Short and Intermediate Term Financial Planning January, 2010.
Short Term Financial Management
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Transcript of Short Term Financial Management
Short-Term Financial Management
TVU Reading CollegeMBA Managerial Finance Lecture 3
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BasicsWorking Capital Basics The assets/liabilities that are required
to operate a business on a day-to-day basis Cash Accounts Receivable Inventory Accounts Payable Accruals
These assets/liabilities are short-term in nature and turn over regularly
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Working Capital, Funding Requirements, and the Current Accounts
Gross Working Capital (GWC) represents the investment in assetsWorking Capital Requires Funds Maintaining a working capital balance
requires a permanent commitment of funds Example: Your firm will always have a
minimum level of Inventory, Accounts Receivable, and Cash—this requires funding
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Working Capital, Funding Requirements, and the Current Accounts
Spontaneous Financing Your firm will also always have a
minimum level of Accounts Payable—in effect, money you have borrowed Accounts Payable (and Accruals) are
generated spontaneously Offset the funding required to support
assets Net working capital is Gross Working Capital –
Current Liabilities (or spontaneous financing) Reflects the net amount of funds needed
to support routine operations
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Objective of Working Capital Management
To run the firm efficiently with as little money as possible tied up in Working Capital Involves trade-offs between easier
operation and the cost of carrying short-term assets Benefit of low working capital
Able to funnel money into accounts that generate a higher payoff
Cost of low working capital Risky
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The Cash Conversion Cycle
time = 0
Purchase rawmaterials on account
Operating cycle
Sell finished goodson account
Collect accountsreceivable
Average Collection PeriodAverage Age of Inventory
Average paymentperiod
Cash Conversion Cycle
Time
Payment mailed
Operating cycle
• Time from the beginning of the production to the time when cash is collected from sale
• Financing the operating cycle is costly, so firms have an incentive to shrink it. Cash
conversion cycle
• Operating cycle less the average payment period on accounts payable
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Cost Tradeoffs in Working Capital Accounts
Financing costs resulting from the use of less expensive short-term financing rather than more expensive long-term debt and equity financing
Cost of reduced liquidity caused by increasing current liabilities
Accounts payable, accruals, and notes payable
Short-Term Financing
Order and setup costs associated with replenishment and production of finished goods
Carrying cost of inventory, including financing, warehousing, obsolescence costs, etc.
Inventory
Opportunity cost of lost sales due to overly restrictive credit policy and/or terms
Cost of investment in accounts receivable and bad debts
Accounts receivable
Illiquidity and solvency costsOpportunity cost of fundsCash and marketable securities
Operating Assets
Cost 2 * Shortage Costs(cost of holding too little of operating asset)
Cost 1(holding cost)
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Cost Trade-offs in Short-Term Financial Management
Trade-off of Short-Term Financial Costs
Account Balance
Co
st
Cost 1
Cost 2
Total Cost
Inventory Management
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Inventory ManagementMismanagement of inventory has the potential to ruin a companyInventory is not the direct responsibility of the finance department Usually managed by a functional area
such as manufacturing or operations However, finance department has an
oversight responsibility for inventory management Monitor level of lost of obsolete inventory Supervise periodic physical inventories
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Benefits and Costs of Carrying Adequate Inventory
Benefits Reduces stockouts and backorders Makes operations run more smoothly, improves
customer relations and increases sales
Costs Interest on funds used to acquire inventory Storage and security Insurance Taxes Shrinkage Spoilage Breakage Obsolescence
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Inventory Control and ManagementInventory management refers to the overall way a firm controls inventory and its cost Define an acceptable level of
operating efficiency with regard to inventory
Try to achieve that level with the minimum inventory cost
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Economic Order Quantity (EOQ) ModelEOQ model recognizes trade-offs between carrying costs and ordering costs Carrying costs increase with the
amount of inventory held Ordering costs increase with the
number of orders placed
EOQ minimizes the sum of ordering and carrying costs
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EOQ (Q*)Total costs = Ordering costs + Carrying costsTotal costs = (number of orders per year Cost per order) + (Avg. INV Annual carrying cost per unit)Total costs = (D/Q S) + (Q/2 C)EOQ
CSD
Q2*
365
**
DQ
T D
Q*365oror
• Optimal length of one inventory cycle
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Safety Stocks, Reorder Points and Lead Times
Safety stock provides a buffer against unexpectedly rapid use or delayed delivery An additional supply of inventory that is
carried at all times to be used when normal working stocks run out
Rarely advisable to carry so much safety stock that stockouts never happen Carrying costs would be excessive
Ordering lead time is the advance notice needed so that an order placed will arrive at the needed time Usually estimated by the item’s supplier
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Tracking Inventories—The ABC SystemSome inventory items warrant a great deal of attention Are very expensive Are critical to the firm’s processes or to
those of customers
Some inventory items do not warrant a great deal of attention Commonplace, easy to obtain
An ABC system segregates items by value and places tighter control on higher cost (value) pieces
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Just In Time (JIT) Inventory SystemsSuppliers deliver goods to manufacturers just in time (JIT)Theoretically eliminates the need for factory inventoryA late delivery can stop a factory’s entire production lineJIT works best with large manufacturers who are powerful with respect to the supplier Supplier is willing to do almost anything to
keep the manufacturer’s business
Management of Accounts Receivable
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Accounts Receivable Management
• Determine its credit standards.
• Set the credit terms.• Develop collection policy.• Monitor its A/R on both
individual and aggregate basis.
If a company decides to offer trade credit, it
must:
Credit standards
• Apply techniques to determine which customers should receive credit.
• Use internal and external sources to gather information relevant to the decision to extend credit to specific customers.
• Take into account variable costs of the products sold on credit.
Credit selection
techniques
Five C’s of Credit
Credit scoring
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Five C’s of Credit
– Character: The applicant’s record of meeting past obligations; desire to repay debt if able to do so
– Capacity: The applicant’s ability to repay the requested credit
– Capital: The financial strength of the applicant as reflected by its ownership position
– Collateral: The amount of assets the applicant has available for use in securing the credit
– Conditions: Refers to current general and industry-specific economic conditions
Framework for in-depth credit analysis that is typically used for high-value credit requests:
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Credit Scoring
Uses statistically-derived weights for key credit characteristics to predict whether a credit applicant
will pay the requested credit in a timely fashion.
Used with high volume/small dollar credit requests Most commonly used by large credit card operations, such as
banks, oil companies, and department stores.
• An example…
ABC Co Ltd uses credit scoring to make credit decisions. Decision rule is:• Credit Score > 75: extend standard credit terms• 65 < Credit Score < 75: extend limited credit (convert
to standard credit terms after 1 year if account is properly maintained)
• Credit Score < 65: reject application
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Credit Scoring of a Consumer Credit Application by ABC Co
83.251.00
8.500.1085Years on job
9.000.1090Years at address
20.000.2580Payment history
18.750.2575Income range
15.000.15100Home ownership
12.000.1580Credit references
Weighted Score
[(1) X (2)](3)
Predetermined Weight
(2)
Score(0 to 100)
(1)
Financialand Credit Characteristics
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Changing Credit Standards
• Increase in sales and profits (if positive contribution margin), but higher costs from additional A/R and additional bad debt expense.
Credit standards relaxed
• Reduced investment in A/R and lower bad debt, but lower sales and profit.
Credit standards tightened
An example…YMCc wants to evaluate the effects of a relaxation of its credit standards:
• YMCo sells CD organizers for £12/unit. All sales are on credit. YMC expects to sell 140,000 units next year.
• Variable costs are £8/unit and fixed costs are £200,000 per year.
• The change in credit standards will result in:• 5% increase in sales; average collection period will
increase from 30 to 45 days; increase in bad debt from 1% to 2%.
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Effects of Changes in Credit Standards for YMCo
Cost Variable - Price Sales Margin on Contributi Sales Marginal profit fromincreased sales
28,000 £8/un) - (£12/un un £7000
return required investment additional Cost of marginalinvestment in A/R
receivable accounts ofturnover
sales annual ofcost variabletotalAverage investment in
accounts receivable (AIAR)
Additional profit contribution from sales
Cost of the marginal investment in accounts receivables
To compute additional investment, use the following equations:
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Cost of the marginal investment in accounts receivables
cost/unit variable salesunit annual Total variable cost of annual sales (TVC)
£1,120,000 £8/un un 140,000TVCCURRENT
£1,176,000 £8/un un 147,000TVCPROPOSED
(ACP) period collection average
365Turnover of account
receivable (TOAR)
r times/yea2.12days 30
365
ACP
365TOAR
CURRENTCURRENT
r times/yea1.8days 54
365
ACP
365TOAR
PROPOSEDPROPOSED
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Cost of the marginal investment in accounts receivables
£91,803.2812.2
£1,120,000TOARTVC
AIARCURRENT
CURRENTCURRENT
8£145,185.18.1
£1,176,000TOARTVC
AIARPROPOSED
PROPOSEDPROPOSED
return required investment additional Cost of marginalinvestment in A/R
£6,406 return required AIAR- AIAR( CURRENTPPROPOSED )
Compute additional investment and, assuming a required return of 12%, compute cost of marginal
investment in A/R.
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Cost of Marginal Bad Debt Expense
£35,2800.02£1,764,000 rate expensedebt bad )SalesBDE PROPOSEDPROPOSED (
£16,8000.01£1,680,000 rate expense debt bad )SalesBDE CURRENTCURRENT (
£18,480£16,800-35,280 £Cost of marginal bad debt expense
Net profit for the credit decision
Marginal profit from increased
sales
Cost of marginalinvestment in A/R
Cost of marginal
bad debts= - -
= £28,000 - £6,406 - £18,480 = £3,114
3. Cost of marginal bad debt expense
Subtract the current level of bad debt expense (BDECURRENT) from the expected level of bad debt expense (BDEPROPOSED).
4. Net profit for the credit decision
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Credit Monitoring
Credit monitoring
• The ongoing review of a firm’s accounts receivable to determine if customers are paying according to stated credit terms
Techniques for credit
monitoring
• Average collection period• Ageing of accounts receivable• Payment pattern monitoring
dayper sales average
receivable accounts period collection Average
Average collection period: the average number of days credit sales are outstanding
Ageing of accounts receivable: schedule that indicates the portions of total A/R balance
outstanding
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Credit Monitoring
Payment pattern: the normal timing within which a firm’s customers pay their accounts
• Percentage of monthly sales collected the following month
• Should be constant over time; if payment pattern changes, the firm should review its credit policies
• An example…• DJM Manufacturing determined that:
• 20% of sales collected in the month of sales, 50% in the next month and 30% two months after the sale.
• Can use payment pattern to construct cash receipts from the cash budget:• If January sales are £400,000, DJM expects to collect
£80,000 in January, £200,000 in February, and £120,000 in March.
Management of Cash
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Cash Management
Cash management: the collection, concentration, and disbursement of funds
Cash manager
responsible for
• Cash management• Financial relationships with banks• Cash flow forecasting• Investing and borrowing• Development and maintenance of
information systems for cash management
Float: funds that have been sent by the payer but not yet usable funds to the company
Mail float Processing float
Availability float
Clearing float
Time
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Costs of Holding Cash
Opportunity Costs
Trading costs
Total cost of holding cash
C*
Costs of holding cash
Size of cash balance
The investment income foregone when holding cash.
Trading costs increase when the firm must sell securities to meet cash needs.
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The Baumol Model
C* Size of cash balance
FT
KC
C2
cost Total
FT
C
Trading costs
The optimal cash balance is found where the opportunity costs equals the trading costs
FK
TC 2*
Opportunity Costs KC 2
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The Baumol Model
Opportunity Costs = Trading Costs
The optimal cash balance is found where the opportunity costs equals the trading costs
Multiply both sides by C
FC
TK
C 2
FTKC 2
2
K
FTC
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K
TFC
2*
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Implications of the Miller-Orr Model
To use the Miller-Orr model, the manager must do four things:
1. Set the lower control limit for the cash balance.
2. Estimate the standard deviation of daily cash flows.
3. Determine the interest rate. 4. Estimate the trading costs of buying and
selling securities.
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Implications of the Miller-Orr Model
The model clarifies the issues of cash management: The best return point, Z, is positively
related to trading costs, F, and negatively related to the interest rate K.
Z and the average cash balance are positively related to the variability of cash flows.
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Cash Position Management
Cash position management: collection, concentration, and disbursement of funds on a daily
basis
Smaller companies set target cash balance for their current (Checking) accounts.
Bank account analysis
statement
• Bank provides report to its customers to show recent activity in firms’ accounts.
• Banks cannot pay interest on corporate Current (checking) account balances.
• Firms use earnings credit for balances to offset charges.
Management of short-term investing if the company has a surplus of funds and borrowing arrangements if company has a temporary deficit of funds
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Collections
Primary objective: speeding up collections
Collection systems: function of the nature of the business
Field-banking system
• Collections are made over the counter (retail) or at a collection office (utilities).
Mail-based system
• Mail payments are processed at companies’ collection centers.
Electronic payments
• Becoming increasingly popular because they offer advantages to both parties.
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Collections
Lockbox system(USA)
• Speeds up collections because it affects all components of float.
• Customers mail payments to a post office box.
• Firm’s bank empties the box and processes each payment and deposits the payments in the firm’s account.
• Lockboxes reduce mail and clearing time.
Perform cost-benefit analysis to determine if lockbox system worth using
where,cos ) - LC r (FVR t) t (Net benefi a• FVR = float value reduction in dollars
• ra = cost of capital
• LC = annual operating cost of the lockbox system
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Funds Transfer Mechanisms
Depository transfer checks(USA)
• Unsigned check drawn on one of the firm’s bank accounts and deposited in another of the firm’s bank accounts
Automated direct debit
transfers
• Preauthorized electronic withdrawal from the payer’s account
• Settle accounts among participating banks. Individual accounts are settled by respective bank balance adjustments.
• Transfers clear in one day.
BACS / Chaps/ Swift
transfers
• Electronic communication that, via bookkeeping entries, removes funds from the payer’s bank and deposits the funds in the payee’s bank.
• Bacs – bankers automated clearing system (4 days)
• Chaps Clearing Houses Automated payment system (Same day transfers)
• Swift – International Payments Mechanism
Managing Accounts Payable
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Accounts Payable Management
Management of time from purchase of raw materials until payment is placed in the mail
Accounts payable
functions
• Examine all incoming invoices and determine the amount to be paid.
• Control function: cash manager verifies that invoice information matches purchase order and receiving information.
Decide between centralized or decentralized payables and payments systems
If supplier offers cash discounts, analyze the best alternative between paying at the end of credit
period and taking the discount.
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Disbursements Products and MethodsZero-balance accounts (ZBAs): disbursements accounts that always have end-of-day balance of zero
Allows the firm to maximize the use of float on each cheque, without altering the float time of its suppliers
Keeps all cash in interest-bearing accounts
Controlled disbursement: Bank provides early notification of cheque presented
against a company’s account every day.
Positive pay: Company transmits to the bank a cheque-issued file to the bank when cheques are issued.
Cheque-issued file includes cheque number and amount of each item.
Used for fraud prevention
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Developments in Accounts Payable and Disbursements
Integrated (comprehensive) accounts payable: outsourcing of accounts payable or
disbursements operations
Purchasing/procurement cards: increased use of credit cards for low-dollar
indirect purchases
Imaging services: Both sides of the cheque, as well as
remittance information, is converted into digital images.
Useful when incorporated with positive pay services
Financing Working Capital
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Sources of Short-term FinancingSpontaneous financing Accounts payable and accruals
Unsecured bank loansCommercial paperSecured loans
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Spontaneous FinancingAccruals Money you owe employees, for example, for
work performed but for which they have not yet been paid Tend to be very short-term
Accounts payable (AKA trade credit) Money you owe suppliers for goods you
bought on credit Credit Terms: Terms of trade specify when you
are to repay the debt Example of terms of trade: 2/10, net/30
You must pay the entire amount by 30 days If you pay within 10 days, you will receive a 2%
discount
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Spontaneous FinancingThe prompt payment discount Passing up prompt payment discounts
is generally a very expensive source of financing
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Spontaneous FinancingAbuses of Trade Credit Terms Trade credit, while originally a service
to a firm’s customers, has become so commonplace it is now expected Companies offer it because they have to
Stretching payables is a common abuse of trade credit Paying payables beyond the due date
(AKA: leaning on the table) Slow paying companies receive poor
credit ratings in credit reports issued by credit agencies
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Unsecured Bank LoanRepresent the primary source of short-term loans for most companiesPromissory note (AKA Notes Payable) Note signed promising to repay the
amount borrowed plus interest Bank usually credits the amount to
borrower’s checking account
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Unsecured Bank LoansLine of credit Informal, non-binding agreement between
bank and firm that specifies the maximum amount firm can borrow over a specific time frame (usually a year) Borrower pays interest only on the amount borrowed
Revolving credit agreement Similar to a line of credit except bank
guarantees the availability of funds up to a maximum amount (effectively a binding agreement) Borrower pays a commitment fee on the
unborrowed funds (whether they are used or not)
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Unsecured Bank LoansCompensating balances A minimum amount by which the
borrower’s bank account cannot drop below (therefore it is unavailable for use)
Increases the effective interest rate on a loan
Typically between 10% and 20% of amounts loaned
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Unsecured Bank LoansClean-Up Requirements Theoretically a firm can constantly
roll-over its short-term debt Borrow on a new note to pay off an old
note Risky for both the firm and the bank
Banks require that borrowers clean up short-term loans once a year Remain out of short-term debt for a
certain time period
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Commercial PaperNotes issued by large, financially-strong firms and sold to investors Basically a short-term corporate bond
Unsecured (usually) Buyers are usually other institutions (insurance
companies, mutual funds, banks, pension funds) Maturity is less than 270 days Considered a very safe investment, therefore
pays a relatively low interest rate Rather than paying a coupon rate, interest is
discounted Commercial paper market is rigid and formal—no
flexibility in repayment terms
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Short-Term Credit Secured by Current Assets
Debt is secured by the current asset being financedMore popular in some industries than in others Common in seasonal businesses
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Short-Term Credit Secured by Current Assets
Receivables Financing: Accounts receivable represent money that is
to be collected in the near future Banks recognize that this money will be
collected soon are are willing to lend money based on this soon-to-be-collected money Invoice discounting: firm sells AR to lender but
retains control of control of the accounts AR are now paid directly to lender to a specified
account Factoring AR: firm sells AR to lender (at a) and
the lending firm (factor) takes control of the accounts
AR are now paid directly to lender Lender assumes responsibility for credit control &
collection
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Short-Term Credit Secured by Current Assets
Pledging Accounts Receivable (US Variant of Invoice Discounting) Firm promises to use the money paid from the
collected accounts to pay off bank loan Accounts Receivable still belong to firm which
still collects the accounts If firm doesn’t repay, lender has recourse to borrower
Lender can provide General line of credit tied to all receivables
Lender likely to advance at most 75% of the balance of accounts
Specific line of credit tied to individual accounts receivable
Evaluates based on creditworthiness of account Lender likely to advance as much as 90% of the
balance of accepted accounts
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Short-Term Credit Secured by Current Assets
Factoring Accounts Receivable Firm sells Accounts Receivable to lender (at
a severe discount) and the lending firm (factor) takes control of the accounts Accounts Receivable are now paid directly to
lender Factor usually reviews accounts and only
accepts accounts it deems creditworthy Factors offer a wide range of services
Perform credit checks on potential customers Advance cash on accounts it accepts or remit cash
after collection Collect cash from customers Assume the bad-debt risk when customers don’t
pay
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Short-Term Credit Secured by Current Assets
Inventory Financing (Common in USA) Use a firm’s inventory as collateral for a short-term
loan Popular but subject to a number of problems
Lenders aren’t usually equipped to sell inventory Specialized inventories and perishable goods are difficult
to market Types of methods used
Blanket liens—lender has a lien (claim) against all inventories of the borrower but borrower remains in physical control of inventory
Chattel mortgage agreement—collateralized inventory is identified by serial number and can’t be sold without lender’s permission (but borrower remains in physical control of inventory)
Warehousing—collateralized inventory is removed from borrower’s premises and placed in a warehouse (borrower’s access controlled by third party)
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Short-Term Financial ManagementLength of cash conversion cycle determines the amount of resources the firm must invest in its operations.Cost trade-offs apply to managing cash and marketable securities, accounts receivable, inventory and accounts payable.Objective for account receivable: collect accounts as quickly as possible without
losing sales.
Objective for accounts payable: pay accounts as slowly as possible without
damaging firm’s credit.
Working Capital Finance Principle is to Match Length of Finance with Asset