EFB210 Lecture Notes - Lecture 12: Cash Cash, Treasury Management, Accounts Payable
Lecture 12: Working Capital Management
Exam -> Topics 6 – 12
Management of Short-Term Assets
- Short-terms assets have lives of days, weeks or months.
- They include:
o Inventory
▪ Manufacturer: raw material, work in progress and finished goods
▪ Retailer: merchandise
o Liquid Assets
▪ All companies: cash – ash is kig
▪ Others (larger): bills of exchange and over-night deposits are good
substitutes or cash (highly liquid) and can provide higher returns.
▪ All companies: short-term liabilities are also an important source of liquid
fuds. Fo eaple, ak oedafts poide at all, eolig lie of edit
used by many businesses to smooth cash flow requirements.
o Accounts Receivable
▪ Most companies: short-term credit is extended to customers when goods
are sold on invoice.
- Despite their short lives and their small size, relative to large long-term capital investments,
the investment in short-term assets still requires a commitment of capital. Therefore, like all
investments they should generate an appropriate return.
- Moreover, the investment in short-term assets is often a necessity of business as the firm
eeds to geeate usiess ad eet its ash flo euieets.
- In the perfect markets world (no fees, no taxes, no delays and full information), there is no
need to be concerned about short-term assets.
o Thees o eed to hold a ateials eause the a e istatl odeed ad
delivered.
o Thees o eed to hold liuid assets eause all assets ae liuid.
o And by saying that all assets are liquid, account receivables are also liquid and can
easily be converted into cash – albeit at their present value.
- Therefore, if we are to consider the management of short-term assets, we cannot start in
the frictionless world as we have done in most topics examined to date.
- What frictions exist:
o There are delays and uncertainties:
▪ Raw materials take time to deliver. Failure to have the required materials
may delay or stop the production process, which can be very costly in terms
of lost production and fixed costs.
▪ Customers may require stock immediately. Failure to have the stock results
in lost sales and potential loss of customers.
▪ Wages, interest and accounts payable must be paid and require access to
cash. If you delay paying wages, employees will be unhappy at best. If you
delay paying your interest, penalties may apply and it may increase the cost
of future borrowings. If you do not pay your accounts payable, you may
have no other option than to purchase goods C.O.D. (cash on delivery) in the
future.
▪ Will mean that you are too much of a credit risk to the supplier
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- Thee ae legal, adiistatie ad disoutig osts.
o Converting accounts receivable to cash can be costly. Can have high fees and can
have relatively large discounts applied (price received relative to book value)
because of costs associated with obtaining information about the creditors in
accounts receivable.
- While this topi is also a topi fo aageet aoutig ad opeatios eseah, it is a
finance topic because it involves investment and we can apply basic financial tools to
analyse these investments.
- Primarily – NPV
o There are cash inflows and outflows
o There is an opportunity cost of funds
o Decisions that have a positive NPV increase value.
o Whe e hae utuall elusie deisios, the one with the largest NPV
maximises firm value.
o The same principle applies to negative NPV investments where the investments are
utuall ilusie – you cannot have one without the other.
Overview of Inventory Management
- Three main types of inventory
o Raw Materials: yet to enter the production process
o Work in Progress: in but not out of the production process
o Finished Goods: finished but not sold
- They can be a major asset
o For example, in 2010 financials, they constituted 34%, 21% and 29% of short-term
assets for Boral, BHP and Paperlinx, respectively.
- Inventory has costs
o Acquisition Costs: ordering, freight and quantity discounts forgone.
o Carrying Costs: Cost of capital, storage, insurance, deterioration and obsolescence,
and price movement
o Stock-Out Costs: no stock, no sale and potential to lose customers
- Optimising these costs is a balance between having too much inventory and not enough
inventory.
Liquidity Management
- Liquid Assets
o comprise cash and those assets that can be converted into cash in a very short time,
and whose cash value can be predicted with a low degree of error, Peiso et al.
(2015).
o Types include:
▪ At call deposits
▪ Short-term marketable securities such as bills of exchange and commercial
paper. We priced bills in Week 2.
- Liquidity Management
o Size and composition of liquid assets and liabilities.
o Note that as liuidit elates to a ailit to aess ash, aess to lies of edit
such as overdrafts are also important.
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- Treasury Management
o Central area or department that manages funding, liquidity and other financial risks
such as interest rate and exchange rate movements.
- By centralising, Treasury can
o match funding inflows and outflows
o raise appropriate levels of funding
o ensure sufficient liquidity for the whole organisation. Note that the liquidity
required by the whole organisation will be less than that of the individual business
units.
o manage and hedge risk
o provide economies of scale, lower administration costs per dollar of assets and,
potentially, lower interest rates.
o provides a high level skill set with a unique perspective on the organisation that may
not be possessed in the individual business units.
AN EXAMPLE:
- An example of the value of treasury management:
- Division A has a cash outflow of $150,000
- Division B has a cash inflow of $50,000
- Assuming that interest rate on borrowed funds is 15% p.a. while the interest rate on savings
is 12% p.a.:
- Interest cost from independent operations over a week would be,
I = -150,000 x 0.15 x 7/365 + 50,000 x 0.12 x 7/365
= -$316.44
- Interest cost from centralisation over a week would be,
I = -100,000 x 0.15 x 7/365
= -$287.67
- Motives
o Transactions: even with perfect certainty, cash inflows do not necessarily match
outflows, hence businesses hold liquid assets to meet cash flow requirements
o Precautionary: in an uncertain world, liquid assets are required to cover unexpected
costs and opportunities. However, the amount required will depend on whether
alternative sources of liquidity are available, e.g. access to an overdraft.
o Speculative: if interests rates increase, the value of longer dated debt securities
decreases more than similar shorter dated debt securities. Therefore, if one is
speculating that interest will increase and prices will fall, then they buy short-dated
(liquid) debt securities.
o Not surprisingly, the first of these is considered the most dominant motive for
liquidity management.
- Major Issues
o If you do not have access to sufficient cash, damage to the business can be untold.
Question:
▪ If a property developer cannot pay his sub-contractors (tradesman) because
of an inability to access cash, how will the sub-contractors react and how
will this affect the value of his development?
o If you have a large cash balance, is the business using resources efficiently?
Question:
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Document Summary
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