7

Current Asset
Management
Block, Hirt, and Danielsen
Foundations of Financial Management
18th edition

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 Learning Objectives
• Recall that current asset management involves the
management of cash, marketable securities, accounts
receivable, and inventory.
• Explain what is involved in cash management.
• Explain what is involved in the management of marketable
securities.
• Detail the requirements of accounts receivable management.
• Determine the level of inventory necessary to enhance sales
and profitability.
• Understand that the less liquid an asset is, the higher the
required return.

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 Chapter Opening
• Companies that manage current assets well
establish competitive advantage
• Helps increase market share
• Creates increase in shareholder value through
rising stock price
• Requires careful allocation of resources
among current assets of firm
• Cash, marketable securities, accounts receivable,
and inventory

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 Chapter Opening Continued
• Managing cash and marketable securities
• Primary concern is safety and liquidity
• Secondary attention is on maximizing profitability
• Managing accounts receivable and inventory
• Investment level should not be result of
happenstance or historical determination
• Must meet same return-on-investment criteria
applied to any decision
• Different decision techniques applied to
various forms of current assets

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 Cash Management
• Financial managers actively attempt to keep
cash (nonearning asset) to minimum
• Critical to have sufficient cash for emergencies
• To improve overall profitability of firm
• Minimize cash balances
• Have accurate knowledge of when cash moves in and
out of firm

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 Reasons for Holding Cash Balances
• Transactions balances
• Payments towards planned expenses
• Compensating balances for banks
• Compensate bank for services provided rather than
paying directly for them
• Precautionary needs
• Emergency purposes when cash inflows are less than
projected
• Important in seasonal and cyclical industries

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 Cash Flow Cycle
• Cash moves through a firm on a daily, weekly,
and monthly cycle
• Relies on:
• Payment pattern of customers
• Speed at which suppliers and creditors process
checks
• Efficiency of banking system
• Inflows and outflows of cash must be
synchronized properly for transaction purposes

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 Cash Flow Cycle Continued
• Cash inflows driven by sales and influenced by
• Type of customers
• Customers’ geographical location
• Product being sold
• Industry
• Firms use cash to make various payments to
• Interest to lenders
• Dividends to stockholders
• Taxes to the government
• Accounts payable to suppliers
• Wages to workers and replace inventory

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 Figure 7-1 The Cash Flow Cycle

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 Figure 7-2 Expanded Cash Flow Cycle

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 Collections and Disbursements
• Critical function of financial manager is
managing cash inflows and payment outflows
• Electronic transfer mediums change time period
between payment and collection
• Cash flow cycle still affected by collection
mechanisms
• Lockboxes
• U.S. mail system
• International sales, etc.

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 Float
• Difference between firm’s recorded amount
and amount credited to firm by bank
• Two types of float
• Mail float
• Occurs because of time mail takes to be delivered
• Clearing float
• Occurs because of time check takes to be cleared
• Small businesses and individuals encounter this
most often

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 Float Continued
• Large corporations avoid these two floats
because of widespread use of electronic
payments
• Check Clearing for the 21st Century Act of
2003 (Check 21 Act)
• Allows banks and others to electronically process
checks
• Float will eventually be eliminated altogether

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 Improving Collections and
Extending Disbursements
• Improving collection
• Setting up multiple collection centers at different
locations
• Adopt lockbox system for fast check clearance at
lower costs
• Extending disbursement
• General trend
• Speed up processing of incoming checks
• Slow down payment procedures

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 Cost-Benefit Analysis
• Expenses from use of remote collection and
disbursement centers involve additional costs
• Expenses must be compared to benefits that
may accrue through use of these operations

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 Figure 7-3 Cash Management Network

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 Electronic Funds Transfer
• Funds moved between computer terminals
without use of “check”
• Reduces float through use of terminal
communications between store and the bank
• Automatically charged against bank account before
leaving the store
• Automated clearinghouses (ACH)
• Transfers information between financial institutions and
between accounts using computer tape
• The fastest growing area is P2P transfers

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 Electronic Funds Transfer Continued

• International electronic funds transfer carried

out through SWIFT (Society for Worldwide
Interbank Financial Telecommunications)
• Proprietary secure messaging system
• Encrypts each message
• Authenticates every money transaction
• Assumes financial liability for accuracy,
completeness, and confidentiality of transaction

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 Figure 7-4 Thirteen-Year SWIFTNet FIN
Message Traffic

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 International Cash Management
• International cash management vs. domestic-
based systems
• Payment methods differ from country to country
• Subject to international boundaries, time zones,
currency fluctuations, interest rate changes
• Differing banking systems and check-clearing
processes
• Differing account balance management and
information reporting systems
• Cultural, tax, and accounting differences

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 International Cash Management
Continued
• Hold cash balances in one currency vs.
another to take advantages of high interest
rates
• Financial managers try to keep cash in country
with strong currency
• Sweep account
• Allows companies to maintain zero balances
• Excess cash swept into interest-earning account

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 Marketable Securities
• Funds held for other than immediate transaction purposes
should be invested in interest-earning securities
• Types of short-term investments
• Treasury bills
• Federal agency securities
• Certificates of deposit
• Commercial paper
• Banker’s acceptances
• Eurodollar certificates of deposit
• Passbook savings accounts
• Money market funds
• Money market accounts

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 Figure 7-5 An Examination of Yield and
Maturity Characteristics

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 Table 7-1 Types of
Short-Term Investments

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 Management of Accounts Receivable
• Accounts receivable as an investment
• Based on whether level of return on investment equals or
exceeds potential gain from other investments
• Optimizing return based on appropriate risk and liquidity
considerations
• Credit policy administration has three primary policy
variables to consider
• Credit standards
• Terms of trade
• Collection policy

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 Figure 7-6 Financing Growth in
Accounts Receivable

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 Credit Standards
• Determine nature of credit risk based on
• Prior records of payment, financial stability,
current net worth, other related factors
• 5 Cs of credit to indicate whether a loan will
be paid on time, late or not at all
• Character
• Capital
• Capacity
• Conditions
• Collateral

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 Credit Standards Continued
• Dun & Bradstreet Information Services (DBIS)
• Most prominent source of business information
• Produces business information analysis tools
• Publishes reference books
• Provides computer access to information
• Assigns Data Universal Number System (D-U-N-S)
• Unique nine-digit code for each business in information
base
• Used to track whole families of companies related
through ownership

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 Figure 7-7 D-U-N-S Numerical Tracking
System

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 Terms of Trade
• Stated terms of credit extension
• Have strong impact on eventual size of accounts
receivable balance
• Creates need for firms to consider use of cash
discounts

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 Collection Policy
• A number of quantitative measures are applied to
assess credit policy:
• Average collection period
• An increase would indicate poor credit administration

Average collection period = Accounts receivable

Average daily credit sales

• Ratio of bad debts to credit sales

• An increasing ratio may indicate too many weak
accounts or an aggressive market expansion policy
• Aging of accounts receivable
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 An Actual Credit Decision
• Brings together various elements of accounts
receivable management

Accounts receivable = Sales = $10,000 = $1,667

Turnover 6
• An average investment of $1,667 is fetching an aftertax return
of $480, which is approximately 28.8%.

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 Inventory Management
• Inventory has three basic categories
• Raw materials—used in products
• Work in process—partially completed products
• Finished goods—ready for sale
• Amount of inventory affected by
• Sales
• Production
• Economic conditions
• Inventory is least liquid of current assets;
should provide highest yield
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 Level versus Seasonal Production
• Level (even) production
• Allows maximum efficiency in manpower and
machinery usage
• May result in high inventory buildup before
shipment, particularly in seasonal business
• Seasonal production
• Eliminates inventory buildup problems
• May result in unused capacity during slack periods
• May result in overtime wages and inefficiencies
arising out of overused equipment

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 Inventory Policy in Inflation (and
Deflation)
• Inventory position can be protected in an
environment of price instability by
• Taking moderate inventory positions
• Hedging with a futures contract to sell at a
stipulated price some months from now
• Rapid price movements in inventory may have
a major impact on the reported income of the
firm

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 The Inventory Decision Model
• Two basic costs associated with inventory
• 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 or
perishability and price change
• Ordering costs
• Cost of ordering
• Cost of processing inventory into stock

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 Figure 7-8 Determining the Optimum
Inventory Level

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 Economic Ordering Quantity

where,
S = Total sales in units
O = Ordering cost for each order
C = Carrying cost per unit in dollars

Assuming:
S = 2000 units; O = $8; C = $0.20;

EOQ = 2 × 2,000 × $8 = $32,000 = 160,000 = 400 units

$0.20 $0.20

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 Figure 7-9 Inventory Usage Pattern

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 Table 7-2 Total Costs for Inventory

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 Safety Stocks and Stockouts
• Stockout occurs when firm is
• Out of specific inventory item
• Unable to sell or deliver product
• Safety stock of inventory reduces risk of losing
sales
• Increases cost of inventory due to rise in carrying
costs
• Cost should be offset by
• Eliminating lost profits due to stockouts
• Increased profits from unexpected orders
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 Safety Stocks and Stockouts Continued
• Assuming that EOQ = 400 units and safety stock = 50
units
Average inventory = EOQ + Safety stock
2
Average inventory = 400 + 50
2
• The inventory carrying costs will now increase to $50

Carrying costs = Average inventory in units × Carrying cost per

unit
= 250 × $0.20 = $50

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 Just-in-Time Inventory Management

• Basic requirements for JIT

• Quality production that continually satisfies
customer requirements
• Close ties among suppliers, manufacturers, and
customers
• Minimizes level of inventory
• Cost savings from lower inventory
• On average, JIT has reduced inventory-to-sales
ratio by over 10 percent over last decade

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 Other Benefits
• Reduction of warehouse space for inventory
• Reduction of construction and overhead
expenses for utilities and manpower
• Better technology with development of
electronic data interchange systems (EDI)
• Between suppliers and production and
manufacturing departments
• Reduction in rekeying errors and form duplication
• Reduction in costs from quality control
• Elimination of waste
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 The Downside of JIT
• Integration costs of JIT system
• Parts shortages could lead to lost sales and
slow growth
• Unforecasted increase in sales
• Inability to keep up with demand
• Unforecasted decrease in sales
• Inventory can pile up during recession
• Revaluation may be needed in high-growth
industries fostering dynamic technologies

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