1. 16 - 1 Copyright © 1999 by the Foundation of the American College of Healthcare Executives CHAPTER 16 Current Asset Management and Financing Investment and financing policies Cash and marketable securities management Receivables and inventory management Short-term financing

2. 16 - 2 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Short-Term Financial Management Short-term financial management involves all current asset accounts and most current liability accounts. The primary goal of short-term financial management is to support operations at the lowest possible cost: Must have sufficient current assets. Must ensure liquidity

3. 16 - 3 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Current Asset Investment Policies CA ($) Utilization High Moderate Low

4. 16 - 4 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Current Asset Investment Policies Factors affecting current asset levels Level of business risk High business risk - greater level of current assets required (safety stocks) Low business risk - lower level of current assets required Opportunity costs of capital Interest rates Market returns on investment capital

5. 16 - 5 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Current Asset Financing Policies Moderate. Matches the maturity of the assets with the maturity of the financing. Uses permanent capital to finance permanent assets. Uses temporary financing to finance temporary assets. Aggressive. Uses short-term financing to finance permanent assets. Conservative. Uses permanent capital to finance temporary assets.

6. 16 - 6 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Years $ Permanent CA Fixed Assets Temporary CA Lower dashed line, more aggressive. Higher dotted line, more conservative. ST Financing: Loans LT Financing: Stock and Bonds

7. 16 - 7 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cash Management The goal of cash management is to hold the minimum amount necessary to meet liquidity requirements. The primary cash management techniques are: Cash flow synchronization Float management Acceleration of receipts Disbursement control Costs of cash management initiatives must have corresponding benefits.

8. 16 - 8 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cash Flow Synchronization The greater the timing match between a business’ cash inflows and outflows, the lower the required cash balance. Some businesses are able to bill customers on a cycle that promotes cash flow synchronization. The cash budget is the best method for monitoring cash management.

9. 16 - 9 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Float Net float is the difference between the cash amount on the firm’s books and the amount on the bank’s books. Suppose Family Healthcare writes $2,000 in checks daily. It takes 6 days for these to be received and clear the banking system, so its disbursement float is $12,000. Family Healthcare receives $3,000 in checks daily which are cleared in 3 days. Thus, its collections float is $9,000. Its net float is $12,000 - $9,000 = $3,000.

10. 16 - 10 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Acceleration of Receipts Net float is maximized by accelerating receipts and slowing disbursements. Some techniques used for receipt acceleration are: Lockboxes Concentration banking Automated clearinghouses Federal Reserve wire system

11. 16 - 11 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Disbursement Control Disbursement control is the “flip side” of receipt acceleration. Some techniques used for disburse- ment control are: Payables centralization Master and zero-balance accounts Controlled (remote) disbursement

12. 16 - 12 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Marketable Securities Management Businesses hold marketable securities for two primary reasons: As an interest earning substitute for cash. As a temporary repository for cash being accumulated to meet a specific need. In reality, cash management and marketable securities management are accomplished simultaneously.

13. 16 - 13 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Marketable Securities (Cont.) Characteristics of marketable securities In general, marketable securities are chosen on the basis of safety: Protection of principal is primary. Amount of return is secondary. Specific securities used depend on the: Expected holding period. Size of the business.

14. 16 - 14 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Receivables Management Importance of receivables management to HSO’s (third party predominance) Financing of A/R with short-term debt vs. equity (cost of capital issues) Goal of A/R mgmt. is to minimize the carrying costs Acceleration of A/R receipts

15. 16 - 15 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Receivables Management Monitoring A/R position Factors affecting A/R balance -- credit sales volume and avg. collection period (ACP) ACP = Avg. A/R balance divided by average daily credit sales Comparison of ACP to historical/industry Limitations of using ACP to monitor A/R position (influence of sales volume)

16. 16 - 16 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Receivables Management Monitoring A/R position Aging schedules of A/R accounts Influence of sales volume changes on average age of A/R accounts Uncollected A/R balance schedule -- factors out influence of fluctuations in sales volume on A/R balance and ACP Interpretation of uncollected A/R balance schedule

17. 16 - 17 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Receivables Management Management interventions to improve A/R position Reasonably aggressive collections policy “Early payment” discounts Electronic billing/payment methods

18. 16 - 18 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Inventory Management Relationship to receivables management Consequences of poor inventory mgmt. Too little inventory (stockouts) Too much inventory (tied up cash) Inventory management methods Computerized inventory control systems Just in time inventory methods

19. 16 - 19 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Inventory Management Inventory Management Methods Economic Ordering Quantity (EOQ) model Minimize the costs of holding inventory Total inventory costs as a function of inventory carrying costs and inventory ordering costs Does not consider the cost of the inventory Allow for identification of optimal “ordering quantity” per order to minimize costs (ICC, IOC)

20. 16 - 20 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Inventory Management Inventory Management Methods Economic Ordering Quantity (EOQ) model Examples of ICC (storage, insurance, financing) Estimation of ICC as a percentage of total inventory purchase (10-20%) Relationship of ICC to total inventory purchases

21. 16 - 21 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Inventory Management Inventory Management Methods Economic Ordering Quantity (EOQ) model Fixed nature of IOC assumed Examples of IOC (costs of ordering) Estimation of IOC as a function of average inventory purchases Relationship of IOC to total inventory purchases

22. 16 - 22 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Inventory Management Inventory Management Methods Economic Ordering Quantity (EOQ) model Total inventory holding costs (TIC) = ICC + IOC Estimation of EOQ using formula Interpretation of EOQ Equivalence of ICC and IOC at EOQ Minimization of TIC at EOQ Application of EOQ model -- reorder points, safety stock estimation, quantity discounts

23. 16 - 23 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Current Liability Management Current liabilities as source of WC Short-term financing has three primary advantages over long-term: Lower issuance costs Fewer restrictive covenants Generally lower interest rate Major sources for providers: Accruals Accounts payable (trade credit) Bank loans

24. 16 - 24 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Accruals Accruals consist primarily of wages owed to employees and taxes owed to governments. Accruals are free in the sense that no explicit interest is charged. However, managers have little control over the level of accruals, which is influenced more by industry custom and tax laws. Management of accrual accounts (source of short-term financing)

25. 16 - 25 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Accounts Payable (Trade Credit) Trade credit is credit furnished by a firm’s suppliers. Trade credit is often the largest source of short-term credit for most firms. Categories of trade credit Free trade credit Costly trade credit

26. 16 - 26 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Northwest Healthcare buys $3,000,000 (at net) of medical supplies from one of its vendors on terms of 2/10, net 30. How much free and costly trade credit is available from this vendor? Net daily purchases = $3,000,000/360 = $8,333. Calculate net daily purchases

27. 16 - 27 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Gross/Net Breakdown Northwest buys supplies worth $3,000,000 because that is the net, or cash, price. If Northwest does not take the discount, it must pay $3M / 0.98 = $3,061,224 for the supplies. This is the gross, or invoice, price. The difference, $61,224, is a financing cost similar to the interest on a loan.

28. 16 - 28 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Total trade credit= $249,990 Free trade credit= 83,333 Costly trade credit= $166,657 Payables = $8,333 x 10 = $83,333. Payables = $8,333 x 30 = $249,990. Payables level with discount Payables level without discount Credit breakdown Gross/Net Breakdown

29. 16 - 29 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Approximate Cost of Costly Trade Credit Northwest loses $61,224 to obtain $166,657 in extra trade credit, so Cost = = 0.367 = 36.7%. $61,224 $166,657

30. 16 - 30 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Approximate Cost Formula Cost = x Discount % 1 - Discount % 360 Days taken Discount period - = x = 0.0204 x 18 2 98 360 30 - 10 = 0.367 = 36.7%.

31. 16 - 31 Copyright © 1999 by the Foundation of the American College of Healthcare Executives What Should Northwest Do? Northwest should take the $83,333 in free trade credit--it should take all the free trade credit that it can get. However, it should take the costly trade credit only if the implied cost is less than the cost of alternative financing sources. Because Northwest can obtain bank loans at a 10% rate, it should not take the $166,657 in costly trade credit.