FINANCE MANAGEMENT FIN420 chp 6

Working Capital Management Chapter 6

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Since about half of the typical firm’s capital is invested

in current assets, decisions need to be made on

managing the working capital at its optimum level as

well as deciding on ways of financing them.

Learning objectives

After learning this chapter, you should be able to:

1. Describe the concept of working capital

2. Determine the optimal cash balance

3. Make decision on choosing marketable securities

4. Make decision on credit policy

5. Calculate economic order quantity for inventory.

Working Capital

Management

GOAL

Chapter 6 Working Capital Management

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6.0 INTRODUCTION

Working capital management involves day-to-day decisions regarding investment in current

assets and how these assets are to be financed. It concerns with all aspects of the

administration of the firm's current assets and current liabilities and involves making

decisions regarding:

1. the appropriate levels and mix of current assets,

2. the appropriate levels and mix of current liabilities

These decisions must be based on the firm's need for adequate liquidity that is sufficient

cash on hand to meet all short-term obligations. It will affect the firm's riskiness and the

expected rate of return, and hence its value. The effects of these decisions on larger firms

are less drastic compared to smaller firms due to their flexible financing sources. However, it

can significantly affect its risk, return, and share price.

Failure to manage the current assets' components effectively and efficiently will lead to

financial problems that may force the company into technical insolvency, and eventually

bankruptcy. Low investment in current assets could lead to financial distress and

complications, but relatively high investments will result in lower productivity of assets and

lower profits. This interplay of risk-return trade-off must be considered explicitly when making

decisions without fail. For example a cash shortage will results in the following sequence of

events:

1. Delays of payment to creditors and suppliers,

2. Inability to secure materials,

3. Low production levels due to lack of materials,

4. Less amount of finished goods available for sales,

5. Low cash flows due to lack of sales resulting in further cash shortages, and

6. Eventually the company will face technical insolvency and bankruptcy.

The challenge is therefore to decide a proper mix of current assets holding that strike a

balance between the to maintain certain level of profitability with appropriate level of risk.

This chapter specifically deals with the management techniques and identification of risk-

return tradeoff in managing the major components of current assets that is cash and

marketable securities, receivable and inventories in details.


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6.1 MANAGEMENT OF CAPITAL WORKING CAPITAL The objective of managing working capital is to achieve risk-return tradeoff that maximizes

the value of the firm. As such, current assets must be available at all time to support the

firm's operations while maintaining its holdings to a minimum amount to reduce investment

and, hence the cost of financing. There are three basic policies that the company can adopt

that are relaxed policy, restricted policy, and moderate policy.

Relaxed policy

This is a low risk policy; whereby the firm will maintains large amount of current

assets coupled with liberal credit policy. It has high liquidity, and potentially low return

from investments due to low productivity of current assets relative to fixed asset.

Restricted policy

On the other hand, restricted policy is a high-risk policy whereby current assets'

holding is reduced to a minimum coupled with stringent credit policy. Lower

investments in current assets enable the firm to increase investment in other

productive investments, and thus will results in higher returns.

Moderate policy

This is a middle of the road policy in between relaxed and restricted policies. It will

result in moderate risk and returns. High current assets' investments such under

relaxed policy will reduce risk of technical insolvency, but at the same time it will

results in lower returns due to lower productivity of current assets. Therefore,

investment in current assets should be at a minimum level without sacrificing the

liquidity requirements. As such more funds are available for investment in fixed

assets that are more productive.

The use of current liabilities or short term financing to finance current assets are

generally less expensive than long-term financing such as long-term debt, preferred

stock, and common equity. Short-term financing represents a relatively lower cost of

capital and could improve the firm's profitability. Consequently, aggressive use of

short-term financing led to a decrease in net working capital, and hence increases

the risk of insolvency.


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6.1.1 Working Capital Strategies

Working capital strategies range from the aggressive to the conservative

approach, in which each will produce different levels of profitability and risk

exposure. To the extreme, aggressive policy sacrifices safety or liquidity for

return, and conservative policy sacrifices return for safety. Under whatever

conditions, the basic risk-return tradeoffs will definitely apply; higher return is

a result of corresponding higher risk.

A typical firm normally has production and sales cycles that vary during the

course of operations. These cycles will result in accumulation and depletion of

the firm's current assets, and therefore its value will fluctuate over time. This

suggests that certain current assets are temporary in nature and others are

permanent.

Permanent Assets It refers to all assets, fixed of current, that are necessary for the firm to

hold at all time regardless of the firm's sales level. Fixed assets are

permanent in nature since it is inflexible in the short-term.

Simultaneously, certain amount of current assets should be on hand

to support operations even if the sales activity is at the lowest such as

a minimum amount of cash. This part of current assets is, therefore

regarded as permanent.

Temporary Assets

It refers to part of current assets that fluctuate directly with changes in

sales level. It is the additional current assets required to support the

increase in sales. This principle work hand in hand with the principles

presented in chapter 6, percent of sales method.

Similarly, the above classifications will also apply to liabilities and

equity. All equity, long-term debts are permanent source of funds.

Certain components of short-term borrowing or current liabilities are

permanent in nature to finance permanent current assets. Others are

temporary to support the need for temporary current assets'

investments.


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The working capital strategies or approaches presented in the

following sections will show the methods of financing these assets. In

each of the approaches presented, the total requirements to finance

temporary current assets are net of spontaneous financing generated

from spontaneous liabilities; such as from accounts payable and

accruals.

Hedging Approach

The hedging approach is where the firm uses temporary financing to

finance temporary current assets (TCA), and permanent financing to

finance permanent assets (FA plus PCA). Therefore, this strategy is in

line with traditional notion where financing maturities should match

with the assets' requirement. Refer to Figure 6-1 for graphic

illustrations.

Figure 6-1 The Hedging Approach

Ringgits TCA PCA FA Time

Since the approach matches the financing duration and the assets'

requirements, there is no need for emergency funds and idle funds are

non-existence. This approach results in moderate risk with moderate

returns. A firm wishing to adopt a financially aggressive or

conservative approach may modify the above approach by focusing

on using more of temporary financing or permanent financing

respectively.

Short-term or Temporary financing

Permanent plus spontaneous financing


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Aggressive Approach

This strategy involves more risk, as it uses short-term or temporary

financing to support a relatively large portion of current assets. In this

approach, a firm would finance all fixed assets and part of permanent

current assets with long-term financing. The firm will resort to short-

term financing to finance the remaining permanent current assets and

temporary current assets. Current ratio under this approach is low and

may equal to less than one. Refer to Figure 6-2 for graphic illustration.

Figure 6-2 The Aggressive Approach

Ringgits

TCA PCA FA Time

Conservative Approach

This approach has the lowest risk among the working capital

approaches. It uses permanent financing to finance the majority of its

assets that includes all permanent assets and part of temporary

assets. It will resort to the use of temporary financing only for peak

requirements or when total assets exceed permanent financing.

Therefore, the firm assured of the availability of funds even during

period of tight money supply. During low requirements, a firm will

invest its excess funds in marketable securities as shown in Figure

6-3.




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Figure 6-3 The Conservative Approach

Ringgits

TCA PCA FA Time

Most of the time the firm will have excess liquidity and this reduces the

need for temporary financing, hence it results in lower risk of technical

insolvency. Conversely, the returns are low. This is due to higher

costs of permanent financing and low returns from marketable

securities investment. Both of these factors combined will result in a

relatively low average return.

Given the three alternative strategies, which approach to maintain

appropriate level of liquidity or margin of safety is the best? There is

no right answer, and it will depend on:

1. The profitability of the firm;

2. The stability of cash flows;

3. The liquidity of the firm's assets;

4. The management attitude towards risk and

5. The expected future interest rates.

The higher the levels of profitability, stability of cash flows and liquidity

of assets tend to reduce the need for current assets to achieve the

desired level of protection against technical insolvency. Other thing

being equal, these conditions may suggest a more aggressive

approach is appropriate. On the other hand, if the above conditions

are reversed, a more conservative approach is more appropriate.

In the case of interest rates, the expectation of higher future rates will

lead to more use of long-term financing. This will ensure that the firm



.


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is able to enjoy a lower interest rate although the rate goes up later. In

this case, hedging and conservative approaches are most likely to be

adopted. Due to the differences in industry liquidity, it is necessary to

analyze the liquidity requirements or current ratio of the firm

accordingly, relative to the firm's stage of operations and management

attitudes.

Risk and Return Tradeoff

To illustrate the effects of the working capital strategies on risk-return

tradeoffs, consider the following examples in Table 6-1. Assume that

Miasma Company is trying to decide the alternative approach to

manage working capital ranging from conservative to aggressive

strategies, while its total assets' components remain constant.

Table 6.1 shows that the return on equity is lowest for the

conservative approach and highest for aggressive approach. This

relates directly to the liquidity and risk position for each of the

approaches; with current assets to current liabilities' ratio of 6:1 (=120

/ 20), 3:1 (=120 / 40), and 1.7:1 (=120 / 70) for conservative, hedging,

and aggressive respectively. Thus, expected return from aggressive

approach should be higher relative to its risk. Financial data in Table

6.1 will substantiate this.

Table 6-1 Effects of Working Capital Strategies on Return on Equity

In thousands of RM

Assets Conservative Hedging Aggressive Current assets 120.00 120.00 120.00

Fixed assets 120.00 120.00 120.00

Total assets 240.00 240.00 240.00


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Liabilities and Equity

Accounts payable 20.00 20.00 40.00

Notes payablea (10%) 0.00 20.00 30.00

Long term debtb (15%) 60.00 40.00 10.00

Equity 160.00 160.00 160.00

Total claims 240.00 240.00 240.00

EBIT/Operating Income 50.00 50.00 50.00

Interest (a + b) 9.00 8.00 4.50

Earnings before taxes 41.00 42.00 45.50

Taxes (40%) 16.40 16.80 18.20

Earnings after taxes 24.60 25.20 27.30

Return on equity 15.38% 15.75% 17.06% 6.2 MANAGEMENT OF CASH

Cash is defined as coins and currency plus demand deposit accounts that are available to

meet immediate payments. It is the most liquid among the firm's asset and often called a

"non earning asset" as its holdings give no return, but are needed to meet all types of

payments required by the firm, without which the firm cannot operate. Therefore, it is crucial

for the firm to hold minimum amount of cash sufficiently to support its normal business

activities. This is crucial for the firm to balance between: (1) the needs for liquidity to meet

maturing obligations, and (2) for profitability by reducing cash holdings. Firms hold cash for

several reasons or motives such as for:

1. Transaction demand. Cash for transaction balances is necessary to meet

obligations or payments arising from normal business activities such as payments for

purchases, wages, taxes, dividends, and etceteras. It relates to day-to-day payments

and collections associated with the business activity.

2. Precautionary demand. The precautionary balances are the "safety stock" of cash

necessary for the firm to meet the unexpected contingencies. The amount the firm

must hold will depend on the predictability of its cash flows; if less predictable, the

larger such balances should be.


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3. Speculative demand. The holding of speculative balances will enable the firm to

take advantage of any investment opportunities or bargain purchases that might arise

in the future.

4. Compensating balances. The compensating balances are necessary to

compensate financial institutions for providing loans and services. It requires that the

firm maintain minimum level of money in its bank's account, normally based on

certain percentage of the loans taken.

With the advancement and development of financial securities, the need to hold cash for

precautionary and speculative purposes seems unnecessary. This is because the cash

requirements can readily be met by borrowed funds and any excess cash is invested in

short-term or marketable securities.

6.2.1 Cash Management Activity

The goal of cash management is to minimize the cash balance while

maintaining certain level of liquidity. Too much liquidity reduces return,

whereas too little, increases risk exposure. As outlined in Figure 6-1, cash

management activity consists of several areas.

Cash Flow management

The cash flow management involves the process of controlling the

cash movement, inflows, and outflows, of the firm to minimize the

cash required to support working capital. Slowing disbursements and

speeding up collections can do this. In addition, it is to the firm's

advantage to maintain good banking relationships so as banking

transactions can be done with ease.

Estimation cash requirements

The estimation of cash requirements involves the preparation of cash

budget, which allow the firm to plan, coordinate, and control the actual

cash flow through the firm. Once the cash flow has been estimated,

the appropriate level of cash holdings can be established.


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Developing borrowing or investment strategies

With the establishment of the appropriate cash balance, the strategies

to finance any cash shortfalls can be developed ahead of time. In case

of cash excess, effective investment strategies can be developed to

use the idle temporary liquidity and earn return.

The cash management activity as outlined in Figure 6-4 and the cash

flow cycle in chapter 9, involves many aspects of the firm's operations.

It relates directly to the management of inventories, marketable

securities portfolio, notes payable, account payable, and account

receivable. Therefore, the management of cash is of utmost important

to the firm as famous quotation puts it "the cash will take care of the

profits if the firm takes care of the cash."

Figure 6-4 The Cash Management Activity

Speeding up receipts

Slowing down disbursement

Management of firm cash flows

Cash budgeting

Maintaining good banking relationship

Determining the optimal cash balances

Short-term financing strategies for cash shortfalls

Marketable securities investment strategies for cash excess

1. Strategies of an efficient cash management

There are several strategies of an efficient cash management

a) Make all payments such as accounts payable as late as possible without damaging the firm’s credit rating.

However at the same time we must take advantage of

any favourable cash discounts offered by the suppliers.

b) Make all collections such as accounts receivable as

soon as possible without losing future sales and use

cash discount’s to encourage early payments of

accounts receivable


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c) Turn over the inventory as quickly as possible and

avoiding stockouts that might result in shutting down

the production line or any loss in sales.

2. Determining Minimum Operating Cash (MOC)

Since the objective of a firm is to run the business effectively

without running out of cash, a firm must keep the minimum cash

balance. By keeping this amount (MOC) it will allow the firm to

invest in various alternatives and to repay debts when they are

due.

Cash balances and safety stock of cash are influenced by the

firm’s production and sales techniques and procedure for

collecting sales receipt and payment for purchases or

operating cycle and cash cycle.

Therefore by efficiently managing these cycles, the financial

manager can maintain a low level of cash investment and

thereby contribute towards maximizing the share value

6.2.2 Operating Cycle, Cash Cycle and Cash Turnover

The operating cycle (OC) is the lag time in days between the purchase of

raw materials and the time cash is collected from sales of finished goods or

receivables. Consequently, cash cycle (CC) is the lag time between cash

outlay to purchase raw materials or inventories and cash is collected from

receivables. Therefore, CC is the amount of time the firm's capital is tied up in

inventories sold. To illustrate this concept, refer to Figure 6.5 that shows the

movement of goods and cash in a normal business operation.


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Figure 6-5 The Operating Cycle, Cash Cycle, and Cash Turnover in Days OC = 110 AAI = 70 ACP = 40 Purchase raw materials on credit Sell finished goods on credit Accounts payable Accounts receivable 0 10 20 30 40 50 60 70 80 90 100 110 Pay accounts payable Collect accounts receivable Cash outflows Cash inflows APP = 30 CC = 80

The cash cycle equals to:

OC0 = Average age of inventory (AAI) + Average collection period (ACP)

= 70 days + 40 days

= 110 days

CC0 = Average age of inventory (AAI) + Average collection period (ACP)

– Average payment period (APP)

= 70 days + 40 days – 30 days

= 80 days

Since cash cycle is a measure of the amount of time cash tied up, lower

operating cycle and cash cycle is better as the firm could recover the cash

outlay in a shorter period.

Another measure of how effective cash is managed in the firm is the cash turnover (CTO). It refers to the number of times the firm's cash is actually

turned over each year and can be calculated as follows:

CTO0 = 360 /Cash cycle

= 360 / 80

= 4.5 times

The firm's cash cycles directly affect the amount of cash that need to be held

at any given time to support the operations. This amount represents the

minimum operating cash (MOC) to avoid any cash shortages in meeting all

its payments. To illustrate, let assume that firm's annual cash expenditures or

outlays are expected at RM300,000.


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MOC0 = Annual Cash Outlays / Cash turnover

= 300,000 / 4.5

= RM66,666.67

Therefore, the firm needs RM66,666.67 as a minimum cash requirement to

support the firm's day-to-day operations without risk of technical insolvency.

This represents a large investment for the company, and it is crucial to

minimize cash cycle and maximize cash turnover, without scarifying the firm's

liquidity and profitability. This can be done by managing the basic elements of

cash cycle that includes accounts payable (APP), accounts receivable (ACP),

and inventories (AAI). There are several strategies to reduce the cash cycles,

hence increase its turnover:

1. Increasing Average Payment Period. It involves delaying payments

on accounts payable as late as possible (ALAP) without damaging the

firm's credit rating. In addition, favorable cash discount should not be

ignored, as the opportunity cost is high if not taken.

2. Reducing Average Inventory of Age. This is to increase inventory

turnover as quickly as possible by: (1) efficient management of

inventories, (2) better production planning, scheduling, and control, (3)

effective sales forecasting, and (4) synchronize the production and

demand.

3. Reducing Average Collection Period. It involves speeding up

collection of account receivable as soon as possible (ASAP) without

losing potential sales. The use of proper techniques such as changes

in credit policies and collection policies that will improve collection

period will benefits the company.

The implementations of the above strategies will reduce cash cycles, and

thus will result in freeing some of the capital tied up in inventories and

account receivable. The freed capital, are available for other investment

opportunities that could provide additional return to the firm and/or reduces

the cost of financing.

To illustrate, let assume that the company in the above example able to:

1. Negotiate a better credit term with its suppliers from net 30 to net 35;


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2. Improve production process and selling effectiveness that reduces

average age of inventory by 10 days to 60 days; and

3. Decrease average collection period by 7 days to 33 days by changing

its credit terms.

Other things being equal, the above changes are expected to improve the

firm's performance, as it will result in lower of cash cycle, higher cash turnover

and lower minimum operating cash.

OC1 = 60 days + 33 days

= 93 days.

CC1 = 60 days + 33 days – 35 days

= 58 days.

CTO1 = 360 / 58

= 6.21 times

MOC1 = 300,000 / 6.21

= RM48,309.17

The above changes will have several impacts:

1. Shorter operating cycle, cash cycle, and thus higher cash turnover.

Change in OC = OC1 – OC0 = 110 – 93

= (17 days)

Change in CC = CC1 – CC0 = 58 – 80

= (22 days)

Change in CTO = CTO1 – CTO0 = 6.21 – 4.5

= 1.71 times

2. Lower minimum operating cash requirements, and hence lower

investment in cash to support the firm's operations.


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Change in investment MOC = MOC1 – MOC0

= 48,309.17 – 66,666.67

= (RM18,357.50)

3. Lower cost of financing and higher profits. If the cost of funds is at 10

percent, the firm can realize a yearly saving of RM1,835.75.

Change in cost of financing = Change in MOC (Cost of funds)

= (18,357.50)(0.10)

= (RM1,835.75)

The effects of lower cash cycle are quite significant for large firms with cash

reserves and cash outlays that run in millions of Ringgits. Proper cash

management will have a direct impact on the firm's liquidity and profits. These

represent a tradeoff that needs to be balanced to ensure that all obligations

can be met without sacrificing the needs for higher profits.

Determine an optimal Cash Balance

To determine a firm’s desired cash level or an optimal amount of cash,

it involves a tradeoff between the opportunity costs of holding too

much cash (carrying costs) and the costs of holding too little cash

(trading costs.)

If a firm tries to keep its cash holding too low, it will be running out of

cash more often than is desirable and thus leads to selling marketable

securities more frequently. Therefore, trading costs will be high when

the size of cash balance is low and vice versa.

In contrast, the opportunity costs of holding cash are very low if the

firm holds very little cash. These costs will increase as the cash

holdings rise because the firm is giving up more and more in interests

(return) that would be earned. An example of trading cost is brokerage

fees or underwriting fees whereas an example of carrying cost is

interest expense. The sum of these costs is shown by the total cost

curve in the diagram below:


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Figure 6-6 Total Cost Curve

From the diagram we can see that the more a firm holds cash, the

lower will be the trading cost. A firm does not have to convert so

many times from marketable securities to cash or vice versa because

it already holds too much cash

At point C* as shown, the minimum total costs occur where these two

individual cost curves crossed. At this point the carrying cost and

trading cost are equal. Therefore this is the optimal cash balance that

the firm should have.

Baumol Model

Baumol Model try to analyze the company’s cash management

problem i.e. to establish the target cash balance

It is an economic model that determines the optimal cash balance by

using Economic Order Quantity (EOQ) concepts. This model

balances the opportunity cost of holding cash (Cc) against the trading

cost (Fc) associated with replenishing the cash account by selling off

marketable securities by borrowing.

Thus, the optimal cash transfer will be : C* = 2(Fc) T Cc

Where C* = optimal cash balance

Fc = trading cost

T = total amount of cash needed in a year

Cc = opportunity cost of carrying cash


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Total costs of cash balances consist of total opportunity cost of

carrying cash and total trading cost of holding cash, so

TC = TCc + TFc = C*(Cc) + T (Fc) 2C* The minimum total costs are achieved when C* is at the optimal cash

transfer.

Example: ABC Company start at week ‘O’ with cash balance of RM1.2 million.

Each week cash outflow MORE than cash inflow by RM600,000. By

the second week RM1.2 will be gone, Cash Balance = 0

Cash Balance

Start RM1.2 million

RM2.4 million

Average RM600,000

RM1.2 million

0 1 2 3 4 5 weeks

By the end of the 2nd week, RM1.2 million has to replenished

If Company start with lower cash balance – last for 1 week will

decrease.

Company has to replenish more often, average balance to

RM300,000. Company will sell securities more often that will result in

higher Trading cost. (brokerage charges will increase)


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In order to determine the optimal strategy, the company need to know 3 things 1. F - Fixed Cost of making securities trade to

replenish cash

2. T - Total amount of cash needed over planning

period

3. R - is the opportunity cost of holding cash i.e. the

interest rate on marketable securities

With this information, ABC can determine the total costs of any

particular cash balance policy i.e. optimal cash balance policy.

SOLD Co. has cash outflow of RM100/day

Interest rate is 5%

Fixed Cost of replenishing cash balance is RM10 per transaction

T Total cash needed for the year

RM100 x 365 = RM36,500

R 5%

F RM10% per transaction

1. C = 2T x F Opportunity Cost = Trading cost R C x R = T x F

2

(Optimal Initial

Cash Balance) C2 = 2T x F R = 2 x RM36500 .05

= 14.6 million

Therefore C = RM3,821


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2. Average Cash Balance = C = 3.821 = RM1, 911 2 2

3. Opportunity Cost = C x R 2 = RM3,821 x 0.5 = RM 96 2 Trading Cost = T x F C = RM36, 500 x RM10 RM3, 821 = RM96

If Company decides to convert their cash 10 times in a year

Therefore C = RM36, 500 = RM3, 650 10 times

Therefore The New Total Cost = [RM3,650 x 0.5]+[RM36,500 x RM10] 3,650 = RM912.50 + RM100

= RM1012.50

To Determine the Opportunity Cost Of Holding Cash

We therefore have to find how much interest if forgone (on average

balance).

Therefore Opportunity = Average Cash Balance x interest Rate

Cost

i.e. = C x R 2

Example:

If the initial cash balance per year is RM1.2 million,

the average cash = RM1.2 2 = RM600,000


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If 10% interest could be earned,

Therefore Opportunity Cost = RM600,000 x 10%

= RM60,000 (to give up i.e. the

Lost)

To determine Trading Cost

We need to know how many times ABC Company will have to sell

marketable securities during the year?

Amount of cash needed = RM600,000/Week x 52 weeks = RM31,200,000

Cash needed per week Initial cash per week RM1, 200,000

= 26 times per year

From the above illustration, it is shown that increased in opportunity

cost will increase the cash average balance

If Fixed Cost per transaction is RM1,000

Trading = 26 times x RM1, 000 per transaction

Cost in a year

= T x Fc C = RM31.2 million x RM1,000 RM1.2 million = RM26, 000 per year

Therefore, Opportunity Cost + Trading Cost = Total Cost

+ RM26 million = RM86 million

This is not optimal

initial Cash balance

because Opportunity

Cost/Trading Cost

In order to get optimal initial cash balance, you have to use Baumol

Model as explained earlier

i.e. C = 2T x FC R


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Assumptions on the model: 1. Cash inflow and cash outflow are certain

2. It does not take into account any seasonal or cyclical trends Implications of the model: 1. The higher the interest rate (opportunity cost), the lower will be

the optimal cash balances

2. The higher the trading cost, the higher will be the optimal cash

balance.

6.2.3 Management of Marketable Securities

The management of cash and marketable securities, in reality cannot be

separated as marketable securities are near-cash items and considered as

part of cash. This is particularly important in the management of the firm's

cash reserve that acts as a "cushion" against technical insolvency. The cash

reserve decisions involve the determination of: (1) appropriate level of liquidity

requirement; and (2) appropriate mix of cash and marketable securities.

Marketable securities are as liquids as cash as it takes a relatively short time

for its conversion to cash without losing the face value. In essence, it

represents a storehouse of liquidity in which to absorb any cash excess and

to convert to cash when the need for cash arises. Due to its nature, it serves

as an investment vehicle for full utilization of idle cash that could provide

some return from the investment. There are two reasons or motives for

holding marketable securities:

1. As a substitute for cash. In many cases, the firm holds marketable

securities for precautionary purposes as a cushion against

unexpected shortage of bank credit and other emergency cash

outflows. Most firms tend to rely on short-term bank credit such as

overdraft for transactions and speculative purposes.

2. As a temporary investment This reason is very important as firm's

cash receipts rarely match its disbursement. The firm invests cash

temporarily in marketable securities to: (1) finance seasonal or cyclical


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need for cash; and (2) meet known future financial requirements. For

example, idle funds available for future dividend payments are

temporarily available for investment in marketable securities that

provides some return before its actual use.

For whatever motives the investments in marketable securities are for, it will

provide return from the investments of idle funds. The marketable securities

portfolio consists of different types of securities that differ in: (1) maturity; (2)

liquidity; and (3) returns.

6.2.4 The Portfolio Selection Process and Criteria

The investment decisions concerning the marketable securities portfolio

should explicitly consider the availability of cash in terms of its amount and its

need in relation to the firm's cash flows. This is in line with its purpose of

investment as a substitute for cash. At times, the need for cash arises in a

relatively short notice that forces the firm to liquidate its marketable securities

holdings on demand.

To meet these stringent requirements, the choice of securities in the portfolio

is in accordance to the nature of cash available for investment: (1) ready cash

segment for immediate cash needs; (2) controllable cash segment for

expenditures that are predictable; and (3) cash segment for speculative

purposes.

Ready cash segment (RCS) It represents cash on call and requires investment in high liquidity

securities. This factor is very important as it guards against the

unexpected cash flows that may occur in the firm, such as the cash

receipts are lower than expected.

Controllable cash segment (CCS)

Unlike ready cash segment, controllable cash segment gives less

emphasis on liquidity. The expected timing and amount of cash

disbursement is known with relative certainty, such as cash for tax and

dividend payment. The cash investment is for the duration of idle time

before it is liquidated to meet the expected cash outflow.


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Free cash segment (FCS) The cash from this segment is normally for speculative purposes, in

which there is no immediate need for the cash involved. Therefore,

yield rather than liquidity is the main criteria in investment to ensure

high return with some degree of safety.

In addition to the above constraints that focus on cash needs, the

individual characteristics of the securities involved represent a major

criterion in marketable securities selection. The risk-return tradeoffs'

factors will play a major role in determining the proper types of

securities a firm will hold. Factors influencing the choice of marketable

securities are:

1. Security. It concerns with the safety of the principal

investment due to the risk of default in principal or interest

payment and capital loss. The risk involved should be at a

minimum level.

2. Liquidity. Another measure of risk is the marketability of the

securities involved. It refers to the ease of converting the

securities to cash without losing the face value. Securities that

have market demand are highly liquid and will satisfy the cash

demand.

3. Yields. The yields or returns are not as important as the first

two factors. It represents a tradeoff between risk and returns in

choosing marketable securities. Given the purpose of the

portfolio as temporary investment and substitute for cash,

yields should be the deciding factor only after both security and

liquidity is accounted for.

Other factors such as event risk, interest rate risk, and inflation risk also

influence the choice of marketable securities. Any event or variables that may

affect the safety, liquidity, and yields of the securities should not be ignored

deciding which marketable securities should be invested in. Thus, proper

analysis of risk-return tradeoffs is necessary in determining the appropriate


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mix of the marketable securities portfolio, so as the investment serves both as

support for liquidity and profitability.

6.2.5 Alternative Investments

In the money market, there are wide ranges of marketable securities

available, which carry various characteristics. The issuers of short-term

securities are either government issues such as treasury bills, or private

issues such as commercial paper.

Treasury bills (T-bills)

It is a Government Issue, and represents the obligation of the

Treasury Department. Most of the T-bills mature in 91-182 days, with

longer maturity such as 9 months or one year are available from time

to time and in smaller amount. The treasury holds a weekly auction at

a discount with the smallest denomination of RM1,000 and considered

as risk-free. Evaluations: High liquidity with strong secondary market,

lowest risk, low return, and caters for segments RCS and CCS.

Treasury notes (T-notes)

Similar to T-bills in that it is the obligations of the Treasury

department. However, its initial maturity is between 1-7 years. T-notes

are part of the marketable securities portfolio because of its high

security and liquidity. Evaluations: High liquidity with strong secondary

market, lowest risk, return is slightly higher than T-bill, and caters for

segments RCS and CCS.

Negotiable certificate of deposits (CDs)

Is a negotiable instrument as an evidence of deposit in a commercial

bank. The amount (smallest RM100,000) and the maturity (commonly

30 days) are dependent on the investor's (depositor's) needs.

Evaluations: High liquidity with strong secondary market, moderate

risk that depends on the bank involved high return and for caters

segments RCS and CCS.


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Commercial paper (CP) Commercial paper is a short-term unsecured promissory note issued

by a large firm with high credit standing. Maturity ranging from 3-270

days, as longer maturity requires a formal registration. Evaluations:

Low liquidity with weak secondary market, moderate risk that depends

on the issuer, return is slightly lower than CDs, and caters for segment

CCS.

Banker's acceptance (BAs) It is similar to cashier's check payable in future, with typical maturity of

30 days or 180 days. Banker's acceptance arises from a short-term

credit arrangement between purchaser and its bank for financing

certain transactions. The purchaser with its bank approval issues a

draft, on which payment is contingent on some events, to the seller for

the amount purchased. The seller who holds BAs, then may sell it at a

discount in the secondary market to obtain immediate funds.

Evaluations: High liquidity with strong secondary market, moderate

risks since it involves three parties, high return similar to CP, and

caters for segments RCS and CCS.

Other types of securities are available for investment that can be

included in the marketable securities portfolio. The five securities

presented above are the most commonly available and demanded in

the money market. As for Malaysian money market, major securities

are: (1) Bankers acceptance; (2) negotiable money market

instruments; (3) Malaysian government securities; (4) Malaysian

government treasury bills; and (5) Cagamas bonds.

The cash management and marketable securities management are

highly dependent on each other, and therefore it must be managed

concurrently. These two liquid assets represent the firm's liquidity that

will determine its long-term viability and ability to increase

stockholders' wealth.


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6.3 MANAGEMENT OF ACCOUNT RECIEVABLE Accounts receivable is the outstanding amount owed to a firm by its customers from credit

sales. Most of the time it represents a significant part of the firm's current asset investment

and need to be managed effectively. The size of investment in accounts receivable, at any

given time, is a function of:

1. The volume of credit sales; and

2. The average collection period.

Both of these factors have a direct relationship with the firm's credit and collection policies.

Since accounts receivable is an important link in the working capital management, the

establishment and implementation of these policies will have a direct impact on the firm's

operations and profitability as a whole.

6.3.1 Credit Policy

Credit policy is a system or procedures in managing accounts receivable that

includes credit standards, credit terms, and collection activities. Some

policies are sales oriented and accept higher risk, while others are

conservative and sacrifices' sales for safety.

The use of credit or accounts receivable to attract sales is not without costs.

It involves explicit opportunity cost of investment in receivables and thus,

demands careful analysis in deciding the appropriate credit policy for

adoption. It involves a cost-benefit or risk-return tradeoff analysis to ensure

that the investment will contribute enough or more revenues to compensate

the costs involved, hence will ultimately increase the firm's value.

Credit Standards

The credit standard provides the basis for specifying acceptable levels

of credit risk that a firm is willing to bear and in deciding who will

receive credit. In essence, it looks at the minimum financial strengths

and moral standings the applicants should have in order to receive the

credit facilities.


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The purpose of credit standards is to screen potential credit customers

for their ability and willingness to pay the credit facilities given. The

determination of credit risks focuses on several specific factors that

are known as 6C's of credit.

a) Character. A customer's character will determine his

willingness to pay. It is a measure of his moral obligations to

fulfill his promise, and can be determined by looking at his

business and social reputation, his past payment records,

other factors or events that affects his character.

b) Capacity. The capacity is a function of cash flow and will

determine a customer's ability to pay. This involves his ability

to manage the business in generating revenues and meet all

current obligations without affecting his business operations.

c) Capital. The capital will determine a customer's ability to pay.

It concerns with the availability of resources in possession, or

the ability to generate resources to pay debt when due. The

particular factor focuses on the customer's net working capital

as it represents the margin of safety offered to short term

creditors. Other capital such as fixed assets is not available to

pay creditors, unless it is liquidated or mortgaged.

d) Conditions. The conditions concerned with uncontrollable

factors with may affect a customer's operations, hence his

ability to pay. The firm must anticipate existence of external

factors such as: (1) changes in business environment; (2)

political instability; (3) changes in social values; and (4) other

factors that may affect firm's cash flow.

e) Collateral. In most commercial bank loans, collateral is a

perquisite before granting a loan. Collateral, whether tangible

or intangible assets, offers to the bank as commitment, is a

guarantee that the debt will be paid on time. In order to be

acceptable as collateral, the assets must have value, liquid,

and transferable.


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f) Coverage. It refers to the extent the firm is covered with

insurance policy. This is to ensure the firm's ability to start over

or meet payment in case of major disaster.

Because of the subjective nature of the credit risk evaluations, most

firms attempt to classify their customers in several risk classifications,

in accordance to the expected risk of bad debt or default of payment.

a) Most desirable. These are top-rated customers, and are in a

firm's preferred list. This group of customers requires a

minimum supervision or reviews as the risk involved is very

low; minimal risk with low potential for problems.

b) Desirable. These are customers with good ratings, but below

the first group. This group of customers requires more

supervision compared to the top rated customers.

c) Average. These are customers with fair to good ratings, and

may represent a large proportion of the firm's customers. The

firm will have no problems of default under normal economic

circumstances. However, slow payments can occur under

adverse conditions, and therefore need more supervision.

d) Marginal. This group of customers is the least desirable

accounts. Careful screening and close supervisions are

necessary to reduce risk. The accounts involved have the

potential of becoming bad debts under adverse economic

conditions.

It is to the firm's interest to get the best customer mix by ensuring that

the majority of customers are in the first two groups. However, they

actually represent a minority group. Most customers are either

average or marginal. As a rule of thumb, marginal customers should

be part of the customer mix, and 10 percent is a comfortable limit.

Beyond 10 percent mix, a firm is absorbing higher risk than it should

have


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Credit Terms

The credit terms dictate the conditions under which credit given to

customers. It concerns with: (1) cash discount for early payment; (2)

discount period; (3) the length of time credit outstanding; and (4)

financial charges for late payment, if any. The most common credit

and/or payment terms are:

a) Open terms. A line of credit is granted. b) Cash before delivery (CBD). A firm must receive cash before

deliveries can be made. No risk involved, as no credit is

granted.

c) Cash in advance (CIA). Similar to CBD.

d) Cash with order (CWO). Similar to CBD.

e) Cash on delivery (COD). Customer will pay for shipment or

goods when it is received. Some risk involves as customer

may refuse to accept the shipments or give bad checks.

f) Net 30. Payment in full is due full within 30 days after date of

shipment.

g) Net 10 EOM. EOM stands for end of month. A payment in full

is due before the tenth day of the month following shipment.

For example if the shipment is in January, the due date is

before February the 10th. Another similar version is Net 10

MOM (middle of month).

h) 2/10 net 30. If invoice is paid within 10 days from shipment

date, a 2 percent discount is permitted; or else, payment in full

is due within 30 days.

9. 2/10 prox, net 30. If invoice is paid on approximately the tenth

day of the month following shipment date, a 2 percent discount

is permitted; or else, payment in full is due within 30 days.


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10. 2/10 EOM, net 40. If invoice is paid by the tenth day of the

following month, a 2 percent discount is permitted; or else,

payment in full is due in 40 days.

11. 2/10 ROI, net 40. If invoice is paid within 10 days of receipt of

invoice, a 2 percent discount is permitted; or else, the payment

in full is due in 40 days.

The offer of cash discount tends to induce early payments from the

credit customers. The change in credit terms has a direct impact on

average collection period and the level of receivable management,

and thus sales.

Collection Activities

The collection policy provides guidelines for appropriate actions to be

taken when accounts are overdue. It involves the use of certain

procedures to collect past due accounts:

a) Reminder. It is to give reminders to customers that the

account is overdue without payment. The techniques involve

usually by sending postcard, duplicate invoice or statement

with reminder phrases or stickers, brief and courteous letter,

printed cards, and aging schedule for the account with

reminder notes. The objective is to remind customer that the

account is overdue and it is to his advantage to pay the invoice

immediately.

b) Follow Up. If the reminder notes fail getting the customers to

pay, the firm will resort to sending successive follow up letters

with increasing firmness such as telegram, telephone, and

personal visits. The most effective method is personal visit and

is particularly important after the account is overdue for

sometime. The follow up stage may last several months, until

the firm is convinced that the customer is unwilling or unable to

pay.


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c) Drastic Action. The drastic action is the last stage that

includes drawing a draft on a customer, collection by attorney,

or employing collection agency. These actions are as last

resort effort by the firm after follow up fails to collect the past

due accounts as it is drastic and unfriendly. In addition, a firm

may lose these customers and thus future sales.

The collection policies will depend largely on the firm's management

view towards risk. A risk adverse management normally adopts a

more aggressive approach. They are not willing to take much risk as

the accounts aged with time as it may lead to definite bad debts.

6.3.2 Analysis of Key Credit Policy Changes

Any proposed change in credit policy should provide benefits more than the

additional cost incurred. This is in line with the firm's goal to maximize owners'

wealth via the increase in profits while controlling risk at an acceptable level.

The cost-benefit analysis uses incremental approach to look at the

incremental difference or change in sales, costs, and ultimately profits. The

cost-benefit analysis follows certain framework that isolates essential

revenues and cost variables items such as:

Item 1. Contribution from changes in sales. Focus on the incremental

change in sales and its contribution to gross profit.

Item 2. Changes in cost of accounts receivable investment. Focus on

incremental change in the level of receivable investment and the

cost of tied up funds in accounts receivable.

Item 3. Changes in bad debt costs. Focus on incremental change in bad

debt losses due to change in essential credit policy.

Item 4. Changes in other costs. It focuses on the incremental change in

other costs associated with managing the credit accounts such as

cost of discount, cost of running the credit department and

collection expenses.


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Item 5. Incremental profits. It is the net impact of the proposed policy

change on the firm's operating income that provides the basis for

decision-making. Item 5 = 1 – 2 – 3 – 4

Changing Credit Standards.

The change in credit standards will not affect all customers. For

example, if the firm plans to adepts a more stringent standard that

provides credit to those with good ratings, the current marginal

customers will be dropped from the customer mix. Other group of

customers will remain as it is. On the other hand, if less stringent

policy results in an increase in marginal customers while present

customers remain constant. Therefore, the analysis in receivable

investment is the sales change ( ∆S) as shown in step 2 of the

analysis.

To illustrate, consider the financial data for Suria Products Inc.

presented in Table 6-2. In the following examples, “∆” refer to changes

and “tn” refers to time frame where “t=0” is current and “t=1” is the

expected.

Table 6-2 Suria Products Inc. Present Characteristics

S0 : Current sales revenues. RM500,000

AR0 : Current levels of account receivable. RM62,500

ACP0 : Current average collection period. 45 days

P0 : Profit before taxes RM 50,000

D0 : Current discount rate 0%

k : Opportunity cost of funds 10%

V : Variable cost as percentage of sales 80%

Bm0 : Bad debt percentage for marginal customers 8%

Ba0 : Average bad debt 4%

Stated credit terms Net 30 days

Capacity Excess

By using the data in Table 6.2, assume that Suria's management is

planning to change its present credit standards as follows:


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1. More stringent standards (W). The company only extents

credit to customers with default risk of 5% or lower. This would

reduce sales by RM50,000 and increase average collection

period to 60 days for eliminated customers.

2. More Liberal Standards (X). Under this option, the company

is willing to extent credit facilities to customers with default risk

of 15% or less. This should increase sales by RM60,000 and

average collection period for new customers to 70 days.

The above alternatives will have an impact on Suria's profit in three

areas; gross profit margin, cost of investment in receivables, and bad

debt costs. Other costs such as collection expenses may change, but

it is assume to be constant in the case. For more stringent standards:

1. Change in contribution margin (∆CM)

∆CMW = ∆S (CM)

= (S1 – S0)(1 – V)

= (450,000 – 500,000)(1 – 0.80) Where S1

= RM500,000 – RM50,000

= –RM10,000

2. Change in carrying costs (∆CC)

Change in receivable investment (∆RI)

∆RIW = (ACP1 / 360)(V)(∆S)

=(60 / 360)(0.80)( –50,000)

= –RM6,666.67

Therefore, Change in carrying costs (∆CC)

∆CCW = k (∆RIW)

= 0.10 (–6,666.67)

= –RM666.67

Note: Present customers S0 are not

accounted for


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3. Change in bad debt costs (∆BD)

∆BDW = Bm0 (∆S)

= 0.08 (–50,000)

= –RM4,000

4. Changes in other costs: None

5. Incremental profit (IP)

IPW = ∆CMW – ∆CCW – ∆BDW

= –10,000 – (–666.67) – (–4,000)

= –RM5,333.33

The above calculations show that Proposal W reduces Suria's profits

by RM5,333.33, and therefore it should not be accepted. When

dealing with cost-benefit analysis, the decision criterion is to accept

only if the incremental profit is positive. The more relax credit standard

can be evaluated using similar format:

1. Changes in contribution margin (∆CM)

∆CMX = ∆S (CM)

= (S1 – S0)(1 – V)

= (560,000 – 500,000)(1 – 0.80)

= RM12,000

2. Changes in carrying costs (∆CC)

∆CCX = k ((ACP1 / 360)(V)(∆S))

= 0.10((70 / 360)(0.80)(60,000))

= RM933.33

3. Changes in bad debt costs (∆BD)

∆BDX = BmX (∆S)

= 0.15 (60,000)

= RM9,000


Note: Present customers S0 are not

accounted for


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5. Incremental profit (∆IP)

∆IPX = ∆CMX – ∆CCX – ∆BDX

= 12,000 – 933.33 –9,000

= RM2,066.67

On the other hand, proposal X's incremental profit is positive

RM2,066.67. Thus, this policy is acceptable and could improve Suria's

profits.

Changing Credit Terms

The incremental profit analysis to evaluate changes in credit terms will

differ slightly from the analysis of changes in credit standards. Unlike

changes in credit standards, any changes in credit terms will affect all

customers regardless of whether they are new or old, or their risk

classifications. For example, if more relaxed terms such as net 40

instead of net 30 are offered, all customers will obviously take

advantage of the lenient terms. Therefore, the analysis of changes in

credit terms will use average values as shown in the following

examples.

Instead of changing credit standards, Suria Products Inc. decides to

investigate the possibility of changing credit terms; either to tighten or

to liberalize the present term of net 30. The followings are the

proposed changes in credit terms:

1. Severe Credit Terms (Y). This involves shortening the current

credit terms of net 30 to net 20. This would reduce sales by

RM40,000 and average collection period by 10 days to 35

days. The lost sales are assumed to be from the marginal

customers, and the bad debt loss is expected at 8%.

2. Relaxed credit terms (Z). It involves lengthening the current

credit terms of net 30 to net 40. This will cause sales to

increase by RM70,000 and average collection period from 45

days to 60 days. With the new terms, the expected bad debt

for new sales is 10%.


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Changes in credit terms will have an impact in three similar areas as

the changes in credit standards; gross profit margin, cost of

investment in receivable, and costs of bad debt. Only the methods of

calculating the changes in receivable investment are different from

that of the changes in credit standards. The revised new formula

consists of two parts; that is changes in receivable investment

associate with original sales and with new sales, instead of one

previously. For proposal Y, the following changes will occur in the

three essential areas:


∆CMY = ∆S (CM)

= (S1 – S0) CM

= (460,000 – 500,000)(1 – 0.8)

= –RM8,000 2. Changes in carrying costs (∆CC)

Changes in receivable investment (∆RI)

∆RIY = [((ACP1 – ACP0) / 360)(S0)) + ((ACP1 / 360)(V)(∆S)]

= [((35 – 45) / 360)(500,000)) + ((35 / 360)(0.80)( –40,000)]

= –RM17,000

Therefore, changes in carrying costs (∆CC)

∆CCY = k (∆RIY)

= 0.10 (–17,000)

= –RM1,700


∆BDY = Bm0 (∆S)

= 0.08 (–40,000)

= –RM3,200


Note: Present customers S0 and ∆S

are not accounted for


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∆IPY = ∆CMY – ∆CCY – ∆BDY

= –8,000 – (–1,700) – (–3,200)

= –RM3,100

The result shows a negative incremental profit of RM3,100 and

therefore, proposal Y is not acceptable to the firm. For proposal Z:


∆CMZ = ∆S (CM)

= (S1 – S0) CM

= (570,000 – 500,000)(1 – 0.80)

= RM14,000

2. Changes in carrying costs (∆CC)

∆CCZ = k [((ACP1 – ACP0) / 360)(S0) + (ACP1 / 360)(V)(∆S)]

= 0.10 [((60-45)/360)(500,000)+(60/360)(0.80)(70,000)]

= RM3,016.67


∆BDZ = BmZ (∆S)

= 0.10(70,000)

= RM7,000



∆IPZ = ∆CMZ – ∆CCZ – ∆BDZ

= 14,000 – 3,016.67 – 7,000

= RM3,983.33

Under proposal Z, Suria's profit will increase by RM3,983.33 and

therefore the proposal is acceptable. The illustrations for Suria do not

use average bad debt percentage as a basis for calculations. Other

problems may not provide details bad debt percentage; that is only

Note: Present customers S0 and ∆S

are not accounted for


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average debt's data provided. To accommodate this data, calculations

for bad debts are as follows:

3. Changes in bad debt costs (∆BD):

∆BD = BD1 – BD0

= (S1)(Ba1) – (S0)(Ba0)

Where Bat : Average bad debt rate for period t

The preceding examples do not consider changes in cash discount for

early payment as a way to liberalize credit and increasing sales. To

illustrate the effects of changes in discount terms, let's assume that

Anis Inc. is currently offering credit terms of 2/10 net 30, and other

characteristics are shown in Table 6.3.

Table 6.3 Anis Inc. Present Financial Characteristics

S0 : Current sales revenues. RM500,000

AR0 : Current levels of account receivable. RM62,500

P0 : Profit before taxes RM 50,000

k : Opportunity cost of funds 10%

V : Variable cost as percentage of sales 80%

D0 : Current discounts 2%

DT0 : Current discounts takers 30%

Stated credit terms 2/10 net 30

Capacity Excess

The company is considering changing the current terms of 2/10 net 30

to 3/7 net 30; and it is estimated that 50% of the customers will take

the discount. In order to simplify the calculations, assume that sales

will remain constant and there is no bad debt involved. The approach

in analyzing these changes is similar to the preceding examples, with

one additional area to focus; that is changes in discount costs. Thus,

the incremental profit formula from the proceeding analysis of changes

in credit terms can be modified to accommodate this, as following

example illustrates.


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The estimations of average collection period for present terms and

proposed terms are necessary if there is no average collection data

available. The estimates can be computed as follows:

ACPt = (DTt)(DPt) + (1 – DTt) CPt

Where ACPt : Approximate average collection period

DTt : Discount takers

DPt : Discount period

CPt : Credit period

ACP0 = (DT0)(DP0) + (1 – DT0) CP0

= (0.30)(10) + (1 – 0.30) 30

= 24 days

ACP1 = (DT1)( DP1) + (1 – DT1)CP1

= (0.50)(7) + (1 – 0.50) 30

= 18.5 days


∆CM = Zero; since sales remain constant

2. Changes in carrying costs (∆CC):

∆CC = k [((ACP1 – ACP0) / 360)(S0) + (ACP1 / 360)(V)(∆S)]

= 0.10[((18.5–24)/360)(500,000) + (18.5 / 360)(0.80)(0)]

= –RM763.89

3. Changes in bad debt costs (∆BD): None

4. Changes in other costs; discount costs(∆DC)

∆DC = (DT1)(S1)(D1) – (DT0)(S0)(D0)

= (0.50)(500,000)(0.03) – (0.30)(500,000)(0.02)

= RM4,500

5. Incremental profit (∆IP):

∆IP = ∆CM – ∆CC – ∆BD – ∆DC

= RM0 – (–763.89) – (0) – (4,500)

= –RM3,736.11


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Offering new discount terms will speed up collection of accounts

receivable by RM7,638.89, which represent RM763.89 savings for the

firm. However, the discount expenses change drastically which give

an incremental profit of negative RM3,736.11. Thus, Anis should not

change its present discount policy.

In the preceding examples presented, it involves only changes in one

of the policy variable at a time. However, the same framework could

be used to evaluate the effects of changes in several policy variables

simultaneously. The equations may become complex, but the

underlying principles are still the same and valid.

6.4 MANAGEMENT OF INVENTORY The financial manager does not have a direct control over inventory investment decision, but

tends to have indirect input as it relates directly to the firm's working capital. Thus, proper

management of these inventories is important as it affects the firm's day-to-day operations

and provides the basis for production and sales. In addition, it represents a significant

investment for most firms. Inventories consist of the firm's stock of raw materials, work in

progress, and finished goods. The characteristics of the inventories are as follows.

a. Raw Materials

It consists of basic raw materials purchased from suppliers to initiate the production

process. The purpose of holding raw materials is to make production function

independent from the purchasing function. That is, any problems with purchasing

function such as shipment delays will not cause production shut down.

b. Work In Process

The work in process is consists of partially finished goods requiring additional work

before they become finished goods and be sold to customers. Its purpose is to make

these production processes independent from each other; that is a break down in

one process will not affect the other operations.


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c. Finished Goods

The finished goods represent products that are completed in the production process

but not sold. Its purpose is to make production function independent from the sales

functions. Any productions slow down will not hamper sales due to the inability to

meet demands.

As in any financial decisions, investment in inventory involves risk-return tradeoffs.

As such, firms with low inventory levels may face potential stock out and production

delays, which results in low inventory cost and potential loss of sales. Firms that

maintain large inventories, on the other hand, can be assured of no production

delays, thus will be able to meet demand and to provide prompt shipment of orders if

necessary; but will experience high inventory costs.

Due to its role in making the firm's function independent from each other and the

financial burden involved, the objectives of the firm's inventory management are:

1. To maximize inventory turnover. That is the same action as to minimize the

investment levels in the inventories. This will release the tied up funds in

inventories, which is less productive, to be used in other more profitable

investment; thus improving the firm's profitability.

2. To carry sufficient inventories. Sufficient inventories are important to satisfy

the production and sales demands. This will smooth out production process

and provides better product selections and prompt deliveries.

Therefore, the firm must determine the "optimal" level of inventories holding to

reconcile both of these conflicting objectives. Proper inventory management will

balance both of these needs, and hence would result in increase stockholders'

wealth. Other reasons for the firm to keep inventory are: (1) it will take some time to

order the raw materials; (2) it will be cheaper to buy in large quantities; and (3)

economic-of-scales.

6.4.1 Economic Order Quantity

There are several techniques in controlling inventory, but the most prevailing

method is the basic economic order quantity (EOQ) model; together with

reorder point and safety stock. EOQ model is a tool to determine the optimal


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order quantity that results in the lowest total inventory cost. The EOQ model

focuses on basic costs associated with inventory management without taking

into considerations the actual cost of the inventory itself. The basic cost

consists of order costs, carrying costs and total inventory costs.

1. Oder Costs (OC). The order costs associate with fixed clerical costs

of placing and receiving and ordering; such as cost of processing,

telephoning, typing, mailing, and receiving orders. It is stated as

Ringgits per order and its annual costs vary inversely with order

quantity. That is high order quantity will reduce the number of orders

per period, and thus the total order cost per period will also decline.

2. Carrying Costs (CC) The carrying costs associate with the cost of

carrying each unit of inventory in the firm's stock per period, normally

on a yearly basis. These costs are commonly stated as Ringgits per

unit per period or as a percentage (approximately 20-25%) of

inventory cost per period. It includes the costs of invested capital and

other costs such as storing, handling, taxes, insuring, physical

damage, obsolescence, and auditing the inventories. The total

carrying cost per period relates directly to the order quantity, that is

higher order quantity will results in higher total carrying cost for the

given period.

3. Total inventory costs (TIC) The total inventory costs are defined as

the sum of total order costs (TOC) and the total carrying costs (TCC). The total inventory costs are important in the EOQ model, as

its objective is to determine the optimal inventory order quantity that

minimizes it. Any order quantity below or above the optimal order

quantity, the firm's total inventory costs not being at a minimum.

However, within the range of plus or minus 20 percent from the stated

EOQ, the total cost function is quite flat.

To determine the optimal order quantity, under EOQ model, two approaches

can be used; graphically or mathematically. The focus in the following

sections is on the latter methods, but to promote better understand of the

concept behind EOQ model, a graphic approach will briefly be presented.

Thus, let:


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D : Usage, demand, or sales in unit per period

O : Order cost in Ringgits per order

C : Carrying cost per unit in Ringgits per period

Q : Order quantity in units; can be EOQ or other quantity

SS : Safety Stock

a. Total ordering costs (TOC)

TOC = Order cost per order (Numbers of orders per period)

= O (D / Q)

b. Total carrying costs (TCC)

TCC = Carrying cost per unit (Average inventory)

= C ((Q / 2) + SS)

c. Total inventory costs (TIC)

TIC = Total ordering costs + Total carrying costs

= TOC + TCC.

The above formula provide the basis for the development of EOQ model

using graphical and mathematical approaches by using financial data from

Table 6-4.

Table 6-4 TOC, TCC, And TIC for Biener Products Inc. C = RM2 O = RM25 D = 3,600

Q TOC TCC TIC

50 units

150

RM1,800

600

RM 50

150

RM1,850

750

300 300 300 600

450

600

200

150

450

600

650

750


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0100200300400500600700800900

10001100120013001400150016001700180019002000

50 100 150 200 250 300 350 400 450 500 550 600 650

Quantity

Cos

ts in

RM

TIC

TCC

TOC

A Graphical Approach

To illustrate, assume that Biener Products Inc. expects to sell 1,800

units of inventory for the coming year. The firm estimates that the cost

of carrying each unit of inventory per year is RM2, and Wiener will

incur RM50 each time an order is placed. The calculated costs

associated with ordering and carrying the inventories for the upcoming

period without safety stocks' requirements are presented in Table 6-4,

based on order quantity of multiples of 50 units per order. By using the

data in Table 6-4, a graph to determine EOQ presented in Figure 6-6

can be developed. It shows the nature of each of the costs functions

relative to order quantity and total costs.

Figure 6-7 A Graphic Presentation of EOQ Model

A Mathematical Approach

The economic order quantity (EOQ) is defined as the order quantity

that minimizes the total inventory costs. Thus, EOQ can be solved

mathematically by setting total ordering cost function equals to total

carrying cost function. By manipulation of these two equations, it wills

results in the following formula:


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EOQ = √ 2DO / C

Thus, substituting Biener's financial data in Table 6-3, EOQ equals to:

EOQ = √ 2(3,600)(25) / 2

= √ 90,000

= 300 units

TIC = TOC + TCC

= 25 (3,600 / 300) + 2 ((300 / 2) + 0)

= 300 + 300

= RM600

The above calculations indicate that both graphical and mathematical

approaches give the same EOQ level. However, the latter approach is

quicker as no elaborate calculations and graphing are necessary.

Shaded area in Table 6-4 represents the cost structure at EOQ of 300

units. Sample calculations for TCC at 300 units:

TIC = O (D / Q) + C ((Q / 2) + SS)

= 25 (3,600 / 300) + 2 ((300 / 2) + 0)

= RM600

Reorder Points and Safety Stock

Up to this point, we work with EOQ assumptions that inventory usage

follows the "saw tooth" pattern as shown in Figure 6-7.

Figure 6-8 Inventory Usage over time for EOQ Model

500

400

300

200 150 100

Q =

Q/2 =

Order Quantity

Time between orders 30 days

Average Inventory

10 20 30 40 50 60 70 80 00


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It implies that the demand for the products is constant and the delivery

for supplies is certain. The firm orders 300 units and uses them for 30

days at a constant rate of 10 units per day (=3,600 Units / 360 Days).

On the day 30, when the stock is depleted to zero, the new order of

300 units will be received instantaneously. Thus, there is a perfect

certainty of usage and delivery.

Figure 6-9 Inventory usage, Reorder Point, and Safety Stock

under EOQ Model

The basic assumptions are not practical as demand may vary from

time to time, and shipment delays are possible. Thus, modifications of

the basic inventory usage are necessary to include reorder point (ROP) and safety stock (SS). This will provide the allowance for

uncertainty in demand and delivery of inventory. Figure 6-8 illustrates

these modifications, with the assumptions of safety stock level at 100

units and delivery or lead-time (L) of 10 days.

From Figure 6-8, with delivery time of 10 days, a reorder point of 150

units should be observed. Reorder point act as an indicator of when

the firm should place an order for the new shipments. To illustrate the

reorder point and safety stock concept, let:

SS : Safety stocks in units

L : Lead-time in days

Lf : Lead-time in days to delivery as a fraction of a year.

Dd : Daily usage, demand, or sales

500

400

300

200 250

100

Q =

(Q/2)+SS =

Order Quantity

Lead-time 10 days

Average Inventory

ROP =

SS =

10 20 30 40 50 60 70 80 00

Expected lead time demand


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Reorder point is a function of lead-time in days multiplied by daily

usage. This is to ensure that inventories arrived in time before safety

stock is affected. Thus, by using Biener's financial data, reorder point

equals to:

ROP = (Lead time in days)(Daily usage rate) + Safety stock

= (L)(Dd) + SS

= (10)(5) + 100

= 150 units

For Biener's inventory control, when the inventory level reaches 150

units the new order must be processed and sent to the supplier. Given

that the delivery is on time, the shipment will arrive on day 30,

whereby the inventory level reaches 100 units; that is the safety stock.

The above mentioned safety stock is set arbitrarily based on usage

allowance of 10 days.

In actual sense, safety stock level should be determined based on the

certainty of usage rates and delivery times, together with the cost in

carrying inventories in stock versus the cost of lost sales from

potential stock out. As a rule of thumb, the equation that gives

approximate appropriate level of safety stock to be held by a firm is:

SS = 1.85 √ (Lf )(D)

= 1.85 √ (10 / 360)3,600

= 1.85 √ 50

= 19 units

The above calculations indicate that Biener should hold 19 units of

safety stock to optimize the cost function and safety needs against

uncertainty of demand and delivery. In all of the preceding examples,

lead-time and usage rate is stated in days and there are 360 days per

year. In actual case, other periods such as weekly and monthly can be

used. As such, periods should be adjusted to 50 weeks and 12

months per year respectively. This change is important to synchronize

the period involved.


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To illustrate the whole concept of EOQ model, consider the following

examples. The Abish Corporation has a monthly usage of 4,000 units.

The cost of placing an order is RM100 and it takes one week for the

shipment to arrive. On average, the inventory carrying cost per unit is

RM0.55 per three months. All orders must be placed in lot of 100 units

and safety stock is required. Assume that 50-week in a year. Thus:

D = 4,000 (12)

= 48,000 units

C = RM0.55 (12 / 3)

= RM2.20

O = RM100

SS = 1.85 √ (Lf )(D)

= 1.85 √ (1 / 50)(48,000)

= 1.85 √ 960

= 57.32 Equals to 58 units

ROP = (L)(Dd) + SS

= (1 (48,000 / 50)) + 58

= 1,018 units

EOQ = √ 2DO / C

= √ (2(48,000)(100)) / RM2.20

= 2,088.93 units

With the presence of constraints in order quantity, that is lot or

multiples of 100 units, some adjustment is necessary if EOQ is not

compatible such as the above example of 2,088.93 units. The order

quantity must be changed accordingly to multiples of 100 since the

firm cannot place an order in quantity of 88.93 units, but a minimum lot

of 100 units. Therefore, the order quantity (Q) is not equal EOQ and

should be changed to 2,100 units. Therefore, TOC, TCC and TIC:


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TOC0 = O (D / Q)

= 100 (48,000 / 2100)

= RM2,285.71

TCC0 = C ((Q / 2) + SS)

= 2.20 ((2,100 / 2) + 58)

= RM2,437.60

TIC0 = TOC + TIC

= 2,285.71 + 2,437.60

= RM4,723.31

Substituting the data for Abish Corporation, the requirements for

safety stock and reorder point is 58 units and 1,018 units respectively.

The total inventory costs involve in the inventory management equals

to RM4,723.31 including the cost of carrying the required safety stock.

If Abish Corporation decides to place an order more or less than EOQ

units at a time, the total inventory costs will increase accordingly.

Now let assume that the supplier is willing to give a quantity discount

of RM0.10 each unit if orders are placed 3,000 units and above. With

this new information, should Abish Corporation take the offers? To

answer this, let order quantity equal 3,000 units and calculate new

level of TIC:

TOC1 = O (D / Q)

= 100 (48,000 / 3,000)

= RM1,600

TCC1 = C ((Q / 2) + SS)

= 2.20 ((3,000 / 2) + 58)

= RM3,427.60

TIC1 = TOC1 + TCC1

= 1,600 + 3,427.60

= RM5,027.60


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If the proposal to order at least 3,000 units per order is accepted, the

total inventory costs will increase and the company is able to save

RM0.10 per unit.

Increase in cost = TIC1 – TIC0

= 5,027.60 – 4,723.31

= RM304.29

Savings = D(Discount per unit)

= 48,000 (0.10)

= RM4,800.00

Incremental Profit = Savings – Increase in cost

= 4,800.00 – 304.29

= RM4,495.71

Therefore, the firm should take the discount offer since the

incremental profit is positive RM4,495.71. The cost-benefit analysis is

important in inventory management as to balance the need for

meeting the production and demands requirement, and the need to

minimize the cost of inventory investment and other related costs.


152 | P a g e

QUESTION 1

Syarikat Emas faces liquidity problem. The firm needs RM500,000 for the next 90 days. Syarikat Emas has decided to use its short-term financing alternatives. The alternatives available are as follows: a) To sell its accounts receivable to a factoring company which will charge 5%

factoring fee, 5% factor’s reserve and 10% interest on advance b) Syarikat Emas can borrow a discounted loan from Bank Merdeka at a rate of

12% per annum

c) To sell commercial papers at 8% interest per annum. The company also has

to bear RM5,000 for cost of issuing the papers

d) Which is the best alternative? Why?

e) Explain a straight loan.

(20 marks)

QUESTION 2

Hitam Manis Distributor has determined the following inventory information:

1. Orders can be placed only in multiples of 100 units

2. Annual usage is 500,000 units. (Assume a fifty-week in your calculations.)

3. The carrying cost if RM10 per unit

4. The ordering cost is RM100 per order

5. The desired safety stock is 2,500 units

6. Delivery time is 5 days.

Given these information:

i) What is the EOQ level?

ii) How much it the total inventory cost?

iii) At what inventory level should a reorder be made?

iv) Define the terms ‘average inventory’ and ‘re-order point or level.’

(20 marks)

FINANCE MANAGEMENT FIN420 chp 6

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