Fin500 PPT CH17

Foundations of Finance
Tenth Edition
Chapter 17
Cash, Receivables, and Inventory
Management
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
Learning Objectives
17.1 Understand the problems inherent in managing the
firm’s cash balances.
17.2 Evaluate the costs and benefits associated with
managing a firm’s credit policies.
17.3 Understand the financial costs and benefits of
managing firm’s investment in inventory.
Managing the Firm’s Investment in
Cash and Marketable Securities
Cash and Marketable Securities
• Cash refers to currency and coins plus demand deposit
accounts.
• Marketable securities includes security investments the
firm can quickly convert to cash balances.
Why a Company Holds Cash
• Cash flow process
– Two typical sources of cash: external and internal
– Irregular increases or decreases in the firm’s cash
holdings can come from several sources:
▪ Sale of securities (stocks and bonds)
▪ Nonmarketable-debt contracts
▪ Payment of dividend, interest, tax bills
▪ Share repurchases
Figure 17.1 The Cash Generation and
Disposition Process
Three Motives for Holding Cash
• Transactions motive
– Balances held to meet cash needs that arise in the
ordinary course of doing business
• Precautionary motive
– Precautionary balance as a buffer
– Maintain balances to satisfy possible, but as yet
unknown, needs
• Speculative motive
– To take advantage of potential profit-making situations
Cash Management Objectives and
Decisions
• Cash management program must minimize the firm’s risk
of insolvency.
• Insolvency—The situation in which the firm is unable to
meet its maturing liabilities on time.
• A company is technically insolvent when it lacks the
necessary liquidity to make prompt payment on its current
debt obligations.
The Cash Balance Trade-Off
• A large cash balance will help minimize the chance of
insolvency, but it penalizes the company’s profitability.
• A smaller cash balance will increase the chance of
insolvency, but it will free up excess cash for investment
and enhance profitability.
Cash Management Objectives (1 of 2)
• Two prime objectives
– Enough cash must be on hand to meet disbursal needs
in the course of doing business.
– Investment in idle cash balances must be reduced to a
minimum.
Cash Management Objectives (2 of 2)
• Two conditions would allow the firm to operate for
extended periods with cash balances near or at zero:
– Completely accurate forecast of net cash flows over
the planning horizon
– Perfect synchronization of cash receipts and
disbursements
Cash Management Decisions
• What can be done to speed up cash collections and slow
down or better control cash outflows?
• What should be the composition of a marketable securities
portfolio?
Collection and Disbursement
Procedures
• The efficiency of firm’s cash management program can be
improved by accelerating cash receipts.
• There are three main delays—referred to as floats—as
shown in Figure 17.2.
Figure 17.2 Ordinary Cash Collection
System
Float and Managing Cash Inflow
(1 of 2)
• Float—The time from when a check is written until the

actual recipient can draw upon or use the funds:
– Mail float
– Processing float
– Availability float
Float and Managing Cash Inflow
(2 of 2)
• Mail float
– Time lapse from the moment a customer mails a
remittance check until the firm begins to process it
• Processing float
– The time required for the firm to process remittance
checks before they can be deposited in the bank
• Availability float
– The time it takes the bank to give the firm credit for the
customer’s payment
Benefit of Float Reduction
• The financial benefit of float reduction can be calculated as
follows:
Float Reduction Example
• If a company with daily sales of $45,062,466 could invest
in marketable securities to yield 4 percent annually and
could eliminate 1 day of float, what would be the annual
savings?
= $45,062,466 × 0.04 = $1,802,499
Managing the Cash Outflow
• Goal: To increase company’s float by slowing down the
disbursement process.
The Composition of a Marketable-
Securities Portfolio
• The general selection criteria for proper marketable-
securities mix include the following:
– Financial risk
– Interest rate risk
– Liquidity
– Taxability
– Yields
Financial Risk
• Refers to the uncertainty of expected returns from a
security attributable to possible changes in the financial
capacity of the security issuer to make future payments to
the security owner.
• If the chance of default on the terms of the instrument is
high, then the financial risk is said to be high.
Interest Rate Risk
• Interest rate risk refers to the uncertainty of expected
return from a financial instrument attributable to changes in
interest rates.
Table 17.1 Market Price Effect of Rise
in Interest Rates
Liquidity
• Liquidity refers to the ability to convert a security into cash.
• Should an unforeseen event require that a significant
amount of cash be immediately available, then a sizable
portion of the portfolio might have to be sold. Manager
should prefer securities that can be sold at or near its
prevailing market price.
Taxability
• The tax treatment of the income a firm receives from its
security investments does not affect the ultimate mix of the
marketable-securities portfolio as much as the criteria
mentioned earlier since interest income from most
instruments is taxable at the federal level.
Yields
• Yield is affected by previous factors of financial risk,
interest rates, liquidity, and taxability.
• The yield criterion involves an evaluation of the risks and
benefits inherent in all of these factors. For example, if a
given risk is assumed, such as lack of liquidity, a higher
yield may be expected on the illiquid instrument.
Table 17.2 Comparing After-Tax Yields
Marketable-Security Alternatives
• Money market securities generally have short-term
maturity and are highly marketable.
• Five key attributes of marketable securities
– Denominations in which securities are available
– Maturities that are offered
– Basis used
– Liquidity of the instrument
– Taxability of the investment returns
Examples of Marketable Securities
(1 of 3)
• U.S. Treasury bills

– Direct obligations of the U.S. government sold by the
U.S. Treasury on a regular basis
• Federal agency securities
– Debt obligations of corporations and agencies that
have been created to effect various lending programs
of the U.S. government
(2 of 3)
• Banker’s acceptances
– Draft (order to pay) drawn on a specific bank by an
exporter in order to obtain payment for goods shipped
to a customer who maintains an account with that
specific bank
• Negotiable certificates of deposit
– Marketable receipt for funds that have been deposited
in a bank for a fixed period
(3 of 3)
• Commercial paper
– Short-term unsecured promissory notes sold by large
businesses
• Repurchase agreements
– Legal contracts that involve the actual sale of securities
by a borrower to the lender, with a commitment on the
part of the borrower to repurchase the securities at the
contract price plus a stated interest charge
• Money market mutual funds
– Pooling of the funds of large number of small savers
Table 17.3 Features of Selected
Money-Market Instruments
Accounts Receivable
Accounts Receivable Management
• Accounts receivable is less liquid compared to cash and
marketable securities. Account receivables typically
comprise more than 25 percent of a firm’s assets.
• Size of investment in accounts receivable is determined by
several factors:
– The percentage of credit sales to total sales
– The level of sales
– Credit and collection policies
Figure 17.3 Determinants of
Investment in Accounts Receivable
Terms of Sale—A Decision Variable
• Identify the possible discount for early payment, the
discount period, and the total credit period.
–
– Thus a customer can deduct a percent if paid within b
days, otherwise it must be paid within c days.
▪ Example Discount of 2 percent if paid
within 10 days; otherwise due in 45 days.
The Type of Customer—A Decision
Variable
• This involves determining the type of customer who
qualifies for trade credit.
• Need to consider the costs of credit investigation,
collection costs, default costs.
• May use credit scoring or a numerical evaluation of each
applicant to determine their short-run financial well-being.
Collection Effort—A Decision
Variable
• The probability of default increases with the age of the
account. Thus, eliminating past-due receivables is key.
One common way of evaluating the situation is with ratio
analysis—average collection period, ratio of receivables to
assets, ratio of credit sales to receivables, ratio of bad debt
to sales.
• A direct trade-off exists between collection expenses and
lost goodwill on one hand and noncollection of accounts on
the other.
Inventory
Inventory Management
• Inventory management involves the control of the assets
that are produced to be sold in the normal course of the
firm’s operations.
• The purpose of carrying inventory is to make each function
of the business independent of every other function—so
that delays or shutdowns in one area do not affect the
production and sale of the final product.
The Inventory Trade-Off
• Risk: If inventory level is low, it is possible that there will
be delays in production and customer delivery.
• Return: Low inventory will reduce storage and handling
costs and release funds tied up in inventory. Thus it will
increase returns.
• Similarly, high levels of inventory will reduce delays but
increase costs.
Types of Inventory
• Raw-materials inventory
– Basic materials purchased to be used in the firm’s
production operations
• Work-in-process inventory
– Partially finished goods requiring additional work before
they become finished goods
• Finished-goods inventory
– Goods on which production has been completed but
are not yet sold
Inventory Management Techniques
• Effective inventory management is directly related to the
size of the investment in inventory.
• Effective management is essential to the goal of
maximization of shareholder wealth.
• To control the investment in inventory, management must
solve two problems:
– The order quantity problem
– The order point problem
The Order Quantity Problem
• Involves determining the optimal order size for an
inventory item given its expected usage, carrying costs,
and ordering costs.
Total Inventory Costs (1 of 2)
Total Inventory Costs (2 of 2)
• Economic order quantity (EOQ) attempts to determine the

order size that will minimize total inventory costs.
Figure 17.4 Inventory Level and the
Replenishment Cycle
Figure 17.5 Total Costs and EOQ
Determination
Assumptions of the EOQ Model
• Constant or uniform demand
• A constant unit price
• Constant carrying costs
• Constant ordering costs
• Instantaneous delivery
• Independent orders
The Order Point Problem (1 of 3)
• The two most limiting assumptions in EOQ—constant
demand and instantaneous delivery—are dealt with
through the inclusion of safety stock.
• Safety stock
– Inventory held to accommodate any unusually large
and unexpected usage during delivery time
• Order point problem
– The decision about how much safety stock to hold or
how low the inventory should be depleted before it is
ordered
• Delivery-time stock—Inventory needed between the
order date and the receipt of the inventory ordered.
• The order point is reached when inventory falls to a level
equal to the delivery-time stock plus the safety stock. See
Figure 17.6.
Figure 17.6 Order Point Determination
Just-in-Time Inventory System
• The goal is to operate with the lowest average level of
inventory possible.
• Within the EOQ model, the basics are to
– Reduce ordering costs
– Reduce safety stocks
• This is achieved by attempts to receive continuous flow of
deliveries of component parts.
• The result is to actually have about 2 to 4 hours’ worth of
inventory on hand.
Inflation and EOQ
• Inflation affects the EOQ model in two ways:
– Anticipatory buying—buying in anticipation of a price
increase to secure the goods at a lower cost.
– Increased carrying costs—as inflation pushes up
interest rates, the costs of carrying inventory increases.
As “C” increases, the optimal EOQ declines in the EOQ
model.
Key Terms (1 of 2)
• Anticipatory buying
• Cash
• Credit scoring
• Delivery-time stock
• Finished-goods inventory
• Float
• Insolvency
• Inventory management
• Just-in-time inventory control system
Key Terms (2 of 2)
• Marketable securities
• Order point problem
• Order quantity problem
• Raw-materials inventory
• Safety stock
• Terms of sale
• Work-in-process inventory
Copyright
This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

Fin500 PPT CH17

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Fin500 PPT CH17

Uploaded by

Copyright:

Available Formats

Foundations of Finance

• Float—The time from when a check is written until the

= $45,062,466 × 0.04 = $1,802,499

• U.S. Treasury bills

• Economic order quantity (EOQ) attempts to determine the

This work is protected by United States copyright laws and is

You might also like