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Chapter VI Current Assets Management
I. What are 'Current Assets'? Current assets are balance sheet accounts that represent the value of all assets that can reasonably expect to be converted into cash within one year. Current assets include cash and cash equivalents, accounts receivable, inventory, marketable securities, prepaid expenses and other liquid assets that can be readily converted to cash.
A. BREAKING DOWN 'Current Assets' Current assets are important to businesses because they can be used to fund day-to-day operations and pay ongoing expenses. Depending on the nature of the business, current assets can range from barrels of crude oil, to baked goods, to foreign currency. On a balance sheet, current assets will normally be displayed in order of liquidity, or the ease with which they can be turned into cash.
Assets that cannot feasibly be turned into cash in the space of a year – or a business' operating cycle, if it is longer – are not included in this category and are instead considered "long-term assets." These also depend on the nature of the business, but generally include land, facilities, equipment, copyrights and other illiquid investments.
Accounts receivable, bills to customers that have yet to be paid, are considered current assets as long as they can be expected to be paid within a year. If a business has been making sales by offering loose credit terms, a chunk of its accounts receivables might not come due for a longer period of time. It is also possible that some accounts will never be paid in full. This consideration is reflected in an allowance for doubtful accounts, which is subtracted from accounts receivable. If an account is never collected, it is written down as a bad debt expense.
Inventory is included as current assets, but this item should be taken with a grain of salt. Different accounting methods can be used to inflate inventory, and in any case it is not nearly as liquid as other current assets. It may not even be as liquid as accounts receivable, which can be sold to third-party collection agencies in a pinch, albeit at a steep discount. Inventories tie up capital, and if demand shifts unexpectedly—which is more common in some industries than others—inventory can become backlogged. A seemingly healthy current assets balance can obscure a weak inventory turnover ratio and other problems.
Prepaid expenses are considered current assets not because they can be converted into cash, but because they are already taken care of, which frees up cash for other uses. As the year progresses, the value of prepaid expenses as assets decreases; they are amortized to reflect this fact. Prepaid expenses could include payments to insurance companies or contractors.
Components of current assets are used to calculate a number of ratios related to a business' liquidity. The cash ratio is the most conservative: it divides cash and cash equivalents by current liabilities, and measures the ability of a company to pay off all of its short-term liabilities immediately.
The quick ratio or acid-test ratio is slightly less stringent: it adds cash and cash equivalents, marketable securities and accounts receivable, and divides the sum by current
liabilities. This gives a more realistic picture of a company's ability to meet its short-term
obligations, but can be skewed by a backlog of accounts receivable.
The current ratio is the most accommodating: it divides current assets by current liabilities. It should be noted that in addition to accounts receivable, this measure includes inventories, so it probably overstates liquidity in many cases, especially for retailers and other inventory-intensive businesses.
In personal finance, current assets include cash on hand and in the bank, as well as marketable securities that are not tied up in long-term investments. In other words, current assets are anything of value that is highly liquid. Current assets can be used to pay outstanding debts and cover liabilities without having to sell fixed assets. 1
II. What is 'Cash Management'
Cash management is the corporate process of collecting and managing cash, as well as using it for (short-term) investing. It is a key component of ensuring a company's financial stability and solvency. Corporate treasurers or business managers are frequently responsible for overall cash management and the related responsibilities to remain solvent.
a. BREAKING DOWN 'Cash Management'
Successful cash management involves not only avoiding insolvency, but also reducing
the length of account receivables (AR), increasing collection rates, selecting appropriate short-
term investment vehicles, and increasing cash on hand to improve a company's cash position and
profitability.
Successfully managing cash is an essential skill for small business developers, because
they typically have less access to affordable credit and have a significant amount of upfront costs
to manage while waiting for receivables. Wisely managing cash enables a company to meet
unexpected expenses, and to handle regularly occurring events such as payroll distribution. 3
b. Functions of Cash Management
Cash management is the treasury function of a business, responsible for achieving optimal efficiency in two key areas: receivables, which is cash coming in, and payables, which is cash going out.
c. Receivables Management
1 Read more: Current Assets Definition | Investopedia http://www.investopedia.com/terms/c/ currentassets.asp#ixzz4O6QZEmhC <accessed October 22,2016>. 2
Cash Management Definition | Investopedia http://www.investopedia.com/terms/c/cash- management.asp#ixzz4O6WKE24p <accessed October 22, 2016>. 3
Ibid.,
company estimates 5,000 pairs of shoes sales each month. ABC forecasts that 80% of the sales is
going to be collected in the month following the sale and the other 20% collected two months after the sale. The beginning cash balance for July is forecasted to be $20,000, and the cash budget assumes 80% of the June sales is going to be collected in July, which equals $240,000, or $300,000 x 80%. ABC also projects $100,000 in cash inflows from sales made earlier in the year. 8
a. How Production Is Calculated ABC must also calculate the production costs required to produce the shoes and meet customer demand. The company expects 1,000 pairs of shoes to be in beginning inventory, which means that 4,000 pairs must be produced in July. If the production cost is $50 per pair, ABC spends $200,000, or $50 x 4,000, on cost of sales, which is the manufacturing cost. The company also expects to pay $60,000 in costs not directly related to production, such as insurance. 9
b. Factoring in a Cash Roll Forward A cash roll forward computes the cash inflows and outflows for a month and uses the ending balance as the beginning balance for the following month. This process allows the company to forecast cash needs throughout the year and changes to the roll forward adjust the cash balances for all future months. In this example, ABC computes the cash inflows by adding the receivables collected during July to the beginning balance, which is $360,000, or $20, beginning balance + $240,000 + $100,000. ABC then subtracts the cash needed to pay for production and other expenses; that total is $260,000, or $200,000 cost of sales + $60,000. ABC’s July ending cash balance is $100,000, or $360,000 cash inflows less $260,000 cash outflows. 10
IV. Cash Management Techniques
Managing cash flow constitutes two important parts:
- Speedy Cash Collections.
- Slowing Disbursements. 11
A. Speedy Cash Collections
Business concern must concentrate in the field of Speedy Cash Collections from customers.For that, the concern prepares systematic plan and refined techniques. These
8 Ibid.,
9 Ibid., 10
Ibid.,
11 http://budgeting.thenest.com/techniques-cash-management-3955.html <accessed October 22, 2016>.
techniques aim at, the customer who should be encouraged to pay as quickly as possible and the
payment from customer without delay. Speedy Cash Collection business concern applies some of the important techniques as follows:
a. Prompt Payment by Customers
Business concern should encourage the customer to pay promptly with the help of offering discounts, special offer etc. It helps to reduce the delaying payment of customers and the
firm can avoid delays from the customers. The firms may use some of the techniques for prompt payments like billing devices, self-address cover with stamp etc.
b. Early Conversion of Payments into Cash
Business concern should take careful action regarding the quick conversion of the payment into cash. For this purpose, the firms may use some of the techniques like postal float,
processing float, bank float and deposit float. 12
c. Concentration Banking
It is a collection procedure in which payments are made to regionally dispersed collection centers, and deposited in local banks for quick clearing. It is a system of decentralized billing and multiple collection points.
d. Lock Box System
It is a collection procedure in which payers send their payment or checks to a nearby post box that is cleared by the firm’s bank. Several times that the bank deposit the check in the firms account. Under the lock box system, business concerns hire a post office lock box at important collection centers where the customers remit payments. The local banks are authorized to open the box and pick up the remittances received from the customers. As a result, there is some extra savings in mailing time compared to concentration bank. 13
B. Slowing Disbursement
An effective cash management is not only in the part of speedy collection of its cash and receivables but also it should concentrate to slowing their disbursement of cash to the customers
or suppliers. Slowing disbursement of cash is not the meaning of delaying the payment or avoiding the payment. Slowing disbursement of cash is possible with the help of the following methods:
a. Avoiding the early payment of cash
12 Ibid.,
13 Ibid.,
B. What It Means
The cash conversion cycle is a metric used to gauge the effectiveness of a company's management and, consequently, the overall health of that company. The calculation measures how fast a company can convert cash on hand into inventory and accounts payable, through sales and accounts receivable, and then back into cash. By combining these activity ratios, the measurement indicates the efficiency of the management's ability to employ short-term assets and liabilities to generate cash for the company. The CCC entails the liquidity risk associated with growth by measuring the length of time that a firm will be deprived of cash if it increases its investment in resources in an effort to elevate sales. It can be especially useful for investors who wish to draw a comparison between close competitors, as a low CCC signifies a well-managed company, and thus can be used to help evaluate potential investments. The CCC should be combined with other metrics, such as the return on equity and return on assets, as an indicator of management effectiveness and company viability. 17
While the term applies to companies in any industry, the cycle is extremely important for retailers and similar businesses, as their operations consist of buying inventories and selling them to customers. The metric does not apply to companies for which this is not the case, such as those in the software or insurance industries. The measure illustrates how quickly a company can convert its products into cash through sales. The shorter the cycle, the less time capital is tied up in the business process, and thus the better for the company's bottom line. 18
An important distinction is that the cycle applies to firms that buy and sell on account, while cash-only firms only accommodate data from sales operations in the equation, as their disbursed cash is directly measurable as purchase of inventory, and their collected cash is measurable as sale of inventory. This direct ratio does not exist for firms that buy and sell on account. Changes in inventory occasion payables and receivables rather than cash flows, and increases and decreases in cash will discount these accounting vehicles from statements. Therefore, the CCC is calculated according to the cycle of cash through receivables, inventory, payables and, eventually, back to cash. 19
C. Why It Matters
The CCC measurement on its own does not carry much meaning. It should generally be used to track a company over several consecutive time periods and compared to multiple competitors. By tracking the CCC over time, patterns of bettering or worsening value can be more telling than a single period's CCC value taken out of context. Similarly, comparing the CCC from one period to that of a competitor or multiple competitors can elucidate which company is succeeding in–and which is failing at–moving inventory, collecting payments and keeping cash on hand. 17
Ibid.,
18
Ibid.,
19 Ibid.,
Based off of CCC reports, analysis of cash flow statements and liquidity position, companies can adjust their standard of credit purchase payments or cash collections from debtors. A company's investment decisions can directly influence its CCC. In times of cheap credit, cash cycles have been slow to shorten, as it becomes more affordable for companies to borrow money toward their inventory investments. In fact, cheap debt has led large retailers and other similar companies to increase their debt loads by more than 60% since 2007 and, according to the Wall Street Journal, "By taking on more debt, companies can invest in operations, and fund dividends and buybacks, without having to generate cash any faster," leading to stagnant CCCs across the board. 20
One exception to this trend, interestingly, is the cash cycle of online retailers. Frequently, because online retailers can pay their suppliers for goods after they receive payment for those goods from customers, they don't need to hold as much inventory in house. And since they are still able to hold onto that cash for a longer period of time, they often actually wind up with a negative CCC. Amazon.com Inc. (AMZN) is a perfect example of this, wildly outperforming its retail competitors, such as Wal-Mart Stores Inc. (WMT), Target Corp. (TGT) and CostCo Wholesale Corporation (COST), in terms of the length of its cash cycle, if not overall revenue.
According to a Forbes calculation of a period running through 2012, Amazon "manages to hold inventory for 28.9 days plus 10.6 days to collect receivables or 40 days in total but then pays accounts payable in 54 days thus achieving a negative cash conversion cycle for Amazon.com of -14 days. You don’t see this that often but definitely a win for Amazon shareholders. Maybe not for the suppliers waiting for their checks." While online retailers generally have this advantage over their brick-and-mortar counterparts, it is important to note that CCC should not be taken out of context, and should be used in conjunction with other metrics. 21
20
Ibid., 21
Ibid.,
