© 2003 McGraw-Hill Ryerson Limited

77Chapt

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Chapt

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Current Asset ManagementCurrent Asset Management

McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited

Prepared by:Terry FegartySeneca College

Revised by:P Chua

© 2003 McGraw-Hill Ryerson Limited

Chapter 7 - Outline

What is Current Asset Management?Cash Management (including Marketable Securities)

Optimum Level of CashUse of FloatWays to Improve CollectionsWays to Extend DisbursementsShort-term Investments

Accounts Receivable Management3 Primary Variables of Credit PolicyThe 4 C’s of Credit

Inventory ManagementEconomic Ordering QuantityJust-In-Time Inventory Systems

Summary and Conclusions

PPT 7-2

© 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

© 2003 McGraw-Hill Ryerson Limited

Cash Management

Goal is to maintain optimum level of cashThis goal can be achieved by:

Manage float efficientlySpeed up collectionsSlow down disbursementsInvest in Marketable Securities

PPT 7-4

© 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

© 2003 McGraw-Hill Ryerson Limited

Federal government securities:Treasury bills ъ 91days $1,000 Excellent Excellent 13.13%

1.91%Treasury bills 182 1,000 Excellent Excellent 13.25 1.97

Provincial government securitiesTreasury bills 91 25,000 Excellent Excellent 13.18 1.95

Nongovernment securities:Term deposits (large) 90 100,000 Good None† 12.75 1.45Term deposits (small) 90 5,000 Good None† 10.00 1.35Commercial paper 90 100,000 Good Fair 13.33 2.04Bankers’ acceptances 90 25,000 Good Good 13.27 2.05Eurodollar deposits (bid) 90 25,000 Good Excellent 12.81 2.11LIBOR (London Interbank Offered Rate) 90 100,000 Good Excellent 12.94 2.14Savings accounts Open None Excellent None† 8.75 .10-

1.00 Bank swap deposits 90 100,000 Excellent None13.23 1.98

Money market deposits (financial institutions) Open 500 Excellent None 10.15 1.00-

1.75 Overnight (call) money 1 day 100,000 ExcellentExcellent

— 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 millionъ In the summer of 1981, 91-day Treasury Bills offered yields in excess of 20%

Table 7-3Types of short-term investments

Yield YieldMinimum Mar. 22, Jan. 3,

Maturity* Amount Safety Marketability 1990‡ 2002

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© 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.

© 2003 McGraw-Hill Ryerson Limited

Table 7-1The use of float to provide funds

Bank Books (usable funds)Corporate Books (amounts actually cleared)

Initial amount $ 100,000 $ 100,000Deposits + 1,000,000 + 800,000Cheques – 900,000 – 400,000

Balance + $ 200,000 + $ 500,000

+ $300,000 float

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© 2003 McGraw-Hill Ryerson Limited

Table 7-2Playing the float

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Bank Books (usable funds)Corporate Books (amounts actually cleared)

Initial amount $ 100,000 $ 100,000Deposits + 1,000,000 + 800,000Cheques – 1,200,000 – 800,000

Balance – $ 100,000 + $ 100,000

+ $200,000 float

* Assumed to remain the same as in Table 7-1.

* *

© 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

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© 2003 McGraw-Hill Ryerson Limited

Figure 7-1Cash management network

LocalOffice

LocalOffice

LocalOffice

LocalOffice

Local Office

Local Office

LocalOffice

LocalOffice

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 remittancetime – 1.5 days

Increase disbursementtime – 1 day

2.5 days freed-upcash balance

2.5 days freed-up cash balance$2 million – average cash movement per day$5 million available funds

Distantdisbursement centre

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© 2003 McGraw-Hill Ryerson Limited

Ways to Extend Disbursements

Mail cheques from remote locations Pay bills beyond the net terms if this is acceptable

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© 2003 McGraw-Hill Ryerson Limited

Accounts Receivable ManagementThe 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

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© 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

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© 2003 McGraw-Hill Ryerson Limited

Table 7-4Dun & Bradstreet credit rating system

Key to RatingsComposite Credit Appraisal

Estimated Financial Strength High Good Fair Limited

5A . . . Over $50,000,000 1 2 3 44A . . . $10,000,000 to 50,000,000 1 2 3 43A . . . 1,000,000 to 10,000,000 1 2 3 42A . . . 750,000 to 1,000,000 1 2 3 41a . . . 500,000 to 750,000 1 2 3 4BA . . . 300,000 to 500,000 1 2 3 4BB . . . 200,000 to 300,000 1 2 3 4CB . . . 125,000 to 200,000 1 2 3 4CC . . 75,000 to 125,000 1 2 3 4DC . . 50,000 to 75,000 1 2 3 4DD . . 35,000 to 50,000 1 2 3 4EE . . 20,000 to 35,000 1 2 3 4FF . . 10,000 to 20,000 1 2 3 4GG . . 5,000 to 10,000 1 2 3 4HH . . Up to 5,000 1 2 3 4

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© 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.

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© 2003 McGraw-Hill Ryerson Limited

Figure 7-4Determining the optimum inventory level

Cost of ordering and carrying inventory ($)

40

80

400

M

Carrying costs

Order size (units)

Ordering costs

Total costs

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© 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)

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© 2003 McGraw-Hill Ryerson Limited

EOQ Calculation

Economic Order Quantity is computed by:

whereS = usage in units per periodO = order cost per orderC = carrying cost per unit per periodQ = 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.

C

OSEOQ

2

© 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 orderC = carrying cost per unit per periodQ = order quantity in units

Average Inventory = EOQ/2

2

CQ

Q

SOTC

© 2003 McGraw-Hill Ryerson Limited

Safety StockDesigned 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 serviceAv inventory (with safety stock) = EOQ/ 2 + safety stockCarrying costs = Ave Inventory (units) x carrying costs per unit

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© 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 systemsQuality control programs

© 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

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