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CHAPTER 22
Current Asset Management

Alternative working capital policies

Cash management
Inventory management
Accounts receivable management

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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)
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 22 - 3

Working capital management:

Includes both establishing working
capital policy and then the day-to-day
control of:
Cash
Inventories
Receivables
Short-term liabilities

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Alternative Current Asset

Investment Policies

Current Assets ($) Relaxed

Moderate

Restricted

Sales ($)

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 22 - 5

A relaxed policy may be appropriate

if it reduces risk more than
profitability.

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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/or
services provided.
Speculation: To take advantage of bargains,
to take discounts, and so on. Reduced by
credit line, marketable securities.
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 22 - 7

Whats the goal of cash management?

To have sufficient cash on hand to

meet the needs listed on the
previous slide.
However, since cash is a non-earning
asset, to have not one dollar more.

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 22 - 8

What is float and how can it be

affected by cash management?

Net float is the difference between

cash as shown on the firms books
and on its banks books.
If it takes the firm 1 day to deposit
checks it receives and it takes its
bank another day to clear those
checks, the firm has 2 days of
collections float.
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 22 - 9
If it takes 6 days for the checks that the
firm writes to clear and be deducted
from firms account, the firm has 6 days
of disbursement float.
The firms net float is the difference
between the disbursement float and the
collections float:
Net float = 6 days - 2 days = 4 days.
If the firm wrote and received $1 million
of checks per day, it would be able to
operate with $4 million less working
capital than if it had zero net float.
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 22 - 10

Cash Budget: The Primary Cash

Management Tool

Purpose: Uses forecasts of cash

inflows, outflows, and ending cash
balances to predict loan needs and
funds available for temporary
investment.
Timing: Daily, weekly, or monthly,
depending upon budgets purpose.
Monthly for annual planning, daily for
actual cash management.
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 22 - 11

Data Required for Cash Budget

1. Sales forecast.
2. Information on collections delay.
3. Forecast of purchases and payment
terms.
4. Forecast of cash expenses: wages,
taxes, utilities, and so on.
5. Initial cash on hand.
6. Target cash balance.
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 22 - 12

Firms Cash Budget

for January and February
Net Cash Flows
January 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
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 22 - 13

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 1,500.00
Surplus $15,357.64 $33,669.49

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 22 - 14

Should depreciation be explicitly

included in the cash budget?

No. Depreciation is a noncash

charge. Only cash payments and
receipts appear on cash budget.
However, depreciation does affect
taxes, which do appear in the cash
budget.

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 22 - 15

What are some other potential cash

inflows besides collections?

Proceeds from fixed asset sales.

Proceeds from stock and bond
sales.
Interest earned.
Court settlements.

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 22 - 16

How can interest earned or paid on

short-term securities or loans be
incorporated 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 line
of cash budget for preceding month.
Note: Interest on any other debt would
need to be incorporated as well.
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 22 - 17

How could bad debts be worked into

the cash budget?

Collections would be reduced by the

amount of bad debt losses.
For example, if the firm had 3% bad
debt losses, collections would total
only 97% of sales.
Lower collections would lead to lower
surpluses and higher borrowing
requirements.
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 22 - 18

What reasons might firm have for

maintaining a relatively
high amount of cash?
If sales turn out to be considerably less
than expected, firm could face a cash
shortfall.
A firm may choose to hold large amounts
of cash if it does not have much faith in
its sales forecast, or if it is very
conservative.
The cash may be there, in part, to fund a
planned fixed asset acquisition.
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 22 - 19

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 the
disruption of production schedules.
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 22 - 20

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.

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 22 - 21

If Firm holding too much inventory:

By holding excessive inventory, the

firm is increasing its operating costs
which reduces its NOPAT. Moreover,
the excess inventory must be
financed, so EVA is further lowered.

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 22 - 22

If Firm reduces its inventory, without

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

Short run: Cash will increase as

inventory purchases decline.
Long run: Company is likely to
then take steps to reduce its cash
holdings.

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 22 - 23

Accounts Receivable Management:

If Companys customers pay less
promptly than those of its competitors:

If Companys days sales outstanding

(DSO) is well above the industry
average then its customers are
paying less promptly.
Firm should consider tightening its
credit policy to reduce its DSO.

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Elements of Credit Policy

Cash Discounts: Lowers price.

Attracts new customers and
reduces DSO.
Credit Period: How long to pay?
Shorter period reduces DSO and
average A/R, but it may
discourage sales.
(More)
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 22 - 25

Credit Standards: Tighter

standards reduce bad debt losses,
but may reduce sales. Fewer bad
debts reduces DSO.
Collection Policy: Tougher policy
will reduce DSO, but may damage
customer relationships.

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 22 - 26

Does Firm face any risk if it tightens its

credit policy?

YES! A tighter credit policy may

discourage sales. Some customers
may choose to go elsewhere if they
are pressured to pay their bills
sooner.

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 22 - 27

If Firm succeeds in reducing DSO

without adversely affecting sales, what
effect 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 in more
productive assets, or pay it out to
shareholders. Both of these actions
would increase EVA.

Copyright 2002 Harcourt, Inc. All rights reserved.