1. Chapter 22 Management of Short-Term Assets: Liquid Assets and Accounts Receivable
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2. Learning Objectives Define liquid assets.
Distinguish between liquidity management and treasury management.
Identify the motives for holding liquid assets.
Prepare a cash budget.
Identify avenues for short-term investment by companies.
Define accounts receivable and distinguish between trade credit and consumer credit.
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3. Learning Objectives (cont.)
Identify the benefits and costs of holding accounts receivable.
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.
Apply financial statement analysis to short-term asset management.
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4. 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.
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5. 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.
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6. 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.
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7. 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.
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.
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8. 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.
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9. Major Issues in Liquidity Management
If cash payments exceed cash receipts:
Need to borrow to make payments (incur interest).
Postpone payments that 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.
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10. 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.
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11. 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.
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12. 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.
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13. The Choice of Short-Term Securities
Interest rate risk, default risk and liquidity risk need to be taken into account when considering the investment of temporarily idle cash.
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.
Cash management trusts.
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14. The Choice of Short-Term Securities (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.)
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15. The Corporate Treasurer and Liquidity Management
Task of the treasurer:
Preparation of cash budgets.
Determination of the optimum cash balance.
Investment of idle cash in short-term investments.
Arrangement of credit facilities to see the company through periods of cash shortage.
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16. 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?
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17. Definitions Accounts receivable Trade credit Consumer credit
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.
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18. Benefits and Costs of Granting Credit
Increased sales.
Costs
Opportunity cost of investment.
Cost of bad debts and delinquent accounts.
Cost of administration.
Cost of additional investment.
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19. 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?
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20. 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
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21. Credit Policy (cont.) Limit of credit extended Credit terms
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.
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22. 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.
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23. 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.
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24. 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.
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25. 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.
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26. 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 that the rate of return falls.
Treasury management refers to liquidity management combined with risk considerations.
Transactions motive considered in detail.
Liquidity management is based on cash budget, cash receipts and payments.
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27. Summary (cont.)
Liquid assets can include government securities, deposits with financial institutions, and commercial bills. Varying marketability and risk.
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.
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