1. Current Asset Management
FHU3213

2. Review: Balance sheet
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3. Learning outcome
Describe the cash conversion cycle and the key strategies for managing it.
Discuss inventory management: differing views, common techniques, and international concerns.
Explain the credit selection process
Review the procedures for quantitatively considering cash discount changes, other aspects of credit terms, and credit monitoring.
Understand the management of receipt disbursements, including float, speeding collections, and slowing payments.
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4. Outline The efficient management of cash Inventory management
Accounts receivable management
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5. The Efficient Management of Cash
Cash balances and safety stock are influenced by the firm’s production and sales techniques and by its procedures for collecting sales receipts and paying for purchases.
These influences can be better understood through analysis of the firm’s operating cycles and cash conversion cycles.
By managing these two cycles efficiently, the financial manager can maintain low level of cash investment and thereby contribute toward maximization of share value

6. Operating Cycles and Cash Conversion Cycle
The Operating Cycle (OC) is the time between ordering materials and collecting cash from receivables.
The Cash Conversion Cycle (CCC) is the time between when a firm pays it’s suppliers (payables) for inventory and collecting cash from the sale of the finished product.
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7. Calculating the OC and CCC
Both the OC and CCC may be computed as shown below.
Where;
AAI = average age of inventory
ACP = average collection period
APP = average payment period
OC=AAI+ACP
CCC=OC −APP=AAI+ACP − APP
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8. Calculating OC - example
Max Company, a producer of paper dinnerware, sells all its merchandize on credit. The credit terms require customer to pay within 60 days of a sale. On average, it takes 85 days to manufacture, warehouse, and ultimately sell a finished good. In other word, the firm’s average age of inventory (AAI) is 85 days. The average collection period (ACP) indicates that it is taking the firm, on average age, 70 days to collect its account receivable. Calculate Max’s OC. OC = AAI + ACP = 85 days + 70 days = 155 days.
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9. Calculating CCC - example
Continuing the MAX company example, the credit terms for raw material purchases currently require payment within 40 days of a purchase, and employees are paid every 15 days. The firms calculated weightage average payment period (APP) for raw materials and labour is 35 days. Calculate MAX’s CCC. CCC= OC – APP = = 120 days.
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10. MAX Company’s OC and CCC
Operating Cycle 155 days (85+70)
Sell finished good on account
Purchase raw material
Collect account receivable
AAI (85 days)
ACP (70 days) 35 85
155
APP = 35 days
Pay account payable
Cash outflow
Cash Conversion Cycle (CCC)
120 days (155-35)
Cash Inflow
Time (days)

11. Which one is better? shorter or longer CCC?
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12. Answer: Shorter CCC Why?
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13. Why a firm needs shorter CCC
Why a firm needs shorter CCC? The longer the cycle, the greater the need for interim financing to pay for the firm’s materials needs. The shorter the cycle, the sooner the firm receives cash that it can reinvest in the firm. A shorter cycle minimizes firm costs.
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14. How a firm can shorten its CCC?
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15. Answers: Strategies for Managing the CCC
Turn over inventory as quickly as possible without stock outs that result in lost sales (Shortened the AAI).
Collect accounts receivable as quickly as possible without losing sales from high-pressure collection techniques (Shortened the ACP).
Pay accounts payable as slowly as possible without damaging the firm’s credit rating(Lengthening the APP).

16. Inventory Management: Inventory Fundamentals
The first component of CCC is the average age of inventory. The objective is to turn over inventory as quickly as possible without losing sales from stock outs.
Classification of inventories:
Raw materials: items purchased for use in the manufacture of a finished product
Work-in-progress: all items that are currently in production
Finished goods: items that have been produced but not yet sold

17. Inventory Management: Differing Views About Inventory
The different departments within a firm (finance, production, marketing, etc.) often have differing views about what is an “appropriate” level of inventory.
Financial managers would like to keep inventory levels low to ensure that funds are wisely invested.
Marketing managers would like to keep inventory levels high to ensure orders could be quickly filled.
Manufacturing managers would like to keep raw materials levels high to avoid production delays and to make larger, more economical production runs.
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18. Techniques for Managing Inventory
The ABC system
Economic Order Quantity (EOQ) Model
Just-in-time (JIT) system
Material requirement planning (MRP)system

19. The ABC system
The ABC system of inventory management divides inventory into three groups of descending order of importance based on the dollar amount invested in each.
A typical system would contain, group A would consist of 20% of the items worth 80% of the total dollar value; group B would consist of the next largest investment, and so on.
A group items would receive intensive monitoring (e.g. daily) because of the high dollar investment involved. B group items are frequently controlled through periodic or perhaps weekly checking of their levels.
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20. The ABC system
C group items are monitored unsophisticated techniques, such as the two bins method.
Two bins method is a method where item is stored in two bins. As an item needed, inventory is removed from first bin. When bin is empty, an order is placed to refill the first bin while inventory is drawn from the second bin.
The large dollar investment in A and B group items suggest the need for better method of inventory management than the ABC system (e.g., The EOQ model)
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21. Techniques for Managing Inventory (cont.)
One of the common technique for determining optimal order size for inventory.
Considers various cost of inventory and then determines what order size minimize total inventory cost.
EOQ assumes relevant cost inventory can be divided into:
Order cost – fixed clerical cost, writing PO and resulting paperwork, and checking order received against invoice
Carrying cost – variable cost per unit of holding an item. E.g., Cost of storage cost, insurance, deterioration, and opportunity cost of having funds invested in inventory.

22. The Economic Order Quantity (EOQ) Model
𝐸𝑂𝑄= 2 ×𝑆×𝑂 𝐶
Where:
S = usage in units per period (year)
O = order cost per order
C = carrying costs per unit per period (year)
Q = order quantity in units

23. The Economic Order Quantity (EOQ) Model – Calculation example
Usage, s = 1600 unit/year
Order cost, o = 50/order
Carrying cost, c= 1 unit/year
Assume that RLB, Inc., a manufacturer of electronic test equipment, uses 1,600 units of an item annually. Its order cost is $50 per order, and the carrying cost is $1 per unit per year. Substituting into the above equation we get:
EOQ= 2 ×S×O C
EOQ= 2 ×1600×50 1
Q = 400 unit

24. The Economic Order Quantity (EOQ) Model – Calculation example
The EOQ can be used to evaluate the total cost of inventory:
1. Order cost = O x S/Q = $50 x (1600/400) = $200
2. Carrying Cost = C x Q/2 = $1 x 400/2 = $200
3. Total Cost of inventory = Ordering Costs + Carrying Costs
= $200 + $200
= $400

25. The Reorder Point Reorder point = lead time in days x daily usage
Once a company has calculated its EOQ, it must determine when it should place its orders.
More specifically, the reorder point must consider the lead time needed to place and receive orders.
If we assume that inventory is used at a constant rate throughout the year (no seasonality), the reorder point can be determined by using the following equation:
If the estimates of lead time and daily usage are correct, the order will be received exactly when the inventory level reaches zero. Because of the difficulty in predicting lead time and daily usage rates, many firms maintain safety stock
Reorder point = lead time in days x daily usage
Daily usage = Annual usage/360

26. Techniques for Managing Inventory (cont.)
The Reorder Point
Using the RIB example above, if they know that it requires 10 days to place and receive an order, and the annual usage is 1,600 units per year, the reorder point can be determined as follows:
Daily usage = 1,600/360 = 4.44 units/day
Reorder point = 10 x 4.44 = or 45 units
Thus, when RIB’s inventory level reaches 45 units, it should place an order for 400 units. However, if RIB wishes to maintain safety stock to protect against stock outs, they would order before inventory reached 45 units.
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27. Accounts Receivable Management
The second component of the cash conversion cycle is the average collection period – the average length of time from a sale on credit until the payment becomes usable funds to the firm.
The average collection period consists of two parts:
the time period from the sale until the customer mails payment, and
the time from when the payment is mailed until the firm collects funds in its bank account.
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28. Accounts Receivable Management
The objective for managing account receivable is to collect accounts receivable as quickly as possible without losing sales from high-pressure collection techniques.
Encompasses three topics:
Credit selection
Credit standards
Credit terms
Credit monitoring

29. Credit Selection
Credit selection involves application of technique for determining which customers should receive credit.
This process involve evaluating the customer’s creditworthiness and comparing it to the firm’s credit standard, its minimum for extending credit to a customer.
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30. Credit Selection Techniques - The Five C’s of Credit
Character: The applicant’s record of meeting past obligations.
Capacity: The applicant’s ability to repay the requested credit.
Capital: The applicant’s debt relative to equity.
Collateral: The amount of assets the applicant has available for use in securing the credit.
Conditions: Current general and industry-specific economic conditions.
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31. Credit Scoring
Credit scoring is a procedure resulting in a score that measures an applicant’s overall credit strength, derived as a weighted-average of scores of various credit characteristics.
The procedure results in a score that measures the applicant’s overall credit strength, and the score is used to make the accept/reject decision for granting the applicant credit.
Credit scoring is mostly used by large credit card operations e.g., bank, oil companies, and department store
The purpose of credit scoring is to make a relatively informed credit decision quickly and inexpensively.

32. Credit Standards
The firm’s credit standard are the minimum requirement for extending credit to a customer.
The major variables to be considered when evaluating proposed changes in in credit standards are sales volume, investment in account receivables and bad debt expense.
Effect of relaxing credit standards:
Relaxing the credit standards will increase the risk of the firm but it may also increase the return (profit) to the firm.
Bad debts and average collection period will both increase with more lenient credit standards, but the increase revenue may produce profit that exceed these cost
If credits standards were tightened, the opposite effects will be expected.

33. Changing Credit Terms
A firm’s credit terms specify the repayment terms required of all of its credit customers.
Credit terms are composed of three parts:
The cash discount
The cash discount period
The credit period
A type of shorthand is used to indicate these term.
For example, credit term stated as 2/10 net 30 mean the purchaser receive 2% cash discount if the bill is paid within 10 days after the beginning of credit period; if the customer does not take the cash discount, the full amount must be paid within 30 days after the beginning of the credit period.

34. Changing Credit Terms
A firm’s credit terms are strongly influenced by the firm’s business. Example: Selling perishable item will have very short credit terms.
A firm wants its credit terms to conform to its industry’s standards. If its terms are more restrictive than its competitors’, it will loose business, but if its terms are less restrictive then it will attract poor-quality customers that probably could not pay.
Bottom line, a firm should compete based on quality and price, not its credit terms.
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35. Credit Monitoring
Credit monitoring is the ongoing review of a firm’s accounts receivable to determine whether customers are paying according to the stated credit terms.
Slow payments are costly to a firm because they lengthen the average collection period and increase the firm’s investment in accounts receivable.
Two frequently used techniques for credit monitoring are the average collection period and aging of accounts receivable.
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36. Credit Monitoring: Average Collection Period
The average collection period (ACP) is the average number of days that credit sales are outstanding and has two parts:
The time from sale until the customer places the payment in the mail, and
The time to receive, process, and collect payment.
The ACP tells the firm, on average, when its customers pay their account
If the firm’s ACP is increasing over time, it has cause for concern about its account receivable
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37. Credit Monitoring: Aging of Accounts Receivable
A first step in analysing accounts receivable problem is to “age” the account receivable.
The aging of accounts receivable requires the firm’s account receivable to be broken down into groups on the basis of the time origin (month-by-month basis) in order to pin point the problem.
If the majority of accounts are 2 months old, then the firm has a general problem and should review its account receivable operations.
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38. Credit Monitoring: Aging of Accounts Receivable
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39. Credit Monitoring:Collection Policy
The firm’s collection policy is its procedures for collecting a firm’s accounts receivable when they are due.
As an account becomes more and more overdue, the collection effort becomes more personal and more intense.
Computers can monitor accounts receivable and send collection letter at certain pre-determined point if payment has not been received.
After a prescribed number of these letter have been sent without any receipt of payment, a special notice will be generated.
At this point, the collection efforts become personal. Actions such as telephone calls, personal visits, and use of collection agency will be taken.
Legal actions is also a possibility.
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41. Management of Receipts & Disbursements
Recall the component of the component of cash conversion cycle
The third component of CCC, the average payment period, also has two parts:
The time from purchase of goods on account until the firm mails its payment
The receipt, the processing, and collection time required by the firm’s suppliers.
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42. Management of Receipts & Disbursements: Float
Float refers to funds that have been sent by the payer but are not yet useable funds to the payee
Float is important in CCC because it lengthen the firm’s ACP and APP. The firm’s goal is speed up ACP and lengthen APP.
Float has three component:
Mail float is the delay between the time when a payer places payment in the mail and the time when it is received by the payee.
Processing float is the delay between the receipt of a check by the payee and the deposit of it in the firm’s account.
Clearing float is the delay between the deposit of a check by the payee and the actual availability of the funds which results from the time required for a check to clear the banking system.

43. Management of Receipts & Disbursements: Technique For Speeding Up Collections
Lockboxes
A lockbox system is a collection procedure in which payers send their payments to a nearby post office box that is emptied by the firm’s bank several times a day.
The firm’s bank empties the post office box regularly, process each payment, and deposit the payment in the firm’s account. Deposit slips, along with payment enclosures, are sent to the firm by the bank so that the firm can credit customers’ account.
A lockbox system reduces the processing time because the bank deposit payments before the firm process them.
Commonly used by large firms whose customers are geographically dispersed.

44. Controlled Disbursing
Management of Receipts & Disbursements: Technique For Slowing Down Payments
Controlled Disbursing
Controlled Disbursing involves the strategic use of mailing points and bank accounts to lengthen the mail float and clearing float respectively.
This approach should be used carefully, however, because longer payment periods may strain supplier relations.
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