LN17 Keown33019306 08 LN17 GE

Chapter 17
Managing Short-
Term Investments
in Current Assets
Learning Objectives
1. Understand the problems inherent in

managing the firm’s cash balances.
2. Evaluate the costs and benefits
associated with managing a firm’s credit
policies.
3. Understand the financial costs and
benefits of managing firm’s investment in
inventory.
Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-2

MANAGING THE FIRM’S
INVESTMENT IN CASH AND
MARKETABLE SECURITIES

Cash and
Marketable Securities
• Cash refers to currency and coins plus

demand deposit accounts.
• Marketable securities includes security

investments the firm can quickly convert to
cash balances.

Why a Company
Holds Cash
Cash Flow Process

• Two typical sources of cash: external and
internal
• Irregular increases or decreases in the
firm’s cash holdings can come from several
sources such as:
– Sale of securities (stocks and bonds)
– Nonmarketable-debt contracts
– Payment of dividend, interest, tax bills
– Share repurchases

Figure 17-1

Three Motives
for Holding Cash
• Transactions Motive
– Balances held to meet cash needs that arise in

the ordinary course of doing business.

Three Motives
for Holding Cash
• Precautionary Motive
– Precautionary balance serves as a buffer

– Maintain balances to satisfy possible, but as yet
unknown, needs

Three Motives
for Holding Cash
• Speculative Motive
– Cash held to take advantage of potential profit-

making situations

Cash Management
Objectives and Decisions
• Cash management program must minimize

the firm’s risk of insolvency.
• Insolvency—The situation in which the firm
is unable to meet its maturing liabilities on
time.
• A company is technically insolvent in that it
lacks the necessary liquidity to make prompt
payment on its current debt obligations.

The Trade-Off
• A large cash balance will help minimize the

chance of insolvency, but it penalizes the
company’s profitability.
• A smaller cash balance will increase the
chance of insolvency, but it will free up
excess cash for investment and enhance
profitability.

Cash Management Objectives
Two prime objectives:

• Enough cash must be on hand to meet
disbursal needs in the course of doing
business.
• Investment in idle cash balances must be
reduced to a minimum.

Cash Management Objectives
• Two conditions would allow the firm to

operate for extended periods with cash
balances near or at zero:
– Completely accurate forecast of net cash flows
over the planning horizon.
– Perfect synchronization of cash receipts and
disbursements.

Cash Management Decisions
• What can be done to speed up cash

collections and slow down or better control
cash outflows?
• What should be the composition of a

marketable securities portfolio?

Collection and
Disbursement Procedures
• The efficiency of firm’s cash management

program can be improved by:
– accelerating cash receipts
– improving the methods used to disburse cash

Speeding up Collection
• What can be done to accelerate collection

procedures?
– Reduce Float
– Lockbox System

Figure 17-2

Float and
Managing Cash Inflow
• Float—The time from when a check is
written until the actual recipient can draw
upon or use the funds:
– Mail Float
– Processing Float
– Transit Float
– Disbursing Float

Float and Managing
Cash Inflow
• Mail Float
– Time lapse from the moment a customer mails a
remittance check until the firm begins to process
it.
• Processing Float
– The time required for the firm to process
remittance checks before they can be deposited
in the bank.

Float and Managing
Cash Inflow
• Transit Float
– The time necessary for a deposited check to clear
through the commercial banking system and
become usable funds to the company.
• Disbursing Float
– Availability of funds in the company’s bank
account during the time the payment check is
clearing through the banking system.

Lockbox Arrangement
• Commercial banking service where

customers mail checks to a post office box
(rather than company) to expedite cash
collection
– The bank providing the lock box service is
authorized to open the box, collect the mail,
process the checks, and deposit the checks
directly into the company’s account.
– See Figure 17-3

Figure 17-3

Benefits of Lockbox Arrangement
• Reduces mail and processing float and can

reduce transit float
• Funds deposited in this manner are usually
available for company use in one business
day or less
• Elimination of clerical functions
• Early knowledge of dishonored checks

Benefit of Float Reduction
• The financial benefit of float reduction can

be calculated as follows:
– Sales per day  days of float reduction 
assumed yield
– Where:
– Sales per day = Annual revenues / days in
year

Example
• If a company with daily sales of

$69,594,521 could invest in marketable
securities to yield 6 percent annually and
could eliminate 4 days of float, what would
be the annual savings?
= $69,594,521 * 4 * 0.06
= $16,702,685

Managing the Cash Outflow
• Goal: To increase company’s float by

slowing down the disbursement and
collection process through:
– Zero balance accounts (ZBA)
– Payable-through drafts (PTD)

Zero Balance Accounts (ZBA)
• Permit centralized control over the cash

outflows while maintaining divisional
disbursing authority.
• Process: Establish zero balance accounts for
all of the firm’s disbursing units. These
accounts are all in the same concentration
bank. Checks are drawn against these
accounts, with the balance in each account
never exceeding $0. Divisional disbursing
authority is thereby maintained at the local
level of managers.

Benefits of
Zero Balance Accounts
– Achieves better control over its cash payments
– Reduces excess cash balances held in regional
banks for disbursing purposes
– Increases disbursing float

Payable-Through Drafts (PTD’s)
• Legal instruments that have the physical

appearance of ordinary checks but are not
drawn on a bank. Instead, PTDs are drawn
on and payment is authorized by the issuing
firm against its demand deposit account.
• Process: Field office issues drafts rather
than checks to settle up payables.
• Benefit: Achieves effective “control-office”
control over field-authorized payments.

Evaluating the Costs of Cash
Management Services
P = (D)(S)(i)
• P = per check processing cost if the system
is adopted
• D = days saved in the collection process or
float reduction
• S = average check size in dollars
• i = daily, before-tax opportunity cost or rate
of return of carrying cash

The Composition of a Marketable-
Securities Portfolio
• The general selection criteria for proper

marketable-securities mix include:
– Financial risk,
– Interest rate risk,
– Liquidity,
– Taxability, and
– Yields

Financial Risk
• Refers to the uncertainty of expected

returns from a security attributable to
possible changes in the financial capacity of
the security issuer to make future payments
to the security owner.
• If the chance of default on the terms of the
instrument is high, then the financial risk is
said to be high.

Interest Rate Risk
• Interest rate risk refers to the uncertainty of

expected return from a financial instrument
attributable to changes in interest rates.

Liquidity
• Liquidity refers to the ability to convert a

security into cash.
• Should an unforeseen event require that a
significant amount of cash be immediately
available, then a sizable portion of the
portfolio might have to be sold. Manager
should prefer securities that can be sold at
or near its prevailing market price.

Taxability
• The tax treatment of the income a firm

receives from its security investments does
not affect the ultimate mix of the
marketable-securities portfolio as much as
the criteria mentioned earlier since interest
income from most instruments is taxable at
the federal level.

Comparison of
After-Tax Yields

Yields
• Yield is affected by previous factors of

financial risk, interest rates, liquidity and
taxability.
• The yield criterion involves an evaluation of
the risks and benefits inherent in all of these
factors. For example, if a given risk is
assumed, such as lack of liquidity, a higher
yield may be expected on the non-liquid
instrument.

Marketable Security Alternatives
• Money market securities generally have

short-term maturity and are highly
marketable.
• Characteristics of Marketable Securities in
terms of five key attributes are:
– Denominations in which securities are available,
– Maturities that are offered,
– Basis used,
– Liquidity of the instrument, and
– Taxability of the investment returns

Examples of
Marketable Securities
• U.S. Treasury Bills

– Direct obligations of the U.S. government sold by
the U.S. Treasury on a regular basis.
• Federal Agency Securities
– Debt obligations of corporations and agencies
that have been created to effect various lending
programs of the U.S. government.

Examples of Marketable
Securities
• Banker’s Acceptances
– Draft (order to pay) drawn on a specific bank by
an exporter in order to obtain payment for goods
shipped to a customer who maintains an account
with that specific bank.
• Negotiable Certificates of Deposit
– Marketable receipt for funds that have been
deposited in a bank for a fixed period.

Examples of Marketable
Securities
• Commercial paper
– Short-term unsecured promissory notes sold by
large businesses.
• Repurchase agreements
– Legal contracts that involve the actual sale of securities by a
borrower to the lender, with a commitment on the part of
the borrower to repurchase the securities at the contract
price plus a stated interest charge.
• Money market mutual funds
– Pooling of the funds of large number of small
savers.

INVESTMENT IN ACCOUNTS
RECEIVABLE

Accounts Receivable Management
• Accounts receivable is less liquid compared

to cash and marketable securities. Account
receivables typically comprise 25% of a
firm’s assets.
• Size of investment in accounts receivable is
determined by:
– The percentage of credit sales to total sales
– The level of sales
– Credit and collection policies

Terms of Sale –
A Decision Variable
• Identify the possible discount for early

payment, the discount period, and the total
credit period.
– They are stated in the form a/b, net c
– Thus a customer can deduct a% if paid within b
days, otherwise it must be paid within c days.
• Example 1/10, net 45 ==> Discount of 2% if paid
within 10 days; otherwise due in 45 days.

The Type of Customer –
A Decision Variable
• This involves determining the type of

customer who qualifies for trade credit.
• Need to consider the costs of credit
investigation, collection costs, default costs.
• May use credit scoring or a numerical
evaluation of each applicant to determine
their short-run financial well-being.

Collection Effort –
A Decision Variable
• The probability of default increases with the
age of the account. Thus, eliminating past-
due receivables is key. One common way of
evaluating the situation is with ratio analysis
– average collection period, ratio of
receivables to assets, ratio of credit sales to
receivables, ratio of bad debt to sales.
• A direct tradeoff exists between collection
expenses and lost goodwill on one hand and
noncollection of accounts on the other.

INVESTMENT IN
INVENTORY

Inventory Management
• Inventory management involves the control

of the assets that are produced to be sold in
the normal course of the firm’s operations.
• The purpose of carrying inventory is to
make each function of the business
independent of each other function—so that
delays or shutdowns in one area do not
affect the production and sale of the final
product.

The Trade-Off
• Risk: If inventory level is low, it is possible

that there will be delays in production and
customer delivery.
• Return: Low inventory will reduce storage
and handling costs and release funds tied up
in inventory. Thus it will increase returns.
• Similarly, high levels of inventory will reduce
delays but increase costs.

Types of Inventory
• Raw materials inventory

– Basic materials purchased to be used in the
firm’s production operations
• Work in process inventory
– Partially finished goods requiring additional work
before they become finished goods
• Finished goods inventory
– Goods on which production has been completed
but are not yet sold

Inventory Management
Techniques
• Effective inventory management is directly
related to the size of the investment in
inventory.
• Effective management is essential to the
goal of maximization of shareholder wealth.
• To control the investment in inventory,
management must solve two problems:
– The order quantity problem
– The order point problem

The Order Quantity Problem
• Involves determining the optimal order size

for an inventory item given its expected
usage, carrying costs, and ordering costs.

Total Inventory Costs

Total Inventory Costs
• Economic order quantity (EOQ) attempts to

determine the order size that will minimize
total inventory costs.

Figure 17-6

Figure 17-7

Assumptions of the
EOQ Model
• Constant or uniform demand
• A constant unit price
• Constant carrying costs
• Constant ordering costs
• Instantaneous delivery
• Independent orders

The Order Point Problem
• The two most limiting assumptions in EOQ—

constant demand and instantaneous delivery
—are dealt with through the inclusion of
safety stock.

• Safety stock
– Inventory held to accommodate any unusually
large and unexpected usage during delivery time
• Order point problem
– The decision about how much safety stock to
hold or how low the inventory should be depleted
before it is ordered

• Delivery-time stock—Inventory needed

between the order date and the receipt of
the inventory ordered.
• The order point is reached when inventory

falls to a level equal to the delivery-time
stock plus the safety stock. See Figure 17-8.

Figure 17-8

Just-in-Time
Inventory System
• The goal is to operate with the lowest average level
of inventory possible.
• Within the EOQ model, the basics are to:
– Reduce ordering costs
– Reduce safety stocks
• This is achieved by attempts to receive continuous
flow of deliveries of component parts.
• The result is to actually have about 2 to 4 hours’
worth of inventory on hand.

Inflation and EOQ
• Inflation affects the EOQ model in two ways:

– Anticipatory buying- buying in anticipation of a
price increase to secure the goods at a lower
cost.
– Increased carrying costs – as inflation pushes up
interest rates, the costs of carrying inventory
increases. As “C” increases, the optimal EOQ
declines in the EOQ model.

Key Terms
• Anticipatory buying
• Cash
• Credit scoring
• Delivery-time stock
• Finished-goods inventory
• Float
• Insolvency
• Inventory management
• Just-in-time inventory control system

Key Terms
• Marketable securities
• Order point problem
• Order quantity problem
• Payable-through drafts (PTD)
• Raw materials inventory
• Safety stock
• Terms of sale
• Work-in-process inventory
• Zero balance accounts (ZBA)

Table 17-1

Table 17-2

Figure 17-4

Figure 17-5

Table 17-4

Table 17-5

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Chapter 17

1. Understand the problems inherent in

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-2

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-3

• Cash refers to currency and coins plus

• Marketable securities includes security

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-4

Cash Flow Process

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-5

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-6

– Balances held to meet cash needs that arise in

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-7

– Precautionary balance serves as a buffer

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-8

– Cash held to take advantage of potential profit-

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-9

• Cash management program must minimize

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-10

• A large cash balance will help minimize the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-11

Two prime objectives:

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-12

• Two conditions would allow the firm to

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-13

• What can be done to speed up cash

• What should be the composition of a

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-14

• The efficiency of firm’s cash management

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-15

• What can be done to accelerate collection

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-16

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-17

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-18

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-19

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-20

• Commercial banking service where

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-21

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-22

• Reduces mail and processing float and can

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-23

• The financial benefit of float reduction can

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-24

• If a company with daily sales of

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-25

• Goal: To increase company’s float by

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-26

• Permit centralized control over the cash

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-27

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-28

• Legal instruments that have the physical

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-29

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-30

• The general selection criteria for proper

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-31

• Refers to the uncertainty of expected

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-32

• Interest rate risk refers to the uncertainty of

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17-33

• Liquidity refers to the ability to convert a