Financial Management (Current Asset Management)

Current Asset Management

 

                        Author's Overview

 

The instructor should stress the profitability-liquidity trade-offs to be found in the current asset accounts.   The student should think of the less liquid current assets as representing a competitive investment for capital.   The four different topics for discussion in the chapter are all worthy of detailed coverage.   The material on cash management has real contemporary importance and is usually of interest to the student who has struggled with his or her own cash management.  The management of accounts receivable and inventories represents an excellent opportunity to cover decision making tools that are an important part of financial management.

 

                                                            Chapter Concepts

 

*          Current asset management is an extension of concepts discussed in the previous chapter and involves the management of cash, marketable securities, accounts receivable and inventory.

 

*          Cash management involves control over the receipt and payment of cash so as to minimize nonearning cash balances.

 

*          The management of marketable securities involves selecting between various short-term investments.

 

*          Accounts receivable and inventory management require credit and inventory level decisions to be made with an eye toward profitability.

 

*          An overriding concept is that the less liquid an asset is, the higher the required return.

 

 

                                              Annotated Outline and Strategy

 

1. Cash Management

 

1. Cash is a necessary but low earning asset.

 

1. Financial managers attempt to minimize cash balances and yet maintain sufficient amounts to meet obligations in a timely manner.

 

1. The three main reasons for holding cash are for:

 

1. Transactions

2. Compensating balances

3. Precautionary needs

 

1. Temporarily, excess cash balances are transferred into interest-earning marketable securities.

 

1. The cash flow cycle can be used to describe how funds move in and out of the firm.

 

PPT 7-8          Expanded Cash Flow Cycle (Figure 7-2)

 

1. E-commerce sales impact cash flow because they typically involve credit cards. Credit card companies typically advance payment to the vendor in 7-10 days.

 

 

1. Collections and Disbursements

 

1. The financial manager attempts to get maximum use of minimum balances by speeding up inflows and slowing outflows.

 

Finance in Action: The Impact of the Internet on Working Capital Management

 

This article discusses the two major trends that will affect corporate practices and profitability. The first trend is the business-to-business (B2B) industry supply, and the second is online auction companies. These two trends will significantly reduce costs and raise industrialized countries’ growth rates about .25 percent over the next decade.

 

 

1. Playing the float: Using the difference in the cash balances shown on the bank's records and those shown on the firm's records.

 

 

 

1. The company’s books reflect a different cash balance than the bank’s books.

2. Float results because it takes time for checks to move through the mail and through the banking system.

3. The Check Clearing for the 21st Century Act allows for electronic check processing so that float is significantly reduced.

4. Tables 7-1 and 7-2 depict float for a firm with $1 million deposited (cleared on day 1 due to Check 21) and $900,000 in checks to suppliers (generating mail float)

 

PPT 7-14        Corporate Books vs. Bank Books – Day One (Table 7-1)

 

PPT 7-15        Corporate Books vs. Bank Books – Day Two (Table 7-2)

 

5. Some firms actually enjoy negative cash balances in financial statements due to float.

 

 

1. Improving collection

 

1. Decentralized collection centers speed collection of accounts receivable by reducing mailing time.

2. Wire transfer of funds-excess cash balances are transferred from collection points to a centralized location for use.

3. Lock-box system-customers mail payment to a post office box serviced by a local bank in their geographical area. Checks are cleared locally and balances transferred by wire to a central location.

 

1. Extended disbursement to take advantage of slower clearing of checks. The primary benefits of speeding up inflows or slowing outflows is the earnings generated from the freed up balances.  The benefits must be weighed against the cost.

 

1. Cost Benefit Analysis

 

1. Electronic Funds Transfer takes place through automated clearing houses and internationally, through SWIFT.

 

1. International Cash Management

 

1. Multinational firms shift funds from country to country daily, maximizing returns and balancing foreign exchange risk.

2. Difference in time zones, banking systems, culture and other differences create a non uniform system in some cases.

3. Over 7700 banks use SWIFT for standardized interbank electronic funds transfer.

 

PPT 7-19        Cash management network (Figure 7-3)

 

 

 

Perspective 7-1:  The instructor may wish to use Figure 7-3 as an example of how funds are freed up.  He or she can then apply a potential rate of return on these funds and relate that to the maximum cost that should be incurred.

 

 

III.      Marketable Securities

 

1. Because marketable securities normally represent funds held in reserve, the maturity should be kept reasonably short to avoid interest rate risk.

 

 

Perspective 7-2:  The instructor can use Table 7-3 to highlight the attributes of the various securities and instruments, stressing the ever-changing nature of the market and competition between financial institutions.  

 

 

1. There is a wide array of securities from which to choose.

 

1. Federal government securities

2. Federal agency securities

3. Nongovernment securities

 

PPT 7-24        An Examination of Yield and Maturity Characteristics (Figure 7-6)

 

 

1. Certificates of deposit

2. Commercial paper

3. Banker's acceptances

4. Eurodollar deposits

5. Savings Accounts

6. Money market funds

7. Money market deposit accounts

 

PPT 7-25        Types of Short-Term Investments (Table 7-3)

 

 

 

1. Management of Accounts Receivable

 

1. Accounts receivable as a percentage of total assets almost doubled between 1960 and the early 2000s for the typical U.S. corporation. The primary reasons for the increases have been:

 

1. Increasing sales.

2. Inflation.

3. Extended credit terms during recessions.

 

1. Accounts receivable are an investment.

 

1. Investment in accounts receivable should generate a return equal to or in excess of the return available on alternative investments.

 

Perspective 7-3: Discuss a credit decision relating the sales function to the credit created by the new accounts.   Stress that the emphasis should be on rate of return.  

 

 

1. There are three primary variables for credit policy administration.

 

1. Credit standards

 

1. The firm screens credit applicants on the basis of prior record of payment, financial stability, current net worth, and other factors.

2. 5 C’s of Credit: character, capital, capacity, conditions, collateral.

3. Dun & Bradstreet Information Services (DBIS)

(1)      Business Information Report

(2)      Commercial Credit Scoring Report

(3)      Industry Credit Score Report (See Table 7-4)

6. D-U-N-S Data Universal Number System is a unique nine digit code used globally and accepted by the United National and other international agencies as a global business identification number. See Figure 7-6.

 

PPT 7-28        Trucking Industry Credit Score Report (Table 7-4)

 

 

2. Terms of trade

 

3. Collection policy: Some measures used to assess collection efficiency are:

 

1. Average collection period.

2. Ratio of bad debts to sales.

3. Aging of accounts receivable.

 

 

1. Inventory Management

 

1. Inventory is the least liquid of current assets.

 

1. A firm's level of inventory is largely determined by the cyclicality of sales and whether it follows a seasonal or level production schedule. The production decision is based on the trade-off of cost savings of level production versus the additional inventory carrying costs.

 

1. Rapid price movements complicate the inventory level decision.

 

1. There are two basic costs associated with inventory:

 

1. Carrying costs:

 

1. Interest on funds tied up in inventory.

2. Warehouse space costs.

3. Insurance.

4. Material handling expenses.

5. Risk of obsolescence (implicit cost).

 

2. Ordering and processing costs

 

1. Carrying costs vary directly with average inventory levels.

 

1. Total carrying costs increase as the order size increases.

 

1. Total ordering costs decrease as the order size increases.

 

1. The first step toward achieving minimum inventory costs is determination of the optimal order quantity. This quantity may be derived by use of the economic order quantity formula:

 

Perspective 7-4:  Combine the EOQ formula with Figure 7-8 to clearly illustrate the impact of selecting the optimum order size.

 

 

 

 

PPT 7-36        Determining the Optimum Inventory Level (Figure 7-9)

 

1. Assumptions of the basic EOQ model:

 

1. Inventory usage is at a constant rate.

2. Order costs per order are constant.

3. Delivery time of orders is consistent and order arrives as inventory reaches zero.

 

1. Minimum total inventory costs will result if the assumptions of the model are applicable and the firm's order size equals the economic ordering quantity.

 

1. Just-in-Time Inventory Management (JIT)

 

1. Began in Japan and now used in the U.S.

2. Suppliers are located near manufactures who are able to make orders in small lot sizes because of short delivery time.

3. Lower inventory means lower costs

4. .The downside of (JIT) is that any glitch in delivery can shut down the whole production process.

 

 

Finance in Action: NASA-The National Aeronautics and Space Administration Inventory Control System

 

This box illustrates how the use of technology can save time and reduce costs. NASA, with the help of their prime contractor United Space Alliance (USA), have installed a radio frequency data communications system which can pinpoint 98 percent of the 300,000 inventory items found among 100 buildings in a matter of seconds. This system saves almost $1 billion annually by reducing the time it takes to locate equipment. 

 

 

 

                                               Other Supplements to Chapter

 

Cases for Use With Foundations of Financial Management, Modern Kitchenware Co. (cash discount)

 

Cases for Use With Foundations of Financial Management, Fresh & Fruity Foods, Inc. (current asset management).  This case can also be used after Chapter 8 in the text.