Chapter 8 – Managing and Financing Current Assets

Reviewer: Chapter 8 – Managing and Financing Current Assets

Overview

Efficient management of working capital is essential for financial stability and profitability. This chapter covers cash conversion cycles, short-term asset management, and financing strategies to optimize liquidity and minimize financial risk.

Key Concepts & Terminologies

1. Working Capital Management

• Working Capital: The firm's current assets (cash, inventory, accounts receivable).

• Net Working Capital (NWC): The difference between the firm’s current assets and its current liabilities.

• Net Working Capital (NWC)

NWC=Current Assets−Current Liabilities

• A higher NWC reduces insolvency risk but may lower profitability.

• Trade-off Between Profitability & Risk:

  • More current assets → Lower risk, lower profitability

  • More current liabilities → Higher risk, higher profitability

2. Cash Conversion Cycle (CCC)

The CCC measures the time required for a company to convert cash invested in operations into cash received from sales.

2. Cash Conversion Cycle (CCC)

CCC=Average Age of Inventory (AAI)+Average Collection Period (ACP)−Average Payment Period (APP)

• Operating Cycle (OC):

  • OC=AAI+ACP

  • Time from production to cash collection.

• Reducing CCC:

  • Speeding up inventory turnover

  • Collecting receivables faster

  • Delaying payments to suppliers strategically

3. Managing Current Assets

• Inventory Management:

  • ABC System: Prioritizes inventory by value (A = High, B = Medium, C = Low).

  • Economic Order Quantity (EOQ): Optimizes order size to minimize costs.

    EOQ formula:\sqrt{2\cdot S\cdot\frac{O}{C}} ​​, where: S = usage in units per period, O = order cost per order, C = carrying cost per unit per period

  • Just-in-Time (JIT): Minimizes inventory investment by receiving supplies exactly when needed.

  • Materials Requirement Planning (MRP): Inventory management using EOQ concepts and computers to align production needs with inventory.

  • Manufacturing Resource Planning II (MRP II): Advanced system integrating data from finance, accounting, marketing, etc., to generate production plans and financial reports.

  • Enterprise Resource Planning (ERP): System integrating external supplier and customer data with internal data for real-time resource management, delay reduction, and cost control.

• Accounts Receivable Management: The objective for managing accounts receivable is to collect accounts receivable as quickly as possible without losing sales from high-pressure collection techniques.

• Credit Selection and Standards: Credit selection involves determining which customers should receive credit by evaluating their creditworthiness against the firm's minimum credit standards.

• Five Cs of Credit

• 1. Character. The applicant’s record of meeting past obligations.

• 2. Capacity. The applicant’s ability to repay the requested credit, as judged in terms of financial statement analysis focused on cash flows available to repay debt obligations.

• 3. Capital. The applicant’s debt relative to equity.

• 4. Collateral. The amount of assets the applicant has available for use in securing the credit. The larger the amount of available assets, the greater the chance that a firm will recover funds if the applicant defaults.

• 5. Conditions. Current general and industry-specific economic conditions and any unique conditions surrounding a specific transaction.

  • Credit Scoring: Credit scoring is a method used for high-volume, small-dollar credit requests. It uses statistical weights to assess an applicant's financial and credit traits, predicting payment behavior. The resulting score indicates credit strength and helps large credit card operations make fast, cost-effective credit decisions. Regular reevaluation is needed if bad debts increase.

  • Credit Standard:

  • Credit Terms: Defines payment period and discounts (e.g., 2/10, net 30).

    >Cash Discount Period: The number of days after the beginning of the credit period during which the cash discount is available.

    >Credit Period: The number of days after the begging of the credit period until full payment of the account is due.

  • Credit Monitoring: Credit monitoring is an ongoing review of a firm’s accounts receivable to ensure customers pay according to credit terms. It identifies slow payments, which increase the firm’s investment in accounts receivable by lengthening the average collection period. Techniques used in credit monitoring include the average collection period, aging of accounts receivable, and various collection methods.

    • Average Collection Period: The average collection period is the average number of days that credit sales are outstanding. It consists of the time from the sale until the customer mails the payment, plus the time to receive, process, and collect the payment.

    • Aging Schedule: Classifies receivables based on overdue status.

    • Collection Techniques: Letters, phone calls, agencies, legal action.

4. Short-Term Financing Strategies

• Spontaneous Financing: Arises naturally from operations (e.g., accounts payable).

• Negotiated Financing: Includes short-term bank loans, commercial paper, lines of credit, etc.

• Seasonal vs. Permanent Funding Needs:

  • Aggressive Strategy: the firm funds its seasonal requirements with short-term debt and its permanent requirement with long-term debt.

  • Conservative Strategy: the firm funds both its seasonal and its permanent requirements with long-term debt.

5. Financial Markets & Sources of Short-Term Funds

• Money Market: Short-term financial instruments (Treasury bills, commercial paper).

• Capital Market: Long-term financing (stocks, bonds).

• Eurocurrency Market: International equivalent of domestic money markets.

Key Takeaways

• Efficient working capital management improves liquidity & profitability.

• Reducing CCC optimizes cash flow & reduces financing needs.

• Balancing short-term vs. long-term financing is crucial for financial stability.