Current Asset Management Chapter 7 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline Introduction to management of current assets Cash management and its importance Management of marketable securities Management of accounts receivable – credit policy decisions for maximizing profitability Inventory management – determining the level of inventory to enhance sales and profitability Liquidity and required return

Introduction Companies that manage their current assets well, establish a competitive advantage Helps increase their market share Creates an increase in shareholder value through a rising stock price Requires a careful allocation of resources among the current assets of the firm: Cash Marketable securities Accounts receivable Inventory.

Introduction (cont’d) In managing cash and marketable securities Primary concern should be for safety and liquidity Secondary attention should be placed on maximizing profitability In managing accounts receivable and inventory, a stiffer profitability test must be met Investment level should not be a result of happenstance or historical determination Must meet the same return-on-investment criteria applied to any decision. Different decision techniques are applied to the various forms of current assets.

Cash Management Financial managers actively attempt to keep cash (non-earning asset) to a minimum It is critical to have sufficient cash to assuage emergencies To improve overall profitability of a firm: Minimize cash balances Have accurate knowledge of when cash moves in and out of the firm

Reasons for Holding Cash Balances Transactions motive Payments towards planned expenses Compensating balances for banks Compensate a bank for services provided rather than paying directly for them Precautionary needs Emergency purposes

Cash Flow Cycle Cash moves through a firm in a cycle Cash flow relies on: Payment pattern of customers Speed at which suppliers and creditors process checks Efficiency of the banking system Inflows and outflows of cash are to be synchronized properly for transaction purposes.

Cash Flow Cycle (cont’d) Selling on the internet generates cash flow much faster than sales using retailer’s own credit card Financial managers must pay close attention to the percentage of sales generated by: Cash Outside credit cards Company’s own credit cards

Cash Flow Cycle (cont’d) Cash inflows are driven by sales and influenced by the: Customers’ geographical location Product being sold Industry Type of customers Firms use cash to make various payments to: Suppliers Lenders Stockholders Government Workers When cash is needed for current assets, firms generally: Sell the marketable securities Borrow from short-term lenders

Expanded Cash Flow Cycle

Float The time period between the mailing of a check and the collection period Difference between firm’s recorded amount and amount credited to the firm by a bank Two types of float: Mail float: Occurs because of the time a mail takes before it gets delivered. Clearing float: Occurs because of the time a check takes before it gets cleared. For large corporations these floats do not exist anymore because of electronic payments (permissible under Check 21 Act) Check Clearing for the 21st Century Act (Check 21) Allows banks and others to electronically process a check

Improving Collections and Extending Disbursements Setting up multiple collection centers at different locations Adopt lockbox system for expeditious check clearance at lower costs Extending disbursement: General trend: Speedup processing of incoming checks Slow down payment procedures Extended disbursement float – allows companies to hold onto their cash balances for as long as possible

Cost-Benefit Analysis Costs associated with an efficiently maintained cash management program must be compared to the benefits that it provides

Cash Management Network

Electronic Funds Transfer Funds are moved between computer terminals without the use of a ‘check’ Automated clearinghouses (ACH): Transfers information between financial institutions and between accounts using computer tape International fund transfer is carried out through SWIFT (Society for Worldwide Interbank Financial Telecommunications) Uses a proprietary secure messaging system Encrypts each message Authenticates every money transaction by a code using smart card technology Assumes financial liability for the accuracy, completeness, and confidentiality of transaction

International Cash Management Factors differentiating international cash management from domestic based systems: Differing payment methods and/or higher popularity of electronic funds transfer Subject to international boundaries, time zone differences, currency fluctuations, and interest rate changes Differing banking systems and check clearing processes Differing account balance management and information reporting systems Cultural, tax, and accounting differences

International Cash Management (cont’d) Financial managers try to keep cash in a country with a strong currency Sweep account: Allows companies to maintain zero balances Excess cash is swept into an interest-earning account

Marketable Securities Funds held for other than immediate transaction purposes should be invested in interest-earning securities Types of short term investments: Treasury bills Federal agency securities Certificate of deposit Commercial paper Banker’s acceptances Eurodollar certificate of deposit. Passbook savings account Money market fund Money market accounts

An Examination of Yield and Maturity Characteristics

Types of Short-Term Investments

Management of Accounts Receivable Accounts receivable as an investment Should be based on whether the level of return earned on such investment equals or exceeds the potential gain from other investments Credit policy administration Credit standards Terms of trade Collection policy

Credit Standards Determine the nature of credit risk based on: Prior records of payment and financial stability, current net worth, and other related factors 5 Cs of credit: Character Capital Capacity Conditions Collateral

Credit Standards (cont’d) Dun & Bradstreet Information Services (DBIS): Produces business information analysis tools Publishes reference books Provides computer access to information Assigns Data Universal Number System (D-U-N-S) - a unique nine-digit code to each business in its information base

Dun & Bradstreet Report – An Example

Terms of Trade Stated term of credit extension: Has a strong impact on the eventual size of accounts receivable balance Creates a need for firms to consider the use of cash discounts

Collection Policy A number of quantitative measures are applied to asses credit policy: Average collection period An increase would indicate poor credit administration Ratio of bad debts to credit sales An increasing ratio may indicate too many weak accounts or an aggressive market expansion policy Aging of accounts receivable

An Actual Credit Decision Brings together various elements of accounts receivable management Accounts receivable = Sales = $10,000 = $1,667 Turnover 6 An average investment of $1,667 is fetching a post tax profit of $480, which is approximately 28.8%.

Inventory Management Inventory has three basic categories: Raw materials Work in progress Finished goods Amount of inventory is affected by sales, production, and economic conditions As inventory is the least liquid of current assets, it should provide the highest yield

Level versus Seasonal Production Level production Allows maximum efficiency in manpower and machinery usage May result in high inventory buildup particularly in seasonal business Seasonal production Eliminates inventory buildup problems May result in unused capacity during slack periods May result in overtime wages and inefficiencies arising out of overused equipments

Inventory Policy in Inflation (and Deflation) Inventory position can be protected in an environment of price instability by: Taking moderate inventory positions Hedging with a futures contract to sell at a stipulated price some months from now Rapid price movements in inventory may have a major impact on the reported income of the firm

The Inventory Decision Model Carrying costs Interest on funds tied up in inventory Cost of warehouse space, insurance premiums, and material handling expenses Implicit cost associated with the risk of obsolescence and perishability Ordering costs Cost of ordering Cost of processing inventory into stock

Determining the Optimum Inventory Level

Economic Ordering Quantity EOQ = 2SO ; C Where, S = Total sales in units O = Ordering cost for each order C = Carrying cost per unit in dollars Assuming: S= 2000 units; O=$8; C= $0.20; EOQ = 2SO = 2 X 2,000 X $8 = $32,000 = 160,000 C $0.20 $0.20 = 400 units

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 the risk of losing sales 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; EOQ = 400 units and safety stock = 50 units Average inventory = EOQ + Safety stock 2 Average inventory = 400 + 50 The inventory carrying costs will now increase to $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 an 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 rekeying 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 during recession A revaluation may be needed in high-growth industries fostering dynamic technologies