CHAPTER 16 Current Asset Management and Financing

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Copyright © 1999 by the Foundation of the American College of Healthcare Executives

CHAPTER 16Current Asset Management

and Financing

Investment and financing policies

Cash and marketable securities management

Receivables and inventory management

Short-term financing

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Short-Term Financial Management

Short-term financial management involves all current asset accounts and most current liability accounts.

The primary goal of short-term financial management is to support operations at the lowest possible cost:Must have sufficient current assets.Must ensure liquidity

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Current Asset Investment Policies

CA ($)

Utilization

High

Moderate

Low

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Current Asset Investment Policies

Factors affecting current asset levelsLevel of business risk

• High business risk - greater level of current assets required (safety stocks)

• Low business risk - lower level of current assets required

Opportunity costs of capital• Interest rates• Market returns on investment capital

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Current Asset Financing Policies

Moderate. Matches the maturity of the assets with the maturity of the financing.Uses permanent capital to finance permanent

assets.Uses temporary financing to finance temporary

assets.Aggressive. Uses short-term financing to

finance permanent assets.Conservative. Uses permanent capital to

finance temporary assets.

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Years

$

Permanent CA

Fixed Assets

Temporary CA

Lower dashed line, more aggressive. Higher dotted line, more conservative.

ST Financing:Loans

LT Financing:Stock andBonds

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Cash Management

The goal of cash management is to hold the minimum amount necessary to meet liquidity requirements.

The primary cash management techniques are:Cash flow synchronizationFloat management

• Acceleration of receipts• Disbursement control

Costs of cash management initiatives must have corresponding benefits.

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Cash Flow Synchronization

The greater the timing match between a business’ cash inflows and outflows, the lower the required cash balance.

Some businesses are able to bill customers on a cycle that promotes cash flow synchronization.

The cash budget is the best method for monitoring cash management.

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Float

Net float is the difference between the cash amount on the firm’s books and the amount on the bank’s books.Suppose Family Healthcare writes $2,000 in checks daily.

It takes 6 days for these to be received and clear the banking system, so its disbursement float is $12,000.

Family Healthcare receives $3,000 in checks daily which are cleared in 3 days. Thus, its collections float is $9,000.

Its net float is $12,000 - $9,000 = $3,000.

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Acceleration of Receipts

Net float is maximized by accelerating receipts and slowing disbursements.

Some techniques used for receipt acceleration are:LockboxesConcentration bankingAutomated clearinghousesFederal Reserve wire system

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Disbursement Control

Disbursement control is the “flip side” of receipt acceleration.

Some techniques used for disburse-ment control are:Payables centralizationMaster and zero-balance accountsControlled (remote) disbursement

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Marketable Securities Management

Businesses hold marketable securities for two primary reasons:As an interest earning substitute for cash.As a temporary repository for cash being accumulated

to meet a specific need.

In reality, cash management and marketable securities management are accomplished simultaneously.

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Marketable Securities (Cont.)

Characteristics of marketable securities In general, marketable securities are chosen on the

basis of safety:Protection of principal is primary.Amount of return is secondary.

Specific securities used depend on the:Expected holding period.

Size of the business.

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Receivables Management

Importance of receivables management to HSO’s (third party predominance)

Financing of A/R with short-term debt vs. equity (cost of capital issues)

Goal of A/R mgmt. is to minimize the carrying costs

Acceleration of A/R receipts

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Monitoring A/R positionFactors affecting A/R balance -- credit sales volume

and avg. collection period (ACP)ACP = Avg. A/R balance divided by average daily

credit salesComparison of ACP to historical/industryLimitations of using ACP to monitor A/R position

(influence of sales volume)

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Monitoring A/R positionAging schedules of A/R accountsInfluence of sales volume changes on average age

of A/R accountsUncollected A/R balance schedule -- factors out

influence of fluctuations in sales volume on A/R balance and ACP

Interpretation of uncollected A/R balance schedule

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Management interventions to improve A/R positionReasonably aggressive collections policy“Early payment” discountsElectronic billing/payment methods

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Inventory Management

Relationship to receivables management

Consequences of poor inventory mgmt.Too little inventory (stockouts)

Too much inventory (tied up cash)

Inventory management methodsComputerized inventory control systems

Just in time inventory methods

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Inventory Management MethodsEconomic Ordering Quantity (EOQ) model

• Minimize the costs of holding inventory

• Total inventory costs as a function of inventory carrying costs and inventory ordering costs

• Does not consider the cost of the inventory

• Allow for identification of optimal “ordering quantity” per order to minimize costs (ICC, IOC)

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• Examples of ICC (storage, insurance, financing)

• Estimation of ICC as a percentage of total inventory purchase (10-20%)

• Relationship of ICC to total inventory purchases

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• Fixed nature of IOC assumed

• Examples of IOC (costs of ordering)

• Estimation of IOC as a function of average inventory purchases

• Relationship of IOC to total inventory purchases

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• Total inventory holding costs (TIC) = ICC + IOC

• Estimation of EOQ using formula

• Interpretation of EOQ

• Equivalence of ICC and IOC at EOQ

• Minimization of TIC at EOQ

• Application of EOQ model -- reorder points, safety stock estimation, quantity discounts

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Current Liability Management

Current liabilities as source of WCShort-term financing has three

primary advantages over long-term:Lower issuance costsFewer restrictive covenantsGenerally lower interest rate

Major sources for providers:AccrualsAccounts payable (trade credit)Bank loans

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Accruals

Accruals consist primarily of wages owed to employees and taxes owed to governments.

Accruals are free in the sense that no explicit interest is charged.

However, managers have little control over the level of accruals, which is influenced more by industry custom and tax laws.

Management of accrual accounts (source of short-term financing)

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Accounts Payable (Trade Credit)

Trade credit is credit furnished by a firm’s suppliers.

Trade credit is often the largest source of short-term credit for most firms.

Categories of trade creditFree trade creditCostly trade credit

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Northwest Healthcare buys $3,000,000 (at net) of medical supplies from one of

its vendors on terms of 2/10, net 30. How much free and costly trade credit

is available from this vendor?

Net daily purchases = $3,000,000/360

= $8,333.

Calculate net daily purchases

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Gross/Net Breakdown

Northwest buys supplies worth $3,000,000 because that is the net, or cash, price.

If Northwest does not take the discount, it must pay $3M / 0.98 = $3,061,224 for the supplies. This is the gross, or invoice, price.

The difference, $61,224, is a financing cost similar to the interest on a loan.

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Total trade credit = $249,990 Free trade credit = 83,333 Costly trade credit = $166,657

Payables = $8,333 x 10 = $83,333.

Payables = $8,333 x 30 = $249,990.

Payables level with discount

Payables level without discount

Credit breakdown

Gross/Net Breakdown

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Approximate Cost ofCostly Trade Credit

Northwest loses $61,224 to obtain $166,657 in extra trade credit, so

Cost = = 0.367 = 36.7%.$61,224

$166,657

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Approximate Cost Formula

Cost = x Discount % 1 - Discount %

360 Days

taken

Discount period

-

= x = 0.0204 x 18 2 98

360 30 - 10

= 0.367 = 36.7%.

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What Should Northwest Do?

Northwest should take the $83,333 in free trade credit--it should take all the free trade credit that it can get.

However, it should take the costly trade credit only if the implied cost is less than the cost of alternative financing sources.

Because Northwest can obtain bank loans at a 10% rate, it should not take the $166,657 in costly trade credit.

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CHAPTER 16 Current Asset Management and Financing

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