Chapter 4

Managing current asset

1
 Determining target cash balance
•purpose of cash management is to hold optimal balance of
cash that is just enough to meet the demand for cash
•Cash balance more than the optimum level will cost the firm’s
profitability
•cash balance that is below the optimum level will
result in poor liquidity.
•Management’s goal should be to maintain levels of
transactional cash balances and
marketable securities investments that contribute to
improving the value of the firm.

2
 Quantitative Models
Baumol model and the Miller-Orr model.

• Baumol model: The model is popularly known as the Baumol’s model.

Founded by William J.Baumol in 1952.
The model states :
– Transactional cash balances by determining optimal cash conversion quantity .
– the optimal amount of cash that should be transferred from marketable securities
to cash
– A portfolio of marketable securities acts as a reservoir for replenishing cash
balances.
– The firm manages this
cash on the basis of the cost of converting marketable securities into cash
(transaction cost) and the cost of holding cash rather than marketable securities
(opportunity cost)

3
 Assumptions
of baumols model
The firm is able to forecast its cash requirements with certainty and
receive a specific amount at regular intervals.

The firm’s cash payments occur uniformly over a period of time,

i.e., a steady rate of cash outflows

The opportunity cost of holding cash is known and does not change
over time.

The firm will incur the same transactional cost whenever it converts
securities to cash.

4
• Let us assume that the firm sells
securities and starts with a cash
balance of C birr.
• firm spends cash, its cash balance
starts decreasing and reaches zero.
• The firm again gets back its money
by selling marketable securities
• As the cash balance decreases
gradually, the average cash
balance will be: C*/2.

5
 Opportunity Cost
• Most firms try to minimize the sum of the cost of holding
cash and the cost of converting marketable securities to
cash
• Opportunity Cost is the interest earnings per birr given up
as a result of holding funds in a non-interest earning cash
account.
• If the opportunity cost is k, then the firm’s holding cost for
maintaining an average cash balance is
k = the opportunity
Holding Cost = k (C* /2) C*= (optimum cash balance)
C*/2 = the average cash balance

6
 Transaction Cost
• whenever the firm converts its marketable securities to cash,
it incurs a cost known as transaction cost such as cost of
placing and receiving an order for cash etc.
• The conversion cost is stated as birr per conversion. Number
of transaction is stated as;

• and transaction cost given a “c” and total cost

7
 Optimum Level of Cash Balance
• The optimum cash balance, C* is obtained when the
total cost is minimum. Tc minimum when holding
cost equal with transaction
• When we solve the total cost equation shown
above to determine the level of C* where total cost
is minimum, we get the following equation for C*:

8
 Example
• The management of Hake Sport, a small distributor of sporting
goods, anticipates Br.1 ,500,000 cash outlays (demand) during
the coming year. A recent study indicates that it costs Br. 30 to
convert marketable securities to cash. The marketable securities
portfolio currently earns an 8% annual rate or return.
• Compute
a) The optimum cash conversion balance (C*)
b) The number of conversions
C)The average cash balance
d) The total cost

9
a)
b) The number of conversion during the year to replenish the account

c. The average cash balance

d. The cost of managing the cash is:

Total cost = k (C*/2) + c (T/C*)
=(0.08 x 1 6,770.50) + (Br.30 x 45) = Br.2,692

10
 The Miller-Orr Model
MO model is considered by
many as more realistic model
b/c it allows the fluctuation in
cash balance from time to time.

It assumes that firm’s cash

flows vary randomly over a
planning period with normal
distribution of zero mean and a
given standard deviation

11
 From figure prior slide,
• MO model provides for two control limits & return point
• the upper control limit
• the lower control limit

• If the firm’s cash flows fluctuate randomly and hit the upper limit,
then it buys sufficient marketable securities& gets back return point.

• when the firm’s cash flows wander and hit the lower limit, it sells
sufficient marketable securities

• The firm sets the lower control limit as per its requirement of
maintaining minimum cash balance.

12
• The difference between the upper limit and the
lower limit depends on the following factors:
– The transaction cost (c)
– The interest rate, (k)
– The standard deviation of net cash flows.
• The formula for determining the distance
between upper and lower control limits
(called Z) is as follows:

13
• Z will be larger if transaction cost is higher or cash flows
show greater fluctuation
• The gap b/n the two limits will come closer as the interest
rate increases, i.e., Z is inversely related to the interest rate
– Upper Limit = Lower Limit + 3Z
– Return Point = Lower Limit + Z. This is the optimum (target) cash
balance.
– Average Cash Balance = Lower Limit + 4/3Z

14
• Example: the management of Hake Sport sets the minimum cash
balance of Br.1 ,000. The cost that converts marketable securities
(MSS) to cash is Br.30; the firm’s MSS portfolio earns an
8%annual return. The variance of Hake Sport’s daily net cash
flows is estimated to be Br. 27,000.

Required: Compute
a) the distance b/n the Upper and the Lower Limits (Z).
b) the Upper limit
c) average cash balance and the
d) target cash balance.

15
Solution

16
 Inventory management
• Inventories constitute the most significant part of current assets.
• Inventories, which may be classified as (1) supplies, (2) raw
materials, (3) work-in process, and (4) finished goods, are an
essential part of virtually all business operations
• The primary objective of inventory management is to ensure
sufficient levels of inventories to maintain an acceptable level of
availability on demand, and minimizing the associated holding and
administrative costs.
• It is essential for every firm to minimize such investments by
avoiding unnecessary storing costs, obsolescence costs, and
purchasing costs.

17
 Objectives of inventory management
• Every business unit is required to maintain certain level of inventories
for efficient and smooth production and sales operations
• Maintain large size of inventories increases investment in CA, &
facilitate successful production cycle, with un-interrupted production
process. However adds storing cost, administrative cost, obsolescence
cost and wastage.

• Lower volumes of inventories may result as decrease in indirect expenses

on one hand and increases production costs on the other as idle machine
hours, idle labor hours

• The twin goals of inventory management are (1) to ensure that the
inventories needed to sustain operations are available, but (2) to hold the
costs of ordering and carrying inventories to the lowest possible level by
determining the optimum level of inventory

18
Example of costs

19
 INVENTORY MANAGEMENT TECHNIQUES

• Efficiently controlled inventories makes the firm

flexible
• Inefficiently controlled inventories results in
unbalanced inventories :inflexibility in production
and operational activities
• Successful inventory management should always aim
for two basic conditions
• Identification of quantity to be ordered, minimizing the
investments in inventories :economic order quantity
• Determines the timing interval for the replenishment of
inventories. re-order point.

20
• Economic order quantity is the inventory
replenishment cycle
• A firm buying raw materials has to decide two
basic criteria influenced by purchasing decisions.
• They are (1) carrying costs of inventory and (2)
ordering cost of inventories.
• Economic order quantity is that level of
inventory, which minimizes the total ordering
costs, and also carrying costs.
21
• Ordering cost of inventory is also called as purchasing
costs of inventory: material requisition, receiving,
inspecting and pre-storing arrangements
• Ordering costs increases with increase in the number of
purchases and decreases on decrease in the number of
purchases.
• Carrying costs are cost of storing the raw materials and
finished goods in the stores: storing expenses, insurance,
taxes, deterioration and obsolescence of materials.
• Increase in the volume of inventories increases carrying
costs and vice-versa
• Inventory carrying cost is always expected to maintain on
the assumption of average volume
22
 Economic Order Quantity (EOQ)
• Economic order quantity is the size of the lot to be
purchased which is economically viable
• Economic order quantity is the point at which
inventory carrying costs are equal to order costs.
Assumptions of EOQ
• The supply of goods is satisfactory.
• The quality to be purchased by the concern is certain.
• The prices of goods are stable.

23
Economic Order Quantity (EOQ)
 Suppose ordering cost per order, O, constant.

 Total ordering cost (TOC) = no. of orders ×

ordering cost per order.

 Number of orders = total annual

requirement(A) ÷ order size (Q)
TOC = (A/Q) × O
24
• Let us further assume that carrying cost per
unit per year, c, is constant.

• The total carrying cost(TCC) = average inventory

(Q/2) × carrying cost per unit per year (c).
• TCC = Q/2 ×c
• Total inventory cost = TOC + TCC
(A/Q×O) + (Q/2 ×c)

25
• When ordering cost decreases, carrying cost
increases and vice – versa.

• Ordering cost increases with decrease in order size.

• Carrying cost decrease with the decrease in order
size.

• At a point where total cost is minimum, TOC and TCC

become equal.

26
• Thus, (A/Q×O) = (Q/2 ×c)
• From this equation we can derive for Q (order
size). At this point Q is Economic Order Quantity
(EOQ) b/c total cost is minimum as follows:
AO/Q =QC/2 → Q2C =2AO → Q2 =2AO/C
• Therefore, Q (EOQ) = √(2AO) ÷ C
Where: A – annual requirement
O- ordering cost per order
C – carrying cost per unit per year.
27
• Example: Phil Company expects to sell 30,000
lamps per month or 360,000 lamps per year.
The carrying cost is $1.20 per lamp and the
fixed ordering cost per order is $375.
1. What is the annual before-tax cost of the
current inventory policy?
• Solution: Annual cost=Ordering cost + Carrying
cost = (12)($375) + (30,000/2)(1.20)
= $4,500 + $ 18,000 = $22,500

28
• When ordering cost decreases, carrying cost
increases and vice – versa.

• Ordering cost increases with decrease in order size.

• Carrying cost decrease with the decrease in order
size.

• At a point where total cost is minimum, TOC and TCC

become equal.

29
• Thus, (A/Q×O) = (Q/2 ×c)
• From this equation we can derive for Q (order size). At
this point Q is Economic Order Quantity (EOQ) b/c total
cost is minimum as follows:
AO/Q =QC/2 → Q2C =2AO → Q2 =2AO/C
• Therefore, Q (EOQ) = √(2AO) ÷ C
Where: A – annual requirement
O- ordering cost per order
C – carrying cost per unit per year.
Note: Graphic presentation should be considered.
30
• Example: Phil Company expects to sell 30,000
lamps per month or 360,000 lamps per year.
The carrying cost is $1.20 per lamp and the
fixed ordering cost per order is $375.
1. What is the annual before-tax cost of the
current inventory policy?
• Solution: Annual cost=Ordering cost + Carrying
cost = (12)($375) + (30,000/2)(1.20)
= $4,500 + $ 18,000 = $22,500
31
2. What is the optimal order quantity according to
the EOQ model?

Solution: Q (EOQ) = √(2AO) ÷ C →

√(2 × 360,000 × 375) ÷1.20 = 15,000 units

3. If the company changes its reorder policy to conform
with the EOQ model, what will be the net savings?

• Solution: no. of orders = (360,000/15,000) = 24

• total cost = Ordering cost + Carrying cost
= (24)($375)+(15,000/2)(1.20)
= $9,000 + $9,000 = $18,000
 Annual cost savings by using EOQ=$4,500
($ 22,500- 18,000).
 REORDER POINT
• Inventory level at which an order should be placed to
replenish the inventory.
• To determine the reorder point under certainty one
should know (a) lead time, (b) average usage of inventory
and (c) economic order quantity or quantity replenished.
• Lead-time is the normal time taken to replenish inventory
after placing an order of the same inventory
• Average usage of inventory is the quantity consumed by
the production process.
Reorder point under certainty
Reorder point = Lead-time X Average usage on inventory (units)

34
• Reorder point under the uncertainty can be
determined as follows:
• Reorder point = {Lead-time X Average usage}+ {safety stock}
• Uncertainty is the condition where, lead-
time may fluctuate, or average inventory
consumption may vary or both

35
• From the following information given below
calculate the inventory reorder point both
under the certainty assumption and under
uncertainty assumption
Given Economic order quantity 2,000 unit
Lead-time 1 week
Average consumption 400 units per week
Uncertainty condition

Lead-time 1 to 1½ week

Average consumption 400 to 500 units

36
 solution
Under Certainty assumption
Reorder point = Lead-time X Average usage on inventory (units)
 
Reorder point = 1 week X 400 units per week
 
Reorder point = 400 units

Under Uncertainty assumption

Reorder point = Lead-time X Average usage + safety stock
 
Reorder point = 1 week X 400 units per week + 400x½ week stock
Reorder point = 400 units + 200 units
 
Reorder point = 600 units
 Just in Time Inventory (JIT)
• Essentially to minimize such inventories and thereby
maximizing the turnover
• In JIT, affirm keeps only enough inventory on hand to
meet immediate production needs
• The JIT system reduces inventory carrying costs by
requiring that the raw materials are procured just in time to
be placed into production.
• If JIT is to be implemented successfully there must be high
degree of coordination and cooperation between the
suppliers and manufacturers and among different
production

38
 INVENTORY CONTROL
• Inventory management should also aim for control over
inventories.
• Therefore a firm should be selective in its approach in
inventories controlling system called as ABC analysis
• ABC analysis that tends to measure significance of each item
of inventories in terms of its value
– Inventories with high value : as ‘A’ class items and are expected to
keep under tight control
– Inventories with low value : expected to have limited or no control
called as ‘C’ class items
– inventories with moderate investment are called as ‘B’ class items
are kept under moderate control measures

39
 4.5. Receivable management
• Reading assignment

40
 CHAPTER FIVE

FINANCING CURRENT ASSETS

41
 Current asset financing policy
•Most businesses experience seasonal and/or cyclical fluctuations.
•For example, construction firms have peaks in the spring and summer,
retailers peak around Christmas,
•All businesses must build up current assets when the economy is strong, but
they then sell off inventories and reduce receivables when the economy
slacks off.
•current assets rarely drop to zero — companies have some permanent
current assets : the current assets on hand at the low point of the cycle
•As sales increase during the upswing, current assets must be increased :these
additional current assets are temporary current asset
–Permanent Current Assets Current assets that a firm must carry even at the trough of it cycles.
–Temporary current asset: Current assets that fluctuate with seasonal or cyclical variations
in sales

42
Alternative current asset financing policy

The manner in which the permanent and temporary current assets

are financed is called the firm’s current asset financing policy
There are three current asset financing policy;
• 1, Maturity Matching
• 2, aggressive approach
• 3, conservative approach.

Financing policies distinguished by the relative amounts of short-term debt used

under each policy
• The aggressive policy called for the greatest use of short-term debt
• Conservative policy called for the least
• Maturity matching fell in between

43
 Maturity matching, or “self-liquidating,”
approach
• A financing policy that matches asset and
liability maturities. This is a moderate
policy.
• At the limit, a firm could attempt to match
exactly the maturity structure of its assets
and liabilities.
Example:
• Inventory expected to be sold in 30 days could
be financed with a 30-day bank loan;
• A machine expected to last for 5 years could be
financed with a 5-year loan;
• A 20-year building could be financed with a 20-
year mortgage bond
Two factors prevent this exact maturity matching:
1) uncertainty about the lives of assets
2) common equity has no maturity 44
 AGGRESSIVE APPROACH
• Aggressive firm finances
all of its fixed assets
with long-term capital
and
• Part of its permanent
current assets with
short-term,
nonspontaneous credit.

45
 CONSERVATIVE APPROACH
• Permanent capital is being used to
finance all permanent asset
requirements and also to meet some
of the seasonal needs.
• In this situation, the firm uses a
small amount of short-term,
nonspontaneous credit to
meet its peak requirements, but it
also meets a part of its seasonal
needs by “storing liquidity” in the
form of marketable securities.

46
 Advantages of short term financing
•Although short-term credit is generally riskier than long-term credit, using
short-term funds does have some significant advantages :
SPEED
A short-term loan can be obtained much faster than long-term credit.
FLEXIBILITY
•Flotation costs are higher for long-term debt than for short-term credit.
•Long term loan agreement includes restrictive covenants prepayment
provision, prepayment penalties can be expensive
•Short-term credit agreements are generally less restrictive.
COST OF BORROWING
•under normal conditions, interest costs at the time the funds are
obtained will be lower if the firm borrows on a short-term rather than a
long-term basis.

47
 Disadvantages of short term financing

• Even though short-term rates are often lower,

short-term credit is riskier for two reasons:
1. short-term credit interest expense will
fluctuate widely
2. If a firm borrows heavily on a short-term
basis, a temporary recession may render it
unable to repay this debt

48
S O U R C E S O F S H O R T- T E R M F I N A N
CING
• There are numerous sources of short-term
funds, and in the following sections we
describe four major types: (1) accruals, (2)
accounts payable (trade credit), (3) bank
loans, and (4) commercial paper

49
 AC C R UA L S
• Continually recurring short-term liabilities, especially
accrued wages and accrued taxes.
• These accruals increase automatically, or spontaneously, as
a firm’s operations expand.
• Further, this type of debt is “free” in the sense that no
explicit interest is paid on funds raised through accruals
• However, a firm cannot ordinarily control its accruals: The
timing of wage payments is set by economic
forces and industry custom, while tax payment dates are
established by law

50
 AC C O U N T S PAYA B L E
(TRADECREDIT)
• Trade Credit: Debt arising from credit sales and recorded
as an account receivable by the seller and as an account
payable by the buyer.
• Accounts payable, or trade credit, is the largest single
category of short-term debt,
• Trade credit is a “spontaneous” source of financing in the
sense that it arises from ordinary business transactions.

51
 Bank loan
• Commercial banks, whose loans generally appear on
balance sheets as notes payable, are second in
importance to trade credit as a source of short-term
financing for nonfinancial corporations
• MATURITY : Bank loans to businesses are frequently
written as 90-day notes, so the loan must be repaid
or renewed at the end of 90 days.

52
 Bank loan
• PROMISSORY NOTE :When a bank loan is
approved, the agreement is executed by signing
a promissory note.
• promissory note : A document specifying the
terms and conditions of a loan, including the
amount, interest rate, and repayment schedule.

53
 C O M M E R C I A L PA P E R
• Commercial paper is a type of unsecured promissory
note issued by large, strong firms and sold primarily to
other business firms, to insurance companies, to pension
funds, to money market mutual funds, and to banks
• Unsecured, short-term promissory notes of large firms,
usually issued in denominations of $100,000 or more and
having an interest rate somewhat below the prime rate

54
 C O M M E R C I A L PA P E R
• MATURITY AND COST
Maturities of commercial paper generally vary from
one day to nine months, with an average of about five
months
• The interest rate on commercial paper fluctuates with
supply and demand conditions — it is determined in
the marketplace, varying daily as conditions change

55
Thank you

56