Current Assets

Management

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Chapter contents
3.1 Working capital terminologies
3.2 Alternative current asset
investment policies
3.3 Cash management
3.4 Receivables management
3.5 Managing inventory

FM II 2
3.1 Working Capital
Management involves managing
the balance between firm’s
short-term assets and its short-
term liabilities.

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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.
 Example: Determine the Net working capital of the organization based on the
following data?
 ABC Company
Balance sheet
December31, 2016
Cash …………………………………………… 3,000
Accounts receivable(A/R)……………………….2,000
Inventory………….……………………………..1,000
Other current assets……………………………...2,000
Equipment…………………………………….…3,000
Total asset…………………………………………………..……...…...11,000
Accounts payable (A/P).…………………………...1,000
Wages payable …………………………………….1,500
Salaries payable …………………………..………. 2,500
Other current liabilities ……………………………...500
Long term liability………………………………… 1,500
Total liabilities.…………………………………………………7,000
Capital,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,4,000
Total liability and capital……………………………………..………….11, 000

FM II 5
Working Capital Policy
 In a narrow sense, the term working capital
refers to net working capital, which is the
difference between total current assets and
total current liabilities. In other words, net
working capital is equal to total current assets
minus total current liabilities.
 In a broad sense, the term working capital
refers to the gross working capital, which
represents the amount of funds invested in
current assets
Financial Management II 6
 Under a broader context, we can classify
working capital as permanent and temporary
working capitals.
 Permanent working capital /permanent
current assets/ is the amount of current
assets required to meet minimum
needs to ensure effective utilization of
fixed assets and for maintaining the
circulation of current assets

Financial Management II 7
 For example, every manufacturing firm
has to maintain a minimum level of raw
materials, work-in-process, finished
goods and cash balance.
Temporary working capital or
temporary current assets, on the
other hand, are the investment in
current assets that varies with
seasonal requirements

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3.2 Working Capital Investment Policy
 Increasing the proportion of current assets
to fixed assets lowers the profitability of
assets (rate of return on assets) but
decreases risk (or increase the liquidity
position of a firm to meet unexpected future
funds requirement).
 Decreasing the proportion of current assets
to fixed assets increases profitability of
assets but it increases the risk (or reduces
the liquidity position of a firm to meet
unexpected future funds requirement).
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There are three alternative working
capital investment policies.
Conservative,
Moderate and
 Aggressive

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 Conservative working capital
investment policy
 The company holds a relatively large
proportion of its total assets in the form of
current assets.
 Results in a lower expected profitability.
 Increases the company’s net working
capital position.
 Resulting in a lower risk.
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 Aggressive working Capital
investment policy
The company holds a relatively small
proportion of its total assets in the
form of current assets.
Yields a higher expected profitability
 Higher risk in contrast to
conservative policy.
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Moderate working capital investment
policy
Expected Profitability and
Risk levels fall between
those of conservative policy
and aggressive policy.

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Factors affecting the optimal level
Working Capital Management.
 Nature and size of business,
❖ Public organizations like electricity, water supply and railways
need very limited working capital investment because they offer
cash sales only and supply services, not products and as such no
funds are tied up in inventories and receivables. On the other hand,
trading firms require less investment in fixed assets but have to
invest large amounts in current assets like inventories, receivables
and cash.

❖ The greater the size of business operations, generally, the larger

will be the investment of working capital 15
 Character of firms’ operations.
❖ In certain industries the demand for
working capital is subject to wide
fluctuations due to seasonal variations.
 Length of production cycles,
❖The longer the manufacturing process,
the larger is the amount of working
capital investment required.

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 Rate of inventory turnover,
❖A firm having a high rate of inventory turnover will
need lower amount of working capital investment as
compared to a firm having a low rate of turnover.
 Seasonal factors and credit policy,
❖During the busy season, a firm requires larger working
capital investment than in the slack season.
❖A firm that purchases on credit and sells its
products/services on cash requires lesser amount of
working capital investment. On the other hand, a firm
buying its requirements for cash and allowing credit to
its customers, shall need larger amount of working
capital investment
FM II 17
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%
How does SKI’s working capital policy
compare with its industry?
 SKI appears to have large amounts of
working capital given its level of sales.
 Working capital policy is reflected in
current ratio, turnover of cash and
securities, inventory turnover, and DSO.
 These ratios indicate SKI has large
amounts of working capital relative to its
level of sales. SKI is either very
conservative or inefficient.
Is SKI inefficient or just conservative?
A conservative (relaxed) policy
may be appropriate if it leads to
greater profitability.
However, SKI is not as profitable as
the average firm in the industry.
This suggests the company has
excessive working capital.
3.3 Cash Management
OBJECTIVES OF CASH MANAGEMENT

 The basic objectives of cash management are two, these

are: -
1. To meet the cash disbursement need (payment schedule)
2. To minimize funds committed to cash balance
(Minimization of Idle cash).
 These two objectives are conflicting and mutually
contradictory and it is the task of cash management to
reconcile them.
FM II 21
Cash conversion cycle
 The cash conversion model focuses on the
length of time between when a company makes
payments to its creditors and when a company
receives payments from its customers.

Inventory Receivables Payables

CCC = conversion + collection – deferral .
period period period
Cash conversion cycle
Inventory Receivables Payables
CCC = conversion + collection – deferral
period period period
Payables
Days per year Days sales
CCC = Inv. turnover + outstanding – deferral
period
CCC = 365 + 46 – 30
4.82
CCC = 76 + 46 – 30
CCC = 92 days.
Cash doesn’t earn a profit, so why
hold it?
1. Transactions – must have some cash to
operate.
2. Precaution – “safety stock”. Reduced by line
of credit and marketable securities.
3. Compensating balances – for loans and/or
services provided.
4. Speculation – to take advantage of bargains
and to take discounts. Reduced by credit
lines and marketable securities.
What is the goal of cash
management?
To meet above objectives, especially
to have cash for transactions, yet not
have any excess cash.
To minimize transactions balances
in particular, and also needs for cash
to meet other objectives.
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”).
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 $4 million
less capital than if it had zero net float.
Cost of holding cash ($)

Total cost of holding cash

Opportunity cost

Trading cost

Size of cash balance (c)

Optimal size of cash
balance

FM II 28
 The opportunity costs: - To determine the
opportunity costs of holding cash, we have to
find out how much interest is forgone. A
company has, on average, C/2 in cash. This
amount could be earning interest at rate R. So
the total dollar opportunity costs of cash
balances are equal to the average cash balance
multiplied by the interest rate.
 Opportunity cost= (C/2) x R

FM II 29
 The trading costs: - To determine the
total trading costs for the year, we need
to know how many times a company
will have to sell marketable securities
during the year. It is determined by
T/C. It costs F dollars each time; so
trading costs are given by
 Trading costs= (T/C) x F

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 The total cost: - Now that we have the opportunity costs and the
trading costs, we can calculate the total cost by adding them together
 Total cost= opportunity cost + Trading costs= (C/2) x R + (T/C) x F
 As the figure is drawn, the optimal size of the cash balance, C*, occurs right
where the two lines cross. At this point, the opportunity costs and the trading costs
are exactly equal. So at C*, we must have that: -Opportunity costs = Trading costs

(C*/2) x R = (T/C*) xF
C*XC* = (2T xF)
R
C*2 = (2T x F)
R
C* = √2T x F
R

FM II 31
xample: - ABC co. has cash out flows of $100 per day, seven days a week. The
terest rate is 5 percent, and the fixed cost of replenishing cash balances is $10
r transaction. What is the optimal cash balance? What is the total cost? T=
65 x days x 100 = $ 36,500

C* = (2T x F) = (2x36,500 x 10) = $ 14.6 million

R 0.05

= $ 3,821

FM II 32
 The average cash balance (C*/2) is
$ 3,821/2 = $ 1,911, so the
opportunity cost is $ 1,911 x 0.05
= $ 96. Because a company needs
$ 100 per day, the $ 3,821
balance will last $3,821/100 =
38.21 days the firm needs to re
supply the account 365/38.21 =
9.6 times per year, so the trading
(order) cost is $ 96. The total cost
is $192.
FM II 33
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.
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
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
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.
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.
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.
Analyze SKI’s forecasted cash budget
 Cash holdings will exceed the target balance
for each month, except for October and
November.
 Cash budget indicates the company is
holding too much cash.
 SKI could improve its EVA by either
investing cash in more productive assets, or
by returning cash to its shareholders.
Why might SKI want to maintain a relatively
high amount of cash?
 If sales turn out to be considerably less than
expected, SKI could face a cash shortfall.
 A company may choose to hold large amounts of
cash if it does not have much faith in its sales
forecast, or if it is very conservative.
 The cash may be used, in part, to fund future
investments.
3.4 Receivables management
 IMPORTANCE OF RECEIVABLES
A) Sales growth: - Credit sales are a powerful stimulant for increasing sales.
Especially during the period of inflation accompanied by recession and stagnation
in the industry. In such situation many customers may not have sufficient cash
for cash purchases. If a firm doesn’t sale on credit it will have fewer customers
and decline in sales. Hence, receivable help growth of sales.
B) Increase in profit: - Increase in profitability by striking a balance between the
cost of extending credit and the gains from sales expansion. The decision to
extend credit to customers involves consideration of the profit to be gained from
the sale against the cost of granting credit (time value of money, collection cost
and risk & loss.)
C) Capability to face competition: - If competitors sale on credit, the firm will be
able to face the competition only by selling on credit. The firm should adopt
similar credit policies with its competitors to retain customers.
D) Protection of Company’s Liquidity: - Slow collection procedures and efforts lead
to rapid deterioration in the company’s cash position.

FM II 42
 FUNCTIONS OF RECEIVABLES MANAGEMENT

1.Formulation of credit policy

2.Evaluation of credit policy
3.Implementation of credit policy
4. Administration and control of credit
policy

FM II 43
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.
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.
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.
 If SKI succeeds in reducing DSO without adversely
affecting sales, what effect would this have on 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
EVA.
The five C’s of Credit
 A firm’s credit analysts often use the five C’s of credit to focus their
analysis on the key dimensions of an applicant’s creditworthiness.
1. Character: the applicant’s record of meeting past obligations-
financial, contractual, and moral. Past payment history as well as
any pending or resolved legal judgments against the applicant would
be used to evaluate its character.
2. Capacity: the applicant’s ability to repay the requested credit.
Financial statement analysis with particular emphasis on liquidity
and debt ratio is typically used to assess the applicant’s capacity.
3. Capital: the financial strength of the applicant as reflected by its
ownership position. Analysis of the applicant’s debt relative to equity
and its profitability ratios are frequently used to assess its capital.

FM II 48
4. Collateral: the amount of assets the applicant has available
for use in securing the credit. The larger the amount of available
assets, the greater the chance that a firm will recover its funds if
the applicant defaults. A review of the applicant’s balance sheet,
asset value appraisals, and any legal claims filed against the
applicant’s assets can be used to evaluate its collateral.
5. Conditions: the current economic and business climate as
well as any unique circumstances affecting either party to the
credit transaction. For example, if the firm has excess inventory
of the item the applicant wishes to purchase on credit, the firm
may be willing to sell on more favorable terms or to less
creditworthy applicants. Analysis of general economic and
business conditions, as well as special circumstances that may
affect the applicant or firm is performed to assess conditions.

FM II 49
3.5 Inventory Management
 There are three general motives for holding
inventories:
➢ Transactions motive emphasizes the need to
maintain inventories to facilitate smooth
production and sales operations. For
uninterrupted and proper running of any firm, it
is necessary to have an appropriate level of
inventory.
➢ Precautionary motive necessitates holding of
inventories to guard against the risk of
unpredictable changes in demand and supply
forces and other factors
➢ Speculative motive influences the decision to
increase or reduce inventory levels to take
advantage of
FM II
price fluctuations. 50
Inventory Management Techniques
 Techniques that are commonly used in managing
inventory are:
1.Economic order quantity (EOQ) model
2.ABC system
3.Reorder point
4.Material requirement planning (MRP)
system and
5.Just-in-time (JIT) system

FM II 51
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.
FM II 53
To calculate the economic order
quantity you need to know:
• The demand of the item per year
• The cost per order
• The carrying cost per unit of inventory
 You can then plug these numbers into
the Wilson Formula, otherwise known
as the economic order quantity
formula:

FM II 54
Where:
D = demand per year
Co = cost per order
Ch = cost of holding per unit of inventory

FM II 55
 Let’s imagine you’re a toy distributor and one of your
best sellers is a spinning top. Every year, your demand
for spinning tops is 15,000. The ordering costs – once
you factor in the cost to create, place, validate, track,
receive orders – comes to £20 per order. Finally, the
holding cost for each spinning top – including rent,
storage space, insurance, etc – ends up as £0.50 per
unit.
 D = 15,000
 Co = £20
 Ch = £0.50

FM II 56
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.
If SKI reduces its inventory, without adversely
affecting sales, what effect will this have on
the cash position?
Short run: Cash will increase as
inventory purchases decline.
Long run: Company is likely to
take steps to reduce its cash
holdings and increase its EVA.