Current Assets Fm

8/7/2019 Current Assets Fm

1/35

22 - 1

Copyright 2002 Harcourt, Inc. All rights reserved.

CHAPTER 22Current Asset Management

Alternative working capitalpolicies

Cash management Inventory management

Accounts receivable management


2/35

22 - 2


Basic Definitions

Gross working capital:

Total current assets.

Net working capital:

Current assets - Current liabilities.

Working capital policy:

The level of each current asset.

How current assets are financed.(More)


3/35

22 - 3


Working capital management:

Includes both establishing workingcapital policy and then the day-to-day

control of:Cash

Inventories

Receivables

Short-term liabilities


4/35

22 - 4


SKI Industry

Current 1.75x 2.25xQuick 0.83x 1.20x

Debt/Assets 58.76% 50.00%Turnover of cash& securities 16.67x 22.22x

DSO (days) 45.00 32.00Inv. turnover 4.82x 7.00x

F.A. turnover 11.35x 12.00xT.A. turnover 2.08x 3.00xProfit margin 2.07% 3.50%ROE 10.45% 21.00%

Selected Ratios for SKI Incorporated

Pay. deferral period 30.00 33.00


5/35

22 - 5


How does SKIs working capital policycompare with the industry?

Working capital policy is reflected in

a firms current ratio, quick ratio,turnover of cash and securities,inventory turnover, and DSO.

These ratios indicate SKI has largeamounts of working capital relativeto its level of sales. Thus, SKI isfollowing a relaxed (fat cat) policy.


6/35

22 - 6


Alternative Current Asset

Investment Policies

Current Assets ($)

Sales ($)

Restricted

Moderate

Relaxed


7/35

22 - 7


Is SKI inefficient or just conservative?

A relaxed policy may be appropriate

if it reduces risk more thanprofitability.

However, SKI is much less

profitable than the average firm inthe industry. This suggests that thecompany probably has excessiveworking capital.


8/35

22 - 8


The cash conversion cycle focuses on thetime between payments made for materialsand labor and payments received fromsales:

Cash Inventory Receivables Payables

conversion = conversion + collection - deferral .cycle period period period

Cash Conversion Cycle


9/35

22 - 9


Cash Conversion Cycle (Cont.)

CCC = +

CCC = + 45 30

CCC = 75 + 45 30

CCC = 90 days.

Days per yearInv. turnover

Payablesdeferralperiod

Days salesoutstanding

3604.82


10/35

22 - 10


The cash conversion cycle focuses on thetime between payments made for materialsand labor and payments received fromsales:

Cash Inventory Receivables Payables

conversion = conversion + collection - deferral .cycle period period period

What does the cash conversion cycle tell

us about working capital management?

Cash Conversion Cycle


11/35

22 - 11


Cash Management:

Cash doesnt earn interest,so why hold it?

Transactions: Must have some cash to pay

current bills. Precaution: Safety stock. But lessened

by credit line and marketable securities.

Compensating balances: For loans and/orservices provided.

Speculation: To take advantage of bargains,to take discounts, and so on. Reduced bycredit line, marketable securities.


12/35

22 - 12


Whats the goal of cash management?

To have sufficient cash on hand tomeet the needs listed on theprevious slide.

However, since cash is a non-earning

asset, to have not one dollar more.


13/35

22 - 13


Ways to Minimize Cash Holdings

Use lockboxes.

Insist on wire transfers fromcustomers.

Synchronize inflows and outflows.

Use a remote disbursementaccount.

(More)


14/35

22 - 14


Increase forecast accuracy toreduce the need for a cash safetystock.

Hold marketable securities insteadof a cash safety stock.

Negotiate a line of credit (alsoreduces need for a safety stock).


15/35

22 - 15


What is float and how can it be

affected by cash management?

Net float is the difference betweencash as shown on the firms booksand on its banks books.

If it takes SKI 1 day to deposit checks

it receives and it takes its bankanother day to clear those checks,SKI has 2 days ofcollections float.


16/35

22 - 16


If it takes 6 days for the checks that SKIwrites to clear and be deducted fromSKIs account, SKI has 6 days ofdisbursement float.

SKIs net float is the difference betweenthe disbursement float and thecollections float:

Net float = 6 days - 2 days = 4 days.

If SKI wrote and received $1 million ofchecks per day, it would be able tooperate with $4 million less workingcapital than if it had zero net float.


17/35

22 - 17


Cash Budget: The Primary Cash

Management Tool

Purpose: Uses forecasts of cash

inflows, outflows, and ending cashbalances to predict loan needs andfunds available for temporaryinvestment.

Timing: Daily, weekly, or monthly,depending upon budgets purpose.Monthly for annual planning, dailyfor actual cash management.


18/35

22 - 18


Data Required for Cash Budget

1. Sales forecast.

2. Information on collections delay.

3. Forecast of purchases and paymentterms.

4. Forecast of cash expenses: wages,

taxes, utilities, and so on.5. Initial cash on hand.

6. Target cash balance.


19/35

22 - 19


SKIs Cash Budget

for January and February

Net Cash FlowsJanuary February

Collections $67,651.95 $62,755.40

Purchases $44,603.75 $36,472.65

Wages 6,690.56 5,470.90

Rent 2,500.00 2,500.00

Total payments $53,794.31 $44,443.55

Net CF $13,857.64 $18,311.85


20/35

22 - 20


Cash Budget (Continued)

January February

Cash at start $ 3,000.00 $16,857.64

Net CF 13,857.64 18,311.85

Cumulative cash $16,857.64 $35,169.49

Less: target cash 1,500.00 1,500.00Surplus $15,357.64 $33,669.49


21/35

22 - 21


Should depreciation be explicitly

included in the cash budget?

No. Depreciation is a noncashcharge. Only cash payments andreceipts appear on cash budget.

However, depreciation does affecttaxes, which do appear in the cashbudget.


22/35

22 - 22


What are some other potential cash

inflows besides collections?

Proceeds from fixed asset sales.

Proceeds from stock and bondsales.

Interest earned.Court settlements.


23/35

22 - 23


How can interest earned or paid on

short-term securities or loans beincorporated in the cash budget?

Interest earned: Add line in the

collections section. Interest paid: Add line in the payments

section.

Found as interest rate x surplus/loan lineof cash budget for preceding month.

Note: Interest on any other debt wouldneed to be incorporated as well.


24/35

22 - 24


How could bad debts be worked into

the cash budget?

Collections would be reduced by theamount of bad debt losses.

For example, if the firm had 3% baddebt losses, collections would totalonly 97% of sales.

Lower collections would lead tolower surpluses and higherborrowing requirements.


25/35

22 - 25


SKIs forecasted cash budget

indicates that the companys cashholdings will exceed the targeted

cash balance every month, except forOctober and November.

Cash budget indicates the companyprobably is holding too much cash.

SKI could improve its EVA by eitherinvesting its excess cash in moreproductive assets or by paying itout to the firms shareholders.


26/35

22 - 26


What reasons might SKI have for

maintaining a relativelyhigh amount of cash?

If sales turn out to be considerably less

than expected, SKI could face a cashshortfall.

A company may choose to hold largeamounts of cash if it does not have much

faith in its sales forecast, or if it is veryconservative.

The cash may be there, in part, to fund aplanned fixed asset acquisition.


27/35

22 - 27


Inventory Management:

Categories of Inventory Costs

Carrying Costs: Storage and handling

costs, insurance, property taxes,depreciation, and obsolescence.

Ordering Costs: Cost of placing orders,shipping, and handling costs.

Costs of Running Short: Loss of sales,loss of customer goodwill, and thedisruption of production schedules.


28/35

22 - 28


Effect of Inventory Size on Costs

Reducing the average amount of

inventory held generally: Reduces carrying costs.

Increases ordering costs.

Increases probability of a stockout.


29/35

22 - 29


Is SKI holding too much inventory?

SKIs inventory turnover (4.82) isconsiderably lower than the industry

average (7.00). The firm is carrying alot of inventory per dollar of sales.

By holding excessive inventory, the

firm is increasing its operating costswhich reduces its NOPAT. Moreover,the excess inventory must befinanced, so EVA is further lowered.


30/35

22 - 30


If SKI reduces its inventory, without

adversely affecting sales, what effectwill this have on its cash position?

Short run: Cash will increase asinventory purchases decline.

Long run: Company is likely tothen take steps to reduce its cashholdings.


31/35

22 - 31


Accounts Receivable Management:

Do SKIs customers pay more or lesspromptly than those of its

competitors?

SKIs days sales outstanding (DSO)of45 days is well above the industryaverage (32 days).

SKIs customers are paying lesspromptly.

SKI should considertightening itscredit policy to reduce its DSO.


32/35

22 - 32


Cash Discounts: Lowers price.

Attracts new customers andreduces DSO.

Credit Period: How long to pay?

Shorter period reduces DSO andaverage A/R, but it may discouragesales.

Elements of Credit Policy

(More)


33/35

22 - 33


Credit Standards: Tighterstandards reduce bad debt losses,but may reduce sales. Fewer bad

debts reduces DSO.Collection Policy: Tougher policy

will reduce DSO, but may damagecustomer relationships.


34/35

22 - 34


Does SKI face any risk if it tightens its

credit policy?

YES! A tighter credit policy maydiscourage sales. Some customersmay choose to go elsewhere if theyare pressured to pay their bills

sooner.


35/35

22 - 35


If SKI succeeds in reducing DSO

without adversely affecting sales, whateffect would this have on its cash

position?

Short run: If customers pay sooner,this increases cash holdings.

Long run: Over time, the company

would hopefully invest the cash inmore productive assets, or pay itout to shareholders. Both of theseactions would increase EVA.

Documents

Current Assets Fm