Financial Management

Midterm
Module 4: Management of Current Assets

Lesson 1. Managing Cash and Marketable Securities

Cash Management involves the control over the receipts and payments of cash to minimize non-earning cash
balances.

BASIC OBJECTIVE: To keep the investment in cash as low as possible while keeping the firm operating efficiently
and effectively.
1. Accelerate cash inflows by optimizing mechanisms for collecting cash;
2. Monitor the cash disbursement needs or payments schedule;
3. Minimize the amount of idle cash or funds committed to the transaction and precautionary balances; and
4. Avoid misappropriation and handling losses in the normal course of business.

Proper management of cash flows entails the following:

1. Improving forecast of cash flows  
2. Using floats  
3. Synchronizing cash inflows and outflows  
4. Accelerating collection  
5. Controlling disbursements  
6. Obtain additional funds when and where they are needed.

Reasons for Holding Cash Balances:

1. Transaction Facilitation  
2. Precautionary Motive  
3. Compliance with Creditor’s Covenant (compensating balance)  
4. Investment Opportunities 

The company must know how the trade-off between the opportunity costs associated with holding too much
cash against the shortage costs of not having enough cash.  

DETERMINING THE TARGET CASH BALANCE

 Cash Budget – tool used to present the expected cash inflows and cash outflows
 Cash Break-Even Chart – shows the relationship between the company’s cash needs and cash sources. It
indicates the minimum amount of cash that should be maintained to enable the company to meet its
obligations.

Illustration:
XYZ Company manufactures plastic which it sells to other industrial users. The monthly production capacity of
the company is 1,200,000 kilos. Selling price is P2 per kilo. Its cash requirements have been determined as
follows:
a.) Fixed monthly payments amounting to P250,000
b.) Variable cash payments are 50% of sales

Determine the cash breakeven point:

¿ Monthly Payments
Cash Break−even Point=
VC
Sales−
Sales
250,000 250,000
¿ = =P 500,000∨250,000 kilos of plastic
50 % 50 %
100 %−
100 %
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OPTIMAL CASH BALANCE

1. The Baumol Model
 Liquidity management has assumed a greater role over the past decade since cash is needed for
both transactions and precautionary needs in all companies.
 too much liquidity = down the rate of return on total assets employed; too little liquidity
jeopardizes the very existence of the firm itself.
 Balances the opportunity cost of holding cash against the transactions costs associated with
replenishing the cash account by selling off marketable securities or borrowing

In managing the level of cash (currency plus demand deposits) for transaction purposes versus near cash
(marketable securities), the following cost must be considered: 
1. Fixed and variable brokerage fees  
2. Opportunity costs such as interest are forgone by holding cash instead of near cash.  

A. Total Costs of cash balances – holding:

Total Costs=Holding Costs+Transaction Costs

¿ ( Ave .Cash Bal . ) (Opportunity Costs )+( No . of transactions)(Cost per Transaction)

C T
¿ ( K )+ ( F)
2 C

Where:
C = amount of cash raised by selling marketable securities or by borrowing
C/2 = average cash balance
C* = optimal amount of cash to be raised by selling marketable securities or by borrowing
C*/2 = optimal average cash balance
F = fixed costs of making a securities trade or of obtaining a loan
T = total amount of net new cash needed for transactions during the period (usually a year)
K = opportunity cost of holding cash, net equal to the rate of return foregone on marketable securities
or the cost of borrowing to hold cash

B. Minimum Costs of cash balances are achieved when C is set equal to C*, the optimal cash transfer or
optimal cash replenishment level. The formula to find C* is as follows:

C∗¿
√2(Total amount of new net cash required)(¿ Costs of Trading Securities∨Cost of Borrowing)
Opportunity Cost of Holding Cash

OR

C∗¿
√2(T )( F)
K

Illustrative Case 1: Determination of Optimal Average Cash Balance for Baumol Model
To illustrate, consider a business with total payments of P10 million for one year, cost per transaction of P100, and
an interest rate on marketable securities is 8 percent. The optimal cash balance is calculated as follows:
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C∗¿
√2 ( 10 ) ( 100 ) =P158,114
8%
P 158,114
Optimal Average Cash Balance= =P 79,057
2

The firm may also want to hold a safety stock of cash to reduce the probability of a cash shortage to some
specified level. The Baumol model is simple in many respects.

2. The Miller-Orr Model

 Different approach to calculating the optimal cash management strategy.
 It assumes that the distribution of daily net cash flows is normally distributed and allows for
both cash inflows and outflows

L = lower control limit

F = trading cost for marketable securities per transaction
Ó = standard deviation in net daily cash flows
Iday = daily interest rate on marketable securities
Z* = optimal cash return point
H* = upper control limit for cash balances

To compute Z* To compute H*
3 √3 F Ó H∗¿3 Z∗−2 L
2
Z∗¿ +L
4 iday

Illustrative Case II: Calculation of Optimal Return Point and Upper Limit for Miller-Orr Model
Suppose that ABC Inc., would like to maintain its cash account at a minimum level of P100,000, but expects the
standard deviation in net daily cash flows to be P5,000; the effective annual rate on marketable securities will be 8
percent per year, and the trading cost per sale or purchase of marketable securities will be P200 per transaction.

What will be ABC’s optimal cash return point and upper limit?

The daily interest rate on marketable securities will equal to:

As shown in the above computation, the firm will reduce cash to

P126,101.72 by buying the marketable securities when the cash
balance gets up to P178,305.16, and it will increase cash to
P126,101.72 by selling marketable securities when the cash
balance gets down to P100,000.

CASH MANAGEMENT TECHNIQUES

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1. Synchronizing Cash Flows
 a situation in which inflows coincide with outflows thereby permitting a firm to hold low
transaction balances.
 A thorough review of the cash flow analysis, cash conversion cycle, and cash budget would be
most helpful.
2. Using Floats
 Floats
- the difference between the balance shown in a firm’s books and the balance on the bank’s
record
- arises from the delays in mailing, processing, and clearing checks through the banking
system.
 Disbursement Float
- represents the value of the checks the firm has written but which are still being
processed
- have NOT been deducted from the firm’s account balance by the bank.

EXAMPLE: Suppose a firm writes on average checks amounting to P50,000 each day, and it takes 5
days for these checks to clear and to be deducted from the firm’s bank account. This will cause the
firm’s own checkbook to show a balance of P250,000 smaller than the balance on the bank’s
records.

 Collections Float
- represents the number of checks that have been received but have not yet been credited
to the firm’s account by the bank.

EXAMPLE: Suppose that the firm also receives checks in the amount of P50,000 but it loses four
days while they are being deposited and cleared. This will result in P200,000 of collections float.

In total, the firm’s net float, the difference between P250,000 positive disbursement float and the
P200,000 negative collection float, will be P50,000.

If the net float is positive = disbursement float is more than collection float, then the available bank
balance exceeds the book balance. A firm with a positive net float can use it to its advantage and
maintain a smaller cash balance than it would have in the absence of the float.

3. Accelerating Cash Collections

 Can minimize the time lag between the time the customers send the checks to the firm and the
time when the firm can make use of the funds = accelerate the cash inflows of the firm
 Once the credit sales have been affected there should be a built-in mechanism for timely recovery
from the debtors such as:
a. Prompt billing and periodic statements
b. Incentives such as trade and cash discounts
c. Prompt deposit
d. Direct deposit to the firm’s bank account
e. Electronic depository transfer or payment by wire
f. Maintenance of the regional collection office

4. Slowing Disbursements
 lessens the use of the cash balance. This can be done by:
a. Centralized processing of payables
b. Zero balance accounts (ZBA)
c. Delaying payment
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d. Play the float
e. Less frequent payroll

5. Reducing the Need for Precautionary Balance

 Since the transaction and precautionary motives are the important determinants of the cash
requirement, factors influencing their combined level in the firm must be analyzed.
 There are techniques that are available for reducing the need for precautionary balances. These
include:
a. More accurate cash budgeting
b. Lines of credit
c. Temporary investments

Lesson 2: Managing Marketable Securities

OBJECTIVE: Management of cash and marketable securities CANNOT be separated, as management of one implies
management of the other.

Reasons for Holding Marketable Securities

1. They serve as a substitute for cash balances.
2. They are held as a temporary investment
3. They are built up to meet known financial requirements.

Factors Influencing the Choice of Marketable Securities

1. Risks such as:
a. Default risk
- issuer of the security cannot pay the principal or interest at due dates
- The funds invested in short-term marketable instruments should be safe and secure as regards
repayment of principal and interest as and when it matures since the return on short-term
investments is offered less than long-term investments,
- acceptable risk level = lesser commensurate with lower return.
- E.g., commercial paper is offered with credit ratings; government treasury bills, banker’s
acceptance, and certificate of deposits carry minimum default risk.
b. Interest rate risk – declines in market values of the security due to rising interest rates
c. Inflation risk
- risk that inflation will reduce the “real” value of the investment.
- In periods of rising prices, inflation risk is lower on investments (e.g., common stock, real
estate) whose returns tend to rise with inflation than on investments whose returns are fixed
d. Marketability (liquidity) risk
- refers to the risk that securities cannot be sold at close to the quoted market price and is
closely associated with liquidity risk.
- Liquidity is the basic objective of investment in these instruments.
- It should offer the facility of a quick sale in the market as and when the need arises for cash,
with low transaction cost, without loss of time, and no erosion of amounts invested with a fall in
the price of investments.
e. Event risk
- The probability that some event (e.g., merger, recapitalization, or a leveraged buyout) will
occur and suddenly will increase a firm’s default risk.
- Bonds issued by regulated companies such as banks or electric utilities generally have lesser
event risk than bonds issued by industrial and service companies.
- Treasury securities usually DO NOT carry any risk, barring national disaster.
- Long-term securities are affected more by unfavorable events than short-term securities.

2. Maturity
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 Marketable securities held should mature or can be sold at the same time cash is required.
Firms generally invest in marketable securities that have relatively short maturities.
 The maturity periods of different investments should match with the payment obligations like
dividend payments, tax payments, capital expenditure, and interest payments on debt instruments.
 Many firms restrict their temporary investments to those maturing in less than 90 days.
 Short-term investments relatively carry lesser return than long-term investments, since the default
risk and interest rate risk are minimized with short-term instruments.

3. Yield or returns on securities

 Generally, the higher a security’s risk, the higher its required return.
 Corporate investors, like other investors, must make a trade-off between risk and return when
choosing marketable securities.
 Because these securities are generally held either for a specific known need or for use in
emergencies, the portfolio should consist of highly liquid short-term securities issued by the
government or very strong corporations.
 Treasures should not sacrifice safety for higher rates of return.

Types of Marketable Securities

Types of Marketable Definition Maturity
Securities
1. Money Market  most suitable investment for idle funds. One year or less
Instruments  The market for short-term debt instruments.
 high-grade securities characterized by a high degree of
safety of principal

Two types:
a. Discount paper
- Less than its par or face value
- Investor’s income = security’s purchase price less par
value
- At maturity: receives the face value or par value
b. Interest-bearing
- Pay interest based on the par/face value and the
period (days/months)
2. Treasury Bills (or  short-term government securities One year or less
Risk-Free Security)  issued at a discount from face value
 tax-exempt with a high degree of marketability
3. Other Short-term  Unsecured Few days to 270
Commercial Papers  Discounted days
Issued by Finance  Can be interest-bearing
Companies, Banks,
and Other
Corporations
4. Negotiable Certificates  Short-term loans to commercial banks Few weeks to
of Deposit  Some default and interest rate risks several years
 Can be easily sold to prior maturity
5. Repurchase  sale of government securities (e.g., treasury bills) or Short-term
Agreements (REPOS) other securities by a bank or securities dealer with an overnight to a
agreement to repurchase few days
 attractive to corporations because of their flexibility or
maturities
 little risk because of their short maturity and the
commitment of the borrower to repurchase the securities
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at a fixed or higher specified price
6. Banker’s Acceptance  time draft is drawn on, and accepted by a bank usually Few weeks to 9
used as a source of financing in international trade months
 sold as discount paper
 yields on acceptance are competitive because of low
default risk owing to as many as three parties who may be
liable for payment at maturity
7. Money Market Mutual  open-ended mutual fund that invests in money-market
Fund (MMMF) instruments
 sell shares to investors and then accumulate the funds to
acquire money market instruments
 allow small investors to participate directly in high-
yielding securities that are often denominated in large
amounts
 highly liquid because they can be sold bank to the fund
any time
 Returns or yields depend on the money market
instruments held in the portfolio of the fund

Lesson 3. Managing Receivables

OBJECTIVE:
 To ensure that the firm’s investment in accounts receivable is appropriate and contributes to
shareholder wealth maximization.
 Responsibility of the finance officer: To evaluate the pertinent costs and benefits related to credit
extension, finance the firm’s investment in accounts receivable, implement the firm’s credit policy, and
enforce collection.

CREDIT POLICY
 is a set of guidelines for extending credit to customers.
 The success or failure of a business depends primarily on the demand for its products – as a rule, the higher
its sales, the larger its profits, and the higher the value of its stock.
 Sales - depend on several factors, some exogenous but under the control of the firm.
 The major controllable variables which affect the demand are sales prices, product quality, advertising,
and the firm’s credit policy.
 It generally covers the following variables:
1. Credit Standards
 refer to the minimum financial strength of an acceptable credit customer and the amount
available to a different customer.
 have a significant influence on sales
 If the credit policy is relaxed, while sales may increase, the quality of accounts receivable may
suffer.
 To measure the credit quality and customer’s creditworthiness, the following areas are
generally evaluated:
o Character, capacity, capital, collateral, and conditions

2. Credit Terms
 involve both the length of the credit period and the discount given.
 Credit period is the length of time buyers are given to pay their purchases.
 Discounts are price reductions for early payment.
 The discount specifies what the percentage reduction is and when the payment must be to be
eligible for the discount.
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3. Collection Policy
 refers to the procedures the firm follows to collect past-due accounts.
 For example, a letter may be sent to customers when the bill is 10 days past due; a more severe
letter, followed by a telephone call, may be used if payment is not received within 30 days; and
the account may be turned over to a collection agency after 90 days.

4. Delinquency and Default

 Whatever credit policies a business firm may adopt, there will be some customers who will
delay and others who will default entirely, thereby increasing the total accounts receivable
costs.

SUMMARY OF TRADE-OFFS IN CREDIT AND COLLECTION POLICIES

TRADE-OFFS
Benefit/s Cost/s
1. Relaxation of a. Increase in sales and total contribution a. Increase in credit processing costs.
Credit margin b. Increase in collection costs
Standards c. Higher default costs (bad debts)
d. Higher capital costs (opportunity costs)
2. Lengthening of a. Increase in sales and total contribution a. Higher capital costs (opportunity cost of
credit period margin higher investment in receivables)
3. Granting cash a. Increase in sales and total contribution a. Lesser profit
discount margin
b. Opportunity income on lower
investment in receivable
4. Intensified a. Lower default costs (had debts) a. Higher collection expenses
collection b. Lower opportunity cost or capital costs b. Lower sales
efforts

MARGINAL OR INCREMENTAL ANALYSIS OF CREDIT POLICIES

 performed in terms of a systematic comparison of the incremental returns and the incremental costs
resulting from a change in the firm’s credit policy.
 Whenever the incremental profit from a proposed change in the management of accounts receivable
exceeds the required return or incremental costs of the additional investment, the change should be
implemented.

Illustrative Case I: Relaxation of Credit Policy

ABC Corporation’s products sell for P10 a unit of which P7 represents variable costs before taxes including credit
department costs. Current annual credit sales are P2.4 million. The firm is considering a more liberal extension of
credit, which will result in a slowing in the average collection period from one month to two months.

The relaxation in credit standards is expected to produce a 25% increase in sales. Assume that the firm's required
rate of return on investment is 20% before taxes. Bad debt losses will be 5% of incremental sales and collection
expenses will increase by P20,000.

Required: Should the company liberalize its credit policy?

Incremental contribution margin from additional units (60,000 x P3) P180,000

Less: Bad debts (P600,000 x 5%) 30,000
Collection expenses 20,000 (50,000)
Net incremental profit P130,000

Required return on additional investment:

Level of receivables after change in credit policy (3 million/6mos) P(500,000)
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Present level of receivables (2.4 million/12 mos.) 200,000
P 300,000
Additional receivables:
Additional investment in receivables (P300,000 x 70%) P210,000
Multiply by: Required return 20%
Required return on additional investment P 42,000

Conclusion: In as much as the profit on additional sales of P130,000, exceeds the required return on the additional
investment of P42,000, the firm would be well-advised to relax its credit standards
Lesson 4. Management of Inventories

OBJECTIVE:
 Inventory is the stockpile of the product the firm is offering for sale and the components that make up a
product.
 Responsibility of the financial officer: To maintain a sufficient amount of inventory to ensure the smooth
operations of the firm’s production and marketing functions and at the same time avoid tying up funds in
excessive and slow-moving inventory.

INVENTORY MANAGEMENT TECHNIQUES

Inventory Planning
 involves the determination of what inventory quality, quantity, timing, and allocation should be in order
to meet future business requirements.
 EOQ model and Reorder Point.

1. Economic Order Quantity (EOQ) a. Total Inventory Costs = Total Ordering Costs + Total

√
Carrying Costs
2 x Annual Demand∈Units x Cost per order
EOQ= b. Total Ordering Costs =
Carrying Costs per unit Annual Demand∈Units
EOQ∨Order ¿ x Ordering Costs per Unit ¿
c. Total Carrying Costs = Average Inventory x Carrying
Costs per unit
d. Average Inventory = EOQ∨Order ¿ ¿2 ¿
2. Reorder Point = Lead Time Usage + Safety Stock

LEVEL MONITORING AND INVENTORY CONTROL SYSTEMS

 Inventory control is the regulation of inventory within predetermined limits.
 Effective inventory management should provide adequate stocks to meet the requirements of the
business, while at the same time keeping the required investment to a minimum.

Inventory Control Systems:

1. Fixed Order Quantity System
 each time the inventory goes down to a predetermined level known as the reorder point, an
order for a fixed quantity is placed.
 requires the use of perpetual inventory records or the continuous monitoring of the inventory
level.
2. Fixed Reorder Cycle System
 periodic review or the replacement system where orders are made after a review of inventory
levels has been done at regular intervals.
 An order is placed if, at the time of the review, the inventory level had gone down since the
preceding review, the quantity ordered under this system is variable depending on usage or
demand during the review period

Replenishment level is computed by the following formula: M = B + D (R + L)

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Where:
M = replenishment level in units
B = Buffer stock in units
D = Average demand per day
R = Time interval in days, between reviews
L = Lead time in days

3. Optional Replenishment Systems

 combination of important control mechanisms of the other two systems described above.

Replenishment level is computed by the use of the following equation: P = B + D (L + R/2)

Where:
P = Reorder point in units
B = Buffer Stock in units
D = Average daily demand in units
L = Lead time in days
R = Time between review in days

4. ABC Classification System

 segregation of materials for selective control is made.
 Inventories are classified into “A” or high-value items, “B” or medium-cost items, and “C” or low-
cost items.
 Control may be exercised on these items as follows:
o A items – highest possible controls, including most complete, accurate records,
regular review by a top supervisor, blanket orders with frequent deliveries from the
vendor, close follow-up through the factory deliveries from a vendor, close follow-up
through the factory to reduce lead time, etc. Careful accurate determination of order
quantities and order point with frequent review to reduce, if possible.
o B items – normal controls involving good records and regular attention; good analysis
for EOQ and order point but reviewed quarterly only or when major changes occur.
o C items – simplest possible controls such as periodic review of physical inventory
with no records or only the simplest notations that replenishment stocks have been
ordered; no EOQ or order point calculations.