LECTURE 8
CURRENT ASSET MANAGEMENT
References: Chapter 11(Beal, Goyen,
Shamsuddin, 2e)
THE DUAL MEANING OF CASH
 Cash is all the currency that the firm has on hand.
 Cash is also all the liquid assets that a firm holds or has
ready access to.
THE MOTIVES FOR HOLDING CASH
 John Maynard Keynes suggested that there are three
reasons that cash is held:
 the transactions motive
 the precautionary motive
 the speculative motive.
THE MOTIVES FOR HOLDING CASH
The transactions motive
 Cash is held so transactions – sales and purchases –
may be successfully completed.
 In regards to the holdings of currency, a shortage of
change can impact on a business.
 With regards to the larger meaning of cash, it is important
that firms have enough liquid assets to pay for their
purchases in a timely manner.
THE MOTIVES FOR HOLDING CASH
The precautionary motive
 Precaution involves prudent actions taken early to ensure
a good outcome or to forestall an adverse effect.
 However, holding cash reserves normally has an
opportunity cost through the loss of interest or alternative
investment earnings.
 But can possibly keep some precautionary funds in shortterm securities.
THE MOTIVES FOR HOLDING CASH
The speculative motive
 The speculative motive involves holding cash to make
speculative purchases when the opportunity arises.
 Speculation involves the purchase of an asset for
eventual resale with a view to profit, but where there is a
strong element of risk.
MANAGING CASH
 The issues that are related to the management of cash
include:
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
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the timing of cash flows
the financial imperative of having sufficient cash
the cost of holding cash
the cost of not having enough cash.
MANAGING CASH
The timing of cash flows
 Cash moves into the firm from possibly six major
sources:
•
•
•
•
•
cash sales
credit sales, when the debtors pay their accounts
sales of used or unwanted assets
short-term loans
long-term loan funding
MANAGING CASH
The timing of cash flows
 Cash flows out from the firm to service a further four
needs:
•
•
•
•
purchase of inventories
purchase of labour, materials and other services
purchase of assets
payment of taxes.
 The timing of most of these in and outflows is variable, the
only exceptions being the cash sales and payments by
debtors, the payment of wages and the payment of taxes.
MANAGING CASH
The financial imperative of having sufficient cash
 A firm must always have sufficient cash on hand to meet
its financial obligations otherwise it could become
insolvent.
 An insolvent firm is unable to pay its bills or meet its
financial obligations on time.
 Financial managers face a trade-off between risk and
return when contemplating how much cash to hold.
MANAGING CASH
The cost of holding cash
 The cost of holding cash may be thought of in terms of
two issues:
• the opportunity cost of holding currency, rather than shortterm securities, or the cost of holding very short-term
securities instead of longer-term securities.
• the cost of ensuring physical security of currency.
MANAGING CASH
The cost of not having enough cash
 The cost of not having enough cash at the required time
may be the loss of the business.
 It is possible to put the lack of cash into a continuum and
trace the effects. Figure 11.2 shows such a continuum.
MANAGING CASH
The cost of not having enough cash
 Temporary cash shortages may be overcome by
arranging emergency loans. However, as a general rule,
the more desperate the need, the higher the cost of
emergency funds.
 If a firm gains a reputation as a ‘late payer’, its suppliers
become progressively reluctant to supply.
 Eventually some suppliers will supply only for cash.
USING ELECTRONIC FUNDS TRANSFER
(EFT)
Benefits and costs of EFTPOS
 By offering EFTPOS to their customers, businesses
can:
• attract more sales and increase turnover
• decrease the need for change and the opportunity costs
of keeping it
• reduce currency inflow and thus reduce security and
banking risks and costs
• be paid faster.
USING ELECTRONIC FUNDS TRANSFER
(EFT)
Benefits and costs of EFTPOS
 On the negative side, there are additional costs to
offering EFTPOS to customers.
 The cost of all these benefits is about a net
0.2 – 0.3% for credit card payments compared with cash
and a net 0.5% for credit card payments compared with
cheque payments.
 With debit card payments, there is no net cost.
USING ELECTRONIC FUNDS TRANSFER
(EFT)
Use of direct entry (DE)
 The most common examples of direct credit are the
payment of wages and salaries by large and mediumsized firms to their employees; the payment of dividends
and interest to investors; and the payment of suppliers
by large firms with thousands of suppliers.
 Direct debits are currently being used by many types of
firms, especially for customers’ regular payments such
as telephone and water bills.
DEBTORS AND ACCOUNTS RECEIVABLE
Benefits and costs of granting credit
 The benefits of granting credit include:
• increased sales
• reduced cost of making sales.
 The costs of granting credit include:
• the opportunity cost of the funds tied up
• the cost of the proportion of slow payers and bad debts
• the cost of administering the system.
DEBTORS AND ACCOUNTS RECEIVABLE
Determinants of the level of debtors
Total sales
 The value of total sales has an impact on the value of
credit sales, so long as the firm exercises a policy of
offering sales on credit.
 It follows that the greater the total sales, the greater the
credit sales and the greater the value of debtors.
DEBTORS AND ACCOUNTS RECEIVABLE
Determinants of the level of debtors
Credit policies
 Credit policies determine the value of credit sales.
 Credit policies may be conveniently broken up into four
parts:
•
•
•
•
deciding to offer credit, or not
selecting suitable creditworthy customers
setting credit limits
deciding payment terms.
DEBTORS AND ACCOUNTS RECEIVABLE
Determinants of the level of debtors
Collection policies and procedures
 In order to ensure that it receives the highest
proportion of its accounts receivable possible, a
supplier must have set policies and procedures in
place, monitor the ageing of accounts and apply the
procedures vigorously.
DEBTORS AND ACCOUNTS RECEIVABLE
Determinants of the level of debtors
Collection policies and procedures
 The collection process often follows a pattern like
this:
•
•
•
•
send an ‘account rendered’ statement
post an ‘account overdue letter’
telephone to speak to the responsible person
put the unpaid account into the hands of a solicitor or
collection agency
• in some cases with goods may be reclaimed by the
seller.
DEBTORS AND ACCOUNTS RECEIVABLE
Determinants of the level of debtors
Collection policies and procedures
 Firms may judge the effectiveness of their credit
policies and processes by making use of ratio
analysis.
 The most useful ratio is the average collection
period (ACP), which is average debtors divided by
average daily credit sales.
DEBTORS AND ACCOUNTS RECEIVABLE
Romalpa clauses
 Romalpa clauses are legal conditions included on
credit sales documentation to ensure title to the
goods described does not pass to the buyer until the
goods are fully paid for.
MANAGING INVENTORIES
Types of inventories
 There are three types of inventories:
• raw materials
• work in progress
• finished goods
 Raw materials are held by all types of manufacturers to
ensure that production may be carried on without delay,
should there be any interruption in normal receivables.
MANAGING INVENTORIES
Benefits and costs of holding inventories
 Some of the benefits of holding stock may include are:
• sales are made and profits gained
• goodwill is built up
 The costs of holding stocks include:
• ordering costs
• holding costs
MANAGING INVENTORIES
Management techniques
 Three management techniques discussed are:
• anticipatory buying
• maintaining minimum safety level of stock
• economic order quantity (EOQ) theory
 Anticipatory buying is undertaken to buy in stock before
an anticipated or known shortage or price rise occurs.
MANAGING INVENTORIES
Management techniques
 Second, many managers maintain either an explicit or
implicit minimum safety level of stock. The level is
explicit when documented in stock management records,
or implicit when the requisite level is an idea or ‘feeling’
on the part of the manager.
 The third technique involves the economic order quantity
(EOQ) theory.
MANAGING INVENTORIES
Management techniques
 The EOQ tool is based on the knowledge that the cost of
stock consists of the holding costs and the ordering costs.
 EOQ calculates the optimal size of each new order by
combining the fixed order cost (which, of course, declines
per unit as order size increases) with the increasing
holding costs.
 EOQ theory combines holding costs, ordering costs and
total demand over a planning period to estimate the
optimal size of each order.
MANAGING INVENTORIES
Management techniques
 The EOQ theory assumes Q is the inventory order size. If
no stock were re-ordered until inventory had fallen to
zero, the average inventory level over a planning period
would be Q/2.
 Total inventory costs equal holding costs plus ordering
costs.
 If holding costs per unit equal H, the total holding costs
equal QH/2.
MANAGING INVENTORIES
Management techniques
 Similarly, if total demand over the planning period is D,
orders are made in lot sizes of Q and the ordering is O per
order, then total ordering cost is DO/Q.
 Total costs are thus (QH/2) + (DO/Q).
 The holding costs curve must be a line rising through the
origin (see figure 11.5).
 Ordering costs must be a negatively sloped line, as the
fixed amount, DO, is spread over ever-increasing order
MANAGING INVENTORIES
Management techniques
 These two curves may be summed vertically o give a total
cost curve, (QH/2) + (DO/Q).
 The total cost curve will be U-shaped or concave to the
horizontal axis, and the minimum cost point will be where
the two curves intersect at Q1.
LECTURE EXAMPLE
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
A local gift shop is attempting to determine how
many sets of wine glasses to order. The store feels it
will sell approximately 800 sets in the next year at a
price of $18 per set. The wholesale price that the
store pays per set is $12. The costs of holding one
set of wine glasses are estimated at $1.50 and
ordering costs are estimated at $15.
REQUIRED
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
Calculate the EOQ
Use formula for Q = √(2DO/H)
MANAGING INVENTORIES
Management techniques
 Unfortunately, the EOQ model rests on several unrealistic
assumptions:
• demand is known and constant from day to day
• ordering and holding costs are known and constant
• delivery is instantaneous
MANAGING INVENTORIES
Just-in-time
 The Just-in-time (JIT) philosophy encompasses more
than merely limited inventories.
 It emphasizes demand-driven production, reduction in
setup times, high quality, continuous improvement and
multiskilled workers as well as smaller inventories.
 The reduction of inventories provides the benefits of
savings in carrying costs through reduced spoilage and
handling costs, lower insurance costs etc.
MANAGING INVENTORIES
Just-in-time
 However, the reduction of inventories also exposes
inefficiencies in the manufacturing system, as the
unplanned increase or decrease in inventories no longer
masks manufacturing problems.
 To achieve reduced raw material inventory, long-term
relationships with reliable suppliers is important.
 JIT involves many direct and indirect costs which may
offset many of its benefits.
End of Lecture!!