BUSINESS FINANCE:

Managing Current Assets

 Alternative working capital policies

 Cash management
 Inventory management
 Accounts receivable management
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Working capital terminology
 Gross working capital – total current assets.
 Net working capital – current assets minus
non-interest bearing current liabilities.
 Working capital policy – deciding the level
of each type of current asset to hold, and
how to finance current assets.
 Working capital management – controlling
cash, inventories, and A/R, plus short-term
liability management.
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 Factors to Consider in
Managing Working Capital
 Appropriate Level – this refers to adequacy of
working capital (Consider: Nature of business
and length of operating cycle)
 Structural Health – this refers to composition
of working capital (Consider: Need of cash,
accounts receivable and other current assets)
 Liquidity – this refers to the relative
transformation (and its rate) of current assets
into more liquid current assets (e.g. cash and
marketable securities). 15-3
 In general, sound working
capital policy requires:
 Managing cash and its temporary investment
efficiently. (Cash/Marketable Securities
Management)
 Ensuring efficient manufacturing operations and
sound material procurement. (Inventory
Management)
 Drafting and implementing effective credit and
collection policies. (Receivable Management)
 Seeking favorable terms from suppliers and other
temporary creditors. (Short-Term Credit Financing)
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 Selected ratios for SKI Inc.
SKI Ind. Avg.
Current 1.75x 2.25x
Debt/Assets 58.76% 50.00%
Turnover of cash & securities 16.67x 22.22x
DSO (days) 45.63 32.00
Inv. turnover 4.82x 7.00x
F. A. turnover 11.35x 12.00x
T. A. turnover 2.08x 3.00x
Profit margin 2.07% 3.50%
ROE 10.45% 21.00%

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 CASH & MARKETABLE
SECURITIES (MS) MANAGEMENT

 CASH MANAGEMENT – involves the

maintenance of the appropriate level of cash
to meet the firm’s cash requirements and to
maximize income on idle funds.
 MS MANAGEMENT – involves the process
of planning and controlling investment in
marketable securities to meet the firm’s cash
requirements and to maximize income on
idle funds. 15-6
 Objective of Cash & MS
Management
 To minimize the amount of cash on
hand while retaining sufficient
liquidity to satisfy business
requirements (e.g. take advantage of
cash discounts, maintain credit rating,
meet unexpected needs)

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 Cash doesn’t earn a profit, so
why hold it?
1. Transaction Motive (Liquidity Motive)
– must have some cash to operate. (cash is
held to facilitate normal transactions of the
business)
2. Precautionary Motive (Contingent Motive)
– “safety stock”. Reduced by line of credit and
marketable securities. (Cash is held beyond the
normal operating requirement level to provide for
buffer againts contingencies, such as slow-down in
accounts receivable collection, possibilities of
strikes, etc.
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 Cash doesn’t earn a profit, so
why hold it?
3. Compensating balance requirements
(Contractual Motive) – for loans and/or services
provided. (Company is required by a bank to
maintain a certain compensating balance in its
demand deposit account as a condition of a loan
extended to it.)
4. Speculative Motive – to take advantage of
bargains and to take discounts. Reduced by credit
lines and marketable securities. (Cash is held to
avail of business incentives (e.g. discounts) and
investment opportunities.
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 Optimal Cash Balance :
Baumol Model

OCB =
Total Cost of Cash Balance = Holding Costs + Transaction Costs
 Holding Cost = Average Cash Balance* x Opportunity Cost

 Transaction Costs = Number of Transactions** x Cost per Transaction

*Average Cash Balance = OCB / 2

** Number of Transactions = Annual Cash Requirement / OCB
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 CASH CONVERSION CYCLE
 Is the average length of time a peso is tied
up in current assets. It runs from the date
the company makes payment of raw
materials to the date company receives cash
inflows thru collection of accounts receivable.
It is also known as the cash flow cycle.

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 CASH CONVERSION CYCLE
Inventory Conversion Period Inventory / CGS* per day
Receivables / Sales per
Add: Receivable Collection Period day
Less: Payable Deferral Period Payables / Purchases per day
Cash Conversion Cycle
*Alternatively, sales per day may be also used to compute
conversion period. The intention is to use an amount in
proportion to unit sales.

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 CASH CONVERSION CYCLE

• The firm’s goal should be to shorten

its cash conversion cycle without
hurting operations.
• The longer the cash conversion cycle,
the greater the need for external
financing (hence, the more cost of
financing.
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 CASH MANAGEMENT
STRATEGIES

1. Accelerating collections (e.g. lockbox

system)
2. Slowing disbursements (e.g. playing
the floats)
3. Reducing precautionary idle cash
(e.g. zero-balance accounts)

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Ways to minimize cash holdings
 Use a lockbox.
 Insist on wire transfers from customers.
 Synchronize inflows and outflows.
 Use a remote disbursement account.
 Increase forecast accuracy to reduce
need for “safety stock” of cash.
 Hold marketable securities (also reduces
need for “safety stock”).
 Negotiate a line of credit (also reduces
need for “safety stock”).
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What is “float”, and how is it affected
by the firm’s cash manager?
 Float is the difference between cash as
shown on the firm’s books and on its
bank’s books.
 If SKI collects checks in 2 days but those
to whom SKI writes checks don’t process
them for 6 days, then SKI will have 4 days
of net float.
 If a firm with 4 days of net float writes and
receives $1 million of checks per day, it
would be able to operate with $4 million
less capital than if it had zero net float.
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Types of Float


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 Examples of Collection Float

1. MAIL Float – amount of customers’ payments that

have been mailed by customers but not yet
received by the seller-company.
2. PROCESSING Float – amount of customers’
payments that have been received by the seller
but not yet deposited.
3. CLEARING Float – amount of customers’ checks
that have been deposited but have not cleared
yet. 15-18
 Good cash management
suggests that positive float
should be maximized (negative
float minimized).

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 MARKETABLE SECURITIES
 It is a short-term money market instruments
that can easily be converted to cash.
 CERTIFICATES of DEPOSITS - savings
deposits at financial institutions (e.g. time
deposit)
 MONEY MARKET FUNDS – shares in a fund
that purchases higher-yielding bank CDs,
commercial paper, and other large-
denomination, higher-yielding securities.15-20
 MARKETABLE SECURITIES
 GOVERNMENT SECURITIES
Treasury Bills – debt instruments
representing obligations of the government
issued by the Central Bank and usually sold at
a discount through competitive bidding.
CB Bills or Certificates of Indebtedness
- Represent indebtedness by the Central Bank

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 MARKETABLE SECURITIES
 COMMERCIAL PAPERS – unsecured short-
term promissory notes issued by
corporations with very high credit standing

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Cash budget:
The primary cash management tool
 Purpose: Forecasts cash inflows,
outflows, and ending cash balances.
Used to plan loans needed or funds
available to invest.
 Timing: Daily, weekly, or monthly,
depending upon purpose of forecast.
Monthly for annual planning, daily for
actual cash management.

15-23
SKI’s cash budget:
For January and February
Net Cash Inflows
Jan Feb
Collections $67,651.95 $62,755.40
Purchases 44,603.75 36,472.65
Wages 6,690.56 5,470.90
Rent 2,500.00 2,500.00
Total payments $53,794.31 $44,443.55
Net CF $13,857.64 $18,311.85
15-24
SKI’s cash budget
Net Cash Inflows
Jan Feb
Cash at start if
no borrowing $ 3,000.00 $16,857.64
Net CF 13,857.64 18,311.85
Cumulative cash 16,857.64 35,169.49
Less: target cash 1,500.00 1,500.00
Surplus $15,357.64 $33,669.49

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Should depreciation be explicitly
included in the cash budget?
 No. Depreciation is a noncash
charge. Only cash payments and
receipts appear on cash budget.
 However, depreciation does affect
taxes, which appear in the cash
budget.

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What are some other potential
cash inflows besides collections?
 Proceeds from the sale of fixed
assets.
 Proceeds from stock and bond
sales.
 Interest earned.
 Court settlements.

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How could bad debts be worked
into the cash budget?
 Collections would be reduced by the
amount of the bad debt losses.
 For example, if the firm had 3% bad
debt losses, collections would total
only 97% of sales.
 Lower collections would lead to
higher borrowing requirements.

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ACCOUNT RECEIVABLE
MANAGEMENT
 Involves the determination of
the amount and terms of credit
to extend to customers and
monitoring receivables from
credit customers.

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 ACCOUNT RECEIVABLE
MANAGEMENT
 Objective: to collect AR as quickly as
possible without losing sales from high-
pressure collection techniques.
 Accomplishing this goal encompasses
three topics : (1) credit selection and
standards, (2) credit terms, (3)
collection and monitoring program.
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 ACCOUNT RECEIVABLE
MANAGEMENT
 Considering this trade-off:
Offering liberal and relaxed credit
terms attracts more customers while it
would entail more costs of AR such as
collection, bad debts and interest
(opportunity costs).

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Elements of credit policy
1. Credit Period – How long to pay? Shorter
period reduces DSO and average A/R, but it
may discourage sales.
2. Cash Discounts – Lowers price. Attracts new
customers and reduces DSO.
3. Credit Standards – Tighter standards tend to
reduce sales, but reduce bad debt expense.
Fewer bad debts reduce DSO.
4. Collection Policy – How tough? Tougher
policy will reduce DSO but may damage
customer relationships.
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 FACTORS TO CONSIDER FOR
ACCOUNTS RECEIVABLE POLICY

 CREDIT STANDARD
Who (customers) will be granted credit?
How much is the credit limit?
What are the Factors to consider in
establishing credit standard?

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 FACTORS TO CONSIDER FOR
ACCOUNTS RECEIVABLE POLICY
 The Five C’s of Credit:
Character – customers’ willingness to pay
Capacity – customers’ ability to generate cash
flows
Capital – customers’ financial sources (i.e. net
worth)
Conditions – current economic or business
conditions
Collateral – customers’ assets pledged to secure
debt. 15-34
 FACTORS TO CONSIDER FOR
ACCOUNTS RECEIVABLE POLICY
 CREDIT TERMS
This defines the credit period and discount
offered for customer’s prompt payment. The
following costs associated with the credit terms
must be considered: cash discounts, credit
analysis and collections costs, bad debt losses
and financing costs.

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 FACTORS TO CONSIDER FOR
ACCOUNTS RECEIVABLE POLICY
 COLLECTION PROGRAM
Shortening the average collection period may
preclude too much investment in receivable
(low opportunity cost) and too much loss due
to delinquency and defaults. The same could
also result to loss of customers if harshly
implemented.

15-36
Do SKI’s customers pay more or less
promptly than those of its competitors?

 SKI’s DSO (45.6 days) is well above the

industry average (32 days).
 SKI’s customers are paying less
promptly.
 SKI should consider tightening its credit
policy in order to reduce its DSO.

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Does SKI 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.

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 INVENTORY
MANAGEMENT
 Refers to the process of formulation
and administration of plans and policies
to efficiently and satisfactorily meet
production and merchandising
requirements and minimize cost relative
to inventories.

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 INVENTORY
MANAGEMENT
 OBJECTIVE:
To maintain inventory at a level that best
balances the estimates of actual savings,
the cost of carrying additional inventory,
and the efficiency of inventory control.

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 INVENTORY
MANAGEMENT TECHNIQUE
 INVENTORY PLANNING
- Involves determination of the quality
and quantity and location of inventory, as
well as the time of ordering, in order to
minimize costs and meet future business
requirements. (e.g. Economic Order
Quantity, Just-In-Time (JIT) System
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 INVENTORY
MANAGEMENT TECHNIQUE
 INVENTORY CONTROL
- Involves regulation of inventory within
predetermined level; adequate stocks
should be able to meet business
requirements, but the investment in
inventory should be at the minimum.

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 SYSTEMS OF INVENTORY
CONTROL
 JUST-IN-TIME PRODUCTION SYSTEM
- A “demand pull” (driven by demand)
system in which each component of a
finished good is produced when needed
by the next production stage.

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 SYSTEMS OF INVENTORY
CONTROL
 FIXED ORDER QUANTITY system
- An order for a fixed quantity is placed
when the inventory level reaches the
reorder point. This is consistent with EOQ
concept.

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 SYSTEMS OF INVENTORY
CONTROL
 PERIODIC REVIEW OR REPLACEMENT
system
- Orders are made after a review of
inventory level has been done at regular
intervals

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 SYSTEMS OF INVENTORY
CONTROL
 OPTIONAL REPLENISHMENT system
- Combination of fixed order and
replacement system

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 SYSTEMS OF INVENTORY
CONTROL
 MATERIALS REQUIREMENT PLANNING
(MRP)
- Is a “push through” system that is
designed to plan and control materials
used in production based on
computerized system that manufactures
finished goods based on demand
forecasts. 15-47
 SYSTEMS OF INVENTORY
CONTROL
 MANUFACTURING RESOURCE
PLANNING (MRP-II)
- A closed loop system that integrates
various functional areas of a
manufacturing company (e.g. inventories,
production, sales and cash flows). It is
developed as an extension of MRP.
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 SYSTEMS OF INVENTORY
CONTROL
 ENTERPRISE RESOURCE PLANNING
(ERP)
- Integrates information systems of all
functional areas in a company. Every
aspect of operations is interconnected as
the company is connected with its
customers and suppliers.
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 SYSTEMS OF INVENTORY
CONTROL
 ABC CLASSIFICATION System
- Inventories are classified for selective control
- A items – high value requiring highest
possible control
- B items – medium cost items requiring
normal control
- C items – low cost items requiring the
simplest possible control
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Types 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 or
customer goodwill, and the disruption of
production schedules.
Reducing the average amount of inventory
generally reduces carrying costs, increases
ordering costs, and may increase the costs of
running short. 15-51
Is SKI holding too much
inventory?
 SKI’s inventory turnover (4.82) is
considerably lower than the industry
average (7.00). The firm is carrying a lot of
inventory per dollar of sales.
 By holding excessive inventory, the firm is
increasing its costs, which reduces its ROE.
Moreover, this additional working capital
must be financed, so EVA is also lowered.

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