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Current

Asset
Managemen
t

7
Prepared by:

Michel Paquet
SAIT Polytechnic
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2012 McGraw-Hill Ryerson Limited

Chapter 7 - Outline

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What is Current Asset Management


Cost-Benefit Analysis
Cash Management
Marketable Securities
Management of Accounts Receivable
Inventory Management
Summary and Conclusions
2012 McGraw-Hill Ryerson Limited

Learning Objectives
1. Extend Chapter 6 concepts of liquidity and risk
to current asset management recognizing that a
firms investment in current assets should
achieve an adequate return for its liquidity and
risk. (LO1)
2. Examine cash management as the control of
receipts and disbursements to minimize
nonearning cash balances while providing
liquidity and describe techniques to make cash
management more efficient. (LO2)
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Learning Objectives
3. Define the various marketable securities
available for investment by the firm and
calculate the yield on these instruments. (LO3)
4. Characterize accounts receivable as an
investment resulting from the firms credit
policies, outline the considerations in granting
credit, and evaluate a credit decision that
changes credit terms to stimulate sales. (LO4)

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Learning Objectives
5. Assess inventory as an investment and
apply techniques to reduce the costs of
this investment. (LO5)

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LO1

Current Asset Management


Current asset management is controlling
and managing the current assets of a firm
Most time-consuming job of a financial
manager
Deals with allocating resources among the
current assets cash, marketable
securities, accounts receivable, and
inventory
Crucial to long-term success or failure of a
business
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LO1

Cost-Benefit Analysis
Cost-benefit analysis provides a framework to
identify all the resultant changes arising from
a decision.
It must consider explicit and implicit costs and
benefits.
Opportunity costs are implicit costs and are
forgone benefits from next best alternatives.
-- e.g. opportunity costs of having capital tied up in
current assets are the lost benefits from investing
capital in other profitable investments.

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LO1

Cost-Benefit Analysis
Good value-adding decisions will ensue when
the benefits exceed the costs.
In general, the return (on investment, ROI) is
monies received
r
net capital tied up

In addition to safety and liquidity, the financial


manager must also make sure that the return
on current assets (r) must exceed the cost of
borrowing and/or the opportunity cost.
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LO2

Cash Management
Maintain optimum level of cash
Use the float
Speed up collections
Extend disbursements
Use cash budgets

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LO2

Cash Management
Financial managers want to keep cash
balances to a minimum
There are 2 reasons for holding cash
1. for everyday transactions (main reason)
2. for precautionary needs (emergencies)

Goals are to speed up the inflow of cash (or


improve collections) and slow down the
outflow of cash (or extend disbursements)
Also will attempt to play the float
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LO2

Optimum Level of Cash


How much to keep in
cash?
Transaction needs?
Cash flows predictable?
Borrowing
arrangements?
Interest rates?

Keep safety level in cash,


invest the excess

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Low-risk, liquid
investments

Savings accounts
Money market funds
Term deposits
Treasury bills
US $ deposits

Earn small return on excess


funds
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LO2

Table 7-1

The use of float to provide funds


Corporate
Books
Initial amount$ 100,000
Deposits + 1,000,000
Cheques
900,000
Balance

+ $ 200,000

Bank Books (usable funds)


(amounts actually cleared)
$ 100,000
+ 800,000
400,000
+ $ 500,000
+ $300,000 float

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LO2

Table 7-2

Playing the float


Corporate
Books

Bank Books (usable funds)


(amounts actually cleared)

Initial amount
100,000
$ 100,000
Deposits + 1,000,000*
800,000*
Cheques
1,200,000
800,000
Balance
+ $ 100,000

$ 100,000

+ $200,000 float
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LO2

Ways to Improve Collections


Timely processing and deposit of cheques received
Regional Collection Centres
speeds up collection of A/R and reduces mailing time

Lockbox System
when customers mail payment to a local post office box instead
of to the company headquarters

Electronic Funds Transfer / Electronic Data Interchange


exchange of payments and information between companies
computers

Use of debit cards (Interac) and preauthorized cheques


a system where payments are automatically deducted from a
bank account

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LO2

Ways to Extend Disbursements


Mail cheques from remote locations
Play the Float
Electronic Funds Transfer

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LO2

Figure 7-1

Cash management network


Local
Local
Office
Office

Local
Local
Office
Office

Local
Local
Office
Office

Local
Local
Office
Office

Local
Local
Office
Office

Local
bank
branch

Local
bank
branch

Local
bank
branch

Local
bank
branch

Local
bank
branch

Centralbank
bankaccount
account
Central
Corporateheadquarters
headquarters
Corporate

2.5 days freed-up cash balance


$2 million average cash
movement per day
$5 million available funds
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Reduce remittance
time 1.5 days
Increase disbursement
time 1 day
2.5 days freed-up
cash balance
Distant
disbursement
centre
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LO2

Cash Management Analysis


Using a cost-benefit analysis, we may decide whether to
set up a new cash management system.

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LO3

Marketable Securities
Excess cash should be invested in short-term securities
(marketable securities).
Factors to consider in choosing these securities:
yield
maturity
minimum investment required
safety
marketability
Yield (return) on marketable securities:
100 P 365
r

P
d
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LO3
Figure 7-2
An examination of
yield and maturity
characteristics

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LO3

Table 7-3
Hierarchy of money market instruments and rates
Yield
Mar. 22,
1990

Yield Apr.
29, 2011

Prime rate (best corporate customers)

14.25

3.00

Bank rate (Bank of Canadas rate to banks, dealers)

13.38

1.25

Investment

Maturity*

Minimum
Amount

Treasury bills

6 m.

$1,000

LIBOR (London Interbank Offered


Rate)

3 m.

Commercial (corporate) paper

Safety

Marketability

Excellent

Excellent

13.25

1.08

100,000

Good

Excellent

12.94

0.27

3 m.

100,000

Good

Fair

13.33

1.07

Bankers acceptances

3 m.

25,000

Good

Good

13.27

1.12

Provincial government treasury bills

3 m.

25,000

Excellent

Excellent

3.18

1.01

Federal government treasury bills

3 m.

1,000

Excellent

Excellent

13.13

0.92

Overnight repo

Day

100,000

Excellent

Excellent

--

1.0008

Overnight financing rate (call money)

Day

100,000

Excellent

Excellent

--

.9972

500

Excellent

None

10.15

1.00

Money market deposits

Open

Term deposits and GICs

90

5,000

Good

None

12.75

0.50

Open

None

Excellent

None

8.75

0.00-1.25

Savings accounts

* Many of these securities can be purchased with different maturities than those indicated.
Though not marketable, these investments are highly liquid and can often be withdrawn without penalty.
Quoted yields are often for wholesale amounts above $1 million
In the summer of 1981, 3-month Treasury Bills offered yields in excess of 20%

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LO4

Management of Accounts Receivable


Trade credit facilitates sales.
Trade credit is an effective financing source for
smaller firms as they lack access to capital
markets or bank financing.
Accounts receivable should be deemed as an
investment.
The return on this current asset should be
compared with the direct cost of borrowing or the
opportunity cost of investing in other assets.
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LO4

Credit Policy Administration


3 things to consider in deciding whether to extend
credit:
Credit Standards
determine credit rating of customers
4 Cs of credit
credit agencies, bureaus
Terms of Trade
e.g. 2% / 10days / net 30 days
Collection Policy
Average Collection Period
Ratio of Bad Debts to Credit Sales
Aging of Accounts Receivable
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LO4

Figure 7-4

Financing growth in accounts receivable


Forgo
12%
return
Build-up
10%
return
Forgo
8%
return

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7.5%
cost

7%
cost

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LO4

Customer Credit Profile - The 4 Cs


CHARACTER - willingness to pay
Supplier, legal, union problems?
Willing to provide information?

CAPACITY - ability to pay


Past & future profits?
Good management?

CAPITAL - net worth


Growing assets? Low debt?

CONDITIONS - state of industry, economy


Impact on customer
How customer adapts to changing conditions

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LO4

An Actual Credit Decision

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LO5

Inventory Management
Inventory is divided into 3 categories:
1. Raw Materials
2. Work in Progress (WIP) or Unfinished Goods
3. Finished Goods

There are 2 basic costs associated with inventory:


1. Ordering Costs
2. Carrying Costs

Optimum level of inventory will satisfy customer


demand / production requirements while
minimizing ordering and carrying costs
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LO5

Level vs. Seasonal Production


Level Production:
producing the same (equal) amount each month
inventory costs are higher
operating costs are lower

Seasonal Production:
producing a different amount each month (based
on the season)
inventory costs are lower
operating costs are higher
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LO5

Inventory Costs
Carrying Costs
Storage
Insurance
Financing costs
Shortages
Damages
Write-offs of
obsolete stock

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Order Costs
Purchasing
Systems
Receiving

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LO5

Figure 7-4

Determining the optimum inventory level


Cost of ordering and carrying inventory ($)
Total costs
Carrying costs
80

40

Ordering costs
400
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Order size (units)


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LO5

Ordering Inventory
How much do you order at one time? Depends on:

Forecast sales or usage


Cost of placing and receiving order
Inventory carrying costs
Economies of scale

ECONOMIC ORDERING

QUANTITY

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LO5

Economic Ordering Quantity


Economic Ordering Quantity (EOQ):
the optimal (best) amount for the firm to
order each time
occurs at the low point on the total cost
curve
the order size where total carrying costs
equal total ordering costs (assuming no
safety stock)
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LO5

Economic Ordering Quantity


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

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LO5

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 $8 =
C
$0.20

$32,000 = 160,000
$0.20
= 400 units

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LO5

Economic Ordering Quantity


The total inventory costs are given by:
TC =

SO + CQ
Q
2

Where,
S = Total sales in units
O = Ordering cost for each order
C = Carrying cost per unit in dollars
Q = Quantity per order
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LO5

Safety Stock
Safety Stock:
Extra inventory the firm keeps in stock in
case of unforeseen problems
Minimum level of inventory planned
Designed to minimize stock outs
Management decision based on risk of stock
out, desired level of service

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LO5

Safety Stock
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

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LO5

Just-In-Time Inventory Systems


Common Features
Minimum levels of
inventory
Orders in small lot sizes
Computerized order and
inventory systems
Electronic data
interchange
Short delivery times
Small number of suppliers
Quality control programs

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Potential Benefits
Lower carrying
costs
Automatic ordering
Fewer accounting
errors
Lower quality
control costs
Elimination of waste

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Summary and Conclusions


Current assets represent a sizable investment.
Firms should apply the cost-benefit analysis to
allocate financial resources among cash,
marketable securities, accounts receivable and
inventory.
In cash management, the firm should try to keep
the balance just adequate for transaction and
compensating purposes.
The firm should speed up cash collection and
extend cash disbursement.
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Summary and Conclusions


Excess short-term funds should be placed in
marketable securities.
Accounts receivable facilitate sales at the same
time are also an investment of the firm.
Management of accounts receivable calls for
determining credit standards and the forms of
credit to be offered as well as the development
of an effective collection policy.
Firms manage inventory using such techniques
as the economic ordering quantity and the
just-in-time model.
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