©2009 McGraw-Hill Ryerson Limited 1 of Current Asset Management Prepared by: Michel Paquet SAIT Polytechnic ©2009 McGraw-Hill Ryerson Limited

2 of 41 Chapter 7 - Outline What is Current Asset Management Cost-Benefit Analysis Cash Management Marketable Securities Management of Accounts Receivable Inventory Management Summary and Conclusions

©2009 McGraw-Hill Ryerson Limited 3 of 41 1.Extend concepts of liquidity and risk to current asset management recognizing that a firm’s investment in current assets should achieve an adequate return for its liquidity and risk. (LO1) 2.Discuss cash management as the control of receipts and disbursements to minimize nonearning cash balances while providing liquidity and describe techniques to make cash management more efficient. (LO2) Learning Objectives

©2009 McGraw-Hill Ryerson Limited 4 of 41 3.Define the various marketable securities available for investment by the firm and calculate the yield on these instruments. (LO3) 4.Describe accounts receivable as an investment resulting from the firm’s credit policies, outline the considerations in granting credit, and evaluate a credit decision that changes credit terms to stimulate sales. (LO4) Learning Objectives

©2009 McGraw-Hill Ryerson Limited 5 of 41 5.Describe inventory as an investment and apply techniques to reduce the costs of this investment. (LO5) Learning Objectives

©2009 McGraw-Hill Ryerson Limited 6 of 41 Current Asset Management Current asset management is controlling and managing the current assets of a firm Most time-consuming job of a financial manager Deals with allocating resources among the current assets – cash, marketable securities, accounts receivable, and inventory Crucial to long-term success or failure of a business LO1

©2009 McGraw-Hill Ryerson Limited 7 of 41 Cost-Benefit Analysis Cost-benefit analysis provides a framework to identify all the resultant changes arising from a decision. It must consider explicit and implicit costs and benefits. Opportunity costs are implicit costs and are forgone benefits from next best alternatives. -- e.g. opportunity costs of having capital tied up in current assets are the lost benefits from investing capital in other profitable investments. LO1

©2009 McGraw-Hill Ryerson Limited 8 of 41 Cost-Benefit Analysis Good value-adding decisions will ensue when the benefits exceed the costs. In general, the return (on investment, ROI) is In addition to safety and liquidity, the financial manager must also make sure that the return on current assets (r) must exceed the cost of borrowing and/or the opportunity cost. LO1

©2009 McGraw-Hill Ryerson Limited 9 of 41 Maintain optimum level of cash Use the float Speed up collections Extend disbursements Use cash budgets LO2 Cash Management

©2009 McGraw-Hill Ryerson Limited 10 of 41 Cash Management Financial managers want to keep cash balances to a minimum There are 2 reasons for holding cash 1.for everyday transactions (main reason) 2.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) Also will attempt to “play the float” LO2

©2009 McGraw-Hill Ryerson Limited 11 of 41 Optimum Level of Cash How much to keep in cash? Transaction needs? Cash flows predictable? Borrowing arrangements? Interest rates? Keep safety level in cash, invest the excess Low-risk, liquid investments Savings accounts Money market funds Term deposits Treasury bills US $ deposits Earn small return on excess funds LO2

©2009 McGraw-Hill Ryerson Limited 12 of 41 Table 7-1 The use of float to provide funds Bank Books (usable funds) Corporate Books(amounts actually cleared ) Initial amount$ 100,000$ 100,000 Deposits+ 1,000, ,000 Cheques– 900,000– 400,000 Balance+ $ 200,000+ $ 500,000 + $300,000 float LO2

©2009 McGraw-Hill Ryerson Limited 13 of 41 Table 7-2 Playing the float Bank Books (usable funds) Corporate Books(amounts actually cleared) Initial amount$ 100,000$ 100,000 Deposits + 1,000, ,000 Cheques– 1,200,000– 800,000 Balance– $ 100,000+ $ 100,000 + $200,000 float * Assumed to remain the same as in Table 7-1. ** LO2

©2009 McGraw-Hill Ryerson Limited 14 of 41 Ways to Improve Collections Timely processing and deposit of cheques received Regional Collection Centres –speeds up collection of A/R and reduces mailing time Lockbox System –when customers mail payment to a local post office box instead of to the company headquarters Electronic Funds Transfer / Electronic Data Interchange –exchange of payments and information between companies’ computers Use of debit cards (Interac) and preauthorized cheques –a system where payments are automatically deducted from a bank account LO2

©2009 McGraw-Hill Ryerson Limited 15 of 41 Ways to Extend Disbursements Mail cheques from remote locations “Play the Float” Electronic Funds Transfer LO2

©2009 McGraw-Hill Ryerson Limited 16 of 41 Figure 7-1 Cash management network Local Office Local Office Local Office Local Office Local Office Local Office Local Office Local Office Local Office Local Office Local bank branch Local bank branch Local bank branch Local bank branch Local bank branch Central bank account Corporate headquarters Central bank account Corporate headquarters Reduce remittance time – 1.5 days Increase disbursement time – 1 day 2.5 days freed-up cash balance 2.5 days freed-up cash balance $2 million – average cash movement per day $5 million available funds Distant disbursement centre LO2

©2009 McGraw-Hill Ryerson Limited 17 of 41 Cash Management Analysis Using a cost-benefit analysis, we may decide whether to set up a new cash management system. LO2

©2009 McGraw-Hill Ryerson Limited 18 of 41 Marketable Securities Excess cash should be invested in short-term securities (marketable securities). Factors to consider in choosing these securities: yield maturity minimum investment required safety marketability Yield (return) on marketable securities: LO3

©2009 McGraw-Hill Ryerson Limited 19 of 41 FIGURE 7-2 An examination of yield and maturity characteristics LO3

©2009 McGraw-Hill Ryerson Limited 20 of 41 Prime rate (best corporate customers) 14.25% 4.75% Bank rate (Bank of Canada’s rate to banks, dealers) Treasury bills6 m. $1,000 ExcellentExcellent LIBOR (London Interbank Offered Rate) 3 m. 100,000 Good Excellent Commercial (corporate) paper 3 m. 100,000 Good Fair Bankers’ acceptances 3 m. 25,000 Good Good Provincial government Treasury bills3 m.25,000ExcellentExcellent Federal government treasury bills 3 m. 1,000 Excellent Excellent Overnight repo day 100,000 Excellent Excellent Overnight financing rate (call money) day 100,000 Excellent Excellent Money market deposits Open 500 Excellent None Term deposits and GICs 905,000 GoodNone† Savings accountsOpen None ExcellentNone† * Many of these securities can be purchased with different maturities than those indicated. † Though not marketable, these investments are highly liquid and can often be withdrawn without penalty. ‡ Quoted yields are often for wholesale amounts above $1 million ъ In the summer of 1981, 3-month Treasury Bills offered yields in excess of 20% Table 7-3 Hierarchy of money market instruments and rates Yield MinimumMar. 22,Aug. 22, Maturity*AmountSafetyMarketability1990‡2008 LO3

©2009 McGraw-Hill Ryerson Limited 21 of 41 Management of Accounts Receivable Trade credit facilitates sales. Trade credit is an effective financing source for smaller firms as they lack access to capital markets or bank financing. Accounts receivable should be deemed as an investment. The return on this current asset should be compared with the direct cost of borrowing or the opportunity cost of investing in other assets. LO4

©2009 McGraw-Hill Ryerson Limited 22 of 41 Credit Policy Administration 3 things to consider in deciding whether to extend credit: Credit Standards determine credit rating of customers 4 C’s of credit credit agencies, bureaus Terms of Trade e.g. 2% / 10days / net 30 days Collection Policy Average Collection Period Ratio of Bad Debts to Credit Sales Aging of Accounts Receivable LO4

©2009 McGraw-Hill Ryerson Limited 23 of 41 Figure 7-3 Financing growth in accounts receivable Forgo 8% return Buildup 10% return Forgo 12% return 7.5% cost 7% cost LO4

©2009 McGraw-Hill Ryerson Limited 24 of 41 Customer Credit Profile - The 4 C’s CHARACTER - willingness to pay –Supplier, legal, union problems? –Willing to provide information? CAPACITY - ability to pay –Past & future profits? –Good management? CAPITAL - net worth –Growing assets? Low debt? CONDITIONS - state of industry, economy –Impact on customer –How customer adapts LO4

©2009 McGraw-Hill Ryerson Limited 25 of 41 D & B credit rating system LO4

©2009 McGraw-Hill Ryerson Limited 26 of 41 D & B Report LO4

©2009 McGraw-Hill Ryerson Limited 27 of 41 An Actual Credit Decision LO4

©2009 McGraw-Hill Ryerson Limited 28 of 41 Inventory Management Inventory is divided into 3 categories: 1.Raw Materials 2.Work in Progress (WIP) or Unfinished Goods 3.Finished Goods There are 2 basic costs associated with inventory: 1.Ordering Costs 2.Carrying Costs Optimum level of inventory will satisfy customer demand / production requirements while minimizing ordering and carrying costs LO5

©2009 McGraw-Hill Ryerson Limited 29 of 41 Level vs. Seasonal Production Level Production: –producing the same (equal) amount each month –inventory costs are higher –operating costs are lower Seasonal Production: –producing a different amount each month (based on the season) –inventory costs are lower –operating costs are higher LO5

©2009 McGraw-Hill Ryerson Limited 30 of 41 Inventory Costs Carrying Costs Storage Insurance Financing costs Shortages Damages Write-offs of obsolete, unsaleable stock Order Costs Purchasing Systems Receiving LO5

©2009 McGraw-Hill Ryerson Limited 31 of 41 Figure 7-4 Determining the optimum inventory level Cost of ordering and carrying inventory ($) M Carrying costs Order size (units) Ordering costs Total costs LO5

©2009 McGraw-Hill Ryerson Limited 32 of 41 Ordering Inventory How much do you order at one time? Depends on: –Forecast sales or usage –Cost of placing and receiving order –Inventory carrying costs –Economies of scale ECONOMIC ORDERING QUANTITY LO5

©2009 McGraw-Hill Ryerson Limited 33 of 41 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) LO5

©2009 McGraw-Hill Ryerson Limited 34 of 41 Economic Ordering Quantity 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 perish-ability. Ordering costs –Cost of ordering. –Cost of processing inventory into stock LO5

©2009 McGraw-Hill Ryerson Limited 35 of 41 EOQ = 2SO C Where, S = Total sales in units O = Ordering cost for each order C = Carrying cost per unit in dollars; Assuming: EOQ = 2SO = 2 X 2,000 X $8U = $32,000 = 160,000 C $0.20 $0.20 = 400 units LO5 Economic Ordering Quantity

©2009 McGraw-Hill Ryerson Limited 36 of 41 Economic Ordering Quantity The total inventory costs are given by: TC = SQ + CQ Q 2 Where, S = Total sales in units O = Ordering cost for each order C = Carrying cost per unit in dollars Q = Quantity per order LO5

©2009 McGraw-Hill Ryerson Limited 37 of 41 Safety Stock: –“Extra” inventory the firm keeps in stock in case of unforeseen problems –Minimum level of inventory planned –Designed to minimize stock outs –Management decision based on risk of stock out, desired level of service LO5 Safety Stock

©2009 McGraw-Hill Ryerson Limited 38 of 41 Assuming that; Average inventory = EOQ + Safety stock 2 Average inventory = The inventory carrying costs will now increase by $50. Carrying costs = Average inventory in units X Carrying cost per unit = 250 X $0.20 = $50. LO5 Safety Stock

©2009 McGraw-Hill Ryerson Limited 39 of 41 Just-In-Time Inventory Systems Common Features Minimum levels of inventory Orders in small lot sizes Computerized order and inventory systems Electronic data interchange Short delivery times Small number of suppliers Quality control programs Potential Benefits Lower carrying costs Automatic ordering Fewer accounting errors Lower quality control costs Elimination of waste LO5

©2009 McGraw-Hill Ryerson Limited 40 of 41 Summary and Conclusions Current assets represent a sizable investment. Firms should apply the cost-benefit analysis to allocate financial resources among cash, marketable securities, accounts receivable and inventory. In cash management, the firm should try to keep the balance just adequate for transaction and compensating purposes. The firm should speed up cash collection and extend cash disbursement.

©2009 McGraw-Hill Ryerson Limited 41 of 41 Summary and Conclusions Excess short-term funds should be placed in marketable securities. Accounts receivable facilitate sales at the same time are also an investment of the firm. Management of accounts receivable calls for determining credit standards and the forms of credit to be offered as well as the development of an effective collection policy. Firms manage inventory using such techniques as the economic ordering quantity and the just-in-time model.