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Management of short term assets and liabilities

Short term assets and liabilities

• Cash • Investment• Inventories• Receivables• Payables

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Managing Short-Term Assets and Liabilities• Short-term financial management decisions• Why do firms have short-term assets and liabilities?• The importance of short-term assets and liabilities

Strategy for Current Asset and Current Liability Management• Current assets• Current liabilities

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Why to manage short term asset and liabilities

Minimize the working capital needs consistent with other policies

Raise short term funds at the minimum possible cost and deploy short term cash surpluses at the maximum possible rate of return consistent with the firm’s risk preferences and liquidity needs.

Effective management of currency exposureMinimize the overall tax burden.

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Where should surplus cash be held ?

Investing surplus funds

• Yield• Marketability• Exchange Rate Risk• Price Risk• Transactions costs

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Internal sources

External sources

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Financing short term deficits

Inventory

Receivables

Federal, provincialand localgovernments

Moneymarkets and banks

Wages

Purchases

Credit salesCashsales

Raw materials

Otherexpenses

Collection oncredit sales

Taxes

Production

Cash

Securitypurchases

Payment ofinterest

Debt repayment

Short-termborrowings

Interest

Maturedinvestments

Managing Short-Term Assets and Liabilitiesflow diagram

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Strategy for Current Asset and Current Liability Management

Current AssetsEssential elements that must be considered in

establishing a firm's short-term financial management policies are• Cash flows• Liquidity• Risk• The level of returns necessary to compensate for the risk

Four factors affecting the level of current assets• Nature of the firm's business

• Retail firms have much larger inventories than manufacturing firms

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Cont..

The size of the firm• Smaller firms hold more current assets than large firms

Rate of increase (decrease) in sales• As sales increase, current assets increase, along with a

spontaneous increase in accounts payableStability of the firm's sales• The more stable the sales, the lower the level of

current assets

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cont…

Aggressive versus conservative asset management

(a) Aggressive Asset Management

(b) Conservative Asset Management

Total assets

Current assets$55,000

Total assets

Current assets$110,000

Long-term assets$165,000 Long-term assets

$110,000

Time TimeCharacteristics of Aggressive Asset Management

•Low levels of current assets, but effectively and aggressively managed.•Short cash conversion cycle.•Lower expenses and higher revenue leading to higher EBIT.•High risk-high return strategy.

Characteristics of Conservative Asset Management

•High levels of current assets.•Long cash conversion cycle.•Higher expenses and lower revenue leading to lower EBIT.•Low risk-low return strategy.

$ $

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Cont..

• Because current assets never drop to zero, we can think of the firm as having a need for some permanent current assets on an ongoing basis– At the same time, virtually all firms have a need for

seasonal (or temporary) current assets that fluctuate over the year (or business cycle)

• The size of both the permanent and temporary current assets is determined, in part, by how aggressive a firm is toward the level of current assets it maintain.

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cont…

Characteristics of aggressive asset management Lower levels of current assets that are effectively and

aggressively managed Short cash conversion cycle, lowering both receivables

and inventory shortens the firm's operating cycle, which leads to a shorter cash conversion cycle

Lower expense and higher revenue, fewer accounts receivable means lower carrying costs and less bad debts, low inventory also avoids carrying costs and losses due to obsolescence etc., this leads to higher EBIT and ultimately to higher cash flows

High-risk high-expected-return strategy, running out of cash, an aggressive accounts receivable policy could result in lost sales if too low a level is kept 12

Cont..

Characteristics of conservative asset management

High levels of current assets Long cash conversion cycle Higher expense and lower revenue leading to lower

EBIT and ultimately to lower cash flows Low-risk low-expected-return strategy

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Strategy for Current Asset and Current Liability Management

Current LiabilitiesFactors affecting the level of current liabilities

Type of firm• Retail firms carry more accounts payable than

manufacturing firm– Larger inventories lead spontaneously to larger accounts payable

Desired flexibility• The lower the level of current liabilities the greater the

flexibility, because short-term borrowing can generally be easily employed

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cont…

(a) Aggressive Liability Management

(b) Conservative Liability Management

Total liabilitiesand shareholders’equity

Current liabilities$100,000

Current liabilities$30,000

Long-termliabilities$30,000

Time TimeCharacteristics of Aggressive Liability Management

•High levels of current liabilities.•Short cash conversion cycle.•Lower interest costs if short-term rates are lower than long-term rates.•High risk-high return strategy.

Total liabilitiesand shareholders’equity

Shareholders’equity$90,000

}Long-termliabilities$100,000

Shareholders’equity$90,000

Characteristics of Aggressive Liability Management

•Low levels of current liabilities•Long cash conversion cycle.•Higher interest costs if short-term rates are higher than short-term rates.•Low risk-low return strategy.

$ $

Aggressive versus conservative liability management

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Cont…

Characteristics of aggressive liability management High level of current liabilities, accounts payable and

short-term borrowing are used to the greatest extent possible

Short cash conversion cycle, larger payables lead to a shorter payables turnover, longer days payable and a shorter cash conversion cycle

Lower interest costs if short-term rates are lower than long-term rates--the term structure of interest rates is upward sloping

High-risk and high-expected-return strategy, extensive short-term financing through borrowing exposes the firm to interest cost fluctuations which increases the firm's risk exposure

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Cont…

• Characteristics of conservative liability management

Low level of current liabilities Long cash conversion cycle Higher interest costs if long-term rates are higher

than short-term rates Low-risk and Low-expected-return strategy

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Short term financial instruments

• Commercial paper

• Euro commercial paper

• Certificate of deposit

• Euro Certificate of deposit

• Bankers acceptance18

The importance of short-term assets and liabilities

Transactions costs The service fees for buying and selling securities or the

potential loss in value when a "fire sale" must be made

Time delays in the production, marketing, and cash collection Because transactions do not happen instantaneously, many

activities affect current asset and liability needs• Maintaining inventory• Offering credit policies to help sell the product

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conclusion

It minimize idle cashRaising short term funds at the least costDeploying surplus fund at the maximum returnIt Focus on time, currency and liquidity riskIt is an important part of finance manager’s job.

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BIBLIGRAPHY

• Prakash G Apte, “ International finance” a business perspective, second edition.

• VAN HORNE ,“FINANCIAL MANAGEMENT POLICY”, Pearson education, twelfth edition, 2004.

• PANDEY, I.M. , “ FINANCIAL MANAGEMENT” tenth edition.

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THANKS

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