PowerPoint Presentation
prepared by
Traven Reed
Canadore College
chapter 18
Current Asset Management
Corporate Valuation and
Current Asset Management
CH18
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-3
Topics in Chapter
CH18
•
•
•
•
Cash Management
A/R Management
Inventory
Economic Order Quantity
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-4
Goal of cash management
CH18
• Cash is a non-earning asset, i.e.,
not having any return for keeping.
• To have sufficient target cash
balance on hand to conduct
business.
• Cash can provide the necessary
financial slack for firms to take
various opportunities.
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-5
Reasons for holding cash
CH18
• Transactions: Must have some cash to
pay current bills.
• Precaution: “Safety stock.” 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.
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-6
Cash Management
Techniques
CH18
• Increase forecast accuracy to
reduce the need for a cash “safety
stock.”
• Hold marketable securities instead
of a cash “safety stock.”
• Negotiate a line of credit (also
reduces need for a “safety stock”).
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-7
Ways to Minimize Cash
Holdings
CH18
• Synchronize inflows and outflows.
• Use a remote disbursement
account.
• Use lockboxes.
• Insist on wire transfers from
customers.
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-8
Float
CH18
The difference between the balance
shown in a firm’s chequebook and the
balance on the bank’s records.
• Disbursement float (+): Cheques written
by a company that have not yet cleared.
• Collection float (-): Cheques already
deposited that have not yet been cleared.
• Net Float: disbursement float - collection
float.
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18-9
Using Float
CH18
• Creating and Managing Float
– Payers attempt to create delays in the check
clearing process so that they can use their cash
for longer.
– Recipients attempt to remove delays in the
check clearing process to get available cash
sooner.
– Source of delay:
• Time it takes to mail check: mail float
• Time for recipient to process check: processing float
• Time for bank to clear check: clearing float
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-10
Speeding Up Receipts
CH18
• Lockbox plan
– System whereby customers send
payments to a post office box and a
local bank collects and processes the
cheques.
• Payment by wire or automatic debit
– Under an electronic debit system,
funds are automatically deducted from
one account and added to another.
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-11
CH18
Short-term Investments:
Marketable Securities
• The management of cash and
marketable securities cannot be
separated.
• Firms hold marketable securities for the
same reasons as they hold cash
• Firm’s risk-return posture determines the
specific composition of the marketable
securities portfolio after taking into
consideration the interaction of risk,
liquidity, maturity and yield.
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18-12
Marketable Securities
CH18
• If a firm has temporary idle balances of
cash, it may invest them in the money
market, which offers short-term, low risk
and highly liquid securities.
• Holding marketable securities has costs
and benefits
• Short-term investment alternatives
include T-bills, commercial paper,
bankers’ acceptances, Eurodollars, etc.
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-13
Receivables Management
CH18
• Do ABC’s customers pay more or less
promptly than those of its competitors?
• ABC’s days’ sales outstanding (DSO) of
53.1 days is well above the industry
average (30 days).
– ABC’s customers are paying less
promptly.
– ABC should consider tightening its
credit policy to reduce its DSO.
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18-14
Accounts Receivable
CH18
• Firms rather sell for cash than on
credit, but competition forces them
to offer credit
• Goods are shipped, inventories are
reduced, and an account receivable
is created
• Receivables management begins
with the credit policy, and needs a
monitoring system too.
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-15
Elements of Credit Policy
CH18
• 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.
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18-16
Credit Policy (cont’d)
CH18
• 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.
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18-17
Setting Credit Terms
CH18
• Standard credit terms include credit
period and discount
• On a sale with payment terms:
2/10, net 30
• Firm requires payment within 30
days, but offers a 2% discount to
customers who pay in 10 days.
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18-18
Setting Credit Standards
CH18
• Standards set to determine the
amount and nature of credit to
extend to customers.
• The decision requires a measure of
credit quality (i.e. the probability of
a customer’s default)
• Use the credit information in a
judgmental manner for decisions
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18-19
Setting Collection Policy
CH18
• The procedures the firm follows to
collect past-due accounts from
sending friendly reminders to hiring a
collection agency
• Collection process is expensive in
terms of both out-of-pocket
expenditures and lost goodwill
• Policy changes can affect sales,
collection period and bad debt loss
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-20
Setting Cash Discounts
CH18
• Need to balance the costs and
benefits of different cash discounts
• Pros: attracting new businesses,
encouraging early payments
• Cons: dollar cost involved
• If sales are seasonal, firm may use
seasonal dating on discounts: 2/10,
net 30, May 1.
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-21
CH18
Days Sales Outstanding
(DSO)
• DSO = average collection period =
receivables/ADS (i.e. the length of
time the customers to payoff their
credit purchases)
• ADS = average daily sales = annual
sales/365
• Receivables = (ADS)(DSO)
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18-22
Aging Schedule
CH18
• A compilation of accounts
receivable by the age of account.
• A change in DSO or the aging
schedule signals the firm to
investigate its credit policy.
• A deterioration in either of these
measures does not necessarily
indicate the firm’s credit policy has
weakened.
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-23
Aging Schedules
CH18
• Reflect the portion of customers who
are not abiding by the credit term.
Age of Account
(days)
Value of Account Percentage of
($)
Total Value (%)
0 – 10
815,867
47
11 – 30
451,331
26
31 – 45
260,383
15
46 – 60
173,589
10
Over 60
34,718
2
$1,735,888
100%
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-24
CH18
Evaluation of Changes in
Credit Policy
• Sales should increase if firm eases the
credit policy by lengthening the credit
period, relaxing the credit standards and
collection policy, and offering or raising a
cash discount.
• A firm should ease its credit policy only if
the costs of doing so will be offset by higher
expected revenues.
• Cost of carrying receivables = (DSO)(sales
per day)(variable cost ratio)(cost of funds)
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-25
CH18
Detailed Analysis of
Changing Credit Policy
• The best procedure for evaluating a
change in credit policy is to use the
income statement approach.
• Easing the credit policy stimulates
sales to which compared with costs
• Credit-related costs:
– Cost of carrying receivables
– Credit analysis and collection expense
– Bad debt losses
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-26
Changes in Credit Policy
CH18
• Does ABC face any risk if it tightens
its credit policy?
• YES! A tighter credit policy may
discourage sales. Some customers
may choose to go elsewhere if they
are pressured to pay their bills
sooner.
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-27
Analysis of Improved
Receivables
CH18
• If ABC succeeds in reducing DSO
without adversely affecting sales, how
would this affect its cash position?
• Short run: If customers pay sooner, this
increases cash holdings.
• Long run: Over time, the company
would hopefully invest the cash in more
productive assets, or pay it out to
shareholders. Both of these actions
would increase firm value.
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
18-28
Inventory Management
CH18
• Inventory is an important component of
current asset composed of raw materials
to be used in production, work in
process, and finished goods
• The two objectives are:
– Ensure enough inventory to sustain
operations is available.
– Hold the costs of ordering and
carrying inventory to a minimum.
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18-29
Why is inventory management vital
to the financial health of most firms?
CH18
• Insufficient inventories can lead to lost
sales.
• Excess inventories means higher costs
than necessary.
• Large inventories, but wrong items
leads to both high costs and lost sales.
• Inventory management is more closely
related to operations than to finance.
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18-30
Inventory Control
CH18
• Good inventory control system is
dynamic not static.
• Most companies utilize a
computerized inventory system.
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18-31
Just In Time
CH18
• Developed by the Japanese.
• Requires very close coordination
between all parties using JIT
procedures.
• Reduces overall inventory
throughout the production process.
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18-32
Outsourcing
CH18
• Purchase components from outsiders
rather than make them in-house.
• Outsourcing is often combined with
JIT systems to reduce inventory
levels.
• Major reason for outsourcing has
nothing to do with inventory policy.
Inventory cost is the ultimate concern.
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18-33
Categories of Inventory Costs
CH18
• 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.
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18-34
Illustration: Inventory Level
CH18
• Is ABC holding too much inventory?
• ABC’s inventory turnover (3.5) is
considerably lower than the industry
average (6.0). The firm is carrying a lot
of inventory per dollar of sales.
• By holding excessive inventory, the firm
is increasing its operating costs which
reduces its NOPAT. Moreover, the
excess inventory must be financed, so
firm value is further lowered.
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18-35
Illustration: Inventory on
Cash Position
CH18
• If ABC 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.
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18-36
Assumptions of the EOQ Model
CH18
• All values are known with certainty
and constant over time.
• Inventory usage is uniform over time.
• Carrying costs change proportionally
with changes in inventory levels.
• All ordering costs are fixed.
• These assumptions do not hold in the
“real world,” so safety stocks are held.
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18-37
Total Inventory Costs (TIC)
CH18
• TIC = Total carrying costs+ total ordering
costs
• TIC = CP(Q/2) + F(S/Q).
• C = Annual carrying costs (% of inv.).
• P = Purchase price per unit.
• Q = Number of units per order.
• F = Fixed costs per order.
• S = Annual usage in units.
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18-38
Derive the EOQ model from the
total cost equation
CH18
d(TIC) CP FS
=
- 2 =0
dQ
2
Q
Q2
2FS
= CP
2FS
EOQ = Q* = CP

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18-39
Inventory Model Graph
CH18
$
TIC
Carrying
Cost
Ordering Cost
0
EOQ
Units
Average inventory = EOQ/2
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18-40
Assume the following data:
CH18
•
•
•
•
•
P = $200
F = $1,000
S = 5,000
C = 0.2
Minimum order size = 250
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18-41
What is the EOQ?
CH18
2($1,000)(5,000)
EOQ =
0.2($200)

$10,000,000
=
40

=  250,000 = 500 units
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18-42
What are total inventory costs
when the EOQ is ordered?
CH18
TIC = CP(Q/2) + F(S/Q)
= (0.2)($200)(500/2) +
$1,000(5,000/500)
= $40(250) + $1,000(10)
= $10,000 + $10,000 =
$20,000
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18-43
Additional Notes
CH18
Average inventory = EOQ/2
Average inventory = 500/2 = 250
units.
# of orders per year = S/EOQ
# of orders per year = $5,000/50 = 10
At EOQ, total carrying costs = total
ordering costs.
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18-44
What is the added cost if the firm orders
400 units or 600 units at a time rather than
the EOQ?
CH18
400 units:
TIC = CP(Q/2) + F(S/Q)
= 0.2($200)(400/2) + $1,000(5,000/400)
= $8,000 + $12,500 = $20,500
Added cost = $20,500 - $20,000 = $500
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18-45
600 units:
CH18
TIC = CP(Q/2) + F(S/Q)
TIC = 0.2($200)(600/2) + $1,000(5,000/600)
= $12,000 +$8,333 = $20,333
Added cost = $20,333 - $20,000 = $333
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18-46