Current Asset Management

1. Current Asset Management 7

2. 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

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

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

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

6. 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

7. Expanded Cash Flow Cycle

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 cards

9. 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

10. 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

11. Cost-Benefit Analysis • Allows companies to analyze the benefits, received by investing on an efficiently maintained cash management program

12. Cash Management Network

13. 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

14. 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

15. 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

16. An Examination of Yield and Maturity Characteristics • Marketable securities

17. 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

18. 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

19. Types of Short-Term Investments

20. 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

21. 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

22. Dun & Bradstreet Report – An Example

23. 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

24. 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

25. An Actual Credit Decision Accounts receivable = Sales = $10,000 = $1,667 Turnover 6 • Brings together various elements of accounts receivable management

26. 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

27. 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

28. 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

29. 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

30. Determining the Optimum Inventory Level

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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