CURRENT ASSET
MANAGEMENT
Lecture 7
Ph.D Chung Thúy An
Finance and Banking
an.ct@ou.edu.vn
AGENDA
Cash management
Receivables management
Inventory management
Cash management
Operating Cycle
Operating cycle = Inventory period + Accounts receivable period
Cash flow timeline
Operating Cycle
Inventory period = 365 / Inventory turnover
Inventory turnover = Cost of goods sold / Average inventory
Receivables period = 365 / Receivables turnover
Receivables turnover = Credit sales / Average receivables
Reasons for Holding Cash
• Speculative motive: hold cash to take advantage of unexpected opportunities.
• Precautionary motive: hold cash in case of emergencies.
• Transaction motive: hold cash to pay the day-to-day bills.
• Trade-off between opportunity cost of holding cash relative to the transaction
cost of converting marketable securities to cash for transactions.
Terms
NWC = CA - CL
= (Cash + Noncash CA) – CL
Cash = TL + Equity – Noncash CA – LTA
Increase cash? (Sources of Cash)
Decrease cash? (Uses of Cash)
Collection Time
One of the goals of float management is to try to reduce the collection delay.
Investing Idle Cash
Money market: financial instruments with an original maturity of one year or less.
Temporary cash surpluses.
• Seasonal or cyclical activities: buy marketable securities with seasonal
surpluses, convert securities back to cash when deficits occur.
• Planned or possible expenditures: accumulate marketable securities in
anticipation of upcoming expenses.
Seasonal Cash Demands
Characteristics of Short-Term Securities
• Maturity: firms often limit the maturity of short-term investments to 90 days to
avoid loss of principal due to changing interest rates.
• Default risk: avoid investing in marketable securities with significant default
risk.
• Marketability: ease of converting assets to cash.
• Taxability: consider different tax characteristics when making a decision.
Costs of Holding Cash
The BAT Model
• F = The fixed cost of selling securities to raise cash
• T = The total amount of new cash needed
• R = The opportunity cost of holding cash, that is, the interest rate.
• If we start with $C, spend at a constant rate each
period and replace our cash with $C when we run out
of cash, our average
C
• Cash balance will be
2
• The opportunity cost of holding
C C
is × R
2 2
The BAT Model
• As we transfer C each period, we incur a trading
cost of F.
• If we need T in total over the planning period, the
number of times we will pay is T divided by C.
T
• The trading cost is ×F
C
The BAT Model
C T
Total cost = × R + × F
2 C
2T
C*
= ×F
R
The BAT Model
The optimal cash balance is found where the opportunity costs equals the
trading costs.
Opportunity Costs = Trading Costs
C T
×R+ ×F
2 C
Multiply both sides by C
C2 2TF T×F
× R =T × F C* = 2
C = 2×
2 R R
Example - The BAT Model
The A Co. has cash outflows of $500 per day, the interest rate is 10%, and the
fixed transfer cost is $25. Calculate the optimal cash balance.
Answer:
The Miller-Orr Model
Given L, which is set by the firm, the Miller-Orr model solves for C* and U:
3Fσ 2 U* = 3C* −2L
=C* +L
4R
Where σ 2
is the variance of net daily cash flows.
The average cash balance in the Miller-Orr model is:
4C * − L
Average cash balance =
3
Example - The Miller-Orr Model
Suppose F = $25, R = 1% per month, and the variance of monthly cash flows is
$25,000,000 per month. Assume a minimum cash balance of $10,000. Calculate
the upper control limits (U*).
Answer:
Implications of the Miller-Orr Model
To use the Miller-Orr model, the manager must do four things:
1. Set the lower control limit for the cash balance.
2. Estimate the standard deviation of daily cash flows.
3. Determine the interest rate.
4. Estimate the trading costs of buying and selling securities.
Other Factors Influencing the Target Cash Balance
Borrowing
• Borrowing is likely to be more expensive than selling marketable securities.
• The need to borrow will depend on management’s desire to hold low cash
balances.
Receivable management
Credit and Receivables
Granting credit generally increases sales.
Costs of granting credit.
• Chance that customers will not pay (that is, bad debts).
• Financing receivables.
Credit management examines the trade-off between increased sales and the
costs of granting credit.
The Cash Flows of Granting Credit
Terms of Sale
• Basic form: 2/10 net 45.
• 2% discount if paid in 10 days.
• Total amount due in 45 days if discount not taken.
Example:
Buy $500 worth of merchandise with the credit terms given above.
• Pay $500(1 − .02) = $490 if you pay in 10 days.
• Pay $500 if you pay in 45 days.
Example: Cash Discounts
Finding the implied interest rate when customers do not take the discount.
Credit terms of 2/10 net 45.
Credit Policy Effects
Revenue Effects.
• Delay in receiving cash from sales.
• May be able to increase price.
• May increase total sales.
Cost Effects.
• Cost of the sale is still incurred even though the cash from the sale has not
been received.
• Cost of debt – must finance receivables.
• Probability of nonpayment – some percentage of customers will not pay
for products purchased.
• Cash discount – some customers will pay early and pay less than the full
sales price.
Example
Your company is evaluating a switch from a cash only policy to a net 30 policy.
The price per unit is $100, and the variable cost per unit is $40. The company
currently sells 1,000 units per month. Under the proposed policy, the company
expects to sell 1,050 units per month. The required monthly return is 1.5 percent.
What is the NPV of the switch?
Should the company offer credit terms of net 30?
Example
Optimal Credit Policy
Total costs of granting credit include:
• Carrying costs.
• Required return on receivables.
• Losses from bad debts.
• Costs of managing credit and collections.
• Shortage costs.
• Lost sales due to a restrictive credit policy.
• Total cost curve is the sum of carrying and shortage costs.
• Optimal credit policy is where total cost curve is minimized.
Optimal Credit Policy
Collection Policy
Monitoring receivables.
• Keep an eye on average collection period relative to your credit terms.
• Use an aging schedule to determine percentage of payments that are
being made late.
Collection policy.
• Delinquency letter.
• Telephone call.
• Collection agency.
• Legal action.
.
Inventory management
Inventory Management
Inventory can be a large percentage of a firm’s assets.
There can be significant costs associated with carrying too much inventory.
There can also be significant costs associated with not carrying enough
inventory.
Inventory management tries to find the optimal trade-off between carrying too
much inventory versus not enough.
Types of Inventory
Manufacturing firm.
• Raw material – starting point in production process.
• Work-in-progress.
• Finished goods – products ready to ship or sell.
Remember that one firm’s “raw material” may be another firm’s “finished goods.”
Different types of inventory can vary dramatically in terms of liquidity.
Inventory Costs
Carrying costs – range from 20 – 40 percent of inventory value per year.
• Storage and tracking.
• Insurance and taxes.
• Losses due to obsolescence, deterioration, or theft.
• Opportunity cost of capital.
Shortage costs.
• Restocking costs.
• Lost sales or lost customers.
Consider both types of costs and minimize the total cost.
Inventory Management Techniques
Cost minimization is the goal of inventory management.
There are three main techniques used:
• ABC approach.
• Economic order quantity (EOQ) model.
• Derived demand management.
Inventory Management - ABC
• Classify inventory by cost, demand, and need.
• Those items that have substantial shortage costs should be maintained in larger
quantities than those with lower shortage costs.
• Generally maintain smaller quantities of expensive items.
• Maintain a substantial supply of less expensive basic materials.
EOQ Model
The EOQ model minimizes the total inventory cost.
Total carrying cost
= (Average inventory) × (Carrying cost per unit)
= (Q /2)(CC)
Total restocking cost (Fixed cost per order) × (Number of orders)
=
= F (T / Q)
Total cost = Total carrying cost + Total restocking cost = (Q/2)(C C) + F(T/Q)
EOQ model:
2TF
Q* =
CC
EOQ Model
Example - EOQ Model
Consider an inventory item that has carrying cost = $1.50 per unit. The fixed
order cost is $50 per order, and the firm sells 100,000 units per year.
• What is the economic order quantity?
• What are total carrying costs and restocking costs?
Answer:
Extensions to EOQ
Safety stocks
• Minimum level of inventory kept on hand.
• Increases carrying costs.
Reorder points
• At what inventory level should you place an order?
• Need to account for delivery time.
Derived-Demand Inventories
Demand for some inventory types is derived from, or dependent on, other
inventory needs.
Two key methods for managing derived demand:
• Materials requirements planning (MRP): system of planning the levels of
work-in-progress and raw materials based on projected finished goods.
• Just-in-time (JIT) inventory: emphasizes minimizing inventory and
maximizing turnover.
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