Current Asset Management
Author’s Overview
The instructor should stress the profitability-liquidity trade-offs to be found in the current asset
accounts. The student should think of the less liquid current assets as representing a
competitive investment for capital. The four different topics for discussion in the chapter are
all worthy of detailed coverage. The material on cash management has real contemporary
importance and is usually of interest to the student who has struggled with his or her own cash
management. The management of accounts receivable and inventories represents an excellent
opportunity to cover decision-making tools that are an important part of financial management.
Chapter Concepts
LO1. Current asset management is an extension of concepts discussed in the previous chapter
and involves the management of cash, marketable securities, accounts receivable and
inventory.
LO2. Cash management involves control over the receipt and payment of cash so as to
minimize nonearning cash balances.
LO3. The management of marketable securities involves selecting between various short-term
investments.
LO4. Accounts receivable management requires credit policy decisions aimed at maximizing
profitability.
LO5. Inventory management requires determining the level of inventory necessary to enhance
sales and profitability.
LO6. An overriding concept is that the less liquid an asset is, the higher the required return.
Annotated Outline and Strategy
I. Introduction:
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A. The financial manager must anticipate economic conditions and consumer
preferences to effectively allocate resources among current assets.
1. The primary concern in managing cash and marketable securities is safety
and security, then profitability.
2. The focus of managing accounts receivable and inventory should face the
same profitability criteria as any other decision.
3. We use the retail sector in the introduction as an example of the
unpredictability of sales that impacts inventory and receivables
management.
II. Cash Management: Cash is a necessary but low earning asset. Financial managers
attempt to minimize cash balances and yet maintain sufficient amounts to meet obligations in a
timely manner.
A. The three main reasons for holding cash are for:
1. Transactions
2. Compensating balances
3. Precautionary needs
B. The cash flow cycle can be used to describe how funds move in and out of the
firm.
PPT Expanded Cash Flow Cycle (Figure 7-2)
C. E-commerce sales impact cash flow because they typically involve credit cards.
Credit card companies typically advance payment to the vendor within two to
three days. Temporarily, excess cash balances are transferred into
interest-earning marketable securities.
III. Collections and Disbursements
A. The dynamics of check payment processing has significantly reduced the time
delay between mailing a check and the transfer of funds..
Finance in Action: The Impact of the Information Technology on Working Capital
Management
This article discusses the two major trends that affect corporate practices and profitability. The
first trend is the business-to-business (B2B) industry supply exchanges and we use Covisint as
our example. The second trend is online auction companies and we use Perfect Commerce and
Ariba as our examples. These two trends have significantly reduced costs with Ariba estimating
it saves customers $82 million in supply cost daily.
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Education.
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B. Float: Using the difference in the cash balances shown on the bank’s records and
those shown on the firm’s records.
1. The company’s books reflect a different cash balance than the bank’s
books.
2. Float results because it takes time for checks to move through the mail
and through the banking system.
3. The Check Clearing for the 21st Century Act allows for electronic check
processing so that float is significantly reduced.
4. Increasing use of Electronic Funds Transfers will eventually eliminate
float all together.
C. Improving collection
1. Decentralized collection centers speed collection of accounts receivable by
reducing mailing time.
2. Wire transfer of funds-excess cash balances are transferred from collection
points to a centralized location for use.
3. Lock-box system-customers mail payment to a post office box serviced
by a local bank in their geographical area. Checks are cleared locally
and balances transferred by wire to a central location.
D. Extended disbursement to take advantage of slower clearing of checks. The
primary benefits of speeding up inflows or slowing outflows is the earnings
generated from the freed up balances. The benefits must be weighed against the
cost.
E. Cost Benefit Analysis
PPT Cash Management Network (Figure 7-3)
Perspective 7-1: Use Figure 7-3 to illustrate how funds are freed up. Apply a potential rate
of return on these funds and relate that to the maximum cost that should be incurred.
F. Electronic Funds Transfer takes place domestically through automated
clearinghouses and internationally through SWIFT (Society for Worldwide
Interbank Financial Telecommunications).
G. International Cash Management
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1. Multinational firms shift funds from country to country daily, maximizing
returns and balancing foreign exchange risk.
2. Difference in time zones, banking systems, culture, taxes, interest rates,
and other differences create a non uniform system in some cases.
3. Over 10,500 financial institutions in 215 countries use SWIFT for
standardized interbank electronic funds transfer. Figure 7-4 shows the
high annual growth of international electric funds transfers. Each SWIFT
message represents a cash transfer from one account to another.
IV. Marketable Securities
A. Because marketable securities normally represent funds held in reserve, the
maturity should be kept reasonably short to avoid interest rate risk.
B. There is a wide array of securities from which to choose.
1. Federal government securities
2. Federal agency securities
3. Nongovernment securities
a. Certificates of deposit
b. Commercial paper
c. Banker’s acceptances
d. Eurodollar deposits
e. Savings Accounts
f. Money market funds
g. Money market deposit accounts
PPT An Examination of Yield and Maturity Characteristics (Figure 7-5)
Perspective 7-2: Use Table 7-1 to highlight the attributes of the various securities and
instruments, stressing the ever-changing nature of the market and competition between financial
institutions. It is instructive to compare the high interest rate environment of 1980 (before your
students were born) to the historically low interest rates that have existed since 2003. The year
2000 might be an example of more normal rates. The definitions of each type of security are in
the text.
PPT Types of Short-Term Investments (Table 7-1)
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V. Management of Accounts Receivable: Accounts receivable as a percentage of total
assets have been increasing due to: increasing sales, inflation, and extended credit terms during
recessions.
A. Accounts receivable as an investment.
1. Investment in accounts receivable should generate a return equal to or in
excess of the return available on alternative investments.
Perspective 7-3: Discuss a credit decision relating the sales function to the credit created by
the new accounts. Emphasize that the emphasis should be on rate of return and not on the level
of sales.
B. Credit policy administration: There are three primary factors to consider:
1. Credit standards
a. The firm screens credit applicants on the basis of prior record of
payment, financial stability, current net worth, and other factors.
b. 5 C’s of Credit: character, capital, capacity, conditions, collateral.
c. Dun & Bradstreet Information Services (DBIS)
(1) Business Information Report
(2) Commercial Credit Scoring Report
(3) Industry Credit Score Report (See Table 7-2)
d. D-U-N-S Data Universal Number System is a unique nine digit
code used globally and accepted by the United National and other
international agencies as a global business identification number.
See Figure 7-7.
PPT Trucking Industry Credit Score Report (Table 7-2)
2. Terms of trade
3. Collection policy: Some measures used to assess collection efficiency
are:
a. Average collection period.
b. Ratio of bad debts to sales.
c. Aging of accounts receivable.
Perspective 7-4: The section titled “An Actual Credit Decision” brings together the issues
discussed under credit policy administration with a focus on incremental income from
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additional sales as well as an analysis on the marginal rate of return.
VI. Inventory Management
A. Inventory is the least liquid of current assets.
B. A firm’s level of inventory is largely determined by the cyclicality of sales and
whether it follows a seasonal or level production schedule. The production
decision is based on the trade-off of cost savings of level production versus the
additional inventory carrying costs.
C. Rapid price movements complicate the inventory level decision.
D. There are two basic costs associated with inventory:
1. Carrying costs:
a. Interest on funds tied up in inventory.
b. Warehouse space costs.
c. Insurance.
d. Material handling expenses.
e. Risk of obsolescence (implicit cost).
2. Ordering and processing costs
E. Carrying costs vary directly with average inventory levels.
F. Total carrying costs increase as the order size increases.
G. Total ordering costs decrease as the order size increases.
H. The first step toward achieving minimum inventory costs is determination of the
optimal order quantity. This quantity may be derived by use of the economic
order quantity formula:
2
EOQ = SO
C
Where:
S = sales in units
O = the cost to process an order
C = annual carrying costs per unit in dollars
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Perspective 7-5: Combine the EOQ formula with Figure 7-8 to clearly illustrate the impact
of selecting the optimum order size.
PPT Determining the Optimum Inventory Level (Figure 7-8)
I. Assumptions of the basic EOQ model:
1. Inventory usage is at a constant rate.
2. Order costs per order are constant.
3. Delivery time of orders is consistent and order arrives as inventory
reaches zero.
J. Minimum total inventory costs will result if the assumptions of the model are
applicable and the firm’s order size equals the economic ordering quantity.
Finance in Action: NASAThe National Aeronautics and Space Administration Inventory
Control System
This box illustrates how the use of technology can save time and reduce costs. NASA, with the
help of their prime contractor United Space Alliance (USA), have installed a radio frequency
data communications system which can pinpoint 98 percent of the 300,000 inventory items
found among 100 buildings in a matter of seconds. This system saves almost $1 billion annually
by reducing the time it takes to locate equipment.
K. Just-in-Time Inventory Management (JIT)
1. Began in Japan and now used in the U.S.
2. Suppliers are located near manufactures who are able to make orders in
small lot sizes because of short delivery time.
3. Lower inventory means lower costs
4. The downside of (JIT) is that any glitch in delivery can shut down the
whole production process. In 2011 the Tsunami in Japan and the floods in
Thailand are good examples of unexpected events that can cause huge
problems for companies using just-in-time inventory systems.
Other Chapter Supplements
Cases for Use with Foundations of Financial Management
Case 6, Modern Kitchenware Co. (cash discount)
Case 7, Landis Apparel Co.
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Case 8, Fresh & Fruity Foods, Inc. (current asset management); this case can also be used after
Chapter 8 in the text.
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