CTP Exam Quiz 05

Working capital
Working capital is the difference between current assets and current liabilities. Sometime working capital is considered just the current assets and net working capital is the current assets minus the current liabilities. Current assets include cash, securities, accounts receivable, and inventory. Current liabilities include accounts payable and short term debt.

Working capital management strives to balance current assets and liabilities in a way that maintains sufficient cash flow but also maximizes rates of return. This can involve choosing strategies that increase earnings. For example, if the current ratio is high, it indicates low risk, and there will likely be enough cash to pay operating expenses. However, it also means that the cash is likely earning relatively little (low risk generally means low interest rates) and the current liabilities are likely paying high interest rates. This combination can result in a loss of earnings. Working capital management examines these issues using ratio analysis and by assessing the operating cash flow cycle. The best strategy for increasing earnings is then determined.

Conversion cycles
The cash conversion cycle measures the time (average number of days) between cash outflow and cash inflow. Different firms have different conversion cycles.
Manufacturers and retailers have an inventory conversion period. Manufacturers include raw materials when calculating their inventory conversion also known as a day’s inventory. This is the sum of ‘raw material in inventory’ average days, ‘raw material conversion to finished goods’ average days, and the ‘finished goods in inventory’ average days.

Conversion cycles
Service firms often do not have any inventory conversion period. The receivables conversion period is simply the average time it takes to convert sales into cash. The cash conversion cycle can be shortened by altering the other conversion cycles. The inventory conversion cycle could be reduced with a just in time (JIT) strategy which is the practice of only receiving materials as they are needed in production.

Financing permanent current assets
A firm’s permanent current asset base is the level of current assets that must be maintained for efficient operation of the firm and is financed by either short or long term debt. The permanent current asset base can be financed using an aggressive or conservative strategy. A conservative financing strategy involves using secure, but higher cost, long term debt (maturity in excess of a year) to finance permanent current assets. The aggressive financing strategy involves financing most of the permanent current assets and all temporary current assets with less costly ,but more variable, short term debt(maturity in less than a year).

Financing permanent current assets
The main advantages to short term debt are that it is readily available and flexible. Accounts payable can often obtain instant short term credit as sales increase. A main disadvantage of short term debt financing is the frequent need to renew when each loan reaches maturity. This can increase administrative costs.

Short term credit sources
Short term credit can be obtained from many sources including short term bank loans, asset based loans, commercial paper, accounts payable, and accrued expenses. Short term bank loans and bank lines of credit are unsecured loans and require specific approval from the appropriate manager. Asset based loans are
secured bank loans that are backed by a firm’s collateral, like inventory or accounts receivable.

Short term credit sources
Commercial paper is a quick, low cost, short term (maturity of less than 270 days) promissory note issued by larger corporations through dealers. Accounts payable can obtain ‘spontaneous’ short term credit as sales increase. This form of short term credit must be arranged for in advance with the vendors who supply the credit. Accrued expenses are taxes, wages, and other expenses that are paid periodically. During the interval between the periodic payments, these funds can be available for use by the firm.

Credit to customer requirements
Accounts Receivable (A/R), Accounts Payable (A/P) and inventory comprise the main components of a balance sheet. A/R includes billing, collection, and credit. A/P and inventory are self evident. If credit is to be extended, it will be done through A/R via the controller or credit manager. It should be managed in accordance with the firm’s policy. The credit manager should develop and set the terms of a credit policy.

Credit to customer requirements
The credit manager should develop and set the terms of a credit policy. This should include a system of evaluating customer creditworthiness, credit limits, and of prompt customer billing. The credit policy should also include a procedure for collecting on past due accounts. The treasury manager should be in regular communication with the controller on these credit management issues since the disbursement of credit is related to the treasury. The
sales manager should also be kept informed of the credit policy. Credit management may also be outsourced.

Credit to customer requirements
The credit manager should develop and set the terms of a credit policy. This should include a system of evaluating customer creditworthiness, credit limits, and of prompt customer billing. The credit policy should also include a procedure for collecting on past due accounts. The treasury manager should be in regular communication with the controller on these credit management issues since the disbursement of credit is related to the treasury. The
sales manager should also be kept informed of the credit policy. Credit management may also be outsourced.

Trade credit
When a firm extends trade credit to a customer, it should adhere to the firm’s credit policy. This includes the decision to be strict or lenient. A lenient credit policy leads to more sales, but usually higher default rates. A strict credit policy leads to fewer sales but lower default rates. The credit policy should be administered by a credit manager and disclosed to the customer.

Trade credit
The credit policy should be administered by a credit manager and disclosed to the customer. The customer should be aware that to qualify for credit, it must first be verified as creditworthy and this will likely involve a review of the customer’s financial and credit history. The customer should have in writing the terms of the trade credit. The customer should also be aware of the procedures that will be followed in the event the customer is late on payments and/or of defaults on the loan.

Trade credit
The customer should have in writing the terms of the trade credit. The customer should also be aware of the procedures that will be followed in the event the customer is late on payments and/or of defaults on the loan. The firm should also have adequate administrative support in place to facilitate the credit activities (i.e. credit management). Information should be obtained from and given to the finance, accounting, and sales departments since they all would be involved in some aspect of credit management.

Credit worthy verification
Before a firm can extend credit it should verify the credit worthiness of the borrower and should conduct a quantitative credit analysis. A credit worthy customer is one that has an ethical character which is reflected in their business history. The customer should have sufficient capital to repay loans and the capacity to do so, evidenced by liquidity ratios and cash flow statistics. If necessary, the collateral that is used to back a secured loan should be verified. Much of this information can be obtained from the firm’s financial statements.

Credit worthy verification
Before a firm can extend credit it should verify the credit worthiness of the borrower and should conduct a quantitative credit analysis. A credit worthy customer is one that has an ethical character which is reflected in their business history. The customer should have sufficient capital to repay loans and the capacity to do so, evidenced by liquidity ratios and cash flow statistics. If necessary, the collateral that is used to back a secured loan should be verified. Much of this information can be obtained from the firm’s financial statements.

Credit worthy verification
Research companies like Dun and Bradstreet provide company credit reports for a fee. A quantitative credit analysis includes using the financial statement information to derive a firm’s debt management ratios and liquidity ratios. It should also review the firm’s return on equity, return on assets, and return on sales measures to assess profitability.

Credit terms
There are several forms of trade credit a firm can extend to a customer that includes installment, revolving, open account (the most common), and commercial letter of credit (L/C). An L/C is the most complex and is usually used in the import/ export trades. Some terms of credit include:
• Consignment is when buyer only pays seller after the goods are sold
• Cash terms where the buyer has 7-10 days to pay in full
• Net terms where payment should be made in full within a set number of days (30-90)
• Discount terms is part of net terms where a discount is offered if paid in full during the first few days of the net period
• Monthly billing can include net or discount terms

Credit terms
There are several forms of trade credit a firm can extend to a customer that includes installment, revolving, open account (the most common), and commercial letter of credit (L/C). An L/C is the most complex and is usually used in the import/ export trades. Some terms of credit include:
• Monthly billing can include net or discount terms
• Cash on delivery (COD)
• Cash Before Delivery (CBD)
• Draft/bill of lading usually used for shipping trade and requires a legal document accompany the goods being shipped and all participants (delivery, recipient, etc.) must sign it.
• Seasonal dating is used by seasonal industries and payment is permitted at the end of the season

Technology on A/R and A/P
The accounts receivable (A/R) and accounts payable (A/P) departments of firms are being affected by the advance in technology in several ways. ‘ECommerce’ utilizes secure internet, intranet, and extranet (i.e. vendor) networks to conduct business electronically. It uses improved Electronic Data Interchange (EDI) and Financial Electronic Data Interchange (FEDI) which is making it easier for business to be conducted largely online. Administrative processes are streamlined, quick, and cost effective. Payments can be made electronically through the Electronic Invoice Presentation and Payment (EIPP) system.

Technology on A/R and A/P
The EIPP also enables billing information and statements to be sent electronically. This greatly reduces the time A/R spends on processing invoices and makes A/R management more suitable to outsourcing. Transactions made through the Automated Clearing House (ACH), which is an electronic funds-transfer system, have been greatly improved and expedited. A/P is also able to make disbursements through these same systems. However, to maximize benefits from Ecommerce, firms need to update their computer systems.

A/P and treasury of firm
Accounts payable (A/P) is required to keep track of invoices, authorize payments, and monitor compliance with terms. A/P can be centralized (more efficient and cost effective) or decentralized (more personalized relationships). In either case, after an invoice is approved, it gets sent to the treasury where payment is physically disbursed, either electronically or in the form of a check. It is very important that the treasury and A/P communicate when an invoice is approved and when a cleared item is reconciled.

A/P and treasury of firm
Previously, many software programs did not integrate A/P and treasury functions. However, Enterprise Resource Planning (ERP) systems that include treasury management functions make this communication automatic. So, when choosing a Treasury/ A/P disbursement program a firm should be sure that information is easily accessible to all necessary parties yet not vulnerable to unauthorized use which can lead to fraud. Company funds should only be accessible by authorized persons. Also, it should make payment disbursement efficient and easily monitored.

Inventory management
Inventory can be classified as either finished goods, work in progress (WIP), scrap/obsolete goods, raw materials, or stores and supplies. Inventory is essential to a firm’s production and growth, yet it can be costly to keep. Sometimes inventory of raw materials is kept for speculative purposes or in anticipation of a shortage. Often raw materials are kept because it is more cost effective to receive it in a large order compared to several smaller orders, or because the supplier is unable to deliver frequently enough.

Inventory management
Firms have to make decisions about managing inventory. They have to decide how much inventory to keep on hand as well as the costs, benefits, and financing of keeping that level of inventory. The Just In Time (JIT) method of inventory management strives to cut inventory costs by standardizing the production process which usually eliminates waste yet maintains quality. JIT inventory management has led to more cost effective improvements like having the supplier keep track of a firm’s inventory (i.e. supplier managed replenishment programs). A ‘paid on production’ arrangement is similar to a retail consignment arrangement in that payment is made as the materials are used.

Non-cash payment methods
A non-cash payment method has three main phases: issuing payment, clearing payment, and settling payment. The issuing phase includes instructions about the amount to be paid, the recipient of the payment, and the method of payment (i.e. check, wire transfer, money order, etc.). The clearing phase is when the given instructions are transmitted to the parties concerned. The settlement phase is the active part where funds are actually transferred from one account to another. That is, one account is debited and the other is credited with the specified amount.

Non-cash payment methods
Two kinds of non-cash payment methods that use physical mediums are checks and credit/debit cards. In the U.S., there are three electronic payment networks. The automated clearing house (ACH) is a network that is used for smaller value electronic payments. Fed wire and the Clearing House for Interbank Payment System (CHIPS) facilitate immediate wholesale electronic funds transfers.

Settling payments
When a bank receives a payment either through check or electronically, it may or may not be final. Wire transfers (i.e. Fedwire) are final. However, Regulation E requires that consumers be given a certain amount of time to challenge a check, credit card, or debit payment or to return the purchased item. This kind of payment is provisional because the credited account could have the credit reversed. Usually, challenging a payment must be done within 60 days of the transaction, after which time the payment can be settled .

Settling payments
The payment settlement phase transfers the funds by debiting one account and crediting the other matched account. This is adjusting the accounts. There are various ways a depository institution can settle payments. Intra day settlement adjusts all accounts at set intervals throughout the day. Net settlement matches transactions as they occur, but does not actually transfer funds until the end of the day. Gross settlement payments adjust accounts on a per item basis.

Check clearing process
Even though the use of checks is declining in favor of electronic payments, checks are still the most common method of non-cash payment used in the U.S. In addition to personal information about the consumer, a check contains several key pieces of information that is necessary for clearing purposes. Much of this information is preprinted on the bottom of the check on the magnetic Ink Character Recognition (MICR) line. The 9 digit transit routing number (TRN) identifies the issuing bank. The TRN enables the recipient bank to route the information back to that issuing bank for clearing.