Chapter16 current asset management
-
Upload
marmara4 -
Category
Economy & Finance
-
view
386 -
download
2
Transcript of Chapter16 current asset management
CONTEMPORARY FINANCIAL MANAGEMENT
Chapter 16:
Current Asset Management
INTRODUCTION
The first half of the chapter reviews the various cash management decisions made by financial managers.
Financial managers must consider the risk- return trade-offs characteristic of these decisions.
The second half of the chapter discusses the management of accounts receivable and inventory.
2
THE BALANCE SHEET
Current Assets Current Liabilities
Cash Accounts Payable
Securities Current Portion of LT Debt
Accounts Receivable
Total Current Liab
Inventory
Total Current Assets Owner’s Equity
Fixed Assets
Total Assets Total Liab & OE
3
CASH AND MARKETABLE SECURITIES
On the Balance Sheet, the most liquid assets are listed first. These consist of cash & marketable securities.
Cash consists of currency and deposits in checking accounts
Marketable securities consist of short-term investments made with idle cash
4
CASH MANAGEMENT FUNCTION
The cash management function is concerned with determining:
The optimal size of a firm’s liquid asset balance The most efficient methods of controlling the collection and
disbursement of cash The appropriate types and amounts of
short-term investments
5
CASH MANAGEMENT DECISIONS
Must consider the risk versus expected return trade-offs from alternative policies
Too little cash increases risk; too much cash reduces return (cash is a non-earning asset)
The safest and most liquid securities also carry the lowest expected return
Thus the function of the financial manager is to find an appropriate balance between maximizing return and minimizing risk
6
CASH MANAGEMENT DECISIONS
The financial manager must determine the optimal size of the cash balance, recognizing:
Holding excess liquid assets results in an opportunity cost (liquid assets are the lowest return assets)
Inadequate liquid balances may result in costs arising from:
Missed cash discounts Deterioration of the firm’s credit rating Higher interest costs Risk of insolvency
7
REASONS FOR HOLDING LIQUID ASSETS
Transactions: to ensure the firm can meet its obligations as they come due
Precautionary: to guard against future cash flow shortfalls
Speculative: to allow for potential acquisitions or major investments
Future requirements: to prepare for fixed and known obligations, such as tax payments, dividends, etc.
8
CASH BUDGET
The first step in cash management is the preparation of a cash budget showing forecasted receipts & disbursements
The cash budget may be for a daily, weekly or monthly cycle
The cash budget reveals any cumulative cash flow shortages or surpluses
The cash budget is required because cash inflows and outflows are seldom synchronized
9
ISSUES IN THE COLLECTION OF CASH
Management's goal Speed the collection of cash and/or slow the disbursement of
cash
Float – reconciling the differences between bank account balances and accounting records
Methods of expediting the collection of cash Decentralized collection system Lockbox
10
FLOAT Positive Float
Bank balance is greater than that shown by the firm’s accounting records
Negative Float Bank balance is less than that shown by the firm’s accounting
records
11
COMPONENTS OF FLOAT Mail Float
delay between when a cheque is sent to a payee and its receipt by the payee
Processing Float time between receipt of payment by a payee and the deposit of the
payment in the payee’s account
Clearing Float time between depositing a cheque and having available spendable
funds
12
ELECTRONIC FUNDS TRANSFER
Electronic funds transfer mechanisms are quickly reducing the importance of float management techniques for many companies
13
EXPEDITING THE COLLECTION OF CASH
Decentralized collection centers – to reduce delays due to mail, cheques are sent to local collection centers, where they are deposited
The firm then transfers all deposits into one concentrator account, from which cheques are written
14
EXPEDITING THE COLLECTION OF CASH
A Lockbox is similar to a decentralized collection center, except a local bank empties the box, deposits payments into the firm’s account and makes a report of the payments.
Lockboxes may involve significant fees
More beneficial for small number of larger deposits
Evaluation involves comparison of costs versus benefits of faster collection
15
SLOWING CASH DISBURSEMENTS Zero-balance system
Transfers cash in the exact amount required for the cleared checks
Drafts Deposit funds only after the draft is presented for payment
Synchronize deposits with check clearings Requires accurate estimates of float
16
CASH MANAGEMENT FOR SMALL FIRMS
Less-extensive access to capital markets
Cash shortage may be more expensive to rectify
Many small businesses are often growing rapidly, leading to constant cash shortages
Small firms often have low cash balances
17
CHOOSING MARKETABLE SECURITIES
Default risk Lowest on T-bills Risk and expected return inversely related
Marketability Ability to sell quickly without significant price concession
Maturity Shorter maturities have less risk of price fluctuation
Rate of return (lowest priority item)
18
EXAMPLES OF MARKETABLE SECURITIES
Treasury Bills Short-term government note issued at a discount with
principal repaid at maturity.
Commercial Paper Short-term unsecured promissory note issued by corporations
with good credit.
Banker’s Acceptance Short-term promissory note issued by a firm and accepted (or
guaranteed) by a commercial bank
19
EXAMPLES OF MARKETABLE SECURITIES
Repurchase Agreements (Repo) agreement whereby a firm with excess cash “buys” a security
today with a subsequent agreement to sell it back at a fixed price on a future date
difference between the purchase price and the sale price is the interest earned during the holding period
20
MULTINATIONAL CORPORATION (MNC) Must track cash balances around the world
Usually have centralized cash management
Employ cash transfer facilities
Variety of investment opportunities to improve short-term borrowing/lending terms
Use multilateral netting Cross-border transactions are netted off to minimize costly
transactions and misdirected funds
21
ACCOUNTS RECEIVABLE (A/R) Accounts Receivable represent a large investment for most
companies
Extend credit when marginal returns from extending credit exceed marginal costs
Liberal credit policy provides extra returns in the form of increased sales and gross profit
Extra costs occur due to: Cost of funds Costs of credit checking Potential for bad debts
22
CREDIT POLICY Credit Standards
Criteria used to screen credit applications Controls the quality of accounts to which credit is extended
Credit Terms Terms and conditions under which credit extended must be
repaid
Collection Efforts Methods employed in an attempt to collect payment on past due
accounts
23
CREDIT TERMS
Credit period Time allowed for payment
Cash discount Allowed if payment is made within a specific period of time Specified as percent of the invoiced amount Granted to speed up collection of A/R
Seasonal dating Offered to retailers on seasonal merchandise Accept delivery well ahead of peak season Pay shortly after peak sales
24
CREDIT STANDARDS
Quality Time a customer takes to repay Probability a customer will fail to repay
Measures of quality Average collection period Bad-debt ratio
25
PRETAX PROFITS FROM GRANTING CREDIT
Marginal profitability of additional sales = Profit contribution ratio × Additional sales
Additional investment in A/R =Additional average daily sales × Avg. collection period
Cost of additional investment in A/R = Additional investment in A/R × Pretax required return
26
PRETAX PROFITS FROM GRANTING CREDIT
Additional bad-debt loss = Bad-debt loss ratio × Additional sales
Cost of additional investment in inventory = Additional inventory × Pretax required return
Net change in pretax profits = Marginal returns – Marginal costs
27
COLLECTION EFFORTS
Balance between leniency and alienating customers
Monitoring status Aging of accounts analysis
Classifying accounts into categories according to the number of days they are past due
Changes in the age composition of accounts may reveal changes in the quality of A/R
28
ANALYSIS OF A CHANGE IN CREDIT POLICY
Increase in the credit period Increase the quantity of goods sold
Liberalization of cash discount Increase in sales & pretax profit contribution Reduction in A/R balance
Additional income from alternative investments Decrease in cost of funds Reduction in cash revenue
29
ANALYSIS OF A CHANGE IN CREDIT POLICY
Increase in collection effort Reduced sales and pretax profit contribution Increased collection expenses Reduced bad-debt losses
30
EVALUATION OF CREDIT APPLICATIONS
Gathering information
How much does the analysis cost?
Numerical scoring system
Five Cs of credit Character Capacity Capital Collateral Conditions
31
INVENTORY
Inventory consists of raw materials, work-in-process and finished goods
Inventory is costly to manage and hold, as it consumes time and requires funding, exactly like a new machine or building
The inventory management problem is to find the lowest level of inventory consistent with maximizing profits
32
TYPES OF INVENTORY Raw materials inventory
Store of items used in the production process May qualify for quantity discounts Assure supply in times of scarcity
Work-in-process inventory Items at some intermediate stage of completion Size related to length and complexity of production cycle
33
TYPES OF INVENTORY Finished goods inventory
Items ready and available for sale Permits prompt filling of orders Large production runs create economies of scale
34
COSTS OF AN INVENTORY POLICY
Ordering costs: Cost of placing and receiving an order of goods
Carrying costs: Cost of holding inventory Expressed as cost per unit per period A percent of the inventory value per period
Stockout costs: Incurred when a firm is unable to fill an order, resulting in: Lost sales Rescheduling production Expediting special orders
35
TYPES OF INVENTORY CONTROL MODELS
Two basic types of inventory control models
Deterministic models – inputs are known with certainty Example: Economic Order Quantity Model
Probabilistic models – inputs are random variables with known probability distributions
Management should choose an inventory control model with a cost and a complexity that is consistent with size of the firm and value of the inventory being managed
36
INVENTORY CONTROL MODELS ABC inventory classification
A – large dollar value items but comprise a relatively small percentage of the total number of items held in inventory. Items may comprise 1- 10% of the number of items carried but be worth
80-90% of the total dollar value of inventory. B – items fall between items A & C C – low dollar value items but comprise a large percentage of the
total items held
The firm will manage its inventory of A items much more closely than its inventory of C items
37
INVENTORY CONTROL MODELS Economic Order Quantity (EOQ) model
EOQ is the order quantity (Q) that minimizes total costs.
Using the value of Q, the optimal length of one inventory cycle (T) can be determined.
38
=* 2SDQ
C=
÷
** Q
TD 365
Q = Order quantityD = Demand for the itemS = Cost of placing and receiving an order (set-up cost)C = Annual cost of carrying one unit of item in inventory
EXAMPLE: EOQ
Sears sells mattresses at all stores located in the Toronto area. The mattresses are stored in a central warehouse. Annual demand is 3,600 mattresses, spread evenly throughout the year. The cost of placing and receiving an order is $31.25. The annual carrying cost is $10 (equal to 20% of the wholesale cost of the inventory). What is the size of the order Sears should place with its supplier to minimize its inventory cost?
39
SOLUTION: EOQ
( ) ( )=
=
2SDQ* =
C
2 $31.25 3,600
$10
150
40
Conclusion:
To minimize its inventory costs, Sears should order 150 mattresses at a time.
EOQ: GRAPHICAL SOLUTION
41Q (Units)
Cost ($)
Total Cost
Q*
CarryingCost = CQ/2
Ordering Cost = DS/Q
INVENTORY CONTROL MODELS
Extensions to the basic EOQ model
Nonzero lead time If a lead time is required for delivery, the order must be placed some
days in advance of a stock-out occurring
Probabilistic inventory control methods Use when input factors, such as demand, lead times, etc are not
known with certainty
42
INVENTORY CONTROL MODELS
Just-In-Time Inventory Management System Inventory supplied
At exactly the right time In exactly the right quantities
Requires close coordination between Company Suppliers
Shorten the operating cycle
Reduce costs
Eliminate wasteful procedures 43
MAJOR POINTS Current assets represent a major investment for many firms
but they are often don’t receive the management attention they deserve.
The job of the financial manager is to find the appropriate balance between minimizing risk and maximizing return.
No one method is “right” for all firms. The method chosen will depend on firm size, complexity and the options currently available to it.
44