EDITION

BRYAN E. MILLING
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I Cash Flow
Problem
I Solver
Common Problems
and Practical Solutions

Bryan E. Milling

Sourcebooks Trade
Naperville, Illinois
Copyright © 1992 by Bryan E. Milling
All rights reserved. No part of this book may be reproduced in any form or by any electronic
or mechanical means including information storage and retrieval systems except in the —
—
case of brief quotations embodied in critical articles or reviews without {permission in writ-
ing from its publisher. Sourcebooks Trade.

Sourcebooks Trade
A Division of Sourcebooks, Inc.
P.O. Box 372
Nap>erville, Illinois, 60566
(708) 961-2161

Design and Production: Monica Paxson

Proofreading: Joyce Petersen

This publication is designed to provide accurate and authoritative information in regard to

the subject matter covered. It is sold with the understanding that the publisher is not engaged
in rendering legal, accounting, or other professional service. If legal advice or other exjpert
assistance is required, the services of a comp>etent professional {person should be sought.

From a Declaration of Principles Jointly Adopted by a Committee of the

American Bar Association and a Committee of Publishers and Associations

Library of Congress Cataloging-in-Publication Data

Milling, Bryan E.
Cash flow problem solver : common problems and practical solutions
/ Bryan E. Milling

p. cm.
ISBN 0-942061-28-4 - ISBN 0-942061-27-6 (pbk.)
Cash Management.
I. II. Title.

HG4028.C45M54 1991
658.1 5’246-dc20 91-29705
CIP

Printed and bound in the United States of America

10 987654321
 Contents

Introduction vii

Part I: The Cash Flow Process

Chapter 1 : Cash Flow: A Practical View 3

Chapter 2: The Costs of Cash Flow Problems 9

Part II: Component Management

Chapter 3: Accounts Receivable in the Cash Flow Process 17
Chapter 4: Component Analysis: Accounts Receivable 23
Chapter 5: Component Management: Credit Terms 29
Chapter 6: Component Management: Credit Policy 41

Chapter 7: Inventory in the Cash Flow Process 53

Chapter 8: Component Analysis: Inventory 61

Chapter 9: Component Management: Quantity Control 67

Chapter 10: Component Management: Accounting Methods 81

iii
 Part III: Structural Management
Chapter 11 : Financial Structure and the Cash Flow Process 93
Chapter 12: Structural Management: A Matter of Balance 101
Chapter 13: Structural Management: Financial Forecasting 107
Chapter 14: Structural Management:
Fixed Assets and Depreciation 117
Chapter 15: Structural Management: Two Break-Even Points 125

Part IV: Leverage Management

Chapter 16: Leverage: A Conceptual View 137
Chapter 17: Leverage: A Mechanical View 149
Chapter 18: Leverage: A Practical View 157
Chapter 19: Leverage from the Trade 167
Chapter 20: Leverage from the Bank 179
Chapter 21: Leverage from the Commercial Finance Company 195
Chapter 22: Leverage from Investors 209
Chapter 23: Leverage: Comparative Analysis 219

Part V: Improving Your Cash Flow

Chapter 24: Accelerating Cash Inflow 227

Chapter 25: Cash Collection Services 235
Chapter 26: Delaying Cash Disbursements 241

IV
 Part VI: Positive Cash Flow Management
Chapter 27: Management Perspectives 255
Chapter 28: Cash Resource Management 259
Chapter 29: The Cash Flow Budget 265

Glossary 277
 Digitized by the Internet Archive
in 2015

https://archive.org/details/isbn_9780942061277
r
Introduction

Cash flow management is essential to the success of every business. In fact,

it is more important than the ability to manufacture a product or generate
often
a sale. You can lose a customer without irreparable damage. But let a gap in your
cash flow cause you to miss a payroll and you are out of business.
The Cash Flow Problem Solver is designed to help you avoid such crises. It
identifies the fundamental principles of cash flow management and tells you how
to apply those principles in your business. However, it isn’t a textbook designed
and accounting. Instead, it is directed toward the
for professionals in finance
business manager whose background is marketing or manufacturing or engineer-
ing —the typical entrepreneur.
Moreover, it takes a profit-oriented approach to cash flow management.
That approach centers on some fundamental financial relationships:
How does a faster accounts receivable turnover rate benefit your bottom
line?
How do idle assets affect your cash flow and profits?
How do you combat a crimp in your cash flow that causes you to lose valuable
trade discounts?
The Cash Flow Problem Solver not only answers these questions but also pro-
vides realistic examples that illustrate the actual dollar cost of cash flow problems
in a business, as well as the bottom-line benefits that can develop from effective
cash flow management.
The emphasis on the bottom-line benefits of effective cash flow management
is designed to hold your interest in a subject that many people find tedious.
Cash Flow Problem Solver

However, the Cash Flow Problem doesn’t stop there. The ideas illustrated in
the book are crystallized in a set of Cash Flow Concepts to encourage you to retain
and utilize them. One Cash Flow Concept may identify a basic objective of
accounts receivable management. Another will provide a signal to help you avoid
a dangerous gap in your cash flow. Still another may suggest a financing method
that will increase your earnings. These Cash Flow Concepts have evolved from my
experience with more than 3,000 businesses encountered during my career in
commercial finance and banking.
Your situation is unique, but your cash flow problems are common to every
business. If you understand the basic concepts, you can adapt them to fit your
special circumstances. Of course, not every concept will be useful to you, but if one
idea serves as a reminder that helps you preserve the financial integrity of your
business or increase your earnings, then your effort in reading this book will be
worthwhile.
The first Cash Flow Concept emphasizes a critical fact:

Concept 1 : Effective cash flow management

isessential to the success of
your business.

For your business to survive, you must have cash to pay expenses and retire
other liabilities on schedule. In addition, cash provides a necessary buffer to help
absorb an unforeseen business crisis or managerial mistake. You can weather a
wildcat strike or a severe drop in sales if you have the necessary cash reserves.

Without those same setbacks can be disastrous.

reserves, the
Also, cash is essential for growth. In fact, no matter how profitable your
business, it cannot grow without an expanding cash flow, either firom retained
earnings or from a combination of earnings and cash obtained from external
financing. As you will see in Chapter 13, cash becomes the limiting factor in the
growth of any business.
Finally, cash is essential for achieving the profit potential of your business. A
dollar held in theform of accounts receivable or inventory cannot be reinvested
profitably until you convert it back into cash. Receivables and inventory are
necessary parts of the cash flow cycle, but cash makes the cycle revolve.
The Cash Flow Problem Solver uses maximum cash generation as the guiding
principle of cash flow management. Your cash flow management effort should
seek the most rapid conversion of your receivables and inventory into cash.
Practical limits on the conversion rate exist in any circumstance. But the effort
recognizes the crucial role that cash plays in achieving the basic business objectives.

viii
 Introduction

To be consistent, we should discuss the efficient use of cash as an asset similar

to accounts receivable and inventory. An overinvestment in cash imposes an
opportunity cost on your business when you could employ that excess profitably
elsewhere. Nevertheless, don’t look for a chapter on the profitable investment of
excess cash. Instead, the book will concentrate on the factors that disrupt a firm’s
cash flow and reduce its earnings.
After all, the lack of sufficient cash is always a problem. Seldom does excess
cash lead to a serious business setback.
The Cash Flora Problem Solver’s approach to cash flow management invites you
to take control of your cash flow — to exercise positive cashflora management. Positive
cash flow management reduces the disruptions and maintains the smooth,
continuous cash flow essential to the growth and profitability of your business.
Although the best management effort will not provide absolute control of your
cash flow, you can solve or avoid many of the common cash flow problems.
Moreover, positive cash flow' management can benefit your bottom line.

IX
 .

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 The Cash
Flow
Process

1 . Cash Flow: A Practical View

2. The Costs of Cash Flow Problems
r
Chapter 1

Cash Flow: A Practical View

The cash flow process in a business operates as a circular system of asset

transformation. In simple form, the system looks like the schematic in Figure 1-1.

Figure 1-1

The Cash Flow Process

CASH

PURCHASE OF
GOODS AND SERVICES

HOLDING OR
MANUFACTURING

Any business begins with cash. The purchase of goods and services, perhaps
coupled with a manufacturing process, transforms that asset into inventory. Each
sale transforms inventory into accounts receivable. Then the collection process
transforms accounts receivable back into cash. If the system works properly, the
process repeats itself in a continuous cycle.
 —
The Cash Flow Process

Of course, the system more complex than the schematic suggests. Trade
is

credit, external financing, and retained earnings increase the total resources
revolving in the cycle. Conversely, debt reduction, dividends, and operating losses
shrink those resources. The periodic purchase of fixed assets, which are not part
of the day-to-day cash flow cycle, further complicates the picture. However, when
—
the process works smoothly, each asset cash, inventory, accounts receivable
moves continuously toward the next phase in the cycle.
The cash flow schematic is simplistic in another respect It implies that the
transformation process operates in a continuous, dynamic cycle. Unfortunately,
the process seldom operates so smoothly. Instead, a firm’s cash flow typically is

erratic and subject to numerous disruptions. Cash Flow ConceptNo. 2 recognizes

that fact:

Concept 2: The cash flow process is an

erratic system of asset
transformation.

For example, inventory sits as an idle asset until it is sold and delivered.
Moreover, the seller must issue the proper invoices to transform sales into
—
accounts receivable. A breakdown in any one of these tasks the sale, the delivery,
—
or the paperwork interrupts the transformation process.
Similarly, until they are collected, accounts receivable serve only as evidence
of the cash proceeds still due from sales. Failure to collect accounts as scheduled
retards the transformation process. Since collection of receivables provides the
major source of cash from operations, slow turning accounts receivable can
threaten the survival of a business.
Even cash itself —the asset that fuels the system—contributes little until the
business converts it into marketable inventory. The unavailability of product
(because of a snowstorm that disrupts delivery of a vital component, or a strike at a
supplier’s facility) leaves cash as an idle asset that is no more productive than unsold
inventory or uncollected accounts receivable. Indeed, cash flow management
becomes a continuous effort to make the transformation process operate smoothly.
Unfortunately, even a conscientious management effort may not preclude
cash flow problems. Many growing, profitable businesses encounter severe cashflow
find that statement surprising, then you probably harbor a common
crises. If you
misconception about the actual operation of the cash flow through a business. That
misconception underlies many of the cash flow problems discussed throughout the
book. Neither a rising sales volume nor a profitable operation spontaneously
produces a positive cash flow. The following discussion illustrates that fact.

4
 Cash Flow: A Practical View

The Illusion of Paper Profits

Dan A. Drake, a dynamic salesman with limited financial expertise, founded

Drake Paper Company in 1987. Although profits were slim, the business grew to
a $100,000 monthly sales volume by the latter part of 1990. In December of that
year, Drake initiated an expansion program designed to produce a 50% increase
in sales and place operations on a highly profitable basis.
The program produced immediate results. Sales increased from $100,000 in
December to $150,000 in January 1991. As the firm’s simplified income statement
indicates, the higher volume generated $15,000 in earnings in the first month:

Drake Paper Company

—
Income Statement 1/1/91 1/31/91

Sales $ 150,000
Cost of Sales (105,000)
Operating Expenses ( 30,0001
Earning $ 15,000

Unfortunately, Drake was unable to enjoy his success. Despite the company’s
profitability, therapid sales increase led to a $25,000 cash flow deficit. By the end
ofJanuary, the firm was out of cash.
Before illustrating the factors that led to Drake’s cash shortage, two facts
about that deficit deserve emphasis.
First, the cash flow deficit was not the result of any extraordinary event.

Rather, it developed naturally from the predictable relationships among the

major elements in Drake’s cash flow.

Second, the deficit came as a complete surprise to Dan Drake. He errone-
ously assumed that a profitable operation automatically produces a positive cash
flow. He suffered from the “illusion of paper profits.”
Drake forgot that the income statement is an accrual statement. It records
saleswhen they occur, not thirty days later, when the business collects the accounts
receivable that proceed from the sales.
Similarly, expenses accrue as incurred, although a company may pay those
obligations in some subsequent period. Some expenses, such as depreciation and
amortization of prepaid items, represent prior cash disbursements. These cloud
the cash flow picture even further.
Accrual accounting remains essential for effective financial management. It
enables a business to gauge its performance over a specific period by correctly
matching revenues and expenses.

5
The Cash Flow Process

However, sales do notnecessarily coincide with cash inflow. Nor do expenses

(or cost of sales) coincide with cash disbursements.
In contrast, cash accounting registers the actual cash flow through a business.
It recognizes the timing of the cash flow into a business from all sources, as well as
the timing of the disbursements required to meet operating expenses and pay for
purchases. A historical cash flow statement reflects actual past inflow and outflow.
A projected statement, based on historical trends, predicts further cash flow.
Had Dan Drake recognized the significant difference between cash account-
ing and the illusory earnings implied by his income statement, the $25,000 deficit
cash flow would not have come as a surprise. His cash flow statement for January
(shown below) reflects the characteristics of Drake’s cash flow:

1. Accounts receivable, which are the company’s only source of cash, turn in
thirty days; Drake collects 100% of the prior month’s sales.
2. Drake purchased $105,000 in inventory in December to meet January’s
forecasted sales volume; to maintain its credit rating, the company has always
paid for every purchase within thirty days.
3. Drake pays all operating expenses as incurred; none is accrued for payment
in the following month.

Based on these characteristics, Drake’s projected (and actual) cash flow for
January developed as follows:

Drake Paper Company

Cash Flow Statement 1/1/91 1/31/91 —
Beginning Cash (in bank) $ 10,000
Collections (December sales) 100,000
Operating Expenses (30,000)
Payments (December purchases) (105.000)
Cash Deficit ($25,000)

Thus an apparent $15,000 profit became a predictable $25,000 cash flow

deficit.The $40,000 difference emphasizes the significant difference between
accrual and cash accounting.
Actually, Drake didn’t experience a deficit cash flow. Instead, he deferred
payment some suppliers, absorbing modest injury to his payment record. His
to
cash flow problem was not disastrous; nevertheless, it could have been avoided.
With the foresight provided by a projected cash flow statement, Drake could have
filled the gap with external financing, additional investment, or perhaps by
accelerating collection of his accounts receivable.

6
 Cash Flow: A Practical View

Drake’s experience illustrates a primary tenet of cash flow management. You

must differentiate between accrued sales and expenses and the cash flow associ-
ated with those transactions. Failure to do so can lead to the financial embarrass-
ment of a sudden cash flow squeeze.
That important distinction deserves emphasis in Cash Flow Concept No. 3:
Concept 3: Positive cash flow management
requires a clear distinction
between accrual accounting and
cash flow accounting.

Other accounting schedules add to the information provided by the basic

income and cash flow statements. These are discussed as they apply to specific
cases throughout the book. First, however, let’s briefly review another financial
statement that serves as a fundamental tool for cash flow management.

The Balance Sheet

The balance sheet is another accrual financial statement. It provides a

snapshot of the financial structure of a business at a particular time. Drake Paper
Company’s experience illustrates how this financial tool can help identify a cash
flow problem. That illustration centers on Drake’s comparative 12/31/90 and
1/31/91 balance sheets in Table 1-1.

The earlier statement reflects the firm’s financial structure as it appeared

before the 50% sales increase. The latter statement shows how that increase
altered Drake’s financial structure. The comparison reiterates what we already
know. By 1/31/91, the firm had depleted its cash.

Table 1-1
Comparative Balance Sheets

12/31/90 1/31/91
Cash $ 10,000
Accounts Receivable 100,000 $150,000
Inventory 105,000 105,000
Other Assets 20,000 20,000

Total Assets $235,000 $275,000

Accounts Payable $105,000 $130,000
Other Liabilities 20.000 20,000

Total Liabilities $125,000 $150,000

Stockholder’s Equity $110,000 $125,000
Liabilities and Equity $235,000 $275,000

7
The Cash Flow Process

We also now see how the effect of January’s sales volume on the other
elements in Drake’s financial structure actually created the cash flow problem.
Accounts receivable increased from $100,000 to $150,000 in one month. That
asset expansion absorbed the firm’s $15,000 profit and the $10,000 in beginning
cash. The cash drain also forced the increase in liabilities reflected in accounts
payable.
Note another fact suggested by the balance sheets. Based on the detrimental
effects of the 50% jump in sales on Drake’s cash flow and financial structure,
further sales expansion becomes impossible. The growth in liabilities already has
outpaced the firm’s cash flow. Another sales increase would again be an accrued
volume, not cash, and would exaggerate the fundamental problem. Indeed, a
larger sales volume will lead to further deterioration in the firm’s financial
structure. Without external financing, accounts payable would fall so far past due
that suppliers would refuse to extend additional credit consideration to the
business.
Neither analysis of the income statement nor a review of the cash flow
statement demonstrates the effect of sales, revenues, and cash flow on the firm’s
financial structure. In fact, a business may have a positive cash flow and a profitable
operation over the short term, while its financial structure develops faults that
portend future problems. In Drake’s case, that came from an increase in accrued
liabilities that outpaced the increase in cash.
Throughout the book, the value of the balance sheet will be illustrated in
identifying and solving specific cash flow problems. Here, that potential is only
suggested so that you will add the balance sheet to the income and cash flow
statements as the fundamental tools for cash flow management.
r
Chapter 2

The Costs of Cosh Flow Problems

Cash flow problems cost money. You may not be aware of the costs, or even
of the problem. Nevertheless, the costs are real.
So, solving your cash flow problems does more than help avoid financial
embarrassment. It also increases your earnings. Higher earnings follow naturally
each time you avoid the potential cost of a cash flow problem. When you recognize
these facts, the cash flow process becomes a profit center for you. And that
perspective can lead to thousands of dollars in bottom-line benefits.

The Direct Cost of a Cosh Flow Problem

Most business managers can calculate the direct cost of a cash flow problem.
You will see numerous calculations as specific problems are discussed throughout
the book. Here we will look at the direct cost of a cash flow problem incurred by
Kamco, Inc., a small wholesaler of rubber tubing products.
Jerry Shipp founded Kamco in 1983. The company has been profitable since
inception and both sales and earnings increased steadily through 1989. However,
,

earnings declined in 1990, despite an 11% rise in sales. As he reviewed his

disappointing results in early 1991, Shipp centered his analysis on the financial
data summarized in Table 2-1.

Shipp quickly recognized that Kamco’s higher interest costs in 1990 led
directly to the decline in earnings. However, he also recognized this expense as
only a symptom of the real problem. Shipp correctly concluded that die higher
interest costs came from the debt necessary to support an extraordinary rise in
The Cash Flow Process

Kamco, Inc.
Table 2-1
Comparative Financial Data

1989 1990
Sales $1,800,000 $2,000,000
Earnings before Interest Expense 90,000 100,000
Interest Expense* (24,0001 (39,6001

Earnings after Interest Expense $ 66,000 $ 60,400

Average Accounts Receivable $ 200,000 $ 330,000

Average Bank Debt* $ 200,000 $ 330,000

*Average interest rate is 12%.

Kamco’s accounts receivable. In fact, bank debt, and interest costs all
receivables,
rose 65% in 1990. Retained earnings and trade normal 11%
credit supported the
expansion in the firm’s other assets. (If the relationship between asset growth and
—
the bottom side of the balance sheet liabilities and stockholders’ equity is —
unfamiliar, see Chapter 12.)
Any excess investment in accounts receivable raises the need for a larger
amount of borrowed money to avoid a cash flow deficit. In this instance, Shipp
measured his overinvestment by comparing his average receivables in 1990 with
—
the total appropriate, or “correct,” for his rise in sales an 1 1 % increase over the
1989 average.

Average investment, 1990 $330,000

“Correct” Investment, 1990 222,000

Overinvestment $108,(X)0

Shipp’s analysis proceeded on the assumption that Kamco’s average invest-

ment in receivables in 1989 is at the proper level. While further analysis might
disprove that assumption, Kamco’s excess investment in accounts receivable in
1990 is certainly no less than $108,000. Moreover, the overinvestment led to a

$12,960 reduction in the firm’s earnings in 1990. That reduction the direct cost —
—
of this cash flow problem came from the extra bank debt, at 12% interest,
required to carry the excess receivables. Indeed, had Shipp held his receivable
investment in line with his sales growth, eliminating the need for extra debt,
Kamco would have had a respectable increase in earnings in 1990 instead of the
actual decline.

10
 The Costs of Cosh Flow Problems

Note that Kamco did not suffer a cash flow crisis. The firm’s borrowing power
provided the cash necessary to meet all of its obligadons satisfactorily. Of course,
that didn’t solve the cash flow problem —
the overinvestment in accounts receiv-
able. Instead, it served only as an expensive method for avoiding a crisis. So,
Kamco’s experience illustrates a cash flow problem can be expensive without
becoming an emergency.

The Indirect Cost of a Cosh Flow Problem

Kamco’s experience shows you should not ignore a cash flow problem simply
because it doesn’t develop into a crisis. In other words, you should not ignore a

cash flow problem merely because you don’t suffer a direct, measurable expense.
The cost of a cash flow problem may not appear as an expense at all, but rather
as profits foregone.
Assume that Kamco has the same overinvestment in receivables, but that it

carries the excess without the comparable increase in bank debts. Presumably, a
strong equity base or lenient trade credit supports the overinvestment instead.
Thus Kamco eliminates the $12,960 in extra interest costs and enjoys an increase
in earnings.
Does that mean that the overinvestment in receivables has no effect on the
company’s bottom line? Indeed not! The overinvestment is still a cash flow
problem, and that problem still hurts Kamco’s earnings. Of course, the damage
isn’t visible in the form of higher interest costs. Instead, Kamco suffers an
opportunity cost. Opportunity cost measures the indirect cost of a cash flow
problem. It represents potential earnings lost.
In this instance, Kamco loses the potential earnings from $108,000 in cash.
Eliminating the overinvestment in receivables would generate that much cash for
profitable use elsewhere. The firm could profit from expanding inventor)^
reducing other bank debt, or merely from the interest earned on a corporate
savings account. Those lost earnings, however calculated, measure the indirect
cost of a cash flow problem. Of course, you won’t find opportunity cost in an
expense account, but the effect on your earnings is the same.
In later chapters, opportunity costs will measure the specific cost of several
cash flow problems. Opportunity cost is measured in terms of the cost of
borrowing. Thus if you have a 12% cost of borrowing, a $100,000 overinvestment
$12,000 (annualized) opportunity cost.
in receivables leads to at least a
While the and circumstance, borrotdng cost
specific rate varies with time
serves as a conservative criterion for measuring opportunity cost. Indeed, you
must earn more than your borrowing cost tojustify incurring any debt at all. You
The Cash Flow Process

should recognize your own opportunity cost in any circumstance. It must be equal
to or larger than your cost of borrowing. It cannot be less.
That suggests the need to recognize the idea in:

Concept 4: Moke the cosh flow process o

profit center in your ousiness.

That management effort can help every business increase its earnings.

Cosh Capability

In the above examples, Kamco never suffers from a cash flow crisis. The firm
had access to the cash necessary to meet all its obligations promptly. In financial
terminology, Kamco had sufficient liquidity for its operations.
Liquidity isan importantconceptfor cash flow management. It indicates tliat

a firm has the capacity to meet its obligations onHowever, liquidity has
time.
other, broad accounting connotations which aren’t necessary for our discussion.
To avoidjargon, and to narrow the subject in order to concentrate on dollar flow,
we measure liquidity in terms of cash capability,\^hic\\ measures the maximum cash
available to a business at any particular time.
Cash capability measures the maximum cash available to support an increase
in any other assets. It defines the practical limit on a firm’s cash flow. Exceeding
your cash capability leads to an unacceptable cash flow deficit or the failure to
meet all obligations promptly. Exceeding your cash capability transforms a
problem into a crisis.
Table 2-2 provides a practical view of cash capability. Firm A has $25,000 in
cash and $100,000 in combined accounts receivable and inventory. The firm also
has $25,000 in additional borrowing power from some external source, perhaps
from a potential bank loan or additional supplier credit. Whatever the source, the
$25,000 borrowing power, coupled with the $25,000 cash on hand, gives the firm
$50,000 in cash capability. It has that much cash available from internal and
external sources to invest in other assets.
Firm B, on the other hand, has exhausted its cash capability. The firm’s
higher investment in accounts receivable and inventory has absorbed all of its cash
reserve and borrowing power. The business has reached the limit of its cash
capability.
Cash capability is more than a catchy phrase. Because it defines the limits of
the cash flow cycle, it is an estimate of your protection against a cash flow crisis.

You may not have a perfectly balanced cycle. Few businesses do. But you can
operate successfrilly so long as you don’t exhaust your cash capability. And the

12
 The Costs of Cosh Flow Problems

Table 2-2
Cash Capability

Firm A Firm B
Cash $ 25,000
Accounts Receivable 50,000 $ 75,000
Inventory 50.000 75.000

Total Assets $125,000 $150,000

Additional Borrowing Power $ 25,000 —
Cash Capability $ 50,000 $ 0

larger your cash capability, the less threat you suffer from any cash problem. The
process that identifies that total deserves emphasis in Cash Flow Concept 5:

Concept 5: A business con measure its cosh

capability as the sum of its cash
reserves plus unutilized
borrowing power.

In any circumstance, a higher level of cash capability creates a larger buffer

against cash flow problems.
At the same time, as Kamco, Inc.’s, experience illustrates, even a business
with an adequate level of cash capability must exercise an attentive cash flow
management effort to avoid the indirect costs of cash flow problems.

13
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 1
"^ — Part
"1

II

Component
Management
3. Accounts Receivable in the
Cash Flow Process
4. Component Analysis:
Accounts Receivable
10.
5. Component Management:
Credit Terms

6. Component Management:
Credit Policy

7. Inventory in the Cash Flow Process

8. Component Analysis: Inventory

9. Component Management:
Quantity Control

Component Management:
Accounting Methods
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 Chapter 3

Accounts Receivable in the Cash Flow Process

Accounts receivable represent the proceeds from a firm’s sales. You trade
your merchandise or service in exchange for your customer’s promise to pay you
in ten days or thirty days or perhaps even later. The payment of those receivables
becomes the primary source of operating cash for your business. Too many
broken promises to pay can leave your business without the funds to meet payroll,
retire expenses, or service debt requirements.
Of course, most business managers are aware of this. But not all can translate
this awareness into successful, efficient cash flow management. This chapter
illustrates the relationship between accounts receivable and the cash flow process.

Collection Period and the Cosh Flow Process

Assuming a constant salesvolume, a single concept—average collection

period — defines the relationship between accounts receivable and the cash flow
process. The average collection period measures the length of time your average
sales dollar remains in the form of an accounts receivable.
Of course, the average collection period alone doesn’t determine the size of
a firm’s investment in receivables. Sales volume also has a direct influence. The
larger the sales volume, the larger the investment in receivables. However,
holding sales constant helps emphasize the critical relationship between accounts
receivable and the cash flow process.
The Production Lumber, Inc. (PLI), demonstrates the relationship. PLI
operates as a wholesale lumber broker. The company purchases lumber in carload
Component Management

lots from west coast mills and ships it directly to its customers. PLI never takes
possession of the lumber and consequently carries no inventory. Thus the firm has
a simple financial structure.
In fact, as indicated in PLI’s 9/30/90 balance sheet (Table 3-1), PLTs only
assets are cash and accounts receivable. Accounts payable make up the only
liabilities.

Table 3-1 reflects the following characteristics about the company’s business:

1 . PLI generates an average sales volume of $5,000 a day, or $150,000 per month.
2. made on thirty day terms, and all customers pay within those
Ail sales are
terms.
3. Purchases average 85% of monthly sales volume; all suppliers require
payment in ten days.

These characteristics leave PLI with an investment in receivables that holds

constant at $150,000. Of course, that investment converts to cash at the rate of
$5,000 a day, reflecting the thirty day collection period for PLI’s receivables.

Table 3-1
Production Lumber, Inc.

9/30/90 Balance Sheet Cash Flow 9/1/90-9/30/90

Cash $ 10,000 Beginning Cash $ 10,000
Accounts Receivable 150,000 Collections (prior
month’s sales) 150.000

Total Assets $160,000 Total Cash Available $160,000

Accounts Payable $ 42,500 Payment for Purchases $127,500
Stockholders’ Equity 117.500 Expenses 32.500

Liabilities & Equity $160,000 Ending Cash $ 10,000

Table 3-1, Column 2, shows that PLI’ s thirty day collection period satisfies the
firm’s present cash flow requirements. Although the constant $10,000 beginning
and ending monthly cash balance shows that the firm is operating only at a break-
— —
even level neither making nor losing money the thirty day collection period
meets the cash flow requirements for PLI’s normal operations.
Now, assume that over the next six months PLI produces the same $150,000
monthly sales volume. However, during that period, the average collection period
stretches from thirty to sixty days. The company still has $5,000 a day in sales, but
the average sales dollar remains as a receivable for sixty days.

18
 Accounts Receivable in the Cash Flow Process

Table 3-2 summarizes the effect that this longer collection period has on
PLI’s financial structure and cash flow.

Table 3-2
Production Lumber, Inc.

3/31/91 Balance Sheet Cash Flow 3/1/91-3/31/91

Cash Beginning Cash —

Accoimts Receivable $300.000 Collections $150,000
Total Assets $300.000 Total Cash Available $150,000
Accounts Payable $182,500 Payment for Purchases $127,500
Stockholders’ Equity 117.500 Expenses 22.500
Liabilities & Equity $300,000 Ending Cash —
Accounts receivable total $300,000. The firm has no beginning and ending
monthly cash balance, and supplier credit stretches well beyond the normal
industry allowance of ten days. Yet nothing has changed in PLTs operation except
the collection period. The firm still has $150,000 in monthly cash collections. But
that cash is not sufficient to pay for the purchases required for the two-month sales
volume. Indeed, receivables now convert to cash at only half the rate at which PLI
generates sales. The inevitable result is a cash flow crisis.

That fact earns recognition in:

Concept 6: The average collection period

defines the relationship
between accounts receivable
and the cash flow process.

The longer the collection period, the higher the investment in accounts
receivable.

Calculating Collection Period

Using Cash Flow Concept No. 6 requires two tasks. First, you must calculate
the average collection period for your accounts receivable. Then you must relate
that period, and changes in that period, to your cash flow.
To calculate the average collection period for your business:

19
Component Management

1. Divide annual sales by 360 to determine your average daily sales volume.
2. Divide that figure into the present balance of your accounts receivable.

For example, if a business has $2 million in annual sales and $200,000 in

accounts receivable, the calculation becomes:

1. Sales per day = $2,000,000 ^ $5,555

360

2. Average Collection _ $2.000.000 _ 35

Period $5,555

Each sales dollar rests in the form of a receivable for 36 days.

Calculating collection period over the previous twelve months usually
provides sufficient accuracy for the cash flow management effort. However, if you

have had a recent fluctuation in sales, you should use a daily sales figure that
reflects that fact. It can make a significant difference.
For example, assume that $600,000 of the above sales volume came in the
most recent quarter. To reflect that, die calculation then becomes:

Sales per day = $600,000 ^

1. $ 6,^66
90 days

2. Average Collection _ $200.000 _ 39

Period $ 6,666

The average collection period becomes significantly shorter. Naturally, that

difference would influence any management decision affecting your investment
in accounts receivable.

Cash Flow and Collection Period

To use the collecdon period in your cash flow management effort, you must
recognize how a change in the collection period affects your cash flow. To repeat
the basic relationship, the longer the collection period, the larger the investment
in accounts receivable. However, positive cash flow management requires a more
precise perspective. That perspective comes in Tables 3-3 and 3-4.
Table 3-3 details the effect different collection periods have on investment
in accounts receivable over a range of daily sales from $1,000 to $5,000 a day. Use
this table to measure the impact changes in collection period have on your cash
flow.

20
 Accounts Receivable in the Cash Flow Process

To illustrate, let’s determine the cash generation potential from a modest

reduction in collection period. Assume that your sales average $2,000 a day and
your average collection period is forty-five days, and you reduce your collection
period to forty days. From Table 3-3, you can see that the shorter collection period
reduces your investment in receivables from $90,000 to $80,000. That reduction
generates $10,000 in cash that you can invest profitably elsewhere, or you can add
it to your cash reserves.

Table 3-4 simplifies the analytic process. It relates the number of days you
reduce your average collection period to the cash that reduction generates. For
example, if you have $2,000 a day in sales, you will generate $6,000 in cash from
a three-day reduction in the average collection period. Viewed from another
perspective, the lower collection period reduces your cash requirements by
$6,000. This can provide a simple solution to many minor cash flow problems.
In any event, remember the basic concept. Reducing the average collection
period improves your cash flow as it converts accounts receivable into cash more
rapidly.
The average collection period calculation provides a fundamental tool for
positive cash flow management. Chapter 4 helps you apply that tool as a criterion
for component management.

Table 3-3
Effect of Collection Period on Investment in Accounts Receivable

Average
Collection
Period
(days) Sales per Day
$ 1,000 $ 2,000 $ 3,000 $ 4,000 $ 5,000

Investment in Accounts Receivable

30 $30,000 $ 60,000 $ 90,000 $120,000 $150,000

35 35,000 70,000 105,000 140,000 175,000
40 40,000 80,000 120,000 160,000 200,000
45 45,000 90,000 135,000 180,000 225,000
50 50,000 100,000 150,000 200,000 250,000
55 55,000 110,000 165,000 220,000 275,000
60 60,000 120,000 180,000 240,000 300,000

21
Component Management

Table 3-4
Effect of a Reduction in
Average Collection Period on Cash Flow

Reduction
in Average
Collection
Period
(days) Sales per Day
$ 1,000 $ 2,000 $ 3,000 $ 4,000 $ 5,000

Cash Generated

1 $ 1,000 $ 2,000 $ 3,000 $ 4,000 $ 5,000

3 3,000 6,000 9,000 12,000 15,000
5 5,000 10,000 15,000 20,000 25,000
7 7,000 14,000 21,000 28,000 35,000
10 10,000 20,000 30,000 40,000 50,000

22
 Chapter 4

Component Analysis: Accounts Receivable

The collection period calculation measures how long it takes to convert your
investment in accounts receivable into cash. But you must proceed beyond that
and identify any compo-
calculation to determine your proper collection period
nent problems that might cause an overinvestment in accounts receivable. This
chapter reviews the fundamental tools for component analysis.

Comparative Analysis: Average Collection Period

The correct collection period translates into the proper investment in

accounts receivable. That becomes the natural target for your component
management effort. That effort can begin with a comparison of your present
average collection period with previous collection periods.
For example, assume thatyou have calculated your average collection period
Chapter 3 and found thatyour average sales dollar rests in the form
as illustrated in
of a receivable for fifty-three days. Using the collection period calculated at the
end of the latest full year of operations as a point of comparison, you have the
following figures:

Current Prior

Average Collection Period (days) 53 42

Average A/R Investment
(per $1,000 in daily sales) $53,000 $42,000
Component Management

Measured against your previous standard, you see an eleven day increase in
your average collection period. That produces an $11,000 dent in your cash
capability for each $1,000 in daily sales.
However, using prior experience as the sole standard for comparison leaves
a gap in your analysis. That assumes the previous average collection period is
appropriate.
Butyou can’t rely on this assumption. Your average collection period last year
does not necessarily define what is appropriate for your business now or in the
future.
Consequently, you need another way to estimate the correct collection
period for your business. You can do that by looking at comparable competitor
standards. Mutual customers, credit terms, and credit policies should lead to
common average collection periods. Unless warranted by special circumstances,
your collection period should approximate your competitors’.
Many business managers are unaware of the availability of their competitors’
financial data for comparative analysis. Of course, few closed corporations release
financial information directly to competitors. But, while preserving anonymity,
many firms provide that data to industry publications, which collate and publish
comparative financial data regularly.
Assume that you find your fifty-three day average collection period compares
unfavorably with a forty day average for your industry. This increases the probability
that you have an over-investment in accounts receivable.
Alternatively, assume that the longer collection period approximates the
industry average. Measured against competitive standards, this year’s fifty-three
day collection period apparently is correct for your business.
That suggests a longer average collection period may stand as a competitive
necessity. That holds true even though the business inevitably sacrifices some cash
capability. That emphasizes the value of comparing your average collection
period against both internal and external standards.
If comparative data from industry sources prove elusive, use the data
provided by Dun and Bradstreet or Robert Morris Associates. These firms collect
and publish a variety of financial data categorized by industry and sales volume.
Most businesses will find representative data drawn from a number of similar firms.
Whatever the source of your data, don’t overlook the value of comparative analysis.

Comparative Analysis: The Receivables/Sales Ratio

Comparative analysis of your collection period, either against internal or

may not identify a recent buildup in accounts receivable. Indeed,
external data,

24
 Component Analysis: Accounts Receivable

an expanding investment can become a problem before it results in a significant

increase in your average collection period, particularly when measured over the
previous twelve months. Consequendy, you also should look at your monthly
“accounts receivable to sales” ratio. That measures the relationship between your
investment in receivables and your sales volume. This might reveal a component
problem before it seriously impairs your cash flow or earnings.
4fThe analytic process is straightforward. At the end of each month, divide
your current investment in accounts receivable by the sales generated during that
month. For example, assume that on June 30, 1991, your investment in receivables
totaled $150,000. During that month, you generated $100,000 in sales. The
calculation becomes:

Accounts Receivable _ $150.000 _ 25

Sales $100,000

Standing alone, the ratio tells you only that your receivables at the end of
June were 150% of sales for that month. But the ratio gains potential as a problem
spotter when you compare it to calculations from previous months. A change in
the ratio can serve as a harbinger of an impending change in the prevailing trend
of your cash flow.
To illustrate, assume that your sales for July 1991 increase to $1 10,000. At the
end of the month, your investment in accounts receivable totals $190,000. A
higher sales volume naturally leads to a larger investment in accounts receivable.
But repeating the calculation, you find:

Accounts Receivable _ $190.000 _ j 7

Sales $110,000

ii'The higher ratio of receivables to sales means that your investment in

accounts receivable grew more rapidly than sales. This change in the relationship
between your investment in receivables and your sales volume often shows the first
sign of a potential component problem.
Of course, you might dispense with the actual calculation each month and
rely on an estimate of the relationship between your sales volume and your
investment in accounts receivable. However, actually going through the calculation
each month helps reduce the potential errors inherent in such estimates. That
simple calculation, when compared with the calculations from previous months,
can draw attention to a component problem long before it develops into a crisis.
If your business is seasonal and a major portion of your sales occur in a
particular part of the year, adjust your receivables to sales ratio analysis accord-
ingly. Compare your current monthly ratio against thatfor the same month of the

25
Component Management

previous year. This will prevent the distortions that inevitably arise from seasonal
and collections.
fluctuations in sales
That provides another approach to the benefits that can come from this
component management tool. That earns recognition in:

Concept 7: Use comparative analysis to

identify the correct collection
period for your business.

While comparative analysis contributes to your component management

has some natural limitations. As the first step in problem recognition, it
effort, it
enables you to identify a potential overinvestment (or underinvestment) in
accounts receivable. But you must proceed further to find the specific cause of any
deviation from the norm.
Moreover, comparative analysis does not account for the unique character-
isticsof a business thatcanjustify a collection period or a receivables to sales ratio
that differs significantlyfrom the standards. For example, if you boost sales with
the aid of a more lenient credit policy, your collection period naturally will exceed
that of your more conservative competitors. Alternatively, if you are undercapi-
talized, you may need a short collection period to generate the cash necessary for
survival. Your averages will fall below the industry norms.

The Aged Analysis of Accounts Receivable

Another tool for component analysis also enables you to spot problems in
their early stages. In this instance it also helps you identify the specific source of
the problems.
Table 4-1 demonstrates the potential of this tool. With an aging analysis
drawn from a firm that sells on net thirty day terms, the firm expects payment thirty
days from the date of the sale. The analysis is normally constructed as of the last
day of the month.

1. Column 1 includes the debt due from each customer.

2. Column 2 summarizes the accounts due from sales made during the month
just ended, that current accounts not yet due and payable.
is,

3. Column 3 isolates those receivables still due from sales made in the previous
month; those amounts are 1 to 30 days past due.

26
 Component Analysis: Accounts Receivable

Table 4-1
Sample Aged Analysis of Accounts Receivable

1-30 31-60 Over 60

Total Past Past Past
Customer A/R Current Due Due Due
Page Distributing $ 12,000 $ 2,000 $ 4,000 $4,000 $2,000
Jones Manufacturing 27,000 27,000
Sales, Inc. 9,000 9,000 — —
Houston Wire 15,000 — 15,000
American Wholesale 17,000 10,000 4,000 3,000 —
Woodwork, Inc. 3,000 — 3,000
MFI 5,000 5,000 — —
Continental Supply 12,000 12.000
Total $100,000 $65,000 $26,000 $7,000 $2,000

4. Column 4 identifies amounts that remain unpaid from sales made two
months previously; those receivables are 31 to 60 days past due.
5. Column 5 pinpoints any account more than 60 days past due.

Design your aging analysis to suit your own circumstance. For example, a
grocery wholesaler typically on seven day terms. Consequently, she uses a
sells

weekly aging analysis that separates accounts due according to her own special
terms. Similarly, a firm allowing sixty days for payment would acyust the format in
Table 4-1. Regardless of the specific form, however, observe the benefits that you
can derive from an aged analysis of your accounts receivable.
First, the analysis identifies the specific accounts within the total that make
up an overinvestment. Referring to you can easily see the receivables
Table 4-1,
that lengthen the firm’s average collection period beyond thirty days.
Also, the aging analysis can provide a picture of any recent change in the
makeup of a firm’s receivables. Table 4-1 reflects a typical mix of current and past
due accounts. Certainly every business carries some customers that do not pay
prompdy, but if the pattern of past-due accounts changes (by comparison with
aging analysis from previous months) you will see the deviation almost immedi-
,

ately, An aging analysis allows you to spot the early development of a potential
accounts receivable problem.
The accounts in the third column (indicating payments are one to thirty days
past due)may not portend a problem. But as you see an increase in such accounts
from one month to the next, you should recognize an undesirable trend. Unless

27
Component Management

you respond to that trend, it will lead to a longer average collection period and a
higher, more costly investment in accounts receivable.
That adds to the reasons for recognizing the contribution an aging analysis
makes to component management in:

Concept 8: Complete component analysis

requires a monthly aging of
your accounts receivable.

The absence of that cash flow management tool leaves a manager at a

disadvantage.

28
r
Chapter 5

Component Management: Credit Terms

Credit terms set a time limit on each customer’s promise to pay for a
purchase. When he purchases your product or service, the customer understands
that you expect payment within a designated length of time. You agree to “carry”
the customer’s account for the designated period.
If every customer pays in accordance with the designated terms, then those
terms determine your collection period. However, that perfect coincidence rarely
Almost every business has customers who take longer to pay. But your
occurs.
designated credit terms still exert a significant influence on your customer

payment habits and the cash flow in your business. This chapter discusses that
influence.

Credit Terms and the Cash Flow Process

Our initial look at the relationship between your credit terms and the cash
flow process ignores the influence those terms exert on your sales volume. That
look centers on the Hillsboro Ceramics Company, a manufacturer of high grade
industrial ceramics for sale to the pharmaceutical industry. Hillsboro occupies a
unique position. Demand for its products exceeds supply. Consequently, the
company $5,000 daily production on a continuous basis. Taking
sells all its

advantage of this demand/supply relationship, Hillsboro presendy has the

shortest credit terms possible. The company requires cash payment at the time of
purchase. Yet it still sells 100% of its production.
 —

Component Management

At the same time, management recognizes the volatility of the marketplace.

It wants to retain customers when competition increases or demand subsides.
Consequently, it decides to offer “reasonable” terms for payment and absorb the
cost associated with carrying an investment in accounts receivable in exchange for
a loyal customer base in the future.
Before adopting this policy, John Thompson, Hillsboro’s controller, ana-
lyzed the effects the primary alternative credit terms would have on the firm’s cash
flow and earnings. Thompson’s analysis began with the following assumptions:

1. Regardless of the terms offered, Hillsboro will maintain the same $5,000
average daily sales volume; production already equals capacity.
2. The company will incur a 12% per annum cost —financial or opportunity
from carrying an investment in accounts receivable.
3. All customers will pay stricdy in accordance with whatever terms the firm
designates.

Table 5-1 illustrates the investment in receivables (and the cost of carrying
that investment) thatwill resultffom allowing ten, thirty, or sixty days for payment.
In this instance, we assume that the carrying costs translate directly into a
reduction in Hillsboro’s earnings. The results of Thompson’s analysis show that
longer credit terms lead to a higher investment in accounts receivable. Thus they
have a more detrimental effect on earnings.

Table 5-1

Effect of Credit Terms on

Investment in Accounts Receivable

Credit Investment in Carrying Costs at

Terms Accounts Receivable 12% per Year
Net 10 Days $ 50,000 $ 6,000
Net 30 Days 150.000 18,000
Net 60 Days 300.000 36,000

Allowing ten days for payment reduces Hillsboro’s annual earnings by

$6,000, compared to its profits from making all sales for cash. This reduction
comes from the cost of carrying the $50,000 average investment in receivables that
naturally accrues from ten day credit terms. Increasing those terms to thirty days
reduces earnings by $18,000, while sixty day terms assess a $36,000 penalty on
Hillsboro’s bottom line.
important to note how the alternative credit terms affect Hillsboro’s
It is also

cash flow. The ten day terms absorb $50,000 of the firm’s cash capability. Hillsboro

30
 Component Management: Credit Terms

must reduce its cash reserves that much, or it must have a like amount of

borrowing power. Longer terms naturally increase that drain. Indeed, allowing
sixty days for payment absorbs $300,000 of Hillsboro’s cash capability. This is a
substantial consideration, even for a large firm.
Using Thompson’s analysis, Hillsboro’s management decided to absorb the
least expense possible in their effort to build customer loyalty. They selected ten
day credit terms as the standard corporate policy.
Few firms occupy Hillsboro’s enviable position. Demand seldom exceeds
supply on a continuous basis. At the same time, if you can exercise some liberty in
selecting your credit terms, recognize how that decision will affect your cash flow
and earnings. We set that management precept in:

Concept 9: Credit terms directly influence

the cash flow and earnings in
a business.

Don’t exaggerate the significance of the influence credit terms have on your
cash flow and require cash payment for all purchases. The cost of carrying a
reasonable investment in accounts receivable is a normal business expense. In
fact, you often will find that your credit terms have a greater effect on earnings
than your prices.
For example, Hillsboro might increase its prices by 10% to offset the cost of
carrying the investment in receivables that comes with itsnew credit terms. The
price increase would probably be viewed by Hillsboro’s customers as a negligible
price to pay formore liberal credit terms.
Credit terms also exert another influence. They also affect a firm’s sales
volume. So, a manager should recognize that influence when he selects the credit
terms for his business. The following section considers that influence.

Credit Terms, Sales Volume, and Cash Capability

Most businesses have a large number of competitors who offer similar

products and services. Credit terms inevitably become an important part of that
competition. A business might lengthen its credit terms because it will increase
sales.Other competitive factors remaining equal, longer credit terms allow
customers to retain their cash longer without violating the terms. Longer credit
terms increase their cash capability.
The firm that offers longer selling terms suffers an opportunity cost, because
longer terms lead naturally to a larger, more costly investment in accounts

31
Component Management

receivable. So the decision to offer more liberal terms requires a fair estimate of
the trade off between the cost of a larger investment in accounts receivable and
the bottom-line benefits of a higher sales volume.
We use the ABC Distributing Company to illustrate one approach to
analyzing that trade off. ABC is a regional distributor of small electric motors.
Operating in a highly competitive market, the firm can gain no significant
advantage from price structure, product quality, or service capability. So, ABC’s
management explored the potential bottom-line benefits that might come from
allowing longer terms for payment. The analysis began with a review of the
relevant factors in the firm’s current operations:

1. ABC now generates $50,000 per month in sales; in line with industry practice,
all sales are made on thirty day terms. Since all customers observe those
terms, ABC carries a $50,000 investment in accounts receivable.
2. ABC earns a 20% on sales; that is, after covering product and
gross margin
out of each dollar remains to cover the firm’s fixed
sales costs, twenty cents
costs of $7,500 per mondi. In addition, that gross margin must cover ABC’s
1% monthly cost of carrying its investment in accounts receivable.
3. After covering the above costs, ABC’s present sales volume nets $2,000 in
monthly earnings.
Marketing surveys suggest that ABC indeed can increase sales by offering
longer credit terms. In fact, each thirty day increase in ABC’s designated payment
terms will lead to a $10,000 increase in monthly sales. Table 5-2 considers the
effects the higher volume will have on the firm’s earnings and its investment in
accounts receivable.

Table 5-2
Effect of Longer Credit Terms on Sales, Cash Flow, and Earnings

Credit Terms (days)

30 60 90
Sales Volume (monthly) $50,000 $ 60,000 $ 70,000
Average A/R 50,000 120,000 210,000
Gross Margin (20% of sales) 10,000 12,000 14,000

Fixed Costs (7,500) (7,500) (7,500)

A/R Carrying Cost (1% per month) (500) (1.200) (2.100)

Net Monthly Earnings $ 2,000 $ 3,300 $ 4,400

32
 Component Management: Credit Terms

First, note that the analysis assumes that all of ABC’s customers will observe
the longer terms allowed for payment. This is a valid assumption, since no business
should pay sooner than necessary. Nevertheless, each projected increase in credit
terms leads to higher earnings, even after considering the cost of carrying a larger
investment in accounts receivable. The $10,000 sales increase that comes from
lengthening payment terms from thirty to sixty days ultimately translates into a
$1,300 rise in earnings. This becomes an annual $15,600 bottom-line benefit.
Then, increasing its credit terms from sixty to ninety days adds anodier $10,000
to ABC’s monthly volume, and it provides another $1,100 increase in monthly
earnings.
Of course, longer credit terms absorb a firm’s cash capability. Increasing
ABC’s payment terms from thirty to sixty days raised its investment in receivables
from $50,000 to $120,000. That increase uses $70,000 of ABC’s cash capability.
The firm must draw that amount from its cash reserves or borrowing power to
carry the increase in assets.
This analysis ignores another cost inevitably associated with longer credit
terms. Longer credit terms increase the loss a business suffers from bad-debt write-
offs. The new customers you gain with more lenient terms tend to be financially
weaker, perhaps unable to comply with the shorter time allowed for payment by
your competitors. Note that the expense exists, and that tlie example overstates
ABC’s real increase in profits.
Also note that even if you possess unlimited cash capability the potential
gains from longer credit terms aren’t infinite. At some point, die cost of carrying
a gigantic investment in receivables will offset the incremental gains from higher
But within pracdcal limits the potential gains from extended selling terms
sales.
can be significant Remember this as;

Concept 1 0: Longer credit terms can

increase earnings.

Finally, we must add one additional qualification. If you operate in a highly

competitive environment, you may realize only temporary gains from extending
your payment terms. Competitors may emulate your actions as soon as they
recognize your gains. In such instances, your sales may soon return to a lower level,
while the extended payment period remains constant. You end up with the same
salesvolume, but with a higher investment in accounts receivable. A short term
gain turns into a long term reduction in earnings. Consider that potential result
before you lengthen your selling terms.

33
Component Management

Cash Discounts in the Cash Flow Process

Many businesses allow discounts off the original sales price if a customer pays
for a purchase within a short, specified time after shipment For example, a
business might allow a 1 % or 2% discount if a customer pays for a purchase within
ten days. The firm requires full payment if the buyer takes thirty days to pay.
Before you decide to offer cash discounts, you must estimate the resulting
costs and benefits. First, recognize the potential benefits.
When a customer pays in accordance with the discount terms, it shortens
your average collection period and accelerates your cash flow. That reduces your
investment in receivables, as well as the costs associated with carrying that
investment.
However, allowing discounts for early payment also exerts some detrimental
effects on your bottom line. The basic circumstances of the ABC Distributing
Company illustrate how to weigh those negative effects against the benefits. We
will consider the effect on ABC’s cash flow and earnings from offering any one of
three alternative selling terms to its customers:

1. Net 30 days
2. 1% 10, net 30 days
3. 2% 10, net 30 days

We assume that ABC’s sales will remain a constant $50,000 a month regard-
less of the selling terms offered. However, customer payment habits will vary in
response to the different terms. Naturally, ifABC offers no discounts, all customers
will take tlie full tliirty days to pay. At the other extreme, every customer will pay
within ten days in exchange for a 2% discount. This incentive for early payment
is too large for any customer to ignore.
Mixed results come from offering a 1% discount for payment in ten days.
Projections indicate that only half of the firm’s customers will take advantage of
the smaller discount The other half will pay the full price in thirty days.
Table 5-3 summarizes the effects these alternative selling terms have on
ABC’s cash flow and earnings. The summary again assumes that the firm incurs
a 12% annual cost from carrying its investment in accounts receivable. This cost,
added to any discounts allowed, measures the total expenses associated with each
of the alternative selling terms.
Note that ABC suffers the least cost when it offers no discounts for early
payment. While that policy leads to a $50,000 investment in receivables, the firm’s
annual cost of carrying that investment totals $6,000.

34
 Component Management: Credit Terms

Table 5-3
ABC Distributing
Effects of Cash Discounts on Cash Flow and Earnings

Annual Annual
Carrying Cost
Selling % Taking Average Cost Discoimts Effect on
Terms Discounts A/R (12%! Allowed Earnings

Net 30 Days N/A $50,000 $6,000 — ($6,000)

1% 10, Net
30 Days 50% 33,333 3,999 3,000 (6,999)

2% 10, Net
30 Days 100% 16,666 1,999 12,000 (13,999)

Now, note how allowing discounts for early payments affects earnings.
Offering a 1% discount reduces ABC’s earnings by $6,999, compared to die
$6,000 reduction effected by the net thirty day terms. The savings gained from
reducing the size of the firm’s investment in receivables are more than offset by
the cost of the discounts.
Allowing 2% discounts is even more expensive. Not only is the discount
larger but every customer takes it. Indeed, thatpolicyleadsto a$13,999 reduction
in ABC’s earnings.
Observe Table 5-3 from a different perspective, the relationship between
ABC’s payment terms and its investment in accounts receivable. If no discounts
are included in the selling terms, ABC must carry the $50,000 investment in
accounts receivable. It must commit that much cash capability to its investment in
that single asset.
While that investment level is the most profitable, a limited cash capability
may force ABC to offer discounts. A 1% discount reduces the drain on that
capacity to $33,333 while the 2% discount further reduces the investment in
receivables to $16,666. We summarize the trade-offs illustrated in Table 5-3 in:

Concept 1 1 : Trade discounts help a firm's

cash flow at the expense of
its earnings.

Of course, ifyou can reinvest the accelerated cash flow rapidly and profitably,
the earnings you lose from today’s discounts may ultimately increase your profits.
But that doesn’t eliminate the implications of Cash Flow Concept No. 11.

35
Component Management

A Financial View of Trade Discounts

The 2% discount for early payment is irresistible to ABC Distributing’s

customers. But only half of the same customers will take advantage of a 1%
discount allowed for payments made ten days after a purchase. Yet both discounts
reduce net purchase costs. Recognizing the financial view of cash discounts
explains that apparent contradiction.
When you allow a discount for payment in ten days instead of thirty, you
actually pay your customer for the use of his funds for the tu^enty days you
otherwise would have to wait for full payment. Consequently, we can view cash
discounts a business allows for early payments as an interest chai ge a business pays
for borrowed funds. Figure 5-1 illustrates this with a look at a $1 ,000 sale made on
2% 10, net 30 day credit terms.
Figure 5-1
A Financial View of Cash Discounts
(Assume a $1,000 sale made on 2% 10, Net 30 Day credit terms)

I
30 Days 1

I
10 Days 1 20 Days 1

Free credit consideration Financing period; Pays $20 for the

for 10 days in the amount privilege of receiving net $980
of $980. payment 20 days sooner.

If the buyer doesn’t pay for the purchase by the tenth day, he must pay the
full$1,000 list price for the purchase. In that event, the purchaser typically will
delay payment until the end of the thirty day credit term. However, the seller
allows a 2% discount if the purchaser remits payment on the tenth day. That
allowance becomes the interest charge the seller pays to obtain $980 of the
purchaser’s funds twenty days before the required due date. Tlie twenty day term
marks the length of the financing period.
The cost of allowing a $20 discount for early payment may not appear
significant,but that allowance pays for relatively short term financing. To com-
plete our financial view, W'e should translate the cost of the discount allowed into
an annualized interest rate. The proper management perspective develops only
when you annualize that cost.

36
 - .

Component Management: Credit Terms

One approach to developing that perspective begins by determining the

total number of financing periods that accumulate from a firm’s selling terms
during a standard 360 day business year. Referring to Figure 5-1, the seller’s twenty
day financing period occurs eighteen times over the course of the year (360 / 20)
The approximate annualized interest rate appears when you multiply the number
of credit periods in a year by the percentage cost a business incurs from allowing
a single discount.
For example, the business allowing a 1% discount for payment in ten days
incurs an annualized 18% interest charge for the privilege of gaining that
payment twenty days earlier than the limit set by the full thirty day credit period.
The cumulative cost of the 1% discounts a business allows can leave a significant
dent in its earnings.
The same calculation process indicates that a business that allows a 2%
discount for payment in ten days incurs a 36%
annualized charge to gain early
customer remittances. Certainly every businessman will find that rate exorbitant.
The above calculation process can be used to determine the approximate
annual interest rate a business incurs from allowing any discount for early
customer payment. Merely identify the number of credit terms within a year. Then
multiply tliat total by the percentage cost of each discount allowed. The final
answer will not be precise, but itwill be sufficient to enter into the decision process
that determines whether or not a business should allow discounts for early
customer payments.
At the same time, we should review the calculation process that provides a
more accurate measure of the annualized interest charge a business incurs from
allowing discounts for early payments:

Annualized interest _ Discount percent ^

365
cost of allowing ( 100 - discount (Credit limit -
a cash discount percent) discount period)

Using the 2% 10, net 30-day credit terms, we find:

Annualized interest cost = x 365

( 100 % 2 %) (30-10)

98%
^
20
= 37.2%

A business actually incurs an annualized 37.2% interestcharge from allowing

a 2% discount for payment ten days after a purchase instead of full payment in

37
Component Management

thirty days. The same formula can be used to determine the cost of allowing any
discount included in a firm’s credit terms. Table 5-4 displays the cost of allowing
the more common discounts a business may consider offering for early payment.
It also helps explain the different response customers have to a 1% versus a 2%
cash discount allowed for payments made in ten days instead of thirty. Indeed, the
cost a customer pays for missing a discount is die same as a business incurs from
allowing it.

Table 5-4
The Annualized Interest Cost from
Allowing Cash Discounts for Early Payment

Annualized
Percentage
Credit Terms Cost

1/10, Net 30 18.4%

2/10, Net 30 37.2

3/10, Net 30 56.4

1/10, Net 60 7.4

2/10, Net 60 14.9

3/10, Net 60 22.6

A customer will take a 2% discount, even if it leaves him in a cash flow bind,
because losing that discount is equivalent to paying a 37.2% annual borrowing
cost. A customer also suffers a cost when he misses a 1% discount, but the penalty
is less severe. A customer is more likely to pass up the smaller discount as an

alternative to straining his cash capability.

The perceptive reader has by now surmised that a business can profit by
eliminating discounts from its This holds true even if the business
selling terms.
has to use its borrowing power to carry the resulting higher investment in accounts
receivable.
However, that should not prompt any rash action. Other factors also deserve
fair consideration.
For example, industry custom may dictate your selling terms. If your custom-
ers expect cash discounts for early payment, eliminating those discounts will di ive
them to your competitors. In such instances, discounts become a normal business
expense recognized in your price structure.

38
 Component Management: Credit Terms

Don’t overlook the effect that eliminating discounts will have on your cash
flow. This decision can lead to an increase in receivables that may impose a
significant drain on your cash capability. The increase may absorb the cash
reserves and borrowing power that may be essential for the firm’s survival.
Exchanging cash discounts for survival will always remain a fair trade.

39
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r
Chapter 6

Component Management: Credit Policy

Rarely does every customer pay in accordance with a seller’s designated

terms. In some instances, clerical error or honest oversight may delay payment. In
other instances, customers may defer payment to protest some real or imagined
problem with a product or service. In other circumstances, customers who fail to
pay within a firm’s designated terms simply suffer from their own cash flow
problems. They lack the capability to generate or borrow the cash to honor their
obligations promptly.
You could refuse to sell to anyone who failed to pay within your designated
terms, but that restriction might prove to be expensive. Many businesses increase
from sales to slow paying customers.
their earnings
At the same time, too many slow paying customers can create a cash flow
problem. That calls for a well designed credit policy that satisfies your earnings
objectives while still operating within the limits of your cash capability.

This chapter will focus on the impact a change in a firm’s credit policy has
on its sales, cash flow, and earnings. It also introduces the concept of cash
insurance, which employs an insurance policy to protect a business against the
cash drain caused by uncollectible accounts receivable. That protection reduces
the risk a business normally accepts when it carries a significant investment in
receivables.
Component Management

Credit Policy and Cash Flow

Chem-Etch operates as a regional manufacturer of printed circuit boards for

one sense, the firm enjoys an enviable position.
sales to the electronics industry. In
It sells the maximum plant capacity of $3,000 daily for a mondily volume of

$90,000.
However, the company attained that position only after a struggle to achieve
industry acceptance for its products. To earn that acceptance, Chem-Etch adopted
a credit policy that encouraged sales at the expense of its cash capability. In fact,
it willingly sold to customers who clearly lacked the financial ability to pay in
accordance with the thirty day selling terms.
While that policy helped push up the firm’s sales volume, it finally led to a
cash flow problem. By 9/30/90, Chem-Etch’s average collection period reached
75 days. That left the firm with a $225,000 investment in accounts receivable. On
the same day, as illustrated in Table 6-1, the firm reached the natural limit set by
its cash capability. Chem-Etch was out of cash, a common experience among

young, growing businesses. Such businesses often make sales volume a singular
objective and presume that that justifies a liberal credit policy.

Table 6-1
Effect of Credit Policy on Cash Flow
Chem-Etch, Inc.

9/30/90 12/31/90 3/31/91

Daily Sales $ 3,000 $ 3,000 $ 3,000

Collection Period (days) 75 60 45

A/R Investment 225,000 180,000 135,000

Cash — 45,000 90,000

A/R Carrying Cost (at 10% a year) 22,500 18,000 13,500

Reduction in Carrying Cost — 4,500 9,000

Naturally, Chem-Etch’s cash flow problem put an end to that policy. Since
the firm was operating at capacity (and turning down new orders daily) ,
the need
to induce such a liberal policy no longer existed. Consequently, the
sales with
company adopted a more restrictive credit policy that soon reduced its average
collection period to sixty days, still thirty days beyond the firm’s designated terms.
Table 6-1 illustrates the predictable effect of that more restrictive policy. By
12/31/90 Chem-Etch’s investment in accounts receivable dropped to $180,000,
providing the company with a healthy $45,000 cash reserve.

42
 Component Management: Credit Policy

In addition to relieving the cash flow bind, the more restrictive credit policy
provided Chem-Etch with another benefit. It reduced the costs associated with
carrying an investment in accounts receivable. The new policy gave the firm a
$4,500 (annualized) bottom-line benefit.
When the more restrictive policy had no effect on sales, Chem-Etch tight-
ened the credit reins again and set a forty-five day payment period as an objective.
Over the following three months, the firm’s receivables dropped to $135,000, its
cash reserves rose to $90,000, and Chem-Etch began to feel the benefits of a $9,000
reduction in annual carrying costs.
We recognize the relationship illustrated by Chem-Etch’s experience in:

Concept 1 2: Credit policy has a direct effect

on the cosh flow and earnings
in a business.

The following section takes a closer look at that effect.

Credit Policy and Sales Volume

Your credit policy affects sales volume in the same manner as your designated
selling terms. A liberal credit policy contributes to higher sales, while a more
restrictive policy tends to reduce should come as no surprise. After all,
sales. Tliis

whatever your designated selling terms, your credit policy defines your terms.

Your implied terms reflect the average time you actually allow customers to
pay for their purchases. For example, assume that you designate thirty days as your
standard selling terms, but your credit policy approves sales to customers who
habitually pay in sixty days. Inevitably, you will atti act customers precluded from
buying elsewhere because of more restrictive credit requirements. The longer
implied terms encourage an increase in sales.
To understand the relationship between implied terms and your cash flow
and earnings, look again at Table 5-2 in Chapter 5. The same principles apply to
both implied and designated selling terms. Increasing those terms from ten to
either thirty or sixty days will increase your sales volume. Also, the earnings on that
additional volume typically will outpace the rising costs of carrying a larger
investment in accounts receivable. In either instance, longer terms increase both
sales and profits at the expense of your cash capability.
You can’t control your implied terms precisely, but you should recognize the
relationship between your sales volume and the implied terms set by your credit
policy.

43
Component Management

Credit Policy Rules

A tighter credit policy reduces the length of your implied selling terms and
shortens your average collection period. A tighter policy also accelerates collections
and reduces your investment in accounts receivable. It improves your cash flow.
However, a more restrictive credit policy tends to reduce sales. As you tighten
your credit standards, prospective customers must show more financial strengtli
and have a better payment history to qualify for credit consideration. Those who
fail to meet your standards must buy elsewhere. That reduces the number of

prospective customers available to you, and inevitably it reduces your sales

volume.
If the demand for your products or services exceeds your present capacity,
a tighter credit policy may not affect your sales. Normally, however, when you
consider tightening your credit reins, you should weigh the benefits of a better
cash flow against the lower earnings from a reduced sales volume.
Obviously you get the opposite effect from loosening your credit reins. A
more liberal credit policy leads to a longer average collection period and a larger
investment in accounts receivable. That simultaneously absorbs some ofyour cash
capability and hurts your cash flow. A less restrictive policy, which lengthens the
implied term allowed for payment, also encourages a boost in sales because it

expands the pool of potential customers.

Moreover, as suggested in Table 5-2, those longer implied terms ultimately
can increase your earnings. You gain that benefit so long as the profits on the
higher volume offset the rising costs that come from carrying a larger investment
in accounts receivable.
Practical limits exist on the benefits you can derive from a more lenient credit
policy. And you should recognize those limits before you open your credit lines
to any customer who walks in the door.
In any event, never make payment within your designated terms a moral
issue. It is less important that a customer pays within a certain term than it is that
you realize the maximum bottom-line benefits from his purchase. Many business
managers lose sales and earnings because they refuse to allow customers to delay
payments beyond the designated due dates. So long as your designated terms
don’t strain your cash capability, profits take precedence over prompt payment.

The Limits on a Liberal Credit Policy

Longer selling terms, whether designated or implied, can increase your

earnings. You gain that benefit when the profit margin on sales induced by those

44
 —

Component Management: Credit Policy

terms exceeds the cost of carrying a larger investment in accounts receivable. That
potential was illustrated with the case of ABC Distributing Company in Chapter 5.

However, higher earnings from a more liberal credit policy are not auto-
matic. The profit potential from changing your credit policy depends on some key
factors not emphasized in ABC’s experience.
The profit margin you realize from each additional sales dollar stands as the
key factor that determines the benefits that might flow from a more liberal credit
policy. In the case of ABC, a healthy 10% margin on new sales easily offset the
modest 1% per month cost of carrying the firm’s investment in accounts receiv-
able. Obviously, a business that operates with a narrower margin will not enjoy the
same benefits. Nor will the business that suffers an unusually high cost from
carrying its investment in receivables realize similar gains. Those costs often rise

more rapidly than a firm’s investment in receivables.

—
Another factor not considered in ABC’s experience bad-debt write-offs
also exerts a significant influence on the profits you generate with a more liberal
credit policy. Although every business suffers some loss from customers who
ultimately fail to pay for their purchases, the business that adopts a less restrictive
credit policy inevitably will watch that rate rise.
A number of the customers you attract with your liberal policy lack the
capacity to pay within normal industry terms. They have cash flow problems.
Moreover, as you increase the time you allow a customer to pay for a purchase, you
increase the chances that his problems will develop into your disaster. That
inevitably contributes to a higher bad-debt expense.
Below, you will see how that higher expense can offset the benefits of a higher
sales volume. In fact, a small increase in bad-debt experience (as a percentage of
total sales) can make a big dent in your earnings. You can’t predict the size of the
dent accurately, but you can be certain that it will appear. Thus it becomes a factor
in your estimate of the benefits from a more liberal credit policy.
Don’t forget that when you allow longer terms for payment, you must have
the cash capability to absorb the resulting increase in your accounts receivable. In
fact, if a more liberal credit policy would stretch that capability, you might be more
comfortable with lower earnings from your present credit policy. You won’t earn
as much, but you will reduce the risk of having a cash flow problem.
Let’s look at an example that recognizes the limits on the benefits that can
be derived from a more liberal credit policy. That example moves us closer to a real
business environment, and it serves as a model for analyzing your own situation.
The East Texas Service Corporation (ETSC) is a direct competitor of the
ABC Distributing Company. Recognizing the sales increase garnered by ABC’s
longer selling terms, ETSC decided to adopt a similar policy but with two
important differences.

45
Component Management

First, rather than extending its selling terms, ETSC adopted a more liberal
credit policy, graduatlly lengthening implied terms. That approach presumably
its

encouraged the firm’s existing customers to pay in accordance with the designated
thirty day terms, while it still allowed sales to businesses that lacked that capability.
Also, ETSC’s analysis included a fair assessment of the effect longer implied terms
would have on the firm’s bad-debt expense. Recognizing these differences, the
firm’s analysis was based on the following assumptions:

1. Each ten day increase in average collection period that ETSC allows will
increase sales by $300 per day, or $108,000 per year.
2. ETSC earns 9% on sales before deducting any loss from bad debts, or the cost
of carrying the firm’s investment in accounts receivable.
3. The company incurs a 1 2 % annual cost from carrying its average investment
in receivables.
4. The firm’s present thirty day terms result in bad-debt write-offs that amount
to 1% of ETSC’s annual sales volume.
5. Estimates indicate that each ten day increase in the average collection period
will increase that loss rate by one quarter of 1%. For example, a forty day
collection period will increase the loss from bad debts to 1 .25% of total sales.
Table 6-2 summarizes the results of ETSC’s analysis. As anticipated, the sales
gained by increasing the firm’s average collection period from diirty to forty days
lead to higher earnings. While the $2,520 gain is modest, it does represent
earnings foregone with a more restrictive credit policy.
By allowing the average collection period to increase to fifty days, ETSC gains
an additional $1 ,260 in earnings, and total profits rise to $56,700 per year. But that
marks the limit on the company’s gains from a more liberal credit policy. Indeed,
increasing the collection period from fifty to sixty days provides no addition to
earnings, despite another $108,000 increase in sales. Any further increase in
collection period allowed by even more liberal credit guidelines actually reduces
earnings.
ETSC derives from lengthen-
Let’s review the facts that limited the benefits
ing implied terms. The firm’s profit margin (before deducting carrying costs
its

and bad-debt expenses) is a full percentage point below that enjoyed at ABC
Distributing Company. This small difference becomes significant when applied to
the total sales volume in a business. Indeed, it translates into a $10,000 reduction
in earnings on each $1 million volume.
in sales
In addition, ETSC incurs a higher cost from carrying
its investment in

accounts receivable. That difference becomes significant when measured against

a large investment carried for a full year.

46
 Component Management: Credit Policy

Table 6-2
limitB on a Liberal Credit Policy
East Texas Service Corporation
Implied Terms (days)

30 40 50 60 70

Daily Sales $ 2,100 $ 2,400 $ 2,700 $ 3,000 $ 3,300

Annual Sales 756,000 864,000 972,000 1,080,000 1,188,000

AverageA/R 63,000 96,000 135,000 180,000 231,000

EBCC at 9% 68,040 77,760 87,480 97,200 106,920

ARCC at 12% (7,560) (11,520) (16,200) (21,600) (27,720)

Bad Debts (7,560) (10,800) (14,580) (18,900) (23,760)

(as a percent
of annual sales) im. (1-25, %). (1-5%) (1-75%)

Net Earnings $ 52,920 $ 55,440 $ 56,700 $ 56,700 $ 55,440

Finally, the rising bad-debt expense naturally associated with a more liberal
credit policy completes the detrimental effect on tlie gains anticipated from the
higher sales volume. As implied terms increase, so do bad debts. No realistic
analysis can ignore that fact.
How these factors affec tyour business depends on your special circumstance.
Also, you must decide if your cash capability will allow you to carry die incremental
accounts receivable. Then you can determine whether longer implied terms can
be profitable for you.

Credit Policy and Sales Price

We’ve seen that a business inevitably incurs an increase in carrying costs and
bad-debt losses whenever it uses a liberal credit policy to induce a higher sales
volume. Carrying costs increase as a longer average collection period leads to a
larger investment in accounts receivable. At the same time, a business absorbs
higher losses from bad debts. In both instances, the more liberal the credit policy,
the larger the increase in costs. That can can derive
limit the benefits a business
from a more liberal credit policy.
However, a business with sufficient cash capability can adopt another policy
that overcomes that limit. It can adjust prices. Even a modest price adjustment can
offset the higher costs associated with a more liberal credit policy.

47
Component Management

To illustrate the potential of that policy, let’s examine the results tliat come
from a two-tiered price structure tied to customer payment habits. In this instance,
assume that a supplier sets a $10 per unit price for customers who observe his
designated thirty day terms for payment. Customers who take sixty days to pay
must absorb a 10% premium. Product costs in either instance hold constant at $7
per unit. Table 6-3 compares the results that come from selling 1,000-unit lots to
both kinds of customers.

Table 6-3
Credit Policy and Sales Price

30 Days 60 Days
Payment Price Payment Price
($10,001 ($11,001

Units 1,000 1,000

Monthly Sales Volume $10,000 $11,000
Average A/R Investment 10,000 22,000

Gross Earnings Calculation

Sales $10,000 $11,000

Product Costs $7 per Unit
at (7,000) (7,000)
Monthly A/R Carrying Cost
(1% per month) (100) (220)
Bad-Debt Losses (100) (2201

Gross Earnings $ 2,800 $ 3,560

Column 1 measures the gross earnings from sales to customers who observe
the thirty-day payment terms. Deductions for accounts receivable carrying costs
and a bad-debt reserve leave the supplier with $2,800 in gross earnings. Of course,
the business has to cover operating expenses out of tliat margin. But the gross
margin calculation is sufficient for comparison here.
Now, examine Column 2, which shows the results that come from the 10%
price adjustment applied to the same unit volume of sales to customers who take
sixty days to pay.
The firm from that policy. The seller’s investment
suffers two cost increases
in receivables rises. The $11,000 monthly volume translates into a $22,000 higher
average investment in receivables. Also, bad-debt losses increase from 1% to 2%
of the monthly sales volume. That naturally follows from sales to slow paying
customers.

48
 Component Management: Credit Policy

However, the 10% price differential easily offsets both the higher accounts
receivable carrying costs and the increase in losses from bad debts. And the price
adjustment produces a $760 net increment in earnings. That measures the benefit
the seller derives from contributing her cash capability to a slow-paying customer
for an extra thirty days.
In fact, even a 5% price differential would produce a slight increase in

earnings for the supplier. This emphasizes that only a small differential can easily
offset the cost that comes from selling to slow-paying customers. Of course, you
must have the cash capability to carry the investment in receivables that results
from those sales. But if you have the capability, adjusting your prices upward can
increase your earnings.
This potential earns recognition in:

Concept 13: An upward price adjustment

con offset the cost or selling to
slow paying customers.

The customer who pays slowly seldom complains about a modest price
differential.She is more interested in liberal credit consideration that eases the
strain on her own cash flow. Typically, she is willing to pay for that consideration.

Credit Insurance

Despite its long, successful history as a cash management tool, credit

insurance remains an obscure concept to many business managers. Indeed, the
business manager who insures her buildings, equipment, and vehicles against
common perils often overlooks protecting an asset that is often more critical for
the survival of her business —her accounts receivable.
A vehicle theft or a warehouse fire obviously can disrupt a business. But the
inability to collect a large receivablecan cut off the cash flow critical for survival.
The value of credit protection will become apparent as we review the basic concept
and operation of credit insurance. Not only can that protection prevent a cash
flow crisis but it can also lead to higher earnings.

The Indemnification Principle

A business that adopts a more liberal credit policy to increase sales accepts
the risk —indeed, the inevitability—of higher bad-debt write-offs. Certainly, you

49
Component Management

can ofiFset those losses by adopting a complementary policy that adjusts prices
upward to slow paying customers. But that still does not remove the risk.

In fact, you must recognize that bad-debt losses seldom occur in a systematic
proportion to sales. You may accurately project an average loss rate over an

extended period, but each loss actually occurs on an individual, random basis.
For example, a business might realistically anticipate $100,000 in total bad-
debt losses for the next ten years. However, the precise timing of the write-offs
belies prediction. The business might lose $10,000 each year for ten years, or it
might suffer a $100,000 loss in one year, but none in the other nine. A $10,000 loss
from bad debts might not impose a serious strain on your cash flow. However,
taking $100,000 from uncollectible accounts in one year can threaten your firm’s
survival.
Recognizing this fact, credit insurance indemnifies a business against the
catastrophic loss in cash that might occur when a large receivable becomes
uncollectible because of (1) debtor bankruptcy, (2) debtor composition (reorga-
nization of debt by creditors) or (3) any other proceeding that reflects a debtor’s
,

company replaces much of the cash flow

insolvency. In such events, the insurance
that otherwise would be bad-debt write-off. The insurance policy sets the
lost in a
terms of the basic reimbursement.

The Credit Insurance Policy

The credit insurance policy establishes the principles of the relationship

between a business and a credit insurance company. The contract, or policy,
identifies the specific risks that will shift from the business to the insurer.
Usually, a policy provides coverage for losses suffered from any of a firm’s
accounts receivable that become uncollectible. However, that coverage is subject
to two practical limits.
First, company applies a deductible amount to each loss. For
the insurance
example, $10,000 account proves uncollectible under terms of the policy, the
if a

business might receive a $7,500 cash reimbursement from the insurer and absorb
the $2,500 loss. The terms of the contract set the specific deductible amount.
The deductible provision encourages the business to maintain prudent
credit and collection policies. That interest might wane if the firm received 100%
protection against any loss. Credit insurance protects against catastrophe, not
recklessness.
Second, the insurance company limits the maximum coverage for each
debtor. Typically, those limits are tied to ratings established by national credit-
rating agencies, such as Dun and Bradstreet. For example, a company with a D &

50
 Component Management: Credit Policy

B rating of BBl might automatically qualify for a maximum $25,000 in coverage

under terms of the credit insurance policy. A business with a higher rating
qualifies for more coverage. One with a lower rating receives less.

In the absence of ratings, special endorsements specify the amount of risk

acceptable to the insurer. A covered business can extend credit consideration in
excess of the coverage limits, but it must accept die full risk of loss associated widi
that excess.
The cost for credit insurance remains modest While premiums vary, the
coverage may cost 1/4% 1/2% of annual sales. That may be a small price to pay
to
for survival. Moreover, credit insurance can encourage management policies that
pay the cost of the coverage and increase earnings.

Confident Credit Policy

A business can use a more liberal credit policy to encourage a higher sales
volume that increases earnings. Credit insurance contributes an element of
confidence to the businessperson who adopts that policy.
Of course, credit insurance doesn’t provide the cash capability to carry the
increased investment in receivables that results from that policy. A business must
obtain that capability from other sources.
At the same time, credit insurance can give a business manager confidence
that she suffers a reduced risk from an erroneous credit decision. She can
concentrate on sales rather than credit and collections. That benefit earns
emphasis in:

Concept 14: Credit insurance provides

protection against the cash
drain caused by uncollectible
accounts receivable.

Credit insurance doesn’t cover imprudence, but it adds an element of

confidence to a more liberal credit policy. The loss fi^om a mistake will be tangible,
but it won’t be terminal.’
Don’t overlook tlie value of credit insurance. If your business has the cash
capability,you can enjoy higher profits without the threat of uncollectible
accounts. Indeed, such protection may ensure the profitability of a more liberal
credit policy.

51
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r
Chapter 7

Inventory in the Cash Flow Process

To meet customer demand as it arises, most businesses invest in some

quantity of merchandise. That merchandise investment measures the size of a
company’s inventory. Since a business typically pays for its inventory at the time
of purchase or within thirty days thereafter, the size of its investment in inventory
exerts an important influence on its cash flow. This chapter illustrates that
influence.

Inventory and Accounts Receivable

Inventory has the same relationship to the cash flow process as accounts
receivable. But some important differences between the two components make
inventory management more challenging.
For example, accounts receivable are self-liquidating assets. Once a sale is

made, a receivable converts naturally into cash when collected.

Inventory is a less accommodating asset. Indeed, you have to push it through
the cash flow cycle. It sits idle until you generate the sale that converts it into cash
or accounts receivable.
Apart from the purchase cost, it usually is more expensive to carry an
investment in inventory than in accounts receivable. Of course, the financial or
opportunity cost of carrying either investment is the same. Additionally, an
investment in receivables requires a reasonable expenditure for a credit and
collection effort. But these costs seldom match the expenses associated with
carrying inventory.
Component Management

First, you must warehouse your stock. You must buy or lease a facility that
enables you to store and maintain your investment in a salable condition. And the
larger your total inventory, the larger your warehouse expense.
An investment in inventory also requires unavoidable handling costs, such as
personnel, equipment, and processing. You incur tliose costs each time you take
delivery of a new purchase or generate a sale. Naturally, your handling costs
increase proportionately with your sales volume. Moreover, you must insure your
inventory against the threat of fire, theft, and other perils. The larger and more
perishable your inventory, the higher your insurance expense. Wliile you also can
insure accounts receivable against losses from bad debts, the costs are not nearly
comparable your physical inventory.
to those associated with
Finally, many inventory items have
a limited shelf life. For several reasons,
that investment can lose value while a business holds inventory for sale.
For example, a grocer must discard unsold vegetables after only a day or two.
A chemical distributor suffers the same fate with some compounds that lose
potency a week or a mondi after production.
Even nonperishable inventory can lose value while it sits in your warehouse.
In some instances, it may become obsolete, made unsalable by technological
innovation or merely by a change in customer preference. Even a minor im-
provement in a competitor’s product can transform your leading source of
revenue into a back shelf item.
In other instances, competitive price pressure can reduce the value of your
investment. Your inventory inevitably loses some salability whenever your com-
petitors lower prices to attract sales. While you can view that as an opportunity
—
cost ^you end up with a smaller profit margin rather than higher expense the —
effect on your earnings is the same.
The cost of carrying inventory should be kept in perspective. You should
measure the actual or potential costs of carrying inventory against the benefits you
stand to gain from that investment. You can recognize that gain best by comparing
it with your investment in receivables.
Accounts receivable, once generated from sales, become sterile assets. They
contribute nothing until they are converted into cash through collection. In
contrast, any item in your inventory can produce additional profits for your
business, it can contribute a much larger return than any other investment
and
you normally make.
For example, if you generate a $10 sale from an item that costs $7, you gain
a $3 contribution to your operating costs and profits. That gain represents a 42%
return on your investment. Should you repeat that sale, or turn that inventory
item, four times a year, the cumulative annual return on your investment becomes

54
 Inventory in the Cash Flow Process

168% This potential return justifies the higher carrying costs inevitably associated
.

with your investment in inventory. Of course, the potential profits from any
inventory shouldn’t encourage you to carry a quantity that could exhaust your
cash capability. But you should balance tlie potential profits against the cost of
carrying that investment.
You should also recognize one important similarity between accounts receiv-
able and inventory. You can’t reduce your investment in either asset below some
minimum level without hurting your sales and profits. If you shorten your
designated or implied selling terms too much, you will lose sales to your more
liberal competitors. You will reduce your investment in accounts receivable, but
chances are good that you also will reduce your earnings. Lower revenue generally
translates into lower profits.
You when you try to lower your investment in inventoiy
suffer a similar fate
too far. That you begin to lose sales to your better stocked competitors. You
is,

suffer stock-out costs whenever you do not have an item on hand to meet customer
demand.
Stock-out cost is another opportunity cost. But it is more difficult to measure
than one resulting from an overinvestment in accounts receivable or inventory.
As a minimum measure of the expense, you can estimate your stock-out cost
in terms of a customer’s dissatisfaction that arises from having to wait for a
particular item. That dissatisfaction naturally makes him more susceptible to your
competitors.
At the next level, the stock-out cost increases when your customer actually
does buy the product elsewhere. If you regain his business in tlie future, the
potential profit from the single lost sale measures your stock-out or opportunity
cost.
You incur the maximum opportunity cost should you ultimately lose all of the
customer’s future business to a better stocked competitor. Consequently, when
you determine your proper investment in inventory, you must weigh the stock-out
costs that come from having too little inventory against the costs of carrying a
larger investment.

The Average Investment Period

Similar to the collection period calculation in Chapter 3, average investment

period measures the length of time each dollar invested in inventory remains in
that form before a sale converts it into cash or into an account receivable. So, it
provides the conceptual foundation for managing a firm’s investment in inventory.

55
Component Management

The data to illustrate this concept come from the case of Tire Distributors,
Inc., a wholesaler located in a large southwestern state. In summary form, TDI
generated the following results in its fiscal year ending 8/31/90:

Sales $ 2,400,000
Cost of Goods Sold (1,920,000)
Operating Cost (390.000)

Earnings $ 90,000

However, TDI’s profitable operation did not preclude a cash flow problem.
Table 7-1 presents a picture of the problem that gives you a look at the firm’s
8/31/90 balance sheet. That financial statement reflects the following facts about
the company’s operation:

1 . TDI’s $300,000 investment in accounts receivable comes from a forty-five day

collection period and a $200,000 monthly sales volume.
2. At 8/31/90 TDI was carrying a $480,000 investment in inventory.
3. The company presently purchases $160,000 per month from its suppliers, an
amount equal to TDI’s monthly cost of sales.
4. Tlie firm’s suppliers allow a 2% discount for payment within ten days after
a purchase, while the full purchase price is due in thirty days.

It is easy to see that with purchases of $160,000 per month and accounts

payable of $240,000 per month, TDI is violating its suppliers’ payment require-
ments. Even with the aid ofa $250,000 bank loan, the firm is paying suppliers forty-
fivedays after purchase, rather than within the expected thirty days.

Table 7-1
Tire Distributors, Inc.
8/31/90 Balance Sheet

Cash $ 10,000
Accounts Receivable 300,000
Inventory 480.000
Total Assets $790,000

Accounts Payable $240,000

Bank Loan 250.000
Total Liabilities $490,000

Stockholder’s Equity 300.000

Liabilities and Equity $790,000

56
 Inventory in the Cash Flow Process

8/31/90 TDI’s suppliers obviously

In spite of their designated terms, at
tolerated the firm’s payment apparendy were
practices. Indeed, the suppliers
seeking sales more avidly than prompt payment. At the same time, TDI’s payment
practices cost the firm dearly. In fact, the inability to pay for purchases within ten
days cost TDI $3,200 in lost discounts each month ($160,000 x 2%). And that
doesn’t consider the financial or opportunity cost associated with a potential over-
investment in inventory.
Recognizing the expensive cost of a cash flow problem, TDI’s management
searched for a way to take advantage of the lost discounts. As a first step in that
search, management found that the firm needed $187,000 in cash to take supplier
discounts. This totalcomes from the difference between TDI’s actual accounts
payable at 8/31/90 and the amount that would be due if the company took all
available discounts. Thus if TDI took all discounts on $160,000 in monthly
purchases, accounts payable could not exceed the average purchase amount for
any ten day period. That becomes one-third of $160,000, or $53,333. Based on the
$240,000 in accounts payable due, TDI needed $187,000.
Management then began to look for a source for the cash necessary to take
the supplier discounts. Immediately, that search ran into two roadblocks.
First, TDI’s banker refused to increase its loan above tlie $250,000 total
outstanding at 8/31/90. The required $187,000 increase would exceed even a
liberal banker’s limit.
Second, management analyzed the potential benefits that might come from
a reduction in TDI’s average collection period. However, it found diat since the

existing forty-five day collection period approximated the industry average, any
significant reduction imposed by shorter selling terms or a tighter credit policy
would injure sales. Generating cash by reducing the firm’s investment in accounts
receivable was not a realistic alternative.
TDI’s management examined the one remaining potential solution to its
problem. The cash might come from a reduction in the firm’s investment in
inventory. That analysis began with the calculation of the average investment
period.
That calculation involves a two step process:
1 . Divide cost of goods sold by 360 to obtain the average daily cost of goods sold.
2. Divide that total into the firm’s present investment in inventory to find the
average investment period.

TDI’s calculation becomes:

1. Average Daily $1.920.000 $5,333

Cost of Goods Sold 360

57
Component Management

2. Average Investment Period = $480,000 _ qq j)ays

$5,333

At 8/31/90, the average dollar TDI invested in inventory remained in that

form for ninety days.
We illustrate how TDI uses that information to solve its cash flow problem
below. Here, simply recognize that average investment period is analogous to
average collection period. Reducing the length of either period releases cash a
business can reemploy elsewhere.

Using Average Investment Period

Average investment period relates your daily cost of goods sold to your total
investment in inventory. It measures the average number of days’ sales you
maintain in stock. To use that information, you must recognize how a change in
that investment period affects your cash flow.
TDI’s experience illustrates those effects. The average investment period
calculation indicated that the firm had inventory sufficient for ninety days’ sales
at 8/31/90. That calculation averages the investment periods for all of the items
that make up the firm’s total inventory. For example, TDI’s inventory of some tire
sizes was sufficient for only sixty days’ sales, while other sizes on hand would satisfy
normal customer demand for six months or more.
Additional research into supplier shipping habits indicated that TDI seldom
had to wait more than thirty days for delivery of any order placed with any supplier.
Indeed, most suppliers shipped major orders in even less time.
Combining these facts led to a solution of TDI’s cash flow problem. Manage-
ment correctly concluded that it was unnecessary to maintain inventory on hand
sufficientfor ninety days’ sales, when any item in that inventory could be restocked
in thirty days or less.
Thus TDI’s management decided to reduce the average investment period
from ninety to fifty days. This objective would leave the firm with inventory
adequate to service most customer requirements promptly, and it would still carry
inventory necessary for twenty days’ sales beyond the normal restocking period.
That cushion was designed to satisfy extraordinary customer demand or un-
avoidable delays in shipping by suppliers.
Significantly, the lower investment in inventory generated $213,320 in cash
for TDI. Inventory dropped from $480,000 to $266,680. Table 7-2 illustrates the
effect the lower investment had on the firm’s financial structure. Note two
important facts about that structure.

58
 Inventory in the Cash Flow Process

First, the cash enabled TDI to reduce accounts payable to the level necessary

toearn the firm the 2% discounts allowed for payment within ten days. TDI’s
monthly bottom-line benefit from that result translates into a $38,400 annual
increase in earnings. That’s significant in any business league.
Second, the reduction in inventory also added more than $26,000 to the
As the lower investment improved earnings, it also enhanced
firm’s cash reserves.
TDI’s cash position.

Table 7-2
Tire Distributors, Inc.
12/31/90 Balance Sheet

Cash $ 36,653
Accounts Receivable 300,000
Inventory 266.680
Total Assets $603,333

Accounts Payable $ 53,333

Bank Loan 250.000
Total Liabilities $303,333

Stockholders’ Equity 300.000

Liabilities and Equity $603,333

You can easily estimate the potential cash you can generate from a reduction
in inventory.Merely measure your average investment period against tliat actually
required to the real needs of your business. Interrelate your sales projec-
satisfy
tions with each supplier’s ability to deliver his products on time. You may find, as
in TDTs circumstance, that you can reduce your inventory substantially without
hurting your sales volume. Of course, you won’t reduce your inventory to a level
that would increase your stock-out costs. But recognize that excess inventory is not
only cosdy to carry but also absorbs your limited cash capability. Eliminating any
excess inventory improves your cash flow and increases your earnings.
Cash Flow Concept No. 15 provides the foundation for managing a firm’s
investment in inventory;

Concept 1 5: Average investment period

defines the relationship
between your inventory and
the cash flow process.

59
Component Management

Table 7-3 illustrates the direct relationship between average investment

period and cash flow. If your cost of goods sold averages $2,000 per day, then a ten
day reduction in average investment period contributes $20,000 to your cash flow.
If you can effect that reduction without an increase in stock-out costs, you will
generate that much cash from profitable reinvestment elsewhere.

Table 7-3
Effect of Investment Period on Average Total Inventory

Average
Investment
Period
Days Cost of Goods Sold per Day

$ 1,000 $ 2,000 $ 3,000 $ 4,000 $ 5,000

Total Inventory

30 30,000 60,000 90,000 120,000 150,000

35 35,000 70,000 105,000 140,000 175,000
40 40,000 80,000 120,000 160,000 200,000
45 45,000 90,000 135,000 180,000 225,000
50 50,000 100,000 150,000 200,000 250,000
55 55,000 110,000 165,000 220,000 275,000
60 60,000 120,000 180,000 240,000 300,000

Also recognize that reducing your investment in inventory provides a larger

bottom-line benefit than a comparable reduction in accounts receivable. After all,
not only do you reduce the financial (or opportunity) cost of carrying an excess
investment but you reduce the physical carrying costs. The total benefit can be
substantial.

60
r
Chapter 8

Component Analysis: Inventory

The financial formula introduced in Chapter 7 provides useful insight into

the relationship between inventory and the cash flow process. However, you must
proceed beyond those basic calculations to identify any overinvestment in inventory,
as well as to isolate the underlying problem that precipitates that overinvestment.
This chapter facilitates those objectives by reviewing the basic tools for analyzing
inventory in the cash flow process.

Comparative Analysis: Average Investment Period

Component management emphasizes the most efficient, profitable invest-

ment in accounts receivable and inventory in the cash flow process. The emphasis
recognizes that you can have a cash flow adequate for normal operations but still

component. Comparative analysis of a firm’s

carry an excess investment in either
average investment period can help identify an excess investment in inventory.
So, if your current average investment period exceeds that experienced by
your business in prior periods, you may have an overinvestment in inventory.
Further analysis might contradict that view, but any discrepancy from past
performance invites a deeper look.
Similarly, if your investment period is longer than that of your competitors
(perhaps using comparative data available from Dun and Bradstreet or Robert
Morris Associates), an excess investment in inventory may be exerting a subtle,
detrimental effect on your bottom line.
Component Management

Remember also that a significant difference in either instance doesn’t prove

the existence of a component problem. A special sale or an extraordinary
purchase opportunity may justify a temporary overinvestment in inventory mea-
sured by normal standards. But deviations from the norm do call for explanation.
This reaffirms the important benefit you derive from comparative analysis.
It draws attention to the extraordinary, the problem that needs to be corrected,

or the circumstance that at least deserves explanation. Regarding inventory, that

translates into:

Concept 16: Comparative analysis helps

identify the correct average
investment period for your
inventory.

The correct investment period translates into the proper investment level in
inventory.That becomes the target for your component management effort.

Comparative Analysis: The Inventory/Sales Ratio

Continuing the analogy with the comparative analysis of your accounts

receivable, you can use a regular examination of your inventory to sales ratio to
identify a potential overinvestment in inventory. The ratio compares your in-
vestment in inventory to your monthly sales total.
For example, if your inventory at the end of last mon tli totaled $300,000, and
sales for the same montli reached $150,000, the calculation becomes:

Inventory _ $300,000 _ 2
Sales $150,000

Your investment in inventory was twice your sales volume for the month. The
ratio provides a straightforwardsummary of the relationship between those two
critical elements.
Now, assume normal operation requires an investment in inven-
that your
tory that doublesyour monthly sales volume. The ratio then becomes the standard
against which you compare the results of your operations every month.
If any monthly calculation results in a higher inventory to sales ratio — that
is, above 2 to 1 —^you can assume that you have a potential component problem.
Of course, the ratio rises in response to both an increase in inventory and a drop
in sales. So, the immediate problem may not lie in faulty component manage-
ment. Indeed, it may be a problem associated with your sales effort or perhaps with
a general decline in the economy.

62
 Component Analysis: Inventory

Alternatively, should the ratio between inventory and sales fall below 2 to 1,
or whatever standard is appropriate for your business, then you may deserve a
compliment for managing your inventory efficiendy. After all, that result comes
from either a higher sales volume relative to your investment in inventory or a
lower inventory level relative to sales. Over the short term, either circumstance is
desirable.
You also should recognize the other possible implication of a lower inven tory
As you increase sales relative to any investment in inventory, you also
to sales ratio.
increase the risk of incurring stock-out costs. The benefits from a better cash flow
may be offset by the opportunity costs associated with lost sales.
In any instance, the inventory/sales rado serves the same function as any
other tool for comparadve analysis — to draw attention to a potendal over-
investment in inventory. But you must look further to locate the specific source
of that problem.

Turnover Analysis

A periodic count of every item in stock remains the first fundamental

principle of sound inventory management. The physical count serves two primary
objectives.
First, it enables you to verify the accuracy of your accounting procedures that

keep track of your investment in inventory. As you verify the exact amount of each
item in stock, you confirm the value of your investment.
Second, and even more important, the physical count provides the basic data
necessary to perform a turnover analysis of your inventory. Turnover analysis then
becomes a fundamental tool that enables you to control your investment in
inventory.
Average investment period still defines the relationship between your
inventory and the cash flow process. However, thereis a limitation inherent in the

information provided by that calculation. As the term implies, it defines an

“average” relationship. That presumes that every item you stock turns at exactly
the same rate. Thus a sixty day average investment period asserts that each product
that makes up your total investment in inventory moves from purchase to resale
months. It also implies that your stock of every item in inventory is
in exactly two
months’ sales.
sufficient for two
Those are valid assumptions if your inventory includes only one product.
However, most businesses carry a wide variety of different products. Inevitably,
some products turn more rapidly than others.

63
Component Management

Whatever your average investment period, when you consider specific items
within your inventory, you may have an overinvestment in some, the correct
investment in others, and insufficient investment in still others. Consequently,
complete component analysis requires that you go beyond the average investment
period calculation and examine your investment in each product that you carry.
You must perform turnover analysis.
Turnover analysis measures the amount of your investment in each item in
stock against the amount actually required, based onyour recent sales experience.
To illustrate this, we return to the case of Tire Distributors, Inc., discussed in
Chapter 7.

TDI solved its cash flow problem by reducing its average investment in
inventory from a level appropriate for ninety days’ sales to a level still sufficient for
fifty days’ sales. Of course, that reduction didn’t occur spontaneously. Instead, the
firm used turnover analysis to identify the specific tire sizes that made up the

overinvestment in inventory.
The analysis proceeded on three assumptions:

1 . TDI had no need to stock a quantity of any tire above that necessary to satisfy
two months’ sales.

2. TDI measured that standard by looking at the actual sales activity over the
previous sixty days for each tire in stock.

3. As a starting point for analysis, TDI conducted a physical count of its

inventory, which included a breakdown of the number of each tire size in

stock.

Let’s review some of the relevant results of TDI’s analysis illustrated in

Table 8-1.

TDI found 420 tires. Stock No. 100, on hand at 8/31/90. But only 140 had
been sold during the last sixty days. The stock on hand of that single tire was
sufficient for normal demand for the next six months. TDI could carry one tliird
the inventory of that item without the serious risk of incurring any stock-out costs.
Analysis of Stock No. 101 showed that the amount in stock was exactly right
for sixty days’ sales. TDI’s investment in that item was appropriate for its sales
volume.
Now, look No. 102. Although the firm sold 540 units
at the results of Stock
over the previous two month on hand for sale at 8/31/90.
period, only 270 were
Perhaps TDI was awaiting delivery of 270 units to bring that stock item up to the
proper 540 level to meet normal demand. If not, the firm was confronting the
because of a deficient inventory of a rapidly selling tire.
possibility of stock-out costs
TDI’s investments in Stock Nos. 103 and 104 also were excessive. Those items
became candidates for the firm’s reduction program. We find the same result

64
 Component Analysis: Inventory

Table 8-1
Inventory Item Analysis
Tire Distributors, Inc., @ 8/31/90
Tire Number Number Days
Stock in Sold Last Sale in
Number Stock 60 Days Inventory Action

100 420 140 180 Reduce

101 300 300 60 Satisfactory
102 270 540 30 Increase
103 850 170 300 Reduce
104 90 30 180 Reduce
105 63 9 420 Eliminate

from Stock No. 105. However, that item, a relatively small part of TDI’s total
inventory, produced sales of only 9 units over the sample sales period. This
suggests probable obsolescence, and management should eliminate the item
altogether from the investment in inventory.
Of course, TDl may carry' thatitem to meet the sporadic demands of a
customer who buys a significant number of other tire sizes. If not, diat item
becomes excess inventory. It doesn’t generate enough sales to justify carrying it

at all.

Now,
let’s review tlie primary’ benefits of inventory' item analysis.

Item analysis enables you to identify the specific items in stock that make up
an overinvestment in inventory'. Eliminating that excess reduces the size of your
average investment in inventory' and improves your cash flow. It also ser\'es as an
early warning problem spotter, analogous to the aging analysis of accounts
receivable. So, remember:

Concept 1 7: Item analysis identifies the

specificsource of an
overinvestment in inventory.

An overinvestment in inventory seldom develops suddenly. Instead, the

buildup occurs slowly. One item moves more slowly than average, dien anodier.
As you identify these slower moving products on a regular basis, you can make the
appropriate adjustments before die cumulative effects hurt your cash flow or
earnings. Of course, your response might be to lower your inventoiy level or
increase your sales effort for those particular items. In either circumstance, item
analysis provides die signal for action. Used properly, diis problem spotter can
add significant earnings to your bottom line.

65
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 Chapter 9

Component Management: Quantity Control

is the key to successful inventory management. You

Effective quantity control
want maintain an inventory level adequate for anticipated sales requirements
to
while avoiding an overinvestment that exerts a detrimental effect on your cash
flow and earnings. This chapter introduces some cash flow concepts that help
achieve those objectives.

The Elements of Inventory Investment

The proper investment in inventory generates the maximum earnings for a

business without stretching the limit of its cash capability. Of course, no business
maintains that investment continuously. But that objective serves as the normal
target of the quantity control effort.
The stock necessary to satisfy normal day to day sales requirements makes up
the core of that target. For example, assume that an office supply firm sells an
average of 10 boxes of carbon paper per day, or 300 boxes per month. If the firm
buys carbon paper only once a month, then each order should call for no fewer
than 300 boxes. This is the minimum to satisfy normal sales requirements.
Since customer demand fluctuates over any short term period, sales of any
particular item can exceed normal requirements. So an investment in inventory
properly includes some safety stock.
Safety stock describes that part of a firm’s inventory that satisfies a modest,
unanticipated increase in customer demand. It provides a measure of protection
against stock-out costs. For example, the office supply firm might begin each
Component Management

month with an inventory of 330 boxes of carbon paper. While that total exceeds
normal requirements, the 30 extra boxes provide a cushion to satisfy an unan-
ticipated increase in demand. Note that the cost of carrying the safety stock should
be less than the opportunity cost incurred from the loss of those potential sales.
Safety stock also helps to offset shortages that might result from erratic
supplier shipments. An unforeseen strike, snowstorm, or material shortage can
delay shipment of any order. Safety stock helps defer the potential decrease in
sales caused by such disruptions.
Growth stock stands as the final element in a firm’s target investment in
inventory. That stock satisfies the demand created by a projected increase in sales
volume. Certainly no effort to increase sales makes sense unless you carry the stock
necessary to supply the higher volume.
Assume that the office supply firm adds a salesman in an effort to expand its
market. At the same time, the firm must increase its inventory of carbon paper, as
well as all other items, to satisfy the anticipated increase in sales. If tlie higher
volume does not follow, the firm will find itself with a temporary overinvestment
But that is a necessary risk inherent in any push to increase sales. Cash
in inventory.
Flow Concept No. 18 adds up the elements that enter into a firm’s target inventory
investment:

Concept 1 8: Normal stock plus safetv stock

plus growth stock ec^uals the
target investment in inventory.

Of course, the investment in inventory must be properly allocated among the

different products that make up that total. And tlie total should not exceed the
firm’s cash capability.

Estimating Inventory Requirements

A realistic sales projection is a necessary precedent in estimating inventory

requirements. Ideally, that forecast will proceed from a knowledgeable assess-
ment of the projected economic environment, and the anticipated influence that
environment will have on a firm’s market. Recognizing the constraints set by
competition a business then should forecast its annual unit sales volume based on
,

Cash Flow Concept No. 18. And the annual unit projection should be dispersed
across the operating periods —quarters, months, or weeks— tliat are most appro-
priate for setting purchase requirements.
Every sales forecast contains a margin of error. Unpredictable fluctuations
in customer demand remain inevitable. However, that does not eliminate the

68
 Component Management: Quantity Control

contribution a sales forecast makes to the inventory management effort. Even a

casual forecast provides some basis for controlling a firm’s investment in inven-
tory. The business proceeding without a sales forecast lacks the management
premise necessary for that control.
We will examine one approach that relates a firm’s inventory requirements
to a particular sales projection. The approach centers on the experience of Adas
of power transmission belts.
Belts, Inc., a small distributor
Atlas presently generates $200,000 per month in sales. However, over die
next twelve months, the firm expects that volume to increase steadily to $400,000
per month. Specifically, the firm expects the following sales for the next four
quarters:

Quarters
1 2 3 4

Projected Sales $750,000 $900,000 $1,050,000 $1,200,000

Monthly Average 250,000 300,000 350,000 400,000

Beginning with these projecdons, Adas developed its inventory require-

ments for each quarter based on its operational characteristics:

1. Product costs average 75% of sales.

2. Unacceptable stock-out costs are incurred whenever inventory drops below
the level necessary to satisfy two months’ sales volume.
3. Inventory necessary for projected sales must be on hand at die beginning of
each month.

Adas can projectits inventory requirementsfirstbymuldplying the anticipated

monthly volume by 75%, the average cost of sales. Multiplying that total by two
provides the inventory level necessary to satisfy the projected sales volume while
avoiding stock-out costs.
For example, the inventory necessary to begin the firm’s first quarter comes
from the calculation:

Projected Cost Two

Monthly of Months*
Sales Sales Requirements

$250,000 X 75% X 2 = $375,000

The calculation provides an estimate of the company’s total inventory

requirements. The firm must complement the estimate with item analysis,
perhaps coupled with specific product sales projections, to achieve the correct

69
Component Management

inventory mix. Atlas must also relate the estimated inventory requirements to its

cash capability.

Projected Inventory and the Cosh Flow Process

Estimating the inventory requirements necessary to achieve any projected

salesvolume is an essential step in cash flow management. However, if the
inventory requirements exceed the limits set by your cash capability, you must
reduce your ambitions or risk the embarrassment of a cash flow problem.
The eventual results of the projections developed by Atlas Belts indicated a
cash flow deficit. That result, summarized in Table 9-1, reflects additional facts
about the firm’s operations:

1. Atlas will begin the projected year with a $62,500 cash reserve, as indicated
in the first column in Table 9-1.

2. The firm’s credit and collection policies produce a constant thirty day
average collection period from its accounts receivable.
3. All of the firm’s suppliers require payment for all purchases within thirty
days. Wliile they offer no discounts for early payment, suppliers quickly
eliminate slow-paying customers from credit considerations.
4. Atlas earns 5% from all sales.

5. Atlas anticipates no increase in the $200,000 bank loan outstanding at tlie

beginning of the projected year.

Table 9-1
Projected Quarterly Balance Sheets
Atlas Belt, Inc.

1 2 3 4
Cash $ 62,500 $ 12,500 ($ 30,000) ($ 65,000)

Accounts Receivable 200,000 250,000 300,000 350,000

Inventory 375.000 450.000 525.000 600.000

Total Assets $637,500 $712,500 $795,000 $885,000

Accounts Payable $187,500 $225,000 $262,500 $300,000

Bank Loan 200.000 200.000 200.000 200.000

Total Liabilities $387,500 $425,000 $462,500 $500,000

Stockholders’ Equity 250.000 287.500 332.500 385.000

Liabilities & Equity $637,500 $712,500 $795,000 $885,000

70
 Component Management: Quantity Control

Now observe what happens to the firm’s cash position as it hypothetically

achieves the sales projected for the first three quarters during theupcoming year.
To meet supplier requirements Adas must maintain accounts payable on a
thirty day basis. But the increase in receivables and inventory naturally associated
with the higher sales volume absorbs the firm’s cash reserves. In fact, by the end
of the third quarter, the projections indicate an unavoidable and unacceptable
deficit cash position. The cash flow problem develops despite tlie firm’s profitable
operations and efficient accounts receivable management. That suggests the
benefit from:

Concept 19: Estimated inventory

requirements must recognize
the limits set by the cosh
capability in a business.

Atlas either must reduce its projected sales volume for the upcoming year or
obtain additional cash from another source to supplement its cash reserves.
Otherwise, the inventory requirementwould exceed the firm’s cash capability and
result in a serious cash flow problem.

Managing for Profits

Relating inventory requirements to cash capability is an important element

of positive cash flow management. However, if you have adequate cash capability,

you may find it profitable to change your management emphasis. Instead of

seeking the most efficient cash flow, you can direct your management efforts
toward producing the largest bottom-line benefits for your business.
Although seeking maximum profits is a natural business objective, even the
most profitable investment in inventory often exceeds the limits set by a firm’s
cash capability. The experience of Atlas Belts proved that.
We presume here that cash capability doesn’t stand as an obstacle to
profitability. In that happy event, the component management effort changes its
orientation and seeks the most profitable inventory investment level. To find that
level, you must achieve the proper balance between two contradictory categories

of costs.

Acquisition Costs

Everybusiness manager recognizes the direct cost ofacquiring inventory, the

purchase price of the merchandise. However, many overlook other acquisition
costs which increase the actual costs of any particular order.

71
 .

Component Management

A business can measure its acquisition costs (apart from the inventory
purchase price) as the total of the following:

1 The administrative costs that arise from scheduling, entering, and receiving
an order.
2- The labor costs associated with receiving, inspecting, and shelving each
order.
3. The cost of accounting and paying for an order.

Two facts concerning become relevant here.

these costs
First, and labor costs associated with any
the administrative, accounting,
order are more significant than many business managers realize. The cumulative
acquisition costs from numerous orders can exert a significant downward effect
on your earnings.
Second, those cumulative acquisition costs hold relatively constant regard-
less size of the order involved. Apart from the cost of die merchandise, it
of the
costs little more to order and receive 1,000 units for stock than it does 100 units.
Thus you can reasonably conclude that as you increase the size of each order,
you reduce the total number of orders you enter each year. And as you reduce the
number of purchase orders, you reduce your annual cumulative acquisition costs.
To illustrate how reducing these costs can benefit the bottom line in a
business, we will use the experience of the Southwest Light Company, a regional
bulb distributor. For the upcoming year. Southwest projects sales of 24,000
packages of its standard 100 watt bulbs. Beginning with that projection, the firm
analyzed its acquisition costs based on three assumptions:

1. Southwest’s supplier of 100 watt bulbs requires aminimum order of 4,000

however. Southwest can order any amount above that minimum.
units;
2. The company has the warehouse capacity to store the 24,000 units required
for the full year’s projected sales.
3. Southwest’s cumulative acquisition costs total $600 for each order entered.

In this instance, we also assume that Southwest’s unit purchase price remains
constant regardless of the size of the order entered with its supplier.
Table 9-2 illustrates the anticipated results of the firm’s analysis. As South-
—
west reduces the number of orders entered during the year by increasing the
size of each order —
it reduces its annual acquisition costs. In fact, by including the

total annual requirement for 24,000 units in one order. Southwest reduces its
acquisition costs for the year to only $600. That is $3,000 less than the costs the firm
would incur by purchasing the same stock in six minimum order lots.

72
 Component Management: Quantity Control

Table 9-2
Annual Acquisition-Cost Analysis
Southwest Light Company

Order Size (units) 4,000 6,000 8,000 12,000 24,000

Number of Orders 6 4 3 2 1

Annual Acquisition
Costs ($600 per order) $3,600 $2,400 $1,800 $ 1,200 $ 600

The cost relationships associated with acquisition costs receive recognition in:

Concept 20: Inventory acquisition costs rise

os a business increases the
number of orders entered per
year.

Using a single order to obtain your total annual requirement for every item
you stock reduces acquisition cost to a minimum. Of course, as acquisition costs
drop, your average investmentin inventoryincreases. So, another cost consideration
enters into inventory management analysis.

Carrying Costs

The cost a business incurs from carrying inventory remains direcdy related
to the size of its average investment. Naturally, the financial or opportunity costs
proportion to the size of that investment Other carrying costs also increase,
rise in
although the proportions are less precise.
As you increase your investment in inventory, you increase your warehouse
You need more space to store more inventory. As your investment grows, you
costs.
and maintenance costs, as well as an increase in the
also will see rising insurance
expenses that come from deterioration or obsolescence.
It is easy to surmise the cumulative increase in carrying costs easily can offset
the gain you realize from reducing your acquisition costs to a minimum by
reducing the number of orders entered during the year. A two-step analysis
supports this assertion. That analysis proceeds from the following assumptions:

1. A business sells its stock at a constant, predictable rate.

2. A business receives each new order on the same day that it sells the last item
from the previous order.

73
Component Management

3. However determined, all orders for each item are exactly tlie same size.
4. A business has no need to carry any safety stock.
Beginning witli these assumptions, we can calculate the average investment
for each item a business stocks, using the following order quantity:

Average Inventory = Size of Each Order

While the calculation may not provide a precise average, it is sufEiciendy

precise formost business circumstances.
Table 9-3 uses the calculation to estimate Southwest Light’s average invest-
ment in inventory that would result using the order sizes in Table 9-2. Predictably,
Southwest’s average investment in 100 watt bulbs increases as it reduces the
number of orders entered per year.
Table 9-3 also measures the annual carrying costs that the firm can anticipate
from the alternative ordering frequencies. The analysis first translates the in-
vestment into financial terms, using $1.50 per unit as a constant purchase cost.
Then it assumes that carrying costs average 15% of the average investment.
Presumably, the 15% cost includes Southwest’s financial or opportunity costs, as
well as the warehouse, maintenance, insurance, and any other costs that are
necessary to support an investment in inventory.

Table 9-3
Average Investment Analysis
Southwest Light Company

Order Size (units) 4,000 6,000 8,000 12,000 24,000

Average Units in Stock 2,000 3,000 4,000 6,000 12,000

Average Investment at
$1.50 per Unit $3,000 $4,500 $6,000 $9,000 $18,000

Carrying Cost at 15%

of Average Investment $ 450 $ 675 $ 900 $1,350 $ 2,700

Note what happens to Southwest Light’s annual inventory carrying costs as

itreduces the number of times it orders 100 watt bulbs in a year. As the number
of orders decreases, the average investment in inventory rises rapidly. So, too, do
the associated carrying costs. IfSouthwest enters only one order for the year, those
carrying costs rise to $2,V00.

74
 Component Management: Quantity Control

That logical relationship earns emphasis in:

Concept 21 : Annual inventory carryinq costs

rise as the average size or that
investment increases.

Thus, as you reduce acquisition costs by ordering less frequendy, you see a
rise in the cost of carrying your inventory.

Achieving the Most Profitable Balance

You achieve the maximum bottom-line benefits when your average invest-
ment in inventory minimizes the total of your acquisidon and carrying costs. You
can idendfy that investment level in one of two ways.
You can perform a tabular comparison of the costs that come from various
acquisition alternadves. Table 9^ illustrates that approach, again using the
Southwest Light Company data. The table totals the acquisidon and carrying costs
for each purchase quantity considered. The minimum total identifies the order
size —and uldmately the average investment— diatis most profitable (least cosdy)
for the firm.

Table 9-4
Total Inventory Cost Analysis
Southwest Light Company

Order Size (units) 4,000 6,000 8,000 12,000 24,000

Annual Procurement Costs $3,600 $2,400 $1,800 $1,200 $ 600

Annual Carrying Costs 450 675 900 1.350 2.700

Total Costs $4,050 $3,075 $2,700 $2,550 $3,300

Southwest incurs the least cost by ordering 12,000 units twice a year. That
represents the most economic ordering quandty for 100 watt light bulbs. We
crystallize the principle underlying this analysis in:

Concept 22: Profitable inventory

management purcnases major
inventory items in the most
economic quantities.

75
Component Management

As an alternative to the tabular analysis, you can use tlie Economic Ordering
Quantity (EOQ) formula.

The EOQ Calculation

A tabular analysis can become tedious and time consuming. Fortunately, you
can identify the most economic ordering quantity for an item with the aid of an
electronic calculator and the standard financial formula:

EOQ
where
S = Anticipated annual unit sales
O = Fixed costs per order
C = Annual inventory carrying cost, expressed as a percentage of
the product’s purchase price
P = The unit purchase price for the product

To illustrate the calculation process, we use the data from Southwest Light:

S = 24,000 units
O = $600
C = 15%
P = $1.50

The calculation becomes:

EOQ = ^/ 2 X 24,000 x $600 ^ J^ 128,000,000 = ll,313units

^ V (15%) ($1.50)

Southwest Light’s most profitable order quantity is 11,313 units, rather than
the 12,000 units indicated in the tabular comparison. (As a practical matter, the
difference would not produce a significant effect on the firm’s bottom line.)
So, you can isolate your anticipated sales volume, acquisition costs, and
if

carrying costs, you can use the EOQ formula to determine the most profitable
purchase quan tides for the major items that make up your in vestmen t in inventory.
Achieving the objective set forth in Cash Flow Concept No. 22 leads naturally
to the most profitable investment in inventory for your business.

76
 Component Management: Quantity Control

Quantity Discounts in EOQ Analysis

We assumed that Southwest Light’s purchase price for 100 watt bulbs held
constant regardless of the number of units included in any order. Presumably, the
firm paid $1.50 per unit for a 4,000-unit order or a 24,000-unit order.
This isn’t a realistic assumption. Many businesses allow discounts off the list

unit price for larger quantity purchases. Justification for quantity discounts
proceeds from the same logic that underlies the EOQ analysis. It costs litde more
to ship a larger order than a small order. Thus a business reduces its total shipping
costs by filling fewer, larger orders.
Selling in larger quantities also provides other savings for a business.
Typically the firm will carry a lower average investment in stock and enjoy a higher
inventory turnover rate. That translates directly into lower carrying cost.
The cumulative benefits from these reduced costs easily become significant
enough encourage larger orders. Should they
to justify quantity discounts to
become available, you must alter your EOQ analysis to weigh the effect those
discounts might have on your most profitable ordering quantity.
Table 9-5 demonstrates one approach to that analysis. Let’s now assume that
larger quantity purchases earn Southwest Light Co. quantity discounts.

Table 9-5
Effect of Quantity Discounts on EOQ Analysis
Southwest Light Company

Order Size 4,000 8,000 12,000 24,000

Cost (per luiit) $1.50 $1.40 $1.30 $1.20

Annual Cost (24,000 units) $36,000 $33,600 $31,200 $28,800

Annual Procurement Cost 3,600 1,800 1,200 600

Annual Carrying Cost 450 900 1.350 2.700

Total Annual Costs $40,050 $36,300 $33,750 $32,100

The supplier’s pricing structure begins with a $1.50 unit price for quantities
ordered in lots fewer than 8,000. At 8,000 units, the price drops to $1.40, at 12,000
to $1.30, and finally to a low of $1.20 for 24,000 units. Notice how the discounts
affect Southwest Light’s EOQ analysis. Despite higher carrying costs, the firm’s
most profitable ordering quantity rises from 12,000 to 24,000 units. The quantity

77
Component Management

discounts offset the higher carrying costs and contribute to Southwest Light’s
earnings. The potential benefits from quantity discounts are significant.
Remember this as:

Concept 23: EOQ analysis should include

consideration of any available
quantity discounts.

You should take advantage of every bit of profit potential that can come from
your component management effort. But although EOQ analysis can become a
valuable component management tool, you also should consider some inherent
limitations as you weigh the benefits that the analysis offers.
First, remind yourself of the natural limits set by the cash capability in your
business. You can’t enjoy the benefits of large quantity purchases if they lead to
cash flow crises. Certainly a limited cash capability restricts your purchase options,
whatever profit potential you lose.
Also, EOQanalysis ignores inflation as an element in inventory management.
Anticipatory purchasing to beat impending price increases has become an
important concern in practical inventory management. As prices rise more
rapidly, you may find profitable justification to buy as much as your cash capability
will allow, regardless of the decision criteria that come from your EOQanalysis.
Of course, neither qualification negates the value of EOQ analysis. In any
circumstance, the analysis should become a key element in your component
management effort.

The Re-order Point

Determining the economic ordering quantity for a product remains a futile

exercise unless a business also identifies the proper time to place each order with
its supplier. To identify the re-order point for a product:

Reorder Point = Order Lead ^ Average Daily ^ Safety Stock

Time (in days) Sales Rate

Figure 9-1 illustrates the interrelationship between the economic ordering

quantity and re-order point for a product. The illustration develops from several
assumptions:

1. A business averages five unit sales of the product daily.

2. The economic ordering quantity for the product is 100 units.

78
 —

Component Management: Quantity Control

3. The business carries a twenty-five unit safety stock.

4. The firm’s supplier normally makes delivery ten days after receiving each
order.

As indicated in Figure 9-1, as soon as the firm’s inventory level reaches

seventy-five units — ten days’ normal sales plus the twenty-five unit safety stock
the firm should reorder an amount equal to the product’s economic ordering
quantity, or 100 units. Presumably, the order will be received when the firm’s
inventory of the product drops to the twenty-five unit safety stock level. The safety
stock provides the inventory necessary to absorb an unforeseen jump in sales or
delay in delivery.

Figure 9-1
The Reorder Point

Units

•^10 Days 10 Days->-

79
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r Chapter 10

Component Management:
Accounting Methods

Inventory is a unique component in the cash flow cycle. In fact, it is the only
component that changes in value according to the accounting principle you
employ keep track of it. The principles you use to value your inventory affect
to
both the earnings and cash flow in your business. This chapter illustrates the major
alternative accounting principles and the influence each has on a firm’s earnings
and cash flow.

Earnings as Cash Flow

Until now, we have concentrated on factors that affect the day-to-day cash
flow cycle. We alter tliat approach here and note the relationship between
earnings and the cash flow process.
To we use the unusual circumstance of Autry
illustrate this relationship,
Sports, Inc., a wholesale sporting goods operation. Autry recently completed two
consecutive fiscal year ends with exacdy the same investment in accounts receivable
and inventory. The firm maintained the same total accounts payable to suppliers
while incurring no other debt. However, in the interim bounded by the two fiscal
year end statements, Autry Sports generated $100,000 in earnings. Table 10-1
demonstrates how those results affected the firm’s financial structure.
Since all other assets and liabilities remained constant, the earnings trans-
lated directly into a $100,000 increase in Autry’s cash balance. As each dollar in
earnings increased the firm’s net worth, it also expanded its cash reserves.
 /

Component Management

Table 10-1
Comparative Fiscal Year-End Balance Sheets
Autry Sports, Inc.

7/31/89 7/31/90
Cash $ 50,000 $150,000
Accounts Receivable 200,000 200,000
Inventory 300.000 300.000
Total Assets $550,000 $650,000
Accounts Payable $150,000 $150,000
Stockholders’ Equity 400.000 500.000
Liabilities and Equity $550,000 $650,000

Autry’s experience suggests a different definition of cash flow in a business.

It describes the cash a business generates from operations in the course of a year,
or the annual cash flow.
Here we isolate die contribution that comes from earnings. That contribution
can become an important management consideration. After all, earnings
easily
make up another source of cash that can be used to increase assets or decrease
liabilities. Or, from Autry’s example, you can use that contribution to increase
your cash reserves. We recognize that contribution in:

Concept 24: Earnings represent on addition

to the cash flow in a business.

Of course, the cash from earnings flows into a business incrementally

throughout the year. But viewing it on an annual basis provides a better perspective
for understanding the concept.
Note that throughout most of the book we ignore the income tax obligations
that naturally arise in a profitable operation. In most instances, tax considerations
have no effect on the major cash flow concepts that we discuss.
However, the following discussion makes an exception to illustrate the
effects the two major inventory accounting methods have on the cash flow that
proceeds from earnings.

FIFO Versus LIFO Inventory Accounting

A business can value its fiscal year-end inventory in accordance with one of
two major accounting principles.

82
 Component Management: Accounting Methods

FIFO accounting, or first in first out, proceeds on the logical assumption that
a business sells its inventory in the order it is acquired. Presumably, the first item
purchased from a supplier becomes the first product sold to a customer. All
subsequent purchases are then sold sequentially. At the end of the fiscal year,
FIFO accounting values the ending inventory, or unsold stock still on hand, using
the actual dollar cost of the items most recently acquired.
LIFO accounting, or last in first out, assumes that a business sells its inventory
in the reverse order in which it was acquired. Presumably, the business sells its
latest purchase from a supplier before any like item already in stock. Then, at
year’ s end, the business values its unsold inventory using the costs from the earliest
purchases.
We will use the case of Odd Ball Bearing Company to illustrate these
principles. Then, we will measure the effect each alternative has on Odd Ball’s
earnings and cash flow.
Odd Ball Bearing Company, a wholesale distributor of industrial bearings,
recendy completed its first year in business. Table 10-2 summarizes the firm’s
inventory activity during that year. The summary measures the movement of
inventory in terms of the number of units, or boxes of bearings, purchased and
sold, as well as the actual dollar costs associated with those units.
Odd Ball began operations with 1,500 units in stock, each having an average
price of $2.00. Consequently, the firm’s opening day inventory carried a value of
$3,000.
During the first six months in business. Odd Ball purchased 7,500 additional
However, persistent inflation in the bearing business increased
units for inventory.
the average cost per unit during that period to $3.00. The 3,750 units purchased
in the third quarter cost $3.50 each, while the average price rose to $4.50 per unit
for the last 3,750 units purchased during that year.
Measured in terms of actual dollar cost. Odd Ball’s purchases for inventory
in its first year of operation totaled $55,500. This is the total cost of tlie actual
inventory on hand at the end of the year, coupled with whatwas sold during the year.
Using the information in Table 10-2, Odd Ball’s accountant calculated the
fiscal year end value in accordance with each of the two major accounting
alternatives. Using FIFO accounting for the 5,250 units on hand at the end of the
fiscal year, the accountant calculated the following inventory value:

3,750 units x $4.50 = $16,875

1,500 units X $3.50 = $ 5.250
Ending Inventory Value
(5,250 units) = $22,125

83
Component Management

Table 10-2
Annual Inventory Activity
Odd Ball Bearing Company
Cost per Actual
Units Unit Cost
Beginning Inventory 1,500 $2.00 $ 3,000
Purchases:

1st Quarter 3,500 $3.00 $10,500

2nd Quarter 4,000 3.00 12,000
3rd Quarter 3.750 3.50 13,125

4th Quarter 3.750 4.50 16.875

Total Inventory
Available for Sale 16,500 $55,500
Ending Inventory 5,250

* Varies according to which accounting principle is used.

Presumably, all 3,750 units purchased during Odd Ball’s fourtli quarter
remain unsold at year’s end. Also, 1,500 units acquired during the third quarter
remain in stock. Using the prices for the actual purchases within each quarter
$22,150 FIFO value for Odd Ball’s fiscal year end inventory.
results in a
The accountant then valued the firm’s inventory using LIFO accounting.
This method leads to the following valuation for the 5,250 units Odd Ball had on
hand at the end of its fiscal year:

1,500 units X $2.00 $ 3,000

3,750 units x $3.00 $11.250
Ending Inventory Value
(5,250 units) $14,250

LIFO accounting assumes that the firm’s year end inventory includes the
original 1,500 units on hand when the year began, plus the first 3,750 units
acquired during the first six months of operation. The logic of LIFO asserts that
all sales came from the stock purchased after the first 5,250 units. That logic leads

to a $14,250 final value for Odd Ball’s year end inventory, $7,875 less than that
measured by FIFO accounting.
Now let’s see how the alternative inventory values affect Odd Ball’s cash flow.

84
 Component Management: Accounting Methods

Inventory Valuation and Cash Flow from Earnings

The FIFO and LIFO accounting principles exert different influences on a

firm’s earnings calculation. Actual sales remain the same and actual inventory
purchase costs do not change. However, different ending inventory values lead to
different earnings results. That affects a firm’s income tax obligation, which
influences its annual cash flow.
A two-step process illustrates the difference which results from the two
accounting principles. First, we examine the effect the different year-end inven-
tory values have on the cost-of-goods-sold total used to calculate earnings. Then
we look at the effect that calculation has on a firm’s income tax obligation.
Table 10-3 summarizes the firststepin that process with the comparative cost-
of-goods-sold calculations that come from FIFO and LIFO inventory valuations.
Both alternatives begin with Odd Ball’s opening day $3,000 inventory. To
total both calculations add the actual purchase price of the inventory acquired
during the year to obtain the total cost of the inventory available for sale. To
determine the cost of goods sold, each calculation subtracts the alternative
ending inventory values from the total inventory available for sale. We already
know that LIFO accounting produces a lower ending inventory value than does
FIFO accounting. Here that difference leads to a $7,875 higher cost-of-goods-
sold total.

Table 10-3
Comparative Effects of FIFO and UFO
Accounting on the Cost-of-Goods-Sold Calculation
Odd Ball Bearing Company
Beginning Inventory $ 3,000 $ 3,000
Purchases (actual cost) 52.500 52.500
Total Inventory Available for Sale $ 55,500 $ 55,500
Less: Ending Inventory 122.125^ (14.250)

Cost of Goods Sold $ 33,375 $ 41,250

Up accounting alternative has had any effect on Odd

to this point, neither
annual cash flow. Sales revenue remains constant in either circum-
Ball’s daily or
stance, and the actual purchase costs for the firm’s inventory remain the same.
The only comes from the different metliods of valuing the inventory
difference
Odd Ball had on hand at the end of tlie fiscal year.

85
Component Management

Table 10-4 illustrates where that difference becomes relevant. It compares

Odd Ball’s earnings calculations using the cost-of-goods-sold totals derived from
the alternative accounting principles.
FIFO accounting, with the lower cost-of-goods-sold total, leads to pretax
earnings $7,875 above those calculated using the LIFO accounting data. Up to this
point, neither alternative hashad an effect on Odd Ball’s cash flow. However, the
next step in the calculation applies a 40% tax rate to the firm’s pretax earnings.
Now the difference tells.

Table 10-4
Effect of FIFO and LIFO Accounting on Earnings
Odd Ball Bearing Company
Sales $ 60,000 $ 60,000
Cost of Goods Sold (33,375) (41,250)
Operating Expenses ao.ooo) (10.000)

Pre-tax Earnings $ 16,625 $ 8,750

Taxes at 40% (6.650) (3.500)

After-tax Earnings $ 9,975 $ 5,250

FIFO accounting Odd Ball with a $6,650 tax obligation, compared to

leaves
the $3,500 liability that comes from LIFO accounting. Viewed from anotlier
perspective, FIFO accounting increases the firm’s cash income tax obligation
(local, state, and federal) $3,150 above that calculated with the LIFO method.
This difference becomes more explicit by comparing the annual cash flows that
come from the two accounting alternatives.

Comparative Cash Flovy^s

To emphasize the different results that come from FIFO and LIFO account-
ing, we will review the actual annual cash flow that Odd Ball Bearing will
experience in either circumstance. This review relies on the following simplified
assumptions:

1 . Odd Ball offers no credit terms; all sales are made in exchange for cash at the
time of purchase.
2. The firm pays cash for all purchases and operating expenses; Odd Ball defers
no obligation in the form of accounts payable or accrued liabilities.

86
 Component Management: Accounting Methods

3. The company has cash reserves sufficient to handle all business on a cash
basis.

Table 10-5 compares the annual cash required to fund Odd Ball’s operation,
using both accounting alternadves. We ignore cash flow into the business from
sales in this illustration, presuming that it is an element of the cash flow “sufficient”
for operations. Confirming our earlier analysis, LIFO accounting reduces the
cash expenditures required for Odd Ball’s first year in business by $3,150.
To keep both principles in perspective, remember:

Concept 25: LIFO inventory accounting

usually leads to a better annual
cash flow than FIFO accounting.

The difference in cash flow in Odd Ball’s circumstance may not be particu-
larly exciting,but Odd Ball is a very small business. Increase its volume from
$60,000 to $600,000 for the year and the cash benefit from LIFO accounting rises
proportionately to $37,200.

Table 10-5
Effects of FIFO and LIFO Accounting on Cash Flow
Odd Ball Bearing Company

HFO LIFO
Beginning Inventory $ 3,000 $ 3,000
Purchases 52,500 52,500
Operating Expenses 10,000 10,000

Taxes 6,650 3.500

Total Cash Requirements $72,150 $69,000

Now, let’s see how that cash flow affects Odd Ball’s financial structure.

Inventory Valuation and Financial Structure

Let’s look at the different effects LIFO and FIFO accounting have on the
financial structure of a business — the balance sheet. To amplify the effects LIFO
and FIFO have on the balance sheet, we add Odd Ball’s opening day balance sheet,
as illustrated in Table 10-6, Column 1.

87
Component Management

On opening day, the company had only $3,000 in inventory and $25,000 in
cash. Thisis a simple but healthy financial structure for almost any new business.

But now examine the comparative financial structures that exist at the end of Odd
Ball’s first year using the two accounting principles.

Table 10-6
Effect of FIFO and LIFO Accounting on Balance Sheets

Beginning
Balance End of Year End of Year
Sheet HFO UFO
Cash $25,000 $15,850 $19,000
Inventory 3,000 22.125 14.250

Total Assets $28,000 $37,975 $33,250

Stockholders’ Equity $28,000 $37,975 $33,250

As one might suspect, LIFO accounting leaves the firm with $3,150 more cash
on hand than FIFO accounting. This benefit accrues despite the lower earnings
that apparendy result from the LIFO calculation. Of course, the year-end balance
sheet also reflects the lower inventory valuation that comes from LIFO account-
ing. That difference translates ultimately into a lower total for the stockholders’
equity account than with FIFO accounting.
The positive effect that LIFO accounting exerts on Odd Ball’s cash flow is,

psychologically at least, partially offset by an understatement in the firm’s

inventory value and a lower net worth. The lower net worth can become an
argument against LIFO accounting. At the same time, recognize the difference
reflects the accounting principles, not the actual value. Concentrate on the
additional cash a business can gain with the aid of LIFO accounting.

The Logic and Limits of LIFO Accounting

Because a business sells most of its inventory sequentially as purchased, it is

impossible to justify LIFO accounting in physical terms. Nevertheless, LIFO

accounting, which assumes a business sells its inventory in reverse of the order
acquired, is more logical than one might suspect. And it is easy to justify in the
modern economic environment.
That logic argues that a business should relate its current sales to its current
costs. Inan inflationary environment, where prices rise persistently, using the
most recent costs for the cost-of-goods-sold calculation makes more sense than the

88
 Component Management: Accounting Methods

use of older, lower costs that are no longer realistic. While LIFO accounting lowers
a firm’s apparent earnings, it also provides a valuable cash contribution to help
offset the higher cost of replacement inventory. In fact, LIFO accounting represents
a valuable weapon against inflation.
Along with this logic, you also should recognize the limits on LIFO account-
ing. First, the principle exerts a positive influence on cash flow only in an
inflationary environment. In the event that your industry experiences a year of
declining prices, LIFO accounting will lead to higher earnings and a smaller
annual cash flow than FIFO accounting.
The modem economic environment leaves litde hope of declining prices.
Price trends will proceed steadily upward. Should we move into a deflationary era,
LIFO accounting would have a detrimental impact on your cash flow.
LIFO accounting also understates the true financial strength of a business
because it lowers the inventory valuation, earnings, and net worth. To the extent
that the lower values lead to a critical view of creditworthiness, LIFO accounting
becomes detrimental to a business. In any event, those limitations don’t negate
the cash benefits you can derive from LIFO accounting.

89
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Part
III

Structural
Management

1 1 . Financial Structure and the

Cash Flow Process
12. Structural Management:
A Matter of Balance
13. Structural Management:
Financial Forecasting

14. Structural Management:

Fixed Assets and Depreciation

15. Structural Management:

Two Break-Even Points
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 1

r Chapter 1

Financial Structure and the

Cash Flow Process

Even the most proficient component management effort does not preclude
cash flow problems. A satisfactory cash flow requires financially sound interrela-
tionships among all of the elements that appear on your balance sheet. At the
same time, the cash flow cycle ultimately becomes the controlling factor in that
interrelationship.
This chapter examines the minimum cash investment required for a busi-
ness, exclusiveof any potential assistance from creditors. Few enterprises prosper
without financial assistance, but the restriction illustrates a fundamental tenet of
structural management.
Then, we build on that conceptual foundation to illustrate the position
creditors hold in your financial structure. Creditors provide a valuable addition
to your cash capability. In fact, that contribution may provide the boost you need
to achieve a profitable sales volume.

Requirements of the Cash Flow Cycle

The natural cash flow cycle converts cash into inventory, then inventory into
accounts receivable, which convert back into cash. Efficient management of your
and inventory improves cash flow and conU ibutes to higher earnings.
receivables
However, whether your sales volume is large or small, your financial structure
must provide the necessary cash capability.
Structural Management

We use the Bayline Bolt Corporation to illustrate this concept. Bayline, a bolt
wholesaler, was founded recently by Glen Mayes, a salesman with many years of
experience in the industry.
Before beginning operations, Mayes projected his initial cash requirements
based on the following assumptions:

1 . Bayline would generate $1 ,000 per day, or $30,000 per month, in sales from
inception.
2 . The forty-five day collection period standard in the industry will translate
that volume into a $45,000 average investment in accounts receivable.
3. Achieving that sales objective will require a $48,000 average investment in
inventory; a smaller investment will lead to excessive stock-out problems.
4. Bayline’s cost of goods sold will be 80% of its sales, resulting in a 20% gross
profit margin, exclusive of operating expenses.
5. Bayline’s montlily operating costs, exclusive of inventory purchases, will
average $6,000.
6. Presumably, the initial sales volume will provide break-even operating
results; the firm will neither make nor lose money.

Mayes’s projections also recognized a common constraint that is confronted

by many new business ventures. He could not count on trade credit consideration;
all suppliers would require cash payment for all purchases upon delivery.

Beginning with these assumptions, Mayes found that the cash flow cycle set
by the anticipated operating characteristics determined the cash investment
required to initiate operations. The investment had to be sufficient to support tlie
anticipated investment in accounts receivable and inventory, plus provide the
$7,000 Mayes believed was the minimum necessary for operating cash. The
cumulative cash investment had to fund all of the components in the cash flow
cycle.
Table 11-1 demonstrates that requirement with a look at three of Bayline’s
balance sheets.
Prior to initiating operations, Mayes invested $100,000 in cash in the
business.The firm has at this point no other assets or liabilities. Since Bayline lacks
any external credit consideration, the $100,000 also represents the firm’s total
cash capability.
By opening day. Bayline had purchased (for cash) the $48,000 in inventory
necessary to achieve the $1,000 daily sales volume. After opening day, the firm
purchased inventory on a daily basis (again for cash) to replace what was sold.
Remember, Bayline had to maintain that minimum investment to achieve the
projected sales volume.

94
 Financial Structure and the Cash Flow Process

Table 11-1
Relationship Between Financial Structure
and the Cash Flow Cycle
Bayline Bolt Corporation

Comparative Balance Sheets

Prior to 45
Opening Opening Days After
Cash $100,000 $ 52,000 $ 7,000

Accounts Receivable — — 45,000

Inventory 48.000 48.000

Total Assets $100,000 $100,000 $100,000

Liabilities

Stockholders’ Equity $100,000 $100,000 $100,000

Forty-five days after beginning operations, while maintaining tlie $48,000

investment in inventory. Bayline has a $45,000 investment in accounts receivable.
Of course, the remainder of Mayes’s original investment rests in his operating
account.
Column 3 reflects tlie financial structure that evolves naturally from Bayline’s
cash expenditures during the first forty-five days in business. To summarize those

expenditures:

Beginning Cash $100,000

Initial Inventory Purchase (48,000)

Replacement Inventory Purchases

(80% of selling price) (36,000)

Operating Expenses '

(45 days at $6,000 per month) (9.000)

Cash Reserve $ 7,000

Note two important implications suggested by Bayline’s cash flow and

on sales (accrued in the form of 20% of
financial structure. First, the gross profit
the firm’s investment in receivables) exactly offsets the $9,000 in operating
expenses. As anticipated, the $1,000 daily sales volume does result in a break-even
operation. Second, with die $1,000 daily sales volume and the other operating

95
Structural Management

characteristics. Bayline’s investment in accounts receivableand inventory cannot

be than $93,000.
less
A lower inventory level would preclude the daily sales volume necessary to
prevent a loss. So, too, would any attempt to reduce the firm’s average collection
period below the industry average. Enforcing a shorter period would steer
customers toward Bayline’s more lenient competitors. The cash flow cycle set by
the firm’s operating characteristics dictates the initial investment and the result-
ing financial structure necessary to conduct a break-even sales volume. Any
investment less than $100,000 would lead to unavoidable losses. We emphasize
this in:

Concept 26: A balanced financial structure

provides the cash capability
necessary to support the natural
cash flow cycle.

Figure 1 1-1 provides a conceptual view that should help clarify the relation-
ship. Note two additional facts about Bayline’s circumstance forty-five days after
opening.

Figure 11-1
Financial Structure and Cash Flow Cycle

First, so to generate $1,000 a day in sales, the

long as Bayline continues
financial structure will remain unchanged. Each day’s new sales will be exactly
offset by an equal collection of accounts receivable from previous sales. Similarly,
operating expenses will continue to equal Bayline’s gross profit margin from
those sales.

96
 Financial Structure and the Cash Flow Process

Second, without additional cash capability, Bayline cannot increase sales to

a profitable Any increase in sales would require a pro-rata increase in

level.

accounts receivable and inventory that would quickly exhaust tlie firm’s minimal
cash reserves. That would lead to a cash flow problem.
For example, assume Mayes decided to increase Bayline’s daily sales volume
to $1,250 a day, or $37,500 a month, withq,ut increasing the cash investment.
1 1-2 shows the effects of the higher sales volume on Bayline’s financial
Table
structure. Based on the original operating assumptions, that volume would
—
require a $60,000 investment in inventory an amount sufficient for sixty days’
sales—and a $56,250 investment in accounts receivable.

Table 11-2
Effect of Higher Volume on Financial Structure
Bayline Bolt Corporation

Cash ($16,250)

Accounts Receivable 56,250

Inventory 60.000

Total Assets $100,000

Stockholders’ Equity $100,000

Naturally, Bayline would never reach the $16,250 deficit cash position. The
firm’s suppliers, still requiring cash payment on delivery, would cease shipments
assoon as the firm exhausted its cash capability. The higher volume would
produce an unacceptable, unbalanced financial structure.

The Creditor's Contribution to Cash Capability

Glen Mayes quickly recognized that he could not increase his sales volume
above the break-even level without expanding his cash capability. Lacking the
resources to increase his cash investment in Bayline, Mayes pursued a logical
alternative. He negotiated more reasonable payment terms from his suppliers.
Bayline’s suppliers agreed to allow thirty day payment terms for all pur-
chases. This was a reasonable response to a customer who paid cash for $24,000
in purchases each month for several months in a row. Taking advantage of the
cash capability supplied by more liberal payment terms, Mayes quickly pushed
Bayline’s sales up to $1,250 per day. This volume produced two significant
changes in the firm’s financial circumstances.

97
Structural Management

First, the higher volume made Bayline a profitable operation. Since Mayes

held fixed costs constant, the firm began generating the following monthly
earnings:

Sales $ 37,500
Costs of Sales (30,000)

Fixed Costs ( 6 000 )

.

Monthly Earnings $ 1,500

Second, Bayline generated the higher volume without straining its cash
capability. Table 11-3 reflects the creditor’s contribution to Bayline’s financial
structure. (To simplify the illustration, we ignore the profits that come from
Bayline’s higher volume.) The $24,000 in supplier credit enables Bayline to carry
the higher investment in inventory and accounts receivable tliat came with the
sales increase. Figure 11-2 provides a conceptual view of the contribution the
$24,000 in credit consideration made to Bayline’s cash flow and financial struc-
ture.

Table 11-3
Creditor’s Contribution to the Cash Flow Cycle
Bayline Bolt Corporation

Cash $ 7,750

Accounts Receivable 56,250

Inventory 60.000
Total Assets $124,000
Accounts Payable $ 24,000
Stockholders’ Equity 100.000

Liabilities and Equity $124,000

Bayline’s experience demonstrates that credit consideration enables a busi-

ness to increase the total asset investment revolving in its cash flow cycle. The
benefit from that effort is summarized in Cash Flow Concept No. 27:

Concept 27: Credit consideration increases

the cash capability in a
business.

98
 Financial Structure and the Cash Flow Process

Figure 11-2
Creditors* Contribution to the Cash Flow Cycle

Note that a business gains the benefit regardless of the source of the credit
consideration. For example, had Mayes obtained a $24,000 bank loan while
continuing to pay cash for all purchases, tlie financial results would have been the
same. Of course, borrowing costs would have lowered earnings slighdy.

99
 1 ,

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 Chapter 12

Structural Management: A Matter of Balance

A fundamental accounting principle should underlie the management of

your firm’s financial structure. Your assets must equal your liabilities plus stock-
holders’ equity. This chapter demonstrates how you can use this principle to
anticipate the effects of any financial decision on the cash flow process in your
business.

The Balance Sheet Equation

Managing your financial structure and cash flow centers on a basic account-
ing equation:

Total _ Total ^ Stockholders’

Assets Liabilities Equity

Many business managers overlook this fundamental requirement in their

cash flow management. Often they commit themselves to expanding assets
without estimating the effects this expansionwill have on their firms’ financial
structure and the cash flow process. Yet, as suggested by the equation, a $50,000
increase in liabilities or stockholders’ equity (orsome combination of the two)
must accompany a $50,000 increase in total assets. Moreover, both increases in the
balance sheet accounts must observe the demands set by the cash flow cycle.
Structural Management

Cash Capability and Financial Structure

Cash capability describes the total resources a firm has available to finance
an increase in the assets revolving in the cash flow cycle. The total cash capability
in a business is measured as the sum of its cash reserves plus any unused credit
consideration.
However, employing cash capability as a management concept can be
complicated. When you commit some portion of that capability, you must
recognize how that decision affects your financial structure and cash flow cycle.
You must also anticipate both the immediate and future effects of diose decisions.
Failure to estimate carefully the results of any major decision can lead to a cash
flow crisis.

Table 12-1 illustrates this potential problem with a view of the comparative
balance sheets of a small wholesaler, Priority Products, Inc.
Column 1 represents PPPs financial sti'ucture, with a $100,000 monthly sales
volume. That financial statement reflects the characteristics of the firm’s opera-
tions:

1. All customers observe PPI’s thirty day selling terms; the firm collects $100,000
in cash each month from the previous month’s sales.
2. PPI purchases $75,000 per month from its suppliers on thirty day terms; a
strict management policy requires payment in strict accordance with those
terms.
3. Fixed cash expenses average $25,000 per month.

These characteristics leave PPI with a break-even operation. Income equals

expenses, and cash collected each month equals cash expended.

Table 12-1
Structural Management and Cash Capability
Priority Products, Inc.

1 2 3

Cash $ 25,000 $ 25,000

Accounts Receivable 100,000 100,000 $125,000
Inventory 100.000 125.000 125.000
Total Assets $225,000 $250,000 $250,000
Liabilities $ 75,000 $100,000 $100,000
Stockholders’ Equity 150.000 150.000 150.000
Liabilities and Equity $225,000 $250,000 $250,000

102
 Structural Management: A Matter of Balance

Now, consider the results of PPI’s decision to increase sales above the break-
even level.

We will assume that the firm already has $50,000 in additional cash capability
to finance an increase in sales. In addition to the $25,000 in cash reserves, PPI has
$25,000 in unused credit consideration. Recognizing this, PPI’s management
decides to increase the firm’s investment in inventory from $100,000 to $125,000.
Projections suggest that the higher investment will help increase sales to $125,000
per month and lead to profitable operations.
The increase in inventory must use $25,000 of PPI’s cash capability. Either
an increase must supply die funds for
in liabilities or a decrease in cash reserves
the new inventory. Of course, some combination of cash reserves and liabilities
that total $25,000 also would provide the cash capability necessaiy for the
inventory. However, assume that management can exercise only one alternative.
Column 2 recognizes management’s logical option to use the creditors’
consideration to finance the expansion in inventory. Thus, PPI’s inventory, total
assets,and liabilides all rise by $25,000. The financial structure remains balanced.
However, the changes indicated in the financial structure represent only the
inidal effects of the decision to increase inventory. Positive cash flow management
also requires considering the future alteradons in that structure if the sales
projections prove to be accurate.
Column 3 visualizes that future when PPI achieves the higher sales volume
of $125,000 per month, while it also maintains die increased investment in
inventory. We see that the successful sales ejffort leads PPI directly into a cash flow
problem. As sales increased, so did the firm’s investment in accounts receivable.
As that rise absorbed the rest of the firm’s cash capability, cash reserves dropped
to zero. PPI is out of cash.
PPI’s experience illustrates a critical concept. Any decision to increase your
investment in any asset other than cash absorbs some of your cash capability. It
effects a change in your financial structure represented by an increase in liabilities
or a decrease in cash. In any instance, you must have sufficient capability to absorb
die increase or decrease. The critical relationship can be stated succincdy in:

Concept 28: A balance sheet must balance.

The cash flow cycle imposes demands that must be met by die cash capability
held in your financial structure. So, you must look beyond the present and
anticipate the future consequences of your decision.
When any doubts exist about the potential effects of any decision on your
financial structure, turn to Cash Flow Concept No. 28. Then measure the effects

103
Structural Management

your decision has on your financial structure and cash flow cycle. That foresight
may preclude a cash flow problem.

Losses: A Drain on Cash Capability

In the case of Priority Products, we assumed the equity account was constant
in order to orient our primai-y concern —
day-to-day cash flow management. Now,
adopting a slighdy different perspective, let’s examine the effects profits and
losses have on the financial structure and cash capability in a business.
Return to PriorityProduct’s initial balance sheet (now in Table 12-2). We will
now presume PPI holds its investment in accounts receivable and inventory
constant from one year to the next. Assume PPI suffers a $25,000 loss for the year
following the date of the initial balance sheet. That loss translates into an equal
reduction in PPI’s equity account. The equity drops from $150,000 to $125,000.

Table 12-2
Effect of a Loss on Financial Structure
Priority Products, Inc.

1 2 3

Cash $ 25,000 $ 25,000 —

Accounts Receivable 100,000 100,000 $100,000
Inventory 100.000 100.000 100.000

Total Assets $225,000 $225,000 $200,000

Liabilities $ 75,000 $100,000 $ 75,000
Stockholders’ Equity 150.000 125.000 125.000

Liabilities and Equity $225,000 $225,000 $200,000

Of course, no account in a firm’s financial structure can change indepen-

den dy. The balance sheet always balances. Since we are holding PPI’s investment
in accounts receivable and inventory constant, we can anticipate the potential
effects of the loss on the other elements in the firm’s financial structure.
As one extreme, PPI’s total liabilities might increase by $25,000, as shown in
Table 12-2, Column 2. Any increase in liabilities absorbs an equivalent amount of cash
capability. At the other extreme, PPI might hold its liabilities constant at the expense
of its cash reserves. But that policy, reflected in Column 3, leaves the business in a
desperate cash position. Indeed, those reserves dwindle down to nothing.

104
 Structural Management: A Matter of Balance

PPI’s management logically would seek some reasonable balance between

the two extremes. Also, the loss could be offset by addidonal cash investments by
stockholders, or perhaps by negotiating larger lines of credit However, none of
these options changes the point of the illustration. You should foresee the
inevitable penalty that a loss exacts on a firm’s cash capability. We summarize that
effect in:

Concept 29: An operating loss drains an

equivalent amount of cash
capability from a business.

Now, let’s examine the positive side of the picture.

Profits: A Contribution to Cash Capability

An operating profit has an opposite effect from a loss. Table 12-3 helps
illustrate that logical fact
Again we proceed from PPI’s initial balance sheet and assume tliat accounts
receivable and inventory remain constant. We also assume that PPI generates
$25,000 in earnings during the one year period following the initial balance sheet.

Table 12-3
Effect of a Profit on Financial Structure
Priority Products, Inc.

1 2 3

Cash $ 25,000 $ 25,000 $ 50,000

Accounts Receivable 100,000 100,000 100,000
Inventory 100.000 100.000 100.000
Total Assets $225,000 $225,000 $250,000
Liabilities $ 75,000 $ 50,000 $ 75,000
Stockholders’ Equity 150.000 175.000 175.000
Liabilities and Equity $225,000 $225,000 $250,000

Note the have on the firm’s financial structure. Of

effects those profits
course, PPl’sequityaccount increases by an amount equal to the earnings. Profits
translate directly into an increase in the networtli of a business. But as tliat occurs,
other changes also must occur in the firm’s financial structure.

105
Structural Management

Considering the extremes, the $25,000 increase in equity must be matched

by either a matching reduction in total liabilities or by an equivalent increase in
cash. Table 12-3, Columns 2 and 3, illustrates these results.
The positive cash flow manager might select some balance between tlie two
extremes. However, the earnings contribute $25,000 to PPI’s cash capability as
they reduce liabilities or increase cash reserves. That becomes:

Concept 30: Earnings provide an equivalent

increase in cash capability in
a business.

Our illustration centered on the cumulative ejffects of a full year’s operations

profits and losses. Of course, profits and losses typically occur incrementally
throughout the year. In PPI’s experience, for example, we can assume that the
$25,000 in earnings increased the firm’s equity and cash capability at an average
rate of about $2,100 per month. From tliis you should be able to anticipate die
potential benefits held in earnings. You can do that because most businesses
accrue profits in the form of uncollected accounts receivable. The actual cash
flows into the business only when customers pay.
Similarly, you can anticipate the detrimental effects of a loss. An operating
loss usually appears first in the form of accrued expenses or accounts payable. A
loss this month doesn’t drain cash from the business until next mondi. Of course,
the only way you can anticipate either result is to prepare an income statementand
balance sheet prompdy at the end of each month. That information will help you
offset the effects of a loss or take advantage of the cash capability that will flow in
from a profit.

106
r
Chapter 13

Structural Management:
Financial Forecasting

In Chapter 1 the Drake Paper Company’s experience demonstrated the

crucial difference between accrual and cash flow accounting. Drake’s rapid
increase in sales produced higher earnings but left the firm with a cash flow
problem. The earnings rested in the form of uncollected accounts receivable,
while payments to suppliers and operating expenses exhausted Drake’s cash
reserves.
Based on the discussion in Chapters 11 and 12, you now can view Drake’s
problem as a structural one. Since a balance sheet must balance, an increase in
liabilities or stockholders’ equity must match any expansion in assets associated

with a rising sales volume.

Moreover, Drake’s experience is a common occurrence among growing
businesses. Success often leads to cash flow problems. Even a business that
expands at a relatively modest rate can outpace its cash capability.
This makes financial forecasting an essential task for tne business manager
practicing positive cash flow management. Neither the amount nor the source of
the funds necessary to support any increase in assets should come as a surprise.
This chapter illustrates the inevitable financing needs that arise in a growing
business, along with the process that helps you to forecast those needs.
Structural Management

The Growth Syndrome

Most business managers seek growth as a natural business objective. They

press constantly to increase sales this month over last month and this year over last
year. This pressure comes from two primary sources.
First, is an instinctive drive. Failure to satisfy that drive,
the desire for growth
however measured, ultimately leads to frustration. In the business environment,
that drive translates into a constant push for higher sales. In addition, the
expansion rate in a business becomes a measure of relative achievement. Pre-
sumably, a 20% growth rate represents a larger achievement than a 10% growth
rate. Thus growth rate stands as a gauge for comparison among business managers.
Second, the desire for growth is a natural financial requirement. The
business that doesn’t grow stagnates financially, even though it may operate
profitably. Any year inflation outpaces earnings increases, a business inevitably
falls behind. The higher earnings that accompany increasing sales become a
financial requirement. These effects act as natural spurs that encourage business
expansion.

The Structural Limits on Growth

Chapters 11 and 12 emphasized that a firm’s cash flow cycle dictates the
financial structure and cash capability necessary to avoid a cash flow problem. We
examine the same concept here from a different perspective, one that helps
define how rapidly a business can grow without using borrowed funds.
To illustrate, we will use the Energy Window Company, a manufacturer of
thermal glass windows. Since the firm’s product improves insulation, demand is
now sufficient to allow Energy Window to double its present $200,000 monthly
sales volume.
However, before yielding to that demand by increasing production. Herb
Elliot, Energy Window’s controller, measured the effect rapid growth would have
on the firm’s financial structure. He foundthat the realistic limit on that
prospective growth rate fell well below
100%.
Elliot’s analysis began with a review of Energy Window’s relevant charac-
teristics;

1. A sixty day average collection period translates the present volume into a
$400,000 investment in accounts receivable; that collection period is consis-
tent with the industry average.

108
 .

Structural Management: Financial Forecasting

2. Material costs average 75% of sales, or $150,000 per month; experience

indicates that the firm must maintain an inventory sufficient for two months’
sales on hand in order to achieve any projected volume.
3. Suppliers typically allow thirty days for payment. Company policy requires
observance of those terms; consequently, accounts payable cannot
strict

exceed one month’s purchases or 50% of the inventory in stock.

4. The firm maintains a minimum $50,000 cash balance (to satisfy bank
requirements)
5. Any increase in sales requires a proportionate increase in cash, accounts
receivable, and inventory.

These characteristics translate into the financial structure in Table 13-1.

However, note a prominent element that has not been mentioned. Energy
Window presently has a $350,000 bank loan. In fact, the loan provides the cash
capability essential for the business to generate its present $200,000 monthly
volume while paying suppliers for all purchases within the prescribed thirty day
terms. The presence of the bank loan also explains the need for the $50,000
minimum cash balance. Those funds meet tlie bank’s compensating balance
requirements for the loan.

Table 13-1
Energy Window Company

Cash $ 50,000
Accounts Receivable 400,000

Inventory 300.000

Total Assets $750,000

Accounts Payable $150,000
Bank Loan 350.000

Total Liabilities $500,000

Stockholders’ Equity 250.000

Liabilities and Equity $750,000

The need for the bank loan also suggests the critical constraint diat imposes
the natural limit on Energy Window’s growth rate. While observing tlie firm’s
operating requirements, the growth rate cannot outpace the financing available
to support the increase in assets that naturally accompanies higher sales.

109
Structural Management

The problem even more complex than it first appears, since the need for
is

financing typically expands more rapidly than the sales volume in a growing
business. Lenders may set the brake on growth sooner than you might imagine.
To prove these assertions, let’s review Elliot’s original analysis, which now
proceeds in two logical steps.
First, Elliot identified the financing required to support die increase in

Energy Window’s assets anticipated fiom various growdi rates. Second, he

identified the upper limit on the available financing. Table 13-2 summarizes the
first phase in that analysis. It projects the anticipated increase in assets and

corresponding demands for financing tiiat will come from growth rates ranging
from 10% to 50%.
To simplify the illustration, we temporarily ignore the contribution earnings
make toward balancing the firm’s rising assets. As we will see, that contribution is
real, but it does not affect the principal point. That is, the growth rate in a business
is limited by tiie external financing available to support the accompanying

increase in assets.
Now, look at the critical points in Table 13-2. Note that a modest 10%
increase in sales leads to a $75,000 increase in assets. While an increase in supplier
debt —accounts payable—provides $15,000 Energy Window needs an
in support.
additional $60,000 in financing to carry the higher asset investment. (We assume
here that accounts payable automatically expand at the same rate as sales.)
As the projected growth rate increases, the need for additional financing
rises rapidly. Indeed, a 50% expansion rate calls for a $300,000 increase in bank
(or other) financing. Also note that the 50% increase in sales requires an 85%
increase in new external financing. Proportionate debt requirements outpace the
expansion in assets.
Armed with these projections, Elliot then proceeded to the second step in his
analysis. He identified the bank’s lending limits applicable to Energy Window’s
circumstance. Unfortunately, by normal bank credit standards, the firm’s financial
structure does not justify the additional $300,000 in credit consideration neces-
sary to support a 50% growth rate. The financing required to fund a 30% or 40%
expansion rate also is out of the question. Without that financial assistance.
Energy Window must hold its growth rate below those levels.
Actually, we can’t specify the exact amount of financial aid available from
Energy Window’s bank. The final determination requires more precise credit
analysis. Nevertheless, Elliot’s analysis demonstrates the critical point emphasized
in:

Concept 31 : A firm's financial structure limits

its growth rate.

no
 Structural Management: Financial Forecasting

Table 13-2
Growth Financing Requirements
Energy Window Company

Growth Rate 10% 20% 30% 40% 50%

Total Asset Increase $75,000 $150,000 $225,000 $300,000 $375,000

Less: Accounts
Payable Increase (15,000) (30,000) (45,000) (60,000) (75,000)

Additional
Financing Required $60,000 $120,000 $180,000 $240,000 $300,000

Increase in
Necessary Financing in
Proportion to Bank Loan 17% 34% 51% 68% 85%

A growth rate that exceeds the limits set bya firm’s financial structure creates
cash flow problems.

The Financial Forecasting Process

The process that anticipates a firm’s financing requirements proceeds

through five straightforward steps:

1 . Express any projected sales increase as a percentage of the current operating

period’s —the current year, quarter, or month.
2. Multiply the firm’s existing investment in current assets by the percentage
sales increase anticipated during the upcoming operating period. This
expansion the business should expect.
identifies the total asset
3. Multiply the firm’s accounts payable and accrued liabilities by the antici-
pated percentage increase in sales. This identifies tlie financial support for
the asset expansion that will come from the spontaneous increase in
liabilities.

4. Identify the increase in retained earnings the business expects during the
upcoming operating period. This will equal the firm’s anticipated net
earnings, less any dividend payments to stockholders.
5. Subtracting the totals found in steps 3 and 4 from that found in step 2
identifies the firm’s net new financing requirements.

Another look at the Energy Window Company illustrates the financial

forecasting process.

Ill
 —
Structural Management

In this instance, we assume tliat management has arbitrarily decided to push

Energy Window’s monthly average sales volume up to $320,000. This represents
a 60% increase over the $200,000 monthly average produced during the firm’s
fiscal year ending 8/31/91.

In addition, we will move Energy Window a step closer to the real world and
assume that the firm will produce $300,000 in earnings from its $3,840,000 total
sales volume ($320,000 x 12) for the year ending 8/31/92. Half of tliose earnings
will flow from the business in the form of dividend payments to stockliolders. So
Energy Window will retain $150,000 out of its total earnings to help support its
expected expansion in assets. Now we can proceed with the financial forecasting
process.
First, multiplying the firm’s $750,000 in assets on 8/31/91 by 60% indicates

that Energy Window should anticipate a $450,000 increase in its total asset
investment during 1992. The business will need an increase in liabilities and
stockholders’ equity (in any combination) that matches tlie asset expansion.
Energy Window can expect a 60%, or $90,000, increase in its accounts
payable. Presumably, tlie firm’s trade credit lines will expand at the same rate as
its sales. Certainly that will hold true so long as Energy Window maintains the

ability to pay its suppliers promptly. A business that accrues some liabilities
salaries, wages, taxes — would include them in the calculation process, along with
itsaccounts payable.
The spontaneous increase in accounts payable will provide $90,000 in
support for Energy Window’s anticipated increase in assets. As noted, another
$150,000 in support will come from earnings retained in the business. These totals
can be interrelated to forecast Energy Window’s financing requirements for 1992:

Anticipated asset expansion $450,000

Less
Anticipated spontaneous
increase in liabilities (90,000)
Less
Addition to retained earnings (150.000)
Net new financing requirements $ 210,000

Energy Window needs $210,000 in additional financing to maintain a

balanced financial structure during the upcoming year. In tlie absence of that
financing, whatever the source, the mandated 60% increase in sales will create a
severe cash flow problem. Energy Window will quickly exhaust its cash reserves
and lose the ability to honor supplier payment terms. The need for financial
forecasting can be emphasized in:
 Structural Management: Financial Forecasting

Concept 32: Financial forecasting helps

anticipate a firm's financing
requirements.

Tliis foresight can help a business avoid cash flow problems.

In any event, recognize the critical contribution the financial forecasting
process makes to a business. The process enables a business to foresee the need
for new financing. This need does not appear as a surprise that can precipitate a
financial crisis. Instead, a business gains the time necessary to arrange for die new
financing or, as discussed below, effect actions that may reduce the need for
financing.

Offsetting the Financial Limits on Growth

No manager wants to impose limits on the growth rate in his

business
business. So, we should touch on an important concept that can help you
overcome, at least partially, any limits on the growth financing available from
external lenders. Indeed, managing your accounts receivable and inventory more
efficiently generates cash that you can devote to tiie demands of an increasing
sales volume.
To another look at tiie Energy Window Company. We
illustrate, let’s take
previouslyassumed that Energy Window’s sixty day average collection period
would remain constant as sales increased. Thus tiie firm’s investment in receiv-
ables would expand as rapidly as sales.
However, Herb Elliot, seeking to overcome the firm’s financing limits,
connected two important facts. First, he recognized that tiie market demand for
Energy Window’s products provided the major impetus in the drive for expan-
of adequate financing stands as the only obstacle to a 100%
sion. In fact, the lack
tiiat same demand gave the firm the flexibility to impose
increase in sales. Second,
shorter payment terms or a more stringent credit policy without hurting sales.
Effecting either policy would lower the company’s average collection period and
improve its cash flow.
These facts encouraged Elliot to cast a new projection estimating the growth
potential fi-om the cash that would flow from reducing Energy Window’s average
collection period from sixty to forty-five days.
As the first step, Elliot considered the potential benefits from enforcing the
shorter collection period on the firm’s present $200,000 monthly sales volume.
He found that the new policy would lower the investment in receivables from
$400,000 to $300,000. Tliat reduction provides $100,000 in cash for investment
Structural Management

elsewhere. That offers the potential for substantial increase in cash capability even
if company does not press for a higher sales volume.
the
But Energy Window does want to expand sales. So, Elliot proceeded with the
second step in the analysis to project the financing requirements associated with
a higher sales volume. However, he altered diree of diis working assumptions:

1 . Energy Window would quickly develop and maintain a forty-five day average
collection period.
2. The first $100,000 increase in assets from any sales increase would absorb the
cash generated by the lower collection period at 8/31/91.
initially

3. The from its present $200,000 monthly sales volume

firm’s asset base
becomes $650,000 after the reduction in accounts receivable.
Table 13-3 summarizes the results of Elliot’s analysis.

Table 13-3
Lower Average Collection Period
Effect of
on Growth Financing Requirements
Energy Window Company

Growth Rate 10% 20% 30% 40% 50%

Total Asset Increase $ 65,000 $130,000 $195,000 $260,000 $325,000

Less: Accoimts
Payable Increase (15,000) (30,000) (45,000) (60,000) (75,000)

Less:
The cash capability
originally generated by
reducing the collection
period from 60 to 45 days a 00.000) a 00.000) a 00.000) n 00.000) (100.000)

Financing Requirements ($50,000) — $50,000 $100,000 $150,000

The $100,000 in cash that came from die reduction in Energy’s receivables
at8/31/91, coupled with the spontaneous increase in accounts payable, provides
internal financing for the company’s first 20% increase in sales. The business can
generate that increase without any odier external financing. At die same time the ,

lower initial asset base reduces the total asset growth that comes with any
alternative increase in sales (although the growth rate remains the same). Thus
a 50% increase in sales requires $150,000 in new bank financing, only half of diat

114
 Structural Management: Financial Forecasting

called for in the previous projection. And in the firm’s new financial position,
gained with the aid of a shorter collection period, Energy Window’s bank is more
likely to provide the smaller amount of new funds necessary to achieve the 50%
rate of expansion. Thus, better receivables management offsets a major pordon
of the limits set by any external financing source.
Remember tliis as:

Concept 33: Better component management

facilitates growth in a business.

Of course, better component management remains a desirable manage-

ment objective in any instance. But it can make a critical contiibudon to the

financing needs in a rapidly growing business.

115
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 Chapter 14

Structural Management:
Fixed Assets and Depreciation

Maintaining a focus on the day-to-day cash flow process excludes a consider-

on the cash flow process. This
ation of the impact an investment in fixed assets has
impact can be significant, and the significance increases as fixed assets become a
larger element in a firm’s financial structure. This chapter illustrates those facts
and reviews the important concepts that should orient management of a firm’s
investment in fixed assets.

The Initial Investment

A new investment in fixed assets permanently absorbs some of your cash

capability. You mustcommitcash reserves, perhaps coupledwitli external financing,
sufficient to make up the purchase You easily can measure tliat
price of the assets.
direct requirement, but the total cash capability required for a new fixed asset
investment usually exceeds the direct acquisition cost. Failure to anticipate these
additional requirements can lead to a cash flow problem.
To illustrate, let’s look at a proposed $200,000 fixed asset acquisition by the
Growth Company. The assets will facilitate an increase in production and provide
the potential for a $30,000 monthly increase in sales. As a direct requirement, the
Growth Company needs $200,000 in cash capability to complete the acquisition.
However, that does not measure the total cash capability necessary to fund
the new investment. The Growtli Company also should anticipate the cash
capability required to support a larger investment in accounts receivable and
inventory.
Structural Management

For example, assume that the company maintains an investment in inventory

equal to two months’ sales volume and a forty-five day average collection period.
If the company completes the fixed asset acquisition and achieves the projected
increase in sales, the investment in the two major components in the cash flow
cycle will rise as follows:

Inventory (2 times projected sales increase) = $ 60,000

Accounts Receivable (45 x $1,000 increase
in daily sales) = $ 45,000
Total Increase in Component Investment = $105,000

The total cash capability required to fund the Growth Company’s proposed
acquisition is $305,000, or the cost of the investment plus the natural increase in
other assets. Should the firm’s total cash capability fall below $305,000, the
investment will lead to a cash flow problem.
Note that the potential problem exists even if a proposed fixed asset
investment does not relate to projected expansion. For example, upgrading your
plant with modern equipment may require retraining your employees. You may
suffer operating losses — —
a drain on your cash capability during die training
period. In another circumstance, merely replacing old equipmentwith new often
requires a halt in production during installadon. Again, you suffer temporary
losses that increase the cost of the investment.
The cash capability required for an investment in fixed assets is seldom
limited to die purchase price. Therefore, keep in mind:

Concept 34: Anticipate the total cash

capability necessary for an
investment in fixed assets.

Recognizing this fact can reduce the chances of an unhappy surprise, a cash
flow problem.

Depreciation: The Basic Concept

a

In several instances, we have referred to the acquisition of fixed assets as an

investment. Widi qualifications, this remains a realistic view. Fixed asset acquisi-
tions should promise the same return as any other investment. But an investment
in fixed assets hasan important distinguishing characteristic.
With the usual exception of real estate, most productive fixed assets deterio-
rate. Indeed, most fixed assets have a limited life, and ultimately they become
worthless. This fact moves a fixed asset acquisition from the realm of an invest-

118
 Structural Management: Fixed Assets and Depreciation

ment into the category of a normal operating cost. Accountants and tax autliori-
ties define that cost as depreciation. A business recognizes tlie deterioration in any
depreciable asset as an expense prorated over its useful life.

Without losing ourselves complex accounting considerations, we will

in
review the effect depreciation has on the income statement of a business. As an
example, we will take the experience of the KBA Corporation, a small manufac-
turer of specialty steel products.
KBA began operations four years ago with an initial $100,000 cash invest-
ment in machinery and equipment. Original estimates indicated that tliose assets
would have a five year life. At the end of that term, the original investment would
have no value at all.
Relying on those projections, KBA’s accountant recognized the average
annual deterioration in the equipment with a $20,000 depreciation expense.
Using the operating statementfor the firm’sfourth year in business as an example,
that expense reduced die firm’s $20,000 in operadng profits:

Earnings before depreciation $20,000

Depreciation expense (20.000)

Net earnings —
During its fourth year in business, KBA found that it had break-even
operating results. That shows depreciation has die same effect on earnings as any
odier expense.

Depreciation as a Noncash Expense

Depreciadon prorates the cost of a fixed asset over its useful life. However,
it operadng expenses in a business. Depreciadon is
stands apart from most other
a noncash expense. From a different perspective, you can view depreciation as an
addidon to the annual cash flow in a business. To illustrate that view, let’s note die
effect depreciadon has on the cash account at the end of the year of KBA’s break-
even operations.
Table 14-1 compares die fiscal year end balance
sheets for KBA’s third and
fourth years in business. We will assume company’s accounts receivable,
that the
inventory, and total liabilities remain constant from one year to the next.
Note diat despite the break-even operating results in the fourth year, KBA’s
cash balance increases by $20,000. This cash represents die effect of depreciation
on the company’s income statement. Although recognized as an expense, no cash
flowed out of the business to pay it. However, the cash diat develops from the
Structural Management

depreciation expense does not represent the return of KBA’s original investment
in fixed assets. Instead, it merely recognizes tlie annual expenses incurred from
the natural deterioration in those assets. The cash left the business at tlie time of
acquisition. Consequently, no cash flows out when tlie business recognizes these
expenses on die income statement. This fact merits recognition in:

Concept 35: A depreciation expense does

not represent a current cash
outlay.

Note also that financing the acquisition of fixed assets has no effect on the
cash that flows from the depreciation process. Of course, the apparent cash flow
from depreciation contributes to the periodic note payments that result from
external financing. In fact, the lender measures that potential as an element in his
decision to extend fixed asset financing. At the same time, you relate those two
—
elements the cash flow from depreciation and your debt amortization re-
—
quirements in a cash flow budget, not in an operating statement.

Table 14-1
Effect of Depreciation on Annual Cash Flow
KBA Corporation
Third Year Fourth Year
Cash $ 40,000 $ 60,000
Accounts Receivable 200,000 200,000
Inventory 200,000 200,000

Net Fixed Assets (Net of $60,000

accumulated depreciation in the third
year and $80,000 in the fourth year) 40,000 20,000

Total Assets $480,000 $480,000

Total Liabilities $300,000 $300,000
Stockholders’ Equity 180,000 180,000

Liabilities and Equity $480,000 $480,000

Another implication suggested by tiie depreciation process is you must

foresee the eventualneed to replace your depreciable assets. You may not reserve
the cash flow from depreciation specifically for that purpose, but you must
maintain access to the cash capability necessary to replace worn-out equipment.

120
 Structural Management: Fixed Assets and Depreciation

Returning to the concept of earnings as cash flow, remember that earnings

become a direct increase in cash capability. We^\ill interrelate tliatwith deprecia-
tion in:

Concept 36: Earnings plus depreciation

measure the total annual cash
flow generated by a firm's
operations.

This identifies the internal cash a business has to expand its reserves, invest
in other assets, or reduce debt

Depreciation rs a Tax Shield

Depreciation is a source of cash for a business because the accounting

process doesn’t recognize a fixed asset acquisition as an expense at the time oftlie
purchase. Instead, it is a periodic noncash expense. The cumulative cash that
develops from the depreciation process merely matches the original cash outlay
for any particular fixed asset.
At the same time, a profitable business realizes a tangible cash benefit from
depreciation expenses. These noncash expenses reduce the firm’s reported
income and lower its actual income tax obligation.
To illustrate, let’s compare two businesses designated as Corporations A and
B. Both corporations generate $400,000 in income before depreciation and taxes.
Both incur a 40% income tax assessment on their earnings. The only significant
distinction between the two is that Corporation A has $100,000 in depreciation
expenses, while Corporation B has none. That difference leads to the following
view of the two firm’s comparative operating results:

Corporation Corporation
A B
Earnings Before
Depreciation and Taxes $400,000 $400,000
Depreciation 100.000 —
Earnings Before Taxes $300,000 $400,000
Taxes (40%) 120.000 160,000
Earnings After Taxes $150,000 $240,000
Plus Depreciation 100,000 —
Annual Cash Flow $270,000 $240,000

121
Structural Management

The total cash flow generated by a business includes earnings after taxes plus
depreciation. Here Corporation A enjoys $30,000 more in annual cash flow, or
$2*70,000 minus $240,000, The difference develops from the $100,000 in income
shielded by Corporation A’s depreciation expense. This noncash expense saves
$30,000 in taxes, which eventually shows up in the firm’s cash flow.

An Overinvestment in Fixed Assets

By now, we can anticipate the effect an overinvestment in fixed assets has on

Any excess investment absorbs cash that might be used profitably
cash capability.
elsewhere. Indeed, an overinvestment in fixed assets is analogous to an over-
investment in accounts receivable and inventory. However, an overinvestment in
fixed assets is more difficult to cure.
Indeed, a tighter credit and collection policy can reduce a firm’s investment
in accounts receivable. A temporary reduction in purchases will encourage a drop
in inventory. The rapid disposal of excess fixed assets typically stands as a more
difficult task.
Sometimes the excess may be part of a production process that has
assets
capacity well in excess of thedemands set by the firm’s sales volume. The business
can’t eliminate any of the assets without eliminating all of the assets. Thus it must
concentrate on expanding sales volume sufficiently tojustify the higher productive
capacity. In the interim, it must absorb the cost of carrying the excess investment.
In other circumstances, a business manager lacks the time or expertise necessary
to market unnecessary fixed assets. She absorbs the overinvestment until she

stumbles into the sale of the assets, often suffering a significant loss in the process.
An overinvestment in fixed assets also is more expensive than an over-
investment in accounts receivable or inventory. Of course, the financial or
opportunity cost from carrying excess assets in any instance is the same. Using a
10% annual rate, a $100,000 excess investment in fixed assets leads to a $10,000
reduction in earnings.
This detrimental effect is increased by the insurance, storage, and mainte-
nance costs associated with tfie excess fixed assets. Analogous to inventory, it costs
more to carry an investment in fixed assets than in accounts receivable. However,
in a major distinction from accounts receivable and inventory, an overinvestment
in fixed assets commits still further injury to the earnings in a business because of
the higher depreciation expense from that overinvestment.
Thus, a $100,000 excess investment in fixed assets may lead to a $10,000
reduction in annual earnings. The reduction comes from the annual deprecia-

122
 Structural Management: Fixed Assets and Depreciation

tion charge associated with that overinvestment, applying straight line deprecia-
tion over a ten year useful life. In any circumstance, higher depreciation charges

lead to lower earnings.

An Underinvestment in Fixed Assets

An underinvestment in fixed assets should impose no direct cash flow

problem. Fewer assets in one account leave cash capability available for use
elsewhere. However, such an underinvestment often leads to direct and indirect
costs that penalize a firm’s earnings.
The higher direct costs can arise from an operation that, because of the
underinvestment, remains less efficient than an operation with a larger invest-
ment in fixed assets. Higher labor costs and lower productivity associated witli an
inefficientmanufacturing process inevitably shrink a firm’s profit margin.
While the business may remain profitable, the earnings lost from tlie lower
profit margin can be viewed as an opportunity cost. The firm earns less than it
should. Another opportunity cost may come from sales lost as a result of inefficient
or insufficient productive capacity. These opportunity costs may be difficult to
measure, but they are real.

The Proper Investment in Fixed Assets

The proper investment in fixed assets relative to total assets will vary widely
among businesses. A wholesaler may require no fixed assets except the shelves
necessary to store her products and the trucks necessary to deliver them. Alterna-
tively, a manufacturer may carry a larger investment in fixed assets than either
accounts receivable or inventory.
Although the correct investment in any specific case involves many complex
variables, we can demonstrate one fundamental financial tool that can orientyour
analysis. That tool, the sales to net fixed assets ratio, enables you to relate your sales
volume to your net investment in fixed assets and to measure your fixed asset
turnover rate. For example, a business with $1,000,000 in annual sales and a
$100,000 net investment in fixed assets will relate the two totals as follows:

Sales to Net Fixed Assets = Sales

Net Fixed Assets

Sales to Net Fixed Assets = $1,000,000 _ |q

$ 100,000

123
Structural Management

The firm’s sales volume exceeds its investment in fixed assets ten times. Or,
the business turns its fixed assets ten times in the course of the year. The assets
don’t turn in the same way as accounts receivable and inventory, but the fixed asset
turnover rate becomes the primary criterion for measuring tlie efficient use of
fixed assets.
Perhaps the best use of that criterion again comes from a comparison with
the fixed asset turnover rates demonstrated by your competitors (using, for
example. Dun and Bradstreet ratios or Robert Morris Associates Annual State-
ment Studies). Should your fixed asset turnover rate fall below your competitors’,
you may have an overinvestment relative to your sales volume. Conversely, a
turnover rate significantly above your competitors’ may suggest an under-
investment.
In either case, the turnover rate is influenced significantly by the special

characteristics of a business. Moreover, since the calculation relies on depreciated

equipment values, turnover rates may vary significantly among businesses. The
assetsheld in one business may be several years older dian the assets held in
another. That can lead to wide disparities in net fixed asset values.
Subject to logical qualifications, the fixed asset turnover calculation at least
provides the starting point for identifying the appropriate investment level in a
business.

124
r
Chapter 15

Management:
Structural
Two Break-Even Points

Most business managers recognize die concept of break-even analysis. That

analysis identifies die sales volume where totalrevenue exacdy matches expenses.
At diat point, the business neither makes nor loses any money. However, a business
also has a break-even cash flow volume, a point where cash income exactly matches
cash expenses.
Proper cash flow management requires a clear distinction between the two
break-even points. This chapter demonstrates that distinction.

Basic Break-Even Analysis

Break-even analysis begins by dividing a firm’s operating expenses into two

categories. Every expense can be defined as eidier a fixed or a variable cost.
Fixed costshold constant across a specific range of sales. For example, a
business might increase sales from $1 million to $1.5 million without incurring
any increase in rent, utility, or office salary expenses.
Variable costs fluctuate proportionately with any change in sales. Thus a 20%
increase in sales produces a 20% increase in variable costs. Product expenses, sales
commissions, and delivery charges are die more obvious examples of variable
costs. A business doesn’t incur a variable cost unless it generates a sale. Then, it
incurs variable costs proportionately to any sales volume.
Contribution margin becomes die critical third element that enters into break-
even analysis. Contribution margin represents the difference between the selling
Structural Management

priceand the variable cost per unit volume. Contribution margin represents the
proportion of each sales dollar available to pay fixed costs and, ultimately, to provide
any earnings the business might enjoy.
The relationship between contribution margin and a firm’s fixed costs
provides the arithmetic premise for break-even analysis. Let’s examine that re-
lationship from a couple of perspectives.
First, a business suffers a loss from operations so long as the total contribu-

tion margin from sales remains insufficient to cover fixed costs. Remember, fixed
costs hold constant regardless of the sales volume generated.
Second, a business breaks even at that volume where the total contribution
margin from sales exactly equals its fixed costs. Identifying diat point stands as the
obvious objective of break-even analysis.
Third, as sales move above the break-even point,
tlie total contribution margin

from exceeds fixed costs. The excess margin over fixed costs represents
sales
earnings. A business operating above the break-even point generates a profit.
Figure 15-1 provides a conceptual view of the relationship between contribution
margin and the break-even point.
Part a in Figure 15-1 sets the foundation for the illustration. The quantity in
the rectangle on the left represents die total selling price for the product. That
price then separated into its two elements: contribution margin (CM) and
is

variable costs (VC) The square on the right represents fixed costs, segmented by
.

the number of unit contribution margins necessary to cover diose costs. In this
case, there are six.
Observe the relationship as die business begins to generate sales.
First, in part b, five unit sales leave total fixed costs uncovered. The firm’s loss
at that unit volume is equivalent to the contribution margin from a single sale.

Then, increasing sales by one unit, the firm reaches the break-even point,
illustrated in part c. Six-unit sales provide the contribution margin that exactly
covers fixed costs. At this point, total revenue equals total expenses and the
business breaks even.
Part d shows the benefits of operating above die break-even point. The firm
produces earnings equal to the contribution margin from each unit sold in excess
of the break-even volume. After fixed costs are covered, the margin from each
additional sale proceeds direcdy to the bottom line.
Let’s translate this conceptual view into the calculation diat actually identi-
fies die break-even point in a business. That illustration uses the simplified

circumstances of the Strong Electric Motor Company (SEMCO) SEMCO carries .

only one product, a small motor that sells for $7. Since the firm incurs a $4 variable
cost from each unit sold, we find the contribution margin as:

126
 Structural Management: Two Break-Even Points

Figure 15-1
Conceptual View of Break-Even Analysis

CM
T
Total Fixed
Costs
VC
i

b. Fh'c Unit Sales

c. Six Unit Sales

+ CNt
d. Seven Unit Sales
(profit)

Contribution Margin = Selling Price - Variable Cost

Contribution Margin = S7 - $4
Contribution Margin = $3

Assuming that SEMCO’s fixed costs total $90,000 per year, the contribution
margin per unit can be used to calculate the firm’s break-even sales volume. From
Figure 15-1, we know that the break-even volume occurs at that point where the
total contribution margin from all units sold exactly equals fixed costs. Arith-
metically, that becomes:

Break-Even Volume = Total Fixed Costs

Contribution Margin per Unit

127
Structural Management

Entering SEMCO’s data:

Break-Even Volume = = 30,000 units

$3

SEMCO breaks even when sales reach 30,000 units. The company’s sales price
per unit translates that into an annual volume of $210,000 (30,000 x $7).
Now relate this example to two points asserted above. First, each sale in excess
of 30,000 units per year contributes $3 to SEMCO’s earnings. The margin in excess
of fixed costs proceeds directly to the bottom line. Alternatively, should SEMCO
sellfewer than 30,000 electric motors, it will suffer a loss. The total contribution
margin will fall short of tlie amount necessary to cover fixed costs. The amount of
the loss will be $3 for each unit that SEMCO drops below the 30,000 unit sales level.
For example, sales of only 28,000 units will leave SEMCO with a $6,000 loss.
We can summarize the key role contribution margin plays in break-even
analysis in:

Concept 37: A business breaks even when

the contribution marain from
sales exactly covers fixed costs.

Of course, most businesses carry a variety of items at different sales prices,

different variable costs, and thus different contribution margins. That makes
break-even analysis more complex, but it does not affect the essential concept.

Average Contribution Margin

An alternative approach to break-even analysis recognizes the difference in

contribution margins among products with different sales prices and costs. It uses

data extracted directly from a firm’s income statement and relies on the average
contribution margin that comes from each sales dollar. The Able Company’s
experience illustrates this approach to break-even analysis.
As shown in the summary of its income statement, the Able Company
presendy operates profitably:

Sales $ 275,000
Variable Costs (
87 500 )
,

Fixed Costs ( 140 000 )

,

Earnings $ 47,500

However, John Able, the company’s founder, is concerned about the un-
certain economy and a potential reduction in sales. He wants to identify the sales

128
 Structural Management: Two Break-Even Points

decrease the firm can absorb witliout falling below a break-even level of opera-
tions. Since Abie’s product costs and sales prices vary widely, there will be a wide
variation in the contribution margin tliat comes from the sale of different products.
Conceptually, of course, tlie same objective. It identifies
alternative seeks the
die sales volume where the firm’s cumulative contribution margin from all sales
exacdy equals total fixed costs. But since the contribudon margin varies among
products. Able must use a three-step process to achieve that objective.
First, Able must calculate die total contribution margin included in the in-
come statement:

Total Contribudon _ Total _ Total

Margin Sales Variable Costs

Total Contribudon ^ $275,000 - 87,500 = $187,500

Margin

The $187,500 total represents the contribution margin generated from all

sales. So, the next step calculates the average contribution margin per sales dollar.
That average measures a straightfoiward proportional relationship:

Average Conti ibution Total Contribution Marg in

Margin per unit Total Sales

Average Contribution $187.500

Margin per unit $275,000

Average Contribution 68% (or 68 cents

Margin per unit per dollar in sales)

On die average, each dollar in sales provides 68 cents that contributes to the
coverage of fixed costs —and ultimately to any earnings the firm realizes.
We can use diat average contribution margin per unit to calculate Abie’s break-
even point:

Break-Even Sales Volume Eixed Costs

Contribution Margin as % of Sales

Break-Even Sales Volume $140.000

0.68

Break-Even Sales Volume $205,882

The Able Company can suffer a drop in sales of approximately $75,000 and
still not suffer an operating loss. At the same time, note that the calculation

129
Structural Management

process applies to any business. If you can identify your average contribution
margin per sales dollar, you can calculate your break-even point.
One major qualifying assumption applies to this alternative approach. It
presumes that as sales fluctuate the proportionate product mix that makes up any
volume remains constant. A change in that mix naturally will change the average
contribution margin received from each sales dollar.
Obviously, this assumption is not totally realistic. As sales fluctuate, product
mix varies. So this approach to break-even analysis is less precise than the fun-
damental calculation. Nevertheless, the calculation provides a satisfactory esti-
mate for most management purposes.

Cash Flow Break-Even Analysis

Standard break-even analysis identifies the particular sales volume in a busi-

ness where revenues equal expenses. However, not all expenses incurred within
a particular operating period are cash expenses. Depreciation, as well as some less
significant expenses, represents noncash expenses. Gonsequendy, a business can
—
have a cash flow break-even point where die cumulative contribution margin
—
from sales covers fixed cash expenses that falls well below its financial break-
even point.
Part a in Figure 15-2 shows the contribution margin provided by each unit
sale, together with the firm’s total fixed costs. Again, it is apparent that it requires
six unit sales to cover fixed costs fully. However, here die total fixed costs include
depreciation (D) equivalent to the contribution margin from two unit sales.
Note what happens as sales increase. A three unit volume, shown in part b,
leaves the business well below both the financial and cash flow break-even points.
That volume creates a negative cash flow from operations. Cash expenses exceed
cash income. In part c, a four unit volume provides a break-even cash flow. The
total contribution margin from sales covers actual cash expenses.
Finally, part d demonstrates the effect of one unit sale above the cash flow
break-even point. That sale provides a positive cash flow from operations, even
though it leaves the business below die financial break-even point. One more sale
returns the business to the proper break-even point.
The major results can be summarized in:

Concept 38: A business has a break-even

cash flow when the contribution
margin from sales exactly
covers fixed cash costs.

130
 Structural Management; Two Break-Even Points

Figure 15-2
Conceptual View of Cash Flow Break-Even Analysis

CM
t
TotrJ Fixed
Costs
VC

b. Three Unit Sales

c. Four Unit Sales

d. Five Unit Sales

The calculation process that identifies the cash flow break-even point in a
business is identical to that illustrated above. However, instead of using total fixed
costs, the calculation recognizes only fixed cash expenses. Usually that amount is
mereh' the total fixed expenses less depreciation.
For example, looking at SEMCO again, assume that the firm’s $90,000 an-
nual fixed costs include $30,000 in depreciation. To find its cash flow break-even
point

Cash Flow _ Fixed Cash Expenses

Break-Even Point Contribution Margin per Unit

$60,000 _ 20,000 units

$3.00

131
 .

Structural Management

SEMCO has a break-even cash flow when sales reach $140,000 (20,000 x $7)
If your business sells a variety of
products with different contribution mar-
gins, you must use the cumulative contribution
latter calculation to find the
necessary to cover fixed cash expenses.
Break-even cash flow analysis is a useful management tool. But it has limita-
tions because it relies on the accrual accounting process. Thus it does not reflect
the actual timing of the cash flow into and out of a business. Indeed, only an actual
cash flow budget anticipates the physical collection and disbursement of cash.
Over a relevant period, cash flow break-even analysis can still be valuable
because it identifies the sales volume that matches cash revenues to cash expense.
But keep it in perspective. You cannot equate accrual and cash flow accounting.

Fixed Assets and the Break-Even Point

Chapter 14 introduced the fixed asset turnover rate calculation, which helps
identify theproper fixed asset investment level for a business. Break-even analysis
contributes another important perspective. It recognizes depreciation as an
element in total fixed costs. Thus the relationship between a firm’s investment in
fixed assets and break-even analysis follows logically.
As a business expands its investment in fixed assets, the higher depreciation
charge that develops increases total fixed costs. That increases the sales volume
the business must generate to achieve break-even operating results. Alternatively,
a lower investment in fixed assets leads to a lower break-even point.
Of course, is more complex. A larger investment in fixed
the relationship
assets may lead production efficiencies that reduce variable product costs,
to
increasing the contribution margin available from each sales dollar. But that
doesn’t negate the basic relationship between the size of the investment fixed m
assets and break-even analysis. Nor does it eliminate the implications for the fixed
asset investment decision process.
Before makingafixedassetinvestment, measure how it will affectyour break-
even point. If you can’t be assured of the additional sales necessaiy to offset the
higher fixed costs from the investment, you may wisely defer the acquisition.
Alternatively, if you can operate efficiently with a smaller fixed asset invest-
ment, you lower the sales volume necessary to break even and reduce your op-
erating risks. You also must measure the effect of your fixed asset investment on
the contribution margin that you realize from each sale. This consideration falls
naturally into the calculations tliat translate into break-even analysis.

132
 Structural Management: Two Break-Even Points

The Benefits of Break-Even Analysis

Prudent business management often calls for the use of break-even analysis.
But the manager must recognize it as a tool and know how to use it. It is more dian
a gauge of the effect that a firm’s investment in fixed assets has on die break-even
point. From the pessimist’s viewpoint, break-even analysis identifies die worst
circumstances that can exist without suffering a loss fi-om operations. If the
business doesn’t generate a profit, at least it breaks even.
The realistic manager recognizes break-even analysis as a step toward im-
proving the firm’s performance. The analysis categorizes the critical relationships
that determine whether or not a business operates profitably. Should a business
fall below the break-even point, the manager can use the analysis to consider die
alternative solutions to his problem. Aldiough the obvious corrective action in any
instance will appear to be a higher sales volume, that often may not be the best
approach, and certainly it isn’t the only approach.
The depends upon the operating constraints set by the ex-
best alternative
ternal market and its internal operating requirements. Whatever the circum-
stance, break-even analysis isolates the major considerations and serves as a
convenient tool for forecasting the results from any major change.

133
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1
Part
IV

Leverage
Management

1 6. Leverage: A Conceptual View

1 7. Leverage: A Mechanical View
1 8. Leverage: A Practical View
1 9. Leverage from the Trade
20. Leverage from the Bank
21 . Leverage from the Commercial
Finance Company
22. Leverage from Investors
23. Leverage: Comparative Analysis
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 Chapter 16

Leverage: A Conceptual View

Leverage measures the percentage of a firm’s assets supported by debt. For

example, a business with $1 ,000,000 in total assets and $600,000 in debt has a 60%
leverage factor. Understanding the concept of leverage as a basic principle of
financial management will enable you to use leverage beneficially.

Measuring the Benefits of Leverage

You can use an increase in earnings to measure the benefits that a business
realizesfrom the proper use of leverage. However, setting one earnings total
against another can be misleading.
A more reliable criterion for measuring the potential benefits comes from
calculating the return a business produces for its stockholders — the return on
stockholders’ equity, or ROE.
The ROE calculation
measures the earnings a business generates as a pro-
portion of stockholders’ equity. For example, if a business with $200,000 in
stockholders’ equity earns $30,000 in a year, the calculation becomes:

Return on Equity = Earn i ngs

Stockholders’ Equity

roe = $30,000
$200,000

ROE 15%
Leverage Management

On one level, the ROE calculation measures the increase in the value of the
stockholders’ investment from earnings. On another level, it becomes a tool for
analyzing the comparative performance of different businesses. That is, a larger
ROE suggests a better performance.
The earnings total used in the ROE calculation represents a firm’s after-tax
earnings. After all, only net earnings total actually benefits a business —and its

stockholders. Also, the denominator in the calculation employs the stockholders’

equity total as it stands at the beginning of the business year.
Wliile that may appear obvious, some financial philosophers believe the
calculation requires an average equity total, since earnings accrue incrementally
throughout the year. But this approach complicates a straightforward concept.
Using the equity total as it stands at the beginning of a business year provides a
criterion more suitable for comparative analysis.

Leverage and Return on Equity

Leverage can increase the return on the stockholders’ equity in a business.

For an existing business, that result also leads to higher earnings. However, the
two results are not necessarily synonymous.
Let’s look at the experience of Beth Tallman, an entrepreneurial investor
who recently considered a major investment in a new plumbing supply operation.
Tallman centered her analysis on the following characteristics of the proposed
investment:

1. The business required $1,000,000 in total assets to operate profitably.

2. Given diose assets, the business promised earnings of $150,000 in the first
year, excluding any potential interest expenses.
3. The cash was available to finance the $1,000,000 in required assets with an
equal dollar equity investment.
4. Alternatively, he could use as little as $200,000 in cash equity and borrow the
funds necessary to finance the difference in required assets.
5. Any borrowed funds will carry a 10% annual cost.
Recognizing her options, Tallman analyzed the proposed investment using
four different financial structures. Table 16-1 measures the net earnings (after
interest costs)and ROE that would result from each alternative.
As she increases the use of debt instead of equity, Tallman sees the projected
earnings from the new venture drop. For example, using $1,000,000 in equity,
with no debt, promises $150,000 in earnings. At the other extieme, coupling
$800,000 in debt with $200,000 in equity, earnings from the venture ch op to
$70,000. The interest costs associated with the debt absorb the $80,000 difference.

138
 Leverage: A Conceptual View
Table 16-1
Leverage and ROE

Alternative Financial Structures

1 2 3 4

Total Assets $1,000,000 $1,000,000 $1,000,000 $1,000,000

Total Liabilities
(10% annual cost) 200,000 500,000 800,000

Stockholders’ Equity 1,000,000 800,000 500,000 200,000

Earnings Before Interest Costs 150,000 150,000 150,000 150,000

Interest Cost 20.000 50.000 80.000

Earnings S 150,000 S 130,000 S 100,000 S 70,000

Return on Stockholders’ Equity 15% 16.25% 20% 35%

When earnings are used as a criterion, leverage actually appears to be det-

rimental to a business. However, the ROE criterion contradicts that assessment.
Tallman increases the return on the dollars she invests in the business by
using less equity and more leverage. Indeed, an 80% leverage factor raises her
ROE on the minimum $200,000 investment to 35%, compared to the 15% return
she gains by avoiding any debt at all.
We recognize that potential benefit in:

Concept 39: Leverage can increase the

return a business produces on
stockholders' equity.

If Tallman seeks the maximum possible return on her investment, she will
select the option that requires the few’est equity dollars. That allow's her to employ
the difference in cash profitably elsew^here. Carried to the limit, an investor will
never commit a single dollar more than necessar}’.
Let’s look at the same concept from a more familiar perspective.

Leverage and Earnings

Leverage does not have to low^er earnings to induce a higher return on eq-
uit\’. Indeed, the example of Beth Tallman’s analysis w'as designed specifically to
emphasize the critical relationship between leverage and return on the stock-
holders’ investment. Here we will examine the benefits an existing business gains

139
Leverage Management

from using borrowed funds. Our illustration relies on an analysis performed by

the Hopeful Company, a growing business seeking to expand. We will assume that
the company will open the next business year with the financial structure illus-
trated in the first column of Table 1 6-2. That structure includes $1 ,000,000 in total
assets, balanced by $500,000 each in liabilities and stockholders’ equity.

Table 16-2
Debt vs. Equity Financing for Expansion
The Hopeful Company

Equity Debt
Financing Financing
Total Assets $1,000,000 $1,500,000 $1,500,000

Total Liabilities 500,000 500,000 1,000,000

Stockholders’ Equity $ 500,000 $1,000,000 $ 500,000

Earnings before Interest

(15% of average
investment in assets) $ 150,000 $ 225,000 $ 225,000

Less: Interest Expense (50.000) (50.000) (100.000)

Net Earnings $ 100,000 $ 175,000 $ 125,000

Return on Equity 20% 17.5% 25%

Based on several assumptions, the company projected the results from fi-

nancing the next year’s anticipated growth with either debt or equity:
1. Earnings from operations (before deducting interest expenses) historically
provide a 15% return on the firm’s average investment in assets.
2. The projected expansion calls for a $500,000 increase in the firm’s average
investment in assets.
3. The firm can finance the increase in assets with either debt or equity; the firm
absorbs a 10% average expense from the use of debt.

Proceeding from the beginning financial structure. Table 16-2 summarizes

the effect that both debt and equity will have
on Hopeful’s earnings, as well as the
return on the stockholders’ investment. The company increases earnings in
either instance. Certainly, proper financial management should use any external
funds profitably, whether debt or equity. No other result justifies or attiacts cash
from either source. However, as might be anticipated, using debt to finance
Hopeful’s expansion provides a larger return on investment for the firm’s
stockholders. The illustration reinforces Cash Flow Concept No. 39.

140
 Leverage: A Conceptual View
Of course, leverage is not automatically beneficial. To use borrowed funds
properly, you must work within some natural consti aints.

One Limit on Leverage

To benefit from leverage, a firm’s return on assets must exceed the cost of
the borrowed funds. Before illustrating this natural limit, we should establish a
common \iew of the term return on assets, or ROA.
ROA measures a firm’s earnings as a percentage of its total asset investment.
For example, if a business has $100,000 in earnings and $1,000,000 in total assets,
the ROA calculation becomes:

Return on Assets = Net Earnings

Total Assets

ROA = ^ 100 000

. = 10%
$1,000,000
In tliis instance, the total assets figure may represent the firm’s investment

at the beginning of tlie year, the end of the year, or the average that prevails
throughout the year. The latter alternative, perhaps using monthly balance sheet
totals to compute average assets, offers the more logical approach. At the same
time, any of the three alternatives should prove satisfactory so long as you maintain
consistency from one year to the next.
The Hopeful Company’s analysis illustrates the relationship between ROA
and leverage costs. The firm still projects a $500,000 increase in assets. Using
leverage to finance those assets will impose a 10% annual interest expense.
However, we will alter one point in the analysis and assume that the firm is unsure
of the returnit can anticipate from the incremental assets associated with die

expansion. Consequendy, the analysis considers the ultimate change in earnings

across the three most likely outcomes —a 5%, 10%, and 15% ROA. Table 16-3
reflects the analysis.
Should the Hopeful Company realize less than a 10% return on the
proposed incremental assets, die expansion will actually reduce earnings. How-
ever, should the return on assets exceed the cost of the debt (as in Column 3) die ,

use of leverage leads to higher earnings. In that case, borrowing benefits the
bottom line.
So, note one limit on leverage in:

Concept 40: To benefit from leverage, a

firm's return on assets must
exceed the cost of debt.

141
Leverage Management

Table 16-3
How ROA Limits Leverage
The Hopeful Company

ROA ($500,000 in incremental

assets financed with borrowed funds) 5% 10% 15%
Leverage Cost 10% 10% 10%
Incremental Earnings
Before Interest $ 25,000 $ 50,000 $ 75,000
Interest Expense (10%) (50.000) (50.000) (50.000)

Net Change in Earnings ($25,000) — $ 25,000

Now, let’s see how better asset management can improve the return a busi-
ness produces on its stockholders’ equity.

Asset Turnover and Return on Equity

Part II demonstrated the benefits that a business derives from a reduction in

the average size of its investment in accounts receivable and inventory. A reduc-
tion in either instance reduces the total cash capability necessary to support those
investments, contributes to a better cash flow, and leads to higher earnings. Now
we can use the ROE calculation to measure those benefits horn another per-
spective and find that a lower average asset investment for any constant sales
volume increases the return a business produces for its stockholders.
Table 16-4 helps prove tliat point as it compares the ROE generated by two
closely comparable businesses: Company A and Company B.
Both firms enjoyed $100,000 in earnings from a $2,000,000 annual sales
volume, and each employs a 50% leverage factor. One half of each firm’s assets is
financed with debt. However, Company A carries a $1,000,000 investment in total
assets, while Company B generates the same sales volume with only $800,000 in
assets. By dividing annual sales by each firm’s total investment in assets. Company
B turns its total asset investment two and a half times a year, while Company A
manages to turn its assets only twice.
Ultimately, the faster turnover rate reduces tlie stockholders’ investment
necessary to achieve any sales volume. As indicated in Table 16-4, Company B’s
stockholders enjoy a 25% return on equity, while Company A’s investors earned
5% less. That should encourage you once again to exercise the tenets of
competent component management. Turning the assets more rapidly that is, —
—
using them more efficiently increases the return on the stockliolders’ equity.

142
 Leverage: A Conceptual View
Table 16-4
Asset Turnover and ROE
Company Company
A B
Total Assets $1,000,000 $ 800,000

Total Liabilities 500,000 400,000

Stockholders’ Equity 500,000 400,000

Liabilities and Equity 1,000,000 800,000

Sales 2,000,000 2,000,000

Profit Margin 5% 5%
Earnings $ 100,000 $ 100,000

Asset Tiunover 2 2.5

ROE 20% 25%

Leverage and Risk

The relationship between the cost of leverage and the return on a firm’s
assets implicates the other major limit on the use of leverage. Wliile leverage can
increase earnings and ROE, the opposite outcome always remains a possibility.
Using leverage imposes an unavoidable element of risk on a firm. On one
level, leverage may lead to lower rather dian higher earnings. On another, le-
verage may temporarily turn a profitable business into a losing operation. Carried
to tlie worst extreme, the improper use of leverage can destioy a business.
Remember tliis threat as:

Concept 41 : Risk is a natural companion of

leverage.

Financial analysts employ complex models to measure tlie degree of risk

associated with various proportions of leverage in a firm’s financial structure.
However, complex models are not necessary to illustrate tlie fundamental rela-
tionship. We demonstrate that fact below with a simpler view of the relationship
between risk and leverage. However, first let’s look at the circumstances that make
risk an unavoidable companion of leverage.

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Leverage Management

The Uncertainty in Futurity

A business seldom increases leverage —debt a percentage of

its as total as-
—merely finance current of operations. Of course, might use debt
sets to its level it

toreplace obsolete or worn-out equipment. Butin most instances,

leverage usually
precedes— indeed, anticipates— a projected increase volume. in sales
The process follows a logical course.
First, a business projects a larger sales volume. Perhaps it intends to expand
into new areas, introduce a new product, or merely press for a larger share of its
existing market.Then, as a necessary precedent to achieving any such projection,
itmust increase its investment in inventory. That, in turn, may also be preceded
by an expansion in fixed assets. Using borrowed funds to finance the necessary
increase in assets raises the leverage factor in the business.
Should the business achieve the projected sales increase, the leverage be-
comes beneficial. But should the higher volume fail to follow the projected course,
the increased cost from the leverage may lead to lower earnings. The potential for
more than one outcome defines the element of risk associated with leverage.
Uncertainty is a constant companion of futurity. A firm’s projected volume
is subject to all of the vagaries of an uncertain economic environment. A business

may find resistance to projected expansion from a general economic decline or

increased competition. Technological innovation or a change in consumer tastes
may alter customer purchasing habits. A supplier strike may stymie any projection
in the best circumstances. Whatever the source of the problem, the presence of
such potential makes the use of leverage a risky proposition.
Of course, even the business that uses no leverage confronts risk as a natural
element of the economic environment. When leverage enters a financial struc-
ture, the element of risk acquires greater importance. As leverage increases the
return for the business that achieves its goals, it also increases the penalty inflicted
on the business that falls below its projections.

Leverage, Risk, and Return

Our discussion of the impact leverage has on a business serves two functions.
demonstrates die interrelationships between risk, return, and the use of
First, it

leverage.Although leverage can benefit a business that achieves its goals, when
volume falls below projected levels, the business using leverage suffers a larger
setback.

144
 Leverage: A Conceptual View

Second, as a logical extension of the basic concept, it shows how the risks
associated with any operation increase as leverage increases. Low levels of leverage
involve litde risk; high levels of leverage involve high levels of risk. You must find
the level for your business diat provides the best return for the risk you are willing
to accept.
Beth Tallman’s analysis of her proposed investment in a new plumbing
supply operation illustrates the fundamental relationships. Tallman’s initial
analysis compared the earnings and return on stockholders’ equity from four
alternative financial structures. However, the analysis proceeded on the assump-
tion the new business would earn $150,000 before deducting any interest
expense.
Recognizing die uncertainty inevitably associated with diat expected out-
come, Tallman expanded her analysis. She estimated the risk associated with the
alternative financial structures based on the following assumpdons:

1. At any level of sales, the new business would incur $200,000 in fixed costs.
2. Variable costs will average 50% of any sales actually generated.
3. In the worst circumstance, the new company will generate no sales at all; the
most optimisdc projecdon anticipates a $2,000,000 sales volume.

Tallman’s analysis proceeded in two steps. First, she calculated die expected
earnings the business would realize from four alternative sales volumes, ranging
from the worst to the best possible outcomes. (The calculations measure Earnings
Before Interest and Taxes, or EBIT.) Table 16-5 shows the calculations associated
with each outcome.

Table 16-5
Four Potential EBIT Operating Results

1 2 3 4
Sales — $ 500,000 $1,000,000 $2,000,000

Fixed Costs ($200,000) (200,000) (200,000) (200,000)

Variable Costs
(60% of sales) ( 300.000^ (600.000) (1.200.000)

EBIT ($200,000) — $ 200,000 $ 600,000

A glance at Table 16-5 shows that $500,000 stands as the operating break-
even point. Sales in excess of $500,000 will generate operating profits; sales below

145
Leverage Management

that level will leave the firm with an operating loss. Of course, that break-even
point presumes that the firm uses no leverage at all.

As the second step in her analysis, Tallman completed the earnings and ROE
calculations, using the four alternative leverage factors illustrated in Table 16-1:
0%, 20%, 50%, and 80%. Table 16-6 also includes those calculations in order.

Table 16-6
Leverage, Risk, and Return

Financial Structure 1 ; Zero Leverage

EBIT ($200,000) — $200,000 $600,000

Interest Expense
Net Earnings ($200,000) — $200,000 $600,000

ROE 20% — 20% 60%

Financial Structure 2: 20% Leverage

EBIT ($200,000) — $200,000 $600,000

Interest Expense (20.000) ($20,000) (20.000) (20.000)

Net Earnings ($220,000) ($20,000) $180,000 $580,000

ROE (27.5%) (2.5%) 22.5% 72.5%

Financial Structure 3; 50% Leverage

EBIT ($200,000) — $200,000 $600,000

Interest Expense (50,000) (50.000) (50,000) (50.000)

Net Earnings ($250,000) ($50,000) $150,000 $550,000

ROE (50%) (10%) 30% 110%

Financial Structure 4: 80% Leverage

EBIT ($200,000) — $200,000 $600,000

Interest Expense (80.000) (80.000) (80.000) (80.000)

Net Earnings (140%) (40%) 60% 260%

Tallman’s analysis emphasizes the critical interrelationships among lever-

age, risk,and return. First, a higher sales volume increases earnings and return on
equity. This holds true regardless of the financial structure. At the same time, as

146
 Leverage: A Conceptual View
the firm achieves a higher sales volume, ROE increases dramatically because the
financial structure includes greater leverage factors. If tlie firm achieves a $2,000,000
salesvolume with a financial structure that contains an 80% leverage factor, the
return on the stockholders’ equity reaches a remarkable 260%.
However, that is the best possible outcome among a set of projections
looking into an uncertain future. We will look at the odier side of the picture and
measure the risk associated with the leverage factors used in the prospective
investment.
As leverage enhances the return from a successful venture, it also increases
the loss should the firm achieve aminimal volume. Referring again to Table 16-
6, examine the alternative outcomes should the business achieve only a $500,000

sales volume. If the firm has no leverage, that volume produces a break-even
operation. Using leverage, however, converts the break-even results into a loss,
and more leverage leads to losses.
Table 16-7 summarizes the return on equity thatTallman should anticipate
from each sales volume, beginning with each financial structure distinguished by
its leverage factor.
At the bottom ofTable 16-7, note the range of expected outcomes associated
with each leverage factor.
Thus when Tallman projects the results from using absolutely no leverage,
the range between the best and worst possible outcomes is 80%. In the worst
circumstance (no sales at all), she stands to lose 20% of her original investment.
Should the new business achieve a $2,000,000 sales volume, however, using no
leverage yields a 60% ROE.

Table 16-7
Risk, Return, and Leverage:
The Range of Potential Outcome

Range of
Potential Sales Leverage Factor
Volume % 0 20 % 50 % 80 %
ROE at Each Leverace Factor and Sales Voliune
0 (20%) (27.5%) (50%) (140%)
$ 500,000 — (2.5%) (10%) (40%)
$1,000,000 20% 22.5% 30% 60%
$2,000,000 60% 72.5% 110% 260%
Range of Expected ROEs: Low to Hk^h
80% 100% 160% 400%

147
Leverage Management

Compare these outcomes range that results from tire 80% leverage
to the
factor. In the worst circumstance,Tallman theoretically could lose 140% of his
original investment. When the firm uses leverage, interest expense continues
regardless of sales volume. At the same time, should the business generate
$2,000,000 in sales, Tallman’s ROE will reach 260%. In one year, she will realize
a return that is more than two and a half times her original investment.
We acknowledge tliese trade-offs in:
Concept 42: Leverage imposes risk on a
business in exchange for the
promise of a higher return.

With an 80% leverage factor, using ROE as a criterion, we find a 400% range
in the anticipated results from the alternative possible sales volumes. That range
is five times more than diatusing no leverage. The range differentials demonstrate

the critical interrelationships among leverage, risk, and return. Thus a successful
outcome returns larger benefits to the business that uses leverage. And an un-
successful outcome leads to a larger loss.

148
r
Chapter 17

Leverage: A Mechanical View

This chapter outlines the three major categories of leverage available to a

businessand differentiates the mechanics involved witli tlie extension and
repayment of the borrowed funds. Adopting a mechanical view of the major
borrowing alternatives is designed to help you better fit each lending method to
the circumstance that raises tlie need for leverage. Each alternative form of
leverage serves some purposes better than otliers.

The Single Payment Loan

A single payment loan requires repayment in full, including die interest

charge, on a predetermined date. Typically, the repayment follows die grandng
of the loan by ninety days or six months. Less frequendy, it may extend for only
a few days or as long as a year. The lender specifies the required payment date in
the loan document.
Before he extends the loan, a well-informed lender also knows die probable
source of funds necessary to meet the payment schedule. The source isn’t
necessarily specified in the note, but it should be understood in advance. The
maturity of a single payment loan should coincide with the purpose of the loan,
coupled with a realistic projecdon of the date die funds will be available for
repayment.
The more common single payment loans answer the seasonal needs of a
business. For example, a business may borrow to build inventory in anticipation
Leverage Management

of its major selling season. The collection of the accounts receivable from the sales
provides the cash to repay the loan on schedule.
The farmer remains the classic example of the seasonal borrower. He bor-
rows to finance his spring planting and then raises (rather than buys) his inventoiy
during the summer. He harvests his crops in the late summer or early fall. Then,
he repays the lender from the proceeds of the sales. The terms and source of
repayment are clearly recognized by both the borrower and lender on the day the
loan is granted.
Many manufacturers and wholesalers also use seasonal loans. For example,
lawnmower and fertilizer manufacturers and bathing suit and ski distributors
need seasonal loans. Indeed, the single payment loan smooths the cash flow across
many business cycles.
We recognize the primary purpose of a single payment loan in;

Concept 43: A single payment loan answers

a specific business purpose that
provides a well defined source
of repayment.

Single payment loans also answer specific, short term purposes apart from
the seasonal requirements that arise in a business. In one instance, a business
might borrow to fill a temporary gap in its cash flow. Perhaps the inventory
requirements for an unusually large sale drain a firm’s cash reserve. Collection of
the receivables that result from the sale provides the cash to retire the loan. Or a
business might use a single payment loan advantage of a unique profit
to take
opportunity. The loan may facilitate the purchase of some bargain merchandise
or enable the business to obtain quantity or trade discounts.

Calculating the Single Payment Interest Charge

The lender extending a single payment loan charges a stated annual interest
prorated for the fraction of the year that makes up the term of the loan. For
rate,
example, assume a business borrows $100,000 from a lender who charges a 12%
annual interest rate. If the loan extends for a full year, the interest charge totals
$12,000. However, should die term of die loan be only six months, the interest
calculation becomes:

1. $100,000 X 12% = $12,000

2. $12,000 X 0.5 (six months) = $6,000

150
 Leverage: A Mechanical View
Two traditional lender practices can make measuring the true cost of a single
payment loan more complicated than it first appears.
First, lenders do not calculate interest charges based on the calendar year or

specific fractions of that year. Instead, they measure tlie term in days, such as 90,
180, or 365 days.
Second, some lenders do not use an annual interest charge applied to the
pro-rata portion of the year of the loan. Instead, they charge a daily rate derived
from the annual stated rate. Wliile that may imply a proper pro-rata application,
tlie result may differ because of the calculation process that determines the daily

interest charge.
Some lenders use a calculation that proceeds on the presumption a year has
only 360 days. For example, using the 12% annual rate, tlie average daily charge
is found as:

= 0.00033% per day

360

Tlie lender applies that charge to each dollar you use each day. Unfortu-
nately for tlie business borrower, that daily rate exceeds the rate that would come
from the same calculation using a 365 day year.
To illustrate tlie effect that difference has on the actual annual cost of bor-
rowing, compare the actual dollar costa business incurs from the daily rate versus
a true 12% annual cost

1. $100,000 X 0.00033% per day x 365 = $12,165

2 $ 100,000
, X 12 % = $ 12.000
Incremental Cost $ 165

Using the 360 day year increases the cost of borrowing by $165.
Of course, diis difference isn’t significant to any business in a position to use
substantial funds profitably. But the practice increases the lender’s earnings at
your expense.
Also note one advantage you gain when you employ a single payment loan.
You seldom incur a prepayment penalty for retiring a loan prior to the original
maturity date. For example, assume you obtained the $100,000 loan for a six
month, or 180 day, period. However, forty-five days after obtaining the loan, you
find you can repay the lender. The lender will charge you only for the forty-five
days you use the funds, rather tlian for the 180 days. That is a logical, equitable
approach for botli the borrower and lender.

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Leverage Management

The Revolving Loan

A revolving loan is a natural complement to the cash flow cycle in a business.

A revolving loan begins with the lender’ s approval of a specified line of credit,
which authorizes the advance of any loan amount up to that line. However, the
revolving loan agreement involves more than a single advance followed by a
scheduled repayment.
Instead, the loan fluctuates in direct response to the peaks and valleys in a
borrower’s cash flow cycle. Whenever the borrower foresees a demand that will
exhaust his cash reserve, die lender advances funds sufficient to maintain a
positive cash position. Conversely, as the natural cycle generates funds in excess
of those needed for normal reserves, the business repays all or part of the funds
advanced by the lender.
The process repeats itself as often as these peaks and valleys occur in the
firm’s cash flow. Figure 17-1 provides a simplified picture of that relationship.

Figure 17-1
The Revolving Loan and the Cash Flow Cycle

Cash

152
 Leverage: A Mechanical View

Figure 17-1 includes the normal cash flow cycle. However, as suggested by the
overlapping circles, the normal collection of accounts receivable isn’t sufficient
to pay for the inventory purchases in a timely manner. Foreseeing that gap, the
business obtains an advance from its revolving loan to maintain a prompt payment
record. The eventual collection of the receivables repays the advance. However,
while the size of the cash flow gap expands and contracts in response to fluctuating
needs of die business, it seldom disappears completely.
The revolving loan stands as a source of flexible leverage that can answer a
number of business needs that are not served by a single payment or installment
loan.
One measure of flexibility comes from the elimination of any predetermined
repayment schedule. Of course, a revolving loan is not a perpetual, open ended
arrangement. The loan agreement usually matures one year after initiation. So
long as the lender is satisfied with the relationship, he will probably allow annual
extensions or renewals.
The revolving loan also provides flexibility as a source of growth money for
the business that is projecting expansion. If the anticipated growth does not result,
the firm suffers no unnecessary interest expense. Indeed, the revolving loan
imposes no interest expenses except on the funds actually employed. Yet it
provides assurance that the cash needs from expansion will not go unfilled.
Remember the potential benefit as:

Concept 44: A revolvinq loan provides a

source of flexible leverage that
answers a number of cash
needs.

The flexibility to borrow or not to borrow suggests another advantage Uiat

comes with the revolving loan. The borrower pays a simple daily interest rate for
the funds used. This provides reasonable incentive to borrow as little as possible
and to repay as soon as possible. Moreover, that practice benefits both the
borrower and the lender. The borrower can hold die cost of his credit consideration
to a minimum, while the lender is assured that the loan will revolve as agreed. This
fluctuation adds some measure of assurance to the lender regarding the borrower’s
creditworthiness.
A revolving loan does not provide permanent credit consideration. The loan
has a specified maturity date when all unpaid advances fall due. While that usually
results inan extension of the original agreement for anotlier year, the borrower
must meet certain continuing financial requirements. Also recognize that the lack
of positive action to ensure renewal makes the total amount of the unpaid

153
Leverage Management

advances a single payment note on the expiration date of tlie revolving loan
agreement.

The Installment Loan

An installment loan requires repayment of a fraction of the original loan at

regular intervals. The comes on a monthly basis propor-
fraction repaid usually
tionate to the terms of the loan measured in months. For example, each payment
on a $12,000 installment loan in one year will include $1,000 in principal
repayment, plus a portion of the interest due to the lender. One year usually is the
shortest term installment loan available to a business. While shorter terms exist,
they are usually better seiwed by single payment loans. At die other end of die
continuum, it is not uncommon to see an installment loan extend for three, five,
or ten years, depending upon the purpose and circumstance of the loan.
The repayment schedule that distinguishes the installment loan should re-
flect the purpose of the loan.
Most businesses use installmen t loans to purchase fixed assets. Typically those
assets have a useful life that exceeds the term of the loan. So, a business might
employ an installment loan repayable over three years to finance the acquisition
of equipment with a five-year productive life. Of course, die productivity of the
equipment purchased, measured by the cash flow from a rise in revenues or a
reduction in costs, should be sufficient to meet the required loan payments and
provide some bottom-line benefits for the business. The main purpose is summa-
rized in:

Concept 45: Installment loans finance the

purchase of productive assets
that should contribute a positive
cash flow.

When you analyze a prospective fixed asset acquisition, don’ t forget the cash
that flows from the depreciation process. That remains a significant element in
die analysis.

Hybrid Loans

Hybrid loans often combine one or more elements of the three categories of
loans.For example, one hybrid loan mightcallfor installment payments of $2,000
per month for twenty-three months, widi a single “balloon” payment due in the

154
 Leverage: A Mechanical View

twenty-fourtli month. Alternatively, a revolving line of credit might reduce a firm’s

maximum credit line by $10,000 per mondi, allotving the business to fluctuate its
loan within that maximum.
Most often, a lender designs a hybrid loan repayment schedule to corre-
spond with some unique pattern in the borrower’s cash flow. The installment loan
with die balloon payment might reflect die borrower’s limited cash flow in die
early of a fixed asset investment. Presumably, die eventual productivity of the
life

generate the cash necessary for repayment. Similarly, reducing the line
asset will
ofcredit may coincide with the expectation that cash from projected earnings will
reduce the need for borrowed funds.
Don’trestrictyour financial vision to the diree basic types of loans. A creative
lender adapts his credit consideration to your special needs.

Collateral Considerations

Few businesses borrow without pledging collateral to the lender to secure the
loan. That pledge, which may include accounts receivable, inventory, or fixed
assets,may be little more than a formality that adds confidence to the lender’s
credit decision. Or the collateral pledge may directly affect the firm’s borrowing
power.
Standing alone, a collateral pledge to secure a loan seldom justifies credit
consideration. Instead, it provides the final margin of safety that protects a lender.

The role that collateral plays in the credit decision becomes apparent as we review
the rank holds as the anticipated source of repayment for a loan.
it

The primary source of repayment of any credit consideration should come

from tlie normal operations of tlie firm. The source of repayment for a single
payment loan comes from the cyclical or seasonal liquidation of assets held in the
cash flow cycle. Repayment for an installment or revolving loan should proceed
from projected cash flow.
In the latter instance, the lender looks for a historical earnings trend tliat
promises the future profitability necessary to retire any credit consideration.
Those potential earnings also provide a secondary' source of repayment for a
single payment loan if the firm’s cyclical asset liquidation does not proceed as
planned.
Because earnings projections extend into an uncertain future, tlie lender
looks for a potential source of repayment in addition to projected earnings. The
strength held in the borrower’s financial structure usually seiwes as that source.
The lender also measures the ability of a business to absorb a financial setback
without losing the ability to honor its credit consideration.

155
Leverage Management

Finally, the lender seeks collateral as the final hedge against an error in
judgment. If a business generates excessive losses that erode its financial strength
too far, the lender can liquidate the collateral as the final source of repayment.
Thus collateral doesn’tjustify credit consideration. Itmerely adds supportfor the
lender’s positive view of a borrower’s creditworthiness. Collateral simply makes a
good loan better.

Collateral and Borrowing Power

Although collateral does not direcdy justify tlie extension of credit, it often
influences theamount of the credit. Thus an approved loan might become some
proportionate amount of the full value of the pledged asset.
Numerous considerations interact to determine the advance rate, die
maximum loan a lender will grant against any collateral. However, the credit-
worthy borrower can expect the following general relationships to hold true:

Probable Loan Limits

Advance (per each $10,000 in
Collateral Rate collateral value)

Accounts Receivable 60-80% $6,000-8,000

Inventory 20-50% $2,000-5,000
Machinery and Equipment 70-90% $7,000-9,000

The specific applicable advance rate varies widely with the circumstance. For
example, a financially strong borrower qualifies for a higher advance rate than a
business confronting a major cash flow problem. And the more certain the value
held in the collateral, the more the lender is likely to advance.
The advance rate also will vary among lenders. Commercial finance com-
panies feel comfortable advancing funds at rates that approach the high end of
the ranges listed above. Alternatively, banks will be more likely to adopt the lower
limits. Moreover, lenders within the same category often adopt different views.
Lenders still rely primarily on the profitability and financial strength of the
borrower. Collateral doesn’tjustify a loan; it merely increases the probability of
repayment.

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r
Chapter 18

Leverage: A Practical View

Few business managers have the time or inclination to measure the risks
associated with the use of leverage.Nor do they typically calculate die relationship
between the cost and return on assets financed widi any debt.
Instead, most adopt a practical, functional approach to borrowing. They use
leverage to solve a problem or to serve a specific, profitable purpose. This chapter
will identify the practical purposes diat encourage businesses to borrow and
illustrate the potential benefits.

The Need to Borrow

No business should incur any debt haphazardly. Any debt a business uses
should serve a specific, well-defined purpose.
Borrowed funds may solve a problem, facilitate growth, or merely provide the
cash capability to support a larger, more profitable investment in inventory.
Whatever the circumstance, a clear purpose should precede the assumption of
any obligation.
When you borrow, you accept the risk that the funds will no t return an amount
sufficient to pay the cost of borrowing. Tliat failure will hurt your earnings.
You also accept the risk that your business might lack die capacity to honor
its debt obligation in a timely manner. This is the risk of default. Should the lender

allow an extension or renewal, you will suffer no more than a measure of financial
embarrassment. Of course, chances are that the potential default will limit future
credit consideration, limiting your firm’s future prospects.
Leverage Management

Finally, in the most unfortunate circumstance, you also accept the risk that
the ultimate inability to honor your credit obligations satisfactorily will lead to
financial failure. This is the risk of bankruptcy.
A business may borrow to satisfy any number of objectives. However, most
circumstances fall into several categories. Businesses commonly borrow to:
1. Solve a cash flow problem,
2. Facilitate growth,
S. Generate supplier profits, and
4. Enhance financial flexibility.

Let’s review some examples that illustrate each purpose.

Using Leverage to Solve a Cash Flow Problem

In the broadest sense, any use of leverage solves a cash flow problem. After
all, the business with sufficient internal cash capability achieves its business ob-
jectives without external financing. However, borrowing to solve a cash flow
problem seldom arises from a threat to a company’s financial integrity. It might
earn less because it grows more slowly or misses supplier discounts, but the lack
of external financing doesn’t cause financial embarrassment.
Let’s consider the potential benefits a business derives from using leverage
to (1) fill a gap in the cash flow cycle, and (2) gain the cash capability necessary
to achieve a profitable level of operations. Although more than one potential
solution exists for many of these problems, we will assume the business manager
recognizes the fundamental precepts of component and structural management.
Proceeding from that premise, she finds the use of leverage the logical solution
to her problem.

Filling a Gap in the Cash Flow Cycle

A business has a gap in its cash flow cycle whenever it lacks the capacity to
meet all of its obligations in a timely manner. The problem appears when accounts
payable remain unpaid beyond the seller’s original terms, or when scheduled
note payments fall past due, or, in the worst circumstance, when the business fails
to pay its employees prompdy.
A simple example demonstrates a natural business circumstance diat leaves
a gap in the cash flow cycle. Leverage erects the natural bridge across that gap. The
example also reestablishes a fundamental concept that remains critical to positive
cash flow management.

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 Leverage: A Practical View

The example comes from tlie experience of die Tyson Company, an archi-

tectural design firm. As a financially conservative operation, Tyson traditionally

has functioned on a cash basis. The firm used no debt.
However, a recent management decision created a cash flow problem that
necessitated a change in that policy. The problem came with the acceptance of a
design conUact thatled to a $100,000 increase in die firm’s monthly revenue. The
terms of die contract, coupled with the special nature of Tyson’s business, created
an inevitable gap in the cash flow cycle.
One element of that problem stemmed from Tyson’s employee payment
practices. The firm paid its employees twice a mondi, on the fifteenth and the
thirtieth.
The other element came from the terms of die new contract. Tliose terms
restricted Tyson to a monthly billing schedule for work performed by the em-
ployees.
Moreover, the contract allowed Tyson’s customer an additional thirty days
for payment after the
billing date. Table 18-1, a simple cash budget, identifies the
gap in Tyson’s cash flow that develops naturally from these circumstances.

Table 18-1
A Gap in the Ca^sh Flow Cycle
Tyson Company

Cash Out Cash In Cash Gap

9/15 $45,000 — $ 45,000

9/30 45,000 — 90,000

10/15 45,000 — 135,000

10/30 45,000 $100,000 80,000

11/15 45,000 — 125,000

11/30 45,000 100,000 70,000

The firm must meet payroll and cash overhead requirements for three pay
periods prior to receipt of payment for the first month’s billing. The budget projects
a maximum $135,000 gap in the middle of the second month. The gap drops to
$80,000 after Tyson collects payment for the revenue billed at the end of the first
month, then it builds again to $125,000.
Lacking adequate cash reserves, Tyson must use leverage to fill the gap or risk
defaulting on the contract. That valuable contribudon from borrowed funds earns
recognition in:

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Leverage Management

Concept 46: Leverage can fill a gap in your

cash flow.

A gap in cash flow may be more subtle tlian in the case of Tyson Company.
A business may watch a prompt payment record deteriorate as a shrinking bank
account forces a deferral of payments to suppliers. Or a business may find itself
short of the cash required to retire a single payment note originally extended for
ninety days. In fact, a business may have a large gap in its cash flow that is not
directly apparent. The following section illustrates that circumstance.

Filling a Hidden Gap in the Cash Flow Cycle

A business with sufficient cash capability measured by the requirements set

by its investment in operating funds, accounts receivable, and inventory can still
suffer from a gap in its cash flow.
This hidden problem occurs whenever a business improperly matches die
form of its debt to its needs. Table 18-2 summarizes the circumstance of Darnell,
Inc., a modestly successful automobile parts distributor. The firm’s cash flow cycle
reflects three characteristics:

1 . Darnell presently generates $90,000 a mon th in sales, which produces $3,500

a month in earnings.
2. A forty-five
day average collection period (not subject to reduction) ti ans-
$135,000 investment in accounts receivable.
lates into a
3. The $189,000 in inventory, sufficient for diree mondis’ sales, represents the
minimum practical investment for die present sales volume.
Despite the firm’s success, the balance sheet summary in Column 1 reflects
haphazard leverage management that could lead to a serious cash flow problem.
That problem could come from two sources.
First, supplier trade terms prevalent in the industry typically require payment
thirty days after purchase. However, Darnell’s accounts payable represent two
mondis’ purchases. Thus $63,000 out of that total is one to thirty days past due.
Second, Darnell’s balance sheet includes a $74,000 single payment note.
Wliedier that note is due in one day or ninety days is less important than the fact
that Darnell lacks sufficient cash to honor it. The firm’s investment in receivables
and inventory not subject to reducdon; nor
is is a significant increase in cash
reserves from earnings likely.

160
 Leverage: A Practical View

Table 18-2
Leverage Management: Matching Form to Circumstance
Darnell, Inc.

Before After
Restructuring Restructuring

Cash $ 11,000 $ 24,000

Accounts Receivable 135,000 135,000

Inventory 189.000 189.000

Total Assets $335,000 $348,000

Accounts Payable $126,000 $ 63,000

Single Payment Loan 74,000 —
Installment Loan — 150.000

Total Liabilities $200,000 $213,000

Stockliolders’ Equity 135.000 135.000

Liabilities and Equity $335,000 $348,000

Darnell presently has a $1 37,000 gap in its cash flow. This represents tlie total
necessary to honor the existing credit consideration as agreed. The indulgence
displayed by the firm’s creditors provides the cash capability necessaiy for a
$90,000 monthly volume, but maintaining that volume remains subject to the
whim of suppliers anda lender who may not renew or extend a single payment
note.
Consider tlie potential benefit Darnell can derive from rational leverage
management. Assume that the company negotiates a $150,000 installment loan
repayable over seven years, perhaps guaranteed by the Small Business Adminis-
tration (see Chapter 20) Tlie company uses the proceeds from the loan to retire
.

the single payment loan and pay all past due accounts payable. Also, Darnell gains
a $13,000 contribution to its cash reseiwes.
In this instance, one form of leverage merely replaces another. But the al-

ternative form eliminates the gap in the firm’s cash flow. No accounts payable
remain past due. Darnell has no risk of defaulting on a single payment note. The
firm’s earnings are more than sufficient to amortize tlie montlily payment
required to repay the installment loan. So, Darnell no longer operates at die mercy
of its creditors. The potential benefits from leverage in diis instance can be
summarized in:

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Leverage Management

Concept 47: A potential gap in a firm's cash

flow is not always obvious.

Darnell’s experience directly demonstrates the relationship between debt

service requirementsand the cash flow in a business. This relationship often
becomes an important element in a lender’s decision to extend credit consider-
ation. It also should influence your decision to accept that consideration.

Achieving a Profitable Level of Operations

Leverage can help a business achieve a profitable level of operations. But tliat
holds true only when insufficient cash capability is the only obstacle to profit-
ability.

The case of Bayline Bolt Corporation in Chapter 11 illustrated this potential

use of leverage. There the $100,000 used to start the business provided cash
capability sufficient only for a break-even sales volume. The firm’s natural cash
flow cycle at that volume absorbed the full $100,000 in cash.
Then Bayline’s founder negotiated $30,000 in trade credit consideration,
which provided the cash capability necessary for a profitable sales volume. Re-
member, however, that this potential realistically exists only when limited cash
capability is the only obstacle to a profitable sales volume. So remember:

Concept 48: Leverage may provide the cash

capabilitv necessary to achieve
a profitaole sales volume.

Cash Flow Concept No. 48 is most beneficial for a business operating within
reasonable proximity of its break-even sales volume, as in Bayline Bolt’s circum-
stance. In that event, a relatively small increase in sales can have a dramatic effect
on earnings.
At the same time, the farther a business is from that break-even point, the
more questionable the potential benefits from external financing. If the distance
becomes too great, the business will be unlikely to find a lender to extend such
financing.

Using Leverage to Increase Supplier Profits

Many businesses use leverage to facilitate profitable purchase and payment

practices that help increase earnings. In general terms, these benefits are supplier
profits.

162
 Leverage: A Practical Vie>v

The business with sufficient cash capability doesn’t have to use leverage to
benefit from supplier profits. Cash capability, not borrowing, provides the ben-
efits. But a business often justifies the use of leverage and the associated cost to
gain the cash capability to take advantage of substantial supplier profits.

Using Leverage to Take Cash Discounts

You will often find you can profit from using leverage to gain the cash ca-
pability necessary to take cash discounts suppliers allow for early payments. Let’s
examine a case that identifies the actual dollar benefits.
The Bonner Company purchases $200,000 in merchandise each month to
maintain investment in inventory at a level appropriate for its projected sales
its

volume. Half of the firm’s suppliers offer a 2% discount for payment within ten
days, requiring payment in full in tliirty days. Bonner is losing tliose discounts,
although it has the cash capability to pay in thirty days. Presently, the discounts lost
reduce Bonner’s annual earnings as follows:

$1,200,000 X 2% = $24,000

Recognizing the substantial profit penalty imposed by insufficient cash ca-

pability, management decides to borrow the funds necessary to take the 2% dis-
counts.
Since half of the total mondily purchase includes the potential discounts,
Bonner needs two-thirds of that amount to pay for all such purchases in ten days,
leaving ten days’ discountpurchase constandy outstanding. Bonner needs $66,666
to achieve that objective.
Assuming the firm incurs a 12% annual borrowing cost, we can calculate the
potential bottom-line benefits:

Total Annual Discounts Taken $24,000

Annual Borrowing Cost
($66,666) X 12% 8.000
Net Bottom-Line Benefits $16,000

Thus leverage leads to substantial bottom-line benefits when it provides the

capability necessary to take cash discounts.
Note that Bonner would increase earnings even if the necessary leverage cost
24%, or even 30% per year. So don’t let the presumed high cost of borrowing
make you miss out on an increase in earnings. Always measure the actual dollar
cost against the potential benefits.

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Leverage Management

Using Leverage to Take Quantity Discounts

Quantity discounts stand as aless obvious form of supplier profits that can
of leverage. However, tlie potential benefits usually fall well below
justify the use
those from trade discounts. This follows logically when you remember that as you
increase the size of your inventory purchases, you also increase die size of your
average investment in inventory. This, in turn, increases the carrying costs asso-
ciated with that component of the cash flow cycle. Adding leverage costs to
carrying costs can significandy diminish the potential held in quantity discounts.
Nevertheless, the potential does exist. In die proper circumstances, the financial
benefits can be substantial.
The Assembly Company manufactures standard desk lamps. The company
component parts of the lamps. Instead, it purchases
doesn’t produce any of the
each component from various suppliers. Projections for die upcoming year
suggest the realistic potential for the sale of 20,000 desk lamps. Beginning with
that projection, the firm measures the potential increase in earnings available from
suppliers’ quantity discounts.
The analysis began with lamp
a look at the quantity discounts offered by the
base supplier. Table 18-3 includes die supplier’s price structure. Thus the unit
price drops from $4.00 to $3. 10 when a business increases its order size from 1 ,999
to 10,000 units.
Beginning with that schedule, the Assembly Company proceeded with the
analysis on the following assumptions:
1. The company could make twelve monthly purchases of 1,666 units each or
two semiannual purchases of 10,000 units each.
2. The total acquisition and inventory cariying costs incurred in the two alter-
natives are exacdy equal.
3. To purchase the lamp bases, the company will have to borrow an average of
$20,000 for the year, incurring $2,400 in interest costs.

A glanceat Table 18-3 finds that the Assembly Company reaps substantial
benefits from the quantity discounts associated with the larger lot purchase, even
after considering the leverage cost. We emphasize this potential benefit from
borrowed funds in:

Concept 49: Leveraae can lead to supplier

profits from cash and quantity
discounts.

164
 Leverage: A Practical View

Table 18-3
Using Leverage to Obtain Quantity Discount
The Assembly Company

Lot Size Unit Price

2.000-
0-1,999
5.000- $4.00
4,999 $3.70
9,999 $3.40
10,000 + $3.10

Ann ual Cost Based Ann ual Cost Based

on Twelve Monthly on Two Semiannual
Purchase Orders Pm-chase Orders
(1,666 each) (10,000 each)

Total Units 20,000 20,000

Unit Cost $4.00 $3.10

Annual Purchase Cost $80,000 $62,000

Plus: Leverage Cost 2.400

Total Cost $80,000 $59,600

Next, let’s touch on die benefits that can develop when leverage provides a
business widi some financial flexibility.

Using Leverage to Gain Financial Flexibility

Tlie flexibility that leverage pro\ides enables a business to effect profitable

decisions that otherwise might be precluded by a limited cash capability. Some of
those decisions may involve special, one time opportunities for profit.
For example, a business might use its financial flexibility to take advantage
of a special supplier discount in exchange for immediate cash payment. Or the
firm may pursue a larger prospective customer, certain that it has die cash
capability necessaiy to service the customer’s needs.
Here we will emphasize the ongoing bottom-line benefits available to the
business that properly exercises its financial flexibility.
A business might use that flexibility to eliminate discounts from its selling
terms, using the cash capability from the leverage to carry die large investment in
receivables that resultsfrom that policy.
margin warrants, your financial flexibility might allow you to
If your profit
carry that policy anodier step and extend longer selling terms to induce a higher

165
Leverage Management

sales volume. Obviously, you must carefully weigh the cost against the benefits. But
if the potential profits and your financial flexibility prove sufficient, the longer
selling terms may make good business sense.
In any event, note the point of these examples in:

Concept 50: Leverage can provide financial

leads to bottom-
flexibility that
line benefits.

In other circumstances, you might use that financial flexibility to carry a

larger investment in inventory, to move into other product lines, or to expand
your geographical market. Even the conservative business manager benefits from
the financial flexibility provided by leverage. She knows that she has the cash
capability necessary to absorb a financial setback.

Using Leverage to Serve Special Objectives

A business might profitably use borrowed funds to increase sales, take

discounts, or fill a gap in its cash flow cycle. In each instance, however, those
benefits ensue because leverage serves as a natural complement to the firm’s
existing cash capability.
However, a business can also use leverage in cases that are not directly related
to normal operations and that don’t contribute directly to an increase in cash
its

capability or earnings. For example, a business might borrow to buy out some of
its stockholders or to facilitate the acquisition of another operation. In another

circumstance, debt may provide the cash to pay dividends.

Although such objectives may directly or indirectly benefit the business, they
represent unique circumstances that exceed our concern. At the same time,
recognize that any leverage a business employs inevitably affects the cash flow
process. After all, the business that borrows must repay.

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r
Chapter 19

Leverage from the Trade

A supplier contributes leverage to your business whenever he extends open

account credit consideration. This credit consideration allows you to defer cash
payment for a purchase in accordance with the supplier’s standard selling terms.
Conceptually, trade credit provides the same benefits to a business as any
other form of leverage. It increases your cash capability and enables you to satisfy
objectives that might remain out of reach
in the absence of external financing.
However, it is more closely intertwined with the cash flow cycle than any other
form of leverage.

The Mechanics of Supplier Lending

Properly managed, trade credit becomes a hybrid form of the three principal
lending methods discussed in Chapter 17. Trade credit provides a permanent
tlie form of an infinite series of single payment loans.
revolving loan in
Rather than the borrower executing a formal note each time he makes a
purchase, the credit consideration becomes part of the firm’s accounts payable,
the accounting record of amounts due to all suppliers. Each account represents
a promise to pay for a purchase within the allotted time set by the supplier’s
payment terms.
However, trade credit can provide a constant contribution to the cash
capability in a business. Accounts payable, a current liability, becomes permanent
Leverage Management

leverage. A brief look at die experience of the Boone Company with a single
supplier demonstrates that potential.
The Boone Company, a regional manager of trailer axles, recently placed a
$10,000 order for wheel bearings with a new supplier. The supplier approved
open account credit consideration for the purchase in line with the industry’s
standard thirty day terms. Thus payment for the September 1 purchase falls due
on October 1.
Concomitant with the payment scheduled on October 1, Boone repeats the
$10,000 purchase on the same thirty day terms. The simultaneous transactions
lead to a $10,000 continuous contribution to Boone’s cash capability. The
following transaction record illustrates that contribution:

Creditor’s Contribution to Cash Capability

Date Purchase Payment Capabilitv

9/1 $10,000 — $10,000

10/1 $10,000 $10,000 $10,000

Assuming that Boone continues the same purchase/payment cycle, the roll-
over effect translates into a $10,000 revolving line of credit that becomes a
permanent addition to the firm’s cash capability. Similar consideration from a
number of suppliers provides Boone with the support necessary to carry a
profitable investment in inventory.
Before we take a closer look at the Boone Company, let’s review an approach
to analyzing the benefits held in the alternative supplier selling terms.

Comparing the Alternatives

Two interrelated factors ultimately determine the size of the contribution to

cash capability that comes from a supplier’s credit consideration. The primary
influence comes from the supplier’s estimate of his customer’s creditworthiness.
The higher the estimate, the larger the line of credit extended. That line sets the
maximum credit consideration available to the customer at any point. Viewed
from our special perspective, the line of credit sets the maximum contribution a
supplier will commit to the cash capability in a business.
Of course, a business often qualifies for credit lines tiiat exceed its purchase
requirements. In such instances, the supplier’s selling terms specify the cash
capability the business draws from that consideration. Obviously, tiie longer a
supplier allows for payment, the larger the contribution he makes to your cash
capability.

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 Leverage from the Trade

We will illustrate the analytic approach that helps identify the appropriate
supplier when cash capability is the primary consideration. However, this is not
always the ruling factor that selects one supplier instead of another. Many
businesses favor supplier discounts for early payment over tlie additional cash
capability that comes from larger lines of credit or longer terms for payment. Our
illustration also includes that alternative view as an element in the comparative
analysis of supplier selling terms.
Table 19-1 summarizes an analysis performed by Any Company, a diversified
conglomerate. The analysis begins with the following facts:

1 . As a logical necessity for good employee relations. Any Company purchases

$10,000 in each mondi for internal use.
toilet tissue

2. Six potential suppliers (tagged by alphabetical designation in Table 19-1)

can provide a competitive product.
3. The list purchase price from any of the six suppliers is the same.

4. Each supplier approves an unlimited line of credit for Any Company.

Despite and financial strength. Any Company follows a regular

its size
pattern of analysis when no price differential exists among prospective suppliers
of the same product. That analysis examines the competitors’ selling terms from
two perspectives. Each perspective usually favors different suppliers. One perspec-
tive considers the bottom-line benefits that Any Company can gain from discounts

allowed for early payment.

Table 19-1
Cash Capability and Profit Potential
Available from Alternative Credit Terms
(Assumes $10,000 in monthly purchases)

Maximum Maximiun
Potential Potential
Contribution Contribution
to Cash to Annual
Supplier Selling Terms Capability Earnings
A Net 10 ROG
(receipt of goods) $ 3,333
B 1% 10, net 30 10,000 $ 1,200
C 2% 10, net 30 10,000 2,400
D Net 30 10,000
E Net 45 15.000
F Net 60 20.000

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 s

Leverage Management

Note in Table 19-1 that Supplier C’s discount for payment in ten days ratlier
than thirty gives that firm the advantage. Buying toilet tissue from Supplier C each
month for a year yields a $2,400 benefit for Any Company.
The other perspective of Any Company’s analysis contributes information to
a contingency plan for operating in a tight money period. The plan calls for
conservation of the company’s cash as a singular corporate objective during such
periods. Thus, if effected. Any Company will switch its preference from suppliers
who offer discounts to those who provide the largest contribution to the firm’s
cash capability.
Note diat Supplier F’ s sixty day credit terms will gain the firm Any Company’
business in a tightmoney period. These terms provide the maximum potential
contribution of $20,000 to Any Company’s cash capability. That will contribute to
the contingency plan’s primary objective —retention of as much cash in the
business as possible, without eliminating toilet tissue as an employee benefit.
Even though Any Company’s circumstances remain hypodietical, die con-
siderations involved in the alternative decision criteria remain valid. The firm with
adequate cash capability will favor the profit potential available from discounts
even though a business has to borrow to realize diose benefits. Certainly, die cost
of institutional credit seldom exceeds the cost of lost discounts.
Alternatively, die business suffering fi om a fight cash flow abandons trade
discounts in favor of longer terms for payment. Longer terms contribute capabil-
ity that can ease the strain imposed by a cash flow problem.
In both cases, you should remember the tenet held in:

Concept 5 1 : Use the supplier credit terms

that answer the needs of your
business.

Typically, the analysis of alternative supplier credit remains less complicated

than implied in Table 19-1. Suppliers in any industiy usually have similar
designated selling terms. Of course, compare any alternatives that do exist.
From another perspective, the analytic tasks increase in complexity when
you look at implied terms rather than designated terms. Of course, prompt pay-
ment habits open die door to the maximum benefits available from supplier
credit consideration. However, in the midst of a cash flow crunch, you might find
welcome relief from a supplier who designates thirty days for payment but
continues shipments to customers who fall thirty days or more past due.
Because implied terms are nebulous, diey are less subject to objective
analysis. Neverdieless, the careful manager can expand the cash capability in his

170
 Leverage from the Trade

business witli the aid of lenient collectors. Don’t abuse the privilege, but don’t
overlook the potential.

Average Payable Period

Average payable period measures the average length of time that you use
each dollar of trade credit consideration.
To illustrate the calculation process and how it contributes to positive cash
flow management, let’s assume that the Control Company has $170,000 in total
accounts payable at the end of the first quarter of operations for the year. During
this quarter. Control received trade credit consideration for $240,000 in total
purchases. In a ninety day quarter, that translates into $2,666 in average daily
purchases. To calculate the average payment period for the accounts payable diat
remain unpaid at the end of the quarter, we can use the calculation:

Average Payment Period = Account Payable

Average Daily Purchases
on Account
Using the Control Company’s circumstance:

Average Payment Period = $170,000

$ 2,666
Average Payment Period = 64 Days

Each dollar of trade credit consideration contributed to tlie Control Com-

pany remains in tlie business for sixty-four days before being returned to the
supplier in the form of a cash payment.
We summarize the importance of that measure in:
Concept 52: Average payable period defines
the relationship between trade
credit and the cash flow
process.

Recognizing that relationship becomes a critical consideration in cash flow

management.

The Complete Cash Flow Cycle

A conceptual view of the cash flow cycle includes cash, accounts receivable,
and inventory. However, this view is incomplete for most established businesses.

171
Leverage Management

In most businesses, the cash flow cycle should include accounts payable as a
natural component.
As the Boone Company’s experience indicated, the business that maintains
aprompt payment record gains a permanent contribution to its cash capability.
Thus accounts payable (supplier credit consideration) substitute for the cash
purchase of inventory. Sales convert that inventory into accounts receivable.
Proceeds from the collection of the receivables provide the cash to retire the
original credit consideration. Then the cycle begins again.
Of course, a supplier’s selling terms seldom coincide witli the cash conver-
sion period in a business —the length of time it takes to convert a customer’s order
into a collected account. So accounts payable cannot substitute entirely for cash.
Instead, they supplement the original cash invested in a business.
This leads us to a view of the complete cash flow cycle in Figure 19-1. The cash
investment coupled with accounts payable provides the total capability necessary
for tlie purchase of inventory. The cycle then proceeds normally. However, part
of die cash collection retires the original supplier debt, with the remainder the —
—
gross profit margin returning to the firm’s cash account. That cash pays
expenses, while any excess buys more inventory. So long as the cycle operates
satisfactorily, accounts payable remain a natural part of die complete cash flow
cycle.

Figure 19-1
The Complete Cash Flow Cycle

Gross Profit Margin

Let’s further refine our view of the role trade credit plays in a properly
managed cash flow cycle and interrelate the payable period widi the requirements
set by a firm’s cash conversion period.

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 Leverage from the Trade

A closer look at the Boone Company and its presen t operating characteristics
helps demonstrate the interrelationships:

1. Sales presently average $2,000 per day, or $60,000 per month.

2. A sixty-day average collection period leaves the firm with a $120,000 invest-
ment in accounts receivable.
3. Product costs average 75% of each sales dollar.
4. The company maintains inventory on hand sufficient for two months’ sales;

the sixty-day average investment period translates into $90,000 in inventory.

5. Experience indicates a forty-day average payable period satisfies supplier
implied terms for payment.
6. Boone maintains a minimum $10,000 cash operating balance.
Figure 19-2 provides a view of Boone’s complete cash flow cycle. The
company has $220,000 in total assets revolving in the cash flow cycle. Accounts
payable, with a forty-day average payment period, provides the cash capability for
$60,000 of that amount. Purchases average $1,500 per day.

Figure 19-2
Trade Creditors Contribution to Cash Capability
The Boone Company

- $220,000 >

$220,000

173
Leverage Management

This leaves $160,000 in cash capability that comes from the company’s
original cash investment and retained earnings. Now, let’s see how a change in the
company’s operations affects tliose interrelationships.
First, holding the above operating characteristics constant, let’s see how an
increase in sales affects the firm’s financial structure in Figure 19-2. Assume tliat

the company manages an instant 50% We

can anticipate the
increase in sales.
effect the sales increase has on the company’s assets. The investment in cash,
accounts receivable, and inventory increases by 50% or a total of $110,000.
To maintain the necessary balance, other changes in the firm’s financial
structure must provide the cash capability to carry the higher asset investment.
The support that comes from trade creditors emphasizes the natural place
accounts payable hold in the complete cash flow cycle.
As sales increase, the cash capability contributed by trade creditors also rises
in line with the higher volume. Of course, that increase occurs only so long as a
business satisfies its supplier requirements for prompt payment.
The business must maintain an average payable period consistent with
supplier expectations. In the Boone Company’s circumstance, that means paying
for purchases in no more than forty days. At the same time, it must continue
all

to satisfy the credit standards set by its suppliers. The firm must qualify for the
higher lines of credit. However, presuming the business satisfies those constraints,
trade credit usually expands in direct proportion to sales volume. Figure 19-3
demonstrates how that conti ibution affects Boone’s cash flow cycle. We note this
fact in:
Figure 19-3
Spontaneous Increase in Trade Credit

$ 330,000

- $ 330,000

174
 —
Leverage from the Trade

Concept 53: Trade credit provides a

spontaneous increase in cash
capability for a growing
business.

The spontaneous increase in trade credit consideration provides $30,000 of

$110,000 in cash capability necessary to support the higher investment in assets.
Boone’s financial strength and ability to maintain a forty-day average payable
period encourages its suppliers to grow with tlie business. To support the sales
increase, the Boone Company has to obtain $80,000 in cash capability from other
sources. Nevertheless, the spontaneous increase in trade credit is a significant
source of financing for expansion.

Trade Credit Criteria

The benefits you derive from trade credit partially depend on the line of
credit each supplier approves for your business. Of course, that line comes from
the supplier’s estimate of your creditwordiiness. Before extending any credit, he
assesses your capacity to pay.
The complexity of the assessment depends upon the circumstances of the
sale. A large sale to an existing customer or any sale to a new customer might call

for extensive financial analysis similar to that performed by institutional lenders.

However, most trade credit decisions center on one pivotal consideration
payment history. Presuming that past history predicts future performance, the
supplier estimates the probable payment pattern for future purchases.
A long, prompt payment history makes trade credit consideration easily
accessible for a business, while a record for slow payment may resti ict a firm to little

or no consideration. However, often a business achieves favorable results from a

payment history that remains consistent, although it exceeds the supplier’s
designated terms. Table 19-2 helps demonstrate that fact with a review of the
payment buy from the Large Company.
histories of three businesses tliat
All three customers have purchased the same amount from the company in
the last six mondis. All three also have recently entered new orders for $10,000
purchases. The company’s credit manager approves immediate shipment to the
Established Company. The firm’s recent history indicates prompt payment in
accordance with the Large Company’s designated tliirty-day terms.
The credit manager also approves immediate shipment to Contiolled
Growth, Inc. Although Controlled Growth does not pay within the designated
terms, it does follow a consistent payment pattern. The firm lets no payment fall
more than thirty-days past due.

175
Leverage Management

Table 19-2
The Supplier’s Credit Decision

Outstanding
at Month’s 1-30 31-60 60-90
Month Purchases End Current Past Due Past Due Past Due

The Elstablished Company

January $10,000 $10,000 $10,000
February 12,000 12,000 12,000
March 15,000 15,000 15,000
April 10,000 10,000 10,000
May 20,000 20,000 20,000
June 10,000 10,000 10,000

Controlled Growth, Inc.

January $10,000 $20,000 $10,000 $10,000

February 12,000 22,000 12,000 10,000
March 15,000 27,000 15,000 12,000
April 10,000 25,000 10,000 15,000
May 20,000 30,000 20,000 10,000
Jiuie 10,000 20,000 10,000 10,000

The Problem Company

January $10,000 $10,000 $10,000
February 12,000 12,000 12,000
March 15,000 20,000 15,000 $5,000
April 10,000 25,000 10,000 15,000
May 20,000 40,000 20,000 10,000 $10,000
June 10,000 45,000 10,000 20,000 10,000 $5,000

This Many trade credit decisions rely as much on

illustrates a critical point.
payment as on prompt payment, even though the consistent pattern
consistent
may exceed the boundaries set by the creditor’s designated terms. Such consis-
tency usually improves a firm’s potential credit consideration.
A look at Large Company’s third customer, tlie Problem Company, suggests
the rationale behind that presumption. The firm’s prompt payment record has
deteriorated over its recent six month history. Indeed, it is ninety days past due for

176
 Leverage from the Trade

some purchases. That changing pattern probably disqualifies die Problem Com-
pany from any new credit consideration. The slower payment record suggests a
cash flow problem approaching serious proportions.
Payment history isn’t the only element in a supplier’s credit decision, but
consistent payment habits in accordance with the designated terms, or at least
within a reasonable period, help reassure a supplier. Practicing consistent pay-
ment habits can increase the cash capability a business gains from trade credit.

Supplier Relations

Adiscussion of the elements that contribute to a sound relationship between

a business and its suppliers may seem out of place in a book that concentrates on
cash flow management. But the working relationship you have widi your suppliers
has a direct influence on your cash capability. That reladonship affects both the
amount and the terms of the credit consideration your business receives.
Making a major purchase from any supplier involves considerations diat
proceed beyond any potendal credit consideradon. Price structures, product
lines, delivery schedules, and service capabilities also remain relevant. However,
most businesses eventually establish ongoing relationships with their major
suppliers. Once a business establishes such reladonships, it should seek to develop
and maintain the maximum potential cash capability from each supplier’s credit
consideradon.
Two management pracdces contribute to good supplier relations. First,
practice consistent payment payment upsets even die most
patterns. Erratic
padent suppliers. So long as they know when to expect payment for purchases,
even if persistendy late, they can feel comfortable widi the reladonship.
Second, keep the lines of communication open. The more a supplier knows
about your business, the more he can respond to your needs. After all, your
purchases presumably represent profitable sales for his business. The better he
responds to your needs, the more bottom-line benefits he realizes.
From a positive perspecdve, inform major suppliers of your purchasing
plans. Tell them if your projected requirements for credit consideradon exceed
presendy approved lines. In this way, you can lay the groundwork for approval by
giving your suppliers the information that will facilitate the credit decision
process.
From another perspecdve, open lines of communication can help you slip
unscathed through a cash flow problem. Don’t let a supplier learn about that
problem from a break in your payment pattern. Instead, inform him in advance

177
Leverage Management

that you cannot pay according to your usual pattern. Explain your circumstance
andyour problem. Then offer the best estimate of your revised payment schedule.
Most trade creditors can live with a past due account.
Of course, the best supplier relations will not lead to unlimited credit
consideration or to a cure for every cash flow problem, but they often can lead to
more credit consideration and less pressure for prompt payment.

178
r
Chapter 20

Leverage from the Bank

When a business manager seeks leverage in excess of the amount available

from trade creditors, she first looks to her banker. In fact, bank loans are the
second largest form of external financing used by businesses. This chapter
discusses bank credit consideration as an element in cash flow management.

Cash Capability and the Single Payment Loan

The single payment loan serves a specific purpose and has a predetermined
source of repayment. Of course, die purpose may not be fulfilled as predicted, nor
does the repayment always follow prompdy. Nevertheless, the premise that
justifies a single payment loan idendfies each.
The experience of Fawn Chemicals, Inc., demonstrates die contribution that
a single payment loan makes to a business and emphasizes the proper relationship
between the purpose of the loan and the ultimate source of repayment.
Fawn Chemicals manufactures fertilizer for sale to large agricultural produc-
ers.The operating characteristics of the business require a seasonal, single
payment loan. Fawn purchases the chemicals necessary for the fertilizer manufac-
turing process in January of each year. Chemical suppliers allow Fawn thirty day
terms, so all accounts payable must be retired by the end of February.
Fawn’s customers purchase the fertilizer during die planting season in
March and April. However, the producers command terms that allow six months
for payment. This means they defer payment until after they sell their harvests in
September or October.
Leverage Management

Table 20-1 summarizes the natural chain of events that justifies the use of a
single payment loan. The successive financial structures reflect the following
additional characteristics of Fawn Chemicals:

1. Fawn ends each year witli no investment in accounts receivable or inventory,

and it has no debt. At 12/31/90, that left tlie firm with $400,000 in cash,
$100,000 in fixed assets, and a $500,000 net worth.
2. Projections indicate that Fawn will earn $140,000 from a $1,000,000 sales
volume in the upcoming year.
3. That sales volume will require the purchase of $560,000 in agricultural
chemicals.
4. The firm’s operating expenses, including interest costs, average $20,000 per
month.
5. The firm incurs $100,000 in manufacturing expenses, all paid in February.

Table 20-1
The Mechanics of a Single-Payment Note
Fawn Chemical Company

(Fiscal Year End)

12/31/90 1/31/91 2/28/91 4/30/91 10/31/91

Cash $400,000 $280,000 $160,000 $ 120,000 $540,000

Accoiuits Receivable — — — 1,000,000 —

liiventory — 560,000 560,000 — —
Fixed Assets 100.000 100.000 100.000 100.000 100.000

Total Assets $500,000 $940,000 $820,000 $1,220,000 $640,000

Accounts Payable — $460,000 — — —

Bank Loan $460,000 $460,000

Total Liabilities — $460,000 $460,000 $460,000 —

Stockholders' Equity $500,000 $480,000 $360,000 $760,000 $640,000

Liabilities and Equity $500,000 $940,000 $820,000 $1,220,000 $640,000

Let’s trace the chain of events that justifies the need for the single payment
loan and also provides a natural, predictable source of repayment.

180
 Leverage from the Bank

First, in January, Fawn purchases the $560,000 in chemicals necessary for the
projected sales volume. The company pays $100,000 in cash for part of the
inventory, while suppliers allow the balance to be paid in February. As indicated
in Column 2, that leaves the firm with $460,000 in accounts payable due by
February 28. Even the firm’s healthy $280,000 cash balance is insufficient to satisfy
the obligation.
(Observe the $20,000 cash drain imposed by operating expenses for the
month ofJanuary. The lack of any revenue during that period translates that into
a matching $20,000 reduction in the stockholders’ equity account.)
In February (Column 3), Fawn obtains a $460,000 bank loan to retire the
entire amount due to suppliers. The bank extends the single payment loan with
repayment required on or before October 31, 1991. Of course, Fawn incurs
$20,000 in operating expenses again in February; also the firm must absorb the
$100,000 in fertilizer manufacturing expenses. The 2/28/91 financial statement
registers die effects that those expenses have on bodi the cash and equity
accounts.
As predicted. Fawn sells its entire inventory by 4/30/91. The firm registers
those sales in the form of $1 million in accounts receivable. All of the accounts
come due no later than October 31.
Column 4 reflects die impact the sales have on Fawn’s financial structure.
Note, in pardcular, two elements in that structure. First, the accrued profits on the

sales raise Fawn’s equity account to $760,000. At die same time, the monthly
operating expenses drain another $40,000 from the firm’s cash reserves. This
monthly cash drain continues until September, when the producers begin paying
for their purchases as agreed. Indeed, by 10/31/91 Fawn collects all of its accounts
receivable, retires its bank loan, and has a respectable $540,000 cash balance. The
$20,000 in monthly operating expenses will reduce that balance to $500,000 by
year’s end,when the cycle begins again.
Fawn’s experience clearly demonstrates the proper use of a single payment
loan. The loan answered a specific need, providing the cash capability necessary
to pay for inventory purchases. As sales converted die inventory into accounts
receivable, the loan then helped support the investment in receivables. The
ultimate collection of those accounts served as the necessary source of repayment.
Obviously a business does not have to be seasonal to benefit from a single
payment loan. The loan can enable a business to take advantage of a special
inventory purchase or generate an unusually large sale. However, both you and
the lender must relate the loan directly to die purpose and ultimately to the
repayment source.

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Leverage Management

Cash Capability and the Installment Loan

Chapter 14 suggested that a business should use external financing as the

source of the cash capability required to purchase fixed assets. Then Chapter 17
narrowed that perspective, indicating that die source of external financing usually
should be an installment loan. An installment loan allows a business to repay on
a schedule that coincides with the cash flow generated by the investment. Now we
relate the cash that flows from a new investment in fixed assets to the amortization
requirements associated with an installment loan.
From the lender’s perspective, to jusdfy installment loan credit consider-
ation, the annual cash flow in the borrower’s business must equal or exceed the
principal amortization requirements set by any installment loan. The lender
relates that practical requirement to the firm’s total installment debt service,
existing as well as proposed.
This requirement can be clarified with a look at the Collins Company, a small
tubing manufacturer that presently operates at a break-even level. The company
is contemplating the purchase of a $400,000 automated assembly line that

promises a return to profitable operations. The reduction in production costs

should translate into $80,000 a year in earnings.
In conjunction with the proposed acquisition, Collins has requested a
$400,000 bank loan to finance the purchase and installation of the new line.
Despite its break-even operation, the company satisfies the bank’s basic credit
criteria.However, final approval of the credit consideration hinges on the
relationship between Collins’s annual cash flow and the amortization require-
ments for the proposed loan. That phase of the analysis proceeds on several
assumptions:

1. Estimates indicate diat the new machinery and equipment will have a ten
year useful life.

2. The application of straight line depreciation to the new assets will contribute
$40,000 per year to Collins’s cash flow.
3. The existing fixed assets arc fully depreciated and have no ejffect on annual
cash flow measurements.
4. Collins presently has no other fixed debt requirements.
5. The bank’s credit policy precludes extending any installment loan that will
not be repaid in five years or less.

Collins’s banker analyzed these facts in two simple steps. First, she found the
annual cash flow necessary to amortize the $400,000 loan over a five year term.
That amount came from the basic calculation:

182
 —
Leverage from the Bank

Annual Cash Flow _ Loan Amount _ $400,000 _ ^gQ qqq

Requirements Term (in years) 5

Consequently, Collins will need to produce an annual cash flow of at least

$80,000 to meet the debt service requirements on the proposed loan. We ignore
interest expense in this instance, since it would fall into tlie category of normal
operating expenses included in the projected earnings calculadons.
Second, the banker measures the annual cash flow anticipated from the
company’s operations. However, recognizing the uncertainty inevitably associ-
ated with the proposed transformation of the business from a break-even to a
profitable operation, the banker considered tliree alternative outcomes: pessimistic,
optimistic, and an average view.

Cash Flow Cash Flow Total

from from Annual Amortization Loan
Earnings Depreciation Cash Flow Requirement Decision

Pessimist — $40,000 $ 40,000 $80,000 Decline

Optimist $80,000 40,000 120,000 80,000 Approve

Average 40,000 40,000 80,000 80,000 ?

Tlie pessimist’s view presumes that the new investment will have no effect on
Collins’s operating results. The firm will remain a break-even operation. The
annual cash flow will be equal to the annual depreciation.
The optimist’s view accepts the company’s projections. It presumes that the
firm will produce $80,000 a year in earnings and a $120,000 annual cash flow
the earnings plus $40,000 in depreciation.
Logically, the average expectations split the difference between the optimist
and the pessimist. This \iew anticipates future earnings of $40,000 per year, which,
when coupled with depreciation, produces an $80,000 annual cash flow.
The optimistic view encourages approval of the credit consideration. The
prospective cash flow from that perspective stands as 150% of the amount
required for debt amortization. The bank adopting that view will extend the loan.
The pessimist will decline the loan. Since half of the cash flow necessary to
retire the debt comes from projected earnings, he foresees a $40,000 annual
shortfall.
Finally, the lender who holds the average view is left without any clear
decision criteria. Indeed, this view projects an annual cash flow exactly equal to
debt service requirements. However, a slight drop in earnings below the
Collins’s
$40,000 projected reduces the firm’s annual cash flow below the required

183
Leverage Management

$80,000, so the average view must rely on other factors to justify the final credit
decision.
Perhaps surprisingly, the ultimate credit decision in the Collins Company’s
circumstances actually may depend upon the banker’s individual perspective:
whether she is a pessimist, an optimist, or something in between. Whatever her
attitude, however, when she analyzes a prospective installment loan, she will look
closely at the relationship between the firm’s annual cash flow and fixed debt
amortization requirements.
The logic of this attitude recognizes that the principal repayment of a loan
isnot a business expense. It does not appear in the income statement. Instead, the
repayment merely returns borrowed cash capability. The cash for repayment must
come from the liquidation of assets, from funds borrowed from another lender,
or from the annual cash flow from operations.
Lenders who approve an installment loan automatically tie themselves to the
borrower for the term of a note that usually extends several years. In addition, they
recognize that a business might be unwilling or unable to liquidate other assets to
meet its fixed debt requirements. And the lender cannot depend on some other
creditor to provide the cash necessary for installment debt service.
The business with a tight cash flow isn’t the most welcome prospect for a loan.
So the bank (or other lender) looks for an annual cash flow from operations that
is sufficient to meet the debt service requirements. The business that fails to satisfy

that requirement usually has trouble obtaining installment loan credit consid-
eration.

Cash Capability and the Revolving Loan

A revolving loan provides flexible leverage for a business. The business gains
the discretionary use of the lender’s funds up to the limit set by its line of credit.
Table 20-2 presumes that the bank approves a $500,000 line of credit for a
business, extending from the beginning to the end of the calendar year. The
business uses the line during that term as a complement to its normal cash flow
cycle. Thus the borrower obtains $300,000 on January 15 and another $200,000
on March 7. Reflecting a cyclical operation, the firm generates the cash to repay
$400,000 on April 7. The firm obtains another $300,000 onjuly 26 and then retires
the full amount of the loan in three payments during the last quarter of the year.
The flexibility available from a revolving loan is apparent. Unfortunately,
only the stronger, more creditworthy borrowers qualify. Since such firms most
often have resources that preclude the need for such consideration altogether,
the revolving loan becomes a convenience rather than a necessity.

184
 Leverage from the Bank

Table 20-2
A Revolving Line of Credit ($500,000 Maximum)
Available
Loan Cash
Date Borrowed Repaid Balance Capability

January 15 $300,000 — $300,000 $200,000

March 7 200,000 — 500,000 —
April 7 — $400,000 100,000 400,000
JiUy26 300,000 — 400,000 100,000
October 1 — 100,000 300,000 200,000
November 9 — 200,000 100,000 400,000
December 7 — 100,000 — 500,000

The True Cost of Bank Borrowing

Without properly measuring the costs, a borrower can’t determine how

profitable leverage is for her business. Nor can she properly compare tlie costs
among the alternative forms of leverage.
The interest charge sets the basic, or apparent, cost of a bank loan. To
measure the true cost, you must recognize the expenses that arise from compen-
sating balances, commitment fees, restrictive covenants, legal fees, negotiating
renewals, and annual cleanups.
Of course, every borrower does not absorb all of these costs. Birt when

incurred, they can add substantially to the apparent cost of bank borrowing
represented by the stated interest rate.

The Compensating Balance Requirement

A deposit relationship is usually necessary before a bank approves a loan. A

business that borrows from a bank must have, or agree to establish, an operating
account with the lender. This requirement serves tw^o objectives.
First, a prospective borrower’s cash management practices enter into tlie

credit criteria that guide the lending decision. The business tliat maintains a
comfortable cash balance has tlie first line of defense against die direat of
financial reverse. Tliis adds an element of confidence to a lender’s decision to
extend credit.

185
Leverage Management

From a different perspective, the business that holds little cash relative to its

salesvolume constantly confronts the risk of a financial setback. A supplier

pressing for payment of past due accounts, or a major customer who defers
payment for large purchases, can translate that risk into reality. Consequently, the
business has less chance of receiving bank credit.
In either case, the bank’s requirement for the borrower’s operating account
allows the bank to monitor the firm’s cash management practices. It also enables
the bank update that estimate regularly. So it becomes an important element
to
in a continuing lending relationship.
The second objective, however, probably stands higher in the banker’s mind.
That is, it enables the bank to obtain a compensating balance which increases a
bank’s earnings. The cash a business holds for normal transactions often satisfies
a bank’scompensating balance requirements. But if the average deposits are too
bank will require the borrower to carry additional, idle cash sufficient to
low, the
make the compensating balance equal to 20 to 30% of the credit consideration.
The compensating balance provides the bank with additional funds for profitable
lending elsewhere.
As the compensadng balance requirement increases the bank’s earnings, it
also increases a firm’s cost of borrowing. That hurts its earnings. This follows
naturally, since the necessity for a compensating balance forces a business to
borrow more than it actually needs. For example, a business that needs $400,000
in additional cash capability might have to borrow $500,000 to satisfy the bank’s
requirements for a 20% compensating balance. The firm pays for $100,000 in
credit consideration, which lies idle in its checking account.
You measure the cost of a compensating balance by relating the actual dollar
cost of bank credit to the funds you actually employ. Assume a bank approves a
$1 00,000 single payment loan for a business, repayable at the end of one year. The
bank charges a 10% annual interest rate for that consideration, but it requires a
20% compensating balance for the term of the loan.
The compensadng balance requirement raises the firm’s apparent cost of
borrowing:

1. Annual Cost of Borrowing at 10% = $10,000

2. Interest Rate Based on ^ $10.000 ^ 12-1/2%

Funds Actually Used $80,000

The inability to use 20% of the total bank credit consideration raises the
apparent cost of borrowing by 2-1 /2%.
Table 20-3 charts the effect of various compensating balance requirements
on a firm’s apparent cost of borrowing across a range of interest rates.

186
 Leverage from the Bank

The Commitment Fee

A business may obtain a line of credit from a bank merely to provide a cushion
of cash capability to contend with any unforeseen problems. A preapproved line
of credit often makes good business sense. But a business manager should
recognize that she can incur a cost of borrowing even if she never uses the

committed funds.

Table 20-3
Effect of Compensating Balances on the
Cost of Bank Credit Consideration

Compensating Balance Requirements

Stated Rate 10% 20% 30% 40% 50%
True Rate
6% 6.6 7.5 8.5 10 12

6-1/2% 7.2 8.1 9.3 10.8 13

7% 7.8 8.8 10 11.7 14

7-1/2% 8.3 9.3 10.7 12.5 15

8% 8.8 10 11.4 13.3 16

8-1/2% 9.4 10.6 12.1 14.2 17

9% 10 11.25 12.8 15 18

9-1/2% 10.6 11.9 13.6 15.8 19

10% 11.1 12.5 14.3 16.7 20
10-1/2% 11.7 13.1 15 17.5 21

11% 12.2 13.8 15.7 18.3 22

11-1/2% 12.8 14.4 16.4 19.2 23
12% 13.3 15 17.1 20 24

Many banks charge a commitment fee for establishing a line of credit. Tlie
1/4% to 1/2% of the unused portion of the approved line.
fee typically totals
Consequently, a business tliat uses only $100,000 of a $200,000 line of credit will
pay an interest charge for the borrowed funds, plus a $250 to $500 fee for the funds
committed but not employed. A commitment fee may be a small cost to pay for a
cushion of cash capability. But recognize it increases the apparent cost of bank
borrowing.

187
Leverage Management

Restrictive Covenants

A bank often includes restrictive covenants as conditional elements associ-

ated with a term or revolving loan agreement. Violation of a covenant by a
borrower allows the bank to make immediate demand for repayment of any credit
consideration outstanding.
Common restrictive covenants preclude a borrower from incurring addi-
tional debt, paying dividends, increasing the investment in fixed assets, or even
increasing officers’ salaries. The bank also might require the business to satisfy
certain financial constraints.
For example, a bank may expect a business to maintain current assets (cash,
accounts receivable, inventory) that total at least twice the firm’s current liabili-
ties. Similarly, the firm’s total debt in any circumstance might be restricted to an

amount tliat doesn’t exceed the total stockholders’ equity in the business.
From the banker’s perspective, restrictive covenants encourage a borrower
to avoid any action that could prevent her from eventually repaying the credit
consideration. However, the borrower often finds restrictive covenants become
another addition to the apparen t cost of bank credit. The business incurs that cost
when the covenant delays or precludes management actions that can benefit die
business.
Certainly, a bank can waive any covenant diat hampers a borrower. However,
while waidng for that waiver, the business might lose a profitable business
opportunity to a compedtor with the capacity for prompt action. And no matter
how much promise an opportunity may hold, the bank may uldmately refuse to
bend the restrictive covenants. The business may find its potential limited or
stymied altogether.
The cost from restricdve covenants maybe difficult to measure. But that cost
can become a substantial, if indirect, opportunity cost. Remember diat fact before
you accept such binding credit.

Legal Fees

The larger and more complex the lending arrangement, the more likely you
will incur legal fees in addidon to the apparent cost of bank financing. In some
instances, those fees arise when a caudous business manager employs her attorney
to review a loan agreement before execudon. In other instances, the bank passes
the cost of preparing loan documents on to the borrower. In either case, the legal
fees often translate into a substantial increase in the true cost of bank credit
consideration.

188
 Leverage from the Bank

Negotiating Renewals

On may be unable to retire a single payment loan as

occasion, a business
Perhaps the purpose that justified the loan remains unfulfilled.
originally agreed.
Or a changing business environment necessitates a decision that absorbs die cash
earmarked for the repayment
Tlie failure to meet the repayment obligation seldom becomes a cause for
serious concern, so long as the borrower maintains die appropriate credit-
worthiness. However, negotiating an extension or renewal of die loan becomes
another element in the cost of bank financing. You measure diat cost in terms of
die management time devoted to the negotiadng process. It is anodier opportu-
nity cost.
If negotiating a renewal requires no more dian a phone call or a brief visit
to the bank, the cost remains small.can be considered a part of your normal
It

operadng expenses. But as the management time devoted to obtaining renewals

(or new loans) increases, the cost of negotiating rises rapidly. After all, a business
manager can’t employ her management talents while she is locked into loan
negodations. Too much time negotiadng for credit consideration can damage the
bottom-line of a business. The more valuable your time, the larger the cost of
negodating renewals.

Annual Cleanups

Many banks expect their borrowers to repay all loans — that

to operate fi eeis,

of any bank credit consideradon —for each year. This

diirty to ninety days
requirement for an annual cleanup period can become another element in the
true cost of bank credit consideradon.
Tliis requirement doesn’t pose a problem for the seasonal business. The
natural business cycle generates die cash necessary to satisfy the cleanup require-
ment However, the business with a level or expanding sales volume may find the
requirement a burden. Indeed, to sadsfy the call for a cleanup, die business either
must obtain comparable credit consideration elsewhere, usually from tiade
creditors, or temporarily scale down its operations.
If the burden falls on trade creditors, die business may lose trade discounts
that it previously took with the aid of the bank financing. In the extreme
circumstance, the business may suffer injur)' to its credit rating. That can restrict
future operations even further. Alternatively, should the business scale down its

operations for the cleanup period, it another opportunity cost the

will suffer —
potential profits on lost sales. In either case, the cleanup period can prove costly.

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Leverage Management

In any event, recognize that potential cost as one more item that increases
the real cost of bank credit consideration. We recognize the cumulative costs in:
Concept 54: A business manager should
measure of the costs
all
associated with bank credit
consideration.

Now, let’s take a look at the credit criteria that orient most bank lending
decisions.

Bank Credit Criteria

A banker’s credit decision evolves from a number of interrelated factors.

First, the banker estimates the management ability of the business and its

prospects within its industry and within the larger economic environment.
Ultimately, however, the credit decision focuses on tlie financial characteristics of
the business. The banker estimates not only tlie firm’s ability to repay the potential
credit consideration but also its ability to absorb an unforeseen financial setback.

Earning Power

The banker begins her credit analysis with a look at tlie prospective borrower’s
earnings performance. Then she evaluates tlie probability of whether the perfor-
mance will hold constant or improve in the future. The term satisfactory earning
may seem to be a nebulous credit criterion. But the lender expects earnings to
remain realistic relative to sales volume, perhaps compared to other firms in the
borrower’s industry. Moreover, the earnings must be substantial enough to offer
the reasonable promise the credit consideration can be repaid over a realistic
period.
Occasionally a bank may extend credit to a business with a recent history of
losses rather than earnings. Special circumstances mustjustify tliat consideration,
but the banker seldom proceeds farther in her analysis if the business lacks the
prospective earning power sufficient to justify loan approval.

Cash Flow

A profitable operation does not necessarily generate a positive cash flow.

While a business must demonstrate satisfactory earnings, it must also have a cash

190
 Leverage from the Bank

meet all obligations on time. This means the borrower should

flow satisfactory to
have cash capability to pay all trade creditors promptly, service any debt re-
quirements, and maintain cash reserves sufficient to absorb disruptions in its cash
flow cycle.
From a broader perspective, the bank also estimates the prospective borrower’s
measuring the firm’s total investment in cash, accounts receivable, and
liquidity,

inventory against the obligations due to creditors in the near term future. This
comparison of current assets against current liabilities, the current ratio, helps the
banker estimate the probability that the firm will be able to meet its obligations
satisfactorily,even in the event of some business reverse.
For example, a business with $500,000 in current assets and $250,000 in
current liabilities (a two-to-one current ratio) has little risk of defaulting on its
immediate obligations. Alternatively, a business with $500,000 in current assets
and $500,000 in current liabilities has little margin for error. This doesn’t
necessarily imply any immediate financial distress, but it does raise the potential
for problems. And the larger the potential for problems, the less likely it is credit
will be extended.

The Debt/Equity Ratio

As the third major element in her credit analysis, the banker examines the
borrower’s debt to equity ratio. That ratio compares the borrower’s total debt to
the total stockholders’ equity. For example, a business with $200,000 in total
liabilities and $100,000 in equity has a debt/equity ratio of two-to-one. As debt
increases relative to equity, the ratio rises.

A banker will usually be reluctant to lend to a business with a debt/equity

ratio that exceeds two-to-one. Naturally, her reluctance increases as the debt/
equity ratio rises. Conversely, a lower ratio lends reassurance to any positive credit
decision.
The debt/ equity criterion adds two elements to the banker’s credit analysis:
one psychological, one financial. From the psychological perspective, as a firm’s
debt/equity ratio rises above two-to-one, stockholders have less than one dollar
invested in the business, compared to every two dollars (or more) supplied by
creditors. So stockholders have much less to lose than creditors. And the more
liabilides increase relative to equity, the more likely a business is to take higher
risks. The psychological implications of gambling with someone else’s cash —that
is, the creditors’ — tends to reduce the fear of failure.
From the financial perspective, a debt/equity ratio of two-to-one (or lower)
generally allows the business to absorb a short term setback. A drop in sales or a

191
Leverage Management

rise in costs that leads to a temporary loss from operations does not push the
borrower to the brink of financial disaster.
One negative element in the analysis will not necessarily disqualify a business
from credit consideration. Unusual strength in one area can overcome a weakness
in others. For example, the prospectsfor a strong earnings performance can offset
the detrimental influence that comes from tight cash flow and a high debt/equity
ratio. Collateral considerations also often add strength to the decision to extend
credit consideration.
A banker often may extend credit to a business even though it fails to meet
the standard credit criteria. This often occurs when the potential promise in a
young business exceeds the bounds set by its financial circumstances. When the
credit consideration can help the business achieve its potential, the banker might
justify the loan with the aid of a guarantee from the Small Business Administration
(SBA).

SBA Loans

Insufficient cash capability often stands as the primary obstacle to profitabil-

ity.That obstacle grows larger if a weak financial structure precludes standard
bank credit consideration. However, many business managers can overcome diat
obstacle with loans that are funded or guaranteed by the Small Business Admin-
istration. SBA loans fall into two categories: (1) the direct SBA loan and (2) the
indirect SBA guaranteed loan.
The direct SBA loan means that the SBA accepts the application, approves
the request, and extends the credit consideration. No intermediary is involved.
Unfortunately, we can dispense with this category as a potential source of cash
capability witli two brief comments.
First, a business typically qualifies for a direct funded SBA loan only when

other reputable avenues to credit consideration are closed. Such loans may
provide start-up cash for the new, untested business or disaster financing for the
business on the brink of failure. However, relatively few firms qualify.
Second, few direct funded SBA loans are available relative to the number of
applicants. Indeed, budget cutbacks have pushed direct funded SBA loans to the
verge of extinction. This precludes practical consideration of this alternative
source of funds.
In contrast, the indirect SBA guaranteed loan remains readily available from
many banks. Such loans are extended directly by the bank. The borrower’s
promise for repayment is supported by a guarantee provided directly by the Small
Business Administration. That guarantee usually ensures repayment of at least
75% to 90% of the credit consideration.

192
 Leverage from the Bank

Don’t presume that the SBA’s guarantee eliminates a bank’s concern about
a borrower’s creditworthiness. The bank still expects tlie boiTOwer to demonstrate
a fundamentally sound financial status. But that status may still not satisfy the
requirements set by the bank’s normal credit criteria. Perhaps the firm’s debt/
equity ratio is somewhat higher than usual for normal bank credit consideration.
Or the firm may be losing money, held back by insufficient cash capability. Or tlie
prospective borrower’s promise may exceed its past performance.
In such circumstances, the SBA’s guarantee enables die bank to meet the
needs of a worthy customer who fails to qualify for normal credit consideradon. An
SBA guarantee does not make a bad loan good; instead, it makes a good loan better.
One unfortunate myth associated with this category of SBA loans should be
dispelled. Many business managers still shy away from SBA loans because they fear
that there are mountains of paperwork or government interference. In reality,
neither obstacle exists.
After the inidal application process, which is no more tedious than most
other loan applicadons, the only papenvork is die monthly repayment (most SBA
guaranteed loans come in the form of five to seven year installment loans). The
imaginary mountain of paperwork becomes lost in die normal administrative
process. Because you obtain the loan from your bank and work widi your banker,
your contact with the SBA is minimal.
Bank fimded SBA guaranteed loans should not be overlooked as potential
sources of credit consideradon. Often such loans are the logical answer to a firm’s
external financing requirements.

Bank Relations

A sound banking relationship is essential for die long term success of a

business. Indeed, that relationship can ensure diat the business has a source of
external financing to fill a gap in its cash flow cycle. Also, an experienced bank can
provide valuable counsel.
Of course, you don’t establish a sound banking relationship in your first
meeting with a banker. Nor does that relationship automatically follow the
extension of bank credit consideration. Instead, a business builds a bank relation-
ship over a long period and in a manner diat is mutually beneficial for both the
business and the bank. As with any odier lender, die cornerstones of a sound
banking relationship are (1) open lines of communication, (2) timely financial
information, and (3) adequate lender compensation.
The communication process operates most effectively, if not most efficiently,
when it relies on personal contact. The better your personal relationship, the

193
Leverage Management

better yourbank relationship. To enhance die personal relationship, you should

provide the bank widi timely financial information about your business. You
should give the bank your most recent balance sheets and income statements as
soon as they are prepared. The more the banker knows about your financial
circumstances, the more she can contribute to your business.
You also should communicate any actual or potential financial setback to
your banker immediately. She cannot feel comfortable with a relationship that
reveals financial difficulties thirty, sixty, or ninety days after the fact. So long as you
maintain open lines of communication, whether the news is good or bad, your
bank will have incentive to help solve your problems.
Finally, a bank deserves reasonable compensation for its services. Wliile you
should know die true cost of borrowing, you should not ti*y to reduce diat cost
unnecessarily and make your account unprofitable for the bank. When die bank
finds your account profitable, your lines of communication open, and your
financial information timely, you have set the structure for a sound, mutually
profitable relationship.

194
r Chapter 21

Leverage from the

Commercial Finance Company

Many business managers view the commercial finance company as the

lender of last resort, a source of leverage to be used only when other lenders refuse
credit consideration. Unfortunately, this attitude most often arises from igno-
rance. It becomes an obstacle to the success or to die full potendal of many
businesses.
This chapter reviews die two major sources of credit consideration provided
by commercial financing companies: factoring andaccounts receivable financing.

The Collateral-Based Loan

Before extending any loan, a prudent lender assesses the borrower’s credit-
worthiness. A commercial finance company is no exception. But rather than
approving a specific loan, it agrees to advance funds, subject to a realistic upper
limit, in direct proportion to the amount of collateral pledged to secure the credit
consideration.
For example, a commercial finance company might approve an 80% advance
rate,secured by a borrower’s investment in accounts receivable. The borrower
gains access to cash capability in any amount up to the limit set by the proportional
relationship. In diis circumstance, a $100,000 investment in accounts receivable
warrants $80,000 in credit consideration. Should the borrower’s receivables
increase to $150,000, the potential loan rises to $120,000 (80% x $150,000).
Alternatively, a reduction in that investment to $50,000 reduces the firm’s
borrowing power to $40,000 (80% x $50,000).
Leverage Management

The total credit consideration extended by the finance company will not
exceed the collateral value set by the specific advance rate. Collateral-based loans
secured by accounts receivable comprise the major portion of the credit con-
sideration extended by the commercial finance industry.
With some modification, lenders employ the same concepts to provide
leverage secured by inventory and, less frequently, by equipment. The lender
extends credit secured by assets that revolve through the business.

Revolving the Collateral-Based Loan

Unless financing the purchase of fixed assets, many borrowers pledge

collateral only to secure single-payment loans. A business may pledge $100,000 in
accounts receivable to secure an $80,000 bank loan. Collections from the pledged
accounts ultimately repay the loan. Should its cash requirements continue, the
business obtains another loan secured by a new set of accounts receivable.
Continuous requirements call for a series of repetitive single-payment loans.
However, factoring and accounts receivable financing both proceed beyond
the limits set by a series of successive single payment notes. Instead, each translates
collateral-based lending into a fluid, revolving relationship that becomes cash
flow financing. Figure 21-1 illustrates this relationship. View A shows another
perspective of the normal cash flow cycle. After sales convert inventory into
accounts receivable, the business must wait for the term of its average collection
period to obtain the cash to pay expenses or reinvest in inventory.
The collateral-based revolving loan, as shown in B, eliminates the waiting
period and enables a business to obtain the bulk of its cash from sales immediately.
On a continuous basis, as it generates sales, a business can obtain cash secured by
receivables up its advance rate. A business with an 80% advance
to the limit set by
rate generates $8,000 in borrowing power from $10,000 in new sales. That much
cash is available immediately for profitable reinvestment.
At the same time, the ongoing collection of the borrower’s receivables
completes the revolving loan cycle. Logically, the collections provide the cash
necessary to repay previous advances from the lender. The collateral-based
revolving loan becomes cash flowfinancing because the sales-borrowing-repayment
cycle operates continuously. In essence, the system accelerates the cash flow
process.

Cash Flow Financing in Action

The collateral-based revolving loan accelerates cash flow. The borrower

obtains the immediate use of a major portion of each sales dollar without waiting

196
 Leverage from the Commercial Finance Company

to collect the accounts receivable from those sales. To illustrate, let’s look at the
experience of the Crandall Company, an expanding wholesale operation.
Crandall’s growth rate recently led to increasing cash needs that exceeded
the bounds set by standard bank financing. Consequently, the firm arranged for
an accounts receivable revolving loan from a commercial finance company. The
finance company agreed to advance Crandall cash in amounts up to 80% of its
eligible accounts receivable. Table 21-1 tracks the first five days in the operation
of the loan.

Figure 21-1
Normal Cash Flow Cycle

Normal Cash Flow Cycle

A

Cash Flow Financing

B

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Leverage Management

Table 21-1
Cash Flow Financing
The Crandall Company

Daily Unused
A/R Total Cash Cash Loan Cash
Day Sales Collections Balance CapabiUtv Advance Outstanding Capability
1 — — $300,000 $240,000 $240,000 $240,000

2 $50,000 — 350,000 280,000 40,000 280,000 —

3 — $40,000 310,000 248,000 — 240,000 $8,000

4 30,000 — 340,000 272,000 20,000 260,000 12,000

5 — — 340,000 272,000 5,000 265,000 7,000

On day 1, when the revolving loan agreement begins, Crandall’s accounts

receivable total $300,000. The 80% advance rate provides the firm with $240,000
in borrowing power. Initially, Crandall exercises its option to obtain the full
amount of the cash available. It uses that cash to retire its bank debt and perhaps
to pay some past due trade credit.
On day 2, after initiating the loan agreement, Crandall generates $50,000 in
sales but receives no collections from accounts receivable previously outstanding.
So the firm’s total investment in receivables increases to $350,000, which raises its
total borrowing power to $280,000 ($350,000 x 80%).
Crandall again exercises its options and gains an additional $40,000 in cash
from the lender. The sales create new receivables that increase the collateral-
based borrowing power available from the lender.
On day 3, Crandall generates no sales. However, the company does receive
$40,000 in payments on account from its customers. Since the receivables stand
as collateral for the credit consideration, Crandall remits tlie collections to the
lender. Application of the collections to the firm’s outstanding loan balance
completes the revolution of the loan. New sales create new borrowing power;
collections on account reduce any existing loan balance.
Observe the first three days and measure all of the results that come from the
$40,000 in collections. Of course, the firm’s total investment in receivables drops
to $310,000. Simultaneously, the collections reduce Crandall’s total loan balance
to $240,000. But observe that, despite the lack of any new sales, the collections
produce $8,000 in new cash capability, or borrowing power, for the firm.
This new borrowing power develops naturally from the characteristics of the
revolving loan. The lender advances cash only up to 80% of each sales dollar.
However, collections usually represent 100% of each sales dollar. Thus the

198
 Leverage from the Commercial Finance Company

collection “overpays” the original advance. The borrower sees tlie effect of the
overpayment in a rise in his borrowing power equal to 20% of die collected
amount.
On day 4, Crandall receives no collections but generates $30,000 in new sales.
The new sales increase the firm’s cash capability by $24,000 ($30,000 x 80%). We
presume that Crandall’s cash needs will absorb $20,000 of that capability. This
suggests another critical point. The borrower using cash flow financing does not
have to use the full amountof the cash capability available from die lender. He can
use all of it, none of it, or part of it as his cash needs dictate.
It is easy to see how cash flow financing provides an element of flexibility for

the business with fluctuadng cash needs. So long as the excess capability exists, die
business can use leverage in direct response to its cash needs. Indeed, the
collateral-based revolving loan fluctuates in direct response to the sales, collec-
tions, and cash requirements in a business.
On day 5, Crandall generates no new sales and receives no new collections.
However, at the close of die previous day, die company enjoyed $12,000 in unused
cash capability. Crandall obtains $5,000 from that amount on day 5.
The actual administradon of the collateral-based revolving loan is more
complex than the illustration suggests. But the Crandall Company’s experience
demonstrates die basic concept and suggests some of the potendal benefits that
can come from cash flow financing. Our illustration also should encourage you to
adopt a different perspective of the cash flow process.

A New Definition of Cash Flow

The collateral-based revolving loan changes the concept of cash flow. No

longer is it totally dependent on becomes primarily depen-
collections; instead, it

dent on sales. Moreover, it fluctuates on a daily basis depending upon the inter-
relationship of sales, collections, borrowing power, and the needs of die business.
A straightforward relationship identifies the specific cash flow in a business
using every dollar available from the collateral-based revolving loan. Presuming
the business has an 80% advance rate, its cash flow becomes 80% of sales plus 20%
of collections. That cash flows naturally from the mechanical process that revolves
the loan. The borrower obtains up to 80% of any new sales in cash. This is 80% of
the cash flow equation. Subsequendy, as indicated in Crandall’s experience,
collections provide another 20% in cash capability, since they reduce the loan
dollar for dollar.
Different advance rates change the cash flow equation. For example, with
various advance rates, the cash flow becomes:

199
Leverage Management

Advance Rate Cash Flow

70% 70% of sales plus 30% of collections

75 75 25

80 80 20

85 85 15

90 90 10

To the extent you can predict your sales and collections, you can reasonably
estimate the cash flow and benefits you might derive from tlie collateral-based
revolving loan.
Note the business widi excess cash capability gains a unique benefit from this
financing method. It can gain complete control over its cash flow. For example,

assume a business has $320,000 in borrowing power from an 80% advance rate
applied to a $400,000 investment in accounts receivable. However, the company
only uses an average of $200,000 of that borrowing power, leaving $120,000 in
excess or unused cash capability. Here the company can exercise complete
control of its cash flow. It requests cash only when necessary for actual expendi-
ture. It controls its borrowing in direct response to its cash requirements.

Factoring and Accounts Receivable Financing

So far we have categorized factoring and accounts receivable financing as

analogous forms of cash flow financing. Although either alternative activates the
same fundamental concepts, three critical characteristics distinguish these two
financing methods: (1) the matter of notification, (2) credit and collection
services, and (3) the element of cost. As we examine the basic distinctions, the
advantages and disadvantages of each alternative will become apparent.

The Matter of Notification

Both accounts receivable financing and factoring rely on the pledge of a

firm’s receivables to a lender (or factor) to secure a loan. In both, the total cash
capability available from that pledge comes from the application of the contrac-
tual advance rate to the firm’s eligible accounts receivable. (Some receivables tliat

200
 Leverage from the Commercial Finance Company

fall too far past due or whose ultimate collectibility is questionable may receive no
consideration at all in the cash capability calculation.)
Also, in both cases, the loan revolves as die lender advances funds against the
accounts receivable created by new sales, and as he applies the collections from
outstanding accounts against die existing loan balance. However, the first distinc-
don between the two alternatives arises from the factor’s standard practice of
notification.
The factor accepts the pledged accounts as collateral. At die same time,
however, he directs the borrower’s customers to remit payment direcdy to him
rather than to the borrower.
For example, assume that die Best Company factors its accounts receivable.
Using a $10,000 sale as an example, the factoring process proceeds as follows;

1 . Prior to the actual shipment, the Best Company obtains the factor’s approval
of the sale to the Better Company.
2. Subsequent to the shipment, the BestCompany issues an invoice to die Better
Company as evidence of the sale with die designated terms for payment.
3. The Best Company obtains an advance from die factor, up to $8,000, using
the Better Company’s promise to pay as collateral.

4. However, the invoice issued to the Better Company requires remittance

direcdy to die factor.

This summary oversimplifies the factoring process, since the factor often
provides services that proceed well beyond the basic cash advance. But what is

important here is the recognition that a factor notifies your customers to remit
payment directly to him.
Many business managers believe that notification carries a stigma of financial
distress. Consequently, they eliminate the factor as a potential source of credit
consideration. However, factoring offers other benefits that can offset the nega-
tive effects of this imaginary stigma.
In contrast, accounts receivable financing operates on a nonnotification basis.
The lender accepts the receivables as collateral for the loan but allows the
borrower to continue the normal credit and collection process. The lender
receives copies of sales invoices that support the specific pledge, and the borrower
remits collections on accounts to the lender for application against die loan
balance.
However, barring financial disaster on the part of the borrower, his custom-
ers — the debtors whose promises to pay serve as collateral for the loan remain —

201
Leverage Management

unaware of the financing relationship. Nonnotification preserves the confidence

of the financing transaction. We can sum up this basic distinction in:

Concept 55: The matter of notification

distinguishes accounts
receivable financing from
factoring.

Now, let’s turn to another consideration that distinguishes factoring from

accounts receivable financing.

Credit and Collection Services

Credit and collection services are usually included in a factoring arrange-

ment. The borrower agrees not to extend credit to any customer without the
factor’s prior approval. Then, as a logical extension of the notification process, the
factor also becomes responsible for the collection of the firm’s receivables. Any
uncollected accounts ultimately become bad debt losses for the factor, rather than
for the borrower. This arrangement eliminates the need for a firm’s credit and
collection staff. Instead, those functions are provided by the factor’s own experi-
enced staff.

We mark this characteristic of factoring in:

Concept 56: The factor typically supplements

cash flow financing witn credit
and collection services.

In another direct contrast, the lender who provides accounts receivable

financing contributes litde to the borrower’s credit and collection effort. Tire

borrower makes the credit decisions and manages the necessary collection effort.
He absorbs any loss from bad debts. At die same time, the lender may refuse
advances against some accounts receivable if he considers the collateral value to
be questionable. But die decision to extend credit consideration to any customer
remains in the hands of the borrower.

The Element of Cost

You incur a borrowing cost when you use accounts receivable financing or
factoring as a source of leverage. If you use die factor’s credit and collection
services, you pay an additional fee.

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 Leverage from the Commercial Finance Company

Lenders who provide cash flow financing typically charge 4% to 7% over the
prevailing prime lending rate. The uninitiated often consider such rates to be
exorbitant. However, you should recognize two critical facts about tliat charge.
First, the lender properly charges a firm only for the actual dollars borrowed

each day. Thus a 12% annual interest rate becomes a 1/30 of 1% daily charge.
Using $100,000 for one day costs the borrower $33.33. Since a borrower’s cash
usage usually fluctuates on a daily basis, tlie actual dollar cost of cash flow
financing often fallsbelow comparable bank financing. This holds true even
though the bank’s stated annual interest charge is significantly lower.
For example, assume that a business foresees a peak need for $150,000 over
a thirty day period. A bank may satisfy that need witlr a $ 1 50,000 loan for thirty days
at a 10% annual interest rate. The monthly charge for tlie bank’s funds totals
$1,250. However, the business also recognizes tliat its actual need for borrowed
funds fluctuates from day to day. That need never exceeds $150,000, but it often
drops as low as $50,000. Projections indicate that the average daily cash needs for
the montli actually total only $100,000.
Should the business use cash flow financing at a 12% annual interest rate, the
montlily charge for the $100,000 average loan balance totals $1,000, or $250 below
comparable bank financing. Note that the difference becomes larger if we
recognize the cost of a bank’s standard compensating balance requirement.
Second, even when the actual dollar cost is higher, you might still find cash
flow financing preferable to bank financing if it leads to larger net bottom-line
benefits.
The cost of borrowing from a seldom exceeds die cost of accounts
factor
receivable financing. However, in addition to any financing charge, you pay the
factor a commission of 1% to 5% out of each sales dollar to compensate for the
credit and collection services included in the factoring arrangement. The specific
commission rate paid to a factor arises from many interrelated considerations,
such as invoice size, administrative effort, sales volume, and negodation. Since it
includes credit and collection seiwices, factoring exceeds die cost of accounts
receivable financing. We recognize that fact in:

Concept 57: Cost distinguishes factoring

from accounts receivable
financing.

The higher cost of factoring should not preclude it from consideration as a

source of leverage. The factor’s total commissions may be well below the cost of
a competent credit and collecdon effort.

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Leverage Management

The Contribution from Flexible Leverage

Cash flow financing often leads to net bottom line benefits that exceed those
availablefrom bank financing. This holds true even though the actual dollar costs
associated with cash flow financing appear higher. The potential advantage arises
from the flexibility of the lending method and of the lenders who provide it.
Compared to other forms of leverage, cash flow financing can contribute more
cash capability, expanding cash capability, and permanent cash capability.

More Cash Capability

In many circumstances, collateral-based revolving loans provide more cash

capability to a business than alternative financing methods. First, commercial
finance companies employ liberal credit criteria. They are not restricted to the
traditional lending limits on of bank loans. Second, the pledged collateral
tlie size

determines the cash capability available to the borrower. As the total collateral
increases, the firm’s borrowing power increases.
The experience of Marvel Products, Inc., an electronic parts distributor,
demonstrates the benefits. Column 1 in Table 21-2 reflects Marvel’s financial
structure as it stood at 12/31/90.
That structure reflects the following characteristics about Marvel’s circum-
stances:

1. A forty-day average collection period translates the firm’s $2,000 daily sales
volume into an $80,000 investment in accounts receivable.
2. To preclude excessive stock-out costs. Marvel maintains an investment in
inventory sufficient for two months’ sales.
3. The firm’s suppliers allow credit consideration equal to the inventory level
necessary for two months’ sales.

4. Marvel’s bank provided an additional $40,000 in cash capability at 12/31/90.

These characteristics left Marvel witli a satisfactory financial structure.

However, increasing demand for electronic parts encouraged Marvel to expand
its sales volume. In fact, over tlie six months following 12/31/90, the firm pushed

sales up to $4,000 per day.

Unfortunately, the higher sales volume devastated Marvel’s financial struc-
ture. As receivables and inventory increased in line with the higher volume, the
firm no longer paid suppliers on time. As shown in Column 2, the firm’s effort to
observe that policy exhausted its cash reserve.

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 Leverage from the Commercial Finance Company

Table 21-2
Benefits of Increased Cash Capability
Marvel Products, Inc.

12/31/90 6/30/91 6/30/91

Cash $ 20,000 $ 40,000
Accounts Receivable 80,000 $160,000 160,000
Inventory 80.000 160.000 160,000

Total Assets $180,000 $320,000 $360,000

Accoiuits Payable $ 80,000 $280,000 $160,000
Bank Loan 40,000 40,000 —
A/R Financing 128.000
Total Liabilities $120,000 $248,000 $288,000
Stockholders’ Equity $ 60.000 $ 72.000 $ 72.000
Liabilities and Equity $180,000 $320,000 $360,000

Not surprisingly, Marvel’s higher debt/equity ratio at 6/30/91 precluded

additional bank credit consideration. Indeed, tlie firm’s banker demanded
repayment of the $40,000 already committed.
Column 3 shows how cash flow financing solved Marvel’s problem. Since the
firm’s total borrowing power comes from the collateral value (80% x $160,000),
Marvel gains Uie cash adequate to maintain a consistent trade credit record. In
addition, the company has excess borrowing power that it uses to expand its cash
reserves.

Expanding and Permanent Cash Capability

The collateral-based revolving loan expands in direct line witli a borrower’s

growth rate. As sales increase, so does the firm’s borrowing power. BoUi factoring
and accounts receivable financing can provide the cash necessary to fuel rapid
growth. In addition, cash flow financing can provide permanent cash capability
for a business.
This fact stands out as:

Concept 58: A collateral-basedrevolving

loan can become a permanent
source of expanding cash
capability.

205
Leverage Management

Each new sale provides new cash capability to offset the natural reduction in
that capability from collections.
Consequendy, the borrower isn’t concerned with
the cash drain enforced by the maturity of a single payment note. Also, lenders
who provide cash flow financing do not require annual cleanups, so the borrower
can concentrate on sales and not worry about financing.

Credit Criteria

The commercial finance company’s credit analysis proceeds in the same

direction as any otiier lender’s. It begins with an evaluation of the applicant’s
prospects within its industry and economic environment. The
in the general
analysis then proceeds to an analysis of the firm’s past operating results, present
financial condition, and projected cash flow. Finally, it considers the collateral
that provides the critical insurance for eventual repayment.
However, the commercial finance company approaches the major portion
of any credit analysis from a different perspective than tiiat of traditional lenders.
Often, a commercial finance company will approve credit consideration other
lenders might deny.

Financial Credit Criteria

The financial credit criteria employed by a commercial finance company

appear to be remarkably liberal. Neither a high debt/equity ratio nor a low
current ratio necessarily eliminates a prospective borrower from credit consider-
ation. The commercial finance company may disregard ratio analysis altogether
and instead concentrate on two basic financial considerations.
First, the business should have reasonable expectations of profitable opera-
tions. While this seems obvious, the requirement does not disqualify the business
with a recent history of operating losses. Infact, the favorable elements presented

by a business in the midst of a turnaround often justify cash flow financing.

Second, a prospective borrower should demonstrate financial strength
measured by tangible net worth. This is the difference between a firm’s real assets
and liabilities. It excludes assets tiiat have no realistic liquidation value. That
includes intangible assets such as goodwill, leasehold improvements, and loans to
officers. Tangible net worth provides a reasonable estimate of tlie fundamental
financial foundation in a business.
In general terms, the commercial finance company expects a business to
have a tangible net worth sufficient to absorb an ordinary financial setback

206
 Leverage from the Commercial Finance Company
without threatening its survival. Some lenders set a minimum requirement, such
as a $50,000 or $100,000 tangible networth. Others relate the firm’s total debt to
tangible net worth, with no specific debt/ equity ratio automatically requiring a
negative credit decision. A liberal flexibility describes the financial criteria tliat

orient the commercial finance company’s credit decision.

Cash Flow Credit Criteria

A commercial finance company expects a borrower to have a cash flow

satisfactory for normal operations.However, the finance company will include the
proposed credit consideration in its examination of the borrower’s cash flow
projections. Presuming approval of the proposed cash flow financing, the busi-
ness must then demonstrate the capacity to meet all obligations on time. It must
show the ability to pay trade creditors within tlie designated terms and to meet
debt repayment requirements, as well as retire all normal operating expenses on
schedule. The business that can’t satisfy tliese requirements, even with the
proposed credit consideration, does not have a cash flow satisfactory for normal
operations.

Collateral Credit Criteria

Collateral analysis ultimately becomes the pivotal element in the commercial

finance company’s credit decision. Two logical considerations justify that fact.
First, collateral analysis identifies the potential borrowing power available to the
business. Should the borrowing power prove to be inadequate to satisfy the cash
flow credit criteria, the business doesn’t qualify for cash flow financing. Second,
the liberal financial and cash flow criteria require reliance on the value of the
collateral pledged to secure the cash flow financing. This pivotal requirement can
be summarized in:

Concept 59: A commercial finance

company's credit decision
centers on the fundamental
value of the borrower's
collateral.

The collateral value must be sufficient to offset the lack of financial strength
and tight cash flow allowed by the other criteria.

207
Leverage Management

Ultimately, the collateral value comes from the creditworthiness and payment
habits of the firm’s customers. The more likely the customers are to pay for
purchases as agreed, the better the quality of the collateral diat justifies cash flow
financing.

Lender Relations

The collateral-based revolving loan contract specifies the rights and obliga-
borrower and the lender. In addition, it clearly defines the terms of
tions of the
the borrowing relationship, such as advance rate, credit line, and interest charge.
Consequently, the borrower’s personal relationship with the lender has little
influence on the cash capability available to the business.
However, this does not diminish the need for a good working relationship
with the lender. Because the administrative process associated with cash flow
financing typically requires daily contact, the need for a sound relationship
actually becomes even more Open lines of communication provide
significant.
the foundation for that relationship. When you satisfy tlie lender’s need for
information about your business, you allow him to satisfy your need for cash
capability. Open lines of communication ensure a sound relationship for both
parties.

208
r
Chapter 22

Leverage from Investors

Occasionally, a business may need external financing in excess of that

available from The need could arise from the cash demands
institutional lenders.
set by rapid expansion, or because an unbalanced financial structure precludes
institutional credit consideration.
Wliatever the justification, the sale of an equity interest in the business may
become the only source of additional cash capability. This chapter discusses tliat

alternative and weighs the advantages and disadvantages of equity financing. It

also reviews the basic instruments of external financing, including common stock,
preferred stock, and convertible securities. The discussion also touches on
potential sources of equity for independent businesses.

Equity as Leverage

Equity represents the owner’s net financial interest in a business. In simplest

terms, the difference between assets and liabilities measures the size of tliat

interest The net equity includes the common stock, the capital surplus, and
retained earnings included in a firm’s financial structure.
Most businesses begin witli 100% of the ownership interest vested in the
hands of the founder. Of course, the founder typically tiies to maintain complete
ownership. However, the cash needs in a business can exceed the contribution
available from its creditors. If the owner lacks the financial capacity to meet these
needs, she can generate cash by selling some portion of her ownership interest.
In odier words, she might seek external equity financing.
Leverage Management

From the owner’s perspective, using external equity financing to increase the
firm’s cash capability is no different from using credit or
borrowed funds. In both
cases, the external investor commits her funds exchange for the
to the business in
promise of some return on that investment in the future. The business then employs
those funds in away that will keep that promise, as well as increase the return on the
original equity investment. The new equity serves as leverage for the old.

The Advantages of External Equity Financing

In comparison with leverage, external equity financing as a source of cash

capability offers some For example, it does not
distinct advantages for a business.
require repayment, it has no scheduled interest payments,
it enhances credit-

worthiness, and it imposes no personal liability on the original ownership.

In direct contrast to leverage, a business has no obligation to repay external
equity financing on some predetermined date. Indeed, it provides a permanent
contribution to the cash capability of the business. The investor naturally antici-
pates a profitable return from her contribution, but she expects that return to
come from the appreciation in the value of her investment, perhaps enhanced by
future dividend payments.
The business doesn’t guarantee any return on the investment. Neither the
lack of price appreciation nor the failure to receive dividends allows the investor
to withdraw her cash contribution. Dividends and price appreciation of the
investment remain a hope, not a promise.
In another contrast with leverage, external equity financing from the sale of
common stock imposes no fixed charges on the business. The business does not
irrevocably commit any portion of its future earnings to compensate the external
investor. However, external equity financing from the sale of preferred stock or
convertible bonds does impose fixed charges on the firm. The elimination of the
fixed charge obligations comes only from the sale of common stock.
External equity financing also enhances the creditworthiness of a business.
This benefit comes from the increase in financial strength generally represented
by a higher net worth. As the business increases the size of its equity base with the
aid of external financing, it becomes a more attractive risk for its creditors.
Ultimately, it can expand its cash capability beyond the amount contributed by the
external investors.
The first column in Table 22-1 shows the balance sheet of a business that has
exhausted its potential for additional credit consideration. Using a fundamental
credit criterion, the firm’s $1 million in liabilities and $250,000 in equity translate
into a four to one debt/equity ratio. most
Certainly, that exceeds the limits set by
creditors.

210
 Leverage from Investors

Table 22-1
How External Equity Financing
Enh ances Creditworthiness

Total Assets $1,250,000 $1,250,000

Total Liabilities 1,000,000 750,000

Stockholders’ Equity 250,000 500,000

Liabilities and Equity 1,250,000 1,250,000

Debt/Equity Ratio 4 to 1 1.5 to 1

In the second column, observe the benefit that comes from raising $250,000
in cash from the external equity financing. Presuming all of the cash reduces the
firm’s liabilities, that total drops to $750,000. The firm’s equity account rises to
$500,000. The interrelated effects leave the business with a 1.5 to 1 debt/equity
ratio. This new relationship should justify additional credit consideration.
The business can obtain $250,000 in additional cash capability fi om credi-
tors without exceeding the two-to-one debt/ equity relationship, die critical bench
mark for many lenders. Each dollar invested in the firm translates in diis instance
into a potential $2 increase in cash capability. This enhances the direct cash
contribution that comes from external equity financing.
Note diat using the sale of equity to increase cash capability doesn’t affect the
personal financial liability imposed on the original owners. When a closely held
corporadon, one owned by one or a few stockholders, incurs institutional debt,
the lender usually requires the personal guaranty of die individual (s) who
controls a majority of the outstanding stock. That guaranty encourages the proper
disposition of the cash advanced to the corporation. Each dme the business
increases its institudonal debt, the owner also increases her total personal liability
for the firm’s financial obligations.
Equity financing has no effect on the original stockholders’ personal finan-
cial liability. The new investor accepts the risk of loss in exchange for a potentially
substantial return on her investment. Should the business collapse, she loses her
investment. She cannot look to the founders for recovery.

The Disadvantages of External Equity Financing

Before you decide to use external equity financing to expand your cash
you should recognize some potential disadvantages: (1) it dilutes
capability,
ownership control, (2) it often is difficult to obtain, (3) it costs more than debt,
and (4) it becomes inflexible financing.

211
Leverage Management

The first disadvantage is usually the most apparent to the entrepreneurial

business manager. Selling a portion of her business to external investors obviously
dilutes her right of ownership. At the same time, she may lose some management
control.
So, when she decides to sell an interest in her business, the business manager
confronts the prospect of splitting future profits with outsiders. This can become
a psychological burden to the manager who has labored, worried, and risked her
financial wherewithal to build a business. Indeed, the prospect of sharing the
future earnings often becomes the obstacle that eliminates external equity
financing from consideration as a source of cash capability.
Similarly, along with their equity interest, external investors usually expect
a voice in corporate affairs. That voice may express itself only in the form of
representation on the firm’s board of directors, or it may be raised in day-to-day
operations. Naturally, tlie volume of the voice increases according to the proportion
of ownership assumed by the investors.
The original owner can retain conti olling interest in the business, but she
cannot ignore the legal rights of the minority shareholders. External interference
that begins as a nuisance often becomes a severe management problem. The
problem becomes even more severe because of the difficulty the small or medium
size business has in obtaining external equity financing. The number of equity
financing sources is limited. Moreover, the business reluctant to yield a significant
ownership position will find the potential limited even more.
An external investor seldom will make a major cash commitment for a 5%
interest in a business. However, her interest increases as the prospective propor-
tion of ownership increases. Consequendy, the business that seeks external equity
financing usually will be successful only if the investor obtains a significant fraction
of the total ownership. As the size of thatfraction increases, so does the probability
of interference from the new investors. The business manager must confront one
disadvantage or the other.
High cost can become another major disadvantage of external equity
financing. This may appear to contradict our assertion that the lack of fixed debt
service isan advantage of external equity financing. However, a successful
operation eventually incurs more cost from external equity financing than from
comparable amounts of leverage. That cost comes from two sources.
First, selling an interest in a business invites interference from external

investors. Not only does this become a management problem, it also can become
an operating expense for abusiness. Part of the expense arisesfrom the commitment
of management time to nonproductive concerns. Communication may be neces-
sary, but it often becomes a time consuming expense. And this expense increases

212
 Leverage from Investors

in proportion to the external investors’ efiforts to influence the firm’s actual

management. The interference soon translates into a material expense.
Second, the investors’ justifiable expectation of dividends on their invest-
ment can become a perpetual rising expense for a business. The successful
business must pay a portion of its earnings to investors in the form of cash
dividends. The amount paid typically increases as the business becomes more
successful. Unlike debt service, dividends continue — —
and grow over the life of
the firm. In addition, a dollar paid out as a dividend is more expensive than a
dollar paid out as interest expense on debt. Interest payments are tax deductible,
while dividends flow from after tax earnings. Thus the cost of external equity
financing is even more expensive than it appears at first glance.
Another disadvantage is that external equity financing is the least flexible
source of cash capability. Once it is obtained, it cannot be used arbitrarily to
repurchase the investor’s interest. Any repurchase ultimately negotiated becomes
an expensive proposition.
In contrast, a business usually has the option to prepay debt. Early payment
may involve a prepayment penalty, but the penalty will seem
of some fixed debt
modest compared to the premium commanded by an external investor for the
repurchase of her stock.
Of course, inflexibility may not disqualify external equity financing as a
source of cash capability for a business. But before proceeding with any effort to
obtain leverage from investors, consider the advantages and disadvantages.

Equity Instruments

Equity financing can take a variety of different forms. In fact, the variations
are limited only by the imaginations of the business manager in need of equity
financing and the investors who provide it. Nevertheless, the more familiar equity
financing instruments fall into three major categories: (1) common stock, (2)

preferred stock, and (3) convertible securities. Of course, you shouldn’t employ
any of these instruments without measuring the legal and financial ramifications.
Proper consideration of any external equity financing requires professional
advice.

Common Stock

Most external equity financing comes from the sale of common stock. A
share of common stock represents the fundamental unit of ownership in a
business. Thus the business that sells common stock to an external investor yields

213
Leverage Management

some ownership interest to her. As a simple example, assume an investor

purchases 100 shares of common stock in a corporation with 1,000 total shares
outstanding. The investor obtains a 10% ownership interest in the business. This
interest automatically provides the investor with some significant rights.
The stockholder obtains the rights to the net income in the business in
proportion to her pro-rata ownership. Of course, the earnings may not be paid
out. Instead, the business may retain its earnings to finance future operations. But
when they are distributed, the stockholder is legally entitled to her share.
A common stockholder also receives the right to cast a vote on certain
company Each share of
matters, such as the election of the board of directors.
stock entitles the investor to one vote. Consequently, the more shares an investor
holds, the more influence she exerts.
A common stockholder also may receive a privileged position in terms of her
buy any new stock issued by the corporation. This preemptive right gives
rights to
her the option to purchase any new shares and ensures that management
first

cannot subvert the position of present stockholders by selling shares to other

investors without offering them to the existing ownership. This protects the
stockholder against unfair dilution of her ownership interest.

Preferred Stock

Preferred stock remains an alternative to common stock as an instrument for

external equity financing. However, certain undesirable characteristics reduce its

potential value as a source of funds for a small business.

First, preferred stock provides no ownership interest in the firm. The
investor receives the right to a predetermined, fixed dividend, but she obtains no
residual ownership.
Second, while the sale of preferred stock preserves the existing owner’s
posidon, the dividends payable come from after tax earnings. That makes it
substantiallymore expensive than debt. So, preferred stock may be attracdve to
both the business and the investor only when it is issued as a convertible security.

Convertible Securities

In contrast to straight preferred stock, convertible securities can become

useful instruments for external equity financing. A convertible security, either a
bond or a share of preferred stock (designated as converdble when issued), can
be converted into common stock at the option of the holder. Securities offer the
investor two complementary advantages.

214
 Leverage from Investors

she receives a predetermined, fixed income on her investment, either

First,

payments or in preferred dividends. When the business prospers, the

in interest
investor can convert her holdings into common shares at a predetermined
conversion ratio. She has the option to maintain her position as a debtor or she
can become an owner.
Second, convertible securities offer a significant advantage to the business.
The business obtains the investor’s cash capability without yielding any man-
agement control. Convertible securities seldom carry voting rights until formally
transformed into common stock.
As the business achieves its objectives, holders of convertible securities will
exercise their options to obtain common stock. However, that conversion eliminates
the requirement for interest or preferred dividend payments. Convertible secu-
rities may offer a realistic alternative that enables a business to balance the

advantages and disadvantages of external equity financing.

Sources of External Equity Financing

The decision to use external equity financing often proves to be difficult for
the entrepreneurial business manager. However, making the decision may be less
difficultthan searching for financing, since few sources of external equity
financing are available to the small business. Usually, the business is limited to the
potential equity investment from informal (noninstitutional) sources, suppliers
or customers, venture capital companies, or small business investment companies.

Informal Sources

Rarely can a young, small business obtain external equity financing from
institutional sources. Instead, the business manager most often must turn to
informal sources — to friends, relatives, or business acquaintances.
From one perspective, obtaining equityfinancingfrom informal sources can
be beneficial. Personal relationships can overcome some of the problems that
arisefrom investor interference in the business. And the informal source may
accept a smaller ownership position than that normally accepted by institutional
investors.
From another perspective, using personal relationships to generate external
equity financing can lead to problems. Should the business ultimately fail, the
investor’s loss may sour the personal relationship. At best, the relationship will suffer
severe stress.

215
Leverage Management

The availability of external equity financing from informal sources remains

a matter of circumstance. The business manager who has no contact or personal
relationships with investors will find herself shut out from
tliis source. Neverthe-

begin your search for external equity financing close to home. The farther
less,

you proceed from that base, the more difficult the search becomes.

Suppliers and Customers

Occasionally, the business that shows extraordinary promise can obtain

equity financing from major customers or suppliers. The major customer of a
small business might commit equity financing to ensure a dependable source of
supply for a necessary element in itsproduction line. The equity interest encourages
preferred service. Alternatively, a major supplier might venture an investment in
a growing concern to ensure the demand for its product. Helping the customer
grow with an injection of cash ultimately helps the supplier expand her own
operation. Of course, both sources of external equity financing expect a profit-
able return on tlieir investment as the business prospers.

Venture Capital Companies

With the exception of small business investment companies, venture capital

companies offer little potential as a source of external equity financing for most
businesses because they have such restrictive selection requirements. Most ven-
ture capital companies invest only in businesses that display established creden-
tials, exceptional prospects, and extraordinary management ability. The venture

capital company also must foresee a realistic potential for a substantial return on
its investment, usually from a public offering of stock. A business witli modest

prospects, however satisfactory to tlie ownership, will receive little aid from most
of these companies.

Small Business Investment Companies

Among venture capital concerns, the Small Business Investment Company

(SBIC) usually is more accessible to the business in need of external equity
financing. Indeed, SBICs are unique among privately organized venture capital
companies. The distinction arises from the source of the bulk of the funds SBICs
have for investment. As entities licensed and regulated by the Small Business

216
 Leverage from Investors

Administration, SBICs have access to long term federal loans as a source of cash
for venture capital investments.
Not surprisingly, SBICs operate under some restrictions set by the Small
Business Administration. But these restrictions topically favor the business seeking
financial aid.
an SBIC seldom makes a direct equity investment in a business. Instead,
First,

the equity financing usually comes in the form of convertible bonds. The business
pays interest to the SBIC until conversion. But the initial commitment in tlie form
of debt also presences the potential for repayment. Tlie original o\\nership
ultimately may presence its equity position.
Second, the SBIC cannot obtain more than a 49% interest in a business.
While that substantial interest may require active participation in major man-
agement decisions, it still leaves final control of the business in die hands of the
original owners.
Third, as regulated institutions, SBICs have limits on the amount of funds
they can commit to any single operation. Many also have reladvely low investment
limits, such as $50,000 to $200,000. Consequendy, they must seek die bona fide
small business as a prospect for investment.
Certainly, SBICs hope to profit from their investments, but their operating
limitadons force them to adopt a more realistic \iew of the term required for that
return.

217
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r
Chapter 23

Leverage: Comparative Analysis

The comparative should encourage the use of one form of

criteria that
leverage over another can be confusing. When should a business employ trade
credit in preference to institutional leverage? What can make a bank loan more
desirable than leverage from the trade? When does a collateral based revolving
loan become most appropriate for a business?
Unfortunately, no single answer exists for any of these questions. A specific
form of leverage that benefits one business may prove detrimental to another.
However, some common considerations should enter into the leverage decision
process. This chapter reviews those considerations. The discussion will not
necessarily make the leverage decision process a simple task, but it should help
orient the decision process.
The major comparative criteria of the alternative forms of leverage can be
separated into five major categories: availability, profitability, reliability, flexibil-
ity, and risk.

Availability

The form of any debt employed in a business should be appropriate for the
purpose. A business seeking funds
to finance a temporary increase in inventory
willnot consider leasing as a realistic source of leverage. Neither is a collateral-
based revolving loan the appropriate method for financing the purchase of fixed
assets. Recognizing the need to match the form of the leverage to the purpose it
Leverage Management

serves inevitably reduces the number of alternatives that enter into tlie compara-
tive analysis.

The lenders’ standard credit criteria also may reduce the sources of leverage
available. The business with a high debt/ equity ratio may not be eligible for bank
credit consideration. Similarly, the business that lacks an investment in accounts
receivable usually can discount the commercial finance company as a potential
source of leverage.
A business also should consider the acceptability of the alternative forms of
leverage. For example, managementmay consider external equity financing to be
an undesirable Or a business may not use leasing as a matter of
alternative.
financial policy. Or the stigma associatedwith notification may eliminate factoring
as an acceptable form of leverage. Eliminating both the unavailable and unac-
ceptable sources of leverage can quickly narrow tlie list of candidates for external
financing.

Profitability

A business often employs leverage to solve a cash flow problem. In such

instances, the solution takes precedence over profitability as a borrowing objec-
tive. More often, however, a business obtains leverage because the additional cash
capability opens die door to higher profits.
Logically, the business in that circumstance should use the source of
leverage diat ultimately provides the largest contribution to its earnings. Unfor-
tunately, many business managers approach this management objective from the
wi'ong perspective. They concentrate on the comparative costs of the alternative
forms of leverage and decide that the least costly must be the most profitable. This
approach can lead to a false conclusion. In some instances, leverage with a higher
apparent cost ultimately may be most profitable.
Assume that a business needs external financing up to $100,000 over die
next six months. However, the maximum need occurs only five days out of each
month, or a total of thirty days out of the total six month period. Cash require-
ments fluctuate during the other twenty-five days each mondi, but they average
$50,000 per day.
The business has eliminated all but two sources of leverage. It can obtain a
$100,000 single payment bank loan at an 8% annualized rate for the full six month
period, or it can obtain an accounts receivable loan that carries a 12% annual
charge.
A straightforward comparison of die annual interest charges makes the
bank loan the preferable alternative. But the business that uses accounts receiv-

220
 Leverage: Comparative Analysis

able financing borrows only to meet its daily cash requirements. Then it pays a
daily rate (1/365 of the annual rate) for the funds employed.
Now let’s compare the actual dollar cost of bank financing with accounts
receivable financing:

Cost of Bank Financing:

$100,000 at 8% for six months $4,000

Cost of A/R Financing:

$100,000 at 0.033% per day for 30 days $ 990

$50,000 at 0.033% per day for 150 days $2,475

$3,465

Advantage from A/R Financing $ 535

Repeat the experience for another six months and the net bottom line
benefitsfrom accounts receivable financing becomes more than $1,000 higherl
Also, this example doesn’t consider the otlier costs tliat may arise from bank
borrowing, so the advantage gained from accounts receivable financing may
become even larger.
That potential receives emphasis in:

Concept 60: Leverage profitability analysis

concentrates on the net bottom-
line benefits available from the
alternative sources of external
financing.

Comparative leverage analysis may find a relatively expensive lease more

desirable because it leaves funds free for a more profitable investment in

inventory. Or one source of leverage may promise a higher line of credit than
another, again leading to higher net bottom-line benefits. Always proceed beyond
the simple comparison of direct costs, since the leverage that costs more may be
worth more.

Reliability

Leverage contributes cash capability to a business. The borrower employs

its investment in accounts receivable, inventory, or fixed
that capability to increase
assets. Any unanticipated withdrawal of the lender’s contribution can leave die

221
Leverage Management

business with a severe cash flow problem. Consequently, comparative leverage

analysis should include an estimate of the reliability of the prospective lenders.
The estimate measures tlie potential for sudden withdrawal of the lender’s credit
consideration.
Reliability is seldom a concern when the leverage comes from an installment
loan. So long as the borrower meets the repayment schedule set in tlie installment
note, the lender must honor the original agreement.
However, lender reliability becomes a larger concern for the business that
uses a revolving loan or anticipates the renewal or extension of a single payment
note. In either case, continuation of the credit consideration is to some extent
subject to the discretion of the lender. The lender can extend it or end it.

The borrower’s estimate of the lender’s reliability should proceed on two

levels: one financial, the other personal.
The borrower should be certain that the lender has the financial capacity to
continue the credit consideration. Is the lender subject to excessive stiain in a
tight money period? Does the lender have the financial strength to guarantee the
cash advances anticipated from a revolving loan agreement? The business relying
on those funds needs affirmative assurances in both instances. Special expertise
is necessary to evaluate financial institutions, but raising the questions with

prospective lenders will usually provide satisfactory responses.

A borrower also should estimate the reliability of the lending officer
handling his firm’s account. He has a major influence on the lender’s credit
decision. The borrower should seek a strong, reliable representative to ensure
that credit decisions are not subject to the whims of an anonymous committee.
Personal relationships often have a strong influence on the quality and
quantity of consideration a business receives from its creditors. Never take them
for granted.

Flexibility

Lender flexibility refers adapt to the fluctuating needs of

to the capacity to
a business operating in a volatile economic environment. Among other consid-
erations, the analyst should measure the lender’s flexibility by its repayment
requirements, its restrictive covenants, and its potential for expanded credit
consideration.
In response to changing circumstances, a flexible lender readily alters the
repayment requirements established by an original agreement. Should the
purpose that called for a single payment loan remain unfulfilled, tlie lender

222
 Leverage: Comparative Analysis

providesan extension beyond the regular due date. Alternatively, should installment
loan payments become a burden, the flexible lender develops a revised repayment
schedule that fits the firm’s actual cash flow. The revolving loan provides the
maximum flexibility for a borrower. The business employs and repays cash
capability in direct response to its own needs.
The tighter the restrictive covenants in a loan agreement, the less flexible
the lender. Indeed, the borrower may become bound by rigid restrictions that
exclude the potential for numerous profitable business opportunities.
A business should estimate each lender’s response to the expanding cash
requirements of a successful operation. A growing business needs increasing, not
decreasing, amounts of cash. So, a rapidly growing concern should not lock itself
into an inflexible source of leverage that restricts the potential for growth. An
inflexible lender can hamper the success of any operation.

Risk

We define risk narrowly here as the potential for default that arises from the
meet repayment obligations as agreed. A business naturally should
inability to
exclude any form of leverage that raises that Because of future
risk too high.
uncertainty, a business often finds it measure die risk of default.
difficult to
However, some estimate of that risk can develop from a look at the firm’s sales
stability (or predictability), financial condition, and profitability. Of course, die
more stable (predictable) the sales volume in a business, the less the risk of default
from any form of leverage.
In a broad sense, sales stability is directly related to the industry in which the
business operates. The less subject that industry is to technological and economic
disruptions, the more predictable the sales volume of a business becomes. From
a narrower perspective, a business must recognize its posidon within die industry.
The more secure that position, the more predictable the sales. That in turn
reduces the risk of default.
For example, a business operating in the volatile electronics industry might
avoid fixed debt requirements in favor of short term debt that can be paid quickly
from liquidating accounts receivable and inventory. Alternatively, a wholesale
grocer can accept fixed debt obligations, secure that his business will remain
relatively stable whatever the state of the economy.
The characteristics of the firm’s financial structure also affect the risk
associated with leverage. The borrower should assess his financial condition no
less rigorously than he would a prospective lender’s. Often a lender will approve

223
Leverage Management

credit consideration that the business will be ill advised to accept. The business
must assess both tlie profitability and the dangers that come with any credit
consideration.
A business should not accept debt without considering the level of profitabil-
ity that will be necessary to meet the interest and amortization requirements.
While this may seem many borrowers assume debt in an effort to turn a
obvious,
losing operation into a profitable one. From a positive perspective, this decision
may provide the cash capability necessary to achieve that objective. The borrower
should recognize that such debt ultimately can become a burden for the marginal
operation. The interest and repayment requirements can leave the business
deeper in a financial hole than before the debt was incurred.
The risk of default depends upon the types of leverage being considered. An
installment loan, for example, imposes fixed obligations on the business. Without
lender flexibility, financial setbacks cannot relieve the firm of its obligations.
Indeed, fixed debt requirements compound other financial problems.
Alternatively, single payment or revolving loans actually may impose less
financial risk. This holds ti ue so long as the business maintains the collateral
adequate to liquidate the debt. The business may not prosper, but tlie potential
transformation of the collateral into cash reduces the risk of default.
Undoubtedly, a comparative analysis of the various forms of leverage may be
tedious and time consuming. But it can reduce the potential for cash flow
problems and increase your earnings. Moreover, you gain assurance tliatyou have
chosen the proper kind of leverage for your needs.

224
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Chapter 24

Accelerating Cash Inflow

A credit decision must precede an open account sale. A customer seldom

pays for a purchase until he receives an invoice. A past due account pays more
prompdy when you politely remind the customer of his delinquency.
However obvious these facts appear, many business managers overlook the
impact that they have on the rate cash flows into a business. That impact is illus-
trated in this chapter, as well as some principles that will help you to accelerate the
cash inflow into your business.

The Cash Conversion Period

In Partwe analyzed the rate of cash flow into a business using the average
II,

collection period and turnover rate calculations. A lower average collection pe-
riod or a higher turnover rate indicated a more rapid conversion of accounts
receivable into cash. However, the collection period and turnover rate calcula-
tions don’t take into account all of the factors that affect how rapidly cash flows
into a business. Both calculations measure cash flow from the date that a business
generates a sale to the date that it receives payment. This limitation precludes the
sequence of events before and after the sale that affect the cash flow into a busi-
ness.
To measure the rate of cash flow properly, we need to adopt a broader
perspective defined here as the cash conversion period. This period measures tlie
total time lapse between each customer’s decision to purchase a product and the
date the payment for that purchase becomes cash.
Improving Your Cosh Flow

Figure 24-1 lists the factors that enter into the total cash conversion period.
Between the purchase decision and the cash collection are most of the adminis-
trative tasks usually required to complete a sale. You accelerate the cash flow into
your business as you complete each administrative task more efficiently.

Figure 24-1
Cash Conversion Period

228
 Accelerating Cash Inflow

In terms of their influence on the cash flow process, we can identify tlie

common problems that tend to stretch the cash conversion period. We also sug-
gest some practical principles that compress that period.

The Purchase Decision and Purchase Order

A customer’s decision to purchase your product initiates the cash conversion

period. Encouraging the most rapid communication of the customer’s purchase
decision to your business — tliat is, making it as quick and easy as possible for her

to place —
an order is the first step in compressing your cash conversion period.
A purchase order serves as the medium of communication. The nature and
complexity of the business dictate the format of the purchase order. But regard-
less of the format, your customer should be able to transmit her order to you as

rapidly as possible.
The need for rapid communication usually eliminates the postal system. Even
in the best circumstances, using the mail extends your total cash conversion pe-
riod from one to tliree days. Often the delays in mail delivery reach seven days or
more. Of course, for items that don’t affect your earnings, the postal service still

provides the most efficient service because of its low cost. But remember any delay
in receiving your customer’s purchase order affects your bottom line. To over-
come the deficiencies in mail service, you should provide an alternative for your
customers.
For significant purchase orders, make electronic communication available.
That can include telephone, a data phone wire service, or facsimile transmission.
Unfortunately, many business managers concentiate on the personnel and
equipment costs involved in these alternatives. They overlook the one to seven day
reduction in their cash conversion periods that results fi om eliminating mail delays.
Certainly that benefit often is more difficult to measure.
Electronic communication of purchase orders generally is suitable only
when you have an ongoing relationship with a customer. But repeat customers
usually make up the bulk of a firm’s sales. So using electronic communication
for them helps you improve service and accelerate your cash flow.
After you receive a purchase order, you should complete the sale smootlily
and with a minimum of paperwork. However, the flow of paperwork often is less
of an obstacle to the completion of a sale than the credit decision tliat must
precede it.

229
Improving Your Cosh Flow

The Credit Decision

A credit decision remains a necessary precedent to an open account sale. So,

a business should expedite credit decisions for all significant orders. Each day a
business delays that decision lengthens the cash conversion period.
Whenever possible, approve lines of credit ior major customers in advance.
Anticipate their needs before they exceed their credit limits.
You lose little if a customer does not use her full credit line. However, cus-
tomers that do increase their purchases will find their orders delivered more
prompdy. Preapproved credit facilitates the completion of a sale and improves
your service capability. A faster response inevitably offers a competitive advantage.
You can use the same procedure for prospective new customers. Check the
creditworthiness of a significant new account in advance, before you receive a
large order. Obtaining the information for a credit estimate —
bank checks,
—
supplier checks can take several days. That lengthens your cash conversion period.
If you delay too long, you risk losing the sale to a competitor with a more efficient
credit decision process.
Of course, don’t sacrifice reliable credit analysis for speedy approval. Even
a modest increase in bad debt losses can offset the benefits from a shorter cash
conversion period. At the same time, any element in the administrative envi-
ronment that delays the completion of a sale hampers the smooth flow of cash into
your business.

The Shipment

To avoid delays in shipment, you should have a well organized shipping

department that meshes witli your administrative environment. Inefficient ship-
ping procedures seldom become a major problem for most businesses, but a less
obvious administrative problem may interfere with prompt shipment. That occurs
when a business has an inefficient inventory control system.
An inventory control system should answer two essential needs in a business:
(1) it should maintain a current record of the amount of each item in stock and
(2) it should locate that stock. Neither element should be left to chance or
memory.
Accountants refer to this as a perpetualinwentorf. The system logs the sale and
purchase of each item in inventory as it occurs. At any time, the log specifies tlie
total inventory of each item held in stock. The log also should identify the exact
location of the items.

230
 ,

Accelerating Cash Inflow

Computerized inventory control systems now make a perpetual inventory

control system a competitive necessity in most businesses. Indeed, the business
without such a system operates at a competitive disadvantage.
The perpetual inventory system offers another benefit for the business that
seeks an efficient administrative environment: When you apply EOQ analysis to
the major items in your inventory, you can specify the reorder point for each item
in stock. When the inventory falls to the reorder point, the “buy signal” tells you
to restock, thus avoiding unnecessary stock-out costs.

The Billing

Issuing the invoice remains the final step in the adminisU ative process tliat
completes a sale. The invoice identifies die merchandise sold, die shipment date
(usually supported by a copy of die bill of lading or other evidence of shipment)
and the amount due from the purchaser. For two reasons, the prompt completion
and transmission of the invoice is an important element in die cash conversion
process.
First, few purchasers will pay for merchandise prior to receipt of the invoice.
The invoice typically serves as the trigger for the payment process in the ac-
counting system in most businesses. Second, the invoice date usually initiates the
payment period defined by a firm’s selling terms.
To illustrate the significance of timely invoice preparation, we will assume
thatyour designated selling terms call for payment within thirty days from the date
of the invoice. Ifyour administrative structure delays preparation of an invoice for
seven days after shipment, for example, you actually allow the customer thirty-
seven days for payment. The invoice preparation period lengthens your cash
conversion period by seven days.
Your administrative environment should allow for the completion and
transmission of every invoice as soon as possible after shipment, preferably on the
same day. Each day’s delay reduces the rate at which cash flows into your business.
Unless precluded by industiy standards, you should require payment for
purchases in accordance with your designated invoice terms. That means thatyou
should not render a monthly statement of account to trigger customer payments.
Rendering statements is a cosdy, time consuming, and self-defeating ad-
ministrative process. And allowing customers to pay in response to monthly
statements rather than to purchase invoices adds from one to thirty days to the
cash conversion period. Customers will ignore invoices and wait for monthly
statements. That can extend your cash conversion period significandy. It also can

231
Improving Your Cosh Flow

damage your earnings, even though you may have the cash capability to support
the associated increase in accounts receivable.

Average Collection Period

The average collection period usually remains the largest fraction of the cash
conversion period. So, you need a competent credit and collection eflfort.

Thorough research into a prospective customer’s credit history will lengthen the
cash conversion period, but diat is preferable to an increase in bad-debt write-offs.
You should seek a balance between the need for an efficient decision process and
the need to exercise sound credit judgment.
You should complement your credit decision with a collection effort that
encourages payment within your designated terms. Select the average collection
period that satisfies your earnings objectives within the constraints set by your cash
flow. Then design and use a collection policy that supports your cash flow needs.

The Payment

The prompt collection of your accounts receivable naturally is important,

but a customer’s method of payment also affects your cash conversion period.
Usually the customer mails a check to your office on the date payment is due. Of
course, any postal delay lengthens your cash conversion period.
You may reduce that delay from one to three days by using a post office box
as your business address. The rental fee typically remains an incidental expense
compared to the benefits from a shorter cash conversion period.
An alternative payment method eliminates any reliance on the postal system.
The xtnre transfer proces?, transmits payments through the electronic network that
unites the banking system. This process can transfer money from your customer’s
bank account to your bank account in a matter of hours.
Wire transfers eliminate the delays that can arise from the postal system, the
administrative sti ucture in your business, or the check clearing process. Unfor-
tunately, your cash conscious customers will be reluctant to approve your request
for payment by wire transfer. The system improvesyour cash flow, but it hurts theirs.
Because the benefits are significant when large accounts are involved, you may
want to make an effort to persuade them.

232
 Accelerating Cash Inflow

Processing the Payment

The wire transfer collection system allows collections to be deposited before

they are processed through the firm’s accounting system. The business that re-
payments directly should also deposit collections before processing the
ceives
accompanying paperwork. After all, your cash capability remains unchanged until
they are deposited.
A business should have an efficient accounting system for recording cus-
tomer payments. However, that recording process can proceed from remittance
advice or photocopies, instead of from the check itself. Use any procedure that
reduces your cash conversion period and accelerates your cash flow.

233
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Chapter 25

Cash Collection Services

Improving cash flow is always a desirable management objective. But there

are practical limits on the improvement you can gain from even the most con-
certed direct management effort. So, you may find it beneficial to complement
your internal effort with the contribution available from tliird party, cash collec-
tion services.
The major third party services that can improve cash flowcome from three
sources: banks, factors, and collection agencies. Each source provides facilities or
expertise that is not available or economical within many businesses.

Bank Collection Services

Bank services that can improve die cash flow into a business fall into two
categories. One includes lockbox seiwices, which are most beneficial to businesses
with geographically dispersed customers. The other describes services that bypass
part or all of the normal check payment and clearing process.

Lockboxes

Two interrelated circumstances lengthen the cash conversion period in a

business with geographically dispersed customers. TogeUier, those circumstances
can severely affect cash flow.
Improving Your Cosh Flow

One circumstance arises from the delays inherent in the postal system. Such
delays become more significant as the distances between a business and its cus-
tomers increase. A business may wait three days for a payment mailed by a
customer located 500 miles away. That wait may increase to seven days if the
customer is located 3,000 miles away.
Bank lockbox services can reduce the delays in both directions. Essentially,
a lockbox represents a post office box that is controlled by a bank. A distant
business with customers in the bank’s area directs remittances to the lockbox. The
bank collects and immediately deposits the customer payments, forwarding tlie
remittance advice to the business by mail.
The lockbox service reduces mail delays because the bank is located close to
the firm’s customers. In addition, the service reduces processing delays, since the
bank deposits collections into the payee’s account immediately. The remittance
advice (or photocopies of the checks) provides the business with the information
necessary for the accounting process.
Lockbox services also accelerate the check clearing process. Since the payers
are located in the bank’s vicinity, their checks will clear rapidly. That reduces the
waiting period for collected funds. Those funds then are wire transferred regu-
larly to the recipient’s primary bank.
Lockbox services can reduce a firm’s average cash conversion period by five
to ten days, depending upon the location and distribution of its distant customers.
If the payments from those customers are an important proportion of a firm’s cash
flow, the lockbox services can provide a valuable cash collection seiwice.

Check Truncation

Any method that truncates (shortens) the normal check payment and
clearing process can improve cash flow. Banks offer three approaches to check
truncation: preauthorized checks, preauthorized debits, and wire transfers.
Preauthorized checks are signaturelessdemanddepositinstrumentsthatallow
a business to draw directly against customer checking accounts for scheduled
payments. Naturally, a customer must approve the payment process and provide
the business with the preauthorized checks or with the autliority to obtain them.
Additionally, the customer’s bank must enter into the arrangement with a formal
approval of the signatureless payment process.
Preauthorized checks accelerate cash flow by eliminating the wait for the
postal system to deliver customer payments. A business merely deposits the checks
on the scheduled payment dates.

236
 Cash Collection Services

While it improves cash flow, a preauthorized check payment system also can
provide other benefits. First, the system makes cash flow more predictable. A
business holding preauthorized checks isn’ t concerned about the various circum-
stances that can delay the receipt of customer remittances. A more predictable
cash flow reduces the potential for cash flow problems. Second, the system can
reduce billing costs and collection expenses and improve earnings. Indeed,
billing becomes unnecessary for the business holding preauthorized checks.
Certain payment eliminates the potential need for any collection effort.
Logically, the systemis most suitable for fixed dollar repetitive payments. Thus

it is usually employed by businesses that provide scheduled fixed fee services or

those selling higher priced products that customers purchase with installment
loans. However, it can be adapted to any circumstance where a business has an
ongoing relationship with its customers.
Preauthorized “debits” eliminate the need for checks from the payment
system. Here a debit represents a scheduled “checkless” draw against a customer’s
account. With proper autliorization, a bank develops a computerized register of
a firm’s scheduled customer remittances. The register includes the information
necessary to charge the customers’ accounts electronically on the scheduled
payment dates. Again, the system is most suitable for fixed dollar, repetitive
payments.
Preauthorized debits represent a significant improvement over the
preauthorized check payment system. Using electronic fund ti ansfers eliminates
mail float from the payment and check clearing process. At the same time, they
eliminate physical check processing for a business and its bank. That eliminates
any delays inherent in either accounting system.
While still in its incipient stages, preauthorized debits are the forerunner of
the process that will eliminate checks from the payment system. Eventually, all
payments will occur as electronic fund transfers from one account to another.
Efficient electronic flind transfer systems (EFTS) will make this a “checkless” society.
Wire transfers also eliminate checks from the payment system, and funds are
transmittedelectronically on the same dayremitted. In contrastwith preauthorized
debits, they must be by the customer remitting payment. Once remitted,
initiated
a business gains tlie same benefits as the preauthorizea debit payment system.

Factor Collection Services

Chapter 21 discusses factoring as a source of cash flow financing. The fac-

toring arrangement creates a revolving loan secured by a firm’s receivables. While

237
Improving Your Cosh Flow

also providing credit and collection services, the factor advances funds secured by
the firm’s uncollected accounts receivable. The collections then retire the prior
advances. Traditionally, that specific financing arrangement is defined as “ad-
vance” factoring.
In several respects, maturity factoring operates in a similar way to tlie advance
factoring arrangement described in Chapter 21:

1 . Upon receipt of an order, a business submits it to a factor for credit approval.

2. After credit approval, the business ships the order.
3. The firm bills its customers in the usual manner, except that each invoice
carries a printed notice requesting that payment be made directly to the
factor.

At this point comes the primary distinction between advance and maturity
factoring arrangements. The business using maturity factoring does not obtain
cash advances secured by the uncollected receivables. Instead, the factor remits
payment on invoices to the business on the predetermined maturity date.
The maturity date typically is defined as the date when the invoice should be
paid in practice by customers. It is based on historical analysis of a firm’s average
collection period. Consequently, the maturity date employed in die factoring
arrangement may not agree widi die invoice selling terms.
Maturity factoring makes cash flow predictable. Indeed, the factor is obli-
gated to remit payments on the specified maturity date. That obligation exists
whether or not the factor has collected the actual customer payments. At the same
time, he does not remit payment equal to the full face value of a firm’s sales
invoices. Instead, he holds back reserves equivalent to 10 to 20% of a firm’s re-
ceivables. That reserve absorbs credits created by merchandise returns and al-
lowances for discounts.
A business also gains another benefit from maturity factoring. The factor
assumes all of the expenses associated with the credit and collection function.
Indeed, maturity factoring normally operates on a nonrecourse, notification
basis. That is, the factor purchases the receivables outright and absorbs any losses
from bad-debt write-ofis. Thus the business using maturityfactoring does notincur
the personnel and operating expenses necessary to conduct the credit and col-
lection effort. It shifts those expenses onto the factor, along with the risks of
incurring any bad-debt write-offs.
A business must compensate a factor for his services. The specific cost of
maturity factoring varies with the type of industry, annual sales volume, average
sales amount, number of customers, and the maturity date employed in the
factoring process. The cost typically varies from 3/4 of 1 % to 3% of a firm’s annual

238
 Cash Collection Services

sales volume. Of course, a factor also charges interest for any funds advanced as
loans —or advance factoring.
Although many businesses can benefit from maturity factoring, the cumu-
lative benefits from it should justify the costs.

Collection Agency Services

Almost every business has some slow paying customers. A conscientious

most of those customers from falling too far past
collection effort helps prevent
due. Occasionally, however, the effort to collect an excessively past due account
becomes an expensive, time consuming burden. In that case, it may be beneficial
to employ a collection agency.
Collection agencies specialize in the pursuit of overdue accounts for a fee.
Thus they seek payments using correspondence and telephone contacts; larger
past due accounts may warrant a personal visit by a professional collector.
Experience indicates that the same efforts by a collection agency produce
better results. An impartial agency, drawing on its experience with a wide variety
of difficult debtors, often can collect with fewer follow-ups than the business that
extended the credit. Most businesses, if financially able, prefer not to have a
reputation of being dunned by collection agencies. So tliey often respond rapidly.
A business incurs little risk from the decision to use a collection agency. When
an account appears to be uncollectible, afirm’s final collection letter or phone call
should notify tlie delinquent debtor diat his account will be assigned to a collection
agency if payment isn’t made within a specified time (usually ten days).
Collection agencies typically allow a “free demand period” after receiving an
assignment. That period, usually ten days, waives any collection fee if the customer
makes payment within that time. If payment results from the collection agency’s
efforts, a business pays a proportion of the amounts collected as a fee.
Fees for collecting small accounts often are as much as 50% of tlie amount
The proportionate fee then drops as the amount collected rises. For
collected.
example, a collection agency may expect a 25% fee (or $250) for collecting a
$1,000 account. The pro-rata fee then may drop to 20% for amounts collected in
excess of the $1,000 amount.
Sometimes even a collection agency cannot collect a past due account. So
many agencies retain attorneys who specialize in credit collection lawsuits.Wlien
warranted by a sound claim and the financial ability of the customer to pay, a
lawsuit will ensue (with the claimant’s approval).
Wlien an account appears to be uncollectible, a business has little to lose by
employing a collection agency. While the commission for any collection might be

239
Improving Your Cosh Flow

20% to 50% of the amount paid, the business still may realize significant net cash
benefits. We recognize the potential contribution from those services in:

Concept 61 : Cosh collection services con help

accelerate the cash flow into a
business.

Don’t turn to a collection agency every time a customer falls a few days past
due. But a collection agency may help when a customer resists a normal collection
effort to pursue a past due payment.

240
r
Chapter 26

Delaying Cash Disbursements

While accelerating cash inflow, a business also should delay its cash dis-
bursements. A business should delay disbursements as long as possible in order to
extract the maximum benefit from every dollar tliat flows through the firm. This
chapter reviews the management techniques diat contribute to that objective while
preserving a firm’s creditworthiness.

Liability Management

Conscientious liability management defers cash outflow. This effort pro-

ceeds on an obvious premise: Pay no bill before it is due. Never abuse a creditor’s
consideration, but never prepay a liability. Retain every dollar as long as possible.
Some additional considerations also enter into liability management:
1. The potential for longer credit terms from competitive suppliers.
2. The trade-off between missing trade discounts and deferring payments to
suppliers.
3. The potential for deferring payment of accrued liabilities.

Before we examine the considerations, let’s review a basic tool that gauges
the benefits a business obtains from effective liability management.
Improving Your Cosh Flow

The Complete Average Payment Period

Deferring liability payments enables a business to use its creditors’ dollars for
a longer time. Calculating a firm’s average payment period provides an important
perspective of the benefits that can develop from that effort. The calculation
measures the average length of time a business employs each dollar in credit
consideration, exclusive of direct loans. Chapter 19 illustrated that calculation
using only accounts payable. While that perspective remains useful, the illustra-
tion here encompasses all day to day credit consideration.
The average payment period calculation proceeds tliough six steps:
1. Identify the total credit purchases made during the year.
2. Identify the total annual operating expenses that originally appeared as
accrued liabilities, such as accrued salaries, taxes, and rental obligations.
3. Combine the totals found in Steps 1 and 2.

4. Divide the sum in Step 3 by 360; this measures the average daily credit
consideration (ADCC) received by the business.
5. Combine current outstanding accounts payable and accrued liabilities.
6. Divide the sum found in Step 5 by your average daily credit consideration.

Assume that a firm’s open account purchases for the year totaled $3 million.
Also, $500,000 in operating expenses originally appeared in the form of accrued
liabilities. The firm’s average daily credit consideration can be calculated as:

Annual Purchases +
_ Annual Accrued Liabilities
360

/^cc = $3.QQQ>Q00 + $500.000

360

ADCC = $9,722

The firm obtained a daily average of $9,722 in credit consideration from one
source or another during the year.
Finally, note that die accounts payable and accrued liabilities total $350,000.
This enables us to complete the average payment period calculation:

Accounts Payable +
Average Payment Period = Accrued Liabilities
Average Daily
Credit Consideration

242
 Delaying Cash Disbursements

Average Payment Period = $350,000

$9,722

Average Payment Period = 36 days

Thefirm employed the average dollar in credit consideration for thirty-six

days. Each day that liability management can extend the payment period defers
$9,722 in cash outflow. We also can say that each day’s extension in the average
payable period provides that much incremental free financing for the business.
Table 26-1 provides a view of the benefits that can develop from extending tlie

average payment period.

Table 26-1
Extending the Average Payment Period

Average Daily
Credit Incremental Average Payment Period
Consideration 1 3 5 10 20

Total Deferred Cash Outflow

$ 1,000 $ 1,000 $ 3,000 $ 5,000 $ 10,000 $ 20,000

3,000 3,000 9,000 15,000 30,000 60,000

5,000 5,000 15,000 25,000 50,000 100,000

8,000 8,000 24,000 40,000 80,000 160,000

10,000 10,000 30,000 50,000 100,000 200,000

For example, a business that employs $5,000 in average daily credit consid-
eration defers $40,000 in cash outflow when it extends its average payment period

by eight days. That represents $40,000 in free financing the business can use to
reduce other liabilities, increase o ther assets, or replenish cash reserves. The benefit
from the effort can be summarized in:

Concept 62: Delaying cash disbursements

increases the cash capability in
a business.

Recognizing the major tenet that helps extend a firm’s payment period —
pay no bill before it is due —
let’s look at the other major considerations that enter
into liability management.

243
Improving Your Cosh Flow

Negotiated Payment Terms

Most suppliers in a particular industiy have comparable selling terms.

Whenever significant differences in those terms exist, a business should extend its
average payment period by buying from the supplier who allows the longest terms.
Even if no differences exist, a business often can negotiate longer selling terms
from its suppliers. Some suppliers may allow longer payment terms to secure a
larger order. Others may exchange longer payment terms for customer loyalty.
Suppliers are sometimes willing to sacrifice a better cash flow for the profitability
that grows out of long term business relationships.
Never assume that a supplier’s selling terms are etched in stone. With suf-
any supplier will extend her standard terms. Negotiating
ficient justification,
longer terms can allow you to extend your average payment period.

Cash Discounts Versus Deferred Payments

A business should delay payment for a purchase until the due date set by the
supplier’s selling terms. This defers cash outflow and extends the average pay-
ment period. However, when a supplier offers a cash discount for early payment,
compare the potential gain from that discount against the benefits of deferred
payment.
For example, assume that a business buys $10,000 in merchandise each montli
from a supplier who offers 1 % 10, net 30 day payment terms. The supplier allows
a 1% discount, or $100, if the business pays for each purchase witliin ten days. But
the business must pay the full purchase price if it defers payment until the end of
the thirty day credit term.
Over the course of the year the business can accumulate $1,200 in cash
discounts. Standing alone, this does not justify making the payment for each
purchase in ten days ratlier than thirty. Instead, the business should identify the
annualized interest rate it earns by taking the cash discount. If that yield exceeds
the firm’s borrowing cost, the discount is worth taking. If the cost of borrowing
exceeds the interest yield, the business should abandon the discounts and pay die
full purchase price at the end of the thirty day term.
The logic of viewing discounts as interest income asserts that a supplier ac-
tually borrows money from its customers when it allows a cash discount for early
payment. The discount becomes the interest charge for the loan. Wlien a business
pays its supplier in ten days rather than thirty, the early payment becomes a twenty
day loan. The supplier’s 1% discount represents the interest charge for using the

244
 Delaying Cash Disbursements

firm’s funds for that period. The supplier doesn’t have the use of those funds for
that twenty day period when the business takes thirty days to pay. But neither does
she have to pay any interest in the form of a cash discount.
If we view an early payment in exchange for a cash discount as a short term
loan to a supplier, we should then focus on tlie annualized interest yield the business
earns from that loan. That yield can be identified with the formula:

Interest Yield _ Discount %

from Cash Discount 100% - Discount %
X 360,
Final Due Date - Discount Period
Note that the difference between the final due date and the discount period
measures the term of the “loan” to a supplier when a business takes a cash dis-
count. Using the example above, we can determine the yield the business obtains
from a 1% discount:
Interest Yield from 1% 360
Cash Discount 100%-!% 30-10

Interest Yield X 360

99% 20

Interest Yield = 1.01% X 18

The business that receives a 1% cash discount for paying a supplier in ten
days instead of thirty earns an 18.2% annualized rate from the funds used to make
that payment. Thus the business should take that discount so long as its borrowing
cost remains below that level. Then the benefits from the 1 % discount rate exceed
the real or opportunity costs the business would incur from deferring payment
until the end of die thirty day credit term.
Usually a business should take all cash discounts of 1% or more when the
suppliers require full payment in thirty days. If a supplier offers extended terms,
it may become beneficial to forego an early payment cash discount. Always com-

pare the direct or opportunity cost of the funds to be employed with die annu-
alized earnings rate from taking the discount.
The more traditional perspective of the cost of a cash discount presumes diat
the cost a business incurs when it misses a discount matches die yield it earns by
taking one. When a business fails to take a discount, the firm pays the supplier for
the privilege of taking the full credit term allowed for payment. The business should
balance that cost against the cost of die funds invested in the operadon by credi-
tors and stockholders.

245
Improving Your Cosh Flow

Deferring Payment of Accrued Liabilities

A business can use its accrued liability accounts to defer cash outflow. For
example, a less frequent employee payment schedule can make a significant
contribution to that objective. The business that pays its employees weekly should
explore the possibility of a biweekly payment schedule. An existing biweekly
schedule may open the door to a monthly pay schedule. Limits exist on the length
of time a business can defer payment for any accrued liability, but a business
should take advantage of any realistic opportunity.

Float

Most business managers recognize how float benefits the business that finds
itself temporarily short of cash.
To take advantage of supplier discounts or other profitable opportunities,
you can make payments with checks that exceed your actual cash balances. Of
course, you should realistically expect to have the cash inflow necessary to pay
those checks before they clear through the banking system.
Float can be defined as the difference between a firm’s internal record of its
prevailing cash balance and the amount registered by its bank. For example,
assume that a firm’s current checkbook balance is $50,000. On the same day, bank
records show that the business has $100,000 on deposit. This means the business
has $50,000 in uncleared checks outstanding, or $50,000 in float.
A comparative look at the cash transactions recorded by a business and its

bank clarify the definition of float. Assume that a business begins a week with a
$100,000 actual bank balance. The firm’s own records also register a $100,000
balance. In an unusual departure from tlie norm, the two totals agree.
During die week the business collects and deposits $100,000 in customer
payments. It also writes $50,000 in checks each day to pay its own suppliers. As the
week ends, the firm’s records show that the business has a $50,000 negative cash
balance.
Only $1 50,000 in checks reach the firm’s bank for payment during the week,
so astlie week ends, bank records show that the business still has $50,000 in cash

on deposit. The difference between the firm’s account and the bank record
represents the creation of $100,000 in float. A summary of tlie week’s transactions
provides another view of that benefit:

246
 Delaying Cash Disbursements

Corporate Books Bank Books

Beginning Balance $100,000 $100,000

Deposits 100,000 100,000

Checks ( 250 000 )

. ( 150 000 )
.

Ending Balance ($ 50 000 )

, $ 50,000

Float $100,000

Here the business actually employs only half the available float. This may
represent the limit set by anticipated cash collections, since the business must
garner sufficient deposits to pay the outstanding checks before they reach the
bank for payment. That benefit can be summarized:

Concept 63: Float management helps

increase a firm's cash
capability.

Before illustrating the techniques for effective float management, let’s first
look at another view of the benefits of using float. Indeed, float contributes more
to a business than a temporary cure for a cash shortage. Often it becomes a
permanent fixture in a firm’s financial structure.

The Phantom Asset

The Aggressive Corporation demonstrates the benefits thatcan develop when

a business enjoys the continuous use of a specific amount of float. Aggressive’s
financial stiucture is illustrated in Table 26-2, Column 1. Although die firm’s
financial structure is relatively sound, note the apparent need for a $100,000 bank
loan.
Also note that the corporation writes $300,000 in checks each month to pay
for inventory purchases and operating expenses. Since purchases and expenses
occur evenly throughout the month, the firm writes an average of $10,000 in
checks each day. The discovery of the float inherent in that pattern eliminates the
need for a $100,000 bank loan.
Aggressive’s accountant found that the average day’s payments required seven
days to clear through the banking system. Of course, many checks cleared more
rapidly, whereas others traveled up to two weeks before reaching the bank for

247
Improving Your Cosh Flo>v

payment. But the average clearing time for all payments was seven days. That created
$70,000 in permanent float for the corporation. While Aggressive’s books regis-
tered a $70,000 cash balance, there was $140,000 in tlie firm’s bank account.
After recognizing this, the Aggressive Corporation decided to retire its
$ 100,000 bank loan, which reduced its actual checking account balance to $40,000.
The new financial structure is shown in Table 26-2, Column 2. The difference
between the $30,000 cash deficit apparent in that structure and the $40,000
positive bank balance comes from the $70,000 in float.
The corporation’s float actually becomes a phantom asset. It enables the
corporation to conduct its normal operations with $70,000 less than actually
appears necessary. In Aggressive’s case, float helps to eliminate the need for
external financing. When managed properly, float can make a valuable contribu-
tion toward the effort to defer the cash flow out of a business.

Table 26-2
Adding Float to the Financial Structure
The Aggressive Corporation

Disregarding Float Using Float

Cash $ 70,000 ($ 30,000)

Other Assets 430.000 430.000

Total Assets $500,000 $400,000
Accounts Payable $150,000 $150,000
Bank Loan 100.000 —
Total Liabilities $250,000 $150,000
Stockholders’ Equity 250.000 250.000

Liabilities and Equity $500,000 $400,000

Float Management

Float measures the time lapse between the date you write a check and the
date that check reaches your bank for payment. Determining die float available
to a business is a simple but tedious task. To make that estimate, a cash flow
manager charts the date she writes die check to pay her creditors and compares
those dates to the time the checks actually reach her bank for payment. The latter
date is stamped by the bank on the back of each check. Assuming that her monthly

248
 Delaying Cash Disbursements

payment habits remain regular, the manager can measure her float with enough
precision to make it a profitable management tool.
Table 26-3, a simplified approach to float management, tracks the actual
movement of cash into and out of a business and interrelates that movement with
that cash capability that comes from float.

On 8/1, the business begins with $100,000 in collected cash in its checking
account. No unpaid checks are presently outstanding. On 8/2, the business writes
and mails $30,000 in checks to pay suppliers. Although the checking account
balance drops to $70,000, the actual cash held in the bank account remains un-
changed. The checks are in the mail and are not affecting the firm’s cash account.
Wliile the checks are outstanding, the business could use the cash in its bank
account. Consequently, the float in this instance raises total cash capability to
$130,000.
On 8/3, the business writes no more checks but receives $25,000 in cash
collections on account. That raises tlie checking account balance to $95,000 and
tlie actual bank balance to $125,000. (We assume here that the bank allows the

customer immediate credit for all deposits, not an unrealistic expectation for the
business thatcarriesa reasonable collected balance tliroughout most of the montli.)
Coupled with the floatfrom the $30,000 in checks written on 8/2, the firm’s
total cash capability rises to $155,000. On 8/4, the business writes and mails an-
other $60,000 in payments to suppliers, which raises the total float to $90,000 and
the cash capability to $215,000.
Then, on 8/5, tlie $30,000 in checks written on 8/2 reach the bank for
payment. We assume a conservative four day average float period in tliis instance.
That lowers the firm’s bank balance to $95,000 and its cash capability to $155,000.
The $60,000 reduction measures the total of the unpaid checks no longer out-
standing, plus the actual reduction in cash required to pay tlie checks.
On 8/6, the firm writes another $75,000 in checks. This lowers the check-
book balance to a negative $40,000. The company has a book overdraft, although
the actual bank balance remains a comfortable $95,000. Now we can estimate the
real significance of float management.
Perhaps the payments mailed on 8/6 enable the firm to take 2% discounts
that would be missed if tlie firm delayed payment until it received the actual cash
collections necessary to honor the checks. Or die firm may be observing payment
witliin the supplier’s terms in order to maintain its credit rating. In either case, the
firm gains benefits that would be lost without the use of float.
Continuing the example set in Table 26-3, on 8/7 the company writes an-
other $25,000 in checks. This raises the book overdraft to $65,000. On the same
day, the firm’s actual bank balance drops to $35,000 as the $60,000 in checks reach

249
 (

Improving Your Cosh Flow

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250
 Delaying Cash Disbursements

the bank for payment. However, the firm’s total cash capability remains at
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Finally, on 8/9, the business receives $ 1 50,000 in collections, easily sufficient
to cover all checks outstanding. The bulk of the firm’s float evaporates on 8/10
as the $75,000 in checks written on 8/6 reach the bank for payment.
Obviously, you can’ t manage your float with the precision presumed in Table
26-3. Some checks clear in two days, some in ten. Absolute predictability is im-
possible. Nor can you be sure that your bank will provide instant credit for col-
lections. However, this is the usual procedure so long as you don’t continuously
demand the use of the balances represented by your uncollected checks.
Proper float management also can increase your earnings. Indeed, you don’t
need to suffer from a cash flow squeeze to benefit from float. If your business has
adequate cash for normal operations, you can improve your earnings by investing
the cash equivalent of float.
Also recognize that two separate components make up the total float avail-
able to a business. One component, postal float, measures the lengUi of dine it

takes for a payment be delivered to a creditor. The otlier, bank float, registers
to
the length of time it takes your creditors’ deposits to reach your bank for payment.
Of course, you have no influence over bank float. You can estimate the dine
it takes for your check to clear, but you can’t extend it for your benefit. At the same

dme, the percepdve manager will anticipate the potential in lengthening postal
float. She doesn’t mail her payments to her supplier’s post office box, but to her

firm’s street address. This increases the delivery time by a day or two, thus adding
to your total float. So long as your payment is postmarked on the due date, most
suppliers will consider your payment as prompt.
Never abuse a creditor’s consideradon, but use float to expand your cash
capability and increase your earnings.

251
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r
Chapter 27

Management Perspectives

Maximum cash generation is usually the primary objective of the cash flow
manager. This objective develops from the assumption tliat a business benefits
from any action designed to improve its cash flow. However, cash flow manage-
ment is not an isolated task in the operation of a business. It interrelates with every
aspect of it. So any management effort must first serve the basic objectives of the
business, even though those objectives may conflict witli die idea of maximum
cash generation.
This chapter considers the major implications diat this requirement raises
for the cash flow manager. Specifically, we discuss the appropriate cash flow
management perspectives when the primary objectives of a business become
survival, profitability, growth, and maximum earnings.
Of course, a business often works toward several objectives simultaneously.
In fact, can aim toward all four. The priorities may vary, but they ultimately
it

remain compatible with one anotiier. At the same time, identify one primary
objective to orient your management decisions.

Perspectives for Survival

becomes the primary objective for the business suffering financial

Survival
any degree. The temporary inability to pay all obligations promptly
distress of
measures one level of distress. So long as creditors accept deferred payments, the
problem may pose little threat to the survival of tiie business. Of course, the threat
 .

Positive Cash Flo>v Management

increases if the term of the deferred payments falls too far past due. Suppliers may
cease shipments of replacement inventory. Without products to sell the business
will quickly fail.

The tlireat becomes even more severe when suppliers seek recourse by
forcing a business into bankruptcy. Although suppliers seldom recover significant
amounts from bankrupt concerns, the threat often forces many businesses into
voluntary bankruptcy actions. The bankrupt business rarely returns to active
operations.
The most immediate threat to the survival of a business occurs when it cannot
meet payroll requirements. Suppliers accept deferred payments more readily
than employees. No doubt the employee who isn’t paid on Friday won’t return to
work on Monday.
From the cash flow manager’s perspective, the desire for survival encourages
tlie original objective of cash flow management — maximum cash generation. Thus
the manager seeks to convert the firm’s investment in receivables and inventory
into cash as rapidly as possible. He also seeks that objective even though it tem-
porarily damages sales and profits. Obviously if the business doesn’t survive die
short term, long term prospects become irrelevant.
The desire for survival again raises the specter of risk as an element in the
operation of a business. Even if a business is not faced with any immediate threat

to continued operations, risk should be a relevant consideration. This means

its

that the desire for growth and profitability may become secondary if achieving either
objective threatens die survival of the firm.
A measure of risk is involved in every business operation, but the size of the
risk should be commensurate with the size of the potential reward. An imbalance
in favor of risk could lead to a firm’s ultimate demise.

Perspectives for Profitability

The higher the profits a business generates, the more successful it is. How-
ever, the drive for higher profits often raises higher levels of risk. As the firm
stretches for a more rapid increase in earnings, it inevitably risks its survival. This
encourages many businesses to accept a “reasonable” level of profits. The business
earns less, but it is more likely to survive.
The business that seeks a reasonable, satisfactory level of profits isn’t nec-
essarily eliminating growth or maximum profits as business objectives. Instead, it

may be building those objectives into the foundation for long term stability.

No standard definition identifies the satisfactory level of earnings. A pro-

portionate increase of 5%, 10%, or 15% over the previous year’s results may be

256
 Management Perspectives

satisfactory to some businesses. Others may look for a specific dollar increase in
earnings each year. Still others may measure the return as a percentage of dieir
anticipated sales volume. However defined, the satisfactory earnings level recog-
nizes two facts of business life.

First, earnings must be sufficient to offset the detrimental effects of inflation.

The business thatfails to match the rate of inflation falls behind, even though it

registers an apparent increase in profits.

Second, the business sets its satisfactory earnings level in line with some
measure, however imprecise, of the risk associated with its operations. It will not
chase earnings if that effort would impose risk beyond the acceptable level. Again,
this recognizes that the size of the risk and the potential return in any operation
tend to increase proportionately.
The cash flow manager who seeks satisfactory earnings without inordinate
risk adjusts his activities accordingly. His cash management decisions seek to
preserve tlie financial integrity of the business without seriously impairing its

desired earnings level. He will not risk a gap exchange

in tlie firm’s cash flow in
for an extra dollar of earnings beyond the desired level. Neither will he allow an
overinvestment in receivables or inventory merely because they promise more
rapid growth. Indeed, he constantly seeks a balance between profitability and the
security that comes from a healthy cash position.

Perspectives for Growth

Rapid expansion often orients the drive of the ambitious entrepreneur. He

measures success not in terms of profitability, but by this year’s sales volume, and
inevitably he either accepts or ignores the risk that is a natural companion to
accelerated growth.
Rapid growth is accompanied by a need for external financing tliat actually
expands more rapidly than a firm’s sales volume. The limit on the financing
available to a business becomes the primary restriction on its growth potential. At
the same time as a business increases the use of external financing relative to equity,
,

it raises the risk of a major financial setback. Broad swings in operating results

naturally accompany the use of higher degrees of leverage.

The cash flow manager serving his growth objective adjusts his approach
accordingly. He first discounts the value held in excess cash reserves that provide
insurance for survival. A business cannot grow without committing itself to a rising
investment in inventory and accounts receivable, even at the expense of its cash
reserves.

257
Positive Cash Flow Management

Next, he designs a credit and collection policy that encourages sales, even at
the expense of carrying a larger investment in receivables. In fact, the growth
oriented business may suffer a lower profit margin per sales dollar because of the
carrying costs involved in its investment in receivables and inventory.
Finally, the cash flow manager in the rapidly growing business cannot over-
look the use of leverage. Leverage is the single necessity for the expanding con-
cern. The business can accept lower earnings and higher risks, but without
expanding its use of borrowed funds, it will not continue to grow.

Perspectives far Maximum Earnings

A business might ignore all other objectives in its pursuit of maximum

earnings. The business manager who selects this objective is less concerned with
growth than with an immediate increase in earnings (although the two typically
are interrelated)He also blinds himself to much of the risk involved in the drive
.

toward maximum profitability.

In this case, the cash flow manager must allow profitability to take prece-
dence over the desire for efficient cash flow. Thus a more liberal credit policy that
increases earnings might be acceptable, even tliough it absorbs cash reserves.
Similarly, the business might add to that strain by expanding its investment in
inventory in the pursuit of profitability.
The desire for every last dollar of profits should not push the firm toward a
cash flow disaster. Sound business sense recognizes the limits on any objective. But
the cash flow manager must recognize and accept the higher risk of a cash flow
problem that naturally develops when a business selects maximum profitability
over liquidity as primary objective.
its

In any event, recognize this as another perspective that reminds us of:

Cancept 64: The cash flaw manager must

arient his effart taward the
fundamental abjectives af the
firm.

Each firm’s objective will have a significant influence on its cash flow man-
agement effort.

258
r
Chapter 28

Cash Resource Management

While day-to-day cash flow management should remain your primary focus,
you should also recognize the need to maintain the proper balance among the
sources and uses of cash capability. Failure to do tliat can lead to cash flow
problems. Consequently, this chapter discusses the fundamental elements of cash
resourcemanagement.
Cash resource management adopts a comprehensive view of a business’s cash
receipts and outlays. From this broad perspective, the effort focuses on the source
of cash capability, the use of cash capability, and the interrelationship of the two.
The basic objective of cash resource managementis to use cash capability to reflect
the characteristics of each source.

Cash Resource Analysis

Cash resource analysis concentrates on the changes tliat occur in a firm’s

between two time periods. Properly categorized, the changes
financial structure
represent the source and disposition of the net cash capability gained by the
business over that period.
To illustrate, we use two consecutive fiscal year end balance sheets of the
Parker Company, a small valve manufacturer. The first step in the analysis,
summarized in Table 28-1, isolates the increase or decrease in each balance sheet
account (except cash) from one year to the next.
Positive Cash Flow Management

Table 28-1
Comparative Year End Balance Sheets
Fiscal
The Parker Company

12/31/89 12/31/90 Changes

Cash $100,000 $ 75,000

Accounts Receivable 110,000 170,000 $ 60,000

Inventory 160,000 195,000 35,000

Fixed Assets (net) 60,000 250,000 190,000

Prepaid Expenses 20.000 10.000 ao.oool

Total Assets $450,000 $700,000

Accounts Payable $100,000 $220,000 $120,000

Other Liabilities 30,000 20,000 (10,000)

Long-Term Debt 100.000 200.000 100.000

Total Liabilities $230,000 $440,000

Stockholders’ Equity $220,000 $260,000 $ 40.000

Liabilities and Equity $450,000 $700,000

The next step places the net change in each account into one of two cat-
egories. Each change translates into either a source or a use of cash capability in
the business.
A business gains an increase in its cash capability from:

1. A decrease in assets (other than cash)

2. An increase in liabilities

3. An increase in stockholders’ equity

Alternatively, a business employs cash capability to:

1. Increase assets
2. Decrease liabilities
3. Decrease stockholders’ equity

Table 28-2 illustrates a format that facilitates this phase of the analysis and
provides a concise picture of the disposition of the net cash capability available to
the business.

260
 Cash Resource Management

Table 28-2
Cash Resource Analysis
The Parker Company

Beginning Cash Reserves (12/31/89) $100,000

Sources of Cash Capability:

1. Reduction in prepaid expenses $ 10,000

2. Increase in accoimts payable 120,000

3. Increase in long-term debt 100,000

4. Increase in stockholders’ equity 40.000

Total Sources of Cash Capability $370,000

Uses of Cash Capability;

1. Increase in accomits receivable $ 60,000

2. Increase in inventory 35,000

3. Increase in net fixed assets 190,000

4. Decrease in other liabilities 10.000

Total Uses ($295,000)

Ending Cash Reserves ( 12/31/90) $ 75,000

The Parker Company ended 12/31/89 with $100,000 in cash reserves.

Changes in its produced an additional $270,000
financial structure during 1990
in cash capability. An increase in credit consideration in the form of accounts
payable and long term debt provided $220,000 of that added capability. Also,
Parker enjoyed another $40,000 contribution from an increase in stockholders’
equity, presumably from profitable operations during the year (although a part
of that increase might have come from the sale of common stock).
Finally, a net reduction in prepaid expenses translated into a $10,000
increase in total cash capability. A reduction in prepaid expenses as a source of
cash capability may appear questionable. Yet conceptually, the liquidation of any
asset (except cash) becomes additional cash capability for the business. Here the
liquidation of the prepaid expenses lowers the actual cash expended for opera-
tions during the year ending 2/31/90. The business is merely regaining the cash
capability used in the previous period to pay the expenses in advance.
The $10,000 reduction in prepaid expenses raises the total cash capability
company to $370,000. Had the company held all other elements
available to the

261
Positive Cash Flow Management-

in its financial structure constant, the 12/31/90 balance sheet would have in-

cluded $370,000 in cash reserves. Instead, the company decided to employ the
bulk of that capability for other purposes. In fact, other changes in the financial
structure absorbed $295,000 of the $370,000 total.
The major part of the cash capability contributed to a $190,000 increase in
net fixed assets. An additional $95,000 supported an increase in Parker’s invest-
ment in accounts receivable and inventory. Finally, it managed a $10,000 reduc-
tion in other liabilities, ending 12/31/90 with $75,000 in cash reserves. Table 28-
2 summarizes the net cash capability that flowed from changes in the company’s
financial structure, as well as the ultimate disposition of that capability. This
disposition also is reflected directly in die financial structure.
The final step in cash resource analysis is less precise than the first two. In fact,
it requires no direct calculation. Instead, you complete the analysis with a critical

assessment of the relationship between the sources and uses of cash capability
represented by the changes in the financial structure. This assessment compares
the source of the cash capability to die disposition of that capability, and it op-
erates according to two fundamental principles;

1. The cash capability devoted to permanent assets should come from an in-
crease in stockholders’ equity or long term debt.
2. The cash capability devoted to current assets may come from an increase in
accounts payable or other short term liabilities.

Thus a business should not use

trade credit as the source of cash capability
to finance the purchase of fixed assets. The business that makes that mistake
invites a cash flow problem, since the trade credit comes due almost immediately.
Indeed, permanent assets should have the support of a permanent source of
capability.
Alternatively, so long as the business maintains prompt payment habits, trade
credit may be the appropriate source of cash capability to finance an increase in
receivables or inventory. Again, cash resource management seeks the proper
match between the sources and uses of cash capability in the business. A business
also may use fixed sources — —
long term debt and equity to support its permanent,
minimum investment in current assets, but this also represents a proper match.
Finally, the business must recognize the ultimate effect of the interrela-
tionships on its cash reserves. If other sources are exhausted, the decision to use
cash capability for any purpose naturally absorbs some of these reserves. This can
be summarized in:

262
 Cash Resource Management

Concept 65: Positive cash flo>v management

properly matches the source
and use of any cash capability
used in a business.

Referring to Table 28-2, note that the Parker Company has some cause for
concern. It increasesnet investment in fixed assets between 12/31/89 and
its

12/31/90 by $190,000. Yet stockholders’ equity and long term debt registered an
increase of only $140,000. Thus $50,000 out of the cash capability devoted to the
fixed assets had to come from other sources. In this instance, accounts payable
increased by $120,000, while Parker’s investment in receivables and inventory
rose by only $95,000. Consequently, Parker used $25,000 in supplier credit con-
sideration as a source of cash for tlie increase in fixed assets. Another $25,000
came from a reduction in cash reserves.
The Parker Company remains in a relatively healthy financial position, but
improperly matching the sources and the uses of cash capability has reduced its
financial flexibility. Another increase in current assets may impose an additional
drain on cash reserves that will reduce that flexibility even furdier.
Use the Parker Company’s case as a reminder of tlie need to interrelate
and uses of cash capability.
periodically the sources

263
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 Chapter 29

The Cash Flow Budget

The cash flow budget provides tlie signals that spur the positive management
actions necessary to fill any impending gaps in tlie cash flow cycle. Indeed, it

becomes the focal point of your cash flow management effort. This chapter
reviews the basic concepts for developing a cash flow budget.

Financial and Cash Transactions

A manufacturer or wholesaler seldom generates a sale directly in exchange

for cash. Instead, he trades his product for his customer’s promise to pay for the
purchase in accordance with his designated selling terms. A business typically
purchases inventory on the same basis. Cash payment usually follows the actual
purchase by thirty days.
Unfortunately, the basic accounting process does not distinguish between
financialand cash transactions. On the seller’s side, a financial transaction re-
quires a record of the sale on the day it occurs, even though no cash actually

changes hands. The buyer’s side similarly records a purchase (although not
necessarily an expense) and at the same time records an increase in inventory and
,

accounts payable. But the financial transaction has no immediate effect on either
business’s cash reserves.
The process often appears more confusing because die accrual accounting
process also requires balance sheet entries reflecting the exchange of cash that
completes a financial transaction. The business incurs no expense at the time of
the transaction, even though cash flows out of the business.
Positive Cash Flow Management-

Financial accounting enables a business to measure its financial perfor-

mance by properly matching its revenues and expenses as they occur. But accrual
accounting does not provide a proper picture of a firm’s actual cash flow. This
picture comes from the record of cash receipts and payments diat register the
actual exchange of cash.
The exchange of cash completes a business transaction. It represents eitlier
a customer’s payment for a purchase or a business’s final fulfillment of its own
obligations. The record of cash receipts and disbursements reflects the actual cash
flow into and out of a business. That record provides the proper picture of the cash
flow whether or not the financial transactions coincide with the cash transactions.
Positive cash flow management clearly distinguishes between financial and cash
transactions.

The Cash Flow Budgeting Process

A cash flow budget projects the cash receipts and disbursements anticipated
in the normal course of business. But the budget proceeds beyond the simple
summation of the year’s upcoming activity to project the actual time that cash will
flow in and out. Our illustration projects tliat flow on a montlily basis, but you
could also project a weekly or even a daily cash flow.
The precision of the budget depends on the characteristics of the business
coupled with a reasonable estimate of its cash capability. The larger that capability,
the more cushion the business has to absorb an unforeseen fluctuation in cash
collections. This will become more apparent as we review the procedures that make
up the basic budgeting process.
Many business managers shy away from cash flow budgeting because they
think it is too esoteric or complex. However, the process can easily be broken down
into five straightforward steps:

1. Forecasting sales,
2 Projecting cash receipts,
3. Projecting cash disbursements,
4. Interrelating cash receipts and cash disbursements, and
5. Filling the gaps.

In the discussion of each step, concentrate on tlie fundamental simplicity of

the process. You will find that even a haphazard effort can provide important
benefits for your business.

266
 The Cash Flow Budget

The Sales Forecast

Any financial plan must begin ^^ith a sales forecast Of course, ever)' pro-

jection contains some uncertainty. Actual sales rarely equate exactly with the
forecast. Variables in the economy, the industr)', and the company preclude
absolute predictability. Nevertheless, this does not eliminate the need or value of
the forecast Even an intuitive effort such as using the pre\ious year’s volume,
adjusted for inflation, pro\ides an adequate basis for the development of a cash
flow budget This effort will enable you to anticipate most major cash flow
problems. Of course, the more accurate your forecast, the better your cash flow'

budget The value of this forecast can be summed up in:

Concept 66: The sales forecastis the

cornerstone of the cash flow
budget.

To illustrate, w'e will use the sales forecast developed by the Prudent Com-
pany, a specialty paper w holesaler with a history' of sound financial planning. For
the first six months of its upcoming fiscal year, the company projects tlie following
monthly sales volume (in Sl,OOOs):

Tanuary February March April May June

$200 $250 $400 $500 $300 $200

This forecast provides the basis for the next tw'o steps in the budgeting
process.

Projecting Cash Receipts

The cash flow budget recognizes that the primary' source of cash flow into a
business comes not from sales (unless the sales are for cash), but from the col-
lection of accounts receiv'able. Consequendy, this step of the process does not look
beyond the anticipated flow from collecdons.
The Prudent Company relies on historical experience to project the cash
flow into the business over the first six months of the upcoming year. This history'
indicates that the company collects its receiv'ables according to the following
pattern:

267
Positive Cash Flow Management

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268
 The Cash Flow Budget

1. 70% in the month immediately following the sale

2. 20% in the second month following the sale

3. 10% in the third month following the sale

Anticipating that the historical collection pattern will extend into the future,
the Prudent Company projects its cash flow for the next six months, as shown in
Table 29-1. (The company’s actual sales for the three months immediately pre-
ceding the projection totaled $200,000 in each month.)
From this pattern, the company anticipates $200,000 in collections in Janu-
ary. These collections represent 70% of December’s sales, 20% of November’s
sales, and 10% of October’s sales. Of course, collections equal to monthly sales are
not usual for the company. A look at the projections for March indicates sales of
$400,000 for the month, but collections from previous sales of only $235,000. This
shows that collections come from prior sales, not the current month’s.
If your sales and average collection period remain constant from month to
month, the cash flow into your business will match your sales volume. A business
with $1,000 in daily sales and a consistent forty day average collection period
generates sales of $30,000 per month and matches that with collections from
previous sales. That simplifies tlie cash flow budgeting process.

Projecting Cash Disbursements

Most cash disbursements by a business fall into one of three basic categories:
(1) to pay for purchases, (2) to pay operating expenses, and (3) to retire debts.
Usually a business can project the expenditures required in each category with
reasonable accuracy.
Ofcourse, the repayment of any scheduled debtobligation stands asacertain
cash expenditure. However, using its makes purchase
sales forecast, a business
and operating expense commitments become relatively certain cash
that also
expenditure requirements. Indeed, it usually must expend the cash appropriate
for those purposes, even though actual sales in a month fall below the level
forecasted.
Note that depreciation does not appear in a firm’s projected cash dis-
bursements. It is a noncash expense, so it is not part of the cash flow budget

To demonstrate the elements that enter into a projection of monthly cash

expenditures, let’s note additional characteristics about Prudent’s business:

1. Cost of goods sold averages 60% of sales.

2. Prudent purchases the inventory for each month’s forecasted sales volume
one month in advance.

269
 .

Positive Cash Flow Management

3. Suppliers allow Prudent thirty days to pay for its purchases; consequently, the
firm pays for all inventory in the month following the actual purchase,
4. Monthly cash operating expenses average 30% of sales.
5. Prudent has $10,000 in monthly debt-service requirements.

Using the sales forecast as a starting point. Table 29-2 projects the Prudent
Company’s cash expenditures for the six mondi period.
In January, Prudent must pay $120,000 for inventory purchased in Decem-
ber. The company purchased that amount based on the January sales forecast.
Cash operating expenses (30% of sales) in January will total $60,000. That,
coupled with the $10,000 fixed debt payment, increases the company’s total cash
needs for the month to $190,000.
Repeating the projection process for the next six months, we find that
Prudent’s monthly cash expenditures peak at $460,000 in April, then drop back
to $190,000 in June. This fluctuation reflects a seasonal demand for Prudent’s
products in the spring.

Table 29-2
Projecting Cash Expenditures
The Prudent Company
(in $l,000s)

Tanuarv Februarv March April May Jxuie

Sales $200 $250 $400 $500 $300 $200

Payments; Purchases
(60% of sales) 120 150 240 300 180 120

Operating Expenses
(30% of sales) 60 75 120 150 90 60

Debt Service 10 10 10 10 10 10

Total Cash Payments $190 $235 $370 $460 $280 $190

The next step interrelates the two cash flow projections and measures the net
effect those flows will have on the company’s cash reserves each month.

Interrelating the Cash Flows

Table 29-3 interrelates the two cash flow projections and isolates the result-
ing net effect on the Prudent Company’s cash reserves. This identifies tlie specific
months in which the company can expect a net increase or decrease in cash.

270
 The Cash Flow Budget

A $10,000 net increase in cash is projected in January. However, over the next
three months, cash expenditures exceed anticipated cash collections by a cumu-
lative total of $280,000. Alternatively, in the final two months of tlie forecast
period. Prudent generates healthy cash surpluses. This follows naturally from the
collection of receivables due from the seasonal peak in sales.

Table 29-3
Interrelating Cash Collections with Cash Expenditures
The Prudent Company
(in $l,000s)

January February March April May Tune

Projected Cash
Collections $200 $200 $235 $350 $455 $350

Projected Cash
Expenditures (190) (235) (370) (460) (280) (190)

Net Effect on
Cash Reserves + 10 (35) (135) (110) + 175 + 160

Now we will use the information in Table 29-3 to project the company’s need
for external financing to offset the impending imbalance in its cash flow.

Filling the Gaps in the Cash Flow Budget

The budgeting process interrelates the Prudent

final step in the cash flow
Company’s cash monthly net inflow or outflow of cash. There is
reserves with the
litde cause for concern so long as die net cash outflow in any month doesn’t
indicate a drain of the company’s cash reserves below some pracdcal minimum.
But if any monthly drain drops operating reserves below the minimum, the
company must seek external financing to fill die gap. Or, alternadvely, it can
execute the posidve management acdon necessary to avoid the gap by reducing
the investment in receivables or inventory or by using some other cash flow acdon
tool.
Note three additional facts about the company’s circumstances:

1. Prudent will open the six month period with a $100,000 cash reserve.
2. It has a $300,000 revolving line of credit.

3. Company policy requires $100,000 in cash as the minimum operating bal-

ance necessary to begin any month.

271
Positive Cash Flow Management •

Table 29-4 interrelates these facts with the previous projections to identify
the potential gaps in Prudent’s cash flow over the forecast period. The projection
also specifies the extent to which Prudent must use its line of credit to satisfy its

cash operating constraints.

Prudent has no cash flow problem projected in January. In fact, the ne t $ 1 0,000
gain enables the company February with $110,000 in cash reserves. In
to enter
February, however. Prudent feels the first effects of the seasonal increase in sales

on its cash reserves. While the $35,000 net cash drain in that month doesn’t create
a problem, does mean that the company must use
it $25,000 of its revolving line
to satisfy its minimum cash operating constraint.

Table 29-4
Filling theGaps in the Cash Flow Budget
The Prudent Company
(in $l,000s)

lanuarv Februarv March April May June

Beginning Cash $100 $110 $100 $100 $100 $100

Net Change + 10 (35) (135) (110) + 175 + 160

Ending Cash
(without borrowing) 110 75 (35) (10) 275 260

Borrowing — 25 135 110 (175) (95)

Ending Cash no 100 100 100 100 165

Cumulative Borrowing — 25 160 270 95 —

The $135,000 net cash drain projected in March emphasizes the critical
justification for the cash flow budgeting process. Failure to foresee that deficit in
the absence of a cash flow budget would have left Prudent with a severe cash flow
problem. Instead, Prudent will anticipate the problem and use an additional
$135,000 of its credit line to maintain tlie $100,000 minimum operating balance.
Prudent borrows another $110,000 in April to reach a peak usage of its ex-
ternal financing of $270,000. The positive cash flow in the following two months
of the projection enables the company to repay its debt and end June with a
comfortable $165,000 in cash reserves. The importance of the cash flow budget
rates recognition in:

Concept 67: A cash flow budget is the single,

indispensable tool for positive
cash flow management.

272
 The Cash Flow Budget

Although many businesses enjoy a more regular cash flow than is apparent
in Prudent’s seasonal business, the cash flowbudget remains valid and, indeed,
indispensable.

Cash Flow Action Tools

The Prudent Company fills the gap in its projected cash flow with the aid of
external financing. This remains the obvious answer to any cash flow problem.
However, the cash flow budget may serve as the signal to initiate other positive
actions that will eliminate aproblem without the aid of external financing. For
example, you might fill the gap with the cash that flows from a reduction in your
investment in accounts receivable. A more restrictive credit policy may generate
cash that eliminates the need for external financing.
Similar logic applies to an investment in inventory. Item analysis may indi-
cate that the business can achieve its projected volume witli less inv^entory. Low-
ering that investment again frees funds that fill the gap in the cash flow budget.

In extreme circumstance, the solution to a projected deficit cash flow

tlie

might come fiom less desirable, although nonetheless necessary', management

decisions. For example, a business might use trade credit as tlie source of external
financing. This means that the business decides to defer pay'ment to suppliers
beyond their designated terms. This solves tlie cash flow problem, but it risks the
business’s credit rating.
Alternatively, the solution might come from a lower sales volume. In other
words, the business might find that it can avoid a deficit cash flow only by lowering
its expectations. Holding expansion in check often becomes a rational alternative
to a cash flowproblem. In any circumstance, whatever management actions you
take, you must first identify the potential problem. This is the critical contribution
that comes from the cash flow budget.

Cash Safety Stock

Since we have often drawn assumptions that set the minimum level of cash
a business needs for normal operations, let’s rev'iew a basic approach that helps
identify that minimum level of operating cash.
From one perspective, you can view' cash reserv'es as you view your investment
in inventory. In other w'ords, your cash reserves should be sufficient to meet daily
cash expenditure. To add some cash safety stock
that basic inventory',. you should
to absorb any unforeseen expenditure requirements. You might also carry' an

273
Positive Cash Flow Management.

additional investment in cash sufficient to take advantage of profitable opportu-

nities that require cash.
Here we focus on the method that determines the practical minimum cash
balance necessary for normal operations including the appropriate safety stock.
You identify that balance from a straightforward analysis of your own historical
experience. You merely calculate your average daily cash expenditures over recent
months. Then, recognizing the special characteristics of your business, you esti-

mate the appropriate cash reserves as a specific number of days’ average cash
outflow.
For example, assume thatyour business made $180,000 in cash expenditures
ineach of the last three months. Using a thirty day month as the basis for analysis,
your average daily outflow comes from the calculation:

Monthly Cash
Average Daily _ Expenditure _ $180,000 _ qqq
Cash Expenditure 30 30

The business expends an average of $6,000 in cash per day. However, unless
you are certain that daily cash collections will equal or exceed daily cash expen-
ditures, you must carry some cash safety stock —
cash equivalent to several days’
—
expenditures to reduce the risk of not meeting all obligations on time.
You can identify that balance with another simple calculation. Relying on the
example above, a business might determine that cash sufficient to meet six days’
average expenditures is sufficient for normal operations. In that event, the
minimum required balance is found as:
Average Daily ^ Days Cash _ Minimum Operating
Expenditure Required Balance

$6,000 X 6 = $36,000

In this instance, whenever the balance drops below $36,000, the manager
should use an action tool appropriate to regain that minimum level.
Unfortunately, the number of days’ cash safety stock required varies with the
circumstance. You must iden tify that number by considering ( 1 ) the predictability
of cash inflows, (2) the flexibility of cash expenditures, and (3) the availability of
external financing.
First, the certainty associated with your cash collections exerts a direct in-
fluence on the days of cash expenditures required for your reserves. The more
certain the collection rate, the fewer days’ expenditures that are required as a
minimum balance. Alternatively, an erratic collection rate calls for a large cash
reserve. Without the larger reserve, the business with unpredictable collections

274
 The Cash Flow Budget

increases the risk of a cash flow problem — the inability to meet all obligations
promptly.
The flexibility of projected cash expenditures also influences the size of a
business’s necessary cash reserves. If you can defer supplier payments without
losing discounts or impairing future credit consideration, you can reduce your
minimum operating balance. Ifyou lack that flexibility, a larger minimum balance
may be necessary to preserve your financial integrity.
Finally, the pivotal factor that affects the size of a minimum operating cash
balance is a firm’s immediate access to additional external financing. If you have
immediate access to additional financing, you can absorb the risk normally
associated with lower operating balances. In such instances, the failure to receive
anticipated collections is offset easily with perhaps no more than a phone call that
draws on a line of credit.
The business that lacks die ability to obtain an immediate cash advance from
some external financing source must employ larger minimum cash balances. In
any event, the prudent business manager recognizes the need to carry' the ap-
propriate safety stock to avoid an unforeseen disruption in his cash flow. Safety
stock reduces the risk of a cash flow problem.

275
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Glossary

Accounts Payable: Amounts due for purchases made on credit.

Accounts Receivable: A claim against a debtor for merchandise sold or services

rendered in exchange for the customer’s promise to pay.

Accounts Receivable Revolving Loan (ARRL): A unique borrowing method that

employs the firm’s accounts receivable as collateral for a continuous revolv-
ing loan arrangement.

Accounts Receivable Turnover: The net credit sales during a specific period
divided by the average accounts receivable due from trade debtors; evaluates
the quality of the accounts by relating the average total outstanding to the
volume of credit sales.

An accounting method that recognizes sales when made and

Accrual Accounting:
expenses when incurred, regardless of when the cash transactions actually
occur.

Acquisition Cost: The cost a business incurs from purchasing inventory, distinct
from actual product costs, such as ordering costs.

Advance Rate: A percentage measure of the loan value relative to the accounting
value of an asset pledged as collateral for credit consideration.

Aged Analysis of Accounts Receivable: A report showing how long accounts

receivable have been outstanding; it identifies the receivables not past due
and those past due by, for example, one month, two months.
Cash Flow Problem Solver

Annual Cash Flow: The total of a firm’s net income plus depreciation; the total
measures the net incremental cash generated by operations over the course
of a year.

Asset Turnover: The ratio of total sales to total assets; a measure of the efficiency
of asset utilization.

Average Collection Period: The average number of days each credit sales dollar
remains outstanding; a qualitative indicator of the collectibility of a firm’s
accounts receivable.

Average Investment Period: The length of time each dollar remains in inventory
before a sale converts it into cash or accounts receivable.

Average Payable Period: The average length of time a business employs each
dollar of trade credit consideration.

Bad-Debt Write-Off: The loss incurred when an open account sale proves to be
uncollectible.

Balance Sheet: A financial statement that indicates what the firm owns and how
those assets are financed in the form of liabilities and ownership interest.

Break-Even Analysis: An analytic technique for studying the relationships among

fixed costs, variable costs, and profits.

Break-Even Cash Flow: The level of operations where total cash expenses equal
total cash revenue.

Break-Even Point: The volume of sales in a business where total costs equal total
revenue.

Carrying Costs: Financial or operational expenses incurred from a firm’s invest-

ment in assets.

Cash Accounting: An accounting method that recognizes sales and expenses only
when the cash transactions actually occur.

Cash Capability: The total that comes from adding the firm’s cash reserves to any
available but unemployed credit consideration.

Cash Conversion Period: The time lapse between the customer’s decision to
purchase a product and the date the payment for the purchase becomes cash
available for reinvestment.

Cash Flow Cycle: The natural flow of cash through the operations in a business:
cash to inventory to accounts receivable to cash.

278
 Glossary

Cash Insurance: See Credit Insurance.

Collection Period: See Average Collection Period.

Common Stock: A document that represents ownership in a corporation.

Compensating Balance: A required minimum checking account balance that a

firm must maintain as partial consideration for a loan from a commercial
bank.

Component Management: The management effort that concentrates on control of

the firm’s investment in assets.

Contribution Margin: Excess of sales price over variable expenses; an important

element in break-even analysis.

Cost of Goods Sold: The cost associated with units sold during a specific time
period.

Credit Insurance: A unique form of insurance that indemnifies the firm for
material losses because of accounts receivable that become uncollectible.

Credit Policy: The guidelines used in the decision process that approves or disap-
proves of an open account sale.

Current Ratio: Current assets divided by current liabilities; a measure of a firm’s

liquidity.

Days’ Sales in Inventory: See Average Investment Period.

Debt/Equity Ratio: The ratio of the total debt to the total equity employed in a
business.

Depreciation: A deduction of part of the cost of an asset from income in each year
of the asset’s useful life.

EBIT: Earnings before interest and taxes.

Economic Ordering Quantity (EOQ): The optimum (least cost) quantity of

inventory that should be ordered.

Equity: See Stockholders’ Equity.

Factoring: Selling accounts receivable to a finance company or bank.

FIFO Accounting: A system of writing off inventory into cost of goods sold; items
purchased first are written off first; referred to as first in, first out.

Financial Structure: The firm’s balance sheet.

Fixed Assets: Relatively permanent assets used in the operation of a business.

279
Cash Flow Problem Solver

Fixed Asset Turnover: The result obtained by dividing the firm’s sales volume by
its investment in fixed assets; a measure of the efficiency in employing those

assets.

Fixed Costs: Operating costs that remain constant regardless of the firm’s sales
volume; an important element in break-even analysis.

Float: The amount of funds represented in checks that have been written but are
still in process and have not yet been collected.

FYE: Fiscal year-end.

Gross Profit Margin: Total sales minus total cost of goods sold.

Growth Stock: That portion of the firm’s investment in inventory designed to

satisfy an anticipated increase in sales.

Income Statement: A financial statement that measures the profitability of the firm
over a period of time; all expenses are subtracted from sales to arrive at net
income.

Indemnification: The principle of insurance that compensates a policyholder for

incurred losses.

Inventory: Goods, purchased or manufactured, held by a business for sale.

Inventory/Sales Ratio: The proportional relationship between a firm’s investment

in inventory and its monthly sales volume; a criterion for controlling the
firm’s investment in inventory.

Inventory Turnover Rate: The cost of goods sold for a period divided by the firm’s
average investment in inventory; a measure of inventory management effi-
ciency.

Investment: The funds a business invests in accounts receivable, inventory, and

fixed assets.

Invoice: A detailed list of goods shipped or services rendered, with an account of

all charges due from the customer; the bill that evidences a sale.

Item Analysis: the technique that isolates the turnover rate associated with the
specific items that make up the inventory in a business.

Leverage: The ratio between the total debt and the total assets employed in a
business.

LIFO Accounting: A system of writing off inventory into cost of goods sold; items
purchased last are written off first; referred to as last-in, first-out.

280
 Glossary

Line of Credit: An arrangement whereby a financial institution commits itself to

lend up to a specified amount of funds during a specified period.

Liquidity: The ability of a business to meet obligations in a timely manner.

Nonnotification: Part of a lending arrangement whereby a business obtains a loan

secured by accounts receivable; however, the lender does not notify debtors
that receivables are pledged to secure the loan.

Notification: A procedure often employed when a borrower pledges accounts

receivable to secure a loan; the lender advises the debtors that their promises
to pay secure the credit consideration.

Open Account Sale: A sale made in exchange for the purchaser’s promise to pay
on a later date; however, no promissory note is involved.

Opportunity Costs: Earnings that might have been obtained if a productive asset,
service, or capacity had been applied to some alternative use.

Overinvestment: Any cash committed to excess investment in accounts receivable,

inventory, or fixed assets; or, extra assets unnecessary for the firm’s level of
operations.

Physical Count: The actual count of the items held in the firm’s inventory.

Preferred Stock: A hybrid security combining some of the characteristics of both

common stock and debt.

Purchase Order: The document or advice that enters an order for the purchase of
merchandise or services.

Quantity Discounts: Price reductions obtained by purchasing goods in larger lots.

Receivable/Sales Ratio: The proportional relationship between a firm’s invest-

ment in accounts receivable and its monthly sales volume; a criterion for
controlling the firm’s investment in accounts receivable.

Return on Assets (ROA): Earnings divided by average total assets; a profitability

ratio.

Return on Investment (ROI): Earnings divided by average total assets; same as

return on assets. A measure of the firm’s operating efficiency.

Safety Stock: Inventory held by a firm in excess of anticipated requirements to

protect against unforeseen shortages.

Sales/Fixed Assets Ratio: See Fixed Asset Turnover.

281
Cash Flow Problem Solver

Selling Terms: The length of time a seller allows for payment of purchases made
on credit; often includes discounts allowed for early payment.

Stockholders’ Equity: The total of common stock and all retained earnings.

Stock-Out Cost: The opportunity cost that results from the inability to satisfy
customer demand because of insufficient inventory; the firm loses the profit
from a potential sale.

Straight Lin e Depreciation: A method of depreciation that takes the depreciable

cost of an asset and divides it by its useful determine the annual
life to

depreciation expense; straight line depreciation creates a uniform expense

every year an asset is depreciated.

Structural Management: The management perspective that seeks to maintain the

proper balance among the elements that make up the financial structure in a
business.

Tangible Net Worth: The book value of a business less any intangible assets; the

value of the corporeal assets.

Trade Credit: Interbusiness debt that arises from credit sales; recorded as an
account receivable by the seller and as an account payable by the buyer.

Trade Discoimt: A deduction in the list price of goods allowed by a seller in return
for payment within a specified time; for example, 2% 10, netSO day terms
allows a 2% discount from the list price if paid within ten days.

Variable Cost: A cost that is uniform per unit, but that fluctuates in total in direct
proportion to changes in the related total activity or volume; an important
element in break-even analysis.

Wire Transfer: Transfer of funds through the electronic network that unites the
banking system.

282
 About Sourcebooks Trade
In 1990, Sourcebooks Inc., started its trade division. Sourcebooks Trade. Our goal was to
provide easy-to-understand, empowering how-to books for today’s consumers. We began
by developing practical business and finance books. Offering a wide range of expertise, we
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The Basics of Finance: Financiai Toois for Non-Financiai Managers

by Bryan E. Milling

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Cash Fiow Probiem Soiver: Common Probiems and Practicai Soiutions

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IllA PROFITS-ORIENTED APPROACH
TO CASH FLOW MANAGEMENT III
Thousands of business owners have discovered that the Cash Flow Problem Solver: Common
Problems and Practical Solutions is a tool of surpassing value in the day-to-day management of a
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Cited as one of the three books on the "SmartCEO's Reading List"

inINC Magazine. Selected as an alternate of both the Business
Week Book Club and the Fortune Book Club.
In addition, Cash Flow Problem So/ver provides a results-oriented, step-by-step guide with tools

and specific tactics to assure positive cash flow and to help boost a firm's profits.

This book is designed for the independent business manager whose background is marketing or

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questions such as:
• How does a faster accounts receivable turnover rate benefit a firm's bottom-line?
• How do idle assets affect a firm's cash flow and profits?
• How does a business combat a crimp in its cash flow that makes lose valuable trade discounts?
it

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• Realistic examples and illustrations • Bottom-line benefits for effective cash flow management
• Essential principles of financial management

Now in its third edition, Cash Flow Problem Solver \s a proven bestseller and has

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