CHAPTER 4

MANAGING CURRENT ASSETS

Working capital Terminologies
Working capital is defined as a firm’s investments in current assets. A related concept is net
working capital, defined as current assets minus current liabilities. The principal categories of
working capital are current asset consists of cash, marketable securities, accounts receivable and
inventory. Current liabilities include accounts payable, banks loans and notes payable; and
current debt (due in one year).
Working capital policy: refers to the firm’s basic policies regarding 1) target levels for each
category of current assets and 2) how current assets will be financed.
Working capital management: involves the administration, with in policy guidelines, of
current assets and current liabilities.
Cash and marketable security management
Cash and marketable securities are the most liquid of the firm’s assets. Cash is the ready
currency to which all liquid assets can be reduced. Marketable securities are short term, interest-
earning, money market instruments that are used by the firm to obtain a return on temporarily
idle funds. Cash and marketable securities are held by firms to reduce the risk of technical
insolvency by providing a pool of liquid resources for use in making planned as well as
unexpected outlays. The desired balances are determined by carefully considering the motives
for holding them. The higher these balances are, the lower the risk of technical insolvency, and
the lower they are, the higher the risk of technical insolvency.

Motives for holding cash and near cash balances

There are three motives for holding cash and near cash (marketable securities) balances. Each
motive is based on two underlying questions:
1) What is the appropriate degree of liquidity to maintain? And
2) What is the appropriate distribution of liquidity between cash and marketable securities?
A. Transaction motive
Has an objective of holding cash to meet the day-to-day requirements to meet payments, such as
purchases, wages, taxes, and dividends,arising in the ordinary course of business.Transaction-
related needs come from normal disbursement and collection activities of the firm. The
disbursement of cash includes the payment of wages and salaries, trade debts, taxes, and
dividends. Cash is collected from sales from operations, sales of assets, and new financing.
Safety motive
Balances held to satisfy the safety motive are invested in highly liquid marketable securities that
can be immediately transferred from securities to cash. Such securities protect the firm against
being unable to satisfy unexpected demands for cash.
B. Speculative motive
This is a motive of holding cash or near cash to put unneeded funds to work or to be able to
quickly take advantage of unexpected opportunities that may arise. Speculative motive is the

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least common of the three motives.Such opportunities are unusual within the business
operations; hence they may throw more options outside the business like, investment in the bank,
purchase of shares and bonds with an intention to resale, and purchase of government bills.

C. Precautionary motive
Precautionary motive of holding cash is to meet the unexpected business expenses. Cash is held
to meet contingencies in future like emergencies. It is a motive to maintain a safety cushion or
buffer to meet unexpected cash needs. The more predictable the inflows and outflows of cash for
a firm, the less cash that needs to be held for precautionary needs. Ready borrowing power to
meet emergency cash drains also reduces the need for this type of cash balance.

Estimating cash balances

Management’s goal should be to maintain levels of transactional cash balances and marketable
securities investments that contribute to improving the value of the firm. If levels of cash are too
high, the profitability of the firm will be lower than if more optimal balance were maintained.
Firms can use either subjective approaches or quantitative models to determine appropriate
transactional cash balances.
A. Subjective approaches
A subjective approach might be to maintain transactional balances equal to 10 percent of the
following month’s sales. If the forecast amount of sales for the following month is birr 500,000,
the firm would maintain a birr 50,000 ( i.e 0.10 x 500,000) transaction cash balance.
B. Quantitative models
Two quantitative models that management can use to determine the appropriate transactional
cash balances are the Baumol model and the Miller-Orr model.

Baumol Model
A model that provides for cost efficient transactional cash balances; assumes that the demand for
cash can be predicted with certainty and determines the economic conversion quantity (ECQ). It
treats cash as inventory item whose future demand for settling transactions can be predicted with
certainty. Baumol’s cash management model helps in determining a firm’s optimum cash
balance under certainty. In other words, cash inflows and cash outflows are assumed to be
known with certainty. A portfolio of marketable securities acts as a reservoir for replenishing
transactional cash balances. The firm manages this cash inventory on the basis of the cost of
converting marketable securities into cash (the conversion cost) and the cost of holding cash
rather than marketable securities (opportunity cost). The economic conversion quantity (ECQ),
the cost minimizing quantity in which to convert marketable securities to cash is

ECQ = 2 x Conversion cost x demand for cash

Opportunity cost (in decimal form)

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Conversion cost: includes the fixed cost of placing and receiving an order for cash in the amount
ECQ. It includes the cost of communicating the necessary to transfer funds to the cash account,
associated paper work costs, and the cost of any follow up action. The conversion cost is stated
as birr per conversion.

Opportunity cost: is the interest earnings per birr given up during a specified time period as a
result of holding funds in a non-interest earning cash account rather than having them invested in
interest earning marketable securities.

Total cost: is the sum of the total conversion and total opportunity costs. Total conversion cost
equals the cost per conversion times the number of conversions per period. The number of
conversions per period can be found by dividing the period’s cash demand by economic
conversion quantity (ECQ). The total birr opportunity cost equals the opportunity cost (in
decimal form) times the average cash balance. The average cash balance is found by dividing
ECQ by 2. The total cost equation is
Total cost = Transaction cost + Holding cost
= (Cost per conversion x number of conversions)
+ [Opportunity cost (in decimal form) x average cash balance]

The objective of the Baumol model is to determine the economic conversion quantity (ECQ) of
cash that minimizes total cost. Cash transfer that are larger or smaller than ECQ result in higher
total cost.

Illustration: The management of Alem Sport, a small distributor of sporting goods, anticipates
birr 1,500,000 in cash outlays (demand) during the coming year. A recent study indicates that it
costs birr 30 to convert marketable securities to cash. The marketable securities portfolio
currently earns an 8 percent annual rate or return,

Required: Compute Economic conversion quantity (ECQ)?

a. Number of conversions?
b. Average cash balance?
c. Total cost?

Solution:

ECQ= 2 x Conversion cost x demand for cash

Opportunity cost (in decimal form)

= 2 x 30 x 1,500,000

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 0.08 = 33,541 birr

Number of conversion during the year to replenish the account = 1,500,000/33,541= 45

The average cash balance = 33541/2 = Br. 16,770.50

The total cost of managing the cash is

Total cost = (Cost per conversion x number of conversions)

+ [Opportunity cost (in decimal form) x average cash balance]
= (Br.30 x 45) + (0.08 x Br 16,770.50) = Br. 2,692

There are certain assumptions that are made in the model.

1. The firm is able to forecast its cash requirements with certainty and receive a
specific amount at regular intervals.
2. The firm’s cash payments occur uniformly over a period of time i.e. a steady rate
of cash outflows.
3. The opportunity cost of holding cash is known and does not change over time.
Cash holdings incur an opportunity cost in the form of opportunity foregone.
4. The firm will incur the same transaction cost whenever it converts securities to
cash.

Limitations of the Baumol model:

5. It does not allow cash flows to fluctuate.

6. Overdraft is not considered
7. There are uncertainties in the pattern of future cash flows.

MILLER- ORR MODEL

A model that provides for cost efficient transactional cash balances; assumes uncertain cash
flows and determines an upper limit (i.e. the maximum amount) and return point for cash
balances. The return point represents the level at which the cash balance is set, either when cash
is converted to marketable securities or vice versa. Cash balances are allowed to fluctuate
between the upper limit and a zero balance.
Return point: the value for the return point depends on:
1. conversion costs
2. the daily opportunity cost of funds, and
3. The variance of daily net cash flows.
The variance is estimated by using daily net cash flows (inflows minus outflows for the day).
The formula for determining the return point is

Return point = 3 x Conversion cost x Variance of daily net cash flows

3 4 x daily opportunity cost (in decimal form)
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Upper limit: the upper limit for the cash balance is three times the return point.
Cash balance reaches the upper limit: when the cash balance reaches the upper limit, an amount
equal to the upper limit minus the return point is converted to marketable securities.

Cash Balance falls to zero: when the cash balance falls to zero, the amount converted from
marketable securities to cash to
Cash converted is marketable
the amount securities
represented by thelimit
= upper return point. point
– return

Illustration: continuing with the prior example, it costs Alem sport birr 30 to convert marketable
securities to Marketable securities
cash, or vice converted
versa; the firm’s to cash = return
marketable point –portfolio
securities zero balance
earns an 8 percent
annual return, which is 0.0222 percent daily( 8%/360 days). The variance of Alem sport’s daily
net cash flows is estimated to be birr 27,000.

Return point = 3 x Conversion cost x Variance of daily net cash flows

3 4 x daily opportunity cost (in decimal form)

3 x 30 x 27,000
3 4 x 0.000222 = 1,399

The upper limit is 3 x return point

Upper limit = 3 x 1,399 = 4,197
The firm’s cash balance will be allowed to vary between birr 0 and birr 4,197. When the upper
limit is reached, birr 2,798 (4,197- 1,399) is converted from cash to marketable securities that
will earn interest. When the cash balance falls to zero, birr 1,399 (1,399-0) is converted from
marketable securities to cash.

Cash management techniques

To minimize the firm’s financing requirements; financial managers attempt to speed collections
and slow disbursements.

Cash flow synchronization

It is arranging of events that cash receipts coincide with required cash outflows. It reduces the
transaction balances to a minimum, decrease its bank loans, lower interest expenses, and boost
profits.

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Float
In the broadest sense, float refers to funds that have been dispatched by a payer ( the firm or
individual making payment) but are not yet in a form that can be spent by the payee( the firm or
individual receiving payment). Float also exists when a payee has received funds in a spendable
form but these funds have not been withdrawn from the account of the payer. Delays in the
collection –payment system resulting from the transportation and processing of checks are
responsible for float. With electronic payment system float will disappear. However, financial
manager must continue to understand and take advantage of float until that time.

Types of float
1. Collection float: results from the delay between the times when a payer or customer
deducts a payment form its checking account ledger and the time when the payee or
vendor actually receives these funds in a spendable form. Thus collection float is
experienced by the payee and is a delay in the receipt of funds.
2. Disbursement float: results from the lapse between the time when a firm deducts a
payment form its checking account ledger (disburse it) and the time when funds are
actually withdrawn from its account. Disbursement float is experienced by the payer and
is a delay in the actual withdrawal of funds.

Components of float
Both collection float and disbursement float have the same three basic components:
1. Mail float: the delay between the time when a payer places payment in the mail and the
time when it is received by the payee.
2. Processing float: the delay between the receipt of a check by the payee and the deposit of
it in the firm’s account.
3. Clearing float: the delay between the deposit of a check by the payee and the actual
availability of the funds. This component of float is attributable to the time required for a
check to clear the banking system
Speeding up collections
The firm’s objective is not only to stimulate customers to pay their accounts as promptly as
possible but also to convert their payments into a spendable form as quickly as possible- in other
words, to minimize collection float. Some of the techniques to speeding up collections are:
1. Concentration banking: a collection procedure in which payments are made to
regionally dispersed collection centers, then deposited in local banks for quick clearing.
Reduces collection float by shortening mail and clearing float.
2. Lockboxes: a collection procedure in which payers send their payments to a nearby post
office box that is emptied by the firm’s bank several times daily; the bank deposits the
payment checks in the firm’s account. Reduces collection float by shortening processing
float as well as mail and clearing float.
3. Direct send: a collection procedure in which the payee presents payment checks directly
to the banks on which they are drawn, thus reducing clearing float.
4. Preauthorized checks

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 5. Wire transfer.
Receivable Management
Account receivables represent the extension of credit by the firm to its customers. The extension
of credit to customers by most manufacturers is a cost of doing business. By keeping its money
tied up in accounts receivable, the firm loses the time value of the money and runs the risk of
nonpayment by its customers. In return for incurring these costs, the firm can be competitive,
attract and retain customers, and improve and maintain sales and profits.
Generally, the firm’s financial manager directly controls accounts receivable through
involvement in the establishment and management of
1. credit policy, which includes determining credit selection, credit standards, and credit
terms, and 2) collection policy
A firm’s credit selection activity involves deciding whether to extend credit to a customer and
how much credit to extend. Appropriate sources of credit information and methods of credit
analysis must be developed.

The five C’s of Credit

A firm’s credit analysts often use the five C’s of credit to focus their analysis on the key
dimensions of an applicant’s creditworthiness.
1. Character: the applicant’s record of meeting past obligations- financial, contractual, and
moral. Past payment history as well as any pending or resolved legal judgments against
the applicant would be used to evaluate its character.
2. Capacity: the applicant’s ability to repay the requested credit. Financial statement
analysis with particular emphasis on liquidity and debt ratio is typically used to assess the
applicant’s capacity.
3. Capital: the financial strength of the applicant as reflected by its ownership position.
Analysis of the applicant’s debt relative to equity and its profitability ratios are frequently
used to assess its capital.
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
its funds if the applicant defaults. A review of the applicant’s balance sheet, asset value
appraisals, and any legal claims filed against the applicant’s assets can be used to
evaluate its collateral.
5. Conditions: the current economic and business climate as well as any unique
circumstances affecting either party to the credit transaction. For example, if the firm has
excess inventory of the item the applicant wishes to purchase on credit, the firm may be
willing to sell on more favorable terms or to less creditworthy applicants. Analysis of
general economic and business conditions, as well as special circumstances that may
affect the applicant or firm is performed to assess conditions.
The credit analyst typically gives primary attention to the first two C’s – character and capacity-
since they represents the most basic requirements for extending credit to an applicant.
Consideration of the last three C’s – capital, collateral, and conditions- is important in structuring

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the credit arrangement and making the final credit decision, which is affected by the credit
analyst’s experience and judgment.

Collection Policy
It is the set of procedures for collecting accounts receivable when they are due. The
effectiveness of this policy can be partly evaluated by looking at the level of bad debt expenses.
This level of depends not only on collection policy but also on the policy on which the extension
of credit is based. If one assumes that the level of bad debts attributable to credit policy is
relatively constant, increasing collection expenditures can be expected to reduce bad debts.
Popular approaches used to evaluate credit and collection policies include the average collection
period ratio and aging accounts receivable.

Types of collection techniques

A number of collection techniques are employed. As an account becomes more and more
overdue, the collection effort becomes more personal and strict. The basic techniques are:
 Letters: after an account receivable becomes overdue a certain number of days, the firm
normally sends a polite letter reminding the customer of its obligation. Collection letters
are the first step in the collection process for overdue accounts.
 Telephone calls: if letter prove unsuccessful, a telephone call may be made to the
customer to personally request immediate payment
 Personal visits: sending a local salesperson or a collection person to confront the
customer can be a very effective collection procedure.

 Using collection agencies: a firm can turn uncollectible accounts over to a collection
agency or an attorney for collection. The fee for this service are typically quite high; the
firm may receive less than 50% on accounts collected in this way.
 Legal action: legal action is the most stringent step in the collection process. It is an
alternative to the use of a collection agency. Not only is direct legal action expensive, but
it may force the debtor into bankruptcy, thereby reducing the possibility of future
business without guarantying the ultimate receipt of the overdue amount.

Inventory Management
Inventory is a necessary current asset that permits the production -sale process to operate with a
minimum disturbance. The three basic types of inventory are raw materials, work in process, and
finished goods.
Techniques for managing inventory
Techniques that are commonly used in managing inventory are:
1. ABC system
2. Economic order quantity (EOQ) model
3. Reorder point
4. Material requirement planning (MRP) system and
5. Just-in-time (JIT) system

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ABC system
Inventory is divided into three groups, A, B, and C. The A group includes those items that
require the largest birr investment. The B group consists of the items accounting for the next
largest investment. The C group typically consists of a large number of items accounting for a
relatively small birr
Carrying costinvestment.
= C x Q/2 Dividing its inventory into A, B, and C items allows the firm to
determine the level andCtypes
Where is carrying cost percontrol
of inventory unit per period needed. Control of A items should
procedures
Q isuse
be most intensive and the order quantity ininventory
of perpetual units record keeping that allows daily monitoring
of these inventory levels is appropriate. B items are frequently controlled through Periodic
checking- possibly weekly- of their levels. C items could be controlled by using unsophisticated
procedures such as a red ling method, in which a reorder is placed when enough inventory has
been removed from a bin containing the inventory item to expose a red line that has been drawn
around the inside of the bin.
Economic Order Quantity (EOQ)
It is most commonly cited sophisticated tools for determining the optimal order quantity for an
item of inventory. It takes into account various operating and financial costs and determines the
order quantity that minimizes total inventory cost.
Excluding the actual cost of the merchandise, the costs associated with inventory can be divided
into three broad groups: order costs, carrying costs, and total costs.

Order costs: it includes the fixed clerical costs of placing and receiving an order- 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 normally stated as birr per order.

Order cost = O x S/Q

Where O is order cost per order
S is usage in units per period
Q is order quantity in units

Carrying costs are the variable costs per unit of holding an item in inventory for a specified time
period. These costs are typically stated as birr per unit per period. Carrying cost includes storage
costs, insurance costs, the cost of deterioration and obsolescence, and most important, the
opportunity, or financial, cost of tying up funds in inventory.

Total cost is defined as the sum of the order and carrying costs. Total cost is important in the
EOQ model, since the model’s objective is to determine the order quantity that minimizes it.
Total cost = (O x S/Q) + (C x Q/2)

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The stated objective of the EOQ model is to find the order quantity that minimizes the firm’s
total inventory cost. The economic order quantity can be found with the following formula.

EOQ = 2xSxO
C

Example, Assume that XXX Company, a manufacturer of electronic test equipment, uses 1,600
units of an item annually. Its order cost is birr 50 per order, and carrying cost is birr 1 per unit
per year..
Required: Determine the economic order quantity?

EOQ = 2xSxO
C

EOQ = 2 x 1600 x 50
1 = 400 units

Reorder Point
Once the firm has calculated its economic order quantity, it must determine when to place orders.
A reorder point is required that considers the lead time needed to place and receive orders.
Assuming a constant usage rate for inventory, the reorder point can be determined by the
following formula

Reorder point = lead time in days x daily usage

For example, if a firm knows that it requires 10 days to place and receive an order, and if it uses
five units of inventory daily, the reorder point would be 50 units ( 10 days x 5 units per day).
Thus as soon as the firm’s inventory level reaches 50 units, an order will be placed for an amount
equal to the economic order quantity. If the estimates of lead time and daily usage are correct,
the order will be received exactly when the inventory level reaches zero. Because of the
difficulty in precisely predicting lead times and daily usage rates, many firms typically maintain
safety stocks, which are extra inventories that can be drawn down when actual outcomes are
greater than expected.

MRP system
It is a system to determine what to order, when to order, and what priorities to assign to ordering
materials. MRP uses EOQ concepts and a computer to compare production needs to available
inventory balance. The advantage of the MRP system is that if forces the firm to more

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thoughtfully considers its inventory needs and plan accordingly. The objective is to lower the
firm’s inventory investment without impairing production.

Just in time (JIT) system

It is inventory management system that minimizes inventory investment by having material
inputs arrive at exactly the time they are needed for production. Ideally, the firm would have
only work in process inventory. Since its objective is to minimize inventory investment, a JIT
system uses no, or very little, safety stocks. Extensive coordination must exist between the firm,
its suppliers, and shipping companies to ensure that material inputs arrive on time.
The goal of the JIT system is manufacturing efficiency. It uses inventory as a tool for attaining
efficiency by emphasizing quality in terms of both the materials used and their timely delivery.

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