7
Current Asset
Management
Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
•
•
•
•
What is current asset management?
Cash management and its importance.
Management of marketable securities.
Accounts receivable and inventory
management.
• Liquidity vis-à-vis returns.
7-2
What is Current Asset Management?
• Involves the management of cash,
marketable securities, accounts receivable,
and inventory.
• Ensures a competitive advantage and often
creates an increase in shareholder value.
• Primarily concerned with liquidity and safety,
and then on maximizing profits.
7-3
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.
– Steps to improve overall profitability of a firm:
• Minimize cash balances.
• Have accurate knowledge of when cash moves in
and out of the firm.
7-4
Reasons for Holding Cash Balances
• Transactions balances
– Payments towards planned expenses.
• Compensative balances for banks
– Compensate a bank for services provided rather
than paying directly for them.
• Precautionary needs
– Emergency purposes.
7-5
Cash Flow Cycle
• Ensure that cash inflows and outflows are
synchronized for transaction purposes.
– Cash budgets is a tool used to track cash flows
and ensuing balances.
• Cash flow relies on:
– Payment pattern of customers.
– Speed at which suppliers and creditors process
checks.
– Efficiency of the banking system.
7-6
Cash Flow Cycle (cont’d)
• Cash-generating process is continuous
although the cash flow may be unpredictable
and uneven.
• Cash inflows are driven by sales and
influenced by:
– Type of customers.
– Customers’ geographical location.
– Product being sold.
– Industry.
7-7
Expanded Cash Flow Cycle
7-8
E-commerce and Sales
• Benefits: faster cash flow.
– Credit card companies advance cash to the
retailer within 7-10 days against retailer’s with a
30 day payment terms.
• Financial managers must pay close attention
to the percentage of sales generated:
– By cash.
– By outside credit cards.
– By the company’s own credit terms.
7-9
Outcome of Extra Cash
• Account receivable is collected or the credit
card company advances payment.
– Used for various payments such as interest to
lenders, dividends to stockholders, taxes to the
government etc.
– Used to invest in marketable securities.
• Therefore when there is a need for cash a
firm can:
– Sell the marketable securities.
– Borrow funds from short-term lenders.
7-10
Collections and Disbursements
• Primary concern to the financial manager is
the management of:
– Cash inflows - still affected by collection
mechanisms.
– Payment outflow.
7-11
Float
• Difference between firm’s recorded amount
and amount credited to the firm by a bank.
– Arises due to time delays in mailing, processing
and clearing checks through the banking
system.
– Can be managed to some extent by combining
disbursements and collection strategies.
– Main challenge: the physical presentation of the
check to the issuing bank.
7-12
Float (cont’d)
• Check Clearing for the 21st Century Act
(Check 21)
– Allows banks and others to electronically
process a check.
• Factors that help in reducing float:
– Ease of credit and debit cards payments and online banking for customers.
– Wire transfers for corporations.
– Rise of Internet commerce.
7-13
Use of Float – Day one
7-14
Use of Float – Day two
7-15
Improving Collections
• Setting up multiple collection centers at
different locations.
• Adopt lockbox system for expeditious check
clearance at lower costs.
7-16
Extending Disbursements
• General trend:
– Speed up processing of incoming checks.
– Slow down payment procedures.
• Extended disbursement float - allows companies to
hold onto their cash balances for as long as possible.
7-17
Cost-Benefit Analysis
• Allows companies to analyze the benefits,
received by investing on an efficiently
maintained cash management program.
7-18
Cash Management Network
7-19
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.
– Central clearing facilities include:
• National Automated Clearinghouse Association
(NACHA)
• Federal Reserve system
• Electronic Payment Network
• VISA
7-20
International Electronic Funds
Transfer
• Carried out through Society for Worldwide
Interbank Financial Telecommunications
(SWIFT).
– Uses a proprietary secure messaging system.
– Each message is encrypted.
– Every money transaction is authenticated by a
code, using smart card technology.
– Assumes financial liability for the accuracy,
completeness, and confidentiality of transaction.
7-21
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.
7-22
International Cash Management
(cont’d)
• Financial managers try to keep as much
cash as possible in a country with a strong
currency and vice versa.
• Sweep account:
– Allows companies to maintain zero balances.
– Excess cash is swept into an interest-earning
account.
7-23
An Examination of Yield and
Maturity Characteristics
• Marketable securities
7-24
Types of Short-Term Investments
7-25
Management of Accounts
Receivable
• Accounts receivable as an investment.
– Should be based on the level of return earned
equals or exceeds the potential gain from other
investments.
• Credit policy administration
– Credit standards
– Terms of trade
– Collection policy
7-26
Credit Standards
• Determine the nature of credit risk based on:
– Prior records of payments and financial stability
– Current net worth and other related factors
• 5 Cs of credit:
– Character
– Capital
– Capacity
– Conditions
– Collateral
7-27
Dun and Bradstreet Report – An
Example
7-28
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.
7-29
Collection Policy
•
A number if quantitative measures applied
to asses credit policy.
– Average collection period
– Ratio of bad debts to credit sales
– Aging of accounts receivable
7-30
An Actual Credit Decision
•
Brings together various elements of
accounts receivable management.
Accounts receivable =
Sales = $10,000 = $1,667
Turnover
6
7-31
Inventory Management
• Inventory has three basic categories:
– Raw materials used in the product
– Work in progress, which reflects partially
finished products
– Finished goods, which are ready for sale.
• Amount of inventory is affected by sales,
production, and economic conditions.
• Inventory is the least of liquid assets - should
provide the highest yield.
7-32
Level versus Seasonal Production
• Level production
– Maximum efficiency in manpower and
machinery usage.
– May result in high inventory buildup.
• Seasonal production
– Eliminates inventory buildup problems.
– May result in unused capacity during slack
periods.
– May result in overtime labor charges and
overused equipment repair charges.
7-33
Inventory Policy in Inflation and
Deflation
• Inventory position can be protected in an
environment of price instability by:
– Taking moderate inventory positions (by not
committing at a single price).
– Hedging with a futures contract to sell at a
stipulated price some months from now.
• Rapid price movements in inventory may
also have a major impact on the reported
income of the firm.
7-34
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 perish-ability.
• Ordering costs
– Cost of ordering.
– Cost of processing inventory into stock.
7-35
Determining the Optimum Inventory
Level
7-36
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:
EOQ = 2SO = 2 X 2,000 X $8U = $32,000 = 160,000
C
$0.20
$0.20
= 400 units
7-37
Inventory Usage Pattern
7-38
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 such risks.
– Increases cost of inventory due to a rise in
carrying costs.
– This cost should be offset by:
• Eliminating lost profits due to stock outs
• Increased profits from unexpected orders.
7-39
Safety Stocks and Stock Outs
(cont’d)
• Assuming that;
Average inventory = EOQ + Safety stock
2
Average inventory = 400 + 50
2
The inventory carrying costs will now increase by $50.
Carrying costs = Average inventory in units X Carrying cost
per unit
= 250 X $0.20 = $50.
7-40
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 average, JIT has reduced inventory to sales
ratio by 10% over the last decade.
7-41
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 re-keying errors and duplication of
forms.
• Reduction in costs from quality control.
• Elimination of waste.
7-42
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.
• A revaluation may be needed in high-growth
industries fostering dynamic technologies.
7-43