Chapter
7
McGraw-Hill/Irwin
Current Asset
Management
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
•
•
•
•
Introduction to management of current assets
Cash management and its importance
Management of marketable securities
Management of accounts receivable – credit policy
decisions for maximizing profitability
• Inventory management – determining the level of
inventory to enhance sales and profitability
• Liquidity and required return
7-2
Introduction
• Companies that manage their current assets well,
establish a competitive advantage
– Helps increase their market share
– Creates an increase in shareholder value through a
rising stock price
• Requires a careful allocation of resources among
the current assets of the firm:
–
–
–
–
Cash
Marketable securities
Accounts receivable
Inventory.
7-3
Introduction (cont’d)
• In managing cash and marketable securities
– Primary concern should be for safety and liquidity
– Secondary attention should be placed on maximizing
profitability
• In managing accounts receivable and inventory, a
stiffer profitability test must be met
– Investment level should not be a result of happenstance
or historical determination
– Must meet the same return-on-investment criteria
applied to any decision.
• Different decision techniques are applied to the various
forms of current assets.
7-4
Cash Management
• Financial managers actively attempt to keep
cash (non-earning asset) to a minimum
– It is critical to have sufficient cash to assuage
emergencies
– To improve overall profitability of a firm:
• Minimize cash balances
• Have accurate knowledge of when cash moves in
and out of the firm
7-5
Reasons for Holding Cash Balances
• Transactions motive
– Payments towards planned expenses
• Compensating balances for banks
– Compensate a bank for services provided rather
than paying directly for them
• Precautionary needs
– Emergency purposes
7-6
Cash Flow Cycle
• Cash moves through a firm in a cycle
• Cash flow relies on:
– Payment pattern of customers
– Speed at which suppliers and creditors process
checks
– Efficiency of the banking system
• Inflows and outflows of cash are to be
synchronized properly for transaction
purposes.
7-7
Cash Flow Cycle (cont’d)
• Selling on the internet generates cash flow
much faster than sales using retailer’s own
credit card
• Financial managers must pay close attention
to the percentage of sales generated by:
– Cash
– Outside credit cards
– Company’s own credit cards
7-8
Cash Flow Cycle (cont’d)
• Cash inflows are driven by sales and influenced by the:
–
–
–
–
Customers’ geographical location
Product being sold
Industry
Type of customers
• Firms use cash to make various payments to:
–
–
–
–
–
Suppliers
Lenders
Stockholders
Government
Workers
• When cash is needed for current assets, firms generally:
– Sell the marketable securities
– Borrow from short-term lenders
7-9
Expanded Cash Flow Cycle
7-10
Float
• The time period between the mailing of a check and the
collection period
• Difference between firm’s recorded amount and amount
credited to the firm by a bank
• Two types of float:
– Mail float: Occurs because of the time a mail takes before it gets
delivered.
– Clearing float: Occurs because of the time a check takes before it
gets cleared.
• For large corporations these floats do not exist anymore
because of electronic payments (permissible under Check
21 Act)
• Check Clearing for the 21st Century Act (Check 21)
– Allows banks and others to electronically process a check
7-11
Improving Collections and
Extending Disbursements
• Improving collection:
– Setting up multiple collection centers at different
locations
– Adopt lockbox system for expeditious check clearance at
lower costs
• Extending disbursement:
– General trend:
• Speedup processing of incoming checks
• Slow down payment procedures
– Extended disbursement float – allows companies to hold onto their
cash balances for as long as possible
7-12
Cost-Benefit Analysis
• Costs associated with an efficiently
maintained cash management program must
be compared to the benefits that it provides
7-13
Cash Management Network
7-14
Electronic Funds Transfer
• Funds are moved between computer terminals without the
use of a ‘check’
– Automated clearinghouses (ACH): Transfers information between
financial institutions and between accounts using computer tape
• International fund transfer is carried out through SWIFT
(Society for Worldwide Interbank Financial
Telecommunications)
– Uses a proprietary secure messaging system
– Encrypts each message
– Authenticates every money transaction by a code using smart card
technology
– Assumes financial liability for the accuracy, completeness, and
confidentiality of transaction
7-15
International Cash Management
• Factors differentiating international cash
management from domestic based systems:
– Differing payment methods and/or higher popularity of
electronic funds transfer
– Subject to international boundaries, time zone
differences, currency fluctuations, and interest rate
changes
– Differing banking systems and check clearing processes
– Differing account balance management and information
reporting systems
– Cultural, tax, and accounting differences
7-16
International Cash Management
(cont’d)
• Financial managers try to keep cash in a country
with a strong currency
• Sweep account:
– Allows companies to maintain zero balances
– Excess cash is swept into an interest-earning account
7-17
Marketable Securities
• Funds held for other than immediate transaction purposes
should be invested in interest-earning securities
• Types of short term investments:
–
–
–
–
–
–
–
–
–
Treasury bills
Federal agency securities
Certificate of deposit
Commercial paper
Banker’s acceptances
Eurodollar certificate of deposit.
Passbook savings account
Money market fund
Money market accounts
7-18
An Examination of Yield and
Maturity Characteristics
7-19
Types of Short-Term Investments
7-20
Management of Accounts
Receivable
• Accounts receivable as an investment
– Should be based on whether the level of return
earned on such investment equals or exceeds
the potential gain from other investments
• Credit policy administration
– Credit standards
– Terms of trade
– Collection policy
7-21
Credit Standards
• Determine the nature of credit risk based on:
– Prior records of payment and financial stability,
current net worth, and other related factors
• 5 Cs of credit:
– Character
– Capital
– Capacity
– Conditions
– Collateral
7-22
Credit Standards (cont’d)
• Dun & Bradstreet Information Services (DBIS):
–
–
–
–
Produces business information analysis tools
Publishes reference books
Provides computer access to information
Assigns Data Universal Number System (D-U-N-S) - a
unique nine-digit code to each business in its information
base
7-23
Dun & Bradstreet Report – An
Example
7-24
Terms of Trade
• Stated term of credit extension:
– Has a strong impact on the eventual size of
accounts receivable balance
– Creates a need for firms to consider the use of
cash discounts
7-25
Collection Policy
•
A number of quantitative measures are applied to
asses credit policy:
–
Average collection period
•
An increase would indicate poor credit administration
– Ratio of bad debts to credit sales
• An increasing ratio may indicate too many weak accounts
or an aggressive market expansion policy
– Aging of accounts receivable
7-26
An Actual Credit Decision
•
Brings together various elements of accounts receivable
management
Accounts receivable =
Sales = $10,000 = $1,667
Turnover
6
• An average investment of $1,667 is fetching a post tax profit of
$480, which is approximately 28.8%.
7-27
Inventory Management
• Inventory has three basic categories:
– Raw materials
– Work in progress
– Finished goods
• Amount of inventory is affected by sales,
production, and economic conditions
• As inventory is the least liquid of current
assets, it should provide the highest yield
7-28
Level versus Seasonal Production
• Level production
– Allows maximum efficiency in manpower and
machinery usage
– May result in high inventory buildup particularly
in seasonal business
• Seasonal production
– Eliminates inventory buildup problems
– May result in unused capacity during slack
periods
– May result in overtime wages and inefficiencies
arising out of overused equipments
7-29
Inventory Policy in Inflation (and
Deflation)
• Inventory position can be protected in an
environment of price instability by:
– Taking moderate inventory positions
– Hedging with a futures contract to sell at a
stipulated price some months from now
• Rapid price movements in inventory may
have a major impact on the reported income
of the firm
7-30
The Inventory Decision Model
• Carrying costs
– Interest on funds tied up in inventory
– Cost of warehouse space, insurance premiums,
and material handling expenses
– Implicit cost associated with the risk of
obsolescence and perishability
• Ordering costs
– Cost of ordering
– Cost of processing inventory into stock
7-31
Determining the Optimum Inventory
Level
7-32
Economic Ordering Quantity
EOQ = 2SO ;
C
Where,
S = Total sales in units
O = Ordering cost for each order
C = Carrying cost per unit in dollars
Assuming:
S= 2000 units; O=$8; C= $0.20;
EOQ = 2SO = 2 X 2,000 X $8 = $32,000 = 160,000
C
$0.20
$0.20
= 400 units
7-33
Safety Stocks and Stock Outs
• Stock out occurs when a firm is:
– Out of a specific inventory item
– Unable to sell or deliver the product
• Safety stock reduces the risk of losing sales
– Increases cost of inventory due to a rise in
carrying costs
– This cost should be offset by:
• Eliminating lost profits due to stockouts
• Increased profits from unexpected orders
7-34
Safety Stocks and Stock Outs
(cont’d)
• Assuming that; EOQ = 400 units and safety stock = 50 units
Average inventory = EOQ + Safety stock
2
Average inventory = 400 + 50
2
The inventory carrying costs will now increase to $50
Carrying costs = Average inventory in units × Carrying cost
per unit
= 250 × $0.20 = $50
7-35
Just-in-Time Inventory Management
• Basic requirements for JIT:
– Quality production that continually satisfies
customer requirements
– Close ties between suppliers, manufactures, and
customers
– Minimization of the level of inventory
• Cost Savings from lower inventory:
– On an average, JIT has reduced inventory to
sales ratio by 10% over the last decade
7-36
Advantages of JIT
• Reduction in space due to reduced
warehouse space requirement
• Reduced construction and overhead
expenses for utilities and manpower
• Better technology with the development of
electronic data interchange systems (EDI)
– EDI reduces rekeying errors and duplication of
forms
• Reduction in costs from quality control
• Elimination of waste
7-37
Areas of Concern for JIT
• Integration costs
• Parts shortages could lead to lost sales and
slow growth
– Un-forecasted increase in sales:
• Inability to keep up with demand
– Un-forecasted decrease in sales:
• Inventory can pile up during recession
• A revaluation may be needed in high-growth
industries fostering dynamic technologies
7-38