1. Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Current Asset Management 7

2. 1-2 Chapter Outline What is current asset management Cash management and its importance Management of marketable securities Accounts receivable and inventory management Inventory management and policy decisions required Liquidity vis-à-vis returns

3. 1-3 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

4. 1-4 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 –Steps to improve overall profitability of a firm: Minimize cash balances Have accurate knowledge of when cash moves in and out of the firm

5. 1-5 Cash Management Use cash budgets Speed up collections Extend disbursements Maintain optimum level of cash Invest excess cash LT 7-3

6. 1-6 Reasons for Holding Cash Balances Transactions balances –Payments towards planned expenses Compensative balances for banks –Compensate a bank for services provided rather than paying directly for them Precautionary needs –Emergency purposes

7. 1-7 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 excess Low-risk, liquid investments Savings accounts Money market funds Term deposits Treasury bills US $ deposits Earn small return on excess funds LT 7-4

8. 1-8 Collection and Disbursements The financial manager attempts to get maximum use of minimum balances by speeding inflows and slowing outflows. Playing the float: Using the difference in the cash balances shown on the bank ’ s records and those shown on the firm ’ s records.

9. 1-9 Expanded Cash Flow Cycle

10. 1-10 Cash Flow Cycle Cash flow relies on: –Payment pattern of customers –Speed at which suppliers and creditors process checks –Efficiency of the banking system Cash inflows are driven by sales and influenced by: –Type of customers –Customers’ geographical location –Product being sold –Industry

11. 1-11 Cash Flow Cycle (cont’d) When the cash balance increases, the extra cash can be –Used for various payments to lenders, stockholders, government, etc –Used to invest in marketable securities When there is a need for cash a firm can : –Sell the marketable securities –Borrow funds from short-term lenders

12. 1-12 Float Difference between firm’s recorded amount and amount credited to the firm by a bank Two types of float: –Mail float: Arises duet to the time it takes to deliver a check. –Clearing float: Arises due to the time it takes to clear a check once the payment is made Both these floats do not exist anymore due to: –Electronic payments –Check Clearing for the 21 st Century Act Check Clearing for the 21 st Century Act (Check 21) –Allows banks and others to electronically process a check

13. 1-13 Components of Collection Time Collection time Mailing Processing Availability time delay delay Customer Check Deposit Cash mails is is is check received made available

14. 1-14 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+ 800,000 Cheques– 900,000– 400,000 Balance+ $ 200,000+ $ 500,000 + $300,000 float PPT 7-1

15. 1-15 Playing the float PPT 7-1 Bank Books (usable funds) Corporate Books(amounts actually cleared) Initial amount$ 100,000$ 100,000 Deposits + 1,000,000+ 800,000 Cheques– 1,200,000– 800,000 Balance– $ 100,000+ $ 100,000 + $200,000 float * Assumed to remain the same as in Table 7-1. **

16. 1-16 Improving Collections and Extending Disbursements Improving collection: –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

17. 1-17 Cash Management Network

18. 1-18 Cost-Benefit Analysis Allows companies to analyze the benefits, received by investing on an efficiently maintained cash management program

19. 1-19 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 –Each message is encrypted –Every money transaction is authenticated by a code, using smart card technology –Assumes financial liability for the accuracy, completeness, and confidentiality of transaction

20. 1-20 Factors influence the choice of marketable securities 1. Yield 2. Maturity (interest rate risk) 3. Minimum investment required 4. Safety 5. Marketability

21. 1-21 An Examination of Yield and Maturity Characteristics Marketable securities

22. 1-22 Marketable Securities When a firm has excess funds, it should be converted from cash into interest-earning securities 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

23. 1-23 Types of Short-Term Investments

24. 1-24 Reasons for the increase of accounts receivable 1. Increasing sales 2. Inflation 3. Extend credit terms during recession

25. 1-25 Management of Accounts Receivable Accounts receivable as an investment –Should be based on the level of return earned equals or exceeds the potential gain from other investments Credit policy administration –Credit standards –Terms of trade –Collection policy

26. 1-26 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

27. 1-27 Credit Standards (cont’d) Dun & Bradstreet Information Services (DBIS): –Produces business information analysis tools –Publishes reference books –Provides computer access to information –The Data Universal Number System (D-U-N-S) is a unique nine-digit code assigned by DBIS to each business in its information base

28. 1-28 Dun & Bradstreet Report – An Example

29. 1-29 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

30. 1-30 Collection Policy A number if quantitative measures applied to asses credit policy –Average collection period –Ratio of bad debts to credit sales –Aging of accounts receivable

31. 1-31 An Actual Credit Decision Accounts receivable = Sales = $10,000 = $1,667 Turnover 6 Brings together various elements of accounts receivable management

32. 1-32 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 Inventory is the least of liquid assets – should provide the highest yield

33. 1-33 Level versus Seasonal Production Level production –Maximum efficiency in manpower and machinery usage –May result in high inventory buildup Seasonal production –Eliminates inventory buildup problems –May result in unused capacity during slack periods –May result in overtime labor charges and overused equipment repair charges

34. 1-34 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 also have a major impact on the reported income of the firm

35. 1-35 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 perish-ability Ordering costs –Cost of ordering –Cost of processing inventory into stock

36. 1-36 Determining the Optimum Inventory Level

37. 1-37 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: EOQ = 2SO = 2 X 2,000 X $8U = $32,000 = 160,000 C $0.20 $0.20 = 400 units

38. 1-38 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

39. 1-39 Safety Stocks and Stock Outs (cont’d) Assuming that; Average inventory = EOQ + Safety stock 2 Average inventory = 400 + 50 2 The inventory carrying costs will now increase by $50 Carrying costs = Average inventory in units × Carrying cost per unit = 250 × $0.20 = $50

40. 1-40 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

41. 1-41 Just-In- Time Inventory Systems 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 Benefits Lower carrying costs Automatic ordering Fewer accounting errors Lower quality control costs Elimination of waste LT 7-10