Current Asset Management Chapter 7 Chapter 6

Current Asset Management (Chapter 7) (Chapter 6 – pages 143 – 145) n Working Capital Management n Current Asset Investment Policy n Temporary and Permanent n n n Current Assets Zero Working Capital Cash Management Marketable Securities Accounts Receivable Management Inventory Management

Working Capital Management: An Overview n Gross Working Capital -(Current Assets) n New Working Capital - (Current Assets - Current Liabilities) n Working Capital Management n Involves investing in current assets and financing of current assets:

Current Asset Investment Policy n Everything else remaining the same, higher levels of current assets mean lower risk and lower expected return n Lower Risk n Greater ability to meet short-run obligations. n Lower Return n Cash and marketable securities typically yield low returns. Furthermore, when current assets are increased, additional financing costs will be incurred thereby lowering returns. n Lower levels of current assets result in opposite effects.

Alternative Current Asset Investment Policies Current Asset (millions of $) Conservative - low risk Moderate Aggressive - high risk Sales (millions of dollars)

Temporary vs. Permanent Investment in Current Assets n Temporary Investment - Commonly, firms experience short-run fluctuations in current assets. For example, retail department stores will have high levels of inventory around Thanksgiving. In January, the inventory should be low. n Permanent Investment - Firms always have some minimum level of investment in current assets (i. e. , a permanent investment). As a firm grows over time, the level of permanent current assets also grows (e. g. , a supermarket chain with 70 stores will have more permanent inventory than a chain with 4 stores).

Temporary and Permanent Current Assets Millions of dollars Temporary Fluctuations in Current Assets Permanent Current Assets Time Period

Cash Management: An Overview n Beginning Cash Balance + Cash Inflows - - - Speed Up - Cash Outflows - - - Slow Down = Ending Cash Balance - Desired Cash Balance = Surplus or Shortage n If Surplus: Pay off short-term debt or buy marketable securities n If Shortage: Short-term borrowing or sell marketable securities

Desired Cash Balance: n Precautionary Demand - Satisfy possible, but n n as yet indefinite cash needs. Speculative Demand - Build up current cash balances in anticipation of future business costs being lower. Risk Preferences Compensating Balances Transactions Demand - Cash needs arising in the ordinary course of doing business.

Float n Much of cash management is oriented towards managing the float. n Mail Float n Time lapse from the moment a customer mails a remittance check until the firm begins to process it. n Processing Float n Time required for the firm to process remittance checks before they can be deposited in the bank.

Float (Continued) n Transit Float n Time necessary for a deposited check to clear through the commercial banking system and become usable funds to the company. n Disbursing Float n Funds available in the firm’s bank account until its payment check has cleared through the system.

Electronic Funds Transfer n Substantially reduces float n Some Examples: n Automated teller machines n Direct deposit of payroll checks n Paying the supermarket and others with bank cards.

Lock-Box System n Customers mail remittance checks to P. O. Box. n Local bank processes and deposits checks directly into the company’s account. n Reduces mail and processing float. n Also reduces transit float if lock-box is located near Federal Reserve Bank or branches.

Marketable Securities n The marketable securities portfolio is typically used for temporary investments of excess cash, or as a substitute for cash (i. e. , near cash). Therefore, securities in the portfolio are generally safe, shortterm, and highly liquid. n Treasury Bills n Short-term obligations of the federal government with maturities of 91 days to a year. They are traded on a discount basis in bearer form. Not taxable at state and local levels, but taxable at the federal level. n Commercial Paper n Unsecured promissory notes issued by large corporations in amounts of $25, 000 or more (No active secondary market).

Marketable Securities Continued n Negotiable Certificates of Deposit (CDs) Offered by financial institutions (e. g. , banks, S&Ls). Those big business is interested in have $100, 000 minimums. n Banker’s Acceptance: Generally arise out of foreign trade. n Importer (buyer) issues a promise to pay a certain amount to the exporter (seller). n A bank accepts the promise, and commits itself to pay the amount when due. n Exporter (seller) can now sell this acceptance in the marketplace at a discount (a price that is less than the promised amount). n

Accounts Receivable Management n Major Decisions Credit Standards n Credit Terms n Collection Policy n Credit Standards: Will they pay as agreed? n Credit Scoring n Credit Reports n Past Experience n Financial Analysis n Debt Ratios, Liquidity Ratios, Profit Ratios n

Accounts Receivable Management (Continued) n Credit Terms Example: 2/10, net 30 n Collection Policy n Standard Operating Procedures n Be professional, firm, and do not bluff. n Vary procedures with slow payers. n Evaluating Collection Efforts n Average Collection Period, Bad Debt to Sales Ratio, Aging Accounts Receivable, Receivables to Assets Ratio, Credit Sales to Receivables Ratio. n

Inventory Management (Covered in Detail in Production Management) n Basic Costs Associated With Inventory Carrying Costs n storage, insurance, cost of capital used n Ordering Costs n placing orders, shipping and handling n Costs of Running Short n lost sales, reduced customer goodwill n Objective n Minimize total costs associated with managing inventory. n