Current Asset Management Chapter 7 Current Asset Management

Chapter 7 - Outline What is Current Asset Management? Cash Management Ways to Improve Collections Marketable Securities 3 Primary Variables of Credit Policy Economic Ordering Quantity Inventory Management

What is Current Asset Management? Current Asset Management is essentially an extension of working capital management It is concerned with the current assets of a firm (cash, A/R, marketable securities, and inventory) A financial manager needs to remember that the less liquid an asset is, the higher the required return

Cash Management Financial manager wants to keep cash balances to a minimum There are 2 reasons for holding cash: – for everyday transactions (main reason) – for precautionary needs (emergencies) Goals are to speed up the inflow of cash (or improve collections) and slow down the outflow of cash (or extend disbursements) Previously, could attempt to “play the float”

Cash Conversion Cycle Is the length of time from the payment for the purchases of raw materials to the collection of accounts receivable that were generated by the sale of the finished product, (i.e., the time between paying out cash and receiving cash). Cash Conversion Cycle = Inventory Conversion Period + Receivables Collection Period (DSO) - Payable Deferral Period = Inventory/ Sales per Day + Receivables / Sales per day – Payables / Credit purchases per day

Ways to Improve Collections Collection Center – speeds up collection of A/R and reduces mailing time Electronic Funds Transfer (or Wire Transfer of Funds) – a system where payments are automatically deducted from a bank account - Online payment systems Lockbox System – when customers mail payment to a local post office box instead of to the firm

Marketable Securities When a firm has excess funds, it should be converted from cash into interest-earning securities Some Types of securities: Treasury bills: Short-term obligations of the government Treasury notes: Government obligations with a maturity of 1-10 years Federal agency securities: Offerings of government organizations Certificate of deposit: Offered by commercial banks, savings, and other financial institutions Commercial paper: Represents unsecured promissory notes issued by large business organizations Banker’s acceptances: Short-term securities that arise from foreign trade

3 Primary Variables of Credit Policy There are 3 things to consider in deciding whether to extend credit: – Credit Standards (5 Cs- Character, Capital, Capacity, Conditions, Collateral) – Terms of Trade – Collection Policy Average Collection Period Ratio of Bad Debts to Credit Sales Aging of Accounts Receivable

Collection Policy Ratio of bad debts to credit sales A number if quantitative measures applied to asses credit policy - Average collection period Ratio of bad debts to credit sales Aging of accounts receivable

Inventory Management Inventory is divided into 3 categories: – Raw Materials – Work in Progress (WIP) or Unfinished Goods – Finished Goods There are 2 basic costs associated with inventory: – Carrying Costs (TCC) – Ordering Costs (TOC) Total Inventory Costs = TCC + TOC = C (Q/2) + O (S/Q) Where C is carrying cost per unit and O is Cost per order, S is Total sales in units, and Q is units in inventory. Note: Q/2 is average inventory and S/Q is total # of orders Should try to minimize Total inventory Costs

Economic Ordering Quantity Economic Ordering Quantity (EOQ): – the optimal (best) amount for the firm to order each time – occurs at the low point on the total cost curve – the order size where total carrying costs equal total ordering costs (assuming no safety stock) EOQ = (2SO/C)^.5 Where S = Total sales in units, O = ordering costs per order, and C = Carrying Cost per unit Safety Stock: –“extra” inventory the firm keeps in stock in case of unforeseen problems

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EOQ Model Assumes: 1. All values are known with certainty and are constant over time. 2. Inventory usage is uniform over time. 3. Carrying costs increase linearly with inventory level. 4. Ordering costs are fixed per order. A firm may want safety stock to guard against changes in sales rates or production/shipping delays. This amount would be added to the average inventory and would increase inventory carrying costs.

Safety Stocks and Stock Outs Stock out occurs when a firm is: Out of a specific inventory item Unable to sell or deliver the product Safety stock reduces such risks Increases cost of inventory due to a rise in carrying costs This cost should be offset by: Eliminating lost profits due to stockouts Increased profits from unexpected orders

Safety Stocks and Stock Outs (cont’d) Assuming that; Average inventory = EOQ + Safety stock 2 Average inventory = 400 + 50 The inventory carrying costs will now increase by $50 Carrying costs = Average inventory in units × Carrying cost per unit = 250 × $0.20 = $50

Just-in-Time Inventory Management Basic requirements for JIT: Quality production that continually satisfies customer requirements Close ties between suppliers, manufactures, and customers Minimization of the level of inventory Cost Savings from lower inventory: On average, JIT has reduced inventory to sales ratio by 10% over the last decade

Advantages of JIT Reduction in space due to reduced warehouse space requirement Reduced construction and overhead expenses for utilities and manpower Better technology with the development of electronic data interchange systems (EDI) EDI reduces re-keying errors and duplication of forms Reduction in costs from quality control Elimination of waste

Areas of Concern for JIT Integration costs Parts shortages could lead to lost sales and slow growth Un-forecasted increase in sales: Inability to keep up with demand Un-forecasted decrease in sales: Inventory can pile up A revaluation may be needed in high-growth industries fostering dynamic technologies