CHAPTER 22
Current Asset Management
Alternative working capital
policies
Cash management
Inventory management
Accounts receivable management
Basic Definitions
Gross working capital:
Total current assets.
Net working capital:
Current assets - Current liabilities.
Working capital policy:
The level of each current asset.
How current assets are financed.
(More…)
Working capital management:
Includes both establishing working
capital policy and then the day-to-day
control of:
Cash
Inventories
Receivables
Short-term liabilities
Selected Ratios for SKI Incorporated
Current
Quick
Debt/Assets
Turnover of cash
& securities
DSO (days)
Inv. turnover
F.A. turnover
T.A. turnover
Profit margin
ROE
Pay. deferral period
SKI
1.75x
0.83x
58.76%
Industry
2.25x
1.20x
50.00%
16.67x
45.00
4.82x
11.35x
2.08x
2.07%
10.45%
30.00
22.22x
32.00
7.00x
12.00x
3.00x
3.50%
21.00%
33.00
How does SKI’s working capital policy
compare with the industry?
 Working capital policy is reflected in a
firm’s current ratio, quick ratio, turnover
of cash and securities, inventory
turnover, and DSO.
 These ratios indicate SKI has large
amounts of working capital relative to its
level of sales. Thus, SKI is following a
relaxed (fat cat) policy.
Alternative Current Asset
Investment Policies
Current Assets ($)
Relaxed
Moderate
Restricted
Sales ($)
Is SKI inefficient or just conservative?
A relaxed policy may be appropriate
if it reduces risk more than
profitability.
However, SKI is much less
profitable than the average firm in
the industry. This suggests that the
company probably has excessive
working capital.
Cash Conversion Cycle
The cash conversion cycle focuses on the
time between payments made for materials
and labor and payments received from
sales:
Cash
Inventory Receivables Payables
conversion = conversion + collection - deferral .
cycle
period
period
period
Cash Conversion Cycle (Cont.)
Payables
CCC = Days per year + Days sales – deferral
Inv. turnover outstanding
period
CCC = 360 + 45 – 30
4.82
CCC = 75 + 45 – 30
CCC = 90 days.
Cash Conversion Cycle
The cash conversion cycle focuses on the time
between payments made for materials and labor
and payments received from sales:
Cash
Inventory Receivables Payables
conversion = conversion + collection - deferral .
cycle
period
period
period
What does the cash conversion cycle tell us about
working capital management?
Cash Management:
Cash doesn’t earn interest,
so why hold it?
 Transactions: Must have some cash to pay
current bills.
 Precaution: “Safety stock.” But lessened
by credit line and marketable securities.
 Compensating balances: For loans and/or
services provided.
 Speculation: To take advantage of bargains,
to take discounts, and so on. Reduced by
credit line, marketable securities.
What’s the goal of cash management?
To have sufficient cash on hand to
meet the needs listed on the
previous slide.
However, since cash is a non-earning
asset, to have not one dollar more.
Cash Budget: The Primary Cash
Management Tool
Purpose: Uses forecasts of cash
inflows, outflows, and ending cash
balances to predict loan needs and
funds available for temporary
investment.
Timing: Daily, weekly, or monthly,
depending upon budget’s purpose.
Monthly for annual planning, daily
for actual cash management.
Data Required for Cash Budget
1. Sales forecast.
2. Information on collections delay.
3. Forecast of purchases and payment
terms.
4. Forecast of cash expenses: wages,
taxes, utilities, and so on.
5. Initial cash on hand.
6. Target cash balance.
SKI’s Cash Budget
for January and February
Net Cash Flows
January
February
Collections
$67,651.95
$62,755.40
Purchases
$44,603.75
$36,472.65
Wages
6,690.56
5,470.90
Rent
2,500.00
2,500.00
$53,794.31
$44,443.55
$13,857.64
$18,311.85
Total payments
Net CF
Cash Budget (Continued)
Cash at start
Net CF
Cumulative cash
Less: target cash
Surplus
January
February
$ 3,000.00
13,857.64
$16,857.64
1,500.00
$16,857.64
18,311.85
$35,169.49
1,500.00
$15,357.64
$33,669.49
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 do appear in the cash
budget.
What are some other potential cash
inflows besides collections?
Proceeds from fixed asset sales.
Proceeds from stock and bond
sales.
Interest earned.
Court settlements.
How can interest earned or paid on
short-term securities or loans be
incorporated in the cash budget?
 Interest earned: Add line in the
collections section.
 Interest paid: Add line in the payments
section.
 Found as interest rate x surplus/loan line
of cash budget for preceding month.
 Note: Interest on any other debt would
need to be incorporated as well.
What reasons might SKI have for
maintaining a relatively
high amount of cash?
 If sales turn out to be considerably less
than expected, SKI could face a cash
shortfall.
 A company may choose to hold large
amounts of cash if it does not have much
faith in its sales forecast, or if it is very
conservative.
 The cash may be there, in part, to fund a
planned fixed asset acquisition.
Inventory Management:
Categories of Inventory Costs
Carrying Costs: Storage and handling
costs, insurance, property taxes,
depreciation, and obsolescence.
Ordering Costs: Cost of placing orders,
shipping, and handling costs.
Costs of Running Short: Loss of sales,
loss of customer goodwill, and the
disruption of production schedules.
If SKI reduces its inventory, without
adversely affecting sales, what effect
will this have on its cash position?
Short run: Cash will increase as
inventory purchases decline.
Long run: Company is likely to
then take steps to reduce its cash
holdings.
Elements of Credit Policy
 Cash Discounts: Lowers price.
Attracts new customers and
reduces DSO.
 Credit Period: How long to pay?
Shorter period reduces DSO and
average A/R, but it may discourage
sales.
(More…)
Credit Standards: Tighter
standards reduce bad debt losses,
but may reduce sales. Fewer bad
debts reduces DSO.
Collection Policy: Tougher policy
will reduce DSO, but may damage
customer relationships.
Short-Term Financing
Working capital financing policies
Accounts payable (trade credit)
Commercial paper
Short-term bank loans
Secured short-term credit
Working Capital Financing Policies
Maturity Matching: Matches the
maturity of the assets with the
maturity of the financing.
Aggressive: Uses short-term
(temporary) capital to finance some
permanent assets.
Conservative: Uses long-term
(permanent) capital to finance some
temporary assets.
Maturity Matching Financing Policy
$
Temp. C.A.
S-T
Loans
Perm C.A.
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
What are “permanent” assets?
Aggressive Financing Policy
$
Temp. C.A.
S-T
Loans
Perm C.A.
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
More aggressive the lower the dashed line.
Conservative Financing Policy
$
Marketable Securities
Zero S-T
debt
Perm C.A.
Fixed Assets
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Years
The choice of working capital policy is
a classic risk/return tradeoff.
The aggressive policy promises the
highest return but carries the greatest
risk.
The conservative policy has the least
risk but also the lowest expected
return.
The moderate (maturity matching)
policy falls between the two extremes.
What is short-term credit?
What are the major sources?
 Short-term credit: Debt requiring
repayment within one year.
 Major sources:
Accruals
Accounts payable (trade credit)
Commercial paper
– An unsecured obligation issued by a corporation or
bank to finance its short-term credit needs. Maturities
typically range from 2 to 270 days.
Bank loans
 Short-term debt is riskier than
long-term debt for the borrower.
 Short-term rates may rise.
 May have trouble rolling debt over.
 Advantages of short-term debt.
 Typically lower cost.
 Can get funds relatively quickly with
low transactions costs.
 Can repay without penalty.
What is trade credit?
Trade credit is credit furnished by a
firm’s suppliers.
Trade credit is often the largest
source of short-term credit for small
firms.
Trade credit is spontaneous and
relatively easy to get, but the cost
can be high.
What is a secured loan?
In a secured loan, the borrower
pledges assets as collateral for the
loan.
For short-term loans, the most
commonly pledged assets are
receivables and inventories.
Securities are great collateral, but
generally firms needing short-term
loans generally do not have securities.
What are the differences between
pledging and factoring receivables?
If receivables are pledged, the lender
has recourse against both the
original buyer of the goods and the
borrower.
• Offering assets to a lender as collateral for
a loan.
When receivables are factored, they
are generally sold, and the buyer
(lender) has no recourse to the
borrower.