Current Assets
Management
Cash Management
Reasons for Holding Cash
 Transaction balance – A cash balance associated with
payments and collections; the balance necessary for day-today operations.
 Precautionary balance – A cash balance held in reserve for
random, unforeseen fluctuations in cash inflows and
outflows.
 Speculative balance – A cash balance held to enable the
firm to take advantage of any bargain purchases that might
arise.
Types of Float
 Float – The difference between the book balance ( the cash
balance in the firm’s book ) and the available balance ( the cash
balance recorded at the bank ).
 Disbursement float
 Generated when a firm writes checks
 Available balance > book balance
 Collection float
 Generated when a firm received checks
 Available balance < book balance
 Net float = disbursement float + collection float
 If net float is positive, available balance > book balance
 A Firm should be concerned with its net float and available
balance more than with its book balance.
Float Management
 Total collection or disbursement times can be broken
down into three parts:
 Mailing time
 Processing delay
 Availability delay
 Speeding up cash collections involves reducing one or
more of these components. Slowing down cash
disbursement involves increasing one of them.
Measuring Float
 The size of float depends on both the amount and the
time delay involved.
 Example:
Suppose you mail a check each month for $12,000 and
it takes 3 days to reach its destination, 2 day to process,
and 1 day before the bank makes the cash available.
What is the average daily float?
(3+2+1)($12,000)/30 = $2,400
Cost of Float
 The basic cost of collection float to the firm is the
opportunity cost of not being able to use the cash.
 Example:
 The company receives an average of $20,000 in checks per
day. The delay in clearing is typically 4 days. The current
interest rate is 0.02% per day. What is the highest daily fee
the company should be willing to pay to eliminate its float
entirely?
 Collection float = 4($20,000) = $80,000
Maximum daily charge = $80,000(0.0002) = $16
Cash Collection
 Some methods to speed up cash collection
 Lockboxes
 Concentration banking system
 Wire transfers
Cash Collection: Example
 The company is considering a lockbox system which will
reduce the collection time by 2 days. The daily interest rate
is 0.016%. The average number of daily payments to each
lockbox is 8,500 and average size of payment is $108. If the
bank charges a fee of $225 per day, should the lockbox
project be accepted?
 Average daily collections = $108(8,500) = $918,000
PV = 2($918,000) = $1,836,000
PV of cost = $225/0.00016 = $1,406,250
NPV = –$1,406,250 + 1,836,000 = $429,750
The NPV is positive, so the lockbox project should be
accepted.
Cash Disbursements
 Slowing down disbursements can increase
disbursement float, but it may cause ethical problems.
 Controlling disbursements
 Zero-balance account
 Controlled disbursement account
Investing Idle Cash
 Because of seasonal and cyclical activities, to help
finance planned expenditures, or as a contingency
reserve, firms temporarily hold a cash surplus.
 The money market offers a variety of possible shortterm financial assets for the idle cash.
The Target Cash Balance
 The target cash balance involves a trade-off between
the carrying costs and the trading costs.
 The carrying costs
 The opportunity costs of holding cash
 The trading costs
 The costs associated with buying and selling marketable
securities
The BAT Model
 The Baumol-Allais-Tobin (BAT) model is a classic, simple and most
stripped-down sensible model for determining the optimal cash
position.
2TF
C 
R
*
Where
C* – Optimal cash balance
F - Fixed cost of making a securities trade
T - Total amount of new cash needed for transactions during
the relevant period (usually 1 year)
R - Opportunity cost of holding cash, equal to the interest rate
on marketable securities.
 Its chief weakness is that it assumes steady, certain cash outflows.
The BAT Model: Example
 Annual interest rate = 6%
 Fixed order cost = $25
 Total cash needed = $8,500
 C* = [(2T × F)/R]1/2 = [2($8,500)($25)/0.06]1/2
= $2,661.45
Implications of the BAT Model
 The greater the interest rate, the lower is the target
cash balance.
 The greater the order cost, the higher is the target cash
balance.
The Miller-Orr Model
 The Miller-Orr model assume that the cash balance
fluctuates up and down randomly and that the average
change is zero.
 Management set the lower limit, L.
 If the cash balance is between L and U* (the upper
limit), no transaction is made.
 The advantage of the model is that it considers the
effect of uncertainty.
The Miller-Orr Model
2
3
Fσ
C 3
L
4R
*
where
C* – Optimal cash balance
L – Lower control limit of cash balance
s2 – The variance of net daily cash flows
U *  3C *  2 L
where
U* - Upper control limit of cash balance
4C *  L
Average cash balance 
3
The Miller-Orr Model: Example
 The firm has a fixed cost associated with buying and
selling marketable securities of $40. The interest rate is
currently 0.021% per day. The firm has estimated that
the standard deviation of its daily net cash flow is $70.
Management has set a lower limit of $1,500 on cash
holdings.
 C* = L + (3/4 × F × s2 / R]1/3
= $1,500 + [3/4($40)($70)2/0.00021]1/3
= $2,387.90
Implications of Miller-Orr Model
 The greater the interest rate, the lower the target cash
balance.
 The greater the order cost, the higher the target cash
balance.
 The greater the uncertainty is, the greater the
difference between the target balance and the
minimum balance.
 The greater the uncertainty is, the higher the upper
limit and the higher the average cash balance.
Credit Management
Credit Management
 Granting credit normally increases sales.
 Granting credit has both direct and indirect costs.
 Chance that customers will not pay
 Costs of carrying the receivables
 The credit policy involves a trade-off between the
benefits of increased sales and the costs of granting
credit.
Components of Credit Policy
 Terms of sale
 The credit period
 The cash discount and discount period
 The type of credit instrument
 Credit analysis
 Determining the probability that customers will not pay
 Collection policy
 The firm’s toughness or laxity in following up on slow-
paying accounts.
Terms of Sale
 Example: 2/10, net 60
 2% cash discount from the full price if payment is made
in 10 days
 Full amount due in 60 days form the invoice date
 General Form:
 <take this discount off the invoice price> / <if you pay in
this many days>, <else pay the full invoice amount in
this many days>
The Credit Period
 The basic length of time for which credit is granted.
 If a cash discount is offered, the credit period has two
components.
 The net credit period – the length of time the customer has to
pay
 The cash discount period – the time during which the
discount is available
 Factors influencing the length of credit period
 The shorter the buyer’s inventory period, the shorter the
credit period.
 The shorter the operating cycle, the shorter the credit period.
Cash Discounts
 Cash discount is a discount in the price of goods
given to encourage early payment.
 Although the cash discounts are rather small, if
you calculate the cost to the buyer of not paying
early, you will find the interest rate that the buyer
is effectively paying for the trade credit is
extremely high.
 The company benefits when customers forgo
discounts.
Credit instruments
 Open account
 Promissory note
 Commercial draft
 Sight draft
 Time draft
 Trade acceptance
 Banker’s acceptance
 Conditional sales contract
Credit Policy Analysis
 The NPV of granting credit depends on five factors.
 Revenue effects
 Cost effects
 The cost of debt
 The probability of nonpayment
 The cash discount
Evaluating a Proposed Credit Policy: Example
 A company currently has a cash only policy. It is
considering a switch to a net 30 policy. Currently, the price
per unit is $290 and cost per unit is $230. The company
currently sells 1,105 units per month. Under the proposed
policy, the company expects to sell 1,125 units per month.
The price per unit will be $295 and the cost per unit will be
$234. If the required monthly return is 0.95% per month,
what is the NPV of the switch? Should the company offer
credit terms of net 30?
Evaluating a Proposed Credit Policy: Example
 Cash flow from old policy = ($290 – 230)(1,105)




= $66,300
Cash flow from new policy = ($295 – 234)(1,125)
= $68,625
Incremental cash flow = $68,625-66,300 = $2,325
NPV of switching= –[($290)(1,105) + (1,105)($234 – 230)
+ ($234)(1,125 – 1,120)] + ($2,325/0.0095) = –$84,813.16
Since the NPV is negative, the company should not
offer the credit terms of net 30.
Optimal Credit Policy
 The optimal amount of credit the firm should offer
depends on the competitive conditions under which
the firm operates.
 These conditions will determine the carrying costs
associated with granting credit and the opportunity
costs of the lost sales resulting from refusing to offer
credit.
 The optimal credit policy minimizes the sum of
carrying costs and opportunity costs.
Credit Analysis
 The process of deciding whether or not to grant credit
to a particular customer.
 Two steps:
 Gathering relevant information
 Determining creditworthiness
Credit Information
 Financial statements
 Credit reports about the customer’s payment history
with other firms
 Banks
 The customer’ payment history with the firm
Determining Creditworthiness
 Credit evaluation - Five C’s of credit
 Character – the customer’s willingness to meet credit
obligations
 Capacity – the customer’s ability to meet credit
obligations out of operating cash flows
 Capital – the customer’s financial reserves
 Collateral – an asset pledged in the case of default
 Conditions – General economic conditions in the
customer’s line of business
 Credit scoring
One-Time Sale
 NPV = -v + (1 - )P / (1 + R)
where
v - variable cost per unit
 - probability of default
P – price per unit
R – the required return on receivables per month
 It makes sense to grant credit to almost everyone once,
as long as the variable cost is low relative to the price.
One-Time Sale: Example
 Your company is considering granting credit to a
new customer. The variable cost per unit is $20; the
current price is $60; the probability of default is
25%; and the monthly required return is 1%.
 NPV = -$20 + (1-0.25)(60)/(1.01) = $24.55
 The break-even probability
 0 = -20 + (1 - )(60)/(1.01)
  = 66.33%
Repeat Business
 NPV = -v + (1-)(P – v)/R
 Example:
NPV = -$20 + (1-.25)(60 – 20)/0.01 = $2980
 If a customer defaults once, credit can’t be granted
again.
Collection Policy
 Monitor the age of accounts receivable
 Keeping track of ACP though time
 The aging schedule
 Deal with past-due-accounts
 Delinquency letter
 Telephone call
 Collection agency
 Legal action
Inventory Management
Inventory Management
 Inventory management involves determining how
much inventory to hold, when to place order, and how
many units to order at a time.
 Other functional areas will share decision-making
authority regarding inventory.
Types of Inventory
 Manufacturer
 Raw material
 Work-in-progress
 Finished goods
 Things to remember
 One’s raw material may be another’s finished goods.
 Different types of inventory can be different in terms of
liquidity.
 The demand for finished goods is independent.
Inventory Costs
 Carrying costs
 Storage and tracking costs
 Insurance and taxes
 Losses due to obsolescence, deterioration, or theft
 The opportunity cost of capital on the invested amount
 Shortage costs
 Restocking costs
 Costs related to safety reserves
 Inventory management involves a trade-off between the
carrying costs and shortage costs.
The ABC Approach
 An inventory management technique to divide
inventory into three or more groups.
 The underlying rationale is that a small portion of
inventory in terms of quantity might represent a large
portion in terms of inventory value.
The EOQ Model
 The Economic Order Quantity Model is a formula for
determining the order quantity that will minimize total
inventory cost.
 Total carrying costs = (Average inventory)(Carrying cost
per unit) = (Q/2)(CC)
 Total restocking costs = (Fixed cost per order)(Number of
orders) = F(T/Q)
 Total Costs = Carrying cost + Restocking cost = (Q/2)(CC)
+ F(T/Q)
The EOQ Model
 Carrying costs = Restocking costs
(Q/2)(CC) = F(T/Q)
 The EOQ is:
2TF
Q 
CC
 Example: Carrying cost is $1 per unit; fixed order cost is
$5 per order; the firm sells 120,000 units per year.
Q*= [2(120,000)($5)/$1]1/2 = 1,095.45 units
*
Extensions to the EOQ Model
 Safety stocks - The firm reorders when inventory
reaches a minimum level.
 Reorder points - When there are lags in delivery or
production times, the firm reorders when inventory
reaches the reorder point.
 By combining safety stocks and reorder points, the
firm maintains a buffer against unforeseen events.
Managing Derived-demand Inventories
 Materials Requirements Planning (MRP)
 Once finished goods inventory levels are set, it is
possible to determine what levels of work-in-process
inventories must exist to meet the need for finished
goods. From there, it is possible to calculate the quantity
of raw materials that must be on hand.
 Just-in-Time (JIT) Inventory
 A system of inventory control in which a manufacturer
coordinates production with suppliers so that raw
materials or components arrive just as they are needed
in the production process.