SMEs Current Assets Control

The asset turnover of a SME is to some extent determined by a company’s products and industry sector. A low asset turnover signifies a capital intensive business, while a high turnover the reverse. Management effectiveness in controlling all types of company’s assets is vital. Control of current assets is especially important. Management needs to make sure that there is sufficient liquidity in the company to turn operating assets into cash. Many SMEs have more than one half of their money invested in current assets. Therefore, the way these assets are managed, can significantly affect the financial position of the SME. 
  
Working capital, cash management, marketable securities, trade receivables and inventory, represent the current assets of an SME.

The management of working capital involves regulating current assets and current liabilities to achieve a proper balance in terms of risk/return. Cash management attempts to accelerate cash inflow to obtain a return while delaying cash payments. Excess cash can be invested in marketable securities. Managing accounts receivable includes deciding the amount and terms of credit to be given to customers. Inventory management involves determining the optimum amount to order each time in order to minimize total inventory costs while avoiding stock-outs (that lead to lost sales).

WORKING CAPITAL MANAGEMENT

Working capital is equal to current assets. Net working capital equals to current assets minus current liabilities.

Characteristics: Net working capital management requires deciding how to finance current assets (through short-term and/or long-term debt or equity). Net working capital increases when current assets are financed through non-current sources. The liquidity of current assets affects the terms and availability of short-term credit.

Risk/return: Holding more current assets than fixed assets means: [1] reduced liquidity risk, [2] greater flexibility (i.e. current assets can be easily modified as sales volumes changes [3] long-term financing carries a higher cost (although it has less liquidity risk than short-term debt).

Financing: Short-term debt gives the SME flexibility to meet seasonal needs within its ability to repay the loan. Long-term debt is used to finance permanent assets. The golden rule is to finance assets with liabilities of similar maturity (hedging approach).

CASH MANAGEMENT

Generally, cash refers to currency and demand deposits. Cash management involves having the optimum amount of cash to on hand at the right time. The company should know how much cash it needs, how much cash it has, where the cash is, what the sources are and how much can be spent.

The cash level is determined by: [1] liquidity position [2] schedule of debt maturity [3] ability to borrow and how much time is required [4] expected cash-flow [5] risk preferences and [6] credit Lines.

(Smaller cash may be maintained when cash receipts and cash payments are highly synchronized and predictable)

Acceleration of cash inflow may be achieved by:
[1] Fast billing and deposit cheques quickly [2] offer discounts for early payment [3] have cash-on-delivery terms [4] avoid tying up cash unnecessarily in other accounts (i.e. advances to employees, etc).

Delay of cash outflow may be effected by
: [1] centralize the payment operation so that debt may be paid at the most profitable time, [2] make partial payments, [3] use payment drafts on which payment is not made on demand [4] do not pay bills before due dates, [5] delay the frequency of payrolls and [6] disburse commissions on sales when the receivables are collected rather than when the sales are made.

(Various cash models may be used to derive the optimal cash position based on rate of return, costs, fluctuations in cash-flow, etc.)

MARKETABLE SECURITIES

Marketable securities are near-cash assets and are classified under current assets since the intent is to hold them for less than one year (for example treasury bills, commercial paper, certificates of deposit, money market funds, etc.)

MANAGEMENT OF ACCOUNTS RECEIVABLE

The management of accounts receivable improves the company’s cash-flow and profitability.

Credit Policy Considerations

[1] If credit terms are tight, the investment in accounts receivable will be smaller and the bad debts will be fewer. On the other hand, sales will be lower (with an adverse impact in profitability).
[2] If credit terms are liberal, there will be more sales (and may be increased profitability), but there will be a larger investment in accounts receivable and of course more bad debts.
[3] Avoid typically high-risk receivables (i.e. customers in a financially troubled industry).
[4] Revise credit terms as the customer’s financial status changes.
[5] Offer more liberal payment terms in slow seasons to support sales.
[6] Ask for collateral (in support questionable accounts).
[7] Average accounts receivable balance should be equal to (DaysOutstantingxAnnualCreditSales)/360.

Billing Considerations

[1] Bill large sales immediately.
[2] Invoice customers for goods when the order is processed instead of when it is shipped.

Collections

[1] Initiate collection efforts when the first signs of a customer’s financial problems are evident.
[2] Age accounts receivable to identify delinquent customers (compare aging to industry norms, competitors, prior years, etc.).
[3] Compare the credit terms to the length of time the receivables are uncollectible.
[4] Use collection agencies.
[5] Have credit insurance to guard against unusual bad-debt losses.

Tip

Offer a discount for early payment by customers when the return on the funds received exceeds the cost of discount.

Considerations in determining to offer credit to higher-than-normal risk customers

[1] Profitability on additional sales generated versus: additional bad debts, higher investigation and collection costs, opportunity cost of tying up funds in receivables, etc.
[2] When there is idle capacity, the additional profit is the incremental contribution margin (sales minus variable cost), because fixed costs are constant. The incremental investment equals: AvgAccsRecevablex(UnitCost/UnitSellingPrice).

INVENTORY MANAGEMENT

High inventory levels result in increased carrying costs but lower the possibility of stock-outs and production slow-downs resulting from inadequate stocking.

[1] Appraise adequacy of raw material levels.
[2] If prices of raw-materials are expected to sharply increase, buy more now.
[3] Discard slow-moving items to reduce carrying costs and improve cash-flow.
[4] Be alert for inventory build-up.
[5] Minimize inventory levels when cash-flow and liquidity problems exist.
[6] Examine the quality of merchandise received.
[7] Monitor back-orders.
[8] Minimize lead time in the acquisition, manufacturing and distribution functions.
[9] Examine the degree of spoilage and obsolescence.
[10] Appraise high inventory risk items (i.e. technological, fashionable, etc.).


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