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Contemporary Financial Management
Chapter 16:
Current Asset Management
© 2004 by Nelson, a division of Thomson Canada Limited
Introduction
 The first half of the chapter reviews the various
cash management decisions made by financial
managers.
 Financial managers must consider the riskreturn trade-offs characteristic of these
decisions.
 The second half of the chapter discusses the
management of accounts receivable and
inventory.
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© 2004 by Nelson, a division of Thomson Canada Limited
The Balance Sheet
Current Assets
Current Liabilities
Cash
Accounts Payable
Securities
Current Portion of LT
Debt
Accounts
Receivable
Total Current Liab
Inventory
Total Current Assets
Owner’s Equity
Fixed Assets
Total Assets
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Total Liab & OE
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Cash and Marketable Securities
 On the Balance Sheet, the most liquid assets are
listed first. These consist of cash & marketable
securities.
 Cash consists of currency and deposits in
checking accounts
 Marketable securities consist of short-term
investments made with idle cash
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Cash Management Function
 The cash management function is concerned
with determining:
 The optimal size of a firm’s liquid asset balance
 The most efficient methods of controlling the
collection and disbursement of cash
 The appropriate types and amounts of
short-term investments
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Cash Management Decisions
 Must consider the risk versus expected return
trade-offs from alternative policies
 Too little cash increases risk; too much cash
reduces return (cash is a non-earning asset)
 The safest and most liquid securities also carry
the lowest expected return
 Thus the function of the financial manager is to
find an appropriate balance between maximizing
return and minimizing risk
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Cash Management Decisions
 The financial manager must determine the
optimal size of the cash balance, recognizing:
 Holding excess liquid assets results in an
opportunity cost (liquid assets are the lowest
return assets)
 Inadequate liquid balances may result in
costs arising from:
• Missed cash discounts
• Deterioration of the firm’s credit rating
• Higher interest costs
• Risk of insolvency
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Reasons for Holding Liquid Assets
 Transactions: to ensure the firm can meet its
obligations as they come due
 Precautionary: to guard against future cash
flow shortfalls
 Speculative: to allow for potential acquisitions
or major investments
 Future requirements: to prepare for fixed and
known obligations, such as tax payments,
dividends, etc.
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Cash Budget
 The first step in cash management is the
preparation of a cash budget showing forecasted
receipts & disbursements
 The cash budget may be for a daily, weekly or
monthly cycle
 The cash budget reveals any cumulative cash
flow shortages or surpluses
 The cash budget is required because cash
inflows and outflows are seldom synchronized
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Issues in the Collection of Cash
 Management's goal
 Speed the collection of cash and/or slow the
disbursement of cash
 Float – reconciling the differences between bank
account balances and accounting records
 Methods of expediting the collection of cash
 Decentralized collection system
 Lockbox
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Float
 Positive Float
 Bank balance is greater than that shown by the
firm’s accounting records
 Negative Float
 Bank balance is less than that shown by the
firm’s accounting records
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Components of Float
 Mail Float
 delay between when a cheque is sent to a
payee and its receipt by the payee
 Processing Float
 time between receipt of payment by a payee
and the deposit of the payment in the payee’s
account
 Clearing Float
 time between depositing a cheque and having
available spendable funds
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Electronic Funds Transfer
 Electronic funds transfer mechanisms are quickly
reducing the importance of float management
techniques for many companies
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Expediting the Collection of Cash
 Decentralized collection centers – to reduce
delays due to mail, cheques are sent to local
collection centers, where they are deposited
 The firm then transfers all deposits into one
concentrator account, from which cheques are
written
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Expediting the Collection of Cash
 A Lockbox is similar to a decentralized collection
center, except a local bank empties the box,
deposits payments into the firm’s account and
makes a report of the payments.
 Lockboxes may involve significant fees
 More beneficial for small number of larger
deposits
 Evaluation involves comparison of costs versus
benefits of faster collection
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Slowing Cash Disbursements
 Zero-balance system
 Transfers cash in the exact amount required for
the cleared checks
 Drafts
 Deposit funds only after the draft is presented
for payment
 Synchronize deposits with check clearings
 Requires accurate estimates of float
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Cash Management for Small Firms
 Less-extensive access to capital markets
 Cash shortage may be more expensive to
rectify
 Many small businesses are often growing
rapidly, leading to constant cash shortages
 Small firms often have low cash balances
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Choosing Marketable Securities
 Default risk
 Lowest on T-bills
 Risk and expected return inversely related
 Marketability
 Ability to sell quickly without significant price
concession
 Maturity
 Shorter maturities have less risk of price
fluctuation
 Rate of return (lowest priority item)
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Examples of Marketable Securities
 Treasury Bills
 Short-term government note issued at a
discount with principal repaid at maturity.
 Commercial Paper
 Short-term unsecured promissory note issued
by corporations with good credit.
 Banker’s Acceptance
 Short-term promissory note issued by a firm
and accepted (or guaranteed) by a commercial
bank
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Examples of Marketable Securities
 Repurchase Agreements (Repo)
 agreement whereby a firm with excess cash
“buys” a security today with a subsequent
agreement to sell it back at a fixed price on a
future date
 difference between the purchase price and the
sale price is the interest earned during the
holding period
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© 2004 by Nelson, a division of Thomson Canada Limited
Multinational Corporation (MNC)
 Must track cash balances around the world
 Usually have centralized cash management
 Employ cash transfer facilities
 Variety of investment opportunities to improve
short-term borrowing/lending terms
 Use multilateral netting
 Cross-border transactions are netted off to
minimize costly transactions and misdirected
funds
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Accounts Receivable (A/R)
 Accounts Receivable represent a large
investment for most companies
 Extend credit when marginal returns from
extending credit exceed marginal costs
 Liberal credit policy provides extra returns in the
form of increased sales and gross profit
 Extra costs occur due to:
 Cost of funds
 Costs of credit checking
 Potential for bad debts
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Credit Policy
 Credit Standards
 Criteria used to screen credit applications
 Controls the quality of accounts to which
credit is extended
 Credit Terms
 Terms and conditions under which credit
extended must be repaid
 Collection Efforts
 Methods employed in an attempt to collect
payment on past due accounts
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Credit Terms
 Credit period
 Time allowed for payment
 Cash discount
 Allowed if payment is made within a specific
period of time
 Specified as percent of the invoiced amount
 Granted to speed up collection of A/R
 Seasonal dating
 Offered to retailers on seasonal merchandise
 Accept delivery well ahead of peak season
 Pay shortly after peak sales
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Credit Standards
 Quality
 Time a customer takes to repay
 Probability a customer will fail to repay
 Measures of quality
 Average collection period
 Bad-debt ratio
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Pretax Profits From Granting Credit
 Marginal profitability of additional sales = Profit
contribution ratio  Additional sales
 Additional investment in A/R =
Additional average daily sales  Avg. collection
period
 Cost of additional investment in A/R = Additional
investment in A/R  Pretax required return
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Pretax Profits From Granting Credit
 Additional bad-debt loss =
Bad-debt loss ratio  Additional sales
 Cost of additional investment in inventory =
Additional inventory  Pretax required return
 Net change in pretax profits =
Marginal returns – Marginal costs
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Collection Efforts
 Balance between leniency and alienating
customers
 Monitoring status
 Aging of accounts analysis
• Classifying accounts into categories according
to the number of days they are past due
• Changes in the age composition of accounts
may reveal changes in the quality of A/R
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Analysis of a Change in Credit Policy
 Increase in the credit period
 Increase the quantity of goods sold
 Liberalization of cash discount
 Increase in sales & pretax profit contribution
 Reduction in A/R balance
• Additional income from alternative investments
• Decrease in cost of funds
• Reduction in cash revenue
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Analysis of a Change in Credit Policy
 Increase in collection effort
 Reduced sales and pretax profit contribution
 Increased collection expenses
 Reduced bad-debt losses
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Evaluation of Credit Applications
 Gathering information
 How much does the analysis cost?
 Numerical scoring system
 Five Cs of credit





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Character
Capacity
Capital
Collateral
Conditions
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Inventory
 Inventory consists of raw materials, work-inprocess and finished goods
 Inventory is costly to manage and hold, as it
consumes time and requires funding, exactly
like a new machine or building
 The inventory management problem is to find
the lowest level of inventory consistent with
maximizing profits
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Types of Inventory
 Raw materials inventory
 Store of items used in the production process
 May qualify for quantity discounts
 Assure supply in times of scarcity
 Work-in-process inventory
 Items at some intermediate stage of completion
 Size related to length and complexity of
production cycle
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Types of Inventory
 Finished goods inventory
 Items ready and available for sale
 Permits prompt filling of orders
 Large production runs create economies of
scale
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Costs of an Inventory Policy
 Ordering costs: Cost of placing and receiving
an order of goods
 Carrying costs: Cost of holding inventory
 Expressed as cost per unit per period
 A percent of the inventory value per period
 Stockout costs: Incurred when a firm is unable
to



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fill an order, resulting in:
Lost sales
Rescheduling production
Expediting special orders
© 2004 by Nelson, a division of Thomson Canada Limited
Types of Inventory Control Models
 Two basic types of inventory control models
 Deterministic models – inputs are known with
certainty
• Example: Economic Order Quantity Model
 Probabilistic models – inputs are random
variables with known probability distributions
 Management should choose an inventory control
model with a cost and a complexity that is
consistent with size of the firm and value of the
inventory being managed
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Inventory Control Models
 ABC inventory classification
 A – large dollar value items but comprise a
relatively small percentage of the total number
of items held in inventory.
• Items may comprise 1- 10% of the number of
items carried but be worth 80-90% of the total
dollar value of inventory.
 B – items fall between items A & C
 C – low dollar value items but comprise a large
percentage of the total items held
 The firm will manage its inventory of A items
much more closely than its inventory of C items
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Inventory Control Models
 Economic Order Quantity (EOQ) model
 EOQ is the order quantity (Q) that minimizes
total costs.
 Using the value of Q, the optimal length of one
inventory cycle (T) can be determined.
Q* 
2SD
C
*
Q
T* 
D  365
Q = Order quantity
D = Demand for the item
S = Cost of placing and receiving an order (set-up cost)
C = Annual cost of carrying one unit of item in inventory
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Example: EOQ
 Sears sells mattresses at all stores located in the
Toronto area. The mattresses are stored in a
central warehouse. Annual demand is 3,600
mattresses, spread evenly throughout the year.
The cost of placing and receiving an order is
$31.25. The annual carrying cost is $10 (equal
to 20% of the wholesale cost of the inventory).
What is the size of the order Sears should place
with its supplier to minimize its inventory cost?
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© 2004 by Nelson, a division of Thomson Canada Limited
Solution: EOQ
Q* =

2SD
C
2 $31.25 3, 600 
$10
 150
Conclusion:
To minimize its inventory costs, Sears
should order 150 mattresses at a time.
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EOQ: Graphical Solution
Cost
($)
Total
Cost
Carrying
Cost = CQ/2
Ordering
Cost = DS/Q
Q*
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Q (Units)
Inventory Control Models
 Extensions to the basic EOQ model
 Nonzero lead time
• If a lead time is required for delivery, the order
must be placed some days in advance of a
stock-out occurring
 Probabilistic inventory control methods
• Use when input factors, such as demand, lead
times, etc are not known with certainty
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Inventory Control Models
 Just-In-Time Inventory Management System
 Inventory supplied
• At exactly the right time
• In exactly the right quantities
 Requires close coordination between
• Company
• Suppliers
 Shorten the operating cycle
 Reduce costs
 Eliminate wasteful procedures
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© 2004 by Nelson, a division of Thomson Canada Limited
Major Points
 Current assets represent a major investment for
many firms but they are often don’t receive the
management attention they deserve.
 The job of the financial manager is to find the
appropriate balance between minimizing risk
and maximizing return.
 No one method is “right” for all firms. The
method chosen will depend on firm size,
complexity and the options currently available to
it.
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© 2004 by Nelson, a division of Thomson Canada Limited