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Current Asset Management

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline
What is current asset management Cash management and its importance Management of marketable securities Accounts receivable and inventory management Inventory management and policy decisions required Liquidity vis--vis returns

Cash Management
Financial managers actively attempt to keep cash (non-earning asset) to a minimum
It is critical to have sufficient cash to for 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


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


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

Cash Flow Cycle (contd)

Cash inflows are driven by sales and influenced by:
Type of customers Customers geographical location Product being sold Industry

When the cash balance increases, the extra cash can be

Used for various payments to lenders, stockholders, government, etc Used to invest in marketable securities

When there is a need for cash a firm can:

Sell the marketable securities Borrow funds from short-term lenders

Expanded Cash Flow Cycle


E-commerce and Sales

Benefits: faster cash flow
Credit card companies advance cash to the retailer within 710 days against retailers 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 companys own credit cards

Difference between firms recorded amount and amount credited to the firm by a bank Two types of float:
Mail float: Arises duet to the time it takes to deliver a check. Clearing float: Arises due to the time it takes to clear a check once the payment is made

Both these floats do not exist anymore due to:

Electronic payments Check Clearing for the 21st Century Act

Check Clearing for the 21st Century Act (Check 21)

Allows banks and others to electronically process a check


Improving Collections and Extending Disbursements

Improving collection:
Setting up multiple collection centers at different locations Adopt lockbox system for expeditious check clearance at lower costs

Extending disbursement:
General trend:
Speedup processing of incoming checks Slow down payment procedures
Extended disbursement float allows companies to hold onto their cash balances for as long as possible

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


Cash Management Network


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

International fund transfer is carried out through SWIFT (Society for Worldwide Interbank Financial Telecommunications)
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

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

International Cash Management (contd)

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


An Examination of Yield and Maturity Characteristics

Marketable securities


Marketable Securities
When a firm has excess funds, it should be converted from cash into interest-earning securities Types of securities:
Treasury bills: Short-term obligations of the government Treasury notes: Government obligations with a maturity of 1-10 years Federal agency securities: Offerings of government organizations Certificate of deposit: Offered by commercial banks, savings, and other financial institutions Commercial paper: Represents unsecured promissory notes issued by large business organizations Bankers acceptances: Short-term securities that arise from foreign trade


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


Types of Short-Term Investments


Credit Standards
Determine the nature of credit risk based on:
Prior records of payment and financial stability, current net worth, and other related factors

5 Cs of credit:
Character Capital Capacity Conditions Collateral

Credit Standards (contd)

Dun & Bradstreet Information Services (DBIS):
Produces business information analysis tools Publishes reference books Provides computer access to information The Data Universal Number System (D-U-N-S) is a unique nine-digit code assigned by DBIS to each business in its information base


Dun & Bradstreet Report An Example


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


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


An Actual Credit Decision

Brings together various elements of accounts receivable management

Accounts receivable =

Sales = $10,000 = $1,667 Turnover 6


Inventory Management
Inventory has three basic categories:
Raw materials Work in progress Finished goods

Amount of inventory is affected by sales, production, and economic conditions Inventory is the least of liquid assets should provide the highest yield

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

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 also have a major impact on the reported income of the firm

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

Determining the Optimum Inventory Level


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

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 stockouts Increased profits from unexpected orders

Safety Stocks and Stock Outs (contd)

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 Carrying cost per unit

= 250 $0.20 = $50

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

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


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


11th and 13th edition: Problems 10, 14, 17