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8/7/2019 Managing Current Asset Ch.8
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BLEX Program
Financial
Management
Prepared By:
Mr.Aiman Ahmed Ibrahim
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CHAPTER 8
Managing Current Asset
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Working Capital
Working Capital = Current Assets
NetWorking Capital = Current Assets CurrentLiabilities
EquityWorking Capital = Current Assets CurrentLiabilities Long-term Debt
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What is Net Working Capital
Net working capital is calculated as :
current assets minus current liabilities.
If current assets are less than current liabilities,an entity has aworking capital deficiency,
also called aworking capital deficit
.
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What Does Current Assets
Mean? A balance sheet account that represents the
value of all assets that are reasonably
expected to be converted into cash withinone year in the normal course of business.
In personal finance, current assets are all
assets that a person can readily convert to
cash to pay outstanding debts and coverliabilities without having to sell fixed assets
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What Does Current Assets
Mean?
Cash & Cash Equivalents
Short-Term Investments
Inventory
Accounts Receivable
Prepaid Expenses
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An increase in working capital indicates that
the business has either increased current
assets (that is has increased its receivables, orother current assets) or has decreased current
liabilities, for example has paid off some
short-term creditors.
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Cash Operating Cycle
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Working capital management
Decisions relating to working capital and shortterm financing are referred to as working capitalmanagement. These involve managing therelationship between a firm's short-term assetsand its short-term liabilities. The goal of workingcapital management is to ensure that the firm is
able to continue its operations and that it hassufficient cash flow to satisfy both maturingshort-term debt and upcoming operationalexpenses.
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Management of working
capital Working capital also gives investors an idea of
the company's underlying operational efficiency.Money that is tied up in inventory or money that
customers still owe to the company cannot beused to pay off any of the company's obligations.So, if a company is not operating in the mostefficient manner (slow collection), it will show up
as an increase in the working capital. This can beseen by comparing the working capital from oneperiod to another; slow collection may signal anunderlying problem in the company's operations.
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Current Asset Management
Working Capital Management
Current Asset Investment Policy
Temporary and PermanentCurrent Assets
ZeroWorking Capital
Cash Management
Marketable Securities
Accounts Receivable Management
Inventory Management
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Working Capital Management:
GrossWorking Capital -(Current Assets)
Net Working Capital - (Current Assets - CurrentLiabilities)
Working Capital Management
Involves investing in current assets and financing of
current assets:
Current
Liabilities
Long-Term
Financing
Current Asset
Investment
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Current Asset Investment Policy
Everything else remaining the same, higher levels ofcurrent assets mean lower risk and lower expectedreturn
Lower Risk
Greater ability to meet short-run obligations. Lower Return
Cash and marketable securities typically yield low
returns. Furthermore, when current assets are
increased, additional financing costs will be incurredthereby lowering returns.
Lower levels of current assets result in oppositeeffects.
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Alternative Current Asset Investment
Policies
0
2
4
6
8
10
12
14
0 10 20 30 40
Current Asset (millions of $)
Sales (millions of dollars)
Conservative - low risk
Aggressive - high risk
Moderate
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Temporary vs. Permanent Investment
in Current Assets
Temporary Investment - Commonly, firms experienceshort-run fluctuations in current assets. For example,retail department stores will have high levels of inventory
around Thanksgiving. In January, the inventory should below.
Permanent Investment - Firms always have someminimum level of investment in current assets (i.e., apermanent investment). As a firm grows over time, the
level of permanent current assets also grows (e.g., asupermarket chain with 70 stores will have morepermanent inventory than a chain with 4 stores).
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Cash Management:
Beginning Cash Balance
+ Cash Inflows - - - Speed Up
- Cash Outflows - - - Slow Down
= Ending Cash Balance- Desired Cash Balance
= Surplus or Shortage If Surplus: Pay off short-term debt or buy marketable
securities If Shortage: Short-term borrowing or sell marketable
securities
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Desired Cash Balance:
Precautionary Demand - Satisfy possible, but asyet indefinite cash needs.
Speculative Demand - Build up current cash
balances in anticipation of future business costsbeing lower.
Risk Preferences
Compensating Balances
Transactions Demand - Cash needs arising in theordinary course of doing business.
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Accounts Receivable Management
Major Decisions
Credit Standards
Credit Terms
Collection Policy
Credit Standards:Will they pay as agreed?
Credit Scoring
Credit Reports
Past Experience
Financial Analysis
Debt Ratios, Liquidity Ratios, Profit Ratios
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Accounts Receivable Management
(Continued)
Credit Terms
Example: 2/10, net 30
Collection Policy
Standard Operating Procedures
Be professional, firm, and do not bluff.
Vary procedures with slow payers.
Evaluating Collection Efforts
Average Collection Period, Bad Debt to Sales Ratio,Aging Accounts Receivable, Receivables to AssetsRatio, Credit Sales to Receivables Ratio.
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Inventory Management
Basic Costs AssociatedWith Inventory
Carrying Costs
storage, insurance, cost of capital used
Ordering Costs
placing orders, shipping and handling
Costs of Running Short
lost sales, reduced customer goodwill
Objective
Minimize total costs associated with managinginventory.
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Decision criteria
working capital management entails short
term decisions - generally, relating to the
next one year period - which are "reversible".Positive working capital means that the
company is able to pay off its short-term
liabilities. Negative working capital means
that a company currently is unable to meet itsshort-term liabilities with its current assets(cash, accounts receivable and inventory).
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Cash Conversion Cycle
One measure of cash flow is provided by thecash conversion cycle - the net number of daysfrom the outlay of cash for raw material to
receiving payment from the customer. As amanagement tool, this metric makes explicit theinter-relatedness of decisions relating toinventories, accounts receivable and payable,and cash. Because this number effectively
corresponds to the time that the firm's cash istied up in operations and unavailable for otheractivities, management generally aims at a lownet count.
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Cash Conversion Cycle
CCC = # days between disbursing cash and collectingcash in connection with undertaking a discrete unit ofoperations.
=Inventory conversionperiod
+ Receivablesconversion
period
- Payables conversion period
Avg. Inventory COGS /365
+ Avg. AccountsReceivable
Credit Sales /365
- Avg. Accounts PayableCOGS / 365
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More businesses fail for lack of cash
than for want of profit.
If you ....... Then ......
Collect receivables (debtors)
faster Collect receivables (debtors)
slower
Get better credit (in terms of
duration or amount) from
suppliers
Shift inventory (stocks) faster
Move inventory (stocks)slower
You release cash from the
cycle Your receivables soak up
cash
You increase your cash
resources You free up cash
You consume more cash
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Solution:
XYZ's Cash-to-Cash Cycle for the Period January 1 Through January 31
Component Computation Result
Inventory - Average
number of days
($500 + $300 / 2) / ($700 / 31 days) = 17.7
Receivables - Averagenumber of days
uncollected
($400 + $600 / 2) / ($1,000 / 31 days) = 15.5
Days Cash Is Free
Because the Business
Has Not Paid Its Bills
(-$300 + -100 / 2) / ($700 / 31 days) = -8.8
Cash-to-Cash Cycle (in days) 24.4
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FACTORS INFLUENCING WORKING CAPITAL
NEEDS:
Nature of Business.
Seasonality of Operations:
Production Cycle. Production Policy.
Credit Policy.
Market Conditions. Conditions of Supply.
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CONCLUSION:
The objective of financial management is tomaximize the shareholders wealth by generatesufficient profits. The profits generated depend
mainly on sales volume.When the goods arebeing sold on credit as is the normal practice ofbusiness firms today to cope with increasedcompetition the sale of goods cannot beconverted into cash instantly because of time lag
between sales and realization of cash. Furtherthis is possible only through evolving effectiveworking capital policy and better administrationon current assets financing.