ONLINE CHAPTERS
IMPORTANT EQUATIONS
18.1 CCC = OC – APP = AAI + ACP – APP18.2 EOQ=2SO
C■ The cash conversion cycle has three
main components: (1) the average age of
inventory (AAI); (2) the average collection
period (ACP); and (3) the average payment
period (APP). The operating cycle (OC)
is the sum of the AAI and ACP. The cash
conversion cycle (CCC) is OC minus APP.
The length of the cash conversion cycle
determines the amount of resources the
company must invest in its operations.■ The financial manager’s focus when managing
the company’s short-term activities is on
shortening the cash conversion cycle. The
basic strategies are to turn inventory quickly;
collect accounts receivable quickly; pay
accounts slowly; and manage mail, processing
and clearing time efficiently.
■ When managing the company’s short-term
accounts, the financial manager must focus
on competing costs. These cost trade-offs
apply to managing cash and marketable
securities; accounts receivable; inventory;
and accounts payable, accruals and notes
payable. The goal is to balance the cost
trade-offs in a way that minimises the total
cost of each of these accounts, thereby
increasing net cash flows and value.
■ The large inventory investment made by
most companies makes inventory a major
concern of the financial manager, who must
make sure that the amount of money tied up
in inventory – raw materials, work in process
and finished goods – is justified by the
returns generated from such investment.
■ Operations/production managers use a
number of techniques to control inventory.
These include the ABC system, the basic
economic order quantity (EOQ) model,
reorder points and safety stock, material
requirements planning and the just-in-time
(JIT) system. Financial managers tend to
serve a watchdog role over these activities.■ The objective for managing accounts
receivable is to balance the competing interests
of financial managers, who prefer to receive
cash payments sooner, and those of sales
personnel, who wish to use liberal credit terms
to attract new customers. The key aspects
of accounts receivable management include
credit standards, credit terms, collection policy,
credit monitoring and cash application.
■ When analysing credit applicants, the
company can gather information from both
internal and external sources. Two popular
approaches to granting credit to customers
are the five Cs of credit and credit scoring
(for high-volume–low-dollar requests), which
is used to make relatively informed credit
decisions quickly and inexpensively.■ Companies should perform a cost–benefit
analysis of credit standards, credit terms
and other accounts receivable changes to
ensure that such policies are profitable.
Key variables involved in such an analysis
include the marginal profit contribution from
sales, the cost of the marginal investment in
accounts receivable and the cost of marginal
bad debts. Cash discount decisions would
also consider the cost of the cash discount.
■ The company’s collection policy involves
actions aimed at collecting delinquent
accounts; these typically include reminders,
form letters, telephone calls or personal
visits. If these actions are ineffective, the
company sends negative reports to credit
bureaus and may turn over the account to a
collection agency or an attorney.
■ The three most popular techniques for
credit monitoring are the average collection
period, ageing of accounts receivable and
payment-pattern monitoring. Companies
typically make cash application of customer
payments using either the open-item
method or the balance-forward method.LO18.1LO18.2LO18.3LO18.4LO18.5LO18.6SUMMARY