CHAPTER 16Current Asset Management and Financing • Investment and financing policies • Cash and marketable securities management • Receivables and inventory management • Short-term financing
Short-Term Financial Management • Short-term financial management involves all current asset accounts and most current liability accounts. • The primary goal of short-term financial management is to support operations at the lowest possible cost: • Must have sufficient current assets. • Must ensure liquidity
Current Asset Investment Policies CA ($) High Moderate Low Utilization
Current Asset Investment Policies • Factors affecting current asset levels • Level of business risk • High business risk - greater level of current assets required (safety stocks) • Low business risk - lower level of current assets required • Opportunity costs of capital • Interest rates • Market returns on investment capital
Current Asset Financing Policies • Moderate. Matches the maturity of the assets with the maturity of the financing. • Uses permanent capital to finance permanent assets. • Uses temporary financing to finance temporary assets. • Aggressive. Uses short-term financing to finance permanentassets. • Conservative. Uses permanent capital to finance temporary assets.
$ Temporary CA ST Financing: Loans Permanent CA LT Financing: Stock and Bonds Fixed Assets Years Lower dashed line, more aggressive. Higher dotted line, more conservative.
Cash Management • The goal of cash management is to hold the minimum amount necessary to meet liquidity requirements. • The primary cash management techniques are: • Cash flow synchronization • Float management • Acceleration of receipts • Disbursement control • Costs of cash management initiatives must have corresponding benefits.
Cash Flow Synchronization • The greater the timing match between a business’ cash inflows and outflows, the lower the required cash balance. • Some businesses are able to bill customers on a cycle that promotes cash flow synchronization. • The cash budget is the best method for monitoring cash management.
Float • Net float is the difference between the cash amount on the firm’s books and the amount on the bank’s books. • Suppose Family Healthcare writes $2,000 in checks daily. It takes 6 days for these to be received and clear the banking system, so its disbursement float is $12,000. • Family Healthcare receives $3,000 in checks daily which are cleared in 3 days. Thus, its collections float is $9,000. • Its net float is $12,000 - $9,000 = $3,000.
Acceleration of Receipts • Net float is maximized by accelerating receipts and slowing disbursements. • Some techniques used for receipt acceleration are: • Lockboxes • Concentration banking • Automated clearinghouses • Federal Reserve wire system
Disbursement Control • Disbursement control is the “flip side” of receipt acceleration. • Some techniques used for disburse-ment control are: • Payables centralization • Master and zero-balance accounts • Controlled (remote) disbursement
Marketable Securities Management • Businesses hold marketable securities for two primary reasons: • As an interest earning substitute for cash. • As a temporary repository for cash being accumulated to meet a specific need. • In reality, cash management and marketable securities management are accomplished simultaneously.
Marketable Securities (Cont.) • Characteristics of marketable securities • In general, marketable securities are chosen on the basis of safety: • Protection of principal is primary. • Amount of return is secondary. • Specific securities used depend on the: • Expected holding period. • Size of the business.
Receivables Management • Importance of receivables management to HSO’s (third party predominance) • Financing of A/R with short-term debt vs. equity (cost of capital issues) • Goal of A/R mgmt. is to minimize the carrying costs • Acceleration of A/R receipts
Receivables Management • Monitoring A/R position • Factors affecting A/R balance -- credit sales volume and avg. collection period (ACP) • ACP = Avg. A/R balance divided by average daily credit sales • Comparison of ACP to historical/industry • Limitations of using ACP to monitor A/R position (influence of sales volume)
Receivables Management • Monitoring A/R position • Aging schedules of A/R accounts • Influence of sales volume changes on average age of A/R accounts • Uncollected A/R balance schedule -- factors out influence of fluctuations in sales volume on A/R balance and ACP • Interpretation of uncollected A/R balance schedule
Receivables Management • Management interventions to improve A/R position • Reasonably aggressive collections policy • “Early payment” discounts • Electronic billing/payment methods
Inventory Management • Relationship to receivables management • Consequences of poor inventory mgmt. • Too little inventory (stockouts) • Too much inventory (tied up cash) • Inventory management methods • Computerized inventory control systems • Just in time inventory methods
Inventory Management • Inventory Management Methods • Economic Ordering Quantity (EOQ) model • Minimize the costs of holding inventory • Total inventory costs as a function of inventory carrying costs and inventory ordering costs • Does not consider the cost of the inventory • Allow for identification of optimal “ordering quantity” per order to minimize costs (ICC, IOC)
Inventory Management • Inventory Management Methods • Economic Ordering Quantity (EOQ) model • Examples of ICC (storage, insurance, financing) • Estimation of ICC as a percentage of total inventory purchase (10-20%) • Relationship of ICC to total inventory purchases
Inventory Management • Inventory Management Methods • Economic Ordering Quantity (EOQ) model • Fixed nature of IOC assumed • Examples of IOC (costs of ordering) • Estimation of IOC as a function of average inventory purchases • Relationship of IOC to total inventory purchases
Inventory Management • Inventory Management Methods • Economic Ordering Quantity (EOQ) model • Total inventory holding costs (TIC) = ICC + IOC • Estimation of EOQ using formula • Interpretation of EOQ • Equivalence of ICC and IOC at EOQ • Minimization of TIC at EOQ • Application of EOQ model -- reorder points, safety stock estimation, quantity discounts
Current Liability Management • Current liabilities as source of WC • Short-term financing has three primary advantages over long-term: • Lower issuance costs • Fewer restrictive covenants • Generally lower interest rate • Major sources for providers: • Accruals • Accounts payable (trade credit) • Bank loans
Accruals • Accruals consist primarily of wages owed to employees and taxes owed to governments. • Accruals are free in the sense that no explicit interest is charged. • However, managers have little control over the level of accruals, which is influenced more by industry custom and tax laws. • Management of accrual accounts (source of short-term financing)
Accounts Payable (Trade Credit) • Trade credit is credit furnished by a firm’s suppliers. • Trade credit is often the largest source of short-term credit for most firms. • Categories of trade credit • Free trade credit • Costly trade credit
Northwest Healthcare buys $3,000,000 (at net) of medical supplies from one of its vendors on terms of 2/10, net 30. How much free and costly trade credit is available from this vendor? Net daily purchases = $3,000,000/360 = $8,333. Calculate net daily purchases
Gross/Net Breakdown • Northwest buys supplies worth$3,000,000 because that is the net, or cash, price. • If Northwest does not take the discount, it must pay $3M / 0.98 = $3,061,224 for the supplies. This is the gross, or invoice, price. • The difference, $61,224, is a financing cost similar to the interest on a loan.
Gross/Net Breakdown Payables level with discount Payables = $8,333 x 10 = $83,333. Payables level without discount Payables = $8,333 x 30 = $249,990. Credit breakdown Total trade credit = $249,990 Free trade credit = 83,333 Costly trade credit = $166,657
Approximate Cost ofCostly Trade Credit Northwest loses $61,224 to obtain $166,657 in extra trade credit, so $61,224 Cost = = 0.367 = 36.7%. $166,657
Approximate Cost Formula Discount % 360 Cost = x Days taken Discount period 1 - Discount % - 2 360 = x= 0.0204 x 18 98 30 - 10 = 0.367 = 36.7%.
What Should Northwest Do? • Northwest should take the $83,333 in free trade credit--it should take all the free trade credit that it can get. • However, it should take the costly trade credit only if the implied cost is less than the cost of alternative financing sources. • Because Northwest can obtain bank loans at a 10% rate, it should not take the $166,657 in costly trade credit.