18: Cash Conversion, Inventory and Receivables ManagementThe optimum level of short-term financing (accounts payable, accruals and notes payable) involves
the same type of cost trade-offs as demonstrated in Figure 18.2 for operating assets. As noted in the
bottom portion of the accompanying table, as the short-term financing balance increases, the company
faces an increasing cost of reduced liquidity (cost 1). At the same time, the company’s financing costs
(cost 2) decline; short-term financing costs are lower than the alternative of using long-term debt and
equity financing. The optimum amount of short-term financing is one that minimises total cost, as shown
in the graph in Figure 18.2. A decrease in the short-term financing balance would have the opposite
effects on the competing costs.
The financial manager’s primary focus when managing current accounts is to minimise total cost,
and thereby increase shareholder value. Each of these account balances can be evaluated quantitatively
using decision models. The remainder of this chapter, and the following chapter, emphasise effective
techniques and strategies for actively managing the current accounts over which the financial manager
has direct responsibility.
CONCEPT REVIEW QUESTIONS 18-2
3 What general cost trade-offs must the financial manager consider when managing a company’s
operating assets? How do these costs behave as a company considers reducing its accounts
receivable by, say, establishing more restrictive credit terms? How can the company determine the
optimum balance?4 What general cost trade-offs are associated with a company’s level of short-term financing? How do
these costs behave when a company substitutes short-term financing for long-term financing? How
would you model this decision quantitatively to find the optimal level of short-term financing?18-3 INVENTORY MANAGEMENT
Inventory is an important current asset. For the typical Australian manufacturer, inventory represents
between 12% and 20% of total assets – a sizeable investment. Inventory consists of the company’s stock of
raw materials, work in process and finished goods. Although inventory management is the responsibility
of operations and production managers, it is also a major concern of the financial manager because of
the large investments involved.
The company’s goal should be to move inventory quickly in order to minimise its investment. At
the same time, it must be careful to maintain adequate inventory to meet demand and minimise lost
sales caused by stock outages. The financial manager attempts to maintain optimal inventory levels that
reconcile these conflicting objectives. Also, because obsolescence, due perhaps to the production of a
new model of a manufactured good, can severely reduce the value of inventories, the company must
carefully control inventory to avoid potential major losses in asset values.
Here we consider the aspects of inventory that concern the financial manager: the amount invested
in inventory, and several popular techniques for controlling inventory.^1
1 For detailed discussions of these and other inventory management techniques, see Thomas E Vollman, William Lee Berry, David Clay
Whybark and R Robert Jacobs, Manufacturing Planning and Control for Supply Chain Management, 5th edition , 2005, (Burr Ridge, IL:
McGraw-Hill Irwin, p. 20).