1. PowerPoint Presentation prepared by Traven Reed Canadore College

2. chapter 18 Current Asset Management

3. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-3 Corporate Valuation and Current Asset Management

4. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-4 Topics in Chapter Cash Management A/R Management Inventory Economic Order Quantity

5. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-5 Goal of cash management Cash is a non-earning asset, i.e., not having any return for keeping. To have sufficient target cash balance on hand to conduct business. Cash can provide the necessary financial slack for firms to take various opportunities.

6. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-6 Reasons for holding cash Transactions: Must have some cash to pay current bills. Precaution: “Safety stock.” Lessened by credit line and marketable securities. Compensating balances: For loans and/or services provided. Speculation: To take advantage of bargains, to take discounts, and so on. Reduced by credit line, marketable securities.

7. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-7 Cash Management Techniques Increase forecast accuracy to reduce the need for a cash “safety stock.” Hold marketable securities instead of a cash “safety stock.” Negotiate a line of credit (also reduces need for a “safety stock”).

8. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-8 Ways to Minimize Cash Holdings Synchronize inflows and outflows. Use a remote disbursement account. Use lockboxes. Insist on wire transfers from customers.

9. CH18 Float The difference between the balance shown in a firm’s chequebook and the balance on the bank’s records. Disbursement float (+): Cheques written by a company that have not yet cleared. Collection float (-): Cheques already deposited that have not yet been cleared. Net Float: disbursement float - collection float. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-9

10. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-10 Using Float Creating and Managing Float –Payers attempt to create delays in the check clearing process so that they can use their cash for longer. –Recipients attempt to remove delays in the check clearing process to get available cash sooner. –Source of delay: Time it takes to mail check: mail float Time for recipient to process check: processing float Time for bank to clear check: clearing float

11. CH18 Speeding Up Receipts Lockbox plan –System whereby customers send payments to a post office box and a local bank collects and processes the cheques. Payment by wire or automatic debit –Under an electronic debit system, funds are automatically deducted from one account and added to another. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-11

12. CH18 Short-term Investments: Marketable Securities The management of cash and marketable securities cannot be separated. Firms hold marketable securities for the same reasons as they hold cash Firm’s risk-return posture determines the specific composition of the marketable securities portfolio after taking into consideration the interaction of risk, liquidity, maturity and yield. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-12

13. CH18 Marketable Securities If a firm has temporary idle balances of cash, it may invest them in the money market, which offers short-term, low risk and highly liquid securities. Holding marketable securities has costs and benefits Short-term investment alternatives include T-bills, commercial paper, bankers’ acceptances, Eurodollars, etc. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-13

14. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-14 Receivables Management Do ABC’s customers pay more or less promptly than those of its competitors? ABC’s days’ sales outstanding (DSO) of 53.1 days is well above the industry average (30 days). –ABC’s customers are paying less promptly. –ABC should consider tightening its credit policy to reduce its DSO.

15. CH18 Accounts Receivable Firms rather sell for cash than on credit, but competition forces them to offer credit Goods are shipped, inventories are reduced, and an account receivable is created Receivables management begins with the credit policy, and needs a monitoring system too. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-15

16. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-16 Elements of Credit Policy Cash Discounts: Lowers price. Attracts new customers and reduces DSO. Credit Period: How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales.

17. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-17 Credit Policy (cont’d) Credit Standards: Tighter standards reduce bad debt losses, but may reduce sales. Fewer bad debts reduces DSO. Collection Policy: Tougher policy will reduce DSO, but may damage customer relationships.

18. CH18 Setting Credit Terms Standard credit terms include credit period and discount On a sale with payment terms: 2/10, net 30 Firm requires payment within 30 days, but offers a 2% discount to customers who pay in 10 days. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-18

19. CH18 Setting Credit Standards Standards set to determine the amount and nature of credit to extend to customers. The decision requires a measure of credit quality (i.e. the probability of a customer’s default) Use the credit information in a judgmental manner for decisions Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-19

20. CH18 Setting Collection Policy The procedures the firm follows to collect past-due accounts from sending friendly reminders to hiring a collection agency Collection process is expensive in terms of both out-of-pocket expenditures and lost goodwill Policy changes can affect sales, collection period and bad debt lo ss Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-20

21. CH18 Setting Cash Discounts Need to balance the costs and benefits of different cash discounts Pros: attracting new businesses, encouraging early payments Cons: dollar cost involved If sales are seasonal, firm may use seasonal dating on discounts: 2/10, net 30, May 1. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-21

22. CH18 Days Sales Outstanding (DSO) DSO = average collection period = receivables/ADS (i.e. the length of time the customers to payoff their credit purchases) ADS = average daily sales = annual sales/365 Receivables = (ADS)(DSO) Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-22

23. CH18 Aging Schedule A compilation of accounts receivable by the age of account. A change in DSO or the aging schedule signals the firm to investigate its credit policy. A deterioration in either of these measures does not necessarily indicate the firm’s credit policy has weakened. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-23

24. CH18 Aging Schedules Reflect the portion of customers who are not abiding by the credit term. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-24 Age of Account (days) Value of Account ($) Percentage of Total Value (%) 0 – 10815,86747 11 – 30451,33126 31 – 45260,38315 46 – 60173,58910 Over 6034,7182 $1,735,888100%

25. CH18 Evaluation of Changes in Credit Policy Sales should increase if firm eases the credit policy by lengthening the credit period, relaxing the credit standards and collection policy, and offering or raising a cash discount. A firm should ease its credit policy only if the costs of doing so will be offset by higher expected revenues. Cost of carrying receivables = (DSO)(sales per day)(variable cost ratio)(cost of funds) Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-25

26. CH18 Detailed Analysis of Changing Credit Policy The best procedure for evaluating a change in credit policy is to use the income statement approach. Easing the credit policy stimulates sales to which compared with costs Credit-related costs: –Cost of carrying receivables –Credit analysis and collection expense –Bad debt losses Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-26

27. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-27 Changes in Credit Policy Does ABC face any risk if it tightens its credit policy? YES! A tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.

28. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-28 Analysis of Improved Receivables If ABC succeeds in reducing DSO without adversely affecting sales, how would this affect its cash position? Short run: If customers pay sooner, this increases cash holdings. Long run: Over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase firm value.

29. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-29 Inventory Management Inventory is an important component of current asset composed of raw materials to be used in production, work in process, and finished goods The two objectives are: –Ensure enough inventory to sustain operations is available. –Hold the costs of ordering and carrying inventory to a minimum.

30. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-30 Why is inventory management vital to the financial health of most firms? Insufficient inventories can lead to lost sales. Excess inventories means higher costs than necessary. Large inventories, but wrong items leads to both high costs and lost sales. Inventory management is more closely related to operations than to finance.

31. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-31 Inventory Control Good inventory control system is dynamic not static. Most companies utilize a computerized inventory system.

32. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-32 Just In Time Developed by the Japanese. Requires very close coordination between all parties using JIT procedures. Reduces overall inventory throughout the production process.

33. CH18 Outsourcing Purchase components from outsiders rather than make them in-house. Outsourcing is often combined with JIT systems to reduce inventory levels. Major reason for outsourcing has nothing to do with inventory policy. Inventory cost is the ultimate concern. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-33

34. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-34 Categories of Inventory Costs Carrying Costs: Storage and handling costs, insurance, property taxes, depreciation, and obsolescence. Ordering Costs: Cost of placing orders, shipping, and handling costs. Costs of Running Short: Loss of sales, loss of customer goodwill, and the disruption of production schedules.

35. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-35 Illustration: Inventory Level Is ABC holding too much inventory? ABC’s inventory turnover (3.5) is considerably lower than the industry average (6.0). The firm is carrying a lot of inventory per dollar of sales. By holding excessive inventory, the firm is increasing its operating costs which reduces its NOPAT. Moreover, the excess inventory must be financed, so firm value is further lowered.

36. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-36 Illustration: Inventory on Cash Position If ABC reduces its inventory, without adversely affecting sales, what effect will this have on its cash position? Short run: Cash will increase as inventory purchases decline. Long run: Company is likely to then take steps to reduce its cash holdings.

37. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-37 Assumptions of the EOQ Model All values are known with certainty and constant over time. Inventory usage is uniform over time. Carrying costs change proportionally with changes in inventory levels. All ordering costs are fixed. These assumptions do not hold in the “real world,” so safety stocks are held.

38. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-38 Total Inventory Costs (TIC) TIC = Total carrying costs+ total ordering costs TIC = CP(Q/2) + F(S/Q). C = Annual carrying costs (% of inv.). P = Purchase price per unit. Q = Number of units per order. F = Fixed costs per order. S = Annual usage in units.

39. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-39 = - = 0 Q 2 = EOQ = Q*= 2FS CP  d(TIC) dQ CP 2 FS Q 2 2FS CP Derive the EOQ model from the total cost equation

40. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-40 TIC Carrying Cost Ordering Cost 0 EOQ Units $ Average inventory = EOQ/2 Inventory Model Graph

41. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-41 Assume the following data: P = $200 F = $1,000 S = 5,000 C = 0.2 Minimum order size = 250

42. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-42 What is the EOQ? EOQ= = = 250,000 = 500 units 2($1,000)(5,000) 0.2($200)  $10,000,000 40  

43. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-43 What are total inventory costs when the EOQ is ordered? TIC= CP(Q/2) + F(S/Q) = (0.2)($200)(500/2) + $1,000(5,000/500) = $40(250) + $1,000(10) = $10,000 + $10,000 = $20,000

44. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-44 Additional Notes Average inventory = EOQ/2 Average inventory = 500/2 = 250 units. # of orders per year = S/EOQ # of orders per year = $5,000/50 = 10 At EOQ, total carrying costs = total ordering costs.

45. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-45 What is the added cost if the firm orders 400 units or 600 units at a time rather than the EOQ? 400 units: TIC= CP(Q/2) + F(S/Q) = 0.2($200)(400/2) + $1,000(5,000/400) = $8,000 + $12,500 = $20,500 Added cost = $20,500 - $20,000 = $500

46. CH18 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 18-46 600 units: TIC= CP(Q/2) + F(S/Q) TIC= 0.2($200)(600/2) + $1,000(5,000/600) = $12,000 +$8,333 = $20,333 Added cost = $20,333 - $20,000 = $333