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16 - 1 CHAPTER 16 Current Asset Management and Financing n Investment and financing 16 - 1 CHAPTER 16 Current Asset Management and Financing n Investment and financing policies n Cash and marketable securities management n Receivables and inventory management n Short-term financing Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 2 Short-Term Financial Management n Short-term financial management involves all current asset 16 - 2 Short-Term Financial Management n Short-term financial management involves all current asset accounts and most current liability accounts. n The primary goal of short-term financial management is to support operations at the lowest possible cost: l Must have sufficient current assets. l Must ensure liquidity Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 3 Current Asset Investment Policies CA ($) High Moderate Low Utilization Copyright 16 - 3 Current Asset Investment Policies CA ($) High Moderate Low Utilization Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 4 Current Asset Investment Policies n Factors affecting current asset levels l 16 - 4 Current Asset Investment Policies n Factors affecting current asset levels l Level of business risk • High business risk - greater level of current assets required (safety stocks) • Low business risk - lower level of current assets required l Opportunity costs of capital • Interest rates • Market returns on investment capital Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 5 Current Asset Financing Policies n Moderate. Matches the maturity of the 16 - 5 Current Asset Financing Policies n Moderate. Matches the maturity of the assets with the maturity of the financing. l Uses permanent capital to finance permanent assets. l Uses temporary financing to finance temporary assets. n Aggressive. Uses short-term financing to finance permanent assets. n Conservative. Uses permanent capital to finance temporary assets. Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 6 $ Temporary CA ST Financing: Loans Permanent CA LT Financing: Stock 16 - 6 $ 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. Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 7 Cash Management n The goal of cash management is to hold 16 - 7 Cash Management n The goal of cash management is to hold the minimum amount necessary to meet liquidity requirements. n The primary cash management techniques are: l Cash flow synchronization l Float management • Acceleration of receipts • Disbursement control n Costs of cash management initiatives must have corresponding benefits. Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 8 Cash Flow Synchronization n The greater the timing match between a 16 - 8 Cash Flow Synchronization n The greater the timing match between a business’ cash inflows and outflows, the lower the required cash balance. n Some businesses are able to bill customers on a cycle that promotes cash flow synchronization. n The cash budget is the best method for monitoring cash management. Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 9 Float n Net float is the difference between the cash amount 16 - 9 Float n Net float is the difference between the cash amount on the firm’s books and the amount on the bank’s books. l 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. l Family Healthcare receives $3, 000 in checks daily which are cleared in 3 days. Thus, its collections float is $9, 000. n Its net float is $12, 000 - $9, 000 = $3, 000. Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 10 Acceleration of Receipts n Net float is maximized by accelerating receipts 16 - 10 Acceleration of Receipts n Net float is maximized by accelerating receipts and slowing disbursements. n Some techniques used for receipt acceleration are: l Lockboxes l Concentration banking l Automated clearinghouses l Federal Reserve wire system Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 11 Disbursement Control n Disbursement control is the “flip side” of receipt 16 - 11 Disbursement Control n Disbursement control is the “flip side” of receipt acceleration. n Some techniques used for disbursement control are: l Payables centralization l Master and zero-balance accounts l Controlled (remote) disbursement Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 12 Marketable Securities Management n Businesses hold marketable securities for two primary 16 - 12 Marketable Securities Management n Businesses hold marketable securities for two primary reasons: l As an interest earning substitute for cash. l As a temporary repository for cash being accumulated to meet a specific need. n In reality, cash management and marketable securities management are accomplished simultaneously. Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 13 Marketable Securities (Cont. ) n Characteristics of marketable securities n In 16 - 13 Marketable Securities (Cont. ) n Characteristics of marketable securities n In general, marketable securities are chosen on the basis of safety: l Protection of principal is primary. l Amount of return is secondary. n Specific securities used depend on the: l Expected holding period. l Size of the business. Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 14 Receivables Management n Importance of receivables management to HSO’s (third party 16 - 14 Receivables Management n Importance of receivables management to HSO’s (third party predominance) n Financing of A/R with short-term debt vs. equity (cost of capital issues) n Goal of A/R mgmt. is to minimize the carrying costs n Acceleration of A/R receipts Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 15 Receivables Management n Monitoring A/R position l Factors affecting A/R balance 16 - 15 Receivables Management n Monitoring A/R position l Factors affecting A/R balance -- credit sales volume and avg. collection period (ACP) l ACP = Avg. A/R balance divided by average daily credit sales l Comparison of ACP to historical/industry l Limitations of using ACP to monitor A/R position (influence of sales volume) Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 16 Receivables Management n Monitoring A/R position l Aging schedules of A/R 16 - 16 Receivables Management n Monitoring A/R position l Aging schedules of A/R accounts l Influence of sales volume changes on average of A/R accounts l Uncollected A/R balance schedule -factors out influence of fluctuations in sales volume on A/R balance and ACP l Interpretation of uncollected A/R balance schedule Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 17 Receivables Management n Management interventions to improve A/R position l Reasonably 16 - 17 Receivables Management n Management interventions to improve A/R position l Reasonably aggressive collections policy l “Early payment” discounts l Electronic billing/payment methods Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 18 Inventory Management n Relationship to receivables management n Consequences of poor 16 - 18 Inventory Management n Relationship to receivables management n Consequences of poor inventory mgmt. l Too little inventory (stockouts) l Too much inventory (tied up cash) n Inventory management methods l Computerized inventory control systems l Just in time inventory methods Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 19 Inventory Management n Inventory Management Methods l Economic Ordering Quantity (EOQ) 16 - 19 Inventory Management n Inventory Management Methods l 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) Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 20 Inventory Management n Inventory Management Methods l Economic Ordering Quantity (EOQ) 16 - 20 Inventory Management n Inventory Management Methods l 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 Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 21 Inventory Management n Inventory Management Methods l Economic Ordering Quantity (EOQ) 16 - 21 Inventory Management n Inventory Management Methods l 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 Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 22 Inventory Management n Inventory Management Methods l Economic Ordering Quantity (EOQ) 16 - 22 Inventory Management n Inventory Management Methods l 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 Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 23 Current Liability Management n Current liabilities as source of WC n 16 - 23 Current Liability Management n Current liabilities as source of WC n Short-term financing has three primary advantages over long-term: l Lower issuance costs l Fewer restrictive covenants l Generally lower interest rate n Major sources for providers: l Accruals l Accounts payable (trade credit) l Bank loans Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 24 Accruals n Accruals consist primarily of wages owed to employees and 16 - 24 Accruals n Accruals consist primarily of wages owed to employees and taxes owed to governments. n Accruals are free in the sense that no explicit interest is charged. n However, managers have little control over the level of accruals, which is influenced more by industry custom and tax laws. n Management of accrual accounts (source of short-term financing) Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 25 Accounts Payable (Trade Credit) n Trade credit is credit furnished by 16 - 25 Accounts Payable (Trade Credit) n Trade credit is credit furnished by a firm’s suppliers. n Trade credit is often the largest source of short-term credit for most firms. n Categories of trade credit l Free trade credit l Costly trade credit Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 26 Northwest Healthcare buys $3, 000 (at net) of medical supplies from 16 - 26 Northwest Healthcare buys $3, 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? Calculate net daily purchases Net daily purchases = $3, 000/360 = $8, 333. Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 27 Gross/Net Breakdown n Northwest buys supplies worth $3, 000 because that 16 - 27 Gross/Net Breakdown n Northwest buys supplies worth $3, 000 because that is the net, or cash, price. n If Northwest does not take the discount, it must pay $3 M / 0. 98 = $3, 061, 224 for the supplies. This is the gross, or invoice, price. n The difference, $61, 224, is a financing cost similar to the interest on a loan. Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 28 Gross/Net Breakdown Payables level with discount Payables = $8, 333 x 16 - 28 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 Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 29 Approximate Cost of Costly Trade Credit Northwest loses $61, 224 to 16 - 29 Approximate Cost of Costly Trade Credit Northwest loses $61, 224 to obtain $166, 657 in extra trade credit, so $61, 224 Cost = = 0. 367 = 36. 7%. $166, 657 Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 30 Approximate Cost Formula 360 Cost = Discount % x 1 - 16 - 30 Approximate Cost Formula 360 Cost = Discount % x 1 - Discount % Days - Discount taken period = 2 x 360 = 0. 0204 x 18 98 30 - 10 = 0. 367 = 36. 7%. Copyright © 1999 by the Foundation of the American College of Healthcare Executives

16 - 31 What Should Northwest Do? n Northwest should take the $83, 333 16 - 31 What Should Northwest Do? n Northwest should take the $83, 333 in free trade credit--it should take all the free trade credit that it can get. n However, it should take the costly trade credit only if the implied cost is less than the cost of alternative financing sources. n Because Northwest can obtain bank loans at a 10% rate, it should not take the $166, 657 in costly trade credit. Copyright © 1999 by the Foundation of the American College of Healthcare Executives