Chapter 5: Current Asset Management

Purpose of the Chapter:

● Compute for the cash conversion cycle, its funding requirements, and the key strategies
for managing it
● Manage receipts and disbursements including floats, speeding up collection, slowing
down payments, cash concentration, zero balance accounts, and investing in marketable
securities
● Appreciate the use of different techniques in managing current assets
● Evaluate cash discount changes, credit terms, and credit monitoring in improving a
firm’s performance
● Appreciate how accounts receivable policies help the management in improving a firm’s
profitability
● Make decisions involving accounting receivable management
● Compute for EOQ, lead time, lead time usage, reorder point and safety stock
● Apply the techniques learned in inventory management
The basic current assets that an entity can control is:
1. Cash
2. Accounts Receivable
3. Inventory
Although Prepaid Expenses are one of the basic current asset, it cannot be controlled as these
expenses are already paid, are only waiting to be used or for time to exhaust the prepaid
expenses.

Cash Management
Cash Conversion Cycle = Average Age of Receivable + Average Age of Inventory – Average Age
of Payables

Funding Requirements of the Cash Conversion Cycle

The activity of an entity fluctuates over time base on the nature, trend and other aspects so the
cash requirement of an entity also fluctuate over the year.

Permanent versus Seasonal Funding Needs

Permanent Funding Requirement is the constant funding requirement of the company
throughout the year. Seasonal Funding Requirement is the funding requirement that fluctuates
over time.

Aggressive versus Conservative Seasonal Funding Strategies

Short-term funds are typically less expensive than long-term funds. (The yield curve is typically
upward-sloping.) However, long-term funds allow the firm to lock in its cost of funds over a
period of time and thus avoid the risk of increases in short-term interest rates. Also, long-term
funding ensures that the required funds are available to the firm when needed. Short-term
funding exposes the firm to the risk that it may not be able to obtain the funds needed to cover
its seasonal peaks. Under an aggressive funding strategy, the firm funds its seasonal
requirements with short-term debt and its permanent requirements with long-term debt.
Under a conservative funding strategy, the firm funds both its seasonal and its permanent
requirements with long-term debt.
Example: Semper Pump Company has a permanent funding requirement of P135,000 in
operating assets and seasonal funding requirement vary between P0 and P990,000 and average
P101,250. If Semper can borrow short-term funds at 6.25% and long-term funds at 8%, and if it
can earn 5% on the investment of any surplus balances, then the annual cost of an aggressive
strategy for seasonal funding will be:
Aggressive strategy:
Cost of short-term financing (6.25% x 101,250) = P 6,328.13
+Cost of long-term financing (8% x 135,000) = 10,800.00
-Earning on surplus balances (5% x 0) = 0
Total cost of aggressive strategy P17,128.13
Conservative strategy:
Cost of short-term financing (6.25% x 0) = 0
+Cost of long-term financing (8% x 1,125,000) = P90,000.00
-Earning on surplus balances (5% x 888,750) = 44,437.50
Total cost of aggressive strategy 45,562.50

The aggressive strategy has lower cost but has high risk, for example at some point the
company actually needs 1,125,000 (the highest possible funding requirement, 135,000
+1,125,000) but the aggressive strategy only can finance up to 236,250 (101,250 +135,000). The
company would suffer loss of sales, freezing of operations and etc.

Conservative strategy removes the risk from lack of funds by borrowing the highest possible
amount, the company, at an average, would then incur excess of funds which they can invest
for a 5% return, in the problem the excess fund is 888,750 which is computed 1,125,000 –
101,250 – 135,000

Strategies for Managing the Cash Conversion Cycle

The goal of a company is to minimize the length of cash conversion cycle, which minimizes
negotiated liabilities. This goal can be realized through application of the following strategies:
1. Turn over inventory as quickly as possible without stockouts that result in lost sales
 2. Collect accounts receivable as quickly as possible without losing sales from high-
pressure collection techniques
3. Manage mail, processing, and clearing time to reduce them when collecting from
customers and to increase them when paying suppliers
4. Pay accounts payable as slowly as possible without damaging the firm’s credit rating

Managing Receivables

Receivable management involves decisions made by the management to net income:

1. Offer credit sales to customers or stop selling to customers on credit
2. Increase/decrease credit period, discount period or discount rate
3. Increase/decrease the number of collecting officer or salaries of the collecting officer

When deciding the net benefit of the decision is computed:

Increase in net sales XXX
+ cost savings from reduced investment in accounts receivable1 XXX
+ decrease in expenses due to the decision XXX
- opportunity cost of money tied up to accounts receivable1 XXX
- lost sales XXX
- increase in expenses due to the decision XXX
Net Benefit or loss XXX

1
Cost Savings/Opportunity cost = Increase/Decrease in Accounts Receivable x opportunity
cost/rate of return)
Cost Savings if the Accounts Receivable Increases while Opportunity cost if it increases

Example: Max Company has an average collection period of 40 days (turnover = 360/40 = 9). In
accordance with the firm’s credit terms of the net 30, this period is divided into 32 days until
the customers place their payments in the mail and 8 days to receive, process, and collect
payment once they are mailed. Max is considering initiating a cash discount by changing its
credit terms from net 30 to 2/10 net 30. The firm expects this change to reduce the amount of
time until the payment are placed in the maid, resulting in an average collection period of 25
days (turnover = 360/25 = 14.4), Max normally sold 1,100 units but the discount will result in an
increase of sale by 50, the selling price is 3,000 while the variable cost is 2,300. It is estimated
that 80% of the customers with avail the discount. If the opportunity cost is 14%. What is the
net advantage/disadvantage of the decision
Additional profit on sales [50 x (3,000-2300)] P35,000
Cost of marginal investment in AR:
Average AR before the decision
(2,300 x 1,100)
9 P281,111
Average investment with proposed cash discount
(2,300 x 1,150)
 14.4 183,681
Reduction in Accounts Receivable Investment P97,430
Cost saving (0.14 x 97,430) 13,640
Cost of Cash Discount (0.02 x 0.80 x 1,150 x 3,000) (55,200)
Net profit from initiation of proposed cash discount ( 6.640)

Note: 2,300 is the actual investment in AR, which is the variable costs.

Managing Receipts and Disbursements

Average collection period has two parts:

1. The time from sale until the customer mails the payment
2. The receipt, processing, and collection time
Average payment period also has two parts:
1. The time from purchase of goods on account until the firm mails its payment
2. The receipt, processing, and collection time required by the firm’s suppliers.
Float refers to funds that has been set by the payer but are not yet usable funds to the
payee. Float is important n the cash conversion cycle because its presence lengthens both
the firm’s average collection period and average payment period. However, the goal of the
firm should be to shorten its average collection period and lengthen its average payment
period. Both can be accomplished by managing float.

Float has three component parts:

1. Mail float is the time delay between when payment is placed in the main and when it is
received
2. Processing float is the time between receipt of the payment and its deposit into the
firm’s account
3. Clearing float is the time between deposit of the payment and when spendable funds
become available to the firm. The component of float is attributable to the time
required from a check to clear the banking system

Possible techniques are:

1. Speeding up collections
2. Slowing down payments
3. Cash Concentration
4. Zero-Balance Accounts

The net benefit/loss is computed:

Decrease in Collection period x Average daily collections XXX
+Increase in Payment period x Average daily payments XXX
Total XXX
x Opportunity Cost/Rate of Return XXX
Benefit XXX
- Additional Expenses XXX
Net Benefit/Loss XXX

Managing Inventory

Common techniques for Managing Inventory:

1. The ABC System
ABC Inventory System divides the inventory into three categories: A, B, and C. The group
A includes the item with the largest peso investment these are the most expensive and
most important inventory, The group B consist of items that are less expensive and less
important than B, and the group C consist of the least expensive and least important
inventories. The company would then implement controls based on the category,
example category A is tracked down using the perpetual inventory system, has higher
security and etc. Group B, is tracked down using the periodic inventory and so on.
2. Just in Time (JIT) System
JIT is used to minimize inventory investment. JIT means that materials should arrive at
exactly the time they are needed for production, because ideally no inventory is kept by
the company it has the following advantage, No/Low storage/security cost, No/Low
spoilage/breakerage/shrinkage, No/Low money tied to inventory. The JIT system
requires at least two supplier close to the vicinity of the company and an expert to
strategically measures when to order inventories.
3. The Economic Order Quantity (EOQ) Model
One of the most common techniques for determining the optimal order size for
inventory items is the economic order quantity (EOQ) mode. The EOQ model considers
various costs of inventor and then determines what order size minimizes total inventory
cost.
EOQ assumes that the relevant costs of inventory can be divided into order costs and
carrying costs. (The model excludes the actual cost of the inventory item, because it is
uncontrollable) Each of them has certain key components and characteristics. Order
costs include the fixed clerical costs of placing and receiving orders: the cost of writing a
purchase order, of processing the resulting paperwork, and of receiving an order and
checking it against the invoice. Order costs are stated in pesos per order. Carrying costs
include storage costs, insurance costs, the costs of deterioration and obsolescence, and
the opportunity or financial cost of having funds invested in inventory. These costs are
stated in pesos per unit per period.
Order costs decreases as the size of the order increases. Carrying costs, however,
increase with increase in the order size. The EOQ model analyses the tradeoff between
order costs and carrying costs to determine the order quantity that minimizes the total
inventory costs.
Order Cost = Cost per order x (Total Quantity Needed/Order Size)
Carrying Amount = Carrying cost per unit x (Order Size/2)

Because the EOQ is defined as the order quantity that minimizes the total cost function, we
must solve the total cost function for the EOQ. The resulting equation is:

EOQ = 2 x N x O
C

Although the EOQ model has weaknesses, it is certainly better than subjective decision making.
Despite the fact that the use of the EOQ model is outside the control of the financial manager,
the financial manager must be aware of its utility and must provide certain inputs, specifically
with respect to inventory carrying costs.

Reorder Point
Once the firm has determine its economic order quantity, it must determine when to place an
order. The order point reflects the firm’s daily usage of the inventory item and the number of
days needed to place and receive an order. Assuming that inventory is used at a constant rate,
the formula for the reorder point is
Reorder point = Maximum lead time x Daily usage

Lead time is number of days until the ordered inventory is receive. Safety stock is sometimes
kept as an extra inventory.
Safety stock = (Maximum Lead time – Normal Lead time) x Daily usage
Example: MAX Company has an A group inventory item that is vital to the production process.
This item costs P1,500, and Max uses 1,200 units of the item per year. MAX wants to determine
its optima order strategy for the item. To calculate EOQ, we need the following inputs:
Cost per order = P150
Carrying cost per unit = P100

EOQ = 2 x 1,200 x 150

100
EOQ = 60 units

Total Order Cost = 1,200/60 x 150 = 3,000

Total Carrying Cost = 60/2 x 100 = 3,000
At EOQ, Total Order Cost = Total Carrying Cost

The reorder point for MAX depends on the number of days MAX operates per year. Assuming
that MAX operates 250 per year and uses 1,200 units this item, its daily usage is 4.8/units
(1200/250). If the normal lead time is 2 days and the maximum lead time is 4 days. The reorder
point is (4.8 x 4) = 19.2 units or 19 units. It means that orders are made when the inventory falls
19 units. And the safety stocks is (4.8 x 2) = 9.6 units or 10 units.