1. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–1 Chapter 23 Management of Short- Term Assets: Liquid Assets and Accounts Receivable

2. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–2 Learning Objectives Define liquid assets. Distinguish between liquidity management and treasury management. Identify the motives for holding liquid assets. Prepare a cash budget. Apply cash management models.

3. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–3 Learning Objectives (cont.) Identify avenues for short-term investment by companies. Understand the application of portfolio theory to investment in short-term securities. Define accounts receivable and distinguish between trade credit and consumer credit. Identify the benefits and costs of holding accounts receivable.

4. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–4 Learning Objectives (cont.) Identify the four elements of credit policy. Understand the factors in implementing a collection policy. Apply the net present value method to evaluate alternative credit and collection policies. Understand the ways in which accounts receivable may be employed as a means of financing. Apply financial statement analysis to short-term asset management.

5. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–5 Introduction Liquidity is essential in order to ensure that creditors are paid on time. This ensures the business can continue to operate — solvency. However, liquidity is costly and there is a trade off between costs and benefits, along with an optimal level of liquidity. Many companies sell on credit, leading to accounts receivable — need to manage accounts receivable efficiently to maximise company value.

6. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–6 Overview of Liquidity Management Liquid assets – Cash and assets that are readily convertible into cash, such as bills of exchange and treasury notes. Liquidity management – Decisions on the composition and level of a company’s liquid assets. Treasury management – Conducted by a group or department under the control of the company treasurer, to manage the company’s liquidity, and to oversee its exposure to various kinds of financial risk.

7. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–7 Centralisation of Liquidity Management Centralisation allows the matching of inflows and outflows for the whole company, with consequent savings. Centralisation of liquidity management facilitates the development of specialised staff by having them concentrated in one area of the business.

8. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–8 Motives for Holding Liquid Assets Transactions motive – Perfect synchronisation of cash inflows and outflows is virtually impossible to achieve because the timing of a company’s inflows depends on the actions of its customers. – Therefore, liquid assets are held in order to finance transactions undertaken between cash inflows.

9. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–9 Motives for Holding Liquid Assets (cont.) Precautionary motive – Future cash inflows and outflows cannot be predicted with perfect certainty. – Therefore, the possibility exists that extra cash will be needed to meet unexpected costs, or to take advantage of unexpected opportunities.

10. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–10 Motives for Holding Liquid Assets (cont.) Speculative motive – When interest rates increase, there is a fall in the market value of income-producing assets such as bonds. – Individuals forecasting an increase in interest rates may, therefore, sell bonds and, instead, hold cash or bank deposits in order to avoid the resulting capital loss. For most companies transaction-based motives dominate.

11. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–11 Major Issues in Liquidity Management If cash payments exceed cash receipts: – Need to borrow to make payments (incur interest). – Postpone payment which may be disruptive to the business and damage its reputation. If cash receipts exceed cash payments: – Company failing to maximise its resources if a large cash balance is maintained.

12. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–12 Major Issues in Liquidity Management (cont.) Ensure interest costs on short-term debt are not excessive. Consider the effects of bank charges. Liquidity management involves ‘balancing’ several costs and benefits.

13. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–13 Cash Budgeting A forecast of the amount and timing of the cash receipts and payments that will result from a company’s operations over a period of time. Cash budgets assist in forecasting when payments exceed receipts (or vice versa). Forecasts can be on a daily, weekly or monthly basis.

14. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–14 Cash Budgeting (cont.) Preparation – Forecast cash receipts:  Analysis of past sales performance  Projections of likely business and economic conditions  Estimate cash receipts from sales – Forecast cash payments. Compare actual results with forecast results on an ongoing basis.

15. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–15 Cash Management Models Assuming Certainty: Baumol’s Model Holding cash is treated akin to holding inventory. Assumptions – Company has an initial cash balance. – Cash payments are known and occur at a constant rate.

16. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–16 Cash Management Models Assuming Certainty: Baumol’s Model (cont.) Assumptions (cont.) – Upon exhausting initial cash balance, company withdraws some interest-bearing liquid assets and converts them to cash. – Upon exhausting this cash balance, further withdrawals of interest-bearing liquid assets are made and converted to cash. – Withdrawal of funds from interest-bearing liquid assets involves a known transaction cost.

17. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–17 Cash Management Models Assuming Certainty: Baumol’s Model (cont.) Baumol’s model shows that the optimal amount of each withdrawal of funds from liquid assets, W *, can be denoted by:

18. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–18 Cash Management Models Assuming Uncertainty Miller and Orr model – Assumption that, if left unmanaged, the company’s cash balance would follow a random walk with zero drift. – Over any given time period (such as a day), the most likely result is that the cash inflows and outflows will exactly offset each other, with the result that the cash balance is left unchanged. – Although this ‘no change’ scenario is the most likely result, it will be quite rare.

19. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–19 Cash Management Models Assuming Uncertainty (cont.) Miller and Orr model (cont.) – The model proposes that management should intervene in the process by withdrawing cash if the balance becomes too high, and by injecting cash if the balance becomes too low, to restore the cash balance to the target level. – Therefore, cash management is reduced to determining values for the upper limit (U), the lower limit (L), and the target level (T).

20. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–20 Cash Management Models Assuming Uncertainty (cont.) Miller and Orr model (cont.) – The model does not actually determine the lower limit L (as this depends on whether there is an overdraft), but rather, given some predetermined value for L, it then determines the values of U and T in terms of L. – For example, if a company cannot obtain an overdraft, then:

21. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–21 Cash Management Models Assuming Uncertainty (cont.) Miller and Orr model (cont.)

22. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–22 Cash Management Models Assuming Uncertainty (cont.) Deficiencies of the Miller and Orr model: – Basic model does not recognise overdrafts. – It is assumed that action can be taken as soon as the control limit is reached (unlikely in practice). – Assumes fixed transaction costs, whereas, in practice, many transaction costs are variable.

23. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–23 Cash Management Models Assuming Uncertainty (cont.) Deficiencies of the Miller and Orr model (cont.): – Assumes that the cash balance follows a random walk. Therefore, it is likely to understate the ability of management to forecast changes in cash flows. – Assumes that the company can invest in only one type of short-term financial asset.

24. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–24 The Choice of Short-Term Securities If a company decides to invest a temporarily idle cash balance, it must choose an investment that can be converted easily into cash. That investment should be either marketable or mature within a short period of time. Interest rate risk, default risk and liquidity risk need to be taken into account when considering the investment of temporarily idle cash.

25. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–25 Types of Short-Term Investments Purchase of government securities – The most suitable form of government security for short- term investment is treasury notes. – Terms from 5 to 26 weeks. – Marketable and readily converted into cash. – Government bonds have terms measured in years. – However, a previously issued bond may be purchased, either as it approaches maturity, or with the intention of selling it in the future.

26. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–26 Types of Short-Term Investments (cont.) Deposits of funds with financial institutions – The basic terms of the deposit will differ from one kind of institution to another, and a treasurer’s choice will depend on:  The period that the funds are available for investment.  The risk that the company is prepared to accept.  The required rate of return. – Banks – Dealers in the short-term money market – Cash management trusts

27. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–27 Types of Short-Term Investments (cont.) Discounting of commercial bills – There are two ways that a company can invest its idle cash balances in the commercial bills market:  A company can be the original discounter of a commercial bill (supply funds to the drawer of the bill).  A company can ‘rediscount’ a bill that has previously been discounted by another party. (The bill is purchased from another investor in the bills market.)

28. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–28 Portfolio Theory and Cash Management We can treat cash as the risk-free asset, and estimate the rate of return on each short-term security, the variance of the returns on each security, and the covariance of the returns on each security with all other securities. In principle, it is possible to determine the optimum balance between cash and an investment in each short-term security for given risk-return preferences.

29. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–29 Portfolio Theory and Cash Management (cont.) A disadvantage of this approach is that it assumes all short-term securities will be held until the end of the planning period. This denies the important option of being able to convert short-term securities into cash at short notice. Nevertheless, there is still benefit from holding more than one short-term security, if only because of the advantage in having different maturity dates.

30. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–30 The Corporate Treasurer and Liquidity Management Task of the treasurer: – Preparation of cash budgets. – Determination of the optimum cash balance. – The investment of idle cash in short-term investments. – Arrangement of credit facilities to see the company through periods of cash shortage.

31. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–31 Overview of Accounts Receivable Management Seek to identify the impact of decisions on accounts receivable and how to determine the optimal credit and collection policies. Establishment of a credit policy: – Is the company prepared to offer credit? – Assuming credit is to be offered, what standards will be applied in the decision to grant credit to a customer? – How much credit should a customer be granted? – What credit terms will be offered?

32. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–32 Definitions Accounts receivable – Money owed to a business for goods or services sold in the ordinary course of business. Trade credit – Short-term credit provided by suppliers of goods or services to other businesses. Consumer credit – Credit extended to individuals by suppliers of goods and services, or by financial institutions through credit cards.

33. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–33 Benefits and Costs of Granting Credit Benefits – Increased sales Costs – Opportunity cost of investment – Cost of bad debts and delinquent accounts – Cost of administration – Cost of additional investment

34. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–34 Credit Policy ‘Credit policy’ refers to a supplier’s policy on whether credit will be offered to customers and the terms on which it will be offered. The decision to offer credit – Is the company prepared to offer credit? – Offering credit is equivalent to a price reduction. – What do competitors offer?

35. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–35 Credit Policy (cont.) Selection of credit-worthy customers – Company’s past experience with customer – Use of decision tree:  Grant credit immediately  Investigate/Consider  Refuse credit immediately – Cost of granting credit = expected bad debt cost + investment opportunity cost + collection cost – Cost of refusing credit = expected value of marginal net benefit forgone

36. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–36 Limit of credit extended – Setting limits — about risk management. – The more sales on credit, the greater the potential loss from default. – Offer less credit to newer customers. Credit terms – Credit period – Discount period – Discount rate – Effective rate Credit Policy (cont.)

37. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–37 Collection Policy ‘Collection policy’ refers to the efforts made to collect delinquent accounts either informally or by a debt collection agency. Procedures implemented: – Reminder notice – Personal letters and telephone calls – Personal visits – Legal action or debt collection agency Procedures adopted may have an impact on sales.

38. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–38 Evaluation of Alternative Credit and Collection Policies Application of NPV method. Benefits – Measured by the net increase in sales. Costs – Include manufacturing, selling, collection, administration and bad debts.

39. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–39 Evaluation of Alternative Credit and Collection Policies (cont.) Pay attention to the timing of the cash flows. Net cash flows can be discounted at the required rate of return. Analysis undertaken for all credit/collection policies, with the policy generating the highest net present value being the preferred option.

40. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–40 Collection and Credit Policies Discounts for early payment, late payments or failures to pay, together with any collection costs, all reduce the NPV of credit. Company’s policies should be designed so that the costs of extending credit are outweighed by the benefits.

41. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–41 Discounting and Accounts Receivable Financing Discounting is the sale of a company’s accounts receivable at a discount to a financial institution. The discounting company specialises in the administration and collection of accounts receivable and, therefore, may be able to provide these services at a lower cost than the selling company would be able to achieve through its own efforts.

42. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–42 Discounting and Accounts Receivable Financing (cont.) Notification and non-notification agreements – The selling company’s customers are notified that the agreement exists. – The selling company’s customers are not notified about the agreement. Non-recourse factoring – The discounting company assumes the bad-debt risk.

43. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–43 Discounting and Accounts Receivable Financing (cont.) Costs and benefits of discounting – The discounting company will charge a fee of up to 4% of accounts discounted. – Accounts receivable are costly to the company offering credit. – By discounting these accounts receivable, the company will save the interest cost of financing the accounts. – Also eliminate administrative costs — accounts management. – While there are costs associated with discounting, they need to be weighed against potential benefits and cost savings.

44. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–44 Discounting and Accounts Receivable Financing (cont.) Accounts receivable financing – The company borrows funds and pledges its accounts receivable as security for the loan. – Suppliers of this type of finance are usually finance companies. – Generally, finance companies are prepared to lend up to 70% of the total value of all acceptable accounts receivable. – Unacceptable accounts receivable are those that have been outstanding for a lengthy period (e.g. 90 days where the credit policy is 30 days).

45. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–45 Credit Insurance A company may obtain protection against bad-debt losses by taking out a credit insurance policy. These policies may take several forms: – Specific account policies – Whole turnover policies – Protracted default

46. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–46 Summary Company’s liquid assets are cash and short-term investments. Liquidity management refers to decisions with respect to these liquid assets. – Important to meet daily commitments. – Too much means rate of return falls. Treasury management refers to liquidity management combined with risk considerations. Transactions motive considered in detail.

47. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–47 Summary (cont.) Liquidity management is based on cash budget, cash receipts and payments. Cash management models: – Baumol — certainty, cost benefit model, balance costs of liquidity with benefits. – Miller and Orr; Wright — cash balance is random walk, add or deplete based on predetermined limits. Liquid assets can include government securities, deposits with financial institutions, commercial bills. Varying marketability and risk.

48. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–48 Summary (cont.) Accounts receivable — money owed to a business due to sales made on credit. Credit offered in order to attract increased sales. Credit has costs — funds tied up, administration costs, slow and non-paying customers. Credit and collection policies involve evaluation and comparison of costs and benefits of these activities, looking for positive NPV of policy in question.

49. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 23–49 Summary (cont.) Companies can sell accounts receivable (discounting) or use them as security for loans. The factoring company may offer administration and collection services. Credit insurance guarantees part of bad debts for a fee, the insurance premium. Only part of bad debts are covered to prevent firms from offering credit indiscriminately.