Fin M13 Working Capital Management

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SEU_FIN500_PPT_Mod13_Ch17.pptx

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Chapter 17

Cash, Receivables, and Inventory Management

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Learning Objectives

Understand the problems inherent in managing the firm’s cash balances.

Evaluate the costs and benefits associated with managing a firm’s credit policies.

Understand the financial costs and benefits of managing firm’s investment in inventory.

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MANAGING THE FIRM’S INVESTMENT IN CASH AND MARKETABLE SECURITIES

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Cash and Marketable Securities

Cash refers to currency and coins plus demand deposit accounts.

Marketable securities includes security investments the firm can quickly convert to cash balances.

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Why a Company Holds Cash

Cash Flow Process

Two typical sources of cash: external and internal

Irregular increases or decreases in the firm’s cash holdings can come from several sources such as:

Sale of securities (stocks and bonds)

Nonmarketable-debt contracts

Payment of dividend, interest, tax bills

Share repurchases

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Three Motives for Holding Cash

Transactions Motive

Balances held to meet cash needs that arise in the ordinary course of doing business.

Precautionary Motive

Precautionary balance serves as a buffer

Maintain balances to satisfy possible, but as yet unknown, needs

Speculative Motive

Cash held to take advantage of potential profit-making situations

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Cash Management Objectives and Decisions

Cash management program must minimize the firm’s risk of insolvency.

Insolvency—The situation in which the firm is unable to meet its maturing liabilities on time.

A company is technically insolvent in that it lacks the necessary liquidity to make prompt payment on its current debt obligations.

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The Trade-Off

A large cash balance will help minimize the chance of insolvency, but it penalizes the company’s profitability.

A smaller cash balance will increase the chance of insolvency, but it will free up excess cash for investment and enhance profitability.

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Cash Management Objectives

Two prime objectives:

Enough cash must be on hand to meet disbursal needs in the course of doing business.

Investment in idle cash balances must be reduced to a minimum.

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Cash Management Objectives

Two conditions would allow the firm to operate for extended periods with cash balances near or at zero:

Completely accurate forecast of net cash flows over the planning horizon.

Perfect synchronization of cash receipts and disbursements.

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Cash Management Decisions

What can be done to speed up cash collections and slow down or better control cash outflows?

What should be the composition of a marketable securities portfolio?

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Collection and Disbursement Procedures

The efficiency of firm’s cash management program can be improved by:

accelerating cash receipts

improving the methods used to disburse cash

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Speeding up Collection

What can be done to accelerate collection procedures?

Reduce float

Lockbox system

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Float and Managing Cash Inflow

Float—The time from when a check is written until the actual recipient can draw upon or use the funds:

Mail float

Processing float

Transit float

Disbursing float

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Float and Managing Cash Inflow

Mail Float

Time lapse from the moment a customer mails a remittance check until the firm begins to process it.

Processing Float

The time required for the firm to process remittance checks before they can be deposited in the bank.

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Float and Managing Cash Inflow

Transit Float

The time necessary for a deposited check to clear through the commercial banking system and become usable funds to the company.

Disbursing Float

Availability of funds in the company’s bank account during the time the payment check is clearing through the banking system.

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Lockbox Arrangement

Commercial banking service where customers mail checks to a post office box (rather than company) to expedite cash collection

The bank providing the lock box service is authorized to open the box, collect the mail, process the checks, and deposit the checks directly into the company’s account.

See Figure 17-3

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Benefits of Lockbox Arrangement

Reduces mail and processing float and can reduce transit float

Funds deposited in this manner are usually available for company use in one business day or less

Elimination of clerical functions

Early knowledge of dishonored checks

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Benefit of Float Reduction

The financial benefit of float reduction can be calculated as follows:

Sales per day × days of float reduction × assumed yield

Where:

Sales per day = Annual revenues / days in year

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Example

If a company with daily sales of $69,594,521 could invest in marketable securities to yield 6 percent annually and could eliminate 4 days of float, what would be the annual savings? = $69,594,521 * 4 * 0.06 = $16,702,685

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Managing the Cash Outflow

Goal: To increase company’s float by slowing down the disbursement and collection process through:

Zero balance accounts (ZBA)

Payable-through drafts (PTD)

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Zero Balance Accounts (ZBA)

Permit centralized control over the cash outflows while maintaining divisional disbursing authority.

Process: Establish zero balance accounts for all of the firm’s disbursing units. These accounts are all in the same concentration bank. Checks are drawn against these accounts, with the balance in each account never exceeding $0. Divisional disbursing authority is thereby maintained at the local level of managers.

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Benefits of Zero Balance Accounts

Achieves better control over its cash payments

Reduces excess cash balances held in regional banks for disbursing purposes

Increases disbursing float

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Payable-Through Drafts (PTD’s)

Legal instruments that have the physical appearance of ordinary checks but are not drawn on a bank. Instead, PTDs are drawn on and payment is authorized by the issuing firm against its demand deposit account.

Process: Field office issues drafts rather than checks to settle up payables.

Benefit: Achieves effective “control-office” control over field-authorized payments.

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Evaluating the Costs of Cash Management Services

P = (D)(S)(i)

P = per check processing cost if the system is adopted

D = days saved in the collection process or float reduction

S = average check size in dollars

i = daily, before-tax opportunity cost or rate of return of carrying cash

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The Composition of a Marketable-Securities Portfolio

The general selection criteria for proper marketable-securities mix include:

Financial risk

Interest rate risk

Liquidity

Taxability

Yields

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Financial Risk

Refers to the uncertainty of expected returns from a security attributable to possible changes in the financial capacity of the security issuer to make future payments to the security owner.

If the chance of default on the terms of the instrument is high, then the financial risk is said to be high.

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Interest Rate Risk

Interest rate risk refers to the uncertainty of expected return from a financial instrument attributable to changes in interest rates.

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Liquidity

Liquidity refers to the ability to convert a security into cash.

Should an unforeseen event require that a significant amount of cash be immediately available, then a sizable portion of the portfolio might have to be sold. Manager should prefer securities that can be sold at or near its prevailing market price.

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Taxability

The tax treatment of the income a firm receives from its security investments does not affect the ultimate mix of the marketable-securities portfolio as much as the criteria mentioned earlier since interest income from most instruments is taxable at the federal level.

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Yields

Yield is affected by previous factors of financial risk, interest rates, liquidity and taxability.

The yield criterion involves an evaluation of the risks and benefits inherent in all of these factors. For example, if a given risk is assumed, such as lack of liquidity, a higher yield may be expected on the non-liquid instrument.

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Marketable Security Alternatives

Money market securities generally have short-term maturity and are highly marketable.

Characteristics of Marketable Securities in terms of five key attributes are:

Denominations in which securities are available,

Maturities that are offered,

Basis used,

Liquidity of the instrument, and

Taxability of the investment returns

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Examples of Marketable Securities

U.S. Treasury Bills

Direct obligations of the U.S. government sold by the U.S. Treasury on a regular basis.

Federal Agency Securities

Debt obligations of corporations and agencies that have been created to effect various lending programs of the U.S. government.

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Examples of Marketable Securities

Banker’s Acceptances

Draft (order to pay) drawn on a specific bank by an exporter in order to obtain payment for goods shipped to a customer who maintains an account with that specific bank.

Negotiable Certificates of Deposit

Marketable receipt for funds that have been deposited in a bank for a fixed period.

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Examples of Marketable Securities

Commercial paper

Short-term unsecured promissory notes sold by large businesses.

Repurchase agreements

Legal contracts that involve the actual sale of securities by a borrower to the lender, with a commitment on the part of the borrower to repurchase the securities at the contract price plus a stated interest charge.

Money market mutual funds

Pooling of the funds of large number of small savers.

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MANAGING THE FIRM’S INVESTMENT IN ACCOUNTS RECEIVABLE

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Accounts Receivable Management

Accounts receivable is less liquid compared to cash and marketable securities. Account receivables typically comprise 25% of a firm’s assets.

Size of investment in accounts receivable is determined by:

The percentage of credit sales to total sales

The level of sales

Credit and collection policies

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Terms of Sale— A Decision Variable

Identify the possible discount for early payment, the discount period, and the total credit period.

They are stated in the form a/b, net c

Thus a customer can deduct a% if paid within b days, otherwise it must be paid within c days.

Example 1/10, net 45 ==> Discount of 2% if paid within 10 days; otherwise due in 45 days.

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The Type of Customer— A Decision Variable

This involves determining the type of customer who qualifies for trade credit.

Need to consider the costs of credit investigation, collection costs, default costs.

May use credit scoring or a numerical evaluation of each applicant to determine their short-run financial well-being.

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Collection Effort— A Decision Variable

The probability of default increases with the age of the account. Thus, eliminating past-due receivables is key. One common way of evaluating the situation is with ratio analysis – average collection period, ratio of receivables to assets, ratio of credit sales to receivables, ratio of bad debt to sales.

A direct tradeoff exists between collection expenses and lost goodwill on one hand and noncollection of accounts on the other.

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MANAGING THE FIRM’S INVESTMENT IN INVENTORY

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Inventory Management

Inventory management involves the control of the assets that are produced to be sold in the normal course of the firm’s operations.

The purpose of carrying inventory is to make each function of the business independent of each other function—so that delays or shutdowns in one area do not affect the production and sale of the final product.

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The Trade-Off

Risk: If inventory level is low, it is possible that there will be delays in production and customer delivery.

Return: Low inventory will reduce storage and handling costs and release funds tied up in inventory. Thus it will increase returns.

Similarly, high levels of inventory will reduce delays but increase costs.

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Types of Inventory

Raw materials inventory

Basic materials purchased to be used in the firm’s production operations

Work in process inventory

Partially finished goods requiring additional work before they become finished goods

Finished goods inventory

Goods on which production has been completed but are not yet sold

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Inventory Management Techniques

Effective inventory management is directly related to the size of the investment in inventory.

Effective management is essential to the goal of maximization of shareholder wealth.

To control the investment in inventory, management must solve two problems:

The order quantity problem

The order point problem

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The Order Quantity Problem

Involves determining the optimal order size for an inventory item given its expected usage, carrying costs, and ordering costs.

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Total Inventory Costs

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Total Inventory Costs

Economic order quantity (EOQ) attempts to determine the order size that will minimize total inventory costs.

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Assumptions of the EOQ Model

Constant or uniform demand

A constant unit price

Constant carrying costs

Constant ordering costs

Instantaneous delivery

Independent orders

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The Order Point Problem

The two most limiting assumptions in EOQ—constant demand and instantaneous delivery—are dealt with through the inclusion of safety stock.

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The Order Point Problem

Safety stock

Inventory held to accommodate any unusually large and unexpected usage during delivery time

Order point problem

The decision about how much safety stock to hold or how low the inventory should be depleted before it is ordered

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The Order Point Problem

Delivery-time stock—Inventory needed between the order date and the receipt of the inventory ordered.

The order point is reached when inventory falls to a level equal to the delivery-time stock plus the safety stock. See Figure 17-8.

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Just-in-Time Inventory System

The goal is to operate with the lowest average level of inventory possible.

Within the EOQ model, the basics are to:

Reduce ordering costs

Reduce safety stocks

This is achieved by attempts to receive continuous flow of deliveries of component parts.

The result is to actually have about 2 to 4 hours’ worth of inventory on hand.

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Inflation and EOQ

Inflation affects the EOQ model in two ways:

Anticipatory buying—buying in anticipation of a price increase to secure the goods at a lower cost.

Increased carrying costs—as inflation pushes up interest rates, the costs of carrying inventory increases. As “C” increases, the optimal EOQ declines in the EOQ model.

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Key Terms

Anticipatory buying

Cash

Credit scoring

Delivery-time stock

Finished-goods inventory

Float

Insolvency

Inventory management

Just-in-time inventory control system

Marketable securities

Order point problem

Order quantity problem

Payable-through draft (PTD)

Raw-materials inventory

Safety stock

Terms of sale

Work-in-process inventory

Zero balance accounts (ZBA)

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