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Chapter 07
• Current Asset Management
By Md. Shahedur Rahaman
Chowdhury
7-1
Chapter Outline
• What is current asset management• Cash management and its importance• Management of marketable securities• Accounts receivable and inventory
management• Inventory management and policy decisions
required• Liquidity vis-à-vis returns
7-2
7-3
Cash Management
• Financial managers actively attempt to keep cash (non-earning asset) to a minimum– It is critical to have sufficient cash to assuage
emergencies– Steps to improve overall profitability of a firm:
• Minimize cash balances• Have accurate knowledge of when cash moves in and
out of the firm
7-4
Reasons for Holding Cash Balances
• Transactions balances– Payments towards planned expenses
• Compensative balances for banks– Compensate a bank for services provided rather
than paying directly for them• Precautionary needs
– Emergency purposes
7-5
Cash Flow Cycle
• Ensure that cash inflows and outflows are synchronized for transaction purposes– Cash budgets is a tool used to track cash flows
and ensuing balances• Cash flow relies on:
– Payment pattern of customers– Speed at which suppliers and creditors process
checks– Efficiency of the banking system
7-6
Cash Flow Cycle (cont’d)• Cash inflows are driven by sales and influenced
by: – Type of customers– Customers’ geographical location– Product being sold– Industry
• When the cash balance increases, the extra cash can be – Used for various payments to lenders, stockholders, government,
etc– Used to invest in marketable securities
• When there is a need for cash a firm can:– Sell the marketable securities– Borrow funds from short-term lenders
7-7
Expanded Cash Flow Cycle
7-8
E-commerce and Sales
• Benefits: faster cash flow – Credit card companies advance cash to the
retailer within 7–10 days against retailer’s with a 30 day payment terms
• Financial managers must pay close attention to the percentage of sales generated:– By cash– By outside credit cards– By the company’s own credit cards
7-9
Float
• Difference between firm’s recorded amount and amount credited to the firm by a bank
• Two types of float:– Mail float: Arises duet to the time it takes to deliver a check.– Clearing float: Arises due to the time it takes to clear a check once
the payment is made
• Both these floats do not exist anymore due to:– Electronic payments – Check Clearing for the 21st Century Act
• Check Clearing for the 21st Century Act (Check 21) – Allows banks and others to electronically process a check
7-10
Improving Collections and Extending Disbursements
• Improving collection: – Setting up multiple collection centers at different
locations– Adopt lockbox system for expeditious check clearance at
lower costs
• Extending disbursement:– General trend:
• Speedup processing of incoming checks• Slow down payment procedures
– Extended disbursement float – allows companies to hold onto their cash balances for as long as possible
7-11
Cost-Benefit Analysis
• Allows companies to analyze the benefits, received by investing on an efficiently maintained cash management program
7-12
Cash Management Network
7-13
Electronic Funds Transfer• Funds are moved between computer terminals
without the use of a ‘check’– Automated clearinghouses (ACH): Transfers information between
financial institutions and between accounts using computer tape
• International fund transfer is carried out through SWIFT (Society for Worldwide Interbank Financial Telecommunications)– Uses a proprietary secure messaging system– Each message is encrypted– Every money transaction is authenticated by a code, using smart
card technology– Assumes financial liability for the accuracy, completeness, and
confidentiality of transaction
7-14
International Cash Management
• Factors differentiating international cash management from domestic based systems:– Differing payment methods and/or higher popularity
of electronic funds transfer– Subject to international boundaries, time zone
differences, currency fluctuations, and interest rate changes
– Differing banking systems and check clearing processes
– Differing account balance management and information reporting systems
– Cultural, tax, and accounting differences
7-15
International Cash Management (cont’d)
• Financial managers try to keep as much cash as possible in a country with a strong currency and vice versa
• Sweep account: – Allows companies to maintain zero balances– Excess cash is swept into an interest-earning
account
7-16
An Examination of Yield and Maturity Characteristics
• Marketable securities
7-17
Marketable Securities
• When a firm has excess funds, it should be converted from cash into interest-earning securities
• Types of securities:– Treasury bills: Short-term obligations of the government– Treasury notes: Government obligations with a maturity of 1-10
years– Federal agency securities: Offerings of government organizations– Certificate of deposit: Offered by commercial banks, savings, and
other financial institutions– Commercial paper: Represents unsecured promissory notes
issued by large business organizations– Banker’s acceptances: Short-term securities that arise from
foreign trade
7-18
Management of Accounts Receivable
• Accounts receivable as an investment– Should be based on the level of return earned
equals or exceeds the potential gain from other investments
• Credit policy administration – Credit standards– Terms of trade– Collection policy
7-19
Types of Short-Term Investments
7-20
Credit Standards
• Determine the nature of credit risk based on:– Prior records of payment and financial stability,
current net worth, and other related factors• 5 Cs of credit:
– Character– Capital– Capacity– Conditions– Collateral
7-21
Credit Standards (cont’d)
• Dun & Bradstreet Information Services (DBIS):– Produces business information analysis tools– Publishes reference books– Provides computer access to information– The Data Universal Number System (D-U-N-S)
is a unique nine-digit code assigned by DBIS to each business in its information base
7-22
Dun & Bradstreet Report – An Example
7-23
Terms of Trade
• Stated term of credit extension:– Has a strong impact on the eventual size of
accounts receivable balance– Creates a need for firms to consider the use of
cash discounts
7-24
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
7-25
An Actual Credit Decision
Accounts receivable = Sales = $10,000 = $1,667 Turnover 6
• Brings together various elements of accounts receivable management
7-26
Inventory Management
• Inventory has three basic categories:– Raw materials– Work in progress– Finished goods
• Amount of inventory is affected by sales, production, and economic conditions
• Inventory is the least of liquid assets – should provide the highest yield
7-27
Level versus Seasonal Production
• Level production– Maximum efficiency in manpower and
machinery usage– May result in high inventory buildup
• Seasonal production– Eliminates inventory buildup problems– May result in unused capacity during slack
periods– May result in overtime labor charges and
overused equipment repair charges
7-28
Inventory Policy in Inflation (and Deflation)
• Inventory position can be protected in an environment of price instability by:– Taking moderate inventory positions– Hedging with a futures contract to sell at a
stipulated price some months from now• Rapid price movements in inventory may
also have a major impact on the reported income of the firm
7-29
The Inventory Decision Model
• Carrying costs– Interest on funds tied up in inventory– Cost of warehouse space, insurance premiums,
and material handling expenses– Implicit cost associated with the risk of
obsolescence and perish-ability • Ordering costs
– Cost of ordering– Cost of processing inventory into stock
7-30
Determining the Optimum Inventory Level
7-31
Economic Ordering Quantity
EOQ = 2SO ; C
Where,S = Total sales in unitsO = Ordering cost for each orderC = Carrying cost per unit in dollarsAssuming:
EOQ = 2SO = 2 X 2,000 X $8U = $32,000 = 160,000 C $0.20 $0.20
= 400 units
7-32
Safety Stocks and Stock Outs
• Stock out occurs when a firm is:– Out of a specific inventory item– Unable 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
7-33
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
7-34
Just-in-Time Inventory Management
• Basic requirements for JIT:– Quality production that continually satisfies
customer requirements– Close ties between suppliers, manufactures, and
customers– Minimization of the level of inventory
• Cost Savings from lower inventory:– On average, JIT has reduced inventory to sales
ratio by 10% over the last decade
7-35
Advantages of JIT
• Reduction in space due to reduced warehouse space requirement
• Reduced construction and overhead expenses for utilities and manpower
• Better technology with the development of electronic data interchange systems (EDI)– EDI reduces re-keying errors and duplication of
forms• Reduction in costs from quality control• Elimination of waste
7-36
Areas of Concern for JIT
• Integration costs• Parts shortages could lead to lost sales and
slow growth– Un-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
Q
End
7-37
Q & A
7-38
Thank You.
7-39