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Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
Short Term Financial Management
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Short Term Financial Management

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    • 1. Short-Term Financial Management TVU Reading College MBA Managerial Finance Lecture 3
    • 2. Basics <ul><li>Working Capital Basics </li></ul><ul><ul><li>The assets/liabilities that are required to operate a business on a day-to-day basis </li></ul></ul><ul><ul><ul><li>Cash </li></ul></ul></ul><ul><ul><ul><li>Accounts Receivable </li></ul></ul></ul><ul><ul><ul><li>Inventory </li></ul></ul></ul><ul><ul><ul><li>Accounts Payable </li></ul></ul></ul><ul><ul><ul><li>Accruals </li></ul></ul></ul><ul><ul><li>These assets/liabilities are short-term in nature and turn over regularly </li></ul></ul>
    • 3. Working Capital, Funding Requirements, and the Current Accounts <ul><li>Gross Working Capital (GWC) represents the investment in assets </li></ul><ul><li>Working Capital Requires Funds </li></ul><ul><ul><li>Maintaining a working capital balance requires a permanent commitment of funds </li></ul></ul><ul><ul><ul><li>Example: Your firm will always have a minimum level of Inventory, Accounts Receivable, and Cash—this requires funding </li></ul></ul></ul>
    • 4. Working Capital, Funding Requirements, and the Current Accounts <ul><li>Spontaneous Financing </li></ul><ul><ul><li>Your firm will also always have a minimum level of Accounts Payable—in effect, money you have borrowed </li></ul></ul><ul><ul><ul><li>Accounts Payable (and Accruals) are generated spontaneously </li></ul></ul></ul><ul><ul><ul><li>Offset the funding required to support assets </li></ul></ul></ul><ul><ul><ul><ul><li>Net working capital is Gross Working Capital – Current Liabilities (or spontaneous financing) </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Reflects the net amount of funds needed to support routine operations </li></ul></ul></ul></ul></ul>
    • 5. Objective of Working Capital Management <ul><li>To run the firm efficiently with as little money as possible tied up in Working Capital </li></ul><ul><ul><li>Involves trade-offs between easier operation and the cost of carrying short-term assets </li></ul></ul><ul><ul><ul><li>Benefit of low working capital </li></ul></ul></ul><ul><ul><ul><ul><li>Able to funnel money into accounts that generate a higher payoff </li></ul></ul></ul></ul><ul><ul><ul><li>Cost of low working capital </li></ul></ul></ul><ul><ul><ul><ul><li>Risky </li></ul></ul></ul></ul>
    • 6. The Cash Conversion Cycle time = 0 Purchase raw materials on account Operating cycle Sell finished goods on account Collect accounts receivable Average Collection Period Average Age of Inventory Average payment period Cash Conversion Cycle Time Payment mailed Operating cycle <ul><li>Time from the beginning of the production to the time when cash is collected from sale </li></ul><ul><li>Financing the operating cycle is costly, so firms have an incentive to shrink it. </li></ul>Cash conversion cycle <ul><li>Operating cycle less the average payment period on accounts payable </li></ul>
    • 7. Cost Tradeoffs in Working Capital Accounts Financing costs resulting from the use of less expensive short-term financing rather than more expensive long-term debt and equity financing Cost of reduced liquidity caused by increasing current liabilities Accounts payable, accruals, and notes payable Short-Term Financing Order and setup costs associated with replenishment and production of finished goods Carrying cost of inventory, including financing, warehousing, obsolescence costs, etc. Inventory Opportunity cost of lost sales due to overly restrictive credit policy and/or terms Cost of investment in accounts receivable and bad debts Accounts receivable Illiquidity and solvency costs Opportunity cost of funds Cash and marketable securities Operating Assets Cost 2 * Shortage Costs (cost of holding too little of operating asset) Cost 1 (holding cost)
    • 8. Cost Trade-offs in Short-Term Financial Management
    • 9. Inventory Management
    • 10. Inventory Management <ul><li>Mismanagement of inventory has the potential to ruin a company </li></ul><ul><li>Inventory is not the direct responsibility of the finance department </li></ul><ul><ul><li>Usually managed by a functional area such as manufacturing or operations </li></ul></ul><ul><ul><li>However, finance department has an oversight responsibility for inventory management </li></ul></ul><ul><ul><ul><li>Monitor level of lost of obsolete inventory </li></ul></ul></ul><ul><ul><ul><li>Supervise periodic physical inventories </li></ul></ul></ul>
    • 11. Benefits and Costs of Carrying Adequate Inventory <ul><li>Benefits </li></ul><ul><ul><li>Reduces stockouts and backorders </li></ul></ul><ul><ul><li>Makes operations run more smoothly, improves customer relations and increases sales </li></ul></ul><ul><li>Costs </li></ul><ul><ul><li>Interest on funds used to acquire inventory </li></ul></ul><ul><ul><li>Storage and security </li></ul></ul><ul><ul><li>Insurance </li></ul></ul><ul><ul><li>Taxes </li></ul></ul><ul><ul><li>Shrinkage </li></ul></ul><ul><ul><li>Spoilage </li></ul></ul><ul><ul><li>Breakage </li></ul></ul><ul><ul><li>Obsolescence </li></ul></ul>
    • 12. Inventory Control and Management <ul><li>Inventory management refers to the overall way a firm controls inventory and its cost </li></ul><ul><ul><li>Define an acceptable level of operating efficiency with regard to inventory </li></ul></ul><ul><ul><li>Try to achieve that level with the minimum inventory cost </li></ul></ul>
    • 13. Economic Order Quantity (EOQ) Model <ul><li>EOQ model recognizes trade-offs between carrying costs and ordering costs </li></ul><ul><ul><li>Carrying costs increase with the amount of inventory held </li></ul></ul><ul><ul><li>Ordering costs increase with the number of orders placed </li></ul></ul><ul><li>EOQ minimizes the sum of ordering and carrying costs </li></ul>
    • 14. EOQ ( Q *) <ul><li>Total costs = Ordering costs + Carrying costs </li></ul><ul><li>Total costs = (number of orders per year  Cost per order) + (Avg. INV  Annual carrying cost per unit) </li></ul><ul><li>Total costs = ( D / Q  S ) + ( Q /2  C ) </li></ul><ul><li>EOQ </li></ul><ul><li>Optimal length of one inventory cycle </li></ul>or
    • 15. Safety Stocks, Reorder Points and Lead Times <ul><li>Safety stock provides a buffer against unexpectedly rapid use or delayed delivery </li></ul><ul><ul><li>An additional supply of inventory that is carried at all times to be used when normal working stocks run out </li></ul></ul><ul><ul><li>Rarely advisable to carry so much safety stock that stockouts never happen </li></ul></ul><ul><ul><ul><li>Carrying costs would be excessive </li></ul></ul></ul><ul><li>Ordering lead time is the advance notice needed so that an order placed will arrive at the needed time </li></ul><ul><ul><li>Usually estimated by the item’s supplier </li></ul></ul>
    • 16. Tracking Inventories—The ABC System <ul><li>Some inventory items warrant a great deal of attention </li></ul><ul><ul><li>Are very expensive </li></ul></ul><ul><ul><li>Are critical to the firm’s processes or to those of customers </li></ul></ul><ul><li>Some inventory items do not warrant a great deal of attention </li></ul><ul><ul><li>Commonplace, easy to obtain </li></ul></ul><ul><li>An ABC system segregates items by value and places tighter control on higher cost (value) pieces </li></ul>
    • 17. Just In Time (JIT) Inventory Systems <ul><li>Suppliers deliver goods to manufacturers just in time (JIT) </li></ul><ul><li>Theoretically eliminates the need for factory inventory </li></ul><ul><li>A late delivery can stop a factory’s entire production line </li></ul><ul><li>JIT works best with large manufacturers who are powerful with respect to the supplier </li></ul><ul><ul><li>Supplier is willing to do almost anything to keep the manufacturer’s business </li></ul></ul>
    • 18. Management of Accounts Receivable
    • 19. Accounts Receivable Management <ul><ul><li>Determine its credit standards. </li></ul></ul><ul><ul><li>Set the credit terms. </li></ul></ul><ul><ul><li>Develop collection policy. </li></ul></ul><ul><ul><li>Monitor its A/R on both individual and aggregate basis. </li></ul></ul>If a company decides to offer trade credit, it must: Credit standards <ul><ul><li>Apply techniques to determine which customers should receive credit. </li></ul></ul><ul><ul><li>Use internal and external sources to gather information relevant to the decision to extend credit to specific customers. </li></ul></ul><ul><ul><li>Take into account variable costs of the products sold on credit. </li></ul></ul>Credit selection techniques Five C’s of Credit Credit scoring
    • 20. Five C’s of Credit Framework for in-depth credit analysis that is typically used for high-value credit requests: <ul><ul><li>Character: The applicant’s record of meeting past obligations; desire to repay debt if able to do so </li></ul></ul><ul><ul><li>Capacity: The applicant’s ability to repay the requested credit </li></ul></ul><ul><ul><li>Capital: The financial strength of the applicant as reflected by its ownership position </li></ul></ul><ul><ul><li>Collateral: The amount of assets the applicant has available for use in securing the credit </li></ul></ul><ul><ul><li>Conditions: Refers to current general and industry-specific economic conditions </li></ul></ul>
    • 21. Credit Scoring <ul><ul><li>Used with high volume/small dollar credit requests </li></ul></ul><ul><ul><li>Most commonly used by large credit card operations, such as banks, oil companies, and department stores. </li></ul></ul>Uses statistically-derived weights for key credit characteristics to predict whether a credit applicant will pay the requested credit in a timely fashion. <ul><li>An example… </li></ul><ul><li>ABC Co Ltd uses credit scoring to make credit decisions. Decision rule is: </li></ul><ul><ul><li>Credit Score > 75: extend standard credit terms </li></ul></ul><ul><ul><li>65 < Credit Score < 75: extend limited credit (convert to standard credit terms after 1 year if account is properly maintained) </li></ul></ul><ul><ul><li>Credit Score < 65: reject application </li></ul></ul>
    • 22. Credit Scoring of a Consumer Credit Application by ABC Co 83.25 1.00 8.50 0.10 85 Years on job 9.00 0.10 90 Years at address 20.00 0.25 80 Payment history 18.75 0.25 75 Income range 15.00 0.15 100 Home ownership 12.00 0.15 80 Credit references Weighted Score [(1) X (2)] (3) Predetermined Weight (2) Score (0 to 100) (1) Financial and Credit Characteristics
    • 23. Changing Credit Standards <ul><ul><li>Increase in sales and profits (if positive contribution margin), but higher costs from additional A/R and additional bad debt expense. </li></ul></ul>Credit standards relaxed <ul><ul><li>Reduced investment in A/R and lower bad debt, but lower sales and profit. </li></ul></ul>Credit standards tightened <ul><li>An example… YMCc wants to evaluate the effects of a relaxation of its credit standards: </li></ul><ul><li>YMCo sells CD organizers for £12/unit. All sales are on credit. YMC expects to sell 140,000 units next year. </li></ul><ul><li>Variable costs are £8/unit and fixed costs are £200,000 per year. </li></ul><ul><li>The change in credit standards will result in: </li></ul><ul><ul><ul><li>5% increase in sales; average collection period will increase from 30 to 45 days; increase in bad debt from 1% to 2%. </li></ul></ul></ul>
    • 24. Effects of Changes in Credit Standards for YMCo Marginal profit from increased sales Additional profit contribution from sales Cost of the marginal investment in accounts receivables <ul><ul><li>To compute additional investment, use the following equations: </li></ul></ul>Cost of marginal investment in A/R Average investment in accounts receivable (AIAR )
    • 25. Cost of the marginal investment in accounts receivables Total variable cost of annual sales (TVC) Turnover of account receivable (TOAR)
    • 26. Cost of the marginal investment in accounts receivables Cost of marginal investment in A/R Compute additional investment and, assuming a required return of 12%, compute cost of marginal investment in A/R.
    • 27. Cost of Marginal Bad Debt Expense <ul><ul><li>Subtract the current level of bad debt expense (BDE CURRENT ) from the expected level of bad debt expense (BDE PROPOSED ). </li></ul></ul>Cost of marginal bad debt expense 3. Cost of marginal bad debt expense 4. Net profit for the credit decision Net profit for the credit decision Marginal profit from increased sales Cost of marginal investment in A/R Cost of marginal bad debts = - - = £28,000 - £6,406 - £18,480 = £3,114
    • 28. Credit Monitoring Ageing of accounts receivable: schedule that indicates the portions of total A/R balance outstanding Credit monitoring <ul><li>The ongoing review of a firm’s accounts receivable to determine if customers are paying according to stated credit terms </li></ul>Techniques for credit monitoring <ul><li>Average collection period </li></ul><ul><li>Ageing of accounts receivable </li></ul><ul><li>Payment pattern monitoring </li></ul>Average collection period : the average number of days credit sales are outstanding
    • 29. Credit Monitoring Payment pattern: the normal timing within which a firm’s customers pay their accounts <ul><ul><li>Percentage of monthly sales collected the following month </li></ul></ul><ul><ul><li>Should be constant over time; if payment pattern changes, the firm should review its credit policies </li></ul></ul><ul><li>An example… </li></ul><ul><li>DJM Manufacturing determined that: </li></ul><ul><ul><li>20% of sales collected in the month of sales, 50% in the next month and 30% two months after the sale. </li></ul></ul><ul><li>Can use payment pattern to construct cash receipts from the cash budget: </li></ul><ul><ul><li>If January sales are £400,000, DJM expects to collect £80,000 in January, £200,000 in February, and £120,000 in March. </li></ul></ul>
    • 30. Management of Cash
    • 31. Cash Management Cash management: the collection, concentration, and disbursement of funds Float: funds that have been sent by the payer but not yet usable funds to the company Cash manager responsible for <ul><ul><li>Cash management </li></ul></ul><ul><ul><li>Financial relationships with banks </li></ul></ul><ul><ul><li>Cash flow forecasting </li></ul></ul><ul><ul><li>Investing and borrowing </li></ul></ul><ul><ul><li>Development and maintenance of information systems for cash management </li></ul></ul>Mail float Processing float Availability float Clearing float Time
    • 32. Costs of Holding Cash C * Costs of holding cash Size of cash balance The investment income foregone when holding cash. Trading costs increase when the firm must sell securities to meet cash needs. Opportunity Costs Trading costs Total cost of holding cash
    • 33.  
    • 34.  
    • 35. The Baumol Model C * Size of cash balance The optimal cash balance is found where the opportunity costs equals the trading costs Trading costs F K T C   2 * Opportunity Costs K C  2
    • 36. The Baumol Model Opportunity Costs = Trading Costs The optimal cash balance is found where the opportunity costs equals the trading costs Multiply both sides by C F C T K C    2 F T K C    2 2 K F T C    2 2 K TF C 2 * 
    • 37.  
    • 38.  
    • 39. Implications of the Miller-Orr Model <ul><li>To use the Miller-Orr model, the manager must do four things: </li></ul><ul><ul><li>Set the lower control limit for the cash balance. </li></ul></ul><ul><ul><li>Estimate the standard deviation of daily cash flows. </li></ul></ul><ul><ul><li>Determine the interest rate. </li></ul></ul><ul><ul><li>Estimate the trading costs of buying and selling securities. </li></ul></ul>
    • 40. Implications of the Miller-Orr Model <ul><li>The model clarifies the issues of cash management: </li></ul><ul><ul><li>The best return point, Z , is positively related to trading costs, F , and negatively related to the interest rate K . </li></ul></ul><ul><ul><li>Z and the average cash balance are positively related to the variability of cash flows. </li></ul></ul>
    • 41. Cash Position Management <ul><ul><li>Management of short-term investing if the company has a surplus of funds and borrowing arrangements if company has a temporary deficit of funds </li></ul></ul>Cash position management : collection, concentration, and disbursement of funds on a daily basis Smaller companies set target cash balance for their current (Checking) accounts. Bank account analysis statement <ul><ul><li>Bank provides report to its customers to show recent activity in firms’ accounts. </li></ul></ul><ul><ul><li>Banks cannot pay interest on corporate Current (checking) account balances. </li></ul></ul><ul><ul><li>Firms use earnings credit for balances to offset charges. </li></ul></ul>
    • 42. Collections Primary objective: speeding up collections Collection systems: function of the nature of the business Field-banking system <ul><ul><li>Collections are made over the counter (retail) or at a collection office (utilities). </li></ul></ul>Mail-based system <ul><ul><li>Mail payments are processed at companies’ collection centers. </li></ul></ul>Electronic payments <ul><ul><li>Becoming increasingly popular because they offer advantages to both parties. </li></ul></ul>
    • 43. Collections Perform cost-benefit analysis to determine if lockbox system worth using Lockbox system (USA) <ul><ul><li>Speeds up collections because it affects all components of float. </li></ul></ul><ul><ul><li>Customers mail payments to a post office box. </li></ul></ul><ul><ul><li>Firm’s bank empties the box and processes each payment and deposits the payments in the firm’s account. </li></ul></ul><ul><ul><li>Lockboxes reduce mail and clearing time. </li></ul></ul><ul><ul><li>FVR = float value reduction in dollars </li></ul></ul><ul><ul><li>r a = cost of capital </li></ul></ul><ul><ul><li>LC = annual operating cost of the lockbox system </li></ul></ul>
    • 44. Funds Transfer Mechanisms BACS / Chaps/ Swift transfers <ul><ul><li>Electronic communication that, via bookkeeping entries, removes funds from the payer’s bank and deposits the funds in the payee’s bank. </li></ul></ul><ul><ul><li>Bacs – bankers automated clearing system (4 days) </li></ul></ul><ul><ul><li>Chaps Clearing Houses Automated payment system (Same day transfers) </li></ul></ul><ul><ul><li>Swift – International Payments Mechanism </li></ul></ul>Depository transfer checks (USA) <ul><ul><li>Unsigned check drawn on one of the firm’s bank accounts and deposited in another of the firm’s bank accounts </li></ul></ul>Automated direct debit transfers <ul><ul><li>Preauthorized electronic withdrawal from the payer’s account </li></ul></ul><ul><ul><li>Settle accounts among participating banks. Individual accounts are settled by respective bank balance adjustments. </li></ul></ul><ul><ul><li>Transfers clear in one day. </li></ul></ul>
    • 45. Managing Accounts Payable
    • 46. Accounts Payable Management Management of time from purchase of raw materials until payment is placed in the mail Decide between centralized or decentralized payables and payments systems If supplier offers cash discounts, analyze the best alternative between paying at the end of credit period and taking the discount. Accounts payable functions <ul><ul><li>Examine all incoming invoices and determine the amount to be paid. </li></ul></ul><ul><ul><li>Control function: cash manager verifies that invoice information matches purchase order and receiving information. </li></ul></ul>
    • 47. Disbursements Products and Methods <ul><li>Zero-balance accounts (ZBAs): disbursements accounts that always have end-of-day balance of zero </li></ul><ul><ul><ul><li>Allows the firm to maximize the use of float on each cheque, without altering the float time of its suppliers </li></ul></ul></ul><ul><ul><ul><li>Keeps all cash in interest-bearing accounts </li></ul></ul></ul><ul><li>Controlled disbursement: </li></ul><ul><ul><ul><li>Bank provides early notification of cheque presented against a company’s account every day. </li></ul></ul></ul><ul><li>Positive pay: Company transmits to the bank a cheque-issued file to the bank when cheques are issued. </li></ul><ul><ul><ul><li>Cheque-issued file includes cheque number and amount of each item. </li></ul></ul></ul><ul><ul><ul><li>Used for fraud prevention </li></ul></ul></ul>
    • 48. Developments in Accounts Payable and Disbursements <ul><li>Integrated (comprehensive) accounts payable: </li></ul><ul><ul><li>outsourcing of accounts payable or disbursements operations </li></ul></ul><ul><li>Purchasing/procurement cards: </li></ul><ul><ul><li>increased use of credit cards for low-dollar indirect purchases </li></ul></ul><ul><li>Imaging services: </li></ul><ul><ul><li>Both sides of the cheque, as well as remittance information, is converted into digital images. </li></ul></ul><ul><ul><li>Useful when incorporated with positive pay services </li></ul></ul>
    • 49. Financing Working Capital
    • 50. Sources of Short-term Financing <ul><li>Spontaneous financing </li></ul><ul><ul><li>Accounts payable and accruals </li></ul></ul><ul><li>Unsecured bank loans </li></ul><ul><li>Commercial paper </li></ul><ul><li>Secured loans </li></ul>
    • 51. Spontaneous Financing <ul><li>Accruals </li></ul><ul><ul><li>Money you owe employees, for example, for work performed but for which they have not yet been paid </li></ul></ul><ul><ul><ul><li>Tend to be very short-term </li></ul></ul></ul><ul><li>Accounts payable (AKA trade credit) </li></ul><ul><ul><li>Money you owe suppliers for goods you bought on credit </li></ul></ul><ul><ul><ul><li>Credit Terms: Terms of trade specify when you are to repay the debt </li></ul></ul></ul><ul><ul><ul><ul><li>Example of terms of trade: 2/10, net/30 </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>You must pay the entire amount by 30 days </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>If you pay within 10 days, you will receive a 2% discount </li></ul></ul></ul></ul></ul>
    • 52. Spontaneous Financing <ul><li>The prompt payment discount </li></ul><ul><ul><li>Passing up prompt payment discounts is generally a very expensive source of financing </li></ul></ul>
    • 53. Spontaneous Financing <ul><li>Abuses of Trade Credit Terms </li></ul><ul><ul><li>Trade credit, while originally a service to a firm’s customers, has become so commonplace it is now expected </li></ul></ul><ul><ul><ul><li>Companies offer it because they have to </li></ul></ul></ul><ul><ul><li>Stretching payables is a common abuse of trade credit </li></ul></ul><ul><ul><ul><li>Paying payables beyond the due date (AKA: leaning on the table) </li></ul></ul></ul><ul><ul><ul><li>Slow paying companies receive poor credit ratings in credit reports issued by credit agencies </li></ul></ul></ul>
    • 54. Unsecured Bank Loan <ul><li>Represent the primary source of short-term loans for most companies </li></ul><ul><li>Promissory note (AKA Notes Payable) </li></ul><ul><ul><li>Note signed promising to repay the amount borrowed plus interest </li></ul></ul><ul><ul><ul><li>Bank usually credits the amount to borrower’s checking account </li></ul></ul></ul>
    • 55. Unsecured Bank Loans <ul><li>Line of credit </li></ul><ul><ul><li>Informal, non-binding agreement between bank and firm that specifies the maximum amount firm can borrow over a specific time frame (usually a year) </li></ul></ul><ul><ul><ul><li>Borrower pays interest only on the amount borrowed </li></ul></ul></ul><ul><li>Revolving credit agreement </li></ul><ul><ul><li>Similar to a line of credit except bank guarantees the availability of funds up to a maximum amount (effectively a binding agreement) </li></ul></ul><ul><ul><ul><li>Borrower pays a commitment fee on the unborrowed funds (whether they are used or not) </li></ul></ul></ul>
    • 56. Unsecured Bank Loans <ul><li>Compensating balances </li></ul><ul><ul><li>A minimum amount by which the borrower’s bank account cannot drop below (therefore it is unavailable for use) </li></ul></ul><ul><ul><ul><ul><li>Increases the effective interest rate on a loan </li></ul></ul></ul></ul><ul><ul><li>Typically between 10% and 20% of amounts loaned </li></ul></ul>
    • 57. Unsecured Bank Loans <ul><li>Clean-Up Requirements </li></ul><ul><ul><li>Theoretically a firm can constantly roll-over its short-term debt </li></ul></ul><ul><ul><ul><li>Borrow on a new note to pay off an old note </li></ul></ul></ul><ul><ul><ul><ul><li>Risky for both the firm and the bank </li></ul></ul></ul></ul><ul><ul><li>Banks require that borrowers clean up short-term loans once a year </li></ul></ul><ul><ul><ul><li>Remain out of short-term debt for a certain time period </li></ul></ul></ul>
    • 58. Commercial Paper <ul><li>Notes issued by large, financially-strong firms and sold to investors </li></ul><ul><ul><li>Basically a short-term corporate bond </li></ul></ul><ul><ul><ul><li>Unsecured (usually) </li></ul></ul></ul><ul><ul><ul><li>Buyers are usually other institutions (insurance companies, mutual funds, banks, pension funds) </li></ul></ul></ul><ul><ul><ul><li>Maturity is less than 270 days </li></ul></ul></ul><ul><ul><ul><li>Considered a very safe investment, therefore pays a relatively low interest rate </li></ul></ul></ul><ul><ul><ul><li>Rather than paying a coupon rate, interest is discounted </li></ul></ul></ul><ul><ul><ul><li>Commercial paper market is rigid and formal—no flexibility in repayment terms </li></ul></ul></ul>
    • 59. Short-Term Credit Secured by Current Assets <ul><li>Debt is secured by the current asset being financed </li></ul><ul><li>More popular in some industries than in others </li></ul><ul><ul><li>Common in seasonal businesses </li></ul></ul>
    • 60. Short-Term Credit Secured by Current Assets <ul><li>Receivables Financing: </li></ul><ul><ul><li>Accounts receivable represent money that is to be collected in the near future </li></ul></ul><ul><ul><li>Banks recognize that this money will be collected soon are are willing to lend money based on this soon-to-be-collected money </li></ul></ul><ul><ul><ul><li>Invoice discounting: firm sells AR to lender but retains control of control of the accounts </li></ul></ul></ul><ul><ul><ul><ul><li>AR are now paid directly to lender to a specified account </li></ul></ul></ul></ul><ul><ul><ul><li>Factoring AR: firm sells AR to lender (at a) and the lending firm (factor) takes control of the accounts </li></ul></ul></ul><ul><ul><ul><ul><li>AR are now paid directly to lender </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Lender assumes responsibility for credit control & collection </li></ul></ul></ul></ul>
    • 61. Short-Term Credit Secured by Current Assets <ul><li>Pledging Accounts Receivable (US Variant of Invoice Discounting) </li></ul><ul><ul><li>Firm promises to use the money paid from the collected accounts to pay off bank loan </li></ul></ul><ul><ul><li>Accounts Receivable still belong to firm which still collects the accounts </li></ul></ul><ul><ul><ul><li>If firm doesn’t repay, lender has recourse to borrower </li></ul></ul></ul><ul><ul><li>Lender can provide </li></ul></ul><ul><ul><ul><li>General line of credit tied to all receivables </li></ul></ul></ul><ul><ul><ul><ul><li>Lender likely to advance at most 75% of the balance of accounts </li></ul></ul></ul></ul><ul><ul><ul><li>Specific line of credit tied to individual accounts receivable </li></ul></ul></ul><ul><ul><ul><ul><li>Evaluates based on creditworthiness of account </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Lender likely to advance as much as 90% of the balance of accepted accounts </li></ul></ul></ul></ul></ul>
    • 62. Short-Term Credit Secured by Current Assets <ul><li>Factoring Accounts Receivable </li></ul><ul><ul><li>Firm sells Accounts Receivable to lender (at a severe discount) and the lending firm (factor) takes control of the accounts </li></ul></ul><ul><ul><ul><li>Accounts Receivable are now paid directly to lender </li></ul></ul></ul><ul><ul><li>Factor usually reviews accounts and only accepts accounts it deems creditworthy </li></ul></ul><ul><ul><li>Factors offer a wide range of services </li></ul></ul><ul><ul><ul><li>Perform credit checks on potential customers </li></ul></ul></ul><ul><ul><ul><li>Advance cash on accounts it accepts or remit cash after collection </li></ul></ul></ul><ul><ul><ul><li>Collect cash from customers </li></ul></ul></ul><ul><ul><ul><li>Assume the bad-debt risk when customers don’t pay </li></ul></ul></ul>
    • 63. Short-Term Credit Secured by Current Assets <ul><li>Inventory Financing (Common in USA) </li></ul><ul><ul><li>Use a firm’s inventory as collateral for a short-term loan </li></ul></ul><ul><ul><li>Popular but subject to a number of problems </li></ul></ul><ul><ul><ul><li>Lenders aren’t usually equipped to sell inventory </li></ul></ul></ul><ul><ul><ul><li>Specialized inventories and perishable goods are difficult to market </li></ul></ul></ul><ul><ul><li>Types of methods used </li></ul></ul><ul><ul><ul><li>Blanket liens—lender has a lien (claim) against all inventories of the borrower but borrower remains in physical control of inventory </li></ul></ul></ul><ul><ul><ul><li>Chattel mortgage agreement—collateralized inventory is identified by serial number and can’t be sold without lender’s permission (but borrower remains in physical control of inventory) </li></ul></ul></ul><ul><ul><ul><li>Warehousing—collateralized inventory is removed from borrower’s premises and placed in a warehouse (borrower’s access controlled by third party) </li></ul></ul></ul>
    • 64. Short-Term Financial Management <ul><li>Length of cash conversion cycle determines the amount of resources the firm must invest in its operations. </li></ul><ul><li>Cost trade-offs apply to managing cash and marketable securities, accounts receivable, inventory and accounts payable. </li></ul><ul><li>Objective for account receivable: </li></ul><ul><ul><li>collect accounts as quickly as possible without losing sales. </li></ul></ul><ul><li>Objective for accounts payable: </li></ul><ul><ul><li>pay accounts as slowly as possible without damaging firm’s credit. </li></ul></ul><ul><li>Working Capital Finance Principle is to Match Length of Finance with Asset </li></ul>

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