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