1. © 2003 McGraw-Hill Ryerson Limited 7 7 Chapter Current Asset Management McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca College Revised by: P Chua

2. © 2003 McGraw-Hill Ryerson Limited Chapter 7 - Outline  What is Current Asset Management?  Cash Management (including Marketable Securities)  Optimum Level of Cash  Use of Float  Ways to Improve Collections  Ways to Extend Disbursements  Short-term Investments  Accounts Receivable Management  3 Primary Variables of Credit Policy  The 4 C’s of Credit  Inventory Management  Economic Ordering Quantity  Just-In-Time Inventory Systems  Summary and Conclusions PPT 7-2

3. © 2003 McGraw-Hill Ryerson Limited What is Current Asset Management?  Current asset management involves managing the individual CA accounts: Cash/Marketable Securities, Accounts Receivable and Inventory.  Its goal is to achieve a balance between liquidity and profitability that contributes positively to the firm’s value.  A financial manager needs to remember that the less liquid an asset is, the higher the required return, but it is also more risky, that is, the chances of not being able to pay short-term dues is greater. PPT 7-3

4. © 2003 McGraw-Hill Ryerson Limited Cash Management  Goal is to maintain optimum level of cash  This goal can be achieved by:  Manage float efficiently  Speed up collections  Slow down disbursements  Invest in Marketable Securities PPT 7-4

5. © 2003 McGraw-Hill Ryerson Limited Optimum Level of Cash  Cash is non-earning CA item but necessary to maintain liquidity.  Maintain optimum cash level based on transaction and compensating requirements, cash flow projection, borrowing needs.  Invest excess cash in Marketable Securities for precautionary purposes.  Savings accounts  Money market funds  Term deposits  Treasury bills

6. © 2003 McGraw-Hill Ryerson Limited Federal government securities: Treasury bills ъ 91days$1,000ExcellentExcellent13.13% 1.91% Treasury bills1821,000ExcellentExcellent13.25 1.97 Provincial government securities Treasury bills 9125,000ExcellentExcellent13.18 1.95 Nongovernment securities: Term deposits (large) 90100,000GoodNone†12.75 1.45 Term deposits (small) 905,000GoodNone†10.00 1.35 Commercial paper 90100,000GoodFair13.33 2.04 Bankers’ acceptances 9025,000GoodGood13.27 2.05 Eurodollar deposits (bid) 9025,000GoodExcellent12.81 2.11 LIBOR (London Interbank Offered Rate) 90100,000GoodExcellent12.94 2.14 Savings accountsOpen NoneExcellentNone†8.75.10-1.00 Bank swap deposits 90100,000Excellent None13.23 1.98 Money market deposits (financial institutions)Open500ExcellentNone 10.15 1.00-1.75 Overnight (call) money 1 day100,000ExcellentExcellent — 2.24 * Many of these securities can be purchased with different maturities than those indicated. † Though not marketable, these investments are highly liquid and can often be withdrawn without penalty. ‡ Quoted yields are often for wholesale amounts above $1 million ъ In the summer of 1981, 91-day Treasury Bills offered yields in excess of 20% Table 7-3 Types of short-term investments Yield MinimumMar. 22,Jan. 3, Maturity*AmountSafetyMarketability1990‡2002 PPT 7-12

7. © 2003 McGraw-Hill Ryerson Limited Manage Float  Float refers to funds that have been sent by the payer but are not yet usable funds to the payee. Types of Float  Mail Float: time between placing payment in mail and when it is received.  Processing Float: time between receipt of payment and deposit in firm’s account.  Clearing Float: time between deposit of payment and when spendable funds become available.

8. © 2003 McGraw-Hill Ryerson Limited Table 7-1 The use of float to provide funds Bank Books (usable funds) Corporate Books(amounts actually cleared) Initial amount$ 100,000$ 100,000 Deposits+ 1,000,000+ 800,000 Cheques– 900,000– 400,000 Balance+ $ 200,000+ $ 500,000 + $300,000 float PPT 7-6

9. © 2003 McGraw-Hill Ryerson Limited Table 7-2 Playing the float PPT 7-7 Bank Books (usable funds) Corporate Books(amounts actually cleared) Initial amount$ 100,000$ 100,000 Deposits + 1,000,000+ 800,000 Cheques– 1,200,000– 800,000 Balance– $ 100,000+ $ 100,000 + $200,000 float * Assumed to remain the same as in Table 7-1. **

10. © 2003 McGraw-Hill Ryerson Limited Ways to Improve Collections  Can be achieved by timely processing and deposit of cheques received through:  Decentralization of collection by establishing  Regional Collection Centres  speeds up collection of A/R and reduces mailing time  Lockbox System  when customers mail payment to a local post office box instead of to the company headquarters  Electronic Funds Transfer / Electronic Data Interchange  EFT is the exchange of payments and information between companies’ computers  Example is the Use of debit cards (Interac) and preauthorized cheques  a system where payments are automatically deducted from a bank account PPT 7-8

11. © 2003 McGraw-Hill Ryerson Limited Figure 7-1 Cash management network Local Office Local Office Local Office Local Office Local Office Local Office Local Office Local Office Local Office Local Office Local bank branch Local bank branch Local bank branch Local bank branch Local bank branch Central bank account Corporate headquarters Central bank account Corporate headquarters Reduce remittance time – 1.5 days Increase disbursement time – 1 day 2.5 days freed-up cash balance 2.5 days freed-up cash balance $2 million – average cash movement per day $5 million available funds Distant disbursement centre PPT 7-10

12. © 2003 McGraw-Hill Ryerson Limited Ways to Extend Disbursements  Mail cheques from remote locations  Pay bills beyond the net terms if this is acceptable PPT 7-9

13. © 2003 McGraw-Hill Ryerson Limited Accounts Receivable Management The objective for managing accounts receivable is to collect accounts receivable quickly without losing sales. 3 Primary Variables of Credit Policy Administration: Credit Standards  determine credit rating of customers  4 C’s of credit  credit agencies, bureaus Terms of Trade  ex.; 2% / 10days / net 30 days Collection Policy  Average Collection Period  Ratio of Bad Debts to Credit Sales  Aging of Accounts Receivable PPT 7-13

14. © 2003 McGraw-Hill Ryerson Limited Customer Credit Profile - The 4 C’s CHARACTER - willingness to pay  Supplier, legal, union problems?  Willing to provide information? CAPACITY - ability to pay  Past & future profits?  Good management? CAPITAL - net worth  Growing assets? Low debt? CONDITIONS - state of industry,economy  Impact on customer  How customer adapts PPT 7-15

15. © 2003 McGraw-Hill Ryerson Limited Table 7-4 Dun & Bradstreet credit rating system PPT 7-16

16. © 2003 McGraw-Hill Ryerson Limited Inventory Management Optimum level of inventory will satisfy customer demand / production requirements while minimizing inventory costs Inventory can be:  Raw Materials  Work in Progress (WIP) or Unfinished Goods  Finished Goods There are 2 basic costs associated with inventory:  Ordering Costs - may include purchasing, computer, receiving cost, etc.  Carrying Costs - may include storage, insurance, obsolescence costs, etc. PPT 7-17

17. © 2003 McGraw-Hill Ryerson Limited Figure 7-4 Determining the optimum inventory level Cost of ordering and carrying inventory ($) 40 80 400 M Carrying costs Order size (units) Ordering costs Total costs PPT 7-20

18. © 2003 McGraw-Hill Ryerson Limited 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) PPT 7-22

19. © 2003 McGraw-Hill Ryerson Limited EOQ Calculation Economic Order Quantity is computed by: where S = usage in units per period O = order cost per order C = carrying cost per unit per period Q = order quantity in units Assumptions of the basic EOQ model:  Inventory usage is at a constant rate.  Order costs per order are constant.  Delivery time of orders is consistent and order arrives as inventory reaches zero.

20. © 2003 McGraw-Hill Ryerson Limited Total Inventory cost Total Inventory cost is given by the following formula: Where S = usage in units per period O = order cost per order C = carrying cost per unit per period Q = order quantity in units Average Inventory = EOQ/2

21. © 2003 McGraw-Hill Ryerson Limited Safety Stock  Designed to minimize stockouts  “Extra” inventory the firm keeps in stock in case of unforeseen problems  Management decision based on risk of stockout, desired level of service  Av inventory (with safety stock) = EOQ/ 2 + safety stock  Carrying costs = Ave Inventory (units) x carrying costs per unit PPT 7-23

22. © 2003 McGraw-Hill Ryerson Limited Just-In-Time Inventory Systems  Goal of JIT is manufacturing efficiency.  Inventory management technique that minimizes inventory investment by having materials arrive at exactly the time they are needed for production.  Extensive coordination between suppliers, shippers and production line is required.  Computerized order and inventory systems  Quality control programs

23. © 2003 McGraw-Hill Ryerson Limited Summary and Conclusions  Current assets include cash (the most liquid), short-term investments, accounts receivable, and inventory (the least liquid)  We manage cash by making timely collections and disbursements, and investing any temporary surpluses of cash in marketable securities  We manage accounts receivable by applying credit standards, credit terms and collection procedures  We manage inventory using such techniques as the economic ordering quantity and the just-in-time model PPT7-25