deliver the goods, you can arrange a commercial draft.6 This works as follows: You draw a draft ordering payment by the customer and send this to the customer’s bank together with the shipping documents. If immediate payment is required, the draft is termed a sight draft; otherwise it is known as a time draft. Depending on whether it is a sight draft or a time draft, the customer either pays up or acknowledges the debt by signing it and adding the word accepted. The bank then hands the shipping documents to the customer and forwards the money or trade acceptance to you, the seller.
If your customer’s credit is shaky, you can ask the customer to arrange for a bank to accept the time draft and thereby guarantee the customer’s debt. These bankers’ acceptances are often used in overseas trade. The bank guarantee makes the debt easily marketable. If you don’t want to wait for your money, you can sell the acceptance to a bank or to another firm that has surplus cash to invest.
Credit Analysis
There are a number of ways to find out whether customers are likely to pay their debts. For existing customers an obvious indication is whether they have paid promptly in the past. For new customers you can use the firm’s financial statements to make your own assessment, or you may be able to look at how highly investors value the firm.7 However, the simplest way to assess a customer’s credit standing is to seek the views of a specialist in credit assessment. For example, in Chapter 23, we described how bond rating agencies, such as Moody’s and Standard and Poor’s, provide a useful guide to the riskiness of the firm’s bonds.
Bond ratings are usually available only for relatively large firms. However, you can obtain information on many smaller companies from a credit agency. Dun and Bradstreet is by far the largest of these agencies and its database contains credit information on millions of businesses worldwide. Credit bureaus are another source of data on a customer’s credit standing. In addition to providing data on small businesses, they can also provide an overall credit score for individuals.8
Finally, firms can also ask their bank to undertake a credit check. It will contact the customer’s bank and ask for information on the customer’s average balance, access to bank credit, and general reputation.
Of course you don’t want to subject each order to the same credit analysis. It makes sense to concentrate your attention on the large and doubtful orders.
The Credit Decision
Let us suppose that you have taken the first three steps toward an effective credit operation. In other words, you have fixed your terms of sale; you have decided on the contract that customers must sign; and you have established a procedure for estimating the probability that they will pay up. Your next step is to work out which of your customers should be offered credit.
If there is no possibility of repeat orders, the decision is relatively simple. Figure 30.4 summarizes your choice. On one hand, you can refuse credit. In this case, you make neither profit nor loss. The alternative is to offer credit. Suppose that the probability that the customer will pay up is p. If the customer does pay, you receive additional revenues (REV) and you incur additional costs; your net gain is the present value of REV − COST. Unfortunately, you can’t be certain that the customer will pay; there is a probability (1 − p) of default. Default means that you receive nothing and incur the additional costs. The expected profit from each course of action is therefore as follows:
|
Expected Gain |
|
|
Refuse credit |
0 |
|
Grant credit |
pPV (REV − COST) − (1 − p) PV (COST) |
FIGURE 30.4 If you refuse credit, you make neither profit nor loss. If you offer credit, there is a probability p that the customer will pay and you will make REV − COST; there is a probability (1 − p) that the customer will default and you will lose COST.
You should grant credit if the expected gain from doing so is positive.
Consider, for example, the case of the Cast Iron Company. On each nondelinquent sale Cast Iron receives revenues with a present value of $1,200 and incurs costs with a value of $1,000. Therefore the company’s expected profit if it offers credit is
pPV (REV − COST) − (1 − p)PV(COST) = p × 200 − (1 − p) × 1,000
If the probability of collection is 5/6, Cast Iron can expect to break even:
Therefore Cast Iron’s policy should be to grant credit whenever the chances of collection are better than 5 out of 6.
So far, we have ignored the possibility of repeat orders. But one of the reasons for offering credit today is that it may help to get yourself a good, regular customer. Figure 30.5 illustrates the problem. Cast Iron has been asked to extend credit to a new customer. You can find little information on the firm, and you believe that the probability of payment is no better than .8. If you grant credit, the expected profit on this customer’s order is
FIGURE 30.5 In this example there is only a .8 probability that your customer will pay in period 1; but if payment is made, there will be another order in period 2. The probability that the customer will pay for the second order is .95. The possibility of this good repeat order more than compensates for the expected loss in period 1.
You decide to refuse credit.
This is the correct decision if there is no chance of a repeat order. But look again at the decision tree in Figure 30.5. If the customer does pay up, there will be a repeat order next year. Because the customer has paid once, you can be 95% sure that he or she will pay again. For this reason any repeat order is very profitable:
Now you can reexamine today’s credit decision. If you grant credit today, you receive the expected profit on the initial order plus the possible opportunity to extend credit next year:
At any reasonable discount rate, you ought to extend credit. Notice that you should do so even though you expect to take a loss on the initial order. The expected loss is more than outweighed by the possibility that you will secure a reliable and regular customer. Cast Iron is not committed to making further sales to the customer, but by extending credit today, it gains a valuable option to do so. It will exercise this option only if the customer demonstrates its creditworthiness by paying promptly.
Of course real-life situations are generally far more complex than our simple Cast Iron examples. Customers are not all good or all bad. Many of them pay consistently late; you get your money, but it costs more to collect and you lose a few months’ interest. Then there is the uncertainty about repeat sales. There may be a good chance that the customer will give you further business, but you can’t be sure of that and you don’t know for how long she will continue to buy.
Like almost all financial decisions, credit allocation involves a strong dose of judgment. Our examples are intended as reminders of the issues involved rather than as cookbook formulas. Here are the basic things to remember.
1. Maximize profit. As credit manager, you should not focus on minimizing the number of bad accounts; your job is to maximize expected profit. You must face up to the following facts: The best that can happen is that the customer pays promptly; the worst is default. In the best case, the firm receives the full additional revenues from the sale less the additional costs; in the worst, it receives nothing and loses the costs. You must weigh the chances of these alternative outcomes. If the margin of profit is high, you are justified in a more liberal credit policy; if it is low, you cannot afford many bad debts.9
2. Concentrate on the dangerous accounts. You should not expend the same effort on analyzing all credit applications. If an application is small or clear-cut, your decision should be largely routine; if it is large or doubtful, you may do better to move straight to a detailed credit appraisal. Most credit managers don’t make decisions on an order- byorder basis. Instead, they set a credit limit for each customer. The sales representative is required to refer the order for approval only if the customer exceeds this limit.
3. Look beyond the immediate order. The credit decision is a dynamic problem. You cannot look only at the present. Sometimes it may be worth accepting a relatively poor risk as long as there is a good chance that the customer will become a regular and reliable buyer. New businesses must, therefore, be prepared to incur more bad debts than established businesses. This is part of the cost of building a good customer list.
Collection Policy
The final step in credit management is to collect payment. When a customer is in arrears, the usual procedure is to send a statement of account and to follow this at intervals with increasingly insistent letters or telephone calls. If none of these has any effect, most companies turn the debt over to a collection agent or an attorney.
Large firms can reap economies of scale in record keeping, billing, and so on, but the small firm may not be able to support a fully fledged credit operation. However, the small firm may be able to obtain some scale economies by farming out part of the job to a factor.
Factoring typically works as follows. The factor and the client agree on a credit limit for each customer. The client then notifies the customer that the factor has purchased the debt. Thereafter, whenever the client makes a sale to an approved customer, it sends a copy of the invoice to the factor, and the customer makes payment directly to the factor. Most commonly the factor does not have any recourse to the client if the customer fails to pay, but sometimes the client assumes the risk of bad debts. There are, of course, costs to factoring, and the factor typically charges a fee of 1% or 2% for administration and a roughly similar sum for assuming the risk of nonpayment. In addition to taking over the task of debt collection, most factoring agreements also provide financing for receivables. In these cases, the factor pays the client 70% to 80% of the value of the invoice in advance at an agreed interest rate. Of course, factoring is not the only way to finance receivables; firms can also raise money by borrowing against their receivables.
Factoring is common in Europe, but in the United States it accounts for only a small proportion of debt collection. It is most common in industries such as clothing and toys. These industries are characterized by many small producers and retailers that do not have long-term relationships. Because a factor may be employed by a number of manufacturers, it sees a larger proportion of the transactions than any single firm, and therefore is better placed to judge the creditworthiness of each customer.10
There is always a potential conflict of interest between the collection operation and the sales department. Sales representatives commonly complain that they no sooner win new customers than the collection department frightens them off with threatening letters. The collection manager, on the other hand, bemoans the fact that the sales force is concerned only with winning orders and does not care whether the goods are subsequently paid for.
There are also many instances of cooperation between the sales force and the collection department. For example, the specialty chemical division of a major pharmaceutical company actually made a business loan to an important customer that had been suddenly cut off by its bank. The pharmaceutical company bet that it knew its customer better than the customer’s bank did. The bet paid off. The customer arranged alternative bank financing, paid back the pharmaceutical company, and became an even more loyal customer. It was a nice example of financial management supporting sales.
It is not common for suppliers to make business loans in this way, but they lend money indirectly whenever they allow a delay in payment. Trade credit can be an important source of funds for indigent customers that cannot obtain a bank loan. But that raises an important question: If the bank is unwilling to lend, does it make sense for you, the supplier, to continue to extend trade credit? Here are two possible reasons why it may make sense: First, as in the case of our pharmaceutical company, you may have more information than the bank about the customer’s business. Second, you need to look beyond the immediate transaction and recognize that your firm may stand to lose some profitable future sales if the customer goes out of business.11
30-4Cash
In June 2018, Amazon held $16.7 billion in cash and $8.3 billion in short-term securities. Short-term securities pay interest; cash doesn’t. So why do firms such as Amazon hold such large amounts of cash? Why don’t they arrange for the bank to “sweep” the cash at the end of the day into an interest-bearing investment, such as a money-market mutual fund?
There are at least two reasons. First, cash may be left in non-interest-bearing accounts to compensate banks for the services they provide. Second, large corporations may have literally hundreds of accounts with dozens of different banks. It is often better to leave idle cash in these accounts than to monitor every account every day in order to make daily transfers between them.
One major reason for this proliferation of bank accounts is decentralized management. You cannot give a subsidiary operating autonomy without giving its managers the right to spend and receive cash. Good cash management nevertheless implies some degree of centralization. It is impossible to maintain your desired cash inventory if all the subsidiaries in the group are responsible for their own private pools of cash. And you certainly want to avoid situations in which one subsidiary is investing its spare cash at 5% while another is borrowing at 8%. It is not surprising, therefore, that even in highly decentralized companies there is generally central control over cash balances and bank relations.
How Purchases Are Paid For
Many small, face-to-face purchases are made with paper currency. But you probably would not want to use cash to buy a new car, and you can’t use cash to make a purchase over the Internet. There are a variety of ways that you can pay for larger purchases or send payments to another location. Some of the more important ways are set out in Table 30.3.
|
Check When you write a check, you are instructing your bank to pay a specified sum on demand to the particular firm or person named on the check. |
|
Credit card A credit card, such as a Visa card or MasterCard, gives you a line of credit that allows you to make purchases up to a specified limit. At the end of each month, either you pay the credit card company in full for these purchases or you make a specified minimum payment and are charged interest on the outstanding balance. |
|
Charge card A charge card may look like a credit card and you can spend money with it as with a credit card. But with a charge card, the day of reckoning comes at the end of each month, when you must pay for all purchases that you have made. In other words, you must pay off the entire balance each month. |
|
Debit card A debit card allows you to have your purchases from a store charged directly to your bank account. The deduction is usually made electronically and is immediate. Debit cards may be used to make withdrawals from a cash machine (ATM). |
|
Credit transfer With a credit transfer you ask your bank to set up a standing order to make a regular set payment to a supplier. For example, standing orders are often used to make regular fixed mortgage payments. |
|
Direct payment A direct payment (or debit) is an instruction to your bank to allow a company to collect varying amounts from your account, as long as you have been given advance notice of the amount and date. For example, an electric utility company may ask you to arrange an automatic payment of your electricity bills from your bank account. |
TABLE 30.3 Small, face-to-face purchases are commonly paid for with paper currency, but here are some of the other ways to pay your bills
Look now at Figure 30.6. You can see that there are large differences in the ways that people around the world pay for their purchases. For example, checks are almost unknown in Germany, the Netherlands, and Sweden.12 Most payments in these countries are by debit card or credit transfer. By contrast, Americans love to write checks. Each year individuals and firms in the United States write about 12 billion checks.
FIGURE 30.6 How purchases are paid for. Percentage of total volume of cashless transactions, 2016.
Source: Bank for International Settlements, “Statistics on Payment, Clearing, and Settlement Systems in the CPMI Countries—Figures for 2016,” December 2017, www.bis.org/
But throughout the world the use of checks is on the decline. For one-off purchases they are being replaced by credit or debit cards. In addition, mobile phone technology and the Internet are encouraging the development of new infant payment systems. For example,
· Electronic bill presentment and payment (or EBPP) allows companies to bill customers and receive payments via the Internet. EBPP is forecasted to grow rapidly.
· Stored-value cards (or e-money) let you transfer cash value to a card that can be used to buy a variety of goods and services. For example, Hong Kong’s Octopus card system, which was developed to pay for travel fares, has become a widely used electronic cash system throughout the territory.
There are three main ways that firms send and receive money electronically. These are direct payments, direct deposits, and wire transfers.
Recurring expenditures, such as utility bills, mortgage payments, and insurance premiums, are increasingly settled by direct payment (also called automatic debit or direct debit). In this case, the firm’s customers simply authorize it to debit their bank account for the amount due. The company provides its bank with a file showing details of each customer, the amount to be debited, and the date. The payment then travels electronically through the Automated Clearing House (ACH) system. The firm knows exactly when the cash is coming in and avoids the labor-intensive process of handling thousands of checks.
The ACH system also allows money to flow in the reverse direction. Thus while a direct payment transaction provides an automatic debit, a direct deposit constitutes an automatic credit. Direct deposits are used to make bulk payments such as wages or dividends. Again the company provides its bank with a file of instructions. The bank then debits the company’s account and transfers the cash via the ACH to the bank accounts of the firm’s employees or shareholders.
The volume of direct payments and deposits has increased rapidly. You can see from Table 30.4 that the total value of these transactions is over double that of checks.13
|
Volume (millions) |
Value ($ trillions) |
|
|
Checks |
12,263 |
$ 19 |
|
ACH direct payments and deposits |
20,329 |
43 |
|
Fedwire Funds Service |
148 |
767 |
|
CHIPS |
111 |
364 |
TABLE 30.4 Use of payment systems in the United States, 2016
Source: Bank for International Settlements, “Statistics on Payment, Clearing and Settlement Systems in the CPSS Countries—Figures for 2016,” December 2017.
Large-value payments between companies are usually made electronically through Fed-wire or CHIPS. Fedwire is operated by the Federal Reserve system and connects more than 6,000 financial institutions to the Fed and, thereby, to each other.14 CHIPS is a bank-owned system. It mainly handles eurodollar payments and foreign exchange transactions and is used for more than 95% of cross-border payments in dollars. Table 30.4 shows that the number of payments by Fedwire and CHIPS is relatively small, but the sums involved are huge.
Speeding Up Check Collections
Although checks are rarely used for large-value payments, they continue to be widely used for smaller nonrecurring transactions. Check handling is a cumbersome and labor-intensive task. However, changes to legislation in the United States at the beginning of the century have helped to reduce costs and speed up collections. The Check Clearing for the 21st Century Act, usually known as Check 21, allows banks to send digital images of checks to one another rather than sending the checks themselves. Thus, cargo planes no longer crisscross the country taking bundles of checks from one bank to another. Instead, almost all check clearing is now digital. The cost of processing checks is also being reduced by a technological innovation known as check conversion. In this case, when you write a check, the details of your bank account and the amount of the payment are automatically captured at the point of sale, your check is handed back to you, and your bank account is immediately debited.
Firms that receive a large volume of checks have devised a number of ways to ensure that the cash becomes available as quickly as possible. For example, a retail chain may arrange for each branch to deposit receipts in a collection account at a local bank. Surplus funds are then periodically transferred electronically to a concentration account at one of the company’s principal banks. There are two reasons that concentration banking allows the company to gain quicker use of its funds. First, because the store is nearer to the bank, transfer times are reduced. Second, because the customer’s check is likely to be drawn on a local bank, the time taken to clear the check is also reduced.
Concentration banking is often combined with a lockbox system. In this case, the firm’s customers are instructed to send their payments to a regional post-office box. The local bank then takes on the administrative chore of emptying the box and depositing the checks in the company’s local deposit account.
International Cash Management
Cash management in domestic firms is child’s play compared with cash management in large multinational corporations operating in dozens of countries, each with its own currency, banking system, and legal structure.
A single centralized cash management system is an unattainable ideal for these companies, although they are edging toward it. For example, suppose that you are treasurer of a large multinational company with operations throughout Europe. You could allow the separate businesses to manage their own cash, but that would be costly and would almost certainly result in each one accumulating little hoards of cash. The solution is to set up a regional system. In this case the company establishes a local concentration account with a bank in each country. Any surplus cash is swept daily into a central multicurrency account in London or another European banking center. This cash is then invested in marketable securities or used to finance any plants or subsidiaries that have a cash shortage.
Payments can also be made out of the regional center. For example, to pay wages in each European country, the company just needs to send its principal bank a computer file of the payments to be made. The bank then finds the least costly way to transfer the cash from the company’s central accounts and arranges for the cash to be credited on the correct day to the employees in each country.
Rather than actually moving cash between local bank accounts and a regional concentration account, the company may employ a multinational bank with branches in each country and then arrange for the bank to pool all the cash surpluses and shortages. In this case no money is transferred between accounts. Instead, the bank just adds together the credit and debit balances, and pays the firm interest on any surplus.
When a company’s international branches trade with each other, the number of cross- border transactions can multiply rapidly. Rather than having payments flowing in all directions, the company can set up a netting system. Each branch can then calculate its net position and undertake a single transaction with the netting center. Several industries have set up netting systems for their members. For example, more than 200 airlines have come together to establish a netting system for the foreign currency payments that they must make to each other.
Paying for Bank Services
Much of the work of cash management—processing checks, transferring funds, running lock-boxes, helping keep track of the company’s accounts—is done by banks. And banks provide many other services not so directly linked to cash management, such as handling payments and receipts in foreign currency, or acting as custodian for securities.
All these services need to be paid for. Usually payment is in the form of a monthly fee, but banks may agree to waive the fee as long as the firm maintains a minimum average balance in an interest-free deposit. Banks are prepared to do this because, after setting aside a portion of the money in a reserve account with the Fed, they can relend the money to earn interest. Demand deposits earmarked to pay for bank services are termed compensating balances. They used to be a very common way to pay for bank services, but since banks have been permitted to pay interest on demand deposits, there has been a steady trend away from using compensating balances and toward direct fees.
30-5Marketable Securities
In December 2017, Apple was sitting on a $285 billion mountain of cash and fixed-income investments, amounting to about 70% of the company’s total assets. Of this sum, $9.5 billion was kept as cash and the remainder was invested as follows:
|
Fixed-Income Investments |
Value at Cost ($ billions) |
|
Money market and mutual funds |
$ 9.278 |
|
U.S. Treasury and agency securities |
65.193 |
|
Non–U.S. government securities |
8.797 |
|
Certificates of deposit and time deposits |
6.307 |
|
Commercial paper |
5.384 |
|
Corporate securities |
156.868 |
|
Municipal securities |
0.963 |
|
Mortgage- and asset-backed securities |
22.778 |
|
Total |
$275.568 |
Apple’s massive investments in securities came from the torrent of free cash flow produced year after year by its operations. But its investments were interesting for at least two further reasons. First, Apple did not limit its investments to short-term securities. For example, it held $129.3 billion in long-term corporate bonds, included under “Corporate securities.” Second, U.S. tax law has pushed it to leave most of its investments on the books of its overseas subsidiaries. The 35% U.S. tax rate, which was higher than in most other countries, penalized U.S. corporations that repatriated foreign income. That is no longer the case, as we will soon see.
Tax Strategies
Most countries have territorial corporate income taxes: They tax income earned in their own countries but not outside their borders. The United States, on the other hand, has taxed its corporations’ worldwide income. (The U.S. switched to a territorial tax in 2018—more on that later.) Here is how the U.S. tax system used to work. Suppose that Apple’s Irish subsidiary earned profits worth $100,000 in 2017. The subsidiary paid $12,500 at Ireland’s 12.5% corporate tax rate. The U.S. rate in 2017 was 35%, one of the highest corporate tax rates in the world, but the Irish tax could be taken as a credit against U.S. tax. So Apple would have to pay an additional U.S. tax of .35 × 100,000 – 12,500 = $22,500 as soon as its Irish subsidiary sent the profits home. But why pay the extra tax? Why not just leave the money in Ireland? The U.S. tax on foreign income was paid only when income was repatriated.
That is exactly what Apple and other U.S. companies with profits abroad did. [The list of companies with the largest accumulations of overseas profits also includes Microsoft, Alphabet (Google), Cisco Systems, Pfizer, Abbott Labs, and Johnson & Johnson.] They paid other countries’ taxes, almost always at lower rates than 35%, but declined to bring the profits home. The amount of profits left abroad was estimated at more than $2 trillion in 2017.
Starting in 2018, the United States moved to a territorial system with a corporate tax rate reduced to 21%. U.S. corporations are no longer taxed on foreign income and no longer have an incentive to leave profits abroad in low-tax countries. But there is a one-time repatriation tax on profits accumulated abroad through the end of 2017. The tax rate is 15.5% on profits invested in cash and securities and 8% on profits invested in illiquid assets such as plant and equipment. The tax is payable in installments over the eight-year period 2018–2025. So Apple will have to pay tax on its accumulated overseas profits, although at a lower rate than if it had brought the profits home in 2017 or earlier.
In January 2018, Apple responded to the change in the tax law by announcing that it would pay U.S. tax of $38 billion to repatriate $252 billion of profits.
Investment Choices
Most companies do not have the luxury of such huge cash surpluses, but they also park any cash that is not immediately needed in short-term investments. The market for these investments is known as the money market. The money market has no physical marketplace. It consists of a loose collection of banks and dealers linked together by telephones or through the Web. But a huge volume of securities is regularly traded on the money market, and competition is vigorous.
Most large corporations manage their own money market investments, but small companies sometimes find it more convenient to hire a professional investment management firm or to put their cash into a money market fund. This is a mutual fund that invests only in low-risk, short-term securities.
The relative safety of money market funds has made them particularly popular at times of financial stress. During the credit crunch of 2008, fund assets mushroomed as investors fled from plunging stock markets. Then it was revealed that one fund, the Reserve Primary Fund, had incurred heavy losses on its holdings of Lehman Brothers’ commercial paper. The fund became only the second money market fund in history to “break the buck” by offering just 97 cents on the dollar to investors who cashed in their holdings. That week, investors pulled nearly $200 billion out of money market funds, prompting the government to offer emergency insurance to investors.
Calculating the Yield on Money Market Investments
Many money market investments are pure discount securities. This means that they don’t pay interest. The return consists of the difference between the amount you pay and the amount you receive at maturity. Unfortunately, it is no good trying to persuade the Internal Revenue Service that this difference represents capital gain. The IRS is wise to that one and will tax your return as ordinary income.
Interest rates on money market investments are often quoted on a discount basis. For example, suppose that three-month bills are issued at a discount of 5%. This is a rather complicated way of saying that the price of a three-month bill is 100 − (3/12) × 5 = 98.75. Therefore, for every $98.75 that you invest today, you receive $100 at the end of three months. The return over three months is 100/98.75−1 = .0127, or 1.27%. This is equivalent to an annual yield of 5.16%. Note that the return is always higher than the discount. When you read that an investment is selling at a discount of 5%, it is very easy to slip into the mistake of thinking that this is its return.15
Returns on Money Market Investments
When we value long-term debt, it is important to take account of default risk. Almost anything may happen in 30 years, and even today’s most respectable company may get into trouble eventually. Therefore, corporate bonds offer higher yields than Treasury bonds.
Short-term debt is not risk-free, but generally the danger of default is less for money market securities issued by corporations than for corporate bonds. There are two reasons for this. First, the range of possible outcomes is smaller for short-term investments. Even though the distant future may be clouded, you can usually be confident that a particular company will survive for at least the next month. Second, for the most part, only well-established companies can borrow in the money market. If you are going to lend money for just a few days, you can’t afford to spend too much time in evaluating the loan. Thus, you will consider only blue-chip borrowers.
Despite the high quality of money market investments, there are often significant differences in yield between corporate and U.S. government securities. Why is this? One answer is the risk of default. Another is that the investments have different degrees of liquidity or “moneyness.” Investors like Treasury bills because they are easily turned into cash on short notice. Securities that cannot be converted so quickly and cheaply into cash need to offer relatively high yields. During times of market turmoil investors may place a particularly high value on having ready access to cash. On these occasions the yield on illiquid securities can increase dramatically.
The International Money Market
In Chapter 24, we pointed out that there are two main markets for dollar bonds. There is the domestic market in the United States, and there is the eurobond market centered in London. There is also an international market for short-term dollar investments, which is known as the eurodollar market. Eurodollars have nothing to do with the euro, the currency of the European Monetary Union (EMU). They are simply dollars deposited in a bank in Europe.
Just as there is both a domestic U.S. money market and a eurodollar market, so there is both a domestic Japanese money market and a market in London for euroyen. So, if a U.S. corporation wishes to make a short-term investment in yen, it can deposit the yen with a bank in Tokyo or it can make a euroyen deposit in London. Similarly, there is both a domestic money market in the euro area as well as a money market for euros in London.16 And so on.
Major international banks in London lend dollars to one another at the London interbank offered rate (LIBOR). Similarly, they lend yen to each other at the yen LIBOR interest rate, and they lend euros at the euro interbank offered rate, or Euribor. These interest rates are used as a benchmark for pricing many types of short-term loans in the United States and in other countries. For example, a corporation in the United States may issue a floating-rate note with interest payments tied to dollar LIBOR.
If we lived in a world without regulation and taxes, the interest rate on a eurodollar loan would have to be the same as the rate on an equivalent domestic dollar loan. However, the international debt markets thrive because governments attempt to regulate domestic bank lending. When the U.S. government limited the rate of interest that banks in the United States could pay on domestic deposits, companies could earn a higher rate of interest by keeping their dollars on deposit in Europe. As these restrictions have been removed, differences in interest rates have largely disappeared.
In the late 1970s, the U.S. government was concerned that its regulations were driving business overseas to foreign banks and the overseas branches of American banks. To attract some of this business back to the States, the government in 1981 allowed U.S. and foreign banks to establish international banking facilities (IBFs). An IBF is the financial equivalent of a free-trade zone; it is physically located in the United States, but it is not required to maintain reserves with the Federal Reserve and depositors are not subject to any U.S. tax.17 However, there are tight restrictions on what business an IBF can conduct. In particular, it cannot accept deposits from domestic U.S. corporations or make loans to them.
Money Market Instruments
The principal money market instruments are summarized in Table 30.5. We describe each in turn.
TABLE 30.5 Money market investments in the United States
U.S. Treasury Bills The first item in Table 30.5 is U.S. Treasury bills. These are usually issued weekly and mature in four weeks, three months, six months, or one year.18 Sales are by a uniform-price auction. This means that all successful bidders are allotted bills at the same price.19 You don’t have to participate in the auction to invest in Treasury bills. There is also an excellent secondary market in which billions of dollars of bills are bought and sold every day.
Federal Agency Securities “Agency securities” is a general term used to describe issues by government agencies and government-sponsored enterprises (GSEs). Although most of this debt is not guaranteed by the U.S. government,20 investors have generally assumed that the government would step in to prevent a default. That view was reinforced in 2008, when the two giant mortgage companies, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) ran into trouble and were taken into government ownership.
Agencies and GSEs borrow both short and long term. The short-term debt consists of discount notes, which are similar to Treasury bills. They are actively traded and often held by corporations. These notes have traditionally offered somewhat higher yields than U.S. Treasuries. One reason is that agency debt is not quite as marketable as Treasury issues. In addition, unless the debt has an explicit government guarantee, investors have demanded an extra return to compensate for the (small?) possibility that the government would allow the agency to default.
Short-Term Tax-Exempts Short-term notes are also issued by states, municipalities, and agencies such as state universities and school districts.21 These have one particular attraction—the interest is not subject to federal tax.22 Of course, this tax advantage of municipal debt is usually recognized in its price. For many years, triple-A municipal debt yielded 10% to 30% less than equivalent Treasury debt.
Most tax-exempt debt is relatively low risk, and is often backed by an insurance policy, which promises to pay out if the municipality is about to default.23 However, in the turbulent markets of 2008 even the backing of an insurance company did little to reassure investors, who worried that the insurers themselves could be in trouble. The tax advantage of “munis” no longer seemed quite so important.
Variable-Rate Demand Notes There is no law preventing firms from making short-term investments in long-term securities. If a firm has $1 million set aside for an income tax payment, it could buy a long-term bond on January 1 and sell it on April 15, when the taxes must be paid. However, the danger with this strategy is obvious. What happens if bond prices fall by 10% between January and April? There you are with a $1 million liability to the Internal Revenue Service, bonds worth only $900,000, and a very red face. Of course, bond prices could also go up, but why take the chance? Corporate treasurers entrusted with excess funds for short-term investments are naturally averse to the price volatility of long-term bonds.
One solution is to buy municipal variable-rate demand notes (VRDNs). These are long-term securities, whose interest payments are linked to the level of short-term interest rates. Whenever the interest rate is reset, investors have the right to sell the notes back to the issuer for their face value.24 This ensures that on these reset dates the price of the notes cannot be less than their face value. Therefore, although VRDNs are long-term loans, their prices are very stable. In addition, the interest on municipal debt has the advantage of being tax-exempt. So a municipal variable-rate demand note offers a relatively safe, tax-free, short-term haven for your $1 million of cash.
Bank Time Deposits and Certificates of Deposit If you make a time deposit with a bank, you are lending money to the bank for a fixed period. If you need the money before maturity, the bank usually allows you to withdraw it but exacts a penalty in the form of a reduced rate of interest.
In the 1960s, banks introduced the negotiable certificate of deposit (CD) for time deposits of $1 million or more. In this case, when a bank borrows, it issues a certificate of deposit, which is simply evidence of a time deposit with that bank. If a lender needs the money before maturity, it can sell the CD to another investor. When the loan matures, the new owner of the CD presents it to the bank and receives payment.25
Commercial Paper and Medium-Term Notes As discussed in detail in Chapter 24, these consist of unsecured, short- and medium-term debt issued by companies on a regular basis.
Bankers’ Acceptances We saw earlier in the chapter how bankers’ acceptances (BAs) may be used to finance exports or imports. An acceptance begins life as a written demand for the bank to pay a given sum at a future date. Once the bank accepts this demand, it becomes a negotiable security that can be bought or sold through money-market dealers. Acceptances by the large U.S. banks generally mature in one to six months and involve very low credit risk.
Repurchase agreements, or repos, are effectively secured loans that are typically made to a government security dealer. They work as follows: The investor buys part of the dealer’s holding of Treasury securities and simultaneously arranges to sell them back again at a later date at a specified higher price.26 The borrower (the dealer) is said to have entered into a repo; the lender (who buys the securities) is said to have a reverse repo.
Repos sometimes run for several months, but more frequently, they are just overnight (24-hour) agreements. No other domestic money-market investment offers such liquidity. Corporations can treat overnight repos almost as if they were interest-bearing demand deposits.
Suppose that you decide to invest cash in repos for several days or weeks. You don’t want to keep renegotiating agreements every day. One solution is to enter into an open repo with a security dealer. In this case, there is no fixed maturity to the agreement; either side is free to withdraw at one day’s notice. Alternatively, you may arrange with your bank to transfer any excess cash automatically into repos.
Auction-Rate Preferred Stock Common stock and preferred stock have an interesting tax advantage for corporations since firms pay tax on only 50% of the dividends that they receive. So, for each $1 of dividends received, the firm gets to keep 1 − (.50 × .21) = $.895. Thus the effective tax rate is only 10.5%. This is higher than the zero tax rate on the interest from municipal debt but much lower than the 21% rate that the company pays on other debt interest.
Suppose that you consider investing your firm’s spare cash in some other corporation’s preferred stock. The 10.5% tax rate is very tempting. On the other hand, you worry that the price of the preferred shares may change if long-term interest rates change. You can reduce that worry by investing in preferred shares whose dividend payments are linked to the general level of interest rates.27
Varying the dividend payment doesn’t quite do the trick because the price of the preferred stock could still fall if the risk increases. So, a number of companies added another wrinkle to floating-rate preferred. Instead of being tied rigidly to interest rates, the dividend can be reset periodically by means of an auction that is open to all investors. Investors can state the yield at which they are prepared to buy the stock. Existing shareholders who require a higher yield simply sell their stock to the new investors at its face value.
Auction-rate preferred stock is similar to a variable-rate demand note except that the issuer is not obliged to buy the stock back. If no new investors turn up at the auction, the existing shareholders are left holding the baby. That is what happened in 2008. Angry shareholders, who were unable to sell their stock, complained that banks had fraudulently marketed the issues as equivalent to cash, and many of the banks that originally handled the issues agreed to buy them back. Auction-rate preferred stock no longer seemed such a safe haven for cash.
SUMMARY
This chapter examines the current assets and liabilities on the firm’s book balance sheet. The most important current assets are inventories, accounts receivable, cash, and short-term investments. The most important current liabilities are accounts payable and short-term debt, which includes both short-term loans and principal payments on long-term debt coming due in the next 12 months.
Current assets and liabilities constitute the firm’s working capital. The difference between current assets and liabilities is its net working capital.
The composition of working capital varies widely across industries. For example, supermarket chains and other retail businesses must keep large inventories on their shelves and at local warehouses. Railroads and trucking companies, on the other hand, transport other companies’ inventories but hold little or none of their own.
Some companies rely on short-term debt to help finance inventories and accounts receivable. Most companies also get short-term financing from accounts payable. Accounts payable can be low-cost financing if suppliers do not demand cash on delivery (COD) and the firm pays its bills quickly enough to pocket discounts for prompt payment.
Inventories consist of raw materials, work in process, and finished goods. There are benefits to holding inventories. For example, a stock of raw materials reduces the risk that the firm will be forced to shut down production because of an unexpected shortage. But inventories also tie up capital and are expensive to store. The task of the production manager is to strike a sensible balance between these benefits and costs. In recent years, many companies have decided that they can get by on lower inventories than before. For example, some have adopted just-in-time systems that allow the firm to keep inventories to a minimum by receiving a regular flow of components and raw materials throughout the day.
Credit management (the management of receivables) involves five steps:
1. Establish the length of the payment period and the size of any cash discounts for customers who pay promptly.
2. Decide the form of the contract with your customer. For example, if your customer’s credit is shaky, you can ask the customer to arrange a banker’s acceptance. In this case payment is guaranteed by the customer’s bank.
3. Assess your customer’s creditworthiness. You can either do your own homework or rely on a credit agency or credit bureau that specializes in gathering information about the credit standing of firms or individuals.
4. Establish sensible credit limits. Remember your aim is not to minimize the number of bad debts, but to maximize profits. Remember also not to be too shortsighted in reckoning the expected profit. It may be worth accepting marginal applicants if there is a chance that they may become regular and reliable customers.
5. Collect. You need to be resolute with the truly delinquent customers, but you do not want to offend the good ones by writing demanding letters just because their check has been delayed in the mail.
Firms need cash on hand to pay suppliers, meet payrolls, buy equipment, pay debt service, and for all the other transactions required to keep a business humming along smoothly. But idle cash earns no interest. Firms therefore establish systems and procedures to transfer excess cash into central accounts at concentration banks. The transfers are almost always made electronically. The central accounts can then provide cash to plants or subsidiaries that will need it. Remaining cash is invested in the money market, perhaps overnight in repurchase transactions or perhaps in securities with maturities of weeks or months. Companies with permanent cash surpluses sometimes also invest in long-term securities. We noted Apple’s extensive holdings of long-term corporate debt.
FURTHER READING
Here are some general textbooks on working capital management:
J. S. Sagner, Working Capital Management: Applications and Case Studies (New York: John Wiley & Sons, 2014).
J. Zietlow, M. Hill, and T. Maness, Short-Term Financial Management, rev. 5th ed., (San Diego, CA: Cognella Publishing, 2016).
A standard text on the practice and institutional background of credit management is:
R. H. Cole and L. Mishler, Consumer and Business Credit Management, 11th ed. (New York: McGraw-Hill, 1998).
For a more analytical discussion of credit policy, see:
S. Mian and C. W. Smith, “Extending Trade Credit and Financing Receivables,” Journal of Applied Corporate Finance 7 (Spring 1994), pp. 75–84.
M. A. Petersen and R. G. Rajan, “Trade Credit: Theories and Evidence,” Review of Financial Studies 10 (Fall 1997), pp. 661–691.
A useful book on cash management is:
M. Allman-Ward and J. Sagner, Essentials of Managing Corporate Cash (New York: Wiley, 2003).
Two readable discussions of why some companies maintain more liquidity than others are:
A. Dittmar, “Corporate Cash Policy and How to Manage It with Stock Repurchases,” Journal of Applied Corporate Finance 20 (Summer 2008), pp. 22–34.
L. Pinkowitz and R. Williamson, “What Is the Market Value of a Dollar of Corporate Cash?” Journal of Applied Corporate Finance 19 (Summer 2007), pp. 75–84.
For descriptions of the money-market and short-term lending opportunities, see:
F. J. Fabozzi, The Handbook of Fixed Income Securities, 8th ed. (New York: McGraw-Hill, 2012).
F. J. Fabozzi, S. V. Mann, and M. Choudhry, The Global Money Markets (New York: John Wiley, 2002).
Chapter 4 of U.S. Monetary Policy and Financial Markets, available on the New York Federal Reserve website, www.ny.frb.org.
PROBLEM SETS
Select problems are available in McGraw-Hill’s Connect. Please see the preface for more information.
1. Components of working capital Take a look at Figure 30.1. Why do food stores hold large inventories? Why do railroads hold small inventories? Why do you think that pharmaceutical companies hold so much cash and securities? Answer briefly.
2. Components of working capital* True or false?
a. Companies with negative net working capital are usually in financial trouble.
b. Principal payments on long-term debt are shown as current liabilities if due within the next 12 months.
c. Accounts payable are usually a small fraction of the firm’s total liabilities.
d. Accounts receivable are usually the largest category of current assets.
e. Less profitable companies typically hold larger cash balances as a precautionary measure.
f. Well-managed companies invest the majority of their excess cash in short-term securities. They avoid the risks of investing in long-term bonds.
3. Inventory* True or false?
a. Just-in-time inventory systems reduce the cost of managing inventory to zero.
b. Companies hold larger inventories of finished goods when customer demand fluctuates unpredictably.
c. Other things equal, higher real interest rates should lead to lower inventories.
d. Other things equal, lower costs of storage should lead to lower inventories.
4. Inventory What are the trade-offs involved in the decision of how much inventory the firm should carry?
5. Inventory Central banks pushed short-term interest rates down to extremely low levels in the financial crisis that started in 2008. Some Treasury bill rates in Europe were negative. Other things equal, how would you expect corporations’ inventory levels to respond to such a large reduction in interest rates?
6. Inventory Take another look at Example 30.1. Suppose a rise in interest rates increases carrying cost per ton from $55 to $75. What is the effect on economic order quantity?
7. Inventory Polar Express Railroad keeps a $5 million inventory of spare parts on hand for repairing unexpected breakdowns and equipment failures. The inventory is held in one centralized warehouse at a storage cost of $330,000 per year. The inventory has been financed by a short-term bank loan at 6.5% interest.
The operations manager has proposed moving the parts from the centralized warehouse to ten storage locations at the hubs of the Polar Express network. The required total inventory would increase to $7 million because some parts would have to be held in inventory at all 10 locations. Storage costs would increase to $600,000 per year. But having the parts at the hubs would save $400,000 per year in the labor cost of repairs. Also repairs would be completed quicker, improving customer service.
Evaluate the operations manager’s proposal. Assume the opportunity cost of capital is the interest rate on the bank loan.
8. Credit terms* Listed below are some common terms of sale. Can you explain what each means?
a. 2/30, net 60.
b. 2/5, EOM, net 30.
c. COD.
9. Credit terms Some of the items in Problem 8 involve a cash discount. For each of these, calculate the rate of interest paid by customers who pay on the due date instead of taking the cash discount.
10. Credit terms Phoenix Lambert currently sells its goods cash on delivery. However, the financial manager believes that by offering credit terms of 2/10 net 30 the company can increase sales by 4%, without significant additional costs. If the interest rate is 6% and the profit margin is 5%, would you recommend offering credit? Assume first that all customers take the cash discount. Then assume that they all pay on day 30.
11. Credit terms Until recently, Augean Cleaning Products sold its products on terms of net 60, with an average collection period of 75 days. In an attempt to induce customers to pay more promptly, it has changed its terms to 2/10, EOM, net 60. The initial effect of the changed terms is as follows:
|
Average Collection Periods (Days) |
||
|
Percent of Sales with Cash Discount |
Cash Discount |
Net |
|
60 |
30a |
80 |
12. a Some customers deduct the cash discount even though they pay after the specified date.
13. Calculate the effect of the changed terms. Assume
· Sales volume is unchanged.
· The interest rate is 12%.
· There are no defaults.
· Cost of goods sold is 80% of sales.
14. Credit terms Company X sells on a 1/30, net 60 basis. Customer Y buys goods invoiced at $1,000.
a. How much can Y deduct from the bill if Y pays on day 30?
b. What is the effective annual rate of interest if Y pays on the due date rather than on day 30?
c. How would you expect payment terms to change under the following conditions?
i. The goods are perishable.
ii. The goods are not rapidly resold.
iii. The goods are sold to high-risk firms.
15. Credit policy* The Branding Iron Company sells its irons for $50 apiece wholesale. Production cost is $40 per iron. There is a 25% chance that wholesaler Q will go bankrupt within the next six months. Q orders 1,000 irons and asks for six months’ credit. Should you accept the order? Assume that the discount rate is 10% per year, there is no chance of a repeat order, and Q will pay either in full or not at all.
16. Credit policy Look back at Section 30-3. Cast Iron’s costs have increased from $1,000 to $1,050. Assuming there is no possibility of repeat orders, answer the following:
a. When should Cast Iron grant or refuse credit?
b. If it costs $12 to determine whether a customer has been a prompt or slow payer in the past, when should Cast Iron undertake such a check?
17. Credit policy Look back at the discussion in Section 30-3 of credit decisions with repeat orders. If p1 = .8, what is the minimum level of p2 at which Cast Iron is justified in extending credit?
18. Credit policy How should your willingness to grant credit be affected by differences in (a) the profit margin, (b) the interest rate, (c) the probability of repeat orders? In each case, illustrate your answer with a simple example.
19. Credit policy As treasurer of the Universal Bed Corporation, Aristotle Procrustes is worried about his bad debt ratio, which is currently running at 6%. He believes that imposing a more stringent credit policy might reduce sales by 5% and reduce the bad debt ratio to 4%. If the cost of goods sold is 80% of the selling price, should Mr. Procrustes adopt the more stringent policy?
20. Credit policy Jim Khana, the credit manager of Velcro Saddles, is reappraising the company’s credit policy. Velcro sells on terms of net 30. Cost of goods sold is 85% of sales, and fixed costs are a further 5% of sales. Velcro classifies customers on a scale of 1 to 4. During the past five years, the collection experience was as follows:
|
Classification |
Defaults as Percent of Sales |
Average Collection Period in Days for Nondefaulting Accounts |
|
1 |
0 |
45 |
|
2 |
2.0 |
42 |
|
3 |
10.0 |
40 |
|
4 |
20.0 |
80 |
21. The average interest rate was 15%.
22. What conclusions (if any) can you draw about Velcro’s credit policy? What other factors should be taken into account before changing this policy?
23. Credit policy Look again at the last problem. Suppose (a) that it costs $95 to classify each new credit applicant and (b) that an almost equal proportion of new applicants falls into each of the four categories. In what circumstances should Mr. Khana not bother to undertake a credit check?
24. Credit management True or false?
a. Exporters who require greater certainty of payment arrange for the customers to sign a bill of lading in exchange for a sight draft.
b. It makes sense to monitor the credit manager’s performance by looking at the proportion of bad debts.
c. If a customer refuses to pay despite repeated reminders, the company usually turns the debt over to a factor or an attorney.
25. Cash management Complete the passage that follows by choosing the appropriate terms from the following list: lockbox banking, Fedwire, CHIPS, concentration banking.
Firms can increase their cash resources by speeding up collections. One way to do this is to arrange for payments to be made to regional offices that pay the checks into local banks. This is known as _____. Surplus funds are then transferred from the local bank to one of the company’s main banks. Transfers can be made electronically by the _____ or _____ systems. Another technique is to arrange for a local bank to collect the checks directly from a post office box. This is known as _____.
26. Cash management* True or false?
a. “Money market” refers to the system of electronic cash transfers between corporations and within the banking industry.
b. The eurodollar market is a market for exchanging dollars for euros or vice versa.
c. Most large corporations maintain many bank accounts.
d. Yields quoted on a discount basis are always lower than the true interest rate.
e. The cost of holding excess cash is lower when interest rates are lower.
27. Cash management Knob Inc. is a nationwide distributor of furniture hardware. The company now uses a central billing system for credit sales of $180 million annually. First National, Knob’s principal bank, offers to establish a new concentration banking system for a flat fee of $100,000 per year. The bank estimates that mailing and collection time can be reduced by three days. By how much will Knob’s cash balances be increased under the new system? How much extra interest income will the new system generate if the extra funds are used to reduce borrowing under Knob’s line of credit with First National? Assume that the borrowing rate is 12%. Finally, should Knob accept First National’s offer if collection costs under the old system are $40,000 per year?
28. Lockboxes Anne Teak, the financial manager of a furniture manufacturer, is considering operating a lockbox system. She forecasts that 300 payments a day will be made to lockboxes with an average payment size of $1,500. The bank’s charge for operating the lockboxes is $.40 a check. What reduction in the time to collect and process each check is needed to justify the lockbox system?
29. Lockboxes The financial manager of JAC Cosmetics is considering opening a lockbox in Pittsburgh. Checks cleared through the lockbox will amount to $10,000 per day. The lockbox will make cash available to the company three days earlier than is currently the case.
a. Suppose that the bank offers to run the lockbox for a $20,000 compensating balance. Is the lockbox worthwhile?
b. Suppose that the bank offers to run the lockbox for a fee of $.10 per check cleared instead of a compensating balance. What must the average check size be for the fee alternative to be less costly? Assume an interest rate of 6% per year.
c. Why did you need to know the interest rate to answer part (b) but not to answer part (a)?
30. Payment systems A parent company settles the collection account balances of its subsidiaries once a week. (That is, each week it transfers any balances in the accounts to a central account.) The cost of a wire transfer is $10. A check costs $.80. Cash transferred by wire is available the same day, but the parent must wait three days for checks to clear. Cash can be invested at 12% per year. How much money must be in a collection account before it pays to use a wire transfer?
31. Money-market yields In October 2008, six-month (182-day) Treasury bills were issued at a discount of 1.4%. What was the annual yield?
32. Money-market yields* A three-month Treasury bill and a six-month bill both sell at a discount of 10%. Which offers the higher annual yield?
33. Money-market yields In Section 30-5, we described a three-month bill that was issued on an annually compounded yield of 5%. Suppose that one month has passed and the investment still offers the same annually compounded return. What is the percentage discount? What was your return over the month?
34. Money-market yields Look again at Problem 29. Suppose another month has passed, so the bill has only one month left to run. It is now selling at a discount of 3%. What is the yield? What was your realized return over the two months?
35. Money-market securities For each item below, choose the investment that best fits the accompanying description:
a. Maturity often overnight (repurchase agreements/bankers’ acceptances).
b. Maturity never more than 270 days (tax-exempts/commercial paper).
c. Issued by the U.S. Treasury (tax-exempts/three-month bills).
d. Quoted on a discount basis (certificates of deposit/Treasury bills).
e. Sold by auction (tax-exempts/Treasury bills).
36. Money-market securities Consider three securities:
a. A floating-rate bond.
b. A preferred share paying a fixed dividend.
c. A floating-rate preferred.
If you were responsible for short-term investment of your firm’s excess cash, which security would you probably prefer to hold? Could your answer depend on your firm’s tax rate? Explain briefly.
37. Money-market securities Look up current interest rates offered by short-term investment alternatives. Suppose that your firm has $1 million excess cash to invest for the next two months. How would you invest this cash? How would your answer change if the excess cash were $5,000, $20,000, $100,000, or $100 million?
38. Tax-exempts In 2006, agency bonds sold at a yield of 5.32%, while high-grade tax-exempts of comparable maturity offered 3.7% annually. If an investor receives the same after-tax return from corporates and tax-exempts, what is that investor’s marginal rate of tax? What other factors might affect an investor’s choice between the two types of securities?
39. Taxation. What is a territorial corporate income tax system? How does it differ from the U.S. tax system that was in place before 2018? Explain why the U.S. system in 2017 and earlier forced U.S companies to leave and invest profits abroad.
40. Tax-exempts The IRS prohibits companies from borrowing money to buy tax-exempts and deducting the interest payments on the borrowing from taxable income. Should the IRS prohibit such activity? If it didn’t, would you advise the company to borrow to buy tax-exempts?
41. After-tax yields Suppose you are a wealthy individual paying 37% tax on interest income, 20% on dividends, and zero tax on municipal notes. What is the expected after-tax yield on each of the following investments?
a. A municipal note yielding 6.5% pretax.
b. A Treasury bill yielding 8% pretax.
c. A floating-rate preferred stock yielding 7.5% pretax.
How would your answer change if the investor is a corporation paying tax at 21%? What other factors would you need to take into account when deciding where to invest the corporation’s spare cash?
CHALLENGE
38. Credit policy Galenic Inc. is a wholesaler for a range of pharmaceutical products. Before deducting any losses from bad debts, Galenic operates on a profit margin of 5%. For a long time, the firm has employed a numerical credit scoring system based on a small number of key ratios. This has resulted in a bad debt ratio of 1%.
Galenic recently commissioned a detailed statistical study of the payment record of its customers over the past eight years and, after considerable experimentation, identified five variables that could form the basis of a new credit scoring system. On the evidence of the past eight years, Galenic calculates that for every 10,000 accounts, it would have experienced the following default rates:
|
Number of Accounts |
|||
|
Credit Score under Proposed System |
Defaulting |
Paying |
Total |
|
Greater than 80 |
60 |
9,100 |
9,160 |
|
Less than 80 |
40 |
800 |
840 |
|
Total |
100 |
9,900 |
10,000 |
39. By refusing credit to firms with a low credit score (less than 80), Galenic calculates that it would reduce its bad debt ratio to 60/9,160, or just under .7%. While this may not seem like a big deal, Galenic’s credit manager reasons that this is equivalent to a decrease of one-third in the bad debt ratio and would result in a significant improvement in the profit margin.
a. What is Galenic’s current profit margin, allowing for bad debts?
b. Assuming that the firm’s estimates of default rates are right, how would the new credit scoring system affect profits?
c. Why might you suspect that Galenic’s estimates of default rates will not be realized in practice? What are the likely consequences of overestimating the accuracy of such a credit scoring scheme?
d. Suppose that one of the variables in the proposed scoring system is whether the customer has an existing account with Galenic (new customers are more likely to default). How would this affect your assessment of the proposal?
40. The cost of capital for current assets Look again at Problem 7, which asked you to assume that the 6.5% interest rate was the opportunity cost of capital. Was that a reasonable assumption? What should the opportunity cost of capital for inventory depend on? Would it ever make sense to use the firm’s overall weighted average cost of capital? What if the inventory was not spare parts for a railroad, but a risky commodity, for example crude oil stocks held as raw material for a petrochemical plant? Discuss and explain.
FINANCE ON THE WEB
1. The three main credit bureaus maintain useful websites with examples of their business and consumer reports. Log on to www.equifax.com and look at the sample report on a small business. What information do you think would be most useful if you were considering granting credit to the firm?
2. Log on to the Federal Reserve site at www.federalreserve.gov and look up current money market interest rates. Suppose your business has $7 million set aside for an expenditure in three months. How would you choose to invest it in the meantime? Would your decision be different if there were some chance that you might need the money earlier?
1Where the firm uses up materials at a constant rate, as in our example, there is a simple formula for calculating the economic order quantity (or EOQ). Its optimal size = 
= 2,043 tons.
2This is known as a reorder point (or two-bin) system. Some firms use instead a periodic review system, where the firm reviews inventory levels periodically and tops the inventory up to the desired amount.
3These examples of just-in-time and build-to-order production are taken from T. Murphy, “JIT When ASAP Isn’t Good Enough,” Ward’s Auto World, May 1999, pp. 67–73; R. Schreffler, “Alive and Well,” Ward’s Auto World, May 1999, pp. 73–77; and “A Long March: Mass Customization,” The Economist, June 12, 2001, pp. 63–65.
4Standard credit terms in different industries are reported in C. K. Ng, J. K. Smith, and R. L. Smith, “Evidence on the Determinants of Credit Terms Used in Interfirm Trade,” Journal of Finance 54 (June 1999), pp. 1109–1129.
5The cash discount allows you to pay $98 rather than $100. If you do not take the discount, you get a 20-day loan, but you pay 2/98 = 2.04% more for your goods. The number of 20-day periods in a year is 365/20 = 18.25. A dollar invested for 18.25 periods at 2.04% per period grows to (1.0204)18.25 = $1.446, a 44.6% return on the original investment. If a customer is happy to borrow at this rate, it’s a good bet that he or she is desperate for cash (or can’t work out compound interest). For a discussion of this issue, see J. K. Smith, “Trade Credit and Informational Asymmetry,” Journal of Finance 42 (September 1987), pp. 863–872.
6Commercial drafts are sometimes known by the general term bills of exchange.
7We discussed how you can use these sources of information in Section 23-4.
8We discussed credit scoring models in Section 23-4. Credit bureau scores are often called “FICO scores” because most credit bureaus use a credit scoring model developed by Fair Isaac and Company. FICO scores are provided by the three major credit bureaus’—Equifax, Experian, and TransUnion.
9Look back at our first Cast Iron example, where we concluded that the company is justified in granting credit if the probability of collection is greater than 5/6. If the customer pays, Cast Iron will earn a profit margin of 200/1200 = 1/6. In other words, the company is justified in granting credit if the probability of payment exceeds 1 − profit margin.
10If you don’t want help with collection but do want protection against bad debts, you can obtain credit insurance. For example, most governments have established agencies to insure export business. In the United States, this insurance is provided by the Export-Import Bank in association with a group of insurance companies known as the Foreign Credit Insurance Association (FCIA). Banks are much more willing to lend when exports have been insured. (The Export Import Bank’s congressional authorization was suspended for part of 2015. As of early 2018, its authorization extends to September 2019.)
11For some evidence on the determinants of the supply and demand for trade credit, see M. A. Petersen and R. G. Rajan, “Trade Credit: Theories and Evidence,” Review of Financial Studies 10 (July 1997), pp. 661–691.
12For a discussion of the changing pattern of payment methods, see “Innovations in Retail Payments,” Committee on Payment and Settlement Systems, Bank for International Settlements, Basel, Switzerland, May 2012.
13The Automated Clearing House also handles check conversion transactions and nonrecurring transactions made by telephone or over the Internet.
14Fedwire is a real-time, gross settlement system, which means that each transaction over Fedwire is settled individually and immediately. With a net settlement system, transactions are put into a pot and periodically netted off before being settled. CHIPS is an example of a net system that settles at frequent intervals.
15To confuse things even more, dealers in the money market often quote rates as if there were only 360 days in a year. So a discount of 5% on a bill maturing in 91 days translates into a price of 100 − 5 × (91/360) = 98.74%.
16Occasionally (but only occasionally) referred to as “euroeuros.”
17For these reasons, dollars held on deposit in an IBF are classed as eurodollars.
18Three-month bills actually mature 91 days after issue, six-month bills mature in 182 days, and one-year bills mature in 364 days. For information on bill auctions, see www.publicdebt.treas.gov.
19A small proportion of bills is sold to noncompetitive bidders. Noncompetitive bids are filled at the same price as the successful competitive bids.
20Exceptions are the Government National Mortgage Association (Ginnie Mae), the Small Business Administration, the General Services Administration (GSA), the Farm Credit Financial Assistance Corporation, the Agency for International Development, the Department of Veterans’ Affairs (VINNIE MAE), and the Private Export Funding Corporation (PEFCO). Their debts are backed by the “full faith and credit” of the U.S. government.
21Some of these notes are general obligations of the issuer; others are revenue securities, and in these cases, payments are made from rent receipts or other user charges.
22This advantage is partly offset by the fact that Treasury securities are free of state and local taxes.
23Defaults on tax-exempts have been rare and, for the most part, have involved not-for-profit hospitals. However, there have been a number of major defaults of tax-exempt debt. In 1983, Washington Public Power Supply System (unfortunately known as WPPSS or “WOOPS”) defaulted on $2.25 billion of bonds. In 1994, Orange County in California also defaulted after losing $1.7 billion on its investment portfolio. In 2011, Jefferson Country, Alabama, declared bankruptcy with $4.2 billion in municipal debt. The record for municipal bankruptcies is held by Detroit, which filed for bankruptcy in 2013 with $18 to $20 billion of debt.
24Issuers generally support their borrowing by arranging a backup line of credit with a bank, which ensures that they can find the money to repay the notes.
25Some CDs are not negotiable and are simply identical to time deposits. For example, banks may sell low-value nonnegotiable CDs to individuals.
26To reduce the risk of repos, it is common to lend less than the market value of the security. This difference is known as a haircut.
27The company issuing preferred stock must pay dividends out of after-tax income. So most tax-paying firms would prefer to issue debt rather than floating-rate preferred. However, there are plenty of firms that are not paying taxes and cannot make use of the interest tax shield. Moreover, they have been able to issue floating-rate preferred at yields lower than they would have to pay on a debt issue. The corporations buying the preferreds are happy with these lower yields because 50% of the dividends they receive escape tax.