Introduction To Working Capital Management

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Introduction To Working Capital Management

  1. 1. INTRODUCTION TO WORKING CAPITAL MANAGEMENT
  2. 2. Outline <ul><li>Working Capital Defined </li></ul><ul><li>Goals of working capital management </li></ul><ul><li>Cash Conversion Cycle </li></ul><ul><li>Working capital policies </li></ul>
  3. 3. WORKING CAPITAL MANAGEMENT <ul><li>Net Working Capital = Current Assets - Current Liabilities </li></ul>
  4. 4. WORKING CAPITAL MANAGEMENT <ul><li>Goals of Working Capital Management: </li></ul><ul><li>Stimulate sales by offering customers credit (accounts receivable) and ready goods for sale (inventory)  Increase Profits </li></ul><ul><li>Minimize costs by balancing production and sales levels through inventory  Increase Profits </li></ul><ul><li>Secure low cost financing  Increase Profits </li></ul><ul><li>Reach above 3 goals but never run out of cash by having enough cash and marketable securities on hand and/or by limiting use of short-term debt </li></ul>
  5. 5. WORKING CAPITAL MANAGEMENT <ul><li>Issues to Study: </li></ul><ul><li>What types and amounts of current assets should a firm hold? </li></ul><ul><li>What types and amounts of short-term financing should a firm employ? </li></ul><ul><li>How do firms ensure they have enough cash to meet on-going obligations? </li></ul><ul><li>How do firms forecast their cash needs? </li></ul>
  6. 6. Cash Conversion Cycle for a Manufacturing Firm Purchase of Raw Materials Sale on Credit Cash Received From Credit Sale Inventory Conversion Period Average Collection Period Operating Cycle Cash Conversion Cycle Payable Deferral Period Cash Outlay
  7. 7. MANAGEMENT OF CASH CONVERSION CYCLE <ul><li>Cash Conversion Cycle = (Operating Cycle) - (Accounts Payable Deferral Period) </li></ul><ul><li>1. Operating Cycle = The time between ordering or raw materials and receiving cash from credit sales </li></ul><ul><li>2. Inventory conversion period = time required to order, produce and sell final products on credit </li></ul><ul><li>3. Average collection period = time required to collect cash from credit sales </li></ul><ul><li>4. Accounts payable deferral period = time firm is able to delay payment for raw materials, wages and other accounts </li></ul><ul><li>5. Cash conversion cycle = time between payments for raw materials and and labour (resources) and cash collection from sales </li></ul>
  8. 8. OPERATING AND CASH CYCLES FOR DOUG’S DISTRIBUTORS INC. (In this example, we use average balance but could also use year-end figures for inventory, accounts receivable and accounts payable) <ul><li>Inventory Conversion Period </li></ul><ul><li>- Assume that beginning of year inventory balance was $30 and cost of goods sold was $350 </li></ul>
  9. 9. OPERATING AND CASH CYCLES FOR DOUG’S DISTRIBUTORS INC. <ul><li>Receivables Conversion Period or Average Collection Period </li></ul><ul><li>- Assume 100% of sales are on credit </li></ul><ul><li>- Assume that beginning of year accounts receivable was $20 and sales was $500 </li></ul>
  10. 10. OPERATING AND CASH CYCLES FOR DOUG’S DISTRIBUTORS INC. <ul><li>3. Payables Deferral Period </li></ul><ul><li>assume beginning of </li></ul><ul><li>Year accounts payable was </li></ul><ul><li>$20 </li></ul><ul><li>4. Operating Cycle </li></ul><ul><li>= Inventory Conversion Period + Receivables Conversion Period </li></ul><ul><li>= 36.50 days + 18.25 days </li></ul><ul><li>= 54.25 days </li></ul><ul><li>5. Cash Cycle = Operating Cycle - Accounts </li></ul><ul><li> Payable Deferral Period </li></ul><ul><li> = 54.25 days – 26.07 days </li></ul><ul><li> = 28.18 days </li></ul>
  11. 11. Working Capital Policies and the Current Ratio <ul><li>Current Ratio is a measure of the extent to which current Assets are financed by current liabilities </li></ul><ul><li>Current Ratio = Current Assets / Current Liabilities </li></ul><ul><li>Doug’s Distributors has a current ratio of 70/50 or 1.4 </li></ul><ul><li>A current ratio of 1.40 means that for every $1.40 of current assets there is one dollar of current liabilities </li></ul>
  12. 12. Working Capital Policies (Relative to Industry) Higher Profits / Higher Risk Lower Profits / Lower Risk Trade-off Between Profitability and Risk Shorter than Industry Average Longer than Industry Average Operating and Cash Cycles With Short-term Debt With Long-term Debt and Equity How Current Assets are Financed Lower than Industry Average Higher than Industry Average Current Ratio Low High Levels of Current Assets Aggressive Conservative Working Capital Policy
  13. 13. How a Conservative Working Capital Policy Lowers Profitability and Risk (Vice-versa for Aggressive Policy) Less short-term debt payments to meet. With upward-sloping yield curve, interest costs are higher. Equity costs are normally higher Less Short-term Debt /Greater Long-term Liabilities and Equities Won’t miss a potentially profitable sale. Greater cost of financing and possibly more write-offs. Higher Level of Accounts Receivable Fewer Stock-outs Higher carrying costs and higher obsolescence Higher Level of Inventory Less Risk Because Cash is Readily Available Liquid assets earn lower returns than less liquid assets Higher Level of Cash and Marketable Securities Less Risk Lower Return Impact
  14. 14. Working Capital Policies Understanding Liquidity <ul><li>To understand how well a company can meet its ongoing cash obligations (its liquidity), you need to understand whether the firm is using or generating cash flow </li></ul><ul><li>To help you understand the nature of cash flows, you need to know how to develop and interpret a statement of cash flows </li></ul><ul><li>Before developing a statement of cash flows, let us review how the balance sheet and income statements are created </li></ul>
  15. 15. Summary <ul><li>Working Capital = Short-term Assets – Short-term liabilities </li></ul><ul><li>Cash Conversion Cycle </li></ul><ul><ul><li>Operating cycle </li></ul></ul><ul><ul><li>Cash cycle </li></ul></ul><ul><li>Policies </li></ul><ul><ul><li>Aggressive </li></ul></ul><ul><ul><li>Conservative </li></ul></ul>
  16. 16. Statement of Cash Flows Understanding Cash Flows
  17. 17. Outline <ul><li>Preparation of balance sheet and income statement from transactions </li></ul><ul><li>Statement of Cash Flows </li></ul>
  18. 18. Preparing Pro Forma: Supplementary Review of Financial Statement Preparation <ul><li>A balance sheet is a “snap shot” of a company’s affairs; it shows what the company owns (its assets), what it owes (its liabilities) and how much shareholders have invested in the firm (equity) </li></ul><ul><li>Assets = Liabilities + Equity </li></ul><ul><li>An income statement shows how much the company sells (its revenue), what it costs to operate the business (its expenses) and how much is left over for shareholders (profit) </li></ul>
  19. 19. Preparation of the Balance Sheet and Income Statement: A step-by-step example
  20. 20. Preparation of the Balance Sheet and Income Statement: A step-by-step example
  21. 21. Preparation of the Balance Sheet and Income Statement: A step-by-step example
  22. 22. Preparation of the Balance Sheet and Income Statement: A step-by-step example
  23. 23. Preparation of the Balance Sheet and Income Statement: A step-by-step example
  24. 24. Preparation of the Balance Sheet and Income Statement: A step-by-step example
  25. 25. Preparation of the Balance Sheet and Income Statement: A step-by-step example
  26. 26. Preparation of the Balance Sheet and Income Statement: A step-by-step example
  27. 27. Preparation of the Balance Sheet and Income Statement: A step-by-step example
  28. 28. Preparation of the Balance Sheet and Income Statement: A step-by-step example
  29. 29. Preparation of the Balance Sheet and Income Statement: A step-by-step example
  30. 30. Importance of Cash Flows: Liquidity <ul><li>Although Sylvia’s firm is profitable, it is important to understand how it was able to generate enough cash to meet its obligations. In other words, how liquid is Sylvia’s Satins? </li></ul><ul><li>Liquidity is a critical aspect of a company’s financial performance. The payroll must be met. Before a firm can get a loan from a bank or credit from a supplier, it must show itself to be liquid. </li></ul><ul><li>To assess liquidity, we need to understand the factors affecting firm’s on-going ability to generate cash. </li></ul>
  31. 31. Statement of Cash Flows <ul><li>Sales </li></ul><ul><li>- Cost of Goods Sold </li></ul><ul><li>- Selling, General and Administration Expenses Net Income </li></ul><ul><li>- Interest </li></ul><ul><li>- Income Taxes </li></ul><ul><li>+Non-cash expenses e.g.depreciation </li></ul><ul><li>= Cash Flows From Operating Activities </li></ul><ul><li>- Increase in Accounts Receivable </li></ul><ul><li>- Increase in Inventory Change in Net Working Capital </li></ul><ul><li>+ Increase in Accounts Payable </li></ul><ul><li>- Purchases of Fixed Assets Net Capital Expenditures </li></ul><ul><li>+ Sales of Fixed Assets </li></ul><ul><li>- Payments to Owners of Business </li></ul><ul><li>= Cash Generated (Used) By Business Available for Repayment of Debts </li></ul>
  32. 32. Statement of Cash Flows for Sylvia’s Satins
  33. 33. Financing Cash Flow Deficiencies <ul><li>If Sylvia’s Satins used up $31,000 cash in its on-going operations, how was this financed? </li></ul><ul><li>Opening Cash Balance $20,000 </li></ul><ul><li>Less: Cash Used $31,000 </li></ul><ul><li>Cash Surplus (Deficiency) - $11,000 </li></ul><ul><li>Deficiency was financed by bank overdraft </li></ul>
  34. 34. Cash Flow Drivers
  35. 35. Eleven Key Cash Flow Drivers <ul><ul><ul><li> Relationship with Cash Flow </li></ul></ul></ul><ul><li>Sales Growth Usually negative </li></ul><ul><li>Gross Margin % (Gross Profit/Sales) positive </li></ul><ul><li>Selling, General and Administration </li></ul><ul><li>(SGA) as % of Sales negative </li></ul><ul><li>Interest Expense negative </li></ul><ul><li>Non-cash Expenses positive </li></ul><ul><li>6. Income Tax Rate negative </li></ul><ul><li>7. Average Collection Period (ACP) negative </li></ul><ul><li>8. Inventory Conversion Period negative </li></ul><ul><li>9. Accounts Payable Period positive </li></ul><ul><li>10. Net Capital Expenditures negative </li></ul><ul><li>11. Owner’s Withdrawals from Firm negative </li></ul>
  36. 36. Relationship of Expenses to Cash Flow <ul><li>Companies with higher profit margins (firms with low cost of goods sold and low SGA as % of sales) generate more cash </li></ul><ul><li>Conversely, firms that incur losses generally use up cash and will encounter problems repaying loans if losses are not stemmed. LOANS SHOULD NOT BE GRANTED TO FUND SUSTAINED LOSSES OF BORROWERS. </li></ul><ul><li>Significant non-cash expenses provide some relief but only where regular capital expenditures are not required </li></ul>
  37. 37. Relationship of Average Collection Period to Cash Flow <ul><li>Average Collection Period (ACP) is calculated as: </li></ul><ul><li> Accounts Receivable </li></ul><ul><li> Sales/365 </li></ul><ul><li>In case of Sylvia’s Satins, ACP is $30/($40/365) or 274 days </li></ul><ul><li>One can estimate Accounts Receivable as: </li></ul><ul><li>Sales * ACP </li></ul><ul><li> 365 </li></ul><ul><li>If sales double to $80 and ACP remains unchanged, then Accounts Receivable would also double i.e. ($80*274)/365 = $60 </li></ul><ul><li>If ACP decreases in half to 137 days, ending Accounts Receivable would equal ($40*137)/365 = $15 and firm would generate $15 more cash in the year </li></ul>
  38. 38. Relationship of Inventory Conversion Period to Cash Flow <ul><li>Inventory Conversion Period is calculated as: </li></ul><ul><li> Inventory </li></ul><ul><li> Cost of Goods Sold/365 </li></ul><ul><li>In case of Sylvia’s Satins, Inventory Conversion Period is $30/($30/365) or 365 days </li></ul><ul><li>One can estimate Inventory as: </li></ul><ul><li>Cost of Goods Sold * Inventory Conversion Period </li></ul><ul><li> 365 </li></ul><ul><li>If cost of goods sold doubles to $60 and Inventory Conversion Period remains unchanged, then Inventory would also double i.e. ($60*365)/365 = $60 </li></ul><ul><li>If Inventory Conversion Period decreases in half to 183 days, ending inventory would equal ($30*183)/365 = $15 and firm would generate $15 more cash in the year </li></ul>
  39. 39. Relationship of Accounts Payable Period to Cash Flow <ul><li>Payables Deferral Period </li></ul><ul><li>= (Payables)/(Cost of Goods Sold + Other Operating Expenses) X 365 </li></ul><ul><li>In case of Sylvia’s Satins, Payables Deferral Period is ($40)/($30/365) or 487 days </li></ul><ul><li>One can estimate Accounts Payable as: </li></ul><ul><li>Cost of Goods Sold * Accounts Payable Period </li></ul><ul><li> 365 </li></ul><ul><li>If cost of goods doubles and Payables Deferral Period remains unchanged, then Accounts Payable would also double i.e. ($60*487)/365 = $80 </li></ul><ul><li>If company pays its suppliers in half the time, ending accounts payable would equal ($30*243)/365 = $20 and firm would use up $20 more cash in the year </li></ul>
  40. 40. Relationship of Sales Growth to Cash Flow <ul><li>If a company is selling on credit, an increase in sales usually uses up cash as the firm buys/builds more inventory, sells it and then has to wait to get paid by its customers i.e. there is an increase in both inventory and accounts receivable. </li></ul><ul><li>Even for firms that strictly sell on a cash basis, an increase in sales still means that it needs to increase its inventory. </li></ul><ul><li>In most cases, the cash required to build-up inventory and receivables more than offsets payables increase as well as the increased cash flow from operations </li></ul>
  41. 41. Impact of Doubling of Sales of Sylvia’s Satins on Cash Flow of Firm Sales, gross profit, A/R, inventory, payables all double / SGA and non-cash expenses don’t increase with sales / interest increases to $3 with more borrowing / income taxes equal 40% of ($20-2.5-3.0) or $5.8
  42. 42. Relationship of Sales Growth to Cash Flow <ul><li>With increased sales, Sylvia’s Satins would increase its profit from $3,900 to $8,700 but experience an increase in cash outflow from -$31,000 to -$43,000 and therefore end the year with a higher bank overdraft </li></ul><ul><li>Situation would be worse where firm experiences substantial growth and is capital intensive i.e. it needs more capital expenditures to facilitate expansion </li></ul><ul><li>These expenditures place greater pressure on the cash flow of the firm </li></ul>
  43. 43. Relationship of Profitability and Liquidity <ul><li>Most often, clients who strive to be more profitable usually improve their liquidity as higher profit margins and better cost controls enhance cash flows </li></ul><ul><li>Furthermore, a more profitable business makes it easier for the firm to attract other sources of credit as well as outside equity </li></ul><ul><li>However, as shown in the last example, sometimes firms seek to expand their businesses to increase or at least preserve profitability. This puts the client’s desire for profitability at odds with the need to maintain liquidity </li></ul>
  44. 44. Relationship of Capital Expenditures and Liquidity <ul><li>Most firms periodically need to make substantial capital expenditures, at the very least to maintain their operations or to keep up with the competition </li></ul><ul><ul><li>Grocery stores need to replace freezers </li></ul></ul><ul><ul><li>Fashion retailers need new fixtures </li></ul></ul><ul><ul><li>Delivery firms need to replace vans </li></ul></ul><ul><li>These expenditures place a heavy drain on cash flow and consequently: </li></ul><ul><ul><li>Clients should extend life of their fixed assets through preventative maintenance </li></ul></ul><ul><ul><li>Clients should acquire assets with strong warranties and insurance protection </li></ul></ul>
  45. 45. Relationship of Capital Expenditures and Liquidity <ul><li>Financing of Capital Expenditures should be structured so that the period of the repayment of principal matches the life of the asset </li></ul><ul><ul><li>Term financing or lease arrangement for equipment </li></ul></ul><ul><ul><li>Long-term mortgage for real estate </li></ul></ul><ul><li>Excessive use of short-term debt creates too much demand on cash flows in the period when the asset is first acquired </li></ul>
  46. 46. Identifying Trends in Cash Flow Drivers: Case of a company losing to competition Possible Steps to Improve Cash Flows: Limit owner’s withdrawals from firm Review profitability of product mix Review possible cost-cutting measures More Closely Monitor A/R, Inventory and Payables Levels
  47. 47. Identifying Trends in Cash Flow Drivers: Case of a company expanding sales at expense of lower gross profit margins Possible Steps to Improve Cash Flows: Limit owner’s withdrawals from firm Review profitability of expansion plans More Closely Monitor A/R and Payables Levels Increase use of term debt or other long-term financing e.g. equity
  48. 48. Signs of Liquidity Problems <ul><li>Decline in daily or weekly cash inflows </li></ul><ul><li>Profitability and Operating Cash Flow Squeeze -- Increased costs that the firm is unable to pass on to customers </li></ul><ul><li>Unexpected build-up of Accounts Receivable </li></ul><ul><li>Unexpected build-up of Inventory </li></ul><ul><li>Decline in firm’s net working capital, current ratio or an increase in its short-term and total debt ratios (Short-term Debt/ Total Assets and Total Debt/ Total Assets) </li></ul>
  49. 49. Cash Budgets & Pro Forma Statements Forecasting Cash Flows
  50. 50. Outline <ul><li>Why forecast cash flows? </li></ul><ul><li>Cash budget </li></ul><ul><li>Pro Forma </li></ul><ul><ul><li>Income Statement </li></ul></ul><ul><ul><li>Balance Sheet </li></ul></ul><ul><li>Percent of sales method </li></ul>
  51. 51. Managing Liquidity and the Need to Forecast Cash Flows <ul><li>Companies need to plan for their cash needs to ensure they have sufficient cash to: </li></ul><ul><ul><li>Meet on-going obligations such as the payroll </li></ul></ul><ul><ul><li>Meet contingencies such as an increased need for working capital (sensitivity analysis is especially important) </li></ul></ul><ul><ul><li>Be able to invest when attractive opportunities arise </li></ul></ul><ul><li>They need to project a cash budget that forecasts cash inflows and outflows on a monthly basis. </li></ul><ul><li>Cash budgeting is especially important in seasonal and growing businesses. </li></ul><ul><li>Cash budgets should tie in with pro forma income statements and balance sheets. </li></ul>
  52. 52. Preparing Comprehensive Pro Forma Financial Statements Sales Forecast Production Forecast Cash Flow Forecast Pro Forma Income Statement Pro Forma Balance Sheet Sales, production and cash flow forecasts are usually done on a monthly basis whereas pro forma income and balance sheets are done an annual basis
  53. 53. EXAMPLE OF CASH BUDGET AND PRO FORMA FINANCIAL STATEMENTS <ul><li>Key Assumptions for Gadget Company </li></ul><ul><li>(Startup Business) </li></ul><ul><li>Sales </li></ul><ul><li>Monthly sales of 10,000 units </li></ul><ul><li>First month of sales is February 2003 </li></ul><ul><li>Based on contract with distributor </li></ul><ul><li>Cash Budget </li></ul><ul><li>A/R - ½ sales collected within one-month following sale and the other ½ collected two months following sale </li></ul>
  54. 54. Cash Collections from Sales Key Assumptions: Company will sell 10,000 units a month @$1.58 each. Half of accounts receivable will be collected one month after sale. Half of accounts receivable will be collected two months after sale. $7,900 $ 7900 $15,800 March $15,800 $ 7900 $ 7900 $15,800 April 0 0 Total Collections During 2nd Month After Sale During Month After Sale Cash Inflows from AR Collection : $15,800 $0 Sales of Gadget Company February January Month
  55. 55. Cash Collections and Accounts Receivable Key Assumptions: Company sold $173,800 of goods but received only $150,100. The difference of $23,700 represents the increase in accounts receivable during year. Of the $23,700 in accounts receivable at year end, December sales represent $15,800 and half of November sales represent $7,900. $15,800 $7900 $ 7900 $15,800 December $150,100 $ 7 1,1 00 $ 79 ,0 00 $1 73 ,800 Total for Year $15,800 $15,800 Total Collections $ 7900 $ 7900 During 2nd Month After Sale $ 7900 $ 7900 During Month After Sale Cash Inflows from AR Collection : $15,800 $15,800 Sales of Gadget Company November October Month
  56. 56. Cash Payments to Suppliers <ul><li>Key Assumptions: Company will purchase one month in advance of sales. </li></ul><ul><ul><li>- Month-end inventory will equal the current month’s purchases. </li></ul></ul><ul><li>Each unit costs $1.00 to purchase. </li></ul><ul><li>Supplier will be paid one month after purchase. </li></ul>$10,000 $10,000 March $10,000 $10,000 April $10,000 Cash Payment to Suppliers $10,000 $10,000 Purchases of Gadget Company February January Month
  57. 57. Cash Payments and Accounts Payments Key Assumptions: Company purchased $120,000 of goods but paid for only $110,000 by year end. The difference of $10,000 represents the increase in accounts payable during year. The $10,000 accounts payable at year end is for December purchases. $10,000 $ 10,000 December $110,000 $ 120,000 Total for Year $10,000 $10,000 Cash Payments to Suppliers $ 10,000 $ 10,000 Purchases of Gadget Company November October Month
  58. 58. Key Assumptions for Gadget Company <ul><li>Cash Budget </li></ul><ul><li>General and administration costs = $3,750 per month </li></ul><ul><li>Interest is charged on previous month’s loan balance at an annual rate of 12%. The monthly rate is 12%/12 or 1%. </li></ul><ul><li>$10,000 opening cash balance </li></ul><ul><li>Pro Forma Income Statement </li></ul><ul><li>Depreciation = $250 per month </li></ul><ul><li>no accrual is made for interest expense at year end </li></ul>
  59. 59. Cash Budget $1,916 ($5,925) ($13,750) ($3,750) Net Operating Cash Flow ($13,425) ($7,500) $6,250 $10,000 Beginning Cash Balance (Borrowing) $10,000 $10,000 $10,000 Cash Payment to Suppliers $15,800 $7,900 0 0 Total Collections Cash Outflows: April March February January Month ($13,425) $13,825 75 $ 3,750 ($11,509) $13,884 134 $ 3,750 ($7,500) $6,250 Ending Cash Balance (Borrowing) $13,750 $3,750 Total Cash Outflows 0 0 Interest Expense $ 3,750 $ 3,750 General Expenses
  60. 60. Cash Budget (5,506) 2,050 2,050 2,034 Net Operating Cash Flow $10,000 $2,444 $394 (1,639) Beginning Cash Balance (Borrowing) $110,000 $10,000 $10,000 $10,000 Cash Payment to Suppliers $150,100 $15,800 $15,800 $15,800 Total Collections Cash Outflows: Total for Year December November October Month $4,494 $13,750 0 $ 3,750 $4,494 $155,606 606 $ 45,000 $2,444 $394 Ending Cash Balance (Borrowing) $13,750 $13,766 Total Cash Outflows 0 16 Interest Expense $ 3,750 $ 3,750 General Expenses
  61. 63. Gadget Company: Projected Income Statement for Year Ended December 31, 2003 <ul><li>Sales $ 173,800 </li></ul><ul><li>Cost of Goods Sold: </li></ul><ul><li>Purchases 120,000 </li></ul><ul><li>Less: Ending Inventory 10,000 </li></ul><ul><li>110,000 </li></ul><ul><li>Gross Profit 63,800 </li></ul><ul><li>General Expenses 45,000 </li></ul><ul><li>Depreciation 3,000 </li></ul><ul><li>Interest 606 48,606 </li></ul><ul><li>Net Profit $15,194 </li></ul>
  62. 64. Gadget Company: Pro Forma Balance Sheet December 31, 2003
  63. 65. % of Sales Method: Pro Forma Model Ingredients <ul><li>Sales Forecast </li></ul><ul><ul><li>Drives the model </li></ul></ul><ul><li>Pro Forma Statements </li></ul><ul><ul><li>The output summarizing different projections </li></ul></ul><ul><li>Asset Requirements </li></ul><ul><ul><li>Investment needed to support sales growth </li></ul></ul><ul><li>Financial Requirements </li></ul><ul><ul><li>Debt and dividend policies </li></ul></ul><ul><li>The “Plug” ” </li></ul><ul><ul><li>Designated source(s) of external financing </li></ul></ul><ul><li>Economic Assumptions </li></ul><ul><ul><li>State of the economy, interest rates, inflation </li></ul></ul>
  64. 66. Historical Financial Statements for St. Dilbert Pharmaceuticals <ul><li>Total Assets are 200% of sales. ($2 of assets for every $1 of sales.) </li></ul><ul><li>Fixed assets are 60% of total assets, or 120% of sales. </li></ul>$1,000 550 $450 67% 34% 10% 20% 47% $69 Net Income $23 Retained Owner’s Equity 600 Net fixed assets Total Debt $400 Current assets 105 Taxable Income of Net Fixed Assets 120 Depreciation of Sales 235 Costs $500 Sales Total Liabilities $1,000 Total Assets Balance Sheet of Net Income $46 Dividends of Taxable Income 36 Taxes of last period’s Debt 40 Interest Income Statement
  65. 67. Pro Forma Financial Statements Using % of Sales Method <ul><li>Assume that sales grow by 20% to $600 </li></ul><ul><li>Firms needs $2 of assets for every $1 of sales. </li></ul><ul><li>Fixed assets are 60% of total assets. </li></ul>$1,200 n.a. n.a. 67% 34% 10% 20% 47% n.a. Net Income n.a. Retained Owner’s Equity 720 Net fixed asset Total Debt $480 Current assets n.a. Taxable Income of Net Fixed Assets n.a. Depreciation of Sales 282 Costs $600 Sales Total Liabilities $1,200 Total Assets Balance Sheet of Net Income n.a. Dividends of Taxable Income n.a. Taxes of last period’s Debt n.a. Interest Income Statement
  66. 68. Filling in the Blanks <ul><li>Depreciation </li></ul><ul><ul><li>Firm needs $2 of assets for every $1 of sales (total asset turnover is 0.5 or total assets are 200% of sales) </li></ul></ul><ul><ul><ul><li>Total Assets must rise to $1,200 to support $600 of sales </li></ul></ul></ul><ul><ul><ul><li>Fixed Assets are 60% of Total Assets </li></ul></ul></ul><ul><ul><ul><li>Current Assets are 40% of Total Assets </li></ul></ul></ul><ul><ul><ul><li>Depreciation is 20% of Fixed Assets </li></ul></ul></ul><ul><ul><ul><ul><li>Depreciation = 0.2 * (0.6 * $1,200) = $144 </li></ul></ul></ul></ul><ul><ul><ul><li>This depreciation calculation wrong, but close and simple! </li></ul></ul></ul><ul><ul><ul><ul><li>Should calculate depreciation as % of additions to gross fixed assets plus % of last year’s net. </li></ul></ul></ul></ul><ul><li>Interest </li></ul><ul><ul><li>Based on the last end-of-period Debt level (short and long-term). </li></ul></ul><ul><ul><li>Interest = 0.1 * $450 = 45 </li></ul></ul>
  67. 69. Pro Forma Financial Statements Using % of Sales Method Equity is the plug variable $1,200 750 $450 67% 34% 10% 20% 47% 85 Net Income $28 Retained Owner’s Equity 720 Net fixed assets Total Debt $480 Current assets 129 Taxable Income of Net Fixed Assets 144 Depreciation of Sales 282 Costs $600 Sales Total Liabilities $1,200 Total Assets Balance Sheet of Net Income $57 Dividends of Taxable Income 44 Taxes of last period’s Debt 45 Interest Income Statement
  68. 70. Financial Planning <ul><li>Equity is the plug variable. </li></ul><ul><li>Equity rises from $550 to $750, but $28 of this is from retained earnings. </li></ul><ul><li>The difference, $172, is additional equity income necessary to support the increase in sales. </li></ul><ul><li>Debt could also be the plug. Firm could borrow $172 and Debt could rise to $622. </li></ul><ul><li>If new capital not available, then can’t finance sales increase. </li></ul>$1,200 578 $622 Owner’s Equity 720 Net fixed assets Total Debt $480 Current assets Total Liabilities $1,200 Total Assets Balance Sheet with Debt as PLUG
  69. 71. Cash & Marketable Securities
  70. 72. Overview of How Companies Maintain Liquidity <ul><li>By holding cash and marketable securities </li></ul><ul><li>By having ready access to sources of financing </li></ul><ul><ul><li>Access to equity (not always possible or attractive) </li></ul></ul><ul><ul><li>Access to debt through prior commitments from lender e.g. line of credit </li></ul></ul>
  71. 73. Criteria in Selection of Marketable Securities <ul><li>Liquidity – the security should be easy to sell before maturity and the costs involved in selling (transaction costs) should be minimal </li></ul><ul><li>Default Risk – when investing in bonds, there should be little chance the borrower will not repay principal and interest (usually stick with high-grade borrowers) </li></ul><ul><li>Market Risk – there should be little risk that the security’s price will decrease before maturity because of changes in overall market conditions (levels of interest rates and stock market indices); this means that securities are usually short-term, fixed income securities (not long-term bonds and not equities) </li></ul><ul><li>Attractive Return – firms will accept more of the above three risks in order to higher return </li></ul><ul><li>Tax Implications – return is considered on after-tax basis </li></ul>
  72. 74. Criteria in Selection of Marketable Securities 2.87% (highest rated) Low Low / guaranteed by a bank High Banker’s Acceptance 2.87% (highest rated) Yield is higher on lower rated paper Low to Medium / corporate borrower may be affected by stock market conditions Low to Medium / depends on risk of corporate borrower High to Medium Commercial Paper 2.82% (3-month t-bill) Lowest Lowest /obligation of Federal Government Highest T-bills Yield (Feb. 14, 2003) Market Risk Default Risk Liquidity
  73. 75. Other Short-term Investments Used for Liquidity Purposes <ul><li>Overnight loans (large firms lend money on an overnight basis) </li></ul><ul><li>Certificates of Deposits (interest-bearing rather than discount instruments issued by banks and trust companies) </li></ul><ul><li>Negotiable Certificates of Deposit (can be sold before maturity in market) </li></ul><ul><li>Money Market Mutual Fund (pool of short-term money market instruments) </li></ul>
  74. 76. Effective Interest Rate on a Short-term Discount Instrument <ul><li>Effective rate over life of instrument </li></ul><ul><li>Effective annual interest rate </li></ul>
  75. 77. Effective Interest Rate on a Short-term Discount Instrument <ul><li>Example of effective annual interest rate calculation </li></ul><ul><li>T-bill has 90 days to maturity; maturity price is $1,000 but it currently sells for $990 </li></ul>
  76. 78. Approximate Annual Yield Short-term Discount Instrument In the case of t-bills, the approximate yield is referred to as the bond equivalent yield. The bond equivalent yield on the 90-day t-bill is shown below.
  77. 79. Accounts Receivable
  78. 80. Outline <ul><li>Terms </li></ul><ul><li>Extending Credit to New Accounts </li></ul><ul><li>5 C’s of credit </li></ul><ul><li>Monitoring Accounts Receivable through Aging of Accounts </li></ul>
  79. 81. Accounts Receivable Decisions <ul><li>Key Decisions to Make </li></ul><ul><li>1. Terms and conditions of credit sales </li></ul><ul><li>2. Credit analysis </li></ul><ul><li>3. Credit decision. Whether to extend credit to a customer? </li></ul><ul><li>4. Collection policy </li></ul>
  80. 82. Accounts Receivable and Credit Terms <ul><li>Terms and conditions of credit decisions </li></ul><ul><ul><li>No terms – cash on delivery </li></ul></ul><ul><ul><li>Typical Credit Terms – 2/10 net 30; this means that payment is due 30 days following date of invoice and if customer pays by day 10, he/she receives a 2% discount off invoiced price (an incentive to make customers pay early) </li></ul></ul>
  81. 83. Accounts Receivable and Choice of Credit Terms <ul><li>Choice of Credit Terms </li></ul><ul><ul><li>A longer net term means </li></ul></ul><ul><ul><ul><li>More sales and gross profit </li></ul></ul></ul><ul><ul><ul><li>But it also means, </li></ul></ul></ul><ul><ul><ul><li>Higher bad debt </li></ul></ul></ul><ul><ul><ul><li>Increased credit department costs given need to check new applicants </li></ul></ul></ul><ul><ul><ul><li>Increased investment in accounts receivable and potentially inventory </li></ul></ul></ul>
  82. 84. Accounts Receivable and Credit Analysis <ul><li>Example of Impact of Extending Credit to a New Set of Customers </li></ul><ul><ul><li>The new set of customers could increase sales by $60,000. The gross profit margin is 25% and bad debt is estimated to be 3%. Credit department costs are expected to be $3,000 annually. The average collection period is expected to be 4 months. Given an income tax rate of 40%, what is the after-tax rate of return on providing credit to the new set of customers? </li></ul></ul><ul><li>Change in after-tax profit = ($60,000*(25%-3%) –3,000)*(1-0.40) </li></ul><ul><li> = $6,120 </li></ul><ul><li>Investment needed = $60,000*4/12*(1-25%)=$15,000 </li></ul><ul><li>Rate of return = $6,120/$15,000 = 40.8% </li></ul><ul><li>The after-tax rate of return on providing credit to the new set of customers is 40.80% </li></ul>
  83. 85. Exercise #1 <ul><li>A new set of customers could increase sales by $100,000. The gross profit margin is 10% and bad debt is estimated to be 5%. Additional credit department costs are expected to be $3,000 annually. The average collection period is expected to be 3 months. Given an income tax rate of 40%, what is the after-tax rate of return on providing credit to the new set of customers? </li></ul>
  84. 86. Solution <ul><li>Change in after-tax profit </li></ul><ul><li>= ($100,000*(0.10 - 0.05) –3,000)*(1-0.40) </li></ul><ul><li>= $1,200 </li></ul><ul><li>Investment = $100,000*3/12*(1-.10)=$22,500 </li></ul><ul><li>Rate of return = $1,200/$22,500 = 5.3% </li></ul><ul><li>The after-tax rate of return on providing credit to the new set of customers is 5.3% </li></ul>
  85. 87. Exercise #2 <ul><li>You have been approached by your sales staff about selling $100,000 of goods on credit to a new customer. The cost of goods sold on your firm’s products is 80%. Credit department costs are expected to be $2,000 annually to handle this account. The average collection period is expected to be 3 months. The income tax rate is 20%. If you want to earn a 15% after-tax rate of return on providing credit to the new customer, what will be the maximum bad debt expense that can be tolerated? </li></ul>
  86. 88. Solution <ul><li>Let BD be bad debt expense as % of sales </li></ul><ul><li>Gross Margin = 100% -80% =20%. </li></ul><ul><li>Change in after-tax profit = ($100,000*(20%-BD) –2,000)*(1-0.20) </li></ul><ul><li>Investment needed = $100,000*3/12*(80%)=$20,000 </li></ul><ul><li>We need to solve for BD with equation, </li></ul><ul><li>Rate of return = (($100,000*(20%-BD) –2,000)*(1-0.20))/$20,500 = 15% </li></ul><ul><li>(($100,000*(20%-BD) –2,000)*(1-0.20))=$3,075 </li></ul><ul><li>($100,000*(20%-BD) –2,000)= $3,844 </li></ul><ul><li>$100,000*(20%-BD)=$5,844 </li></ul><ul><li>20%-BD=5.844% </li></ul><ul><li>BD=14.156% </li></ul><ul><li>The maximum bad debt expense is 14.156% </li></ul>
  87. 89. THE 5 C’S OF CREDIT ANALYSIS
  88. 90. SCHEDULE OF AGE OF RECEIVABLES
  89. 91. Inventory
  90. 92. Financial Overview of Inventory Management <ul><li>Benefits of Increased Inventory </li></ul><ul><ul><li>quantity discounts for purchasing </li></ul></ul><ul><ul><li>avoids stock outs </li></ul></ul><ul><ul><li>lessens ordering costs </li></ul></ul><ul><li>Costs of Increased Inventory </li></ul><ul><ul><li>Higher carrying costs (Financing, storage, insurance, etc.) </li></ul></ul><ul><ul><li>Potential obsolescence </li></ul></ul>
  91. 93. Short-Term Financing
  92. 94. Outline <ul><li>Selection Criteria </li></ul><ul><li>Covenants </li></ul><ul><li>Effective Annual Rate of Borrowing Instruments </li></ul><ul><ul><li>Line of Credit </li></ul></ul><ul><li>Cost of Trade Credit </li></ul>
  93. 95. Short-term Financing Sources
  94. 96. Criteria in Selecting Short-term Finance <ul><li>Lowest effective net cost considering </li></ul><ul><ul><li>interest </li></ul></ul><ul><ul><li>fees </li></ul></ul><ul><ul><li>offsetting benefits in reduced administrative costs </li></ul></ul><ul><ul><li>net amount borrowed </li></ul></ul><ul><li>Flexibility of Repayment Terms </li></ul><ul><li>Amount of Credit Available </li></ul><ul><li>Conditions of Credit e.g. collateral, covenants etc. </li></ul>
  95. 98. PRIVATE & CONFIDENTIAL Victoria Main Office 1225 Douglas Street Victoria, B.C. V8W 2E6   Bank of Montreal is pleased to offer the following lines of credit to  upon and subject to the following terms and conditions.   Loan Types All loans are payable on demand, subject to periodic review by the Bank not less frequently than annually, unless otherwise indicated.   Interest Rates   For the purpose of this Offer, &quot;Prime Rate&quot; is the floating annual rate of interest established from time to time by the Bank of Montreal as the base rate it will use to determine rates of interest on Canadian dollar loans to customers in Canada and designated as Prime Rate. Prime Rate is currently 6.25% Loan Structure 1) First Bank Cash Management Account (FCMA) $2,750,000.   cont’d   September 8th, 1992
  96. 99. <ul><li>Purpose : Operating assistance. </li></ul><ul><li>  Interest Rate : Prime plus 1/4% </li></ul><ul><li>  Repayment : Interest only, payable monthly. Exact dollar borrowing. </li></ul><ul><li>  Above operating line includes: </li></ul><ul><li>            Maximum $100,000 Letter of Credit facility to cover periodic import of food stuffs. </li></ul><ul><li>            Maximum $250,000 overdraft facility to cover periodic settlement of U.S. payables. </li></ul><ul><li>  Margin Conditions: </li></ul><ul><li>Operating advances contained within 66.6% eligible accounts receivable (60 days and under) plus 50% inventory at cost as indicated by monthly signed Inventory Declarations, Eligible receivables to include current 30/60 day accounts that have formal repayment program established for any over 61 day payments. Estimate of Priority Payables to be provided on monthly Inventory Declaration. </li></ul><ul><li>Secondary Margin </li></ul><ul><li>  Operating advances are not to exceed eligible receivables. </li></ul><ul><li>cont’d  </li></ul>
  97. 100. Information Requirements:          Monthly aged Account Receivable Listings, Inventory and Account Payable Declarations signed by company Signing Officer.          By October 15 th , 1992 ‑ In-house Balance Sheet and Income Statements as at July 31st, 1992.   2) Commercial Mortgage $1,990,000. (Approx. Balance)   Purpose : Refinance existing Commercial Mortgage $1,671,000 with additional $329,000 to repay Demand Loan, Non-Revolving $300,000 balance $29,000 to company current account.   Interest Rate : 11.00%, 3 Year Term due October 1st, 1994 (25 year amortization). Repayment: Monthly blended payments $19,300, 25 year amortization. Security ‑ Already In Place   ‑ Debenture security providing overall Fixed Charge $3,500,000 over property and various company owned vehicles/equipment along with Floating Charge over all other company assets.   Debenture Restrictive Covenants:    Not to declare or pay dividends without Bank approval.    Company not to provide Guarantee to any other financial institution without Bank approval. cont’d  
  98. 101. ‑ Standard Mortgage Clause Fire/All Perils Insurance.  ‑ Assignment of Book Debts.  ‑ Subrogation of shareholder loans signed by   ‑ Subrogation of loan by  Holdings Ltd.  ‑ Corporate Letter of Undertaking re: Financial Test Covenants (To be replaced - replacement letter attached).  ‑ First Commercial Mortgage $2,000,000 providing Fixed Charge over Victoria warehouse complex, including charge over company's freehold and leasehold interest in the subject property.  ‑ General Assignment of Rents.  ‑ Priority Agreement over existing Bank of Montreal Debenture charges.   Security ‑ To Be Obtained  ‑ Revised Corporate Letter of Undertaking, detailed as follows:   1) Maintain debt/equity ratio maximum 2.75:1 as determined by Fiscal 1993 year end Financial Statements with equity defined as Shareholder Loans, Retained Earnings and net tax Bonus Payable.   cont’d  
  99. 102. 2) Achieve Working Capital ratio minimum 1.25:1. (Current liabilities to exclude Directors Wages after tax).   3) Restrict Annual Capital Expenditures to $1,500,000 as detailed in Controller prepared Fiscal 1993 Capital Expenditure Summary. Please note Capital Expenditures at $1,500,000 level are approved in principle in that the Bank will be reviewing the anticipated and resultant financing requirements with you in the near future. ‑ Revised FCMA Agreement. ‑ Insurance Waiver. Given the scale and complexity of company financial operations, we would appreciate the opportunity to revisit the need for provision of Annual Audited year end Financial Statements. cont’d
  100. 103. We are pleased to be of assistance to you. We shall be grateful if you will sign and return copy of this Offer of Credit to the undersigned.   Congratulations on your strong Revenue and Profit performance.   With best wishes for a successful year.      J. Cash Corporate Manager JC/eg   THE UNDERSIGNED HEREBY ACCEPTS THE ABOVE OFFER, ITS TERMS AND CONDITIONS AND AGREES TO BE BOUND THEREBY.   DATED AT VICTORIA, IN THE PROVINCE OF BRITISH COLUMBIA THIS ___ DAY OF SEPTEMBER 1992.  
  101. 104. Example of Typical Bank Loan Covenants for Closely Held Company <ul><li>Gordon Manufacturing is 100% owned by Sam Gordon </li></ul><ul><li>Minimum Current Ratio of 1.25 to ensure liquidity </li></ul><ul><li>Minimum Adjusted Net Worth of $2 million to ensure solvency </li></ul><ul><li>Adjusted Net Worth equals Shareholders Equity from Balance Sheet plus Loans from Shareholder/Related Companies less Loans to Shareholder/Related Companies less Goodwill </li></ul>
  102. 105. Effective Annual Cost of Short-term Financial Instrument <ul><li>Effective before tax rate over life of instrument </li></ul><ul><li>Effective before-tax annual interest rate </li></ul>
  103. 106. Effective Annual Interest Rate on Regular Interest Term Loan <ul><li>Example: A bank charges a 5% annual regular interest rate on a $100,000 91-day term loan. There is an annual fee of 1%. </li></ul><ul><li>Solution: </li></ul><ul><li>Interest paid is 5%* $100,000*91/365 or $1,247 </li></ul><ul><li>Fee is 1%*$100,000*91/365 or $249 </li></ul><ul><li>Net amount borrowed is $100,000 – 1,000 or $99,000 Effective annual interest rate equals </li></ul>
  104. 107. Effective Annual Interest Rate on Discount Interest Term Loan <ul><li>Example: A bank charges a 5% annual discount interest rate on a $100,000 91-day term loan. There is an annual fee of 1%. </li></ul><ul><li>Solution: </li></ul><ul><li>Interest paid is 5%* $100,000*91/365 or $1,247 </li></ul><ul><li> Fee is 1%*$100,000*91/365 or $249 </li></ul><ul><li>Net amount borrowed is $100,000 – 1,247 or $98,753 Effective annual interest rate equals </li></ul>
  105. 108. Line of Credits <ul><li>Used to finance seasonal fluctuations in working capital. </li></ul><ul><li>Firm can borrow up to a maximum level over a specified time period. </li></ul><ul><li>Repayment obligation varies (e.g., 3% of principal per month), although balance must be zero by termination of the loan agreement. </li></ul><ul><li>Borrowing firm may withdraw as need requires up to a preset maximum. </li></ul><ul><ul><li>Committed means bank obliged (written loan agreement) -- fee on unused balance about 1%. ( Commitment fee ) </li></ul></ul><ul><ul><li>Uncommitted means bank not obliged -- no fee on unused balance. </li></ul></ul><ul><li>Bank usually has option to terminate. </li></ul>
  106. 109. Line of Credits <ul><li>Assume interest calculated on average balance of loan used over period. </li></ul><ul><li>Assume commitment fee calculated similarly. </li></ul>
  107. 110. Calculating Effective Interest Rate on Line of Credit <ul><li>Example: A bank charges a 5% interest rate on a $100,000 line of credit for amounts used and a commitment fee of 1% for amounts available but not used. The fee is calculated based on the average unused balance during the period. If average loan balance was $40,000 for 180 days , what was effective interest rate on line of credit? Solution: </li></ul><ul><li>Interest Expense = 5%*$40,000*180/365 or $986 </li></ul><ul><li>Commitment Fee = 1%*60,000*180/365 or $296 Net Amount Borrowed = $40,000 </li></ul><ul><li>Effective Annual Interest Rate equals </li></ul>
  108. 111. Exercise #1 <ul><li>Example: A 120-day $200,000 line of credit. The line of credit would have an annual interest rate of 5% and an annual commitment fee of 1% of the unused balance. During the first 60 days the loan is outstanding, $50,000 will be borrowed. During the last 60 days, $150,000 will be borrowed. </li></ul><ul><li>Interest Expense = 5%*$50,000*60/365 + 5%*$150,000*60/365 = $1,644 </li></ul><ul><li>Commitment Fee = 1%*$150,000*60/365 + 1%*$50,000*60/365 = $329 Net Amount Borrowed = $50,000*60/120 + $150,000*60/120 = $100,000 </li></ul><ul><li>Effective Annual Interest Rate equals </li></ul>
  109. 112. Exercise #2 <ul><li>Example: A 180-day $300,000 line of credit. The line of credit would have an annual interest rate of 6% and an annual commitment fee of 0.5% of the unused balance. During the first 100 days the loan is outstanding, $100,000 will be borrowed. During the last 80 days, $250,000 will be borrowed. </li></ul><ul><li>Interest Expense = 6%*$100,000*100/365 + 6%*$250,000*80/365 = $4,932 </li></ul><ul><li>Commitment Fee = 0.5%*$200,000*100/365 + 0.5%*$50,000*80/365 = $329 Net Amount Borrowed = $100,000*100/180 + $250,000*80/180 = $166,667 </li></ul><ul><li>Effective Annual Interest Rate equals </li></ul>
  110. 113. Additional Exercises <ul><li>For additional exercises on lines of credit, try problems 24.6 and 24.7 and Davis and Pinches </li></ul>
  111. 114. Calculating Effective Cost of Deferring Payment on Accounts Payable <ul><li>Example: A company has 2/10 n45 terms with its supplier. If the company currently pays within 10 days and receives the 2% discount, what is the effective annual cost of delaying payment until day 45? Solution: </li></ul><ul><li>Rather than paying 98% of face value on day 10, company gets to pay 100% of face value on day 45. This is equivalent to borrowing a discount interest loan equal to 98% of face value on day 10 and repaying loan back on day 45. </li></ul><ul><li>Interest Expense = 2% (discount foregone) Net Amount Borrowed: = 98% of face value of payables </li></ul><ul><li>Effective Annual Interest Rate equals </li></ul>
  112. 115. Factoring Receivables <ul><li>Selling receivables to a factor (Finance company) for discounted cash value (with advance factoring) without recourse to the seller (borrower) </li></ul><ul><li>Factor bears risk (where no recourse) and collection expenses </li></ul><ul><li>Fees are fairly high in factoring arrangements; in most industries, factoring is one of the most expensive methods of short-term borrowing </li></ul>
  113. 116. Factoring: Example <ul><li>Don’t Pay for One Full Year! </li></ul><ul><li>Salesperson screens client for credit eligibility with Citifinancial on site using Citi’s in-store computer system. Citi controls credit quality. Bad risks are not offered credit. </li></ul><ul><li>Citi pays Leon’s the discounted value of the purchase price immediately. </li></ul><ul><li>Citi collects full payment from client at end of year. If client can’t pay, then Citi starts charging interest. </li></ul>
  114. 117. Advantages of Factoring Over Pledging of Accounts Receivables <ul><li>Allows Companies to Avoid Credit Checking, Bookkeeping and Collection Costs </li></ul><ul><li>With Advance Factoring, Firms can Shorten Cash Conversion Cycle </li></ul><ul><li>With Non-Recourse Factoring, the Financial Institution Absorbs Bad Debt Losses </li></ul>
  115. 118. Effective Annual Interest Rate of Advance Factoring <ul><li>Example: A company has $200,000 or accounts receivable. A finance company charges a 1% commission on all receivables factored. The finance company will loan an amount equal to 70% of the receivables factored and will charge a 12% annual interest rate on this amount. However, credit department costs will be reduced by $750 a month. The average collection period is 60 days (2 months). What is effective annual cost of factoring? </li></ul><ul><li>Solution: </li></ul><ul><li>Fee is $200,000*1% or $2,000 </li></ul><ul><li>Net amount borrowed is $200,000*70% or $140,000 </li></ul><ul><li>Annual interest paid is 12%* $200,000*70%*60/365 or $2,762 </li></ul><ul><li>Savings over 2 months = $750*2 =$1,500 </li></ul><ul><li>Effective annual interest rate equals </li></ul>
  116. 119. <ul><li>XYZ Corp. currently has monthly receivables of $83,333. It advance factors all receivables to Bank. Receivables typically collected on 25 th of month, so term = 25 days. Bank lends 75% of receivables, charges 1.5% commission and 3% above Prime (Prime=6%). XYZ Corp, saves $1,000 a month on book-keeping and collection expenses. What is the net cost to XYZ? </li></ul><ul><ul><ul><li>Commission = 0.015 * 83,333 = $1,250 </li></ul></ul></ul><ul><ul><ul><li>Savings = -$1,000 </li></ul></ul></ul><ul><ul><ul><li>Interest = 0.09*0.75*$83,333*(25/365) = $385.27 </li></ul></ul></ul><ul><ul><li>Total = $635.27 </li></ul></ul>Exercise #1
  117. 120. <ul><li>Beamscope monthly receivables of $400,000. It advance factors all receivables to Bank. Receivables typically collected at the end of each month, so term = 1 month. Bank lends 70% of receivables, charges 0.5% commission and 2% above Prime (Prime=9%). Beamscope, saves $1,000 a month on book-keeping and collection expenses. What is the net cost? </li></ul><ul><ul><ul><li>Commission = 0.005 * 400,000 = $2,000 </li></ul></ul></ul><ul><ul><ul><li>Savings = -$1,000 </li></ul></ul></ul><ul><ul><ul><li>Interest = (0.09/12)*0.7*400,000 = $2,567 </li></ul></ul></ul><ul><ul><ul><li>Total = $3,567 </li></ul></ul></ul>Exercise #2
  118. 121. Ratio Analysis
  119. 122. Outline <ul><li>Ratios </li></ul><ul><li>Du Pont Analysis </li></ul>
  120. 123. Ratio Analysis <ul><li>Financial ratios show relationships among financial statement accounts. </li></ul><ul><li>Investors predict future earnings and dividends of firm in order to value shares </li></ul><ul><li>Creditors predict likelihood of default by firm on claim </li></ul><ul><li>Management decides upon investment in short and long-term asset and establish amount and type of credit financing </li></ul>
  121. 124. Ratio Analysis Steps: Type: 1. Decide on ratios that are appropriate 2. Calculate ratios 3. Compare ratios to industry norms 4. Evaluate reasons for discrepancies from industry norms 5. Identify trends in ratios over time 6. Evaluate reasons for trends 7. If discrepancies arose because of underlying problems, evaluate alternative solutions to problems. I. Liquidity II. Asset Management Ratios III. Debt Management Ratios IV. Profitability Ratios V. Market Value Ratios
  122. 125. II. Asset Management Ratios - measures how effectively management is utilizing the company’s assets Turnover Measures 1) Inventory Utilization = Sales/Inventory Too “high” Too “low” - loss of profitable sales - obsolescence from stock outs - warehousing constraints -costs from excessive - financing and insurance reordering costs are excessive 2) Average Collection Period = Receivables____ Average Sales per Day Too “low” Too “high” - loss of profitable sales from - bad debt tight credit terms - financing costs 3) Fixed Asset Utilization = Sales/Net Fixed Assets 4) Total Asset Utilization = Sales/Total Assets
  123. 126. III. Debt Management (Leverage) Ratios - measures extent to which non-equity financing is used 1) Total Debt/Total Assets 2) Total Debt/Total Equity 3) Long-term Debt/Common Equity - measures ability of company to meet fixed financing charges with operating income 1) Times Interest Earned = Earnings Before Interest and Taxes (EBIT) Interest Charges 2) Fixed Charge Coverage Ratio
  124. 127. Leverage - creditors will charge higher financing rates to firms which are highly levered 1) Greater likelihood of bankruptcy because of added interest costs 2) Loss of creditors upon liquidation of firm is likely higher because amount of debt increases but liquidation value of assets does not. 3) Common shareholders have smaller stake in firm that is financed by debt rather than solely by equity - may lead them to misappropriate firm assets or take excessive risks especially where firm is nearing bankruptcy.  if firms are too highly leveraged, they may be unable to obtain financing from creditors.
  125. 128. Advantages to Shareholders from Leverage 1) leverage allows firms to experience higher returns in “good” times (but lower returns in “bad” times) - generally expected EPS increases to compensate for greater risk with higher leverage 2) existing shareholders can maintain control by borrowing debt rather than issuing new common shares esp. important for shareholders who are also managers - leverage buy outs 3) tax advantages - interest charges are deductible from taxable income while dividends are not
  126. 129. IV. Profitability Ratios - measure combined effect of liquidity, asset management and leverage on operating results 1) Gross Profit Margin on Sales = Gross Margin/Sales 2) Net Profit Margin on Sales = Net Income Available to Common Shareholders/ Sales 3) Basic Earning Power Ratio = EBIT/Total Assets 4) Return on Total Assets = Net Income Available to Common Shareholders/ Total Assets 5) Return on Equity = Net Income/Common Equity - Profitability analysis often focuses on means to improve the gross margin through new pricing policies, changes in product lines and methods to reduce the cost of goods sold.
  127. 130. V. Market Value Ratios - measures the stock market’s evaluation of liquidity, asset management, debt management and profitability 1) Price Earnings Ratio = Price per share/EPS 2) Market/Book Ratio = Stock Price / Book Value Per Share Book Value Per Share = Shareholders’ Common Equity / Shares Outstanding
  128. 131. The Dupont equation <ul><li>Highlights relationship between financial ratios </li></ul>ROE ROA Net profit margin Asset turnover x x 1+ debt/equity
  129. 132. The DuPont System
  130. 133. Average Industry Ratios
  131. 134. Average Industry Ratios (Continued) Source: Industry Reports (July 5, 1998) The Financial Post Datagroup.
  132. 135. Capstone Case: Working Capital and Financial Statement Analysis Beamscope Canada
  133. 136. Capstone Case: Working Capital and Financial Statement Analysis The chart below shows the price of the stock of Beamscope, a distributor of electronics products in Canada and South America, from 1997 to 2001.
  134. 137. Beamscope’s Working Capital Management <ul><li>Three major problems occurred with working capital in 1997-1998: </li></ul><ul><li>Company couldn’t cope with growth in managing inventory & AR </li></ul><ul><li>Company didn’t properly process goods returned from customers. </li></ul><ul><li>Company didn’t have an adequate returns policies with suppliers. </li></ul>38 91 53 29 62 1.38 1.93 1996 71 118 47 64 54 0.58 1.35 1999 67 64 60 Cash Cycle 115 133 131 Operating Cycle 49 69 71 Days Payable 66 53 4 6 Days Inventory 50 80 84 Average Collection Period 0.44 1.06 1.06 Quick 1.01 1.70 1.61 Current 2000 1998 1997 Ratio
  135. 138. Beamscope’s Debt Management <ul><li>Increased Debt Levels Relative To Equity </li></ul><ul><li>Increase in Accounts Receivable and Inventory needed to be financed. </li></ul><ul><li>Company wrote off Uncollectible Accounts Receivable and Overvalued Inventory in 1999. </li></ul><ul><li>Lower Debt Servicing Ability because of higher interest and lower profits. </li></ul>n.a. n.a. n.a. 0.48 1996 -5.24 1.07 1.29 0.71 1999 -2.62 8.50 9.69 Times Interest Earned 1.36 0.18 0.23 Short-term Debt/Equity 1.37 0.33 0.43 Total Debt/Equity 0.77 0.5 7 0.59 Total Debt/Total Assets 2000 1998 1997 Ratio
  136. 139. Beamscope’s Profitability <ul><li>Company became very unprofitable in 1999 </li></ul><ul><li>Both gross and net profit margins shrunk because of writeoffs in that year. </li></ul><ul><li>DuPont analysis reveals that the lack of operating profitability after 1998 is major reason for low return. </li></ul>4.35 3.41 2.35 2.45 1.93 Total Assets/Equity -29.1% -29.0% 9.6% 8.6% 13.9% Return on Equity 2.4 2.5 2.4 2.3 3.6 Sales/Total Assets -6.7% -8.5% 4.1% 3.5% 7.2% Return on Assets 2.0% 9.8% 1996 -3.4% 2.4% 1999 - 2.8% 1.7% 1.5% Net Profit Margin 4.1% 9.2% 9.6% Gross Profit Margin 2000 1998 1997 Ratio

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