Financial Management Fundamentals
Cash and Accounts Receivable Management
Cash is the most liquid of a company’s
assets. Cash is the sum of currency and
checking account deposits a company has. The cash management function involves:
(1) determining the optimal liquid asset balance
to maintain,
(2) efficient collection and disbursement of cash.
a) Objectives.
·
To keep this non-earning asset to the minimum
Holding
of excess liquid assets results in an opportunity cost resulting from the
income that the firm could earn if these funds were invested in other
productive assets.
·
However not to run out of cash.
Inadequate
liquid balances result in "shortage" costs such as missing cash
discounts, deterioration of the firm's credit rating, higher interest costs on
borrowed funds, and the risk of insolvency.
b) Reasons for holding Cash.
·
Cash required for
expenses, supplies, taxes, payroll, acquiring fixed assets etc. (also what is
known as Business Transactions.)
·
Minimum Balance to be
kept in the Bank.
·
Precautionary balances
(for emergency purposes) where inflows are not certain.
Cash inflows and outflows are seldom
synchronized.
The
first step in cash management is development of a cash budget
showing
the forecasted receipts and disbursement as well as a forecast of any
cumulative shortages or surpluses expected during the budget period.
The
processes of cash collection and disbursement provide the firm with
opportunities to increase the available cash balance without additional total
investment.
A. Float is the difference between the
checking account balances shown
in
the firm's books and those of the bank.
1. Positive or disbursement float occurs
when the balance on the bank's books exceeds that on the firm's books. This occurs because of the delays caused by
mailing disbursement checks and the clearing process.
2. Negative or collection float occurs when
the firm shows a higher balance than the bank.
This depends on the time it takes for deposited checks to clear.
Example
of Float :
The beginning balance of Cash on Dec 1 ,1998 was
AED 100,000.
During the month the company received AED
1,000,000 in cheques from its customers. The company also paid its suppliers
AED 900,000 by cheques during the month. As on Dec 31, 1998; AED 800,000
received by the company was cleared in the bank and AED 400,000 of the cheques
paid had cleared the banking system.
Transactions |
Company's
books |
Bank's
books |
Beginning balance, Dec 1, 1998 |
100,000 |
100,000 |
Receipts |
1,000,000 |
800,000 |
Payments |
900,000 |
400,000 |
Ending
balance, Dec 31, 1998 |
200,000 |
500,000 |
Float
= 500,000 - 200,000 = AED 300,000 (positive float)
The
company has extra AED 300,000 as short-term funds.
Practice
exercise
A Company’s beginning cash balance as per its
books on January 1, 1997 was AED 200,000.
Cash receipts during 1997 totaled AED 750,000. Cash payments amounted to AED 550,000. If the cash balance as per the Bank’s records
on December 31, 1997 is AED 250,000, then how much was the company’s float on
that day?
|
Managing
the Cash Flow Cycle depends on a few things.
·
Faster Collections
·
Delayed Disbursements
1) Faster Collections.
·
Collection centers
through out the marketing area through regional Banks.
·
Lockbox arrangements
·
Daily wire transfers to
the corporate headquarters.
2) Extending
Disbursements.
(
Not very ethical but you could do within limits.)
·
Give a cheque from a
Bank Location that will take a long time to clear.
·
Stretching payables
Accounts Receivable Management
Accounts receivable exist whenever businesses
extend credit to their customers. Trade
credit is credit extended by a company to another company while consumer credit is credit extended by a
company to its ultimate consumers.
Accounts receivable management consists of:
(1)
evaluating individual credit applicants.
(2)
establishing credit and collection policies and
Extension
of credit is essentially an investment decision as it results in an
investment
in accounts receivable, a current asset.
A.
Shareholder wealth is
maximized by investing in accounts receivable as long as expected marginal
returns from the investment exceed expected marginal cost of funds invested.
B.
Marginal returns consist of gross profits from additional sales.
C. Marginal costs include opportunity cost
of capital tied in
accounts
receivable, bad debt losses, cost of checking new
credit
accounts, and collection expenses.
Credit policy administration
A
credit policy includes as its major variables the firm's
a) credit standards
b) credit terms, and
c) collection policy.
Credit
standards
Credit standards are the criteria the firm uses to
screen credit applications to determine whether and in what amount credit
should be extended.
The
"five C's of credit" provide a useful framework for
organizing information about an applicant.
1. Character concerns the applicant's
willingness to meet credit
obligations.
2. Capacity refers to the applicant's
ability to meet obligations based on
his
liquidity and projected cash flows.
3. Capital refers to the applicant's overall financial strength based on
net
worth.
4. Collateral refers to assets that may
be pledged as security. In trade
credit
decisions, collateral is seldom a major consideration since
foreclosing on the pledged assets is
often an expensive and time‑
consuming process which does not
adequately substitute for prompt
receipt of cash.
5. Conditions refer to the general
economic climate and outlook which
may
affect the customer's willingness and ability to pay.
Credit
terms
Credit
terms specify the conditions under which credit extended must be repaid.
1. The credit
period is the time allowed for payment.
2. Cash
discounts are discounts allowed if payment is made within a
specified
period of time. Cash discounts are
usually specified as a
percentage of the invoiced amount and
are granted to speed up
collection of accounts receivable.
Collection policy
The
collection effort consists of the methods employed to attempt to collect
payment on past due accounts.
1. The collection effort must be a balance
between excessive leniency
and the risk of alienating customers.
2. An important part of managing accounts
receivable is monitoring their
status. Some measures used are
a. Average
collection period
b. Ratio
of bad debts to credit sales
c. Aging
of accounts receivable
An aging analysis consists of
classifying accounts into
categories according to the
number of days they are past due.