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