EFB210 Lecture Notes - Lecture 12: Cash Cash, Treasury Management, Accounts Payable
Week 12 Finance 1 Lecture Notes
Working Capital Management
Management of Short-Term Assets
• Short-terms assets have lives of days, weeks or months.
• They include:
o Inventory
o Liquid Assets
o Accounts Receivable
• 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
fi eeds to geeate usiess ad eet its ash flo euieets.
• Inventory:
o Manufacturer: raw material, work in progress and finished goods
o Retailer: merchandise
• Liquid Assets:
o All companies: cash – ash is kig
o Others (larger): bills of exchange and over-night deposits are good
substitutes or cash (highly liquid) and can provide higher returns.
o All companies: short-term liabilities are also an important source of liquid
funds. For example, ak oedafts poide at all, eolig lie of edit
used by many businesses to smooth cash flow requirements.
• Accounts Receivable:
o Most companies: short-term credit is extended to customers when goods are
sold on invoice.
• 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
and delivered.
o Thees o eed to hold liuid assets eause all assets are liquid.
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
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accounts payable, you may have no other option than to purchase
goods C.O.D. (cash on delivery) in the future.
o Thee ae legal, adiistatie ad disoutig osts.
▪ 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 fiae topi eause it ioles iestment 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 deisions, the one with the largest NPV
maximises firm value.
o The same principle applies to negative NPV investments where the
iestets ae 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. 5.
• Types include:
o At call deposits
o 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.
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o Note that as liuidit elates to a ailit to aess ash, aess to lies of
credit such as overdrafts are also important.
• 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 of the value of treasury management:
o Division A has a cash outflow of $150,000
o Division B has a cash inflow of $50,000
o Assuming that interest rate on borrowed funds is 15% p.a. while the interest
rate on savings is 12% p.a.:
o 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
o 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?
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Document Summary
Management of short-term assets: short-terms assets have lives of days, weeks or months, they include: Inventory: liquid assets, accounts receivable, 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 fi(cid:396)(cid:373) (cid:374)eeds to ge(cid:374)e(cid:396)ate (cid:271)usi(cid:374)ess a(cid:374)d (cid:373)eet its (cid:858)(cid:272)ash flo(cid:449)(cid:859) (cid:396)e(cid:395)ui(cid:396)e(cid:373)e(cid:374)ts. For example, (cid:271)a(cid:374)k o(cid:448)e(cid:396)d(cid:396)afts p(cid:396)o(cid:448)ide (cid:858)at (cid:272)all(cid:859), (cid:858)(cid:396)e(cid:448)ol(cid:448)i(cid:374)g(cid:859) li(cid:374)e of (cid:272)(cid:396)edit used by many businesses to smooth cash flow requirements: accounts receivable, most companies: short-term credit is extended to customers when goods are sold on invoice. 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.
