Tài chính doanh nghiệp - Chapter 23: Management of short - Term assets: liquid assets and accounts receivable

Define liquid assets. Distinguish between liquidity management and treasury management. Identify the motives for holding liquid assets. Prepare a cash budget. Apply cash management models.

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Chapter 23 Management of Short-Term Assets: Liquid Assets and Accounts ReceivableLearning Objectives Define liquid assets.Distinguish between liquidity management and treasury management. Identify the motives for holding liquid assets.Prepare a cash budget.Apply cash management models.Learning Objectives (cont.) Identify avenues for short-term investment by companies.Understand the application of portfolio theory to investment in short-term securities.Define accounts receivable and distinguish between trade credit and consumer credit.Identify the benefits and costs of holding accounts receivable.Learning Objectives (cont.) Identify the four elements of credit policy. Understand the factors in implementing a collection policy.Apply the net present value method to evaluate alternative credit and collection policies.Understand the ways in which accounts receivable may be employed as a means of financing.Apply financial statement analysis to short-term asset management.Introduction Liquidity is essential in order to ensure that creditors are paid on time.This ensures the business can continue to operate — solvency.However, liquidity is costly and there is a trade off between costs and benefits, along with an optimal level of liquidity.Many companies sell on credit, leading to accounts receivable — need to manage accounts receivable efficiently to maximise company value.Overview of Liquidity Management Liquid assetsCash and assets that are readily convertible into cash, such as bills of exchange and treasury notes.Liquidity managementDecisions on the composition and level of a company’s liquid assets.Treasury managementConducted by a group or department under the control of the company treasurer, to manage the company’s liquidity, and to oversee its exposure to various kinds of financial risk.Centralisation of Liquidity ManagementCentralisation allows the matching of inflows and outflows for the whole company, with consequent savings.Centralisation of liquidity management facilitates the development of specialised staff by having them concentrated in one area of the business.Motives for Holding Liquid Assets Transactions motivePerfect synchronisation of cash inflows and outflows is virtually impossible to achieve because the timing of a company’s inflows depends on the actions of its customers.Therefore, liquid assets are held in order to finance transactions undertaken between cash inflows.Motives for Holding Liquid Assets (cont.)Precautionary motiveFuture cash inflows and outflows cannot be predicted with perfect certainty.Therefore, the possibility exists that extra cash will be needed to meet unexpected costs, or to take advantage of unexpected opportunities.Motives for Holding Liquid Assets (cont.)Speculative motiveWhen interest rates increase, there is a fall in the market value of income-producing assets such as bonds.Individuals forecasting an increase in interest rates may, therefore, sell bonds and, instead, hold cash or bank deposits in order to avoid the resulting capital loss.For most companies transaction-based motives dominate.Major Issues in Liquidity ManagementIf cash payments exceed cash receipts:Need to borrow to make payments (incur interest).Postpone payment which may be disruptive to the business and damage its reputation.If cash receipts exceed cash payments:Company failing to maximise its resources if a large cash balance is maintained.Major Issues in Liquidity Management (cont.)Ensure interest costs on short-term debt are not excessive.Consider the effects of bank charges.Liquidity management involves ‘balancing’ several costs and benefits.Cash Budgeting A forecast of the amount and timing of the cash receipts and payments that will result from a company’s operations over a period of time.Cash budgets assist in forecasting when payments exceed receipts (or vice versa).Forecasts can be on a daily, weekly or monthly basis.Cash Budgeting (cont.) PreparationForecast cash receipts:Analysis of past sales performanceProjections of likely business and economic conditionsEstimate cash receipts from salesForecast cash payments.Compare actual results with forecast results on an ongoing basis.Cash Management Models Assuming Certainty: Baumol’s ModelHolding cash is treated akin to holding inventory.AssumptionsCompany has an initial cash balance.Cash payments are known and occur at a constant rate.Cash Management Models Assuming Certainty: Baumol’s Model (cont.)Assumptions (cont.)Upon exhausting initial cash balance, company withdraws some interest-bearing liquid assets and converts them to cash.Upon exhausting this cash balance, further withdrawals of interest-bearing liquid assets are made and converted to cash.Withdrawal of funds from interest-bearing liquid assets involves a known transaction cost.Cash Management Models Assuming Certainty: Baumol’s Model (cont.)Baumol’s model shows that the optimal amount of each withdrawal of funds from liquid assets, W *, can be denoted by:Cash Management Models Assuming UncertaintyMiller and Orr modelAssumption that, if left unmanaged, the company’s cash balance would follow a random walk with zero drift.Over any given time period (such as a day), the most likely result is that the cash inflows and outflows will exactly offset each other, with the result that the cash balance is left unchanged. Although this ‘no change’ scenario is the most likely result, it will be quite rare.Cash Management Models Assuming Uncertainty (cont.) Miller and Orr model (cont.)The model proposes that management should intervene in the process by withdrawing cash if the balance becomes too high, and by injecting cash if the balance becomes too low, to restore the cash balance to the target level.Therefore, cash management is reduced to determining values for the upper limit (U), the lower limit (L), and the target level (T).Cash Management Models Assuming Uncertainty (cont.) Miller and Orr model (cont.)The model does not actually determine the lower limit L (as this depends on whether there is an overdraft), but rather, given some predetermined value for L, it then determines the values of U and T in terms of L.For example, if a company cannot obtain an overdraft, then: Cash Management Models Assuming Uncertainty (cont.) Miller and Orr model (cont.)Cash Management Models Assuming Uncertainty (cont.) Deficiencies of the Miller and Orr model:Basic model does not recognise overdrafts.It is assumed that action can be taken as soon as the control limit is reached (unlikely in practice).Assumes fixed transaction costs, whereas, in practice, many transaction costs are variable.Cash Management Models Assuming Uncertainty (cont.) Deficiencies of the Miller and Orr model (cont.):Assumes that the cash balance follows a random walk. Therefore, it is likely to understate the ability of management to forecast changes in cash flows.Assumes that the company can invest in only one type of short-term financial asset.The Choice of Short-Term Securities If a company decides to invest a temporarily idle cash balance, it must choose an investment that can be converted easily into cash.That investment should be either marketable or mature within a short period of time.Interest rate risk, default risk and liquidity risk need to be taken into account when considering the investment of temporarily idle cash.Types of Short-Term Investments Purchase of government securitiesThe most suitable form of government security for short-term investment is treasury notes.Terms from 5 to 26 weeks.Marketable and readily converted into cash.Government bonds have terms measured in years.However, a previously issued bond may be purchased, either as it approaches maturity, or with the intention of selling it in the future.Types of Short-Term Investments (cont.)Deposits of funds with financial institutionsThe basic terms of the deposit will differ from one kind of institution to another, and a treasurer’s choice will depend on:The period that the funds are available for investment.The risk that the company is prepared to accept.The required rate of return.BanksDealers in the short-term money marketCash management trustsTypes of Short-Term Investments (cont.)Discounting of commercial billsThere are two ways that a company can invest its idle cash balances in the commercial bills market:A company can be the original discounter of a commercial bill (supply funds to the drawer of the bill).A company can ‘rediscount’ a bill that has previously been discounted by another party. (The bill is purchased from another investor in the bills market.)Portfolio Theory and Cash ManagementWe can treat cash as the risk-free asset, and estimate the rate of return on each short-term security, the variance of the returns on each security, and the covariance of the returns on each security with all other securities.In principle, it is possible to determine the optimum balance between cash and an investment in each short-term security for given risk-return preferences.Portfolio Theory and Cash Management (cont.)A disadvantage of this approach is that it assumes all short-term securities will be held until the end of the planning period.This denies the important option of being able to convert short-term securities into cash at short notice.Nevertheless, there is still benefit from holding more than one short-term security, if only because of the advantage in having different maturity dates.The Corporate Treasurer and Liquidity ManagementTask of the treasurer:Preparation of cash budgets.Determination of the optimum cash balance.The investment of idle cash in short-term investments.Arrangement of credit facilities to see the company through periods of cash shortage.Overview of Accounts Receivable ManagementSeek to identify the impact of decisions on accounts receivable and how to determine the optimal credit and collection policies.Establishment of a credit policy:Is the company prepared to offer credit?Assuming credit is to be offered, what standards will be applied in the decision to grant credit to a customer?How much credit should a customer be granted?What credit terms will be offered?Definitions Accounts receivableMoney owed to a business for goods or services sold in the ordinary course of business.Trade creditShort-term credit provided by suppliers of goods or services to other businesses.Consumer creditCredit extended to individuals by suppliers of goods and services, or by financial institutions through credit cards.Benefits and Costs of Granting CreditBenefitsIncreased salesCostsOpportunity cost of investmentCost of bad debts and delinquent accountsCost of administrationCost of additional investmentCredit Policy ‘Credit policy’ refers to a supplier’s policy on whether credit will be offered to customers and the terms on which it will be offered. The decision to offer creditIs the company prepared to offer credit?Offering credit is equivalent to a price reduction.What do competitors offer?Credit Policy (cont.) Selection of credit-worthy customersCompany’s past experience with customerUse of decision tree:Grant credit immediatelyInvestigate/ConsiderRefuse credit immediatelyCost of granting credit = expected bad debt cost + investment opportunity cost + collection costCost of refusing credit = expected value of marginal net benefit forgoneLimit of credit extendedSetting limits — about risk management.The more sales on credit, the greater the potential loss from default.Offer less credit to newer customers.Credit termsCredit periodDiscount periodDiscount rateEffective rateCredit Policy (cont.) Collection Policy ‘Collection policy’ refers to the efforts made to collect delinquent accounts either informally or by a debt collection agency.Procedures implemented:Reminder noticePersonal letters and telephone callsPersonal visitsLegal action or debt collection agencyProcedures adopted may have an impact on sales.Evaluation of Alternative Credit and Collection PoliciesApplication of NPV method.BenefitsMeasured by the net increase in sales.CostsInclude manufacturing, selling, collection, administration and bad debts.Evaluation of Alternative Credit and Collection Policies (cont.)Pay attention to the timing of the cash flows.Net cash flows can be discounted at the required rate of return.Analysis undertaken for all credit/collection policies, with the policy generating the highest net present value being the preferred option.Collection and Credit Policies Discounts for early payment, late payments or failures to pay, together with any collection costs, all reduce the NPV of credit.Company’s policies should be designed so that the costs of extending credit are outweighed by the benefits.Discounting and Accounts Receivable FinancingDiscounting is the sale of a company’s accounts receivable at a discount to a financial institution.The discounting company specialises in the administration and collection of accounts receivable and, therefore, may be able to provide these services at a lower cost than the selling company would be able to achieve through its own efforts.Discounting and Accounts Receivable Financing (cont.)Notification and non-notification agreementsThe selling company’s customers are notified that the agreement exists.The selling company’s customers are not notified about the agreement.Non-recourse factoringThe discounting company assumes the bad-debt risk.Discounting and Accounts Receivable Financing (cont.)Costs and benefits of discountingThe discounting company will charge a fee of up to 4% of accounts discounted.Accounts receivable are costly to the company offering credit.By discounting these accounts receivable, the company will save the interest cost of financing the accounts.Also eliminate administrative costs — accounts management.While there are costs associated with discounting, they need to be weighed against potential benefits and cost savings.Discounting and Accounts Receivable Financing (cont.) Accounts receivable financingThe company borrows funds and pledges its accounts receivable as security for the loan.Suppliers of this type of finance are usually finance companies.Generally, finance companies are prepared to lend up to 70% of the total value of all acceptable accounts receivable.Unacceptable accounts receivable are those that have been outstanding for a lengthy period (e.g. 90 days where the credit policy is 30 days). Credit Insurance A company may obtain protection against bad-debt losses by taking out a credit insurance policy. These policies may take several forms:Specific account policiesWhole turnover policiesProtracted defaultSummary Company’s liquid assets are cash and short-term investments.Liquidity management refers to decisions with respect to these liquid assets.Important to meet daily commitments.Too much means rate of return falls.Treasury management refers to liquidity management combined with risk considerations.Transactions motive considered in detail. Summary (cont.) Liquidity management is based on cash budget, cash receipts and payments.Cash management models:Baumol — certainty, cost benefit model, balance costs of liquidity with benefits.Miller and Orr; Wright — cash balance is random walk, add or deplete based on predetermined limits.Liquid assets can include government securities, deposits with financial institutions, commercial bills. Varying marketability and risk.Summary (cont.) Accounts receivable — money owed to a business due to sales made on credit.Credit offered in order to attract increased sales.Credit has costs — funds tied up, administration costs, slow and non-paying customers.Credit and collection policies involve evaluation and comparison of costs and benefits of these activities, looking for positive NPV of policy in question.Summary (cont.) Companies can sell accounts receivable (discounting) or use them as security for loans.The factoring company may offer administration and collection services.Credit insurance guarantees part of bad debts for a fee, the insurance premium.Only part of bad debts are covered to prevent firms from offering credit indiscriminately.
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