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

2. 7-2 Chapter Outline What is current asset management? Cash management and its importance. Management of marketable securities. Accounts receivable and inventory management. Liquidity vis-à-vis returns.

3. 7-3 What is Current Asset Management? Involves the management of cash, marketable securities, accounts receivable, and inventory. Ensures a competitive advantage and often creates an increase in shareholder value. Primarily concerned with liquidity and safety, and then on maximizing profits.

4. 7-4 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. 7-5 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.

6. 7-6 Cash Flow Cycle Ensure that cash inflows and outflows are synchronized for transaction purposes. –Cash budgets is a tool used to track cash flows and ensuing balances. Cash flow relies on: –Payment pattern of customers. –Speed at which suppliers and creditors process checks. –Efficiency of the banking system.

7. 7-7 Cash Flow Cycle (cont’d) Cash-generating process is continuous although the cash flow may be unpredictable and uneven. Cash inflows are driven by sales and influenced by: –Type of customers. –Customers’ geographical location. –Product being sold. –Industry.

8. 7-8 Expanded Cash Flow Cycle

9. 7-9 E-commerce and Sales Benefits: faster cash flow. –Credit card companies advance cash to the retailer within 7-10 days against retailer’s with a 30 day payment terms. Financial managers must pay close attention to the percentage of sales generated: –By cash. –By outside credit cards. –By the company’s own credit terms.

10. 7-10 Outcome of Extra Cash Account receivable is collected or the credit card company advances payment. –Used for various payments such as interest to lenders, dividends to stockholders, taxes to the government etc. –Used to invest in marketable securities. Therefore when there is a need for cash a firm can: –Sell the marketable securities. –Borrow funds from short-term lenders.

11. 7-11 Collections and Disbursements Primary concern to the financial manager is the management of: –Cash inflows - still affected by collection mechanisms. –Payment outflow.

12. 7-12 Float Difference between firm’s recorded amount and amount credited to the firm by a bank. –Arises due to time delays in mailing, processing and clearing checks through the banking system. –Can be managed to some extent by combining disbursements and collection strategies. –Main challenge: the physical presentation of the check to the issuing bank.

13. 7-13 Float (cont’d) Check Clearing for the 21 st Century Act (Check 21) –Allows banks and others to electronically process a check. Factors that help in reducing float: –Ease of credit and debit cards payments and on- line banking for customers. –Wire transfers for corporations. –Rise of Internet commerce.

14. 7-14 Use of Float – Day one

15. 7-15 Use of Float – Day two

16. 7-16 Improving Collections Setting up multiple collection centers at different locations. Adopt lockbox system for expeditious check clearance at lower costs.

17. 7-17 Extending Disbursements General trend: –Speed up processing of incoming checks. –Slow down payment procedures. Extended disbursement float - allows companies to hold onto their cash balances for as long as possible.

18. 7-18 Cost-Benefit Analysis Allows companies to analyze the benefits, received by investing on an efficiently maintained cash management program.

19. 7-19 Cash Management Network

20. 7-20 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. –Central clearing facilities include: National Automated Clearinghouse Association (NACHA) Federal Reserve system Electronic Payment Network VISA

21. 7-21 International Electronic Funds Transfer Carried out through Society for Worldwide Interbank Financial Telecommunications (SWIFT). –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.

22. 7-22 International Cash Management Factors differentiating international cash management from domestic based systems: –Differing payment methods and/or higher popularity of electronic funds transfer. –Subject to international boundaries, time zone differences, currency fluctuations, and interest rate changes. –Differing banking systems, and check clearing processes. –Differing account balance management, and information reporting systems. –Cultural, tax, and accounting differences.

23. 7-23 International Cash Management (cont’d) Financial managers try to keep as much cash as possible in a country with a strong currency and vice versa. Sweep account: –Allows companies to maintain zero balances. –Excess cash is swept into an interest-earning account.

24. 7-24 An Examination of Yield and Maturity Characteristics Marketable securities

25. 7-25 Types of Short-Term Investments

26. 7-26 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

27. 7-27 Credit Standards Determine the nature of credit risk based on: –Prior records of payments and financial stability –Current net worth and other related factors 5 Cs of credit: –Character –Capital –Capacity –Conditions –Collateral

28. 7-28 Dun and Bradstreet Report – An Example

29. 7-29 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. 7-30 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. 7-31 An Actual Credit Decision Accounts receivable = Sales = $10,000 = $1,667 Turnover 6 Brings together various elements of accounts receivable management.

32. 7-32 Inventory Management Inventory has three basic categories: –Raw materials used in the product –Work in progress, which reflects partially finished products –Finished goods, which are ready for sale. Amount of inventory is affected by sales, production, and economic conditions. Inventory is the least of liquid assets - should provide the highest yield.

33. 7-33 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. 7-34 Inventory Policy in Inflation and Deflation Inventory position can be protected in an environment of price instability by: –Taking moderate inventory positions (by not committing at a single price). –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. 7-35 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. 7-36 Determining the Optimum Inventory Level

37. 7-37 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. 7-38 Inventory Usage Pattern

39. 7-39 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 stock outs Increased profits from unexpected orders.

40. 7-40 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 X Carrying cost per unit = 250 X $0.20 = $50.

41. 7-41 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.

42. 7-42 Advantages of JIT Reduction in space due to reduced warehouse space requirement. Reduced construction and overhead expenses for utilities and manpower. Better technology with the development of electronic data interchange systems (EDI). –EDI reduces re-keying errors and duplication of forms. Reduction in costs from quality control. Elimination of waste.

43. 7-43 Areas of Concern for JIT Integration costs. Parts shortages could lead to lost sales, and slow, growth. –Un-forecasted increase in sales: Inability to keep up with demand. –Un-forecasted decrease in sales: Inventory can pile up. A revaluation may be needed in high-growth industries fostering dynamic technologies.