Chapter 07

• Current Asset Management

By Md. Shahedur Rahaman

Chowdhury

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Chapter Outline

• What is current asset management• Cash management and its importance• Management of marketable securities• Accounts receivable and inventory

management• Inventory management and policy decisions

required• Liquidity vis-à-vis returns

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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

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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

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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

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Cash Flow Cycle (cont’d)• Cash inflows are driven by sales and influenced

by: – Type of customers– Customers’ geographical location– Product being sold– Industry

• When the cash balance increases, the extra cash can be – Used for various payments to lenders, stockholders, government,

etc– Used to invest in marketable securities

• When there is a need for cash a firm can:– Sell the marketable securities– Borrow funds from short-term lenders

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Expanded Cash Flow Cycle

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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 cards

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Float

• Difference between firm’s recorded amount and amount credited to the firm by a bank

• Two types of float:– Mail float: Arises duet to the time it takes to deliver a check.– Clearing float: Arises due to the time it takes to clear a check once

the payment is made

• Both these floats do not exist anymore due to:– Electronic payments – Check Clearing for the 21st Century Act

• Check Clearing for the 21st Century Act (Check 21) – Allows banks and others to electronically process a check

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Improving Collections and Extending Disbursements

• Improving collection: – Setting up multiple collection centers at different

locations– Adopt lockbox system for expeditious check clearance at

lower costs

• Extending disbursement:– General trend:

• Speedup processing of incoming checks• Slow down payment procedures

– Extended disbursement float – allows companies to hold onto their cash balances for as long as possible

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Cost-Benefit Analysis

• Allows companies to analyze the benefits, received by investing on an efficiently maintained cash management program

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Cash Management Network

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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

• International fund transfer is carried out through SWIFT (Society for Worldwide Interbank Financial Telecommunications)– 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

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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

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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

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An Examination of Yield and Maturity Characteristics

• Marketable securities

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Marketable Securities

• When a firm has excess funds, it should be converted from cash into interest-earning securities

• Types of securities:– Treasury bills: Short-term obligations of the government– Treasury notes: Government obligations with a maturity of 1-10

years– Federal agency securities: Offerings of government organizations– Certificate of deposit: Offered by commercial banks, savings, and

other financial institutions– Commercial paper: Represents unsecured promissory notes

issued by large business organizations– Banker’s acceptances: Short-term securities that arise from

foreign trade

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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

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Types of Short-Term Investments

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Credit Standards

• Determine the nature of credit risk based on:– Prior records of payment and financial stability,

current net worth, and other related factors• 5 Cs of credit:

– Character– Capital– Capacity– Conditions– Collateral

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Credit Standards (cont’d)

• Dun & Bradstreet Information Services (DBIS):– Produces business information analysis tools– Publishes reference books– Provides computer access to information– The Data Universal Number System (D-U-N-S)

is a unique nine-digit code assigned by DBIS to each business in its information base

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Dun & Bradstreet Report – An Example

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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

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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

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An Actual Credit Decision

Accounts receivable = Sales = $10,000 = $1,667 Turnover 6

• Brings together various elements of accounts receivable management

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Inventory Management

• Inventory has three basic categories:– Raw materials– Work in progress– Finished goods

• Amount of inventory is affected by sales, production, and economic conditions

• Inventory is the least of liquid assets – should provide the highest yield

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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

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Inventory Policy in Inflation (and Deflation)

• Inventory position can be protected in an environment of price instability by:– Taking moderate inventory positions– 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

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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

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Determining the Optimum Inventory Level

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Economic Ordering Quantity

EOQ = 2SO ; C

Where,S = Total sales in unitsO = Ordering cost for each orderC = Carrying cost per unit in dollarsAssuming:

EOQ = 2SO = 2 X 2,000 X $8U = $32,000 = 160,000 C $0.20 $0.20

= 400 units

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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 stockouts • Increased profits from unexpected orders

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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 × Carrying cost per unit

= 250 × $0.20 = $50

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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

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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

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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

Q

End

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Q & A

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Thank You.

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