Introduction to Corporate Finance

ONLINE CHAPTERS

18 -1 THE CASH CONVERSION CYCLE

18 -1a OPERATING CYCLE

A central concept in short-term financial management is the notion of the operating cycle. A company’s

operating cycle (OC) measures the time that elapses from the company’s receipt of raw materials to its

collection of cash from the sale of finished products.

As you might expect, operating cycles vary widely by industry. For instance, a bakery company such

as Baker’s Delight – which uses fresh ingredients, keeps finished goods in inventory for only a day or

LO18.1

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

describe the cash conversion cycle, the

company’s objectives with regard to it

and the actions the company can use to

accomplish these objectives

explain the cost trade-offs the company

must consider when finding the optimal

levels of both operating assets and short-

term financing

discuss the key concerns of the financial

manager with regard to inventory and some

of the popular techniques used to manage it

review the key aspects of a company’s

credit standards, including the five C’s of

credit and the role of credit scoring

analyse proposed changes in a company’s

credit standards and its credit terms

using both descriptive and quantitative

techniques

understand the collection policy procedures

used by companies, the techniques

companies use in credit monitoring and the

cash application process.

LO18.1

LO18.2

LO18.3

LO18.4

LO18.5

LO18.6

We now switch our focus from planning to

operations, and in this chapter describe the

company’s cash conversion and key operating

assets – the current assets needed to support a

company’s day-to-day operations. We discuss

the two key operating assets, inventory and

accounts receivable. Most companies work hard

to reduce the size of their investments in these

types of assets. Of course it is necessary to keep

inventory on hand to keep production flowing

and to satisfy unanticipated customer needs, but

a company that invests too much in inventory is

not deploying its resources efficiently. Indeed,

over the past two decades, the percentage of total

corporate assets tied up in inventory balances has

been in decline, partly because of advances in

information technology that allow companies to

communicate more effectively with vendors and

customers. Likewise, companies routinely sell to

customers on credit (often for competitive reasons),

but without careful analysis behind the decision to

extend credit and monitoring to ensure that credits

are collected, accounts receivable balances can

become excessive.

This chapter focuses on the cash conversion

cycle and the efficient management of inventory

and accounts receivable. We begin with the cash

conversion cycle and the actions that can be

taken to manage it. Next, we describe the cost

trade-offs in short-term financial management.

We then briefly consider the key concerns of the

financial manager with regard to inventory, before

reviewing some popular inventory management

techniques. Next we discuss effective accounts

receivable management and review two important

related concepts, credit standards and credit terms.

Finally, we briefly cover some other receivables

management activities.

operating assets
Cash, marketable securities,
accounts receivable and
inventories necessary to
support the day-to-day
operations of a company