Current Asset Management

Chapter 7

Chapter 7 - Outline

What is Current Asset Management?Cash ManagementWays to Improve CollectionsMarketable Securities3 Primary Variables of Credit PolicyEconomic Ordering QuantityInventory Management

What is Current Asset Management?

Current Asset Management is essentially an extension of working capital management

It is concerned with the current assets of a firm (cash, A/R, marketable securities, and inventory)

A financial manager needs to remember that the less liquid an asset is, the higher the required return

Cash Management

Financial manager wants to keep cash balances to a minimum

There are 2 reasons for holding cash:– for everyday transactions (main reason)– for precautionary needs (emergencies)

Goals are to speed up the inflow of cash (or improve collections) and slow down the outflow of cash (or extend disbursements)

Previously, could attempt to “play the float”

Cash Conversion CycleIs the length of time from the payment for the

purchases of raw materials to the collection of accounts receivable that were generated by the sale of the finished product, (i.e., the time between paying out cash and receiving cash).

Cash Conversion Cycle = Inventory Conversion Period +

Receivables Collection Period (DSO) -

Payable Deferral Period

= Inventory/ Sales per Day +Receivables / Sales per day – Payables / Credit purchases per day

Ways to Improve Collections Collection Center

– speeds up collection of A/R and reduces mailing time

Electronic Funds Transfer (or Wire Transfer of Funds)– a system where payments are automatically

deducted from a bank account- Online payment systems

Lockbox System– when customers mail payment to a local post

office box instead of to the firm

Marketable SecuritiesWhen a firm has excess funds, it should be

converted from cash into interest-earning securities

Some Types of securities:Treasury bills: Short-term obligations of the governmentTreasury notes: Government obligations with a maturity of

1-10 yearsFederal agency securities: Offerings of government

organizationsCertificate of deposit: Offered by commercial banks,

savings, and other financial institutionsCommercial paper: Represents unsecured promissory

notes issued by large business organizationsBanker’s acceptances: Short-term securities that arise

from foreign trade

3 Primary Variables of Credit Policy

There are 3 things to consider in deciding whether to extend credit:– Credit Standards (5 Cs- Character, Capital,

Capacity, Conditions, Collateral) – Terms of Trade– Collection Policy

Average Collection PeriodRatio of Bad Debts to Credit SalesAging of Accounts Receivable

1-10

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

Inventory Management Inventory is divided into 3 categories:

– Raw Materials– Work in Progress (WIP) or Unfinished Goods– Finished Goods

There are 2 basic costs associated with inventory:– Carrying Costs (TCC)– Ordering Costs (TOC)

Total Inventory Costs = TCC + TOC= C (Q/2) + O (S/Q)

Where C is carrying cost per unit and O is Cost per order, S is Total sales in units, and Q is units in inventory.

Note: Q/2 is average inventory and S/Q is total # of orders

Should try to minimize Total inventory Costs

Economic Ordering Quantity

Economic Ordering Quantity (EOQ):– the optimal (best) amount for the firm to order each

time– occurs at the low point on the total cost curve– the order size where total carrying costs equal total

ordering costs (assuming no safety stock)

EOQ = (2SO/C)^.5 Where S = Total sales in units, O = ordering costs per

order, and C = Carrying Cost per unit

Safety Stock:

–“extra” inventory the firm keeps in stock in case of unforeseen problems

PPT 7-7

EOQ Model Assumes:1. All values are known with certainty and are constant

over time.

2. Inventory usage is uniform over time.

3. Carrying costs increase linearly with inventory level.

4. Ordering costs are fixed per order.

A firm may want safety stock to guard against changes in sales rates or production/shipping delays. This amount would be added to the average inventory and would increase inventory carrying costs.

Safety Stocks and Stock OutsStock out occurs when a firm is:

Out of a specific inventory itemUnable 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

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

Just-in-Time Inventory ManagementBasic requirements for JIT:

Quality production that continually satisfies customer requirements

Close ties between suppliers, manufactures, and customers

Minimization of the level of inventoryCost Savings from lower inventory:

On average, JIT has reduced inventory to sales ratio by 10% over the last decade

Advantages of JITReduction in space due to reduced

warehouse space requirementReduced construction and overhead

expenses for utilities and manpowerBetter technology with the development of

electronic data interchange systems (EDI)EDI reduces re-keying errors and duplication

of formsReduction in costs from quality controlElimination of waste

Areas of Concern for JITIntegration costsParts shortages could lead to lost sales and

slow growthUn-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