ISBN: 0-03-028931-9
Chapter 16 Managing Current Assets
This chapter discussed the management of current assets, particularly cash, marketable securities, inventory, and receivables. The key concepts are listed below.
Working capital refers to current assets used in operations, and net working capital is defined as current assets minus current liabilities. Working capital policy refers to decisions relating to current assets and their financing.
The current ratio (current assets divided by current liabilities) and the quick ratio (current assets less inventories divided by current liabilities) are financial measures used to gauge a firm's liquidity.
Working capital management involves the setting of a working capital policy and the execution of that policy in day-to-day operations.
Working capital policy refers to the firm's policies regarding target levels for current assets and how they will be financed.
Under a relaxed current asset investment policy, a firm would hold relatively large amounts of each type of current asset. Sales are stimulated by a liberal credit policy, resulting in a high level of receivables. Under a restricted current asset investment policy, the firm would hold minimal amounts of these items. A moderate current asset investment policy entails a firm holding a moderate level of current assets.
The cash conversion cycle model focuses on the length of time between when the company makes payments and when it receives cash inflows.
The inventory conversion period is the average time required to convert materials into finished goods and then to sell those goods.
The receivables collection period is the average length of time required to convert the firm's receivables into cash, that is, to collect cash following a sale.
The payables deferral period is the average length of time between the purchase of materials and labor and the payment of cash for them.
The cash conversion cycle equals the length of time between the firm's actual cash expenditures to pay for productive resources (materials and labor) and its own cash receipts from the sale of products (that is, the length of time between paying for labor and materials and collecting on receivables).
- Cash Conversion Cycle = Inv.conv.period+Re c.coll.period – Pa
A policy which strives for zero working capital not only generates cash but also speeds up production and helps businesses operate more efficiently. This concept has its own definition of working capital: Inventories + Receivables - Payables. The rationale is that inventories and receivables are the keys to making sales, and that inventories can be financed by suppliers through accounts payable.
The primary goal of cash management is to reduce the amount of cash held to the minimum necessary to conduct business.
The transactions balance is the cash necessary to conduct day-to-day business, whereas the precautionary balance is a cash reserve held to meet random, unforeseen needs. A compensating balance is a minimum checking account balance that a bank requires as compensation either for services provided or as part of a loan agreement. Firms also hold speculative balances, which allow them to take advantage of bargain purchases. Note, though, that borrowing capacity and marketable security holdings both reduce the need for precautionary and speculative balances.
A trade discount is a price reduction that suppliers offer customers for early payment of bills.
A cash budget is a schedule showing projected cash inflows and outflows over some period. The cash budget is used to predict cash surpluses and deficits, and it is the primary cash management planning tool.
A target cash balance is the desired cash balance that a firm plans to maintain in order to conduct business.
Cash management techniques generally fall into five categories: (1) synchronizing cash flows, (2) using float, (3) accelerating collections, (4) determining where and when funds will be needed, and (5) controlling disbursements.
Disbursement float is the amount of funds associated with checks written by a firm that are still in process and hence have not yet been deducted from the firm's bank account.
Collections float is the amount of funds associated with checks written to a firm that have not been cleared, hence are not yet available for the firm's use.
Net float is the difference between disbursement float and collections float, and it also is equal to the difference between the balance in the firm's own checkbook and the balance on the bank's records. The larger the net float, the smaller the cash balance the firm must maintain, so net float is good.
Two techniques that can be used to speed up collections are (1) lockboxes and (2) wire transfers.
Firms can reduce their cash balances by holding marketable securities, which can be sold on short notice at close to their quoted prices. Marketable securities serve both as a substitute for cash and as a temporary investment for funds that will be needed in the near future. Safety is the primary consideration when selecting marketable securities.
Inventory can be grouped into four categories: (1) supplies, (2) raw materials, (3) work-in-process, and (4) finished goods.
The twin goals of inventory management are (1) to ensure that the inventories needed to sustain operations are available, but (2) to hold the costs of ordering and carrying inventories to the lowest possible level.
Inventory costs can be divided into three types: carrying costs, ordering costs, and stock-out costs. In general, carrying costs increase as the level of inventory rises, but ordering costs and stock-out costs decline with larger inventory holdings.
Firms use inventory control systems such as the red-line method and the two-bin method, as well as computerized inventory control systems, to help them keep track of actual inventory levels and to ensure that inventory levels are adjusted as sales change. Just-in-time (JIT) systems are used to hold down inventory costs and, simultaneously, to improve the production process. Out-sourcing is the practice of purchasing components rather than making them in-house.
When a firm sells goods to a customer on credit, an account receivable is created.
A firm can use an aging schedule and the days sales outstanding (DSO) to help keep track of its receivables position and to help avoid an increase in bad debts.
A firm's credit policy consists of four elements: (1) credit period, (2) discounts given for early payment, (3) credit standards, and (4) collection policy. The first two, when combined, are called the credit terms. For example, credit terms of "2/10, net 30" means that a customer can receive a 2% discount if the bill is paid within ten days of the sale, but the bill is due in full by the thirtieth day.
Additional factors that influence a firm's overall credit policy are (1) profit potential and (2) legal considerations.
The basic objective of the credit manager is to increase profitable sales by extending credit to worthy customers and therefore adding value to the firm.
Working capital policy involves two basic issues. The first, determining the appropriate level for each type of current asset, was addressed in this chapter. The second, how current assets should be financed, will be addressed in Chapter 16.
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