XI. Management of Marketable Securities, Receivables and Inventory A.

Marketable Securities Management Firms will maintain levels of marketable securities to ensure that they are able to quickly replenish cash balances and to obtain higher returns than is possible by maintaining cash. Firms will hold securities with very little risk for their immediate cash needs. Highly liquid debt instruments such as commercial paper (short-term marketable promissory notes issued by financial institutions and other corporations), bankers' acceptances (drafts issued and accepted by banks often used in international trade) and various government securities such as Treasury Bills and agency notes are frequently maintained in marketable security accounts. Other highly liquid instruments such as money market funds, negotiable certificates of deposit (Jumbo CD's) and repurchase agreements are also maintained as marketable securities. Common stock may not be as appropriate to allow for the firm's immediate cash needs because of its more volatile nature, but some firms have issued money-market preferred stock with floating rate dividend yields. Table 1 outlines features and types of marketable securities. Features of Suitable Marketable Securities: 1. Maturity: usually less than 90 days. This reduces interest rate risk. 2. Default Risk: usually very low 3. High degree of Liquidity a. can be sold quickly b. low cost of transaction c. no price pressure effect when buying and selling 4. Tax considerations a. firms often use municipal bonds, U.S. Government T-bills, etc. b. dividend exclusions for corporations: up to 80% Suitable Marketable Securities 1. US T-bills: mature in 90, 180, 270 or 360 days. Pure discount 90 & 180 days sold by auction every week; others-every month. 2. US T-Bills & notes-longer than 1 year, no state and local taxes, fairly liquid 3. Federal agency securities: e.g., GNMA; not as marketable but low default risk. Higher interest rate than treasury securities. 4. Short-term tax exempts-states, municipalities, local housing agencies and urban renewal agencies. More default risk and less marketable. Federally tax exempt. 5. Commercial paper-short term securities-usually less than 270 day notes issued by finance companies, banks and corporations. Secondary market can be inactive - not always very marketable. However, issuers will often repurchase early. Moody's Inc. and Standard and Poors Inc. publish quality ratings for these securities. 6. Certificates of Deposit (CD's) - issued by commercial banks and Savings and Loan Institutions 7. Repurchase agreements: buy securities from a bond dealer with agreement for dealer to repurchase at higher prices 8. Eurodollar CD's - dollar deposits in foreign banks 9. Banker's acceptances - time drafts or notes issued by firm that is guaranteed payment by a bank. Often used in foreign trade. Table 1: Features and Types of Marketable Securities
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B. Accounts Receivable Management Firms maintain accounts receivables to stimulate sales. Many clients prefer to make purchases on credit. Liberal accounts receivable policy tends to result in increased sales levels. That is, firms may stimulate their sales levels by relaxing their terms of credit. However, maintenance of accounts receivable represents an opportunity cost to the firm in terms of forgone returns on other assets. Furthermore, accounts receivable represent potential bad debt losses to the firm. The firm must find the appropriate balance of these costs relative to the benefits associated with accounts receivable. This appropriate or optimal balance occurs when the marginal costs of credit policy exactly offset its marginal benefits. In the majority of cases, the credit instrument evidencing the sale will simply be an invoice, usually indicating that the goods have been shipped and signed indicating that they have been received. The invoice will usually specify the terms of payment. For certain larger sales or when collections may be problematic, the credit instrument may be evidenced by a promissory note, a more formal IOU. Terms of payment for goods received or to be received can be specified in a commercial draft. A sight draft calls for immediate payment while a time draft permits payment at a specified later date. When the buyer accepts the time draft, it is called a trade acceptance and may either be maintained by the seller or sold, usually to a bank. Banks frequently purchase trade acceptances and re-sell them with payment guarantees. When banks guarantee and market trade acceptances, they are known as bankers acceptances and are frequently used by firms in marketable securities accounts. Many firms will establish a credit period for their customers but will offer discounts to encourage them to pay early. For example, the terms "2/15, net 45" state that the bill is due in full within forty five days but the customer is offered a two percent discount if it pays within fifteen days. Longer credit periods or more liberal credit terms are likely to stimulate sales, but at the same time, the firm forgoes the use of its money for a greater length of time and increases the potential for bad debt losses. Increasing the percentage discount will help speed the collection process, but at the expense of total cash flows from sales. Many firms will ease credit terms for products that take longer to sell. Such low turnover goods are more likely to be tied up longer as inventory; using liberal credit terms to defer cash receipts from their sale is less costly if the alternative is higher inventory levels. Similarly, more competitive markets for the firms products may also encourage more liberal credit terms since such terms may enhance the firms ability to compete. Before extending credit, the firm will probably wish to investigate the credit-worthiness of the customer. This investigation may simply focus on the firms customers credit history with the firm or may include contacting various credit reporting agencies (such as Dun and Bradstreet), checking with the customer's bank and other suppliers of credit and examining the customers financial statements and operations. The financial statement analysis will probably require the use of financial ratios (discussed in the following chapter), particularly those reflecting the firm's liquidity position. C. Inventory Management Firms generally must maintain inventories of saleable merchandise to ensure that they are able to meet customers' needs for their products. Most firms must also maintain inventories of raw materials and other supplies to ensure an efficient and continuous production process. While management of inventory generally falls into the domain of functional areas other than finance (such as production or purchasing), it is useful for the financial managers to be knowledgeable
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about inventory management to better perform their other managerial functions. Associated with inventories are various costs, including those resulting from ordering inventories and those associated with carrying inventory. Order costs will include all expenses resulting from obtaining inventory such as administrative ordering costs incurred by the firm, fees to agents, and in some cases, shipping costs. Inventory carry costs will include storage expenses such as warehouse heating and lighting costs. Higher inventory levels imply higher carry costs; lower inventory levels imply higher order costs (the firm must obtain inventory more frequently). The firm's objective will be to establish inventory order quantities to balance carry and order costs such that the total costs associated with obtaining and maintaining inventories are minimized. One means of ensuring this minimization is through the use of the Economic Order Quantity (E.O.Q.) model. The E.O.Q. model is simply a generalized version of the Baumol Cash Management Model, and is appropriate for most types of inventory. Order costs in the E.O.Q. model are analogous to transactions costs in the Baumol model; carry costs in the E.O.Q. model are analogous to foregone interest costs in the Baumol model. The E.O.Q. model assumes that inventory demand is known with certainty and that this demand is constant. Firms incur order costs when they acquire additional inventory and incur carry costs for holding inventory. The derivation of the E.O.Q. model is identical to that of the Baumol model (excepting minor changes in input definitions and notation); thus, the optimum inventory quantity (or economic order quantity) for the firm is: (1) EOQ =
2 Or D CC

where (D) is the annual inventory demand, (Or) is the cost of each inventory order and (CC) is the inventory carry cost, measured as a percentage of the dollar value of the inventory carried. For example, if the Fillmore Company incurred a fifty dollar order cost each time it ordered merchandise, its annual carry cost were equal to ten percent of the value of the inventory maintained, and annual demand for its product were $100,000, its economic order quantity for merchandise would be $10,000:
2 50 $100,000 = 100,000,000 = 10,000 .1 The total annual costs ($$$) associated with obtaining and maintaining inventory would be $1000:

EOQ =

$$$* =

EOQ D * $50 + .1 = $500 + $500 = $1,000. EOQ 2

The firm's average inventory level will simply be $5000. Determining a minimum acceptable inventory level would require the same process as determining the minimum acceptable cash balance in the Baumol Model. Order quantities would not be affected by non-zero minimum inventory levels, though the minimum inventory levels would increase average inventory levels.

QUESTIONS AND PROBLEMS

1. The Dillinger Company uses the E.O.Q. model to manage its inventory. The company maintains a minimum inventory level of $5,000 and incurs ordering costs of $50 each time it replenishes its inventory. Its warehouse expenses represent its total inventory carry costs and are approximately ten percent of average inventory levels. Its inventory demand is quite steady at $100,000 per year. Determine the following for the Dillinger Company: a. its economic order quantity b. its optimum average inventory level c. the optimum number of times per year for Dillinger to order new inventory d. its total costs associated with inventory e. the optimum number of days between orders for new inventory
SOLUTIONS

1.

a. E.O.Q. =

2 Or D = cc

2 50 100,000 = 10,000 .1

b. EOQ* + 2min = 10,000 2 c. D = 10 EOQ d. 50 x 10 + .1 x [(10,000/2)+5000] = 1500 e. 365 = 36.5 10