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
• Inventory management and policy decisions
required
• Liquidity vis-à-vis returns
1-2
 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

1-3
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

1-4
 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

1-5
 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

1-6
Expanded Cash Flow Cycle

1-7
 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

1-8
 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

1-9
 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

1-11
Cash Management Network

1-12
 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
1-14
 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

1-15
 An Examination of Yield and
Maturity Characteristics
• Marketable
securities

1-16
 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

1-19
 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
1-20
 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

1-21
Dun & Bradstreet Report – An
Example

1-22
 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

1-23
 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

1-24
 An Actual Credit Decision

• Brings together various elements of

accounts receivable management

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

Turnover 6

1-25
 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

1-26
 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

1-28
 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

1-30
 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
1-31
 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

1-32
 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
1-36