7-1
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
LO2. Cash management involves control over the receipt and payment of cash so as to minimize
nonearning cash balances.
LO4. Accounts receivable management requires credit policy decisions aimed at maximizing
profitability.
LO6. An overriding concept is that the less liquid an asset is, the higher the required return.
7
7-2
Annotated Outline and Strategy
I. Introduction:
A. The financial manager must anticipate economic conditions and consumer
preferences to effectively allocate resources among current assets.
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:
2. Compensating balances for banks
3. Precautionary needs
B. The cash flow cycle can be used to describe how funds move in and out of the firm.
PPT The Cash Flow Cycle (Figure 7-1)
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 7–10 days.
Temporarily, excess cash balances are transferred into interest-earning marketable
securities.
III. Collections and Disbursements
A. The dynamics of check payment processing have significantly reduced the time delay
between mailing a check and the transfer of funds.
7-3
Finance in Action: The Impact of Information Technology on Working Capital
Management
This article discusses the two major trends that affect corporate practices and profitability. The
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.
4. Increasing use of electronic funds transfers will eventually eliminate float
1. Decentralized collection centers speed collection of accounts receivable by
reducing mailing time.
2. Lockbox 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
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 transfers take place domestically through automated clearinghouses
and internationally through SWIFT (Society for Worldwide Interbank Financial
7-4
Telecommunications).
G. International cash management
2. Disparate time zones, banking systems, culture, taxes, interest rates, and other
differences create a nonuniform system in some cases.
3. Over 10,500 financial institutions in 215 countries use SWIFT for
PPT Ten-Year SWIFTNet FIN Message Traffic (Figure 7-4)
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
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
7-5
might be an example of more normal rates. The definitions of each type of security are in the text.
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 records of
payment, financial stability, current net worth, and other factors.
b. 5 Cs 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)
PPT Trucking Industry Credit Score Report (Table 7-2)
PPT D-U-N-S Numerical Tracking System (Figure 7-7)
2. Terms of trade
7-6
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 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.
D. There are two basic costs associated with inventory:
1. Carrying costs:
a. Interest on funds tied up in inventory
E. Carrying costs vary directly with average inventory levels.
F. Total carrying costs increase as the order size increases.
7-7
2
EOQ = SO
C
Where:
S = sales in units
O = the cost to process an order
C = annual carrying costs per unit in dollars
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)
PPT Inventory Usage Pattern (Figure 7-9)
I. Assumptions of the basic EOQ model:
1. Inventory usage is at a constant rate.
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: NASA Experiments with Inventory Tracking on the International Space
Station (ISS)
This box illustrates how the use of technology can save time and reduce costs. NASA is
K. Just-in-Time Inventory Management (JIT)
1. Began in Japan and now used in the U.S.
7-8
Other Chapter Supplements
Cases for Use with Foundations of Financial Management
Case 7, Landis Apparel Co.