Current Assets Management 14 Current Assets Management

14.1 Cash Management

Reasons for Holding Cash Transaction balance – A cash balance associated with payments and collections; the balance necessary for day-to-day operations. Precautionary balance – A cash balance held in reserve for random, unforeseen fluctuations in cash inflows and outflows. Speculative balance – A cash balance held to enable the firm to take advantage of any bargain purchases that might arise.

Types of Float Float – The difference between the book balance ( the cash balance in the firm’s book ) and the available balance ( the cash balance recorded at the bank ). Disbursement float Generated when a firm writes checks Available balance > book balance Collection float Generated when a firm received checks Available balance < book balance Net float = disbursement float + collection float If net float is positive, available balance > book balance A Firm should be concerned with its net float and available balance more than with its book balance.

Float Management Total collection or disbursement times can be broken down into three parts: Mailing time Processing delay Availability delay Speeding up cash collections involves reducing one or more of these components. Slowing down cash disbursement involves increasing one of them.

Measuring Float The size of float depends on both the amount and the time delay involved. Example: Suppose you mail a check each month for $12,000 and it takes 3 days to reach its destination, 2 day to process, and 1 day before the bank makes the cash available. What is the average daily float? (3+2+1)($12,000)/30 = $2,400

Cost of Float The basic cost of collection float to the firm is the opportunity cost of not being able to use the cash. Example: The company receives an average of $20,000 in checks per day. The delay in clearing is typically 4 days. The current interest rate is 0.02% per day. What is the highest daily fee the company should be willing to pay to eliminate its float entirely? Collection float = 4($20,000) = $80,000 Maximum daily charge = $80,000(0.0002) = $16

Cash Collection Some methods to speed up cash collection Lockboxes Concentration banking system Wire transfers

Cash Collection: Example The company is considering a lockbox system which will reduce the collection time by 2 days. The daily interest rate is 0.016%. The average number of daily payments to each lockbox is 8,500 and average size of payment is $108. If the bank charges a fee of $225 per day, should the lockbox project be accepted? Average daily collections = $108(8,500) = $918,000 PV = 2($918,000) = $1,836,000 PV of cost = $225/0.00016 = $1,406,250 NPV = –$1,406,250 + 1,836,000 = $429,750 The NPV is positive, so the lockbox project should be accepted.

Cash Disbursements Slowing down disbursements can increase disbursement float, but it may cause ethical problems. Controlling disbursements Zero-balance account Controlled disbursement account

Investing Idle Cash Because of seasonal and cyclical activities, to help finance planned expenditures, or as a contingency reserve, firms temporarily hold a cash surplus. The money market offers a variety of possible short-term financial assets for the idle cash.

The Target Cash Balance The target cash balance involves a trade-off between the carrying costs and the trading costs. The carrying costs The opportunity costs of holding cash The trading costs The costs associated with buying and selling marketable securities

The BAT Model The Baumol-Allais-Tobin (BAT) model is a classic, simple and most stripped-down sensible model for determining the optimal cash position. Where C* – Optimal cash balance F - Fixed cost of making a securities trade T - Total amount of new cash needed for transactions during the relevant period (usually 1 year) R - Opportunity cost of holding cash, equal to the interest rate on marketable securities. Its chief weakness is that it assumes steady, certain cash outflows.

The BAT Model: Example Annual interest rate = 6% Fixed order cost = $25 Total cash needed = $8,500 C* = [(2T × F)/R]1/2 = [2($8,500)($25)/0.06]1/2 = $2,661.45

Implications of the BAT Model The greater the interest rate, the lower is the target cash balance. The greater the order cost, the higher is the target cash balance.

The Miller-Orr Model The Miller-Orr model assume that the cash balance fluctuates up and down randomly and that the average change is zero. Management set the lower limit, L. If the cash balance is between L and U* (the upper limit), no transaction is made. The advantage of the model is that it considers the effect of uncertainty.

The Miller-Orr Model where C* – Optimal cash balance L – Lower control limit of cash balance s2 – The variance of net daily cash flows U* - Upper control limit of cash balance

The Miller-Orr Model: Example The firm has a fixed cost associated with buying and selling marketable securities of $40. The interest rate is currently 0.021% per day. The firm has estimated that the standard deviation of its daily net cash flow is $70. Management has set a lower limit of $1,500 on cash holdings. C* = L + (3/4 × F × 2 / R]1/3 = $1,500 + [3/4($40)($70)2/0.00021]1/3 = $2,387.90

Implications of Miller-Orr Model The greater the interest rate, the lower the target cash balance. The greater the order cost, the higher the target cash balance. The greater the uncertainty is, the greater the difference between the target balance and the minimum balance. The greater the uncertainty is, the higher the upper limit and the higher the average cash balance.

14.2 Credit Management

Credit Management Granting credit normally increases sales. Granting credit has both direct and indirect costs. Chance that customers will not pay Costs of carrying the receivables The credit policy involves a trade-off between the benefits of increased sales and the costs of granting credit.

Components of Credit Policy Terms of sale The credit period The cash discount and discount period The type of credit instrument Credit analysis Determining the probability that customers will not pay Collection policy The firm’s toughness or laxity in following up on slow-paying accounts.

Terms of Sale Example: 2/10, net 60 General Form: 2% cash discount from the full price if payment is made in 10 days Full amount due in 60 days form the invoice date General Form: <take this discount off the invoice price> / <if you pay in this many days>, <else pay the full invoice amount in this many days>

The Credit Period The basic length of time for which credit is granted. If a cash discount is offered, the credit period has two components. The net credit period – the length of time the customer has to pay The cash discount period – the time during which the discount is available Factors influencing the length of credit period The shorter the buyer’s inventory period, the shorter the credit period. The shorter the operating cycle, the shorter the credit period.

Cash Discounts Cash discount is a discount in the price of goods given to encourage early payment. Although the cash discounts are rather small, if you calculate the cost to the buyer of not paying early, you will find the interest rate that the buyer is effectively paying for the trade credit is extremely high. The company benefits when customers forgo discounts.

Credit instruments Open account Promissory note Commercial draft Sight draft Time draft Trade acceptance Banker’s acceptance Conditional sales contract

Credit Policy Analysis The NPV of granting credit depends on five factors. Revenue effects Cost effects The cost of debt The probability of nonpayment The cash discount

Evaluating a Proposed Credit Policy: Example A company currently has a cash only policy. It is considering a switch to a net 30 policy. Currently, the price per unit is $290 and cost per unit is $230. The company currently sells 1,105 units per month. Under the proposed policy, the company expects to sell 1,125 units per month. The price per unit will be $295 and the cost per unit will be $234. If the required monthly return is 0.95% per month, what is the NPV of the switch? Should the company offer credit terms of net 30?

Evaluating a Proposed Credit Policy: Example Cash flow from old policy = ($290 – 230)(1,105) = $66,300  Cash flow from new policy = ($295 – 234)(1,125) = $68,625 Incremental cash flow = $68,625-66,300 = $2,325  NPV of switching= –[($290)(1,105) + (1,105)($234 – 230) + ($234)(1,125 – 1,120)] + ($2,325/0.0095) = –$84,813.16 Since the NPV is negative, the company should not offer the credit terms of net 30.

Optimal Credit Policy The optimal amount of credit the firm should offer depends on the competitive conditions under which the firm operates. These conditions will determine the carrying costs associated with granting credit and the opportunity costs of the lost sales resulting from refusing to offer credit. The optimal credit policy minimizes the sum of carrying costs and opportunity costs.

Credit Analysis The process of deciding whether or not to grant credit to a particular customer. Two steps: Gathering relevant information Determining creditworthiness

Credit Information Financial statements Credit reports about the customer’s payment history with other firms Banks The customer’ payment history with the firm

Determining Creditworthiness Credit evaluation - Five C’s of credit Character – the customer’s willingness to meet credit obligations Capacity – the customer’s ability to meet credit obligations out of operating cash flows Capital – the customer’s financial reserves Collateral – an asset pledged in the case of default Conditions – General economic conditions in the customer’s line of business Credit scoring

One-Time Sale NPV = -v + (1 - )P / (1 + R) where v - variable cost per unit  - probability of default P – price per unit R – the required return on receivables per month It makes sense to grant credit to almost everyone once, as long as the variable cost is low relative to the price.

One-Time Sale: Example Your company is considering granting credit to a new customer. The variable cost per unit is $20; the current price is $60; the probability of default is 25%; and the monthly required return is 1%. NPV = -$20 + (1-0.25)(60)/(1.01) = $24.55 The break-even probability 0 = -20 + (1 - )(60)/(1.01)  = 66.33%

Repeat Business NPV = -v + (1-)(P – v)/R Example: If a customer defaults once, credit can’t be granted again.

Collection Policy Monitor the age of accounts receivable Keeping track of ACP though time The aging schedule Deal with past-due-accounts Delinquency letter Telephone call Collection agency Legal action

14.3 Inventory Management

Inventory Management Inventory management involves determining how much inventory to hold, when to place order, and how many units to order at a time. Other functional areas will share decision-making authority regarding inventory.

Types of Inventory Manufacturer Things to remember Raw material Work-in-progress Finished goods Things to remember One’s raw material may be another’s finished goods. Different types of inventory can be different in terms of liquidity. The demand for finished goods is independent.

Inventory Costs Carrying costs Shortage costs Storage and tracking costs Insurance and taxes Losses due to obsolescence, deterioration, or theft The opportunity cost of capital on the invested amount Shortage costs Restocking costs Costs related to safety reserves Inventory management involves a trade-off between the carrying costs and shortage costs.

The ABC Approach An inventory management technique to divide inventory into three or more groups. The underlying rationale is that a small portion of inventory in terms of quantity might represent a large portion in terms of inventory value.

The EOQ Model The Economic Order Quantity Model is a formula for determining the order quantity that will minimize total inventory cost. Total carrying costs = (Average inventory)(Carrying cost per unit) = (Q/2)(CC) Total restocking costs = (Fixed cost per order)(Number of orders) = F(T/Q) Total Costs = Carrying cost + Restocking cost = (Q/2)(CC) + F(T/Q)

The EOQ Model (Q/2)(CC) = F(T/Q) Carrying costs = Restocking costs The EOQ is: Example: Carrying cost is $1 per unit; fixed order cost is $5 per order; the firm sells 120,000 units per year. Q*= [2(120,000)($5)/$1]1/2 = 1,095.45 units

Extensions to the EOQ Model Safety stocks - The firm reorders when inventory reaches a minimum level. Reorder points - When there are lags in delivery or production times, the firm reorders when inventory reaches the reorder point. By combining safety stocks and reorder points, the firm maintains a buffer against unforeseen events.

Managing Derived-demand Inventories Materials Requirements Planning (MRP) Once finished goods inventory levels are set, it is possible to determine what levels of work-in-process inventories must exist to meet the need for finished goods. From there, it is possible to calculate the quantity of raw materials that must be on hand. Just-in-Time (JIT) Inventory A system of inventory control in which a manufacturer coordinates production with suppliers so that raw materials or components arrive just as they are needed in the production process.