CONTEMPORARY FINANCIAL MANAGEMENT

Chapter 16:

Current Asset Management

INTRODUCTION

The first half of the chapter reviews the various cash management decisions made by financial managers.

Financial managers must consider the risk- return trade-offs characteristic of these decisions.

The second half of the chapter discusses the management of accounts receivable and inventory.

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THE BALANCE SHEET

Current Assets Current Liabilities

Cash Accounts Payable

Securities Current Portion of LT Debt

Accounts Receivable

Total Current Liab

Inventory

Total Current Assets Owner’s Equity

Fixed Assets

Total Assets Total Liab & OE

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CASH AND MARKETABLE SECURITIES

On the Balance Sheet, the most liquid assets are listed first. These consist of cash & marketable securities.

Cash consists of currency and deposits in checking accounts

Marketable securities consist of short-term investments made with idle cash

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CASH MANAGEMENT FUNCTION

The cash management function is concerned with determining:

The optimal size of a firm’s liquid asset balance The most efficient methods of controlling the collection and

disbursement of cash The appropriate types and amounts of

short-term investments

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CASH MANAGEMENT DECISIONS

Must consider the risk versus expected return trade-offs from alternative policies

Too little cash increases risk; too much cash reduces return (cash is a non-earning asset)

The safest and most liquid securities also carry the lowest expected return

Thus the function of the financial manager is to find an appropriate balance between maximizing return and minimizing risk

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CASH MANAGEMENT DECISIONS

The financial manager must determine the optimal size of the cash balance, recognizing:

Holding excess liquid assets results in an opportunity cost (liquid assets are the lowest return assets)

Inadequate liquid balances may result in costs arising from:

Missed cash discounts Deterioration of the firm’s credit rating Higher interest costs Risk of insolvency

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REASONS FOR HOLDING LIQUID ASSETS

Transactions: to ensure the firm can meet its obligations as they come due

Precautionary: to guard against future cash flow shortfalls

Speculative: to allow for potential acquisitions or major investments

Future requirements: to prepare for fixed and known obligations, such as tax payments, dividends, etc.

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CASH BUDGET

The first step in cash management is the preparation of a cash budget showing forecasted receipts & disbursements

The cash budget may be for a daily, weekly or monthly cycle

The cash budget reveals any cumulative cash flow shortages or surpluses

The cash budget is required because cash inflows and outflows are seldom synchronized

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ISSUES IN THE COLLECTION OF CASH

Management's goal Speed the collection of cash and/or slow the disbursement of

cash

Float – reconciling the differences between bank account balances and accounting records

Methods of expediting the collection of cash Decentralized collection system Lockbox

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FLOAT Positive Float

Bank balance is greater than that shown by the firm’s accounting records

Negative Float Bank balance is less than that shown by the firm’s accounting

records

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COMPONENTS OF FLOAT Mail Float

delay between when a cheque is sent to a payee and its receipt by the payee

Processing Float time between receipt of payment by a payee and the deposit of the

payment in the payee’s account

Clearing Float time between depositing a cheque and having available spendable

funds

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ELECTRONIC FUNDS TRANSFER

Electronic funds transfer mechanisms are quickly reducing the importance of float management techniques for many companies

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EXPEDITING THE COLLECTION OF CASH

Decentralized collection centers – to reduce delays due to mail, cheques are sent to local collection centers, where they are deposited

The firm then transfers all deposits into one concentrator account, from which cheques are written

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EXPEDITING THE COLLECTION OF CASH

A Lockbox is similar to a decentralized collection center, except a local bank empties the box, deposits payments into the firm’s account and makes a report of the payments.

Lockboxes may involve significant fees

More beneficial for small number of larger deposits

Evaluation involves comparison of costs versus benefits of faster collection

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SLOWING CASH DISBURSEMENTS Zero-balance system

Transfers cash in the exact amount required for the cleared checks

Drafts Deposit funds only after the draft is presented for payment

Synchronize deposits with check clearings Requires accurate estimates of float

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CASH MANAGEMENT FOR SMALL FIRMS

Less-extensive access to capital markets

Cash shortage may be more expensive to rectify

Many small businesses are often growing rapidly, leading to constant cash shortages

Small firms often have low cash balances

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CHOOSING MARKETABLE SECURITIES

Default risk Lowest on T-bills Risk and expected return inversely related

Marketability Ability to sell quickly without significant price concession

Maturity Shorter maturities have less risk of price fluctuation

Rate of return (lowest priority item)

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EXAMPLES OF MARKETABLE SECURITIES

Treasury Bills Short-term government note issued at a discount with

principal repaid at maturity.

Commercial Paper Short-term unsecured promissory note issued by corporations

with good credit.

Banker’s Acceptance Short-term promissory note issued by a firm and accepted (or

guaranteed) by a commercial bank

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EXAMPLES OF MARKETABLE SECURITIES

Repurchase Agreements (Repo) agreement whereby a firm with excess cash “buys” a security

today with a subsequent agreement to sell it back at a fixed price on a future date

difference between the purchase price and the sale price is the interest earned during the holding period

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MULTINATIONAL CORPORATION (MNC) Must track cash balances around the world

Usually have centralized cash management

Employ cash transfer facilities

Variety of investment opportunities to improve short-term borrowing/lending terms

Use multilateral netting Cross-border transactions are netted off to minimize costly

transactions and misdirected funds

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ACCOUNTS RECEIVABLE (A/R) Accounts Receivable represent a large investment for most

companies

Extend credit when marginal returns from extending credit exceed marginal costs

Liberal credit policy provides extra returns in the form of increased sales and gross profit

Extra costs occur due to: Cost of funds Costs of credit checking Potential for bad debts

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CREDIT POLICY Credit Standards

Criteria used to screen credit applications Controls the quality of accounts to which credit is extended

Credit Terms Terms and conditions under which credit extended must be

repaid

Collection Efforts Methods employed in an attempt to collect payment on past due

accounts

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CREDIT TERMS

Credit period Time allowed for payment

Cash discount Allowed if payment is made within a specific period of time Specified as percent of the invoiced amount Granted to speed up collection of A/R

Seasonal dating Offered to retailers on seasonal merchandise Accept delivery well ahead of peak season Pay shortly after peak sales

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CREDIT STANDARDS

Quality Time a customer takes to repay Probability a customer will fail to repay

Measures of quality Average collection period Bad-debt ratio

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PRETAX PROFITS FROM GRANTING CREDIT

Marginal profitability of additional sales = Profit contribution ratio × Additional sales

Additional investment in A/R =Additional average daily sales × Avg. collection period

Cost of additional investment in A/R = Additional investment in A/R × Pretax required return

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PRETAX PROFITS FROM GRANTING CREDIT

Additional bad-debt loss = Bad-debt loss ratio × Additional sales

Cost of additional investment in inventory = Additional inventory × Pretax required return

Net change in pretax profits = Marginal returns – Marginal costs

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COLLECTION EFFORTS

Balance between leniency and alienating customers

Monitoring status Aging of accounts analysis

Classifying accounts into categories according to the number of days they are past due

Changes in the age composition of accounts may reveal changes in the quality of A/R

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ANALYSIS OF A CHANGE IN CREDIT POLICY

Increase in the credit period Increase the quantity of goods sold

Liberalization of cash discount Increase in sales & pretax profit contribution Reduction in A/R balance

Additional income from alternative investments Decrease in cost of funds Reduction in cash revenue

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ANALYSIS OF A CHANGE IN CREDIT POLICY

Increase in collection effort Reduced sales and pretax profit contribution Increased collection expenses Reduced bad-debt losses

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EVALUATION OF CREDIT APPLICATIONS

Gathering information

How much does the analysis cost?

Numerical scoring system

Five Cs of credit Character Capacity Capital Collateral Conditions

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INVENTORY

Inventory consists of raw materials, work-in-process and finished goods

Inventory is costly to manage and hold, as it consumes time and requires funding, exactly like a new machine or building

The inventory management problem is to find the lowest level of inventory consistent with maximizing profits

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TYPES OF INVENTORY Raw materials inventory

Store of items used in the production process May qualify for quantity discounts Assure supply in times of scarcity

Work-in-process inventory Items at some intermediate stage of completion Size related to length and complexity of production cycle

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TYPES OF INVENTORY Finished goods inventory

Items ready and available for sale Permits prompt filling of orders Large production runs create economies of scale

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COSTS OF AN INVENTORY POLICY

Ordering costs: Cost of placing and receiving an order of goods

Carrying costs: Cost of holding inventory Expressed as cost per unit per period A percent of the inventory value per period

Stockout costs: Incurred when a firm is unable to fill an order, resulting in: Lost sales Rescheduling production Expediting special orders

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TYPES OF INVENTORY CONTROL MODELS

Two basic types of inventory control models

Deterministic models – inputs are known with certainty Example: Economic Order Quantity Model

Probabilistic models – inputs are random variables with known probability distributions

Management should choose an inventory control model with a cost and a complexity that is consistent with size of the firm and value of the inventory being managed

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INVENTORY CONTROL MODELS ABC inventory classification

A – large dollar value items but comprise a relatively small percentage of the total number of items held in inventory. Items may comprise 1- 10% of the number of items carried but be worth

80-90% of the total dollar value of inventory. B – items fall between items A & C C – low dollar value items but comprise a large percentage of the

total items held

The firm will manage its inventory of A items much more closely than its inventory of C items

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INVENTORY CONTROL MODELS Economic Order Quantity (EOQ) model

EOQ is the order quantity (Q) that minimizes total costs.

Using the value of Q, the optimal length of one inventory cycle (T) can be determined.

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=* 2SDQ

C=

÷

** Q

TD 365

Q = Order quantityD = Demand for the itemS = Cost of placing and receiving an order (set-up cost)C = Annual cost of carrying one unit of item in inventory

EXAMPLE: EOQ

Sears sells mattresses at all stores located in the Toronto area. The mattresses are stored in a central warehouse. Annual demand is 3,600 mattresses, spread evenly throughout the year. The cost of placing and receiving an order is $31.25. The annual carrying cost is $10 (equal to 20% of the wholesale cost of the inventory). What is the size of the order Sears should place with its supplier to minimize its inventory cost?

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SOLUTION: EOQ

( ) ( )=

=

2SDQ* =

C

2 $31.25 3,600

$10

150

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Conclusion:

To minimize its inventory costs, Sears should order 150 mattresses at a time.

EOQ: GRAPHICAL SOLUTION

41Q (Units)

Cost ($)

Total Cost

Q*

CarryingCost = CQ/2

Ordering Cost = DS/Q

INVENTORY CONTROL MODELS

Extensions to the basic EOQ model

Nonzero lead time If a lead time is required for delivery, the order must be placed some

days in advance of a stock-out occurring

Probabilistic inventory control methods Use when input factors, such as demand, lead times, etc are not

known with certainty

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INVENTORY CONTROL MODELS

Just-In-Time Inventory Management System Inventory supplied

At exactly the right time In exactly the right quantities

Requires close coordination between Company Suppliers

Shorten the operating cycle

Reduce costs

Eliminate wasteful procedures 43

MAJOR POINTS Current assets represent a major investment for many firms

but they are often don’t receive the management attention they deserve.

The job of the financial manager is to find the appropriate balance between minimizing risk and maximizing return.

No one method is “right” for all firms. The method chosen will depend on firm size, complexity and the options currently available to it.

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