Introduction To Working Capital Management

INTRODUCTION TO WORKING CAPITAL MANAGEMENT

Outline

Working Capital Defined

Goals of working capital management

Cash Conversion Cycle

Working capital policies

WORKING CAPITAL MANAGEMENT

Net Working Capital = Current Assets - Current Liabilities

Goals of Working Capital Management:

Stimulate sales by offering customers credit (accounts receivable) and ready goods for sale (inventory)  Increase Profits

Minimize costs by balancing production and sales levels through inventory  Increase Profits

Secure low cost financing  Increase Profits

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

Issues to Study:

What types and amounts of current assets should a firm hold?

What types and amounts of short-term financing should a firm employ?

How do firms ensure they have enough cash to meet on-going obligations?

How do firms forecast their cash needs?

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

MANAGEMENT OF CASH CONVERSION CYCLE

Cash Conversion Cycle = (Operating Cycle) - (Accounts Payable Deferral Period)

1. Operating Cycle = The time between ordering or raw materials and receiving cash from credit sales

2. Inventory conversion period = time required to order, produce and sell final products on credit

3. Average collection period = time required to collect cash from credit sales

4. Accounts payable deferral period = time firm is able to delay payment for raw materials, wages and other accounts

5. Cash conversion cycle = time between payments for raw materials and and labour (resources) and cash collection from sales

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)

Inventory Conversion Period

- Assume that beginning of year inventory balance was $30 and cost of goods sold was $350

OPERATING AND CASH CYCLES FOR DOUG’S DISTRIBUTORS INC.

Receivables Conversion Period or Average Collection Period

- Assume 100% of sales are on credit

- Assume that beginning of year accounts receivable was $20 and sales was $500

OPERATING AND CASH CYCLES FOR DOUG’S DISTRIBUTORS INC.

3. Payables Deferral Period

assume beginning of

Year accounts payable was

$20

4. Operating Cycle

= Inventory Conversion Period + Receivables Conversion Period

= 36.50 days + 18.25 days

= 54.25 days

5. Cash Cycle = Operating Cycle - Accounts

Payable Deferral Period

= 54.25 days – 26.07 days

= 28.18 days

Working Capital Policies and the Current Ratio

Current Ratio is a measure of the extent to which current Assets are financed by current liabilities

Current Ratio = Current Assets / Current Liabilities

Doug’s Distributors has a current ratio of 70/50 or 1.4

A current ratio of 1.40 means that for every $1.40 of current assets there is one dollar of current liabilities

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

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

Working Capital Policies Understanding Liquidity

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

To help you understand the nature of cash flows, you need to know how to develop and interpret a statement of cash flows

Before developing a statement of cash flows, let us review how the balance sheet and income statements are created

Summary

Working Capital = Short-term Assets – Short-term liabilities

Cash Conversion Cycle

Operating cycle

Cash cycle

Policies

Aggressive

Conservative

Statement of Cash Flows Understanding Cash Flows

Outline

Preparation of balance sheet and income statement from transactions

Statement of Cash Flows

Preparing Pro Forma: Supplementary Review of Financial Statement Preparation

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)

Assets = Liabilities + Equity

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)

Preparation of the Balance Sheet and Income Statement: A step-by-step example

Importance of Cash Flows: Liquidity

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?

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.

To assess liquidity, we need to understand the factors affecting firm’s on-going ability to generate cash.

Statement of Cash Flows

Sales

- Cost of Goods Sold

- Selling, General and Administration Expenses Net Income

- Interest

- Income Taxes

+Non-cash expenses e.g.depreciation

= Cash Flows From Operating Activities

- Increase in Accounts Receivable

- Increase in Inventory Change in Net Working Capital

+ Increase in Accounts Payable

- Purchases of Fixed Assets Net Capital Expenditures

+ Sales of Fixed Assets

- Payments to Owners of Business

= Cash Generated (Used) By Business Available for Repayment of Debts

Statement of Cash Flows for Sylvia’s Satins

Financing Cash Flow Deficiencies

If Sylvia’s Satins used up $31,000 cash in its on-going operations, how was this financed?

Opening Cash Balance $20,000

Less: Cash Used $31,000

Cash Surplus (Deficiency) - $11,000

Deficiency was financed by bank overdraft

Cash Flow Drivers

Eleven Key Cash Flow Drivers

Relationship with Cash Flow

Sales Growth Usually negative

Gross Margin % (Gross Profit/Sales) positive

Selling, General and Administration

(SGA) as % of Sales negative

Interest Expense negative

Non-cash Expenses positive

6. Income Tax Rate negative

7. Average Collection Period (ACP) negative

8. Inventory Conversion Period negative

9. Accounts Payable Period positive

10. Net Capital Expenditures negative

11. Owner’s Withdrawals from Firm negative

Relationship of Expenses to Cash Flow

Companies with higher profit margins (firms with low cost of goods sold and low SGA as % of sales) generate more cash

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.

Significant non-cash expenses provide some relief but only where regular capital expenditures are not required

Relationship of Average Collection Period to Cash Flow

Average Collection Period (ACP) is calculated as:

Accounts Receivable

Sales/365

In case of Sylvia’s Satins, ACP is $30/($40/365) or 274 days

One can estimate Accounts Receivable as:

Sales * ACP

365

If sales double to $80 and ACP remains unchanged, then Accounts Receivable would also double i.e. ($80*274)/365 = $60

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

Relationship of Inventory Conversion Period to Cash Flow

Inventory Conversion Period is calculated as:

Inventory

Cost of Goods Sold/365

In case of Sylvia’s Satins, Inventory Conversion Period is $30/($30/365) or 365 days

One can estimate Inventory as:

Cost of Goods Sold * Inventory Conversion Period

365

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

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

Relationship of Accounts Payable Period to Cash Flow

Payables Deferral Period

= (Payables)/(Cost of Goods Sold + Other Operating Expenses) X 365

In case of Sylvia’s Satins, Payables Deferral Period is ($40)/($30/365) or 487 days

One can estimate Accounts Payable as:

Cost of Goods Sold * Accounts Payable Period

365

If cost of goods doubles and Payables Deferral Period remains unchanged, then Accounts Payable would also double i.e. ($60*487)/365 = $80

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

Relationship of Sales Growth to Cash Flow

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.

Even for firms that strictly sell on a cash basis, an increase in sales still means that it needs to increase its inventory.

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

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

Relationship of Sales Growth to Cash Flow

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

Situation would be worse where firm experiences substantial growth and is capital intensive i.e. it needs more capital expenditures to facilitate expansion

These expenditures place greater pressure on the cash flow of the firm

Relationship of Profitability and Liquidity

Most often, clients who strive to be more profitable usually improve their liquidity as higher profit margins and better cost controls enhance cash flows

Furthermore, a more profitable business makes it easier for the firm to attract other sources of credit as well as outside equity

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

Relationship of Capital Expenditures and Liquidity

Most firms periodically need to make substantial capital expenditures, at the very least to maintain their operations or to keep up with the competition

Grocery stores need to replace freezers

Fashion retailers need new fixtures

Delivery firms need to replace vans

These expenditures place a heavy drain on cash flow and consequently:

Clients should extend life of their fixed assets through preventative maintenance

Clients should acquire assets with strong warranties and insurance protection

Relationship of Capital Expenditures and Liquidity

Financing of Capital Expenditures should be structured so that the period of the repayment of principal matches the life of the asset

Term financing or lease arrangement for equipment

Long-term mortgage for real estate

Excessive use of short-term debt creates too much demand on cash flows in the period when the asset is first acquired

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

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

Signs of Liquidity Problems

Decline in daily or weekly cash inflows

Profitability and Operating Cash Flow Squeeze -- Increased costs that the firm is unable to pass on to customers

Unexpected build-up of Accounts Receivable

Unexpected build-up of Inventory

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)

Cash Budgets & Pro Forma Statements Forecasting Cash Flows

Outline

Why forecast cash flows?

Cash budget

Pro Forma

Income Statement

Balance Sheet

Percent of sales method

Managing Liquidity and the Need to Forecast Cash Flows

Companies need to plan for their cash needs to ensure they have sufficient cash to:

Meet on-going obligations such as the payroll

Meet contingencies such as an increased need for working capital (sensitivity analysis is especially important)

Be able to invest when attractive opportunities arise

They need to project a cash budget that forecasts cash inflows and outflows on a monthly basis.

Cash budgeting is especially important in seasonal and growing businesses.

Cash budgets should tie in with pro forma income statements and balance sheets.

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

EXAMPLE OF CASH BUDGET AND PRO FORMA FINANCIAL STATEMENTS

Key Assumptions for Gadget Company

(Startup Business)

Sales

Monthly sales of 10,000 units

First month of sales is February 2003

Based on contract with distributor

Cash Budget

A/R - ½ sales collected within one-month following sale and the other ½ collected two months following sale

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

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

Cash Payments to Suppliers

Key Assumptions: Company will purchase one month in advance of sales.

- Month-end inventory will equal the current month’s purchases.

Each unit costs $1.00 to purchase.

Supplier will be paid one month after purchase.

$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

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

Key Assumptions for Gadget Company

Cash Budget

General and administration costs = $3,750 per month

Interest is charged on previous month’s loan balance at an annual rate of 12%. The monthly rate is 12%/12 or 1%.

$10,000 opening cash balance

Pro Forma Income Statement

Depreciation = $250 per month

no accrual is made for interest expense at year end

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

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

Gadget Company: Projected Income Statement for Year Ended December 31, 2003

Sales $ 173,800

Cost of Goods Sold:

Purchases 120,000

Less: Ending Inventory 10,000

110,000

Gross Profit 63,800

General Expenses 45,000

Depreciation 3,000

Interest 606 48,606

Net Profit $15,194

Gadget Company: Pro Forma Balance Sheet December 31, 2003

% of Sales Method: Pro Forma Model Ingredients

Sales Forecast

Drives the model

Pro Forma Statements

The output summarizing different projections

Asset Requirements

Investment needed to support sales growth

Financial Requirements

Debt and dividend policies

The “Plug” ”

Designated source(s) of external financing

Economic Assumptions

State of the economy, interest rates, inflation

Historical Financial Statements for St. Dilbert Pharmaceuticals

Total Assets are 200% of sales. ($2 of assets for every $1 of sales.)

Fixed assets are 60% of total assets, or 120% of sales.

$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

Pro Forma Financial Statements Using % of Sales Method

Assume that sales grow by 20% to $600

Firms needs $2 of assets for every $1 of sales.

Fixed assets are 60% of total assets.

$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

Filling in the Blanks

Depreciation

Firm needs $2 of assets for every $1 of sales (total asset turnover is 0.5 or total assets are 200% of sales)

Total Assets must rise to $1,200 to support $600 of sales

Fixed Assets are 60% of Total Assets

Current Assets are 40% of Total Assets

Depreciation is 20% of Fixed Assets

Depreciation = 0.2 * (0.6 * $1,200) = $144

This depreciation calculation wrong, but close and simple!

Should calculate depreciation as % of additions to gross fixed assets plus % of last year’s net.

Interest

Based on the last end-of-period Debt level (short and long-term).

Interest = 0.1 * $450 = 45

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

Financial Planning

Equity is the plug variable.

Equity rises from $550 to $750, but $28 of this is from retained earnings.

The difference, $172, is additional equity income necessary to support the increase in sales.

Debt could also be the plug. Firm could borrow $172 and Debt could rise to $622.

If new capital not available, then can’t finance sales increase.

$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

Cash & Marketable Securities

Overview of How Companies Maintain Liquidity

By holding cash and marketable securities

By having ready access to sources of financing

Access to equity (not always possible or attractive)

Access to debt through prior commitments from lender e.g. line of credit

Criteria in Selection of Marketable Securities

Liquidity – the security should be easy to sell before maturity and the costs involved in selling (transaction costs) should be minimal

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)

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)

Attractive Return – firms will accept more of the above three risks in order to higher return

Tax Implications – return is considered on after-tax basis

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

Other Short-term Investments Used for Liquidity Purposes

Overnight loans (large firms lend money on an overnight basis)

Certificates of Deposits (interest-bearing rather than discount instruments issued by banks and trust companies)

Negotiable Certificates of Deposit (can be sold before maturity in market)

Money Market Mutual Fund (pool of short-term money market instruments)

Effective Interest Rate on a Short-term Discount Instrument

Effective rate over life of instrument

Effective annual interest rate

Effective Interest Rate on a Short-term Discount Instrument

Example of effective annual interest rate calculation

T-bill has 90 days to maturity; maturity price is $1,000 but it currently sells for $990

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.

Accounts Receivable

Outline

Terms

Extending Credit to New Accounts

5 C’s of credit

Monitoring Accounts Receivable through Aging of Accounts

Accounts Receivable Decisions

Key Decisions to Make

1. Terms and conditions of credit sales

2. Credit analysis

3. Credit decision. Whether to extend credit to a customer?

4. Collection policy

Accounts Receivable and Credit Terms

Terms and conditions of credit decisions

No terms – cash on delivery

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)

Accounts Receivable and Choice of Credit Terms

Choice of Credit Terms

A longer net term means

More sales and gross profit

But it also means,

Higher bad debt

Increased credit department costs given need to check new applicants

Increased investment in accounts receivable and potentially inventory

Accounts Receivable and Credit Analysis

Example of Impact of Extending Credit to a New Set of Customers

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?

Change in after-tax profit = ($60,000*(25%-3%) –3,000)*(1-0.40)

= $6,120

Investment needed = $60,000*4/12*(1-25%)=$15,000

Rate of return = $6,120/$15,000 = 40.8%

The after-tax rate of return on providing credit to the new set of customers is 40.80%

Exercise #1

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?

Solution

Change in after-tax profit

= ($100,000*(0.10 - 0.05) –3,000)*(1-0.40)

= $1,200

Investment = $100,000*3/12*(1-.10)=$22,500

Rate of return = $1,200/$22,500 = 5.3%

The after-tax rate of return on providing credit to the new set of customers is 5.3%

Exercise #2

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?

Solution

Let BD be bad debt expense as % of sales

Gross Margin = 100% -80% =20%.

Change in after-tax profit = ($100,000*(20%-BD) –2,000)*(1-0.20)

Investment needed = $100,000*3/12*(80%)=$20,000

We need to solve for BD with equation,

Rate of return = (($100,000*(20%-BD) –2,000)*(1-0.20))/$20,500 = 15%

(($100,000*(20%-BD) –2,000)*(1-0.20))=$3,075

($100,000*(20%-BD) –2,000)= $3,844

$100,000*(20%-BD)=$5,844

20%-BD=5.844%

BD=14.156%

The maximum bad debt expense is 14.156%

THE 5 C’S OF CREDIT ANALYSIS

SCHEDULE OF AGE OF RECEIVABLES

Inventory

Financial Overview of Inventory Management

Benefits of Increased Inventory

quantity discounts for purchasing

avoids stock outs

lessens ordering costs

Costs of Increased Inventory

Higher carrying costs (Financing, storage, insurance, etc.)

Potential obsolescence

Short-Term Financing

Outline

Selection Criteria

Covenants

Effective Annual Rate of Borrowing Instruments

Line of Credit

Cost of Trade Credit

Short-term Financing Sources

Criteria in Selecting Short-term Finance

Lowest effective net cost considering

interest

fees

offsetting benefits in reduced administrative costs

net amount borrowed

Flexibility of Repayment Terms

Amount of Credit Available

Conditions of Credit e.g. collateral, covenants etc.

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, "Prime Rate" 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

Purpose : Operating assistance.

Interest Rate : Prime plus 1/4%

Repayment : Interest only, payable monthly. Exact dollar borrowing.

Above operating line includes:

 Maximum $100,000 Letter of Credit facility to cover periodic import of food stuffs.

 Maximum $250,000 overdraft facility to cover periodic settlement of U.S. payables.

Margin Conditions:

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.

Secondary Margin

Operating advances are not to exceed eligible receivables.

cont’d

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

‑ 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

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

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.

Example of Typical Bank Loan Covenants for Closely Held Company

Gordon Manufacturing is 100% owned by Sam Gordon

Minimum Current Ratio of 1.25 to ensure liquidity

Minimum Adjusted Net Worth of $2 million to ensure solvency

Adjusted Net Worth equals Shareholders Equity from Balance Sheet plus Loans from Shareholder/Related Companies less Loans to Shareholder/Related Companies less Goodwill

Effective Annual Cost of Short-term Financial Instrument

Effective before tax rate over life of instrument

Effective before-tax annual interest rate

Effective Annual Interest Rate on Regular Interest Term Loan

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%.

Solution:

Interest paid is 5%* $100,000*91/365 or $1,247

Fee is 1%*$100,000*91/365 or $249

Net amount borrowed is $100,000 – 1,000 or $99,000 Effective annual interest rate equals

Effective Annual Interest Rate on Discount Interest Term Loan

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%.

Solution:

Interest paid is 5%* $100,000*91/365 or $1,247

Fee is 1%*$100,000*91/365 or $249

Net amount borrowed is $100,000 – 1,247 or $98,753 Effective annual interest rate equals

Line of Credits

Used to finance seasonal fluctuations in working capital.

Firm can borrow up to a maximum level over a specified time period.

Repayment obligation varies (e.g., 3% of principal per month), although balance must be zero by termination of the loan agreement.

Borrowing firm may withdraw as need requires up to a preset maximum.

Committed means bank obliged (written loan agreement) -- fee on unused balance about 1%. ( Commitment fee )

Uncommitted means bank not obliged -- no fee on unused balance.

Bank usually has option to terminate.

Line of Credits

Assume interest calculated on average balance of loan used over period.

Assume commitment fee calculated similarly.

Calculating Effective Interest Rate on Line of Credit

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:

Interest Expense = 5%*$40,000*180/365 or $986

Commitment Fee = 1%*60,000*180/365 or $296 Net Amount Borrowed = $40,000

Effective Annual Interest Rate equals

Exercise #1

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.

Interest Expense = 5%*$50,000*60/365 + 5%*$150,000*60/365 = $1,644

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

Exercise #2

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.

Interest Expense = 6%*$100,000*100/365 + 6%*$250,000*80/365 = $4,932

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

Additional Exercises

For additional exercises on lines of credit, try problems 24.6 and 24.7 and Davis and Pinches

Calculating Effective Cost of Deferring Payment on Accounts Payable

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:

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.

Interest Expense = 2% (discount foregone) Net Amount Borrowed: = 98% of face value of payables

Factoring Receivables

Selling receivables to a factor (Finance company) for discounted cash value (with advance factoring) without recourse to the seller (borrower)

Factor bears risk (where no recourse) and collection expenses

Fees are fairly high in factoring arrangements; in most industries, factoring is one of the most expensive methods of short-term borrowing

Factoring: Example

Don’t Pay for One Full Year!

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.

Citi pays Leon’s the discounted value of the purchase price immediately.

Citi collects full payment from client at end of year. If client can’t pay, then Citi starts charging interest.

Advantages of Factoring Over Pledging of Accounts Receivables

Allows Companies to Avoid Credit Checking, Bookkeeping and Collection Costs

With Advance Factoring, Firms can Shorten Cash Conversion Cycle

With Non-Recourse Factoring, the Financial Institution Absorbs Bad Debt Losses

Effective Annual Interest Rate of Advance Factoring

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?

Solution:

Fee is $200,000*1% or $2,000

Net amount borrowed is $200,000*70% or $140,000

Annual interest paid is 12%* $200,000*70%*60/365 or $2,762

Savings over 2 months = $750*2 =$1,500

Effective annual interest rate equals

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?

Commission = 0.015 * 83,333 = $1,250

Savings = -$1,000

Interest = 0.09*0.75*$83,333*(25/365) = $385.27

Total = $635.27

Exercise #1

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?

Commission = 0.005 * 400,000 = $2,000

Savings = -$1,000

Interest = (0.09/12)*0.7*400,000 = $2,567

Total = $3,567

Exercise #2

Ratio Analysis

Outline

Ratios

Du Pont Analysis

Ratio Analysis

Financial ratios show relationships among financial statement accounts.

Investors predict future earnings and dividends of firm in order to value shares

Creditors predict likelihood of default by firm on claim

Management decides upon investment in short and long-term asset and establish amount and type of credit financing

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

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

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

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.

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

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.

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

The Dupont equation

Highlights relationship between financial ratios

ROE ROA Net profit margin Asset turnover x x 1+ debt/equity

The DuPont System

Average Industry Ratios

Average Industry Ratios (Continued) Source: Industry Reports (July 5, 1998) The Financial Post Datagroup.

Capstone Case: Working Capital and Financial Statement Analysis Beamscope Canada

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.

Beamscope’s Working Capital Management

Three major problems occurred with working capital in 1997-1998:

Company couldn’t cope with growth in managing inventory & AR

Company didn’t properly process goods returned from customers.

Company didn’t have an adequate returns policies with suppliers.

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

Beamscope’s Debt Management

Increased Debt Levels Relative To Equity

Increase in Accounts Receivable and Inventory needed to be financed.

Company wrote off Uncollectible Accounts Receivable and Overvalued Inventory in 1999.

Lower Debt Servicing Ability because of higher interest and lower profits.

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

Beamscope’s Profitability

Company became very unprofitable in 1999

Both gross and net profit margins shrunk because of writeoffs in that year.

DuPont analysis reveals that the lack of operating profitability after 1998 is major reason for low return.

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