Introduction to Corporate Finance

18: Cash Conversion, Inventory and Receivables Management

This year’s working capital survey draws

some interesting insights coming off a

thriving US economy with the Standard &

Poor’s 500-Stock Index gaining 11% in 2014,

companies in this year’s survey gaining 9%

in value, and revenue increasing 4% for

both. Positive increases in the stock market,

investment activities, consumer confidence,

housing, and employment, to name a few, all

have contributed to an improving economy in

2014 and confident outlook beyond.

However, the findings from this year’s

survey indicate companies have learned

very little from the Great Recession [or

global financial crisis] in terms of their

cash management strategies, taking on

alarming amounts of debt to fund increased

investment activities while doing very little

operationally to improve their own internal

cash generation. ‘Cash is king’ has been a

traditional mantra but ironically, given recent

history, debt has taken over the reins.

Source: The Hackett Group. Used with permission. 2015 US capital working survey, The Hackett Group. http://images.insights.thehackettgroup.com/Web/

TheHackettGroupInc/%7B3ae545f4-4e01-47f9-ab5f-118877260763%7D_HCKT-2015-US-Working-Capital-Survey.pdf?elqTrack=true Accessed 8 September 2015.

18-2 COST TRADE-OFFS IN SHORT-TERM

FINANCIAL MANAGEMENT

When attempting to manage the company’s short-term accounts so as to minimise cash while adequately

funding the company’s operations, the financial manager must focus on competing costs. Decisions with

regard to the optimum levels of both operating assets and short-term financing involve cost trade-offs.

For convenience, we will view the current-account decision strategies as being revenue neutral, and thus

will examine their cost trade-offs solely in terms of minimising total cost. Clearly, with revenue neutral,

minimising total costs should increase the company’s net cash flows and therefore its value. The above

Finance in practice feature, and the full report on which it is based, summarise the recent working capital

practices of a large number of US companies and relates them to their performance.

The optimum levels of the key operating assets – cash and marketable securities, inventory and

accounts receivable – involve trade-offs between the cost of holding the operating asset and the cost of

maintaining too little of the asset. Figure 18.2 depicts the cost trade-offs and optimum level of a given

operating asset. Cost 1 is the holding cost, which increases with larger operating asset account balances.

Cost 2 is the cost of holding too little of the operating asset, which decreases with larger operating asset

account balances. The total cost is the sum of cost 1 and cost 2 associated with a given account balance

for the operating asset. As noted, the optimum balance occurs at the point where total cost is minimised.

The table at the bottom of Figure 18.2 provides more detail on the specific costs for each operating

asset. For example, consider cash and marketable securities. As the balance of these accounts increases,

the opportunity costs and tax costs (cost 1) of the funds held in the company rise. At the same time, the

illiquidity and solvency costs (cost 2) fall; the higher the cash and marketable securities balance, the

greater the company’s liquidity and the lower its likelihood of becoming insolvent. Hence, the optimum

balance of cash and marketable securities is the one that minimises the total of these two competing

costs. We can evaluate the cost trade-offs for inventory and accounts receivable in a similar way, using

the cost descriptions given in the table and relating them to the two cost functions in the figure. Clearly,

in all cases a decrease in the operating asset account balance would have the opposite effect.

LO18.2