Chapter 22
Management of
Short-Term Assets:
Liquid Assets and
Accounts Receivable
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-1
Learning Objectives
• Define liquid assets.
• Distinguish between liquidity management and
treasury management.
• Identify the motives for holding liquid assets.
• Prepare a cash budget.
• Identify avenues for short-term investment by
companies.
• Define accounts receivable and distinguish
between trade credit and consumer credit.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-2
Learning Objectives (cont.)
• Identify the benefits and costs of holding
accounts receivable.
• Identify the four elements of credit policy.
• Understand the factors in implementing a
collection policy.
• Apply the net present value method to evaluate
alternative credit and collection policies.
• Apply financial statement analysis to short-term
asset management.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-3
Introduction
• Liquidity is essential in order to ensure that
creditors are paid on time.
• This ensures the business can continue to operate
— solvency.
• However, liquidity is costly and there is a trade
off between costs and benefits, along with an
optimal level of liquidity.
• Many companies sell on credit, leading to
accounts receivable — need to manage
accounts receivable efficiently to maximise
company value.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-4
Overview of Liquidity
Management
• Liquid assets
– Cash and assets that are readily convertible into cash,
such as bills of exchange and treasury notes.
• Liquidity management
– Decisions on the composition and level of a company’s
liquid assets.
• Treasury management
– Conducted by a group or department under the control of
the company treasurer, to manage the company’s
liquidity, and to oversee its exposure to various kinds of
financial risk.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-5
Centralisation of Liquidity
Management
• Centralisation allows the matching of inflows
and outflows for the whole company, with consequent
savings.
• Centralisation of liquidity management facilitates the
development of specialised staff by having them
concentrated in one area of the business.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-6
Motives for Holding Liquid
Assets
• Transactions motive
– Perfect synchronisation of cash inflows and outflows is
virtually impossible to achieve because the timing of a
company’s inflows depends on the actions of its
customers.
– Therefore, liquid assets are held in order to finance
transactions undertaken between cash inflows.
• Precautionary motive
– Future cash inflows and outflows cannot be predicted
with perfect certainty.
– Therefore, the possibility exists that extra cash will be
needed to meet unexpected costs, or to take advantage
of unexpected opportunities.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-7
Motives for Holding Liquid
Assets (cont.)
• Speculative motive
– When interest rates increase, there is a fall in the market
value of income-producing assets such as bonds.
– Individuals forecasting an increase in interest rates may,
therefore, sell bonds and, instead, hold cash or bank
deposits in order to avoid the resulting capital loss.
• For most companies transaction-based
motives dominate.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-8
Major Issues in Liquidity
Management
• If cash payments exceed cash receipts:
– Need to borrow to make payments (incur interest).
– Postpone payments that may be disruptive to the
business and damage its reputation.
• If cash receipts exceed cash payments:
– Company failing to maximise its resources if a large
cash balance is maintained.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-9
Major Issues in Liquidity
Management (cont.)
• Ensure interest costs on short-term debt are not
excessive.
• Consider the effects of bank charges.
• Liquidity management involves ‘balancing’
several costs and benefits.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-10
Cash Budgeting
• A forecast of the amount and timing of the
cash receipts and payments that will result
from a company’s operations over a period
of time.
• Cash budgets assist in forecasting when
payments exceed receipts (or vice versa).
• Forecasts can be on a daily, weekly or
monthly basis.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-11
Cash Budgeting (cont.)
• Preparation
– Forecast cash receipts:
 Analysis of past sales performance.
 Projections of likely business and economic
conditions.
 Estimate cash receipts from sales.
– Forecast cash payments.
• Compare actual results with forecast results
on an ongoing basis.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-12
The Choice of Short-Term
Securities
• Interest rate risk, default risk and liquidity risk need
to be taken into account when considering the
investment of temporarily idle cash.
• Deposits of funds with financial institutions
– The basic terms of the deposit will differ from one kind
of institution to another, and a treasurer’s choice will
depend on:
 The period that the funds are available for investment.
 The risk that the company is prepared to accept.
 The required rate of return.
– Banks.
– Cash management trusts.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-13
The Choice of Short-Term
Securities (cont.)
• Discounting of commercial bills
– There are two ways that a company can invest its idle
cash balances in the commercial bills market:
 A company can be the original discounter of a commercial
bill (supply funds to the drawer of the bill).
 A company can ‘rediscount’ a bill that has previously been
discounted by another party. (The bill is purchased from
another investor in the bills market.)
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-14
The Corporate Treasurer and
Liquidity Management
• Task of the treasurer:
– Preparation of cash budgets.
– Determination of the optimum cash balance.
– Investment of idle cash in short-term investments.
– Arrangement of credit facilities to see the company through
periods of cash shortage.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-15
Overview of Accounts
Receivable Management
• Seek to identify the impact of decisions on
accounts receivable and how to determine the
optimal credit and collection policies.
• Establishment of a credit policy:
– Is the company prepared to offer credit?
– Assuming credit is to be offered, what standards will be
applied in the decision to grant credit to a customer?
– How much credit should a customer be granted?
– What credit terms will be offered?
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-16
Definitions
• Accounts receivable
– Money owed to a business for goods or services
sold in the ordinary course of business.
• Trade credit
– Short-term credit provided by suppliers of goods or
services to other businesses.
• Consumer credit
– Credit extended to individuals by suppliers of goods
and services, or by financial institutions through
credit cards.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-17
Benefits and Costs of Granting
Credit
• Benefits
– Increased sales.
• Costs
– Opportunity cost of investment.
– Cost of bad debts and delinquent accounts.
– Cost of administration.
– Cost of additional investment.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-18
Credit Policy
• ‘Credit policy’ refers to a supplier’s policy on
whether credit will be offered to customers and
the terms on which it will be offered.
• The decision to offer credit
– Is the company prepared to offer credit?
– Offering credit is equivalent to a price reduction.
– What do competitors offer?
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-19
Credit Policy (cont.)
• Selection of credit-worthy customers
– Company’s past experience with customer.
– Use of decision tree:
 Grant credit immediately.
 Investigate/Consider.
 Refuse credit immediately.
– Cost of granting credit = expected bad debt cost
+ investment opportunity cost + collection cost
– Cost of refusing credit = expected value of marginal
net benefit forgone
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-20
Credit Policy (cont.)
• Limit of credit extended
– Setting limits — about risk management.
– The more sales on credit, the greater the
potential loss from default.
– Offer less credit to newer customers.
• Credit terms
– Credit period.
– Discount period.
– Discount rate.
– Effective rate.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-21
Collection Policy
• ‘Collection policy’ refers to the efforts made to
collect delinquent accounts either informally or by
a debt collection agency.
• Procedures implemented:
– Reminder notice.
– Personal letters and telephone calls.
– Personal visits.
– Legal action or debt collection agency.
• Procedures adopted may have an impact on sales.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-22
Evaluation of Alternative
Credit and Collection Policies
• Application of NPV method.
• Benefits
– Measured by the net increase in sales.
• Costs
– Include manufacturing, selling, collection, administration
and bad debts.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-23
Evaluation of Alternative
Credit and Collection Policies
(cont.)
• Pay attention to the timing of the cash flows.
• Net cash flows can be discounted at the required
rate of return.
• Analysis undertaken for all credit/collection policies,
with the policy generating the highest net present
value being the preferred option.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-24
Collection and Credit
Policies
• Discounts for early payment, late payments or
failures to pay, together with any collection costs
— all reduce the NPV of credit.
• Company’s policies should be designed so that
the costs of extending credit are outweighed
by the benefits.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-25
Summary
• Company’s liquid assets are cash and short-term
investments.
• Liquidity management refers to decisions with
respect to these liquid assets.
– Important to meet daily commitments.
– Too much means that the rate of return falls.
• Treasury management refers to liquidity
management combined with risk considerations.
• Transactions motive considered in detail.
• Liquidity management is based on cash budget,
cash receipts and payments.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-26
Summary (cont.)
• Liquid assets can include government securities,
deposits with financial institutions, and commercial
bills. Varying marketability and risk.
• Accounts receivable — money owed to a business
due to sales made on credit.
• Credit offered in order to attract increased sales.
• Credit has costs — funds tied up, administration
costs, slow and non-paying customers.
• Credit and collection policies involve evaluation
and comparison of costs and benefits of these
activities, looking for positive NPV of policy in
question.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
22-27