Topic 5

Managing Current Assets

 Alternative working capital policies
 Cash management
 Inventory management
 Accounts receivable management
15-1
Working capital terminology
 Gross working capital – total current assets.
 Net working capital – current assets minus
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.
15-2
Solvency vs Liquidity
 Solvency
 ability to discharge any of their obligations on the date it
falls due
 debtor has sufficient assets in cash or in such other forms
that can with virtual certainty converted into cash by the
due date

 Liqudity
 firm is very liquid when much of its assets are in cash or
quasi-cash
 the asset has a market with several active or potential
participants, and can be instantaneously converted into cash
at or just under the market price, or can be bought for cash
at or just above the market price

15-3
Alternative Current Asset
Investment Policies
There are basically three alternative policies regarding the level of current
assets to be carried:
1. Under a relaxed current asset investment policy:
1. Large amounts of cash, marketable securities, and inventories are
carried.
2. Sales are stimulated with a liberal credit policy (so we have high A/R)
3. Usually provides lowest risk and lowest expected return.
2. Under a restricted current asset investment policy:
1. Holdings of cash, marketable securities, inventories, and A/R are
minimized
2. Turnover of current assets is higher. (Each dollar of CA must “work
harder” to produce more sales.)
3. Usually provides highest expected return and highest risk
3. A moderate current asset investment policy falls between the previous
two extremes.

15-4
 Management of Cash:
Cash is the currency and coin the firm has on hand in
petty cash drawers, in cash registers, or in checking
account (also known as current account) at various
commercial banks

Marketable securities are those security investments the

firm can quickly convert into cash balances. Most firms
tend to hold marketable securities with very short
maturity periods. Also known as near cash or near-cash
assets

15-5
Cash doesn’t earn a profit, so
why hold it?
1. Transactions – must have some cash to operate
day-to-day business
2. Precautionary balances in reserve for random,
unforeseen fluctuations in cash flows. (However,
if the firm can borrow on short notice, the need
for this is reduced.) “safety stock”.
3. Compensating balances – Bank balances that a
firm must maintain to compensate the bank for
services rendered or for granting a loan .
4. Speculation – to take advantage of any bargain
purchases that might arise and to take discounts.

15-6
Continued
There are three more specific reasons to maintain an
ample supply of cash and near-cash assets:
1. Suppliers frequently offer trade discounts for
paying bills early. From a financing standpoint, the
cost of not taking these discounts is very high, so
firms should always have enough cash on hand to
take advantage of them.
2. An adequate supply of cash helps keep the firm’s
current and quick ratios high enough to maintain a
good credit rating.
3. An adequate supply of cash helps ensure that the
firm can weather seasonal and cyclical downturns.

15-7
Cash Management Objectives
and Decisions
 Risk-Return Trade-off
 Concerned with minimizing the risk of insolvency,

a situation where the firm is unable to pay its bills

on time
 The firm is said to be technically insolvent if it

lacks the necessary liquidity to make prompt

payments on its current debt obligation
 Financial manager’s responsibility to strike balance

of holding cash, too much or too little, the focal

point of risk return trade-off

15-8
Cash Management Objectives
and Decisions
 A large cash investment minimizes the chances of
insolvency but penalizes company’s profitability
 A small cash investment frees excess balances for
investment in both marketable securities and
longer lived assets; which enhances profitability
and value of the firm’s common share, but
increases the chances of running out of cash

15-9
Cash Management Objectives
and Decisions
 The Objectives
 The risk return trade-off can be reduced to two
prime objectives of cash management system:
 Enough cash must be on hand to meet the disbursal
needs that arise
 Investment in idle cash balances must be reduced to the
minimum

15-10
Cash Management Objectives
and Decisions
 Decisions:
 Initial step to effective cash-management program is
the cash flow forecasting
 Accomplished by the finance function’s evaluation of
data supplied by the marketing and production
functions in the company, using cash budget
 Decisions related to cash balances should answer
 What can be done to speed cash collections and slow down or
better control cash outflows?
 What should be the composition of a marketable-securities
portfolio?
 How should investment in liquid assets be split between actual
cash holdings and marketable securities?

15-11
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.

15-12
Illustration: Construct a Cash Budget
Sun Garden Co values, advertises and sells residential property on behalf of its customers. The
company has been in business for only a short time and is preparing a cash budget for the first
four months of 2006. Expected sales of residential properties are as follows.
2005 2006 2006 2006 2006
Month December January February March April
Units sold 10 10 15 25 30

The average price of each property is RM180,000 and Sun Garden Co charges a fee of 3% of
the value of each property sold. Sun Garden Co receives 1% in the month of sale and the
remaining 2% in the month after sale. The company has nine employees who are paid on a
monthly basis. The average salary per employee is RM35,000 per year. If more than 20
properties are sold in a given month, each employee is paid in that month a bonus of RM140
for each additional property sold.

Variable expenses are incurred at the rate of 0·5% of the value of each property sold and these
expenses are paid in the month of sale. Fixed overheads of RM4,300 per month are paid in the
month in which they arise. Sun Garden Co pays interest every three months on a loan of
RM200,000 at a rate of 6% per year. The last interest payment in each year is paid in
December.

An outstanding tax liability of RM95,800 is due to be paid in April. In the same month Sun
Garden Co intends to dispose of surplus vehicles, with a net book value of RM15,000, for
RM20,000. The cash balance at the start of January 2006 is expected to be a deficit of
RM40,000.

15-13
Items   Jan Feb Mac April

Receipt:          

Cash fees -1%   18000 27000 45000 54000

Credit fees – 2%   36000 36000 54000 90000

Sale of assets         20000

Sub-total   54000 63000 99000 164000

Payments:          

Salaries   26250 26250 26250 26250

Bonus       6300 12600

Expenses   9000 13500 22500 27000

Fixed OH   4300 4300 4300 4300

Taxation         95800

interest       3000  

    39550 44050 62350 165950

Net Cash Flows   14450 18950 36650 -1950

Opening balance   -40000 -22550 -6600 30050

Closing balance   -25550 -6600 30050 28100

           

Workings: December January February March April

Unit sold 10 10 15 25 30

Price per unit (‘000) 180 180 180 180 180

Sales value (‘000) 1800 1800 2700 4500 5400

Cash fees -1% 18000 18000 27000 45000 54000

Credit Fees – 2% 36000 36000 54000 90000 108000

Variable costs 0.5% of value sold   9000 13500 22500 27000

Monthly salary 35000 x 9 employee)/12 months = 26250 per month

Bonus in March (25-20)x 140 x 9 employees = 6300

Bonus in April (30-20)x 140 x 9 employees = 12600

15-14
What to include in a cash
budget?
Receipt of cash may come from one or more of the following:
 Cash sales.
 Payment of debtors (credit sales).
 The sale of fixed assets.
 The issue of new shares or loan stock.
 Receipt of interest and dividends from investments outside the
business.
 Court settlements.

Payments of cash may be for one or more of the following:

 Purchase of stock.
 Payroll costs or other expenses.
 Purchase of capital items.
 Payment of interest, dividends and taxation.

15-15
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.

15-16
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.

15-17
Management will need to take appropriate
action depending on the financial position.
Cash Position Appropriate management action
Short term surplus Pay creditors early to obtain discount.
Attempt to increase sales by increasing
debtors and stocks.
Make short term investments.

Short term deficits Increase creditors.

Reduce debtors.
Arrange an overdraft.

Long term surplus Make long term investments.

Expand operations
Diversify.
Replace / update fixed assets

Long term deficit Raise long term finance. i.e. issue shares
Consider shut down or disinvestment
opportunities.

15-18
STEPS TO CALCULATE MINIMUM
OPERATING CASH (MOC)
Operating Cycle (OC)
Is the time from the beginning of the production
process to the point in time when cash is collected from
the sale of the finished product,
 
OC=AAI + ACP
 
Notes:
AAI = average age of inventory
ACP = average collection period
15-19
 Step 1: 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
15-20
Terms in CCC
 Inventory Conversion Period: days
holding inventory until it's all sold
 Receivables Conversion Period: days
holding receivables until the last cash
collection
 Payables Conversion Period: days
holding accounts payable until it's all paid in
cash (i.e. time before inventory growth hits
cash)
15-21
 Cash conversion cycle
Inventory Receivables Payables
CCC = conversion + collection – deferral
period period period
CCC= AAI + ACP – APP
AAI = average age of inventory
ACP = average collection period
APP = average payment period.

Inventory Acc Payables

CCC = (COGS or Sales) X 365 + Acc Receivables X 365 – (COGS) X 365
( Sales)

15-22
 Step 2: Cash turnover
 CTO = CCC / 360

 Step 3: Minimum Operating Cash

(MOC)
 MOC = total operating expense / CTO

15-23
Example:

Kolan Inc. has annual sales of RM36,500,000

(RM100,000 a day on a 365-day basis). On average,
the company has RM12,000,000 in inventory and
RM8,000,000 in accounts receivable. The company
is looking for ways to shorten its cash conversion
cycle, which is calculated on a 365-day basis. Its
CFO has proposed new policies that would result in
a 20 percent reduction in both average inventories
and accounts receivables. The company anticipates
that these policies will also reduce sales by 10
percent. Accounts payable will remain unchanged at
25 days. What effect would these policies have on
the company’s cash conversion cycle?

15-24
Continued

For this problem we are only interested in the change in

the CCC. We may therefore ignore the Payables Deferral
Period since it is assumed to remain unchanged.
Current CCC = RM12,000,000/RM100,000 +
RM8,000,000/RM100,000 - 25
= 120 + 80 – 25 = 175 days.

New CCC = RM9,600,000/RM90,000 +

RM6,400,000/RM90,000
= 106.67 + 71.11 – 25 = 152.78 days.

Change in CCC = New CCC – Old CCC

= 152.78 – 175
= -22.22 days. Round to 22 days shorter

15-25
Inventory Management
 Objectives of inventories management:
• determine the appropriate amount invested
in inventories before a given sales value
• to minimize total inventory cost
• utilize resources effectively

15-26
Types of inventory costs
Inventory Costs
1. Carrying costs
cost associated with holding inventories, the cost tend to rise

in direct proportion to the average amount of inventory hold

•Storage and tracking

•Insurance and taxes

•Losses due to obsolescence, deterioration, or theft

•Opportunity cost of capital for the invested amount

2. Ordering cost
Cost related to placing and receiving order, it is fixed
regardless of average size of inventories
•transportation cost

•handling and clerical costs of purchasing inventory 15-27

 Types of inventory costs
3. Cost related to stock-out (Costs of running short )
cost incurred when inventory is insufficient to
meet demand
• lost of customer goodwill

• loss of sale

Reducing the average amount of inventory generally

reduces carrying costs, increases ordering costs, and
may increase the costs of running short.

15-28
 Continued

 
DFQC
 

T
o
t
al
In
ve
n
to
r
yc
os
t
= 

 



Q2


D = demand or annual sales in unit

C = carrying cost per unit
F = Fixed ordering cost
Q = economic order quantity

OR

Total Inventory Cost = purchase cost + ordering cost + holding cost

15-29
Economic Order Quantity
EOQ model is an approach used for managing inventory.
The main purpose is:
to determine the quantity of order which minimizes the
total inventory cost

The assumption of the model:

• forecasted sale can be determined perfectly

• sales accrued evenly through out the year

• there is no delivery delay in receiving order

2
(
F)(
D)
E
O
Q
=
C
15-30
 EOQ- Example
Point Sd. Bhd. uses the economic order quantity (EOQ) model to establish
the reorder quantity for raw material Y. The company holds no buffer
stock. Information relating to raw material Y is as follows:

Annual usage 48,000 units

Purchase price RM80 per unit
Ordering costs RM120 per order
Annual holding costs 10% of the purchase price

Required:
(a) Calculate:
(i) the EOQ for raw material Y, and
(ii) the total annual cost of purchasing, ordering and holding
stocks of raw material Y.

(b)The supplier has offered Point Ltd a discount of 1% on the purchase

price if each order placed is for 2,000 units.
(i) Calculate the total annual saving to Point Ltd of accepting this
offer.
15-31
2 (a) (i) Using the formula given:

EOQ = √ [(2 x 120 x 48,000) ÷ (0·10 x 80)] = 1,200 units

RM
(ii) Purchasing cost (48,000 x RM80) 3,840,000
Ordering cost (48,000 ÷ 1,200) x RM120 4,800
Holding costs (1,200 ÷ 2) x RM80 x 0·10] 4,800
––––––––––
Total cost 3,849,600
––––––––––
(b) Purchasing cost (48,000 x RM80 x 0·99) 3,801,600
Ordering cost (48,000 ÷ 2,000) x RM120 2,880
Holding costs [(2,000 ÷ 2) x RM80 x 0·99 x 0·10] 7,920
––––––––––
Total cost 3,812,400
––––––––––
Annual total saving (3,849,600 – 3,812,400) RM37,200

15-32
Issues
Involves risk and return trade-off; i.e. too low inventory pose risk
of shortage in production, and too high inventory increases
inventory costs

INVENTORY LEVEL INCREASES,

RISK OF SHORTAGE DECREASES,
INVENTORY EXPENSES INCREASES

15-33
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.
15-34
 CREDIT POLICY
CREDIT POLICY IS A SET OF DECISIONS ON THE
FOLLOWING:
1. CREDIT TERM
2. CREDIT STANDARD
3. MONITORING AND COLLECTION

15-35
 CREDIT POLICY

1. CREDIT TERM
CREDIT TERM IS A STATEMENT OF THE CREDIT PERIOD AND ANY
DISCOUNTS OFFERED.
EG. 2/10 NET 30 a/b net c

MEANS IF YOU PAY WITHIN 10 DAYS, YOU WILL GET 2% DISCOUNT, THE
PURCHASED MUST BE PAID WITHIN 30 DAYS
a = CASH DISCOUNT (2%)
b = DISCOUNT PERIOD (10 DAYS)
c = NET CREDIT PERIOD (THE LENGTH OF TIME WHICH CREDIT IS
GRANTED) - E.G: 30 DAYS

15-36
 CREDIT POLICY
1. CREDIT TERM (CONTINUE…)
CASH DISCOUNT IS GIVEN TO ENCOURAGE EARLY PAYMENT
FOREGOING THE CREDIT TERM, FIRM WILL LOSS CASH DISCOUNT (COST TO
COMPANY)
FORMULA TO ESTIMATE COST OF LOST CASH DISCOUNT:

ANNUALIZED COST OF a 360 a = credit

FOREGOING DISCOUNT  X term/discount
1 a c  b
b = discount period
a
b
c c = credit period
2/10 net 30 15-37
 CREDIT POLICY
1. CREDIT TERM (CONTINUE…)
EXAMPLE:
DETERMINE THE ANNUALIZED COST OF FOREGOING THE CASH
DISCOUNT ON TERMS 3/10 NET 60

a 360
 X
1 a c  b
0.03 360
 X  0.2226  22.3%
1  0.03 60  10
a = credit
term/discount
b = discount period
15-38
c = credit period
 CREDIT POLICY

1. CREDIT TERM (CONTINUE…)

EXAMPLE:
THE FURNITURE SHOP ORDERS $2000 WORTH OF SUPPLY EVERY 30 DAYS.
IF THEY TAKE ADVANTAGE OF THE 3/10 NET 30 DISCOUNT OFFERED BY
THE SUPPLIER, HOW MUCH WOULD THEY SAVE OVER THE YEAR

3% X $2000 = $60
$60 WOULD BE SAVED ON EACH ORDER
THERE ARE TWELVE 30 DAYS PERIOD IN A YEAR
S0, 12 X $60 = $720 WOULD BE SAVED OVER THE YEAR

15-39
 CREDIT POLICY

1. CREDIT TERM (CONTINUE…)

• PENALTY CHARGES
THE CHARGES IMPOSED ON LATE PAYMENT
E.G: 2/10 NET 30 AND 1.5% INTEREST ON LATE PAYMENT

• CREDIT INSTRUMENT
BASIC EVIDENCE OF INDEBTEDNESS
E.G. INVOICE, PROMISSORY NOTES, COMMERCIAL DRAFT,
SIGHT DRAFT ETC.

15-40
 CREDIT POLICY
2. CREDIT STANDARD/ANALYSIS

CREDIT STANDARD REFERS TO THE STRENGTH AND CREDITWORTHINESS

A CUSTOMER MUST EXHIBIT IN ORDER TO QUALIFY FOR CREDIT

THE PROCESS OF DECIDING WHETHER OR NOT TO EXTEND CREDIT TO A

PARTICULAR CUSTOMER

TWO STEPS:
•GATHERING RELEVANT INFORMATION

•DETERMINING CREDITWORTHINESS

15-41
 CREDIT POLICY
3. MONITORING & COLLECTION PROCEDURES

MONITORING RECEIVABLES IS A KEY TASK IN CREDIT MANAGEMENT.

INDIVIDUAL ACCOUNTS ARE MONITORED TO ENSURE THAT CREDIT
CUSTOMERS ADHERE TO THE FIRM’S STATED CREDIT TERMS AND TO
WARN MANAGEMENT WHEN TROUBLE APPEARS.
THERE ARE 2 ELEMENTS:
1. DAYS SALES OUTSTANDING
•MEASURES HOW MANY DAYS’ WORTH OF CREDIT SALES IS
REPRESENTED BY A/C RECEIVABLES
2. AGING SCHEDULE
•BREAK DOWN TOTAL RECEIVABLES BY AGE, SHOWING THE CURRENT
PERCENTAGE OF RECEIVABLES
15-42
 CREDIT POLICY
3. MONITORING & COLLECTION PROCEDURES

DAYS SALES OUTSTANDING (DSO) / AVERAGE COLLECTION PERIOD (ACP)

ACCOUNT RECEIVABLES
SALES/365

E.G: IF ACCOUNT RECEIVABLES ARE $1,800,000 AND ITS SALES FOR

THE YEAR ARE $14,600,000, THE DSO:

DSO = $1,800,000
$14,600,000 / 365
= 45 DAYS

15-43
 CREDIT POLICY

3. MONITORING & COLLECTION PROCEDURES

EXAMPLE OF AGING SCHEDULE

AGE DOLLAR AMOUNT PERCENT

CURRENT $80 47.1%
1 – 30 DAYS $60 35.3%
31 – 60 DAYS $30 17.6%
TOTAL $170 100.0%

15-44
 CREDIT POLICY
3. MONITORING & COLLECTION PROCEDURES

COLLECTION POLICIES REFER TO THE SET OF ACTIONS A SELLER MAY TAKE

TO ENCOURAGE BUYERS TO ADHERE TO STATED CREDIT TERMS
CREDIT TERM ENFORCEMENT
• DETERMINATION OF LATE PAYMENT
• DIRECT ACTIONS
• LEGAL ACTIONS
• COLLECTION AGENCIES

15-45
Does Company 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.

15-46
If company 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 (Economic Value
Added- estimate of a firm's economic profit - being
the value created in excess of the required return
of the company's shareholders ).

15-47