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    1. 1. CHAPTER 20 Working Capital Management <ul><li>Working Capital Definitions and Policies </li></ul><ul><li>Cash Management </li></ul><ul><li>Inventory Management </li></ul><ul><li>Credit Management </li></ul><ul><li>Short-Term Financing </li></ul><ul><ul><li>Trade Credit </li></ul></ul><ul><ul><li>Bank Debt and Commercial Paper </li></ul></ul><ul><ul><li>Secured Loans </li></ul></ul>
    2. 2. Basic Definitions <ul><li>Gross working capital: </li></ul><ul><li>Total current assets. </li></ul><ul><li>Net working capital: </li></ul><ul><li>Current assets - Current liabilities. </li></ul><ul><li>Net operating working capital (NOWC): </li></ul><ul><li>Operating CA – Operating CL = </li></ul><ul><li>(Cash + Inv. + A/R) – (Accruals + A/P) </li></ul>(More…)
    3. 3. <ul><li>Working capital management: </li></ul><ul><li>Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable. </li></ul><ul><li>Working capital policy: </li></ul><ul><ul><li>The level of each current asset. </li></ul></ul><ul><ul><li>How current assets are financed </li></ul></ul>Please meet Danny the Banker.
    4. 4. Selected Ratios for SKI <ul><li>SKI Industry </li></ul><ul><li>Current 1.75x 2.25x </li></ul><ul><li>Quick 0.83x 1.20x </li></ul><ul><li>Debt/Assets 58.76% 50.00% </li></ul><ul><li>Turnover of cash 16.67x 22.22x </li></ul><ul><li>DSO (365-day basis) 45.63 32.00 </li></ul><ul><li>Inv. turnover 4.82x 7.00x </li></ul><ul><li>F. A. turnover 11.35x 12.00x </li></ul><ul><li>T. A. turnover 2.08x 3.00x </li></ul><ul><li>Profit margin 2.07% 3.50% </li></ul><ul><li>ROE 10.45% 21.00% </li></ul><ul><li>Payables deferral 30.00 33.00 </li></ul>
    5. 5. How does SKI’s working capital policy compare with the industry? <ul><li>Working capital policy is reflected in a firm’s current ratio, quick ratio, turnover of cash and securities, inventory turnover, and DSO. </li></ul><ul><li>These ratios indicate SKI has large amounts of working capital relative to its level of sales. Thus, SKI is following a relaxed policy . </li></ul>
    6. 6. Alternative Current Asset Investment Policies Current Assets ($) Sales ($) Restricted Moderate Relaxed
    7. 7. Is SKI inefficient or just conservative? <ul><li>A relaxed policy may be appropriate if it reduces risk more than profitability. </li></ul><ul><li>However, SKI is much less profitable than the average firm in the industry. This suggests that the company probably has excessive working capital. </li></ul>
    8. 8. <ul><li>The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales: </li></ul><ul><li>Cash Inventory Receivables Payables </li></ul><ul><li>conversion = conversion + collection - deferral . </li></ul><ul><li>cycle period period period </li></ul><ul><li>What does the cash conversion cycle tell us about working capital management? </li></ul>Cash Conversion Cycle
    9. 9. Cash Conversion Cycle (Cont.) CCC = + – CCC = + 45.6 – 30 CCC = 75.7 + 45.6 – 30 CCC = 91.3 days. Days per year Inv. turnover Payables deferral period Days sales outstanding 365 4.82
    10. 10. Shortening the Cash Conversion Cycle <ul><li>Reduce the Inventory Conversion Period by processing and selling goods more quickly </li></ul><ul><li>Reduce the Receivables Collection Period by speeding up collections </li></ul><ul><li>Lengthening the Payables Deferral Period by slowing down the firm’s own payments </li></ul>
    11. 11. Cash Management: Cash doesn’t earn interest, so why hold it? <ul><li>Transactions: Must have some cash to pay current bills. </li></ul><ul><li>Precaution: “Safety stock.” But lessened by credit line and marketable securities. </li></ul><ul><li>Speculation: To take advantage of bargains, to take discounts, and so on. Reduced by credit line, marketable securities. </li></ul><ul><li>Compensating balances: For loans and/or services provided. But, Fee-Based Systems are rapidly replacing compensating balances. </li></ul>
    12. 12. What is the goal of cash management? <ul><li>To reduce cash held to the minimum necessary to conduct business, yet maintain sufficient cash balances to: </li></ul><ul><ul><li>Make timely payments, </li></ul></ul><ul><ul><li>Take trade discounts, </li></ul></ul><ul><ul><li>Maintain firm’s credit rating, and </li></ul></ul><ul><ul><li>Meet unexpected cash needs. </li></ul></ul><ul><li>However, since cash is a non-earning asset , the goal is to have not one dollar more than necessary. </li></ul><ul><li>The Internet and telecommunications technology have dramatically affected cash management. </li></ul>
    13. 13. What are “precautionary” and “speculative” balances? <ul><li>Precautionary balances: Cash reserves for unforeseen inflow/outflow fluctuations. </li></ul><ul><li>Speculative balances: Cash held for possible bargain purchases. </li></ul><ul><li>Both are better met with borrowing capacity and/or liquid securities. </li></ul>
    14. 14. Finance 402 Two Internet Addresses for Cash Management Techniques <ul><li>Bank of America </li></ul><ul><ul><li> </li></ul></ul><ul><li>Wachovia </li></ul><ul><ul><li>http://www. wachovia .com/ corp _inst </li></ul></ul>
    15. 15. Ways to Minimize Cash Holdings <ul><li>Use lockboxes . </li></ul><ul><li>Insist on wire transfers from customers. </li></ul><ul><li>Synchronize inflows and outflows. </li></ul><ul><li>Use a remote disbursement account. </li></ul>(More…)
    16. 16. <ul><li>Increase forecast accuracy to reduce the need for a cash “safety stock.” </li></ul><ul><li>Hold marketable securities instead of a cash “safety stock.” </li></ul><ul><li>Negotiate a line of credit (also reduces need for a “safety stock”). </li></ul>
    17. 17. How can a firm “synchronize” its cash flows and what good would this do? <ul><li>Synchronize cash flows by arranging to bill customers and pay bills on regular “billing cycles” throughout the month. </li></ul><ul><li>Synchronized cash flows reduce the need for cash balances and required bank loans, thus lower interest expense and boost profits. </li></ul>
    18. 18. Define disbursement float, collections float, and net float. <ul><li>Float: The difference between the balance shown in a firm’s checkbook and the balance on the bank’s books. </li></ul><ul><ul><li>“Red Book” Balances </li></ul></ul><ul><li>Disbursement float: Amount of funds tied up in checks the firm has written but which the bank has not yet deducted from its checking account balance. (More...) </li></ul>
    19. 19. <ul><li>Collections float: The time it takes a firm to deposit checks it has received and for the bank to process them and credit the firm’s account with “good” funds. </li></ul><ul><ul><li>Ledger Balances vs. Available Balances </li></ul></ul><ul><li>Net float = positive disbursement float (Good) – negative collections float (Bad) </li></ul>
    20. 20. What is float and how can it be affected by cash management? <ul><li>Float is the difference between the balance shown on the firm’s books and the balance on its bank’s records. </li></ul><ul><li>If it takes SKI 1 day to deposit checks it receives and it takes its bank another day to clear those checks, SKI has 2 days of collections float. </li></ul>
    21. 21. <ul><li>If it takes 6 days for the checks that SKI writes to clear and be deducted from SKI’s account, SKI has 6 days of disbursement float. </li></ul><ul><li>SKI’s net float is the difference between the disbursement float and the collections float: </li></ul><ul><li>Net float = 6 days - 2 days = 4 days . </li></ul><ul><li>If SKI wrote and received $1 million of checks per day, it would be able to operate with $4 million less working capital than if it had zero net float. </li></ul>
    22. 22. Components of Float <ul><li>Mail-Time Float </li></ul><ul><li>Processing Float </li></ul><ul><li>Clearing or Availability Float </li></ul>
    23. 23. Techniques to Accelerate Inflows <ul><li>Lock Box System - Post Office Box </li></ul><ul><ul><li>Retail - Large Number of Consumers </li></ul></ul><ul><ul><li>Wholesale - Typically Businesses </li></ul></ul><ul><li>Automatic Debit - Automated Clearing House (ACH) Debits (Preauthorized) </li></ul><ul><ul><li>e.g. Utilities debit users on a monthly basis </li></ul></ul><ul><li>Payment by Wires </li></ul><ul><li>Field System </li></ul><ul><li>Concentration Banking </li></ul>
    24. 24. Funds transfer tools between banks are used to accelerate inflows <ul><li>Electronic (ACH) depository transfer. Uses data files to transfer funds. One Day Clearing. </li></ul><ul><li>Wires. The concentration bank instructs the field bank to initiate a wire transfer. </li></ul>
    25. 25. Techniques to Manage Disbursements <ul><li>Payables Centralization </li></ul><ul><li>Internet Disbursement </li></ul><ul><li>Controlled Disbursement Accounts </li></ul><ul><ul><li>Formerly Remote Disbursement </li></ul></ul><ul><li>Zero-Balance Accounts </li></ul><ul><ul><li>Money is moved from the Master Account to the Subsidiary Account to “zero” it out. </li></ul></ul><ul><ul><li>Breakdown by type of account and division </li></ul></ul><ul><li>Payable Through Drafts </li></ul><ul><ul><li>An order to pay, but not payable on demand </li></ul></ul>
    26. 26. Additional Disbursement Techniques <ul><li>Automated Clearing House (ACH) Credits </li></ul><ul><ul><li>e. g. Direct Deposit of Payroll </li></ul></ul><ul><ul><li>GM automatically wires funds on 13th day to regular suppliers; no float but GM gets discounts (2/10, n/30). </li></ul></ul><ul><li>With lower interest rates, emphasis has shifted to increased information benefits, ethical behavior, and decreased administrative costs. </li></ul>
    27. 27. Account Analysis <ul><li>Bank Provides Monthly: </li></ul><ul><ul><li>Summary of the Charges for Services Used </li></ul></ul><ul><ul><li>Analysis of the Balances Maintained </li></ul></ul><ul><ul><li>Credits “Earned” on the Balances </li></ul></ul>
    28. 28. Why would a firm hold low- yielding marketable securities ? <ul><li>Substitute for cash balances </li></ul><ul><ul><li>Reduces risk and transactions costs </li></ul></ul><ul><ul><li>Available for “bargain purchases” </li></ul></ul><ul><li>Temporary investment resulting from: </li></ul><ul><ul><li>Seasonal or cyclical operations. </li></ul></ul><ul><ul><li>Need to meet some unknown financial requirement. </li></ul></ul><ul><ul><li>Firm has just sold long-term assets. </li></ul></ul>
    29. 29. What factors should a firm consider when building its marketable securities portfolio? <ul><li>Default risk (safety first) </li></ul><ul><li>Interest rate (price) risk </li></ul><ul><li>Purchasing power (inflation) risk </li></ul><ul><li>Liquidity and marketability risk </li></ul><ul><li>Returns on securities (yield) </li></ul><ul><li>Taxability </li></ul><ul><li>When it might need funds </li></ul><ul><li>Alternatively negotiate a line of credit </li></ul>
    30. 30. Securities suitable to hold as liquid reserves: <ul><li>U.S. Treasury bills </li></ul><ul><li>Commercial paper </li></ul><ul><li>Negotiable CDs </li></ul><ul><li>Money market mutual funds </li></ul><ul><li>Eurodollar market time deposits </li></ul>
    31. 31. Securities not suitable to hold as liquid reserves: <ul><li>Speculative derivatives </li></ul><ul><li>U.S. Treasury notes, bonds </li></ul><ul><li>Corporate bonds </li></ul><ul><li>State and local government bonds </li></ul><ul><li>Preferred stocks </li></ul><ul><li>Common stocks </li></ul>
    32. 32. Cash Budget: The Primary Cash Management Tool <ul><li>Purpose: Uses forecasts of cash inflows, outflows, and ending cash balances to predict loan needs and funds available for temporary investment. </li></ul><ul><li>Timing: Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management. </li></ul>
    33. 33. Data Required for Cash Budget <ul><li>1. Sales forecast. </li></ul><ul><li>2. Information on collections delay. </li></ul><ul><li>3. Forecast of purchases and payment terms. </li></ul><ul><li>4. Forecast of cash expenses: wages, taxes, utilities, and so on. </li></ul><ul><li>5. Initial cash on hand. </li></ul><ul><li>Target cash balance. </li></ul><ul><li>Interest rate on outstanding loans </li></ul>
    34. 34. SKI’s Cash Budget for January and February Net Cash Inflows January February Collections $67,651.95 $62,755.40 Purchases 44,603.75 36,472.65 Wages 6,690.56 5,470.90 Rent 2,500.00 2,500.00 Total payments $53,794.31 $44,443.55 Net CF $13,857.64 $18,311.85
    35. 35. Cash Budget (Continued) January February Cash at start if no borrowing $ 3,000.00 $16,857.64 Net CF (slide 34) 13,857.64 18,311.85 Cumulative cash $16,857.64 $35,169.49 Less: target cash 1,500.00 1,500.00 Surplus $15,357.64 $33,669.49
    36. 36. Should depreciation be explicitly included in the cash budget? <ul><li>No. Depreciation is a noncash charge. Only cash payments and receipts appear in the cash budget. </li></ul><ul><li>However, depreciation does affect taxes , which do appear in the cash budget. </li></ul>
    37. 37. What are some other potential cash inflows besides collections? <ul><li>Proceeds from fixed asset sales . </li></ul><ul><li>Proceeds from stock and bond sales. </li></ul><ul><li>Interest earned. </li></ul><ul><li>Court settlements . </li></ul>
    38. 38. How can interest earned or paid on short-term securities or loans be incorporated in the cash budget? <ul><li>Interest earned : Add line in the collections section. </li></ul><ul><li>Interest paid : Add line in the payments section. </li></ul><ul><li>Found as interest rate x surplus/loan line of cash budget for preceding month. </li></ul><ul><li>Note: Interest on any other debt would need to be incorporated as well. </li></ul><ul><li>Use Spreadsheet systems such as EXCEL. </li></ul>
    39. 39. How could bad debts be worked into the cash budget? <ul><li>Collections would be reduced by the amount of bad debt losses. </li></ul><ul><li>For example, if the firm had 3% bad debt losses, collections would total only 97% of sales. </li></ul><ul><li>Lower collections would lead to lower surpluses and higher borrowing requirements. </li></ul>
    40. 40. SKI’s forecasted cash budget indicates that the company’s cash holdings will exceed the targeted cash balance every month, except for October and November. <ul><li>Cash budget indicates the company probably might be holding too much cash. </li></ul><ul><li>SKI could improve its EVA by either investing its excess cash in more productive assets or by paying it out to the firm’s shareholders. </li></ul>
    41. 41. What reasons might SKI have for maintaining a relatively high amount of cash? <ul><li>If sales turn out to be considerably less than expected, SKI could face a cash shortfall. </li></ul><ul><li>A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative. </li></ul><ul><li>The cash may be there, in part, to fund a planned fixed asset acquisition. </li></ul>
    42. 42. Inventory Management: Categories of Inventory Costs <ul><li>Carrying Costs : Cost of Capital tied up, storage and handling costs, insurance, property taxes, depreciation, and obsolescence. </li></ul><ul><li>Ordering Costs : Cost of placing orders, shipping, and handling costs. Supply Chain Management. </li></ul><ul><li>Costs of Running Short : Loss of sales (from stockouts), loss of customer goodwill, and the disruption of production schedules. </li></ul>
    43. 43. Effect of Inventory Size on Costs <ul><li>Reducing the average amount of inventory held generally: </li></ul><ul><li>Reduces carrying costs. </li></ul><ul><li>Increases ordering costs. </li></ul><ul><li>Increases probability of a stockout. </li></ul><ul><ul><li>Air freight was stopped for a week or so after September 11, 2001 </li></ul></ul><ul><ul><li>Effects of hurricanes </li></ul></ul>
    44. 44. Is SKI holding too much inventory? <ul><li>SKI’s inventory turnover ( 4.82 ) is considerably lower than the industry average ( 7.00 ). The firm is carrying a lot of inventory per dollar of sales. </li></ul><ul><li>By holding excessive inventory, the firm is increasing its operating costs which reduces its NOPAT. Moreover, the excess inventory must be financed, so EVA is further lowered. </li></ul>
    45. 45. If SKI reduces its inventory, without adversely affecting sales, what effect will this have on its cash position? <ul><li>Short run : Cash will increase as inventory purchases decline. </li></ul><ul><li>Long run : Company is likely to then take steps to reduce its cash holdings. </li></ul>
    46. 46. Inventory Control Systems <ul><li>Computerized Inventory Control Systems </li></ul><ul><li>Supply Chain Management </li></ul><ul><li>Just-In-Time (JIT) Systems </li></ul><ul><li>“Out-Sourcing” </li></ul><ul><li>Relationship between production scheduling and inventory levels </li></ul><ul><li>This topic will be discussed further in Chapter 22. </li></ul>
    47. 47. Accounts Receivable Management: Do SKI’s customers pay more or less promptly than those of its competitors? <ul><li>SKI’s days’ sales outstanding (DSO) of 45.6 days is well above the industry average ( 32 days ). </li></ul><ul><li>SKI’s customers apparently are paying less promptly. </li></ul><ul><li>SKI should consider tightening its credit policy to reduce its DSO. </li></ul>
    48. 48. Does SKI face any risk if it tightens its credit policy? YES! A tighter credit policy may discourage sales. Some customers may choose to go elsewhere if they are pressured to pay their bills sooner.
    49. 49. If SKI succeeds in reducing DSO without adversely affecting sales, what effect would this have on its cash position? <ul><li>Short run : if customers pay sooner, this increases cash holdings. </li></ul><ul><li>Long run : over time, the company would hopefully invest the cash in more productive assets, or pay it out to shareholders. Both of these actions would increase EVA. </li></ul>
    50. 50. Credit Management <ul><li>What terms of credit should the firm use? </li></ul><ul><li>To whom should the firm grant credit? </li></ul>
    51. 51. Amount of Credit Outstanding <ul><li>The amount of Credit Outstanding at any given time is dependent on two factors: </li></ul><ul><ul><li>The volume of credit sales </li></ul></ul><ul><ul><li>The average length of time between sales and collections </li></ul></ul>
    52. 52. Monitoring Accounts Receivable <ul><li>Days Sales Outstanding (DSO) or Average Collection Period (ACP) </li></ul><ul><li>Aging Schedules </li></ul>
    53. 53. Monitoring A/R and Seasonal Fluctuations <ul><li>A seasonal increase in sales will increase the numerator more than the denominator, and will raise the DSO </li></ul><ul><ul><li>Thus the DSO will look “worse,” but nothing has happened </li></ul></ul><ul><li>A seasonal increase in sales will increase the amount of A/R that are less than 30 days outstanding </li></ul><ul><ul><li>The Aging Schedule will look “better,” but nothing has happened </li></ul></ul><ul><li>This topic will also be covered in Chapter 21. </li></ul>
    54. 54. <ul><li>Cash discounts </li></ul><ul><li>Credit period </li></ul><ul><li>Credit standards </li></ul><ul><li>Collection policy </li></ul><ul><li>Size of credit line </li></ul>What five variables make up a firm’s credit policy?
    55. 55. Elements of Credit Policy <ul><li>Cash Discounts : Lowers price. Attracts new customers and reduces DSO. </li></ul><ul><li>Credit Period : How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. </li></ul>(More…)
    56. 56. <ul><li>Credit Standards : Tighter standards reduce bad debt losses, but may reduce sales. Fewer bad debts reduces DSO. </li></ul><ul><li>Collection Policy : Tougher policy will reduce DSO, but may damage customer relationships. </li></ul><ul><li>Credit Line : The firm determines the size of the line of credit extended to a particular customer. </li></ul>
    57. 57. Credit Terms <ul><li>Discounts </li></ul><ul><ul><li>For example, 2/10... </li></ul></ul><ul><li>Credit Period </li></ul><ul><ul><li>For example, n/30; or n/30 EOM </li></ul></ul><ul><ul><li>Seasonal Dating, for example n/30, July 1st </li></ul></ul><ul><ul><ul><li>Promotes Sales </li></ul></ul></ul><ul><ul><ul><li>Reduces Inventory </li></ul></ul></ul><ul><ul><ul><li>Smoothes Production </li></ul></ul></ul><ul><ul><ul><li>Transfers Risk of Obsolescence </li></ul></ul></ul><ul><ul><ul><li>Might offer Anticipation Discount </li></ul></ul></ul><ul><ul><ul><li>Covered more fully in Chapter 21 </li></ul></ul></ul>
    58. 58. The six “Cs” of Credit Extension and Standards <ul><li>Character </li></ul><ul><li>Capital </li></ul><ul><li>Collateral </li></ul><ul><li>Capacity </li></ul><ul><li>Conditions </li></ul><ul><li>Country </li></ul>
    59. 59. Credit Standards <ul><li>Might use Dun & Bradstreet ratings: </li></ul><ul><ul><li>1 = excellent </li></ul></ul><ul><ul><li>2 = good </li></ul></ul><ul><ul><li>3 = fair </li></ul></ul><ul><ul><li>4 = limited </li></ul></ul><ul><li>Credit Scoring Systems </li></ul><ul><ul><li>Multiple Discriminant Analysis (MDA) </li></ul></ul><ul><li>Judgmental Scoring Systems </li></ul>
    60. 60. Sources of Credit Information <ul><li>The Seller’s Prior Experience </li></ul><ul><li>Credit Associations </li></ul><ul><ul><li>Credit Interchange </li></ul></ul><ul><li>Credit Rating Agencies </li></ul><ul><ul><li>Dun & Bradstreet </li></ul></ul><ul><ul><li>Equifax </li></ul></ul><ul><ul><li>Experian </li></ul></ul><ul><ul><li>Trans Union </li></ul></ul><ul><ul><li>Fair Isaac </li></ul></ul><ul><li>Analysis of Customer’s Financial Statements </li></ul><ul><li>Customer Visit </li></ul>
    61. 61. Credit Investigation Proceed Sequentially in examining credit worthiness and making the credit decision. Begin with the least costly and time consuming method. Then ask, is it worth it to continue further? Use of computers in Relational Data Bases and Data Warehouses.
    62. 62. Collection Policy <ul><li>Procedures the firm uses to collect past-due accounts </li></ul><ul><ul><li>Charges for late payments </li></ul></ul><ul><ul><li>Letters </li></ul></ul><ul><ul><li>Phone calls </li></ul></ul><ul><ul><li>Legal action </li></ul></ul>
    63. 63. If a firm has no bad debts, does that mean that the credit manager is doing a good job? <ul><li>No! The credit policy may be too restrictive, and the firm may be losing sales, profits and stockholder wealth. </li></ul>
    64. 64. Size of Credit Line <ul><li>A key option is that the seller may grant a limited amount of credit, called a credit line or credit limit. </li></ul><ul><li>Possible reasons for this limit: </li></ul><ul><ul><li>Limits are not as enforced as rejection </li></ul></ul><ul><ul><li>Increases in production costs </li></ul></ul><ul><ul><li>Funds Constraints </li></ul></ul>
    65. 65. Working Capital Financing Policies <ul><li>Moderate : matches the maturity of the assets with the maturity of the financing. </li></ul><ul><ul><li>Self-liquidating approach </li></ul></ul><ul><li>Aggressive : uses short-term (temporary) capital to finance some permanent assets. </li></ul><ul><li>Conservative : uses long-term (permanent) capital to finance some temporary assets. </li></ul>
    66. 66. <ul><li>The choice of working capital financing policy is a classic risk/return tradeoff. </li></ul><ul><li>The aggressive policy promises the highest return but carries the greatest risk. </li></ul><ul><li>The conservative policy has the least risk but also the lowest expected return. </li></ul><ul><li>The moderate (maturity matching) policy falls between the two extremes. </li></ul>
    67. 67. Moderate Financing Policy Years $ Perm NOWC Fixed Assets Temp. NOWC What are “permanent” current assets? S-T Debt (Temporary) L-T Fin: Stock, Bonds, Spon. C.L. (Permanent)
    68. 68. Relatively Aggressive Financing Policy Years $ Perm NOWC Fixed Assets Temp. NOWC More aggressive the lower the dashed line. S-T (temporary) Debt L-T Fin: Stock, Bonds, Spon. C.L.
    69. 69. Conservative Financing Policy Fixed Assets Years $ Perm NOWC L-T Fin: Stock, Bonds, Spon. C.L. Marketable Securities S-T Financing Requirements
    70. 70. What Is Short-term Credit? What Are the Major Sources? <ul><li>Short-term credit : Debt requiring repayment within one year. </li></ul><ul><li>Major sources : </li></ul><ul><ul><li>Accruals </li></ul></ul><ul><ul><li>Accounts payable (trade credit) </li></ul></ul><ul><ul><li>Commercial paper </li></ul></ul><ul><ul><li>Bank loans </li></ul></ul><ul><ul><ul><li>Unsecured Loans </li></ul></ul></ul><ul><ul><ul><li>Secured Loans - Accounts Receivable </li></ul></ul></ul><ul><ul><ul><li>Secured Loans - Inventory </li></ul></ul></ul>
    71. 71. Choosing a Source of Short Term Financing <ul><li>Cost </li></ul><ul><ul><li>Annual Percentage Rate </li></ul></ul><ul><ul><li>Effective Annual Rate (Compounded Rate) </li></ul></ul><ul><li>Impact on credit rating </li></ul><ul><li>Reliability </li></ul><ul><li>Restrictions </li></ul><ul><ul><li>Degree to which assets are encumbered </li></ul></ul><ul><li>Flexibility </li></ul><ul><li>Availability </li></ul>
    72. 72. What are the advantages of short-term debt vs. long-term debt? <ul><li>Lower cost-- yield curve usually slopes upward. </li></ul><ul><li>Can get funds relatively quickly with lower flotation costs. </li></ul><ul><li>Repayment penalties can be expensive for long-term debt </li></ul><ul><li>Long-term debt typically contain more restrictive covenants. </li></ul>
    73. 73. What are the disadvantages of short-term debt vs. long-term debt? <ul><li>Short-term debt is riskier than long-term debt for the borrower. </li></ul><ul><ul><li>The required repayment comes quicker. </li></ul></ul><ul><ul><li>May have trouble rolling debt over . </li></ul></ul><ul><li>Short-term rates may rise </li></ul><ul><ul><li>With long-term debt, interest rates will be relatively stable over time. </li></ul></ul>
    74. 74. Is There a Cost to Accruals, and Do Firms Have Much Control Over Them? <ul><li>Accruals increase automatically as a firm’s operations expand. </li></ul><ul><li>Accruals are “free” in the sense that no explicit interest is charged. </li></ul><ul><li>A firm has little control over the level of accruals, They are influenced more by industry custom, economic factors, and tax laws than by managerial actions. </li></ul><ul><li>Spontaneous source of funds. </li></ul>
    75. 75. What Is Trade Credit? <ul><li>Trade credit is credit furnished by a firm’s suppliers . </li></ul><ul><li>Trade credit is often the largest source of short-term credit for small firms. </li></ul><ul><li>Trade credit is spontaneous and relatively easy to get , but the cost can be high . </li></ul>
    76. 76. Advantages of Trade Credit <ul><li>Flexible in amount </li></ul><ul><li>Informal - no restrictions placed on the user </li></ul><ul><li>Very convenient and easy to obtain </li></ul><ul><li>Easy for the small firm to obtain </li></ul>
    77. 77. Disadvantages of Trade Credit <ul><li>Limited in amount </li></ul><ul><li>Not a direct source to pay other bills </li></ul><ul><li>Can affect credit rating </li></ul><ul><ul><li>“ Stretching” accounts payable </li></ul></ul><ul><ul><ul><li>Pay beyond the due date - </li></ul></ul></ul>
    78. 78. SKI buys $506,985 net, on terms of 1/10, net 30, and pays on Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit? <ul><li>Net daily purchases = $506,985/365 </li></ul><ul><li>= $1,389. </li></ul><ul><li>Annual gross purch. = $506,985/(1-0.01) </li></ul><ul><li> =$512,106 </li></ul>
    79. 79. Gross/Net Breakdown <ul><li>Company buys goods worth $506,985. That’s the cash price. </li></ul><ul><li>They must pay $5,121 more if they don’t take discounts. </li></ul><ul><li>Think of the extra $5,121 as a financing cost similar to the interest on a loan. </li></ul><ul><li>Want to compare that cost with the cost of a bank loan. </li></ul>
    80. 80. Payables level if take discount: Payables = $1,389(10) = $13,890. Payables level if don’t take discount: Payables = $1,389(40) = $55,560. Credit Breakdown: Total trade credit = $55,560 Free trade credit = 13,890 Costly trade credit = $41,670
    81. 81. Finance 402 Nominal [Annual Percentage Rate (APR)] Cost of Costly Trade Credit But the $5,121 is paid all during the year, not at year-end, so Effective Annual Rate (EAR) rate is higher. Record purchases on books as net purchases and discounts lost as an interest expense. Firm loses 0.01($512,106) = $5,121 of discounts to obtain $41,670 in extra trade credit, so r Nom = = 0.1229 = 12.29%. $5,121 $41,670
    82. 82. Finance 402 Nominal (APR) Cost Formula, 1/10, net 40 Pays 1.01% 12.167 times per year.
    83. 83. Effective Annual Rate (EAR), 1/10, net 40 Periodic rate = 0.01/0.99 = 1.01%. Periods/year = 365/(40 – 10) = 12.1667. EAR = (1 + Periodic rate) n – 1.0 = (1.0101) 12.1667 – 1.0 = 13.01%. Normally, it is cheaper to borrow the money from the bank and take discounts.
    84. 84. “ Stretching” Accounts Payable <ul><li>Effect on credit rating - reputation as a “slow payer” </li></ul><ul><li>Suppliers start requiring the firm to pay cash </li></ul><ul><li>Late payment penalties </li></ul>
    85. 85. Choosing a Bank (Negotiated Source of Funds) <ul><li>Willingness to assume risks </li></ul><ul><li>Advise and counsel </li></ul><ul><li>Loyalty to customers </li></ul><ul><li>Maximum loan size </li></ul><ul><li>Specialization </li></ul><ul><li>Merchant Banking capabilities </li></ul><ul><li>Other Services </li></ul><ul><ul><li>Technology and telecommunications </li></ul></ul><ul><li>Discussed in Chapter 21 </li></ul>
    86. 86. Bank Short Term Credit Forms <ul><li>A Line of Credit is a informal or formal understanding between the bank and the borrower indicating the maximum credit the bank will extend to the borrower. </li></ul><ul><ul><li>One year or less </li></ul></ul><ul><ul><li>Can be tied to LIBOR, Prime, Fed Funds Rate </li></ul></ul><ul><ul><li>Often includes a “cleanup provision” </li></ul></ul>more
    87. 87. Bank Short Term Credit Forms - continued <ul><li>A Revolving Credit Agreement (“Revolver”) is a formal (legal) arrangement often used by large firms. </li></ul><ul><ul><li>Can be more than one year , e. g. three years. </li></ul></ul><ul><ul><li>Usually calls for a commitment fee. </li></ul></ul><ul><li>We will calculate the APR and EAR of bank loans in Chapter 21. </li></ul>
    88. 88. Promissory Note <ul><li>Negotiated source of funds </li></ul><ul><li>Amount borrowed </li></ul><ul><li>Percentage interest rate </li></ul><ul><li>Repayment schedule </li></ul><ul><ul><li>Series of Installments </li></ul></ul><ul><ul><li>or Lump sum </li></ul></ul><ul><li>Collateral specified as security </li></ul><ul><li>Other terms and conditions </li></ul><ul><ul><li>Typically 90 days and renewable </li></ul></ul>
    89. 89. Commercial Paper <ul><li>A type of unsecured (normally), discounted, large denomination, promissory note, typically issued by large, strong firms (Net Worth>$100 million) </li></ul><ul><ul><li>Sold to other business firms, money market funds, pension funds, foundations, wealthy individuals, and insurance companies </li></ul></ul><ul><ul><li>Maturities vary from one to nine months </li></ul></ul><ul><ul><li>Can be asset-backed </li></ul></ul><ul><li>Direct Placement vs. Dealer Placement </li></ul><ul><li>Rated by Moody’s, Standard & Poors, Fitch’s </li></ul>
    90. 90. Advantages of Commercial Paper <ul><li>Cheaper, as the effective interest rate is typically less than the prime rate </li></ul><ul><li>Size of market available is large </li></ul><ul><li>Medium-sized firms may use bank guarantees and enter the market </li></ul>
    91. 91. Disadvantages of Commercial Paper <ul><li>Impersonal market </li></ul><ul><li>Dealers prefer to handle the paper of firms where borrowings are $10 million or more </li></ul><ul><li>Can’t pay off prior to maturity </li></ul><ul><li>270 day maximum maturity </li></ul><ul><li>100% credit line needed to back up commercial paper in most cases </li></ul><ul><li>Amount of funds in market may be limited </li></ul>
    92. 92. Commercial Paper (CP) <ul><li>Short term notes issued by large, strong companies. SKI couldn’t issue CP--it’s too small. </li></ul><ul><li>CP trades in the market at rates just above T-bill rate. </li></ul><ul><li>CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes. </li></ul>
    93. 93. What Is a Secured Loan? <ul><li>In a secured loan, the borrower pledges assets as collateral for the loan. </li></ul><ul><li>For short-term loans, the most commonly pledged assets are receivables and inventories. </li></ul><ul><li>Securities are great collateral, but firms needing short-term loans generally do not have securities on hand . </li></ul>
    94. 94. Important Legal Forms <ul><li>UCC form-1 : filed with Secretary of State to establish collateral claim. Prospective lenders will do a claims search, and won’t make the loan if a prior UCC-1 has been filed. </li></ul><ul><li>Security Agreement : standard form under the Uniform Commercial Code . Specifies when lender can claim collateral if default occurs. </li></ul>
    95. 95. What Are the Differences Between Pledging and Factoring Receivables? <ul><li>If receivables are pledged , the lender has recourse against both the original buyer of the goods and the borrower. </li></ul><ul><ul><li>Normally non-notification for remittances </li></ul></ul><ul><li>When receivables are factored , they are generally sold, and the lender has no recourse to the borrower. </li></ul><ul><ul><li>Normally notification for remittances </li></ul></ul><ul><ul><li>Credit Cards are an example </li></ul></ul>
    96. 96. Aspects of Factoring <ul><li>Maturity Factoring </li></ul><ul><ul><li>Continuous process </li></ul></ul><ul><ul><li>Funds are received at maturity </li></ul></ul><ul><ul><li>Factor performs: </li></ul></ul><ul><ul><ul><li>Credit Checking and Investigation </li></ul></ul></ul><ul><ul><ul><li>Collections </li></ul></ul></ul><ul><ul><ul><li>Absorbs Bad Debt Expenses (Risk Bearing) </li></ul></ul></ul><ul><li>Discount Factoring </li></ul><ul><ul><li>Additional function of lending is performed as firm receives the funds in advance </li></ul></ul><ul><ul><li>Flexible financing </li></ul></ul>
    97. 97. Drawbacks of Factoring <ul><li>Non-interest costs - e.g. 1 % to 3% of the amount of the invoice accepted by Factor </li></ul><ul><li>Constraints imposed on the seller </li></ul><ul><li>Administrative costs </li></ul><ul><li>Other creditors are placed at a disadvantage because A/R is used as collateral </li></ul><ul><li>Interest costs if Discount Factoring is used </li></ul>
    98. 98. Shakespeare and Factoring <ul><li>King Henry IV </li></ul><ul><li>The Merchant of Venice </li></ul><ul><li>The Comedy of Errors </li></ul><ul><li>Othello </li></ul>
    99. 99. What Are the Three Forms of Inventory Financing? <ul><li>Blanket lien: Gives the lender a lien against all of the borrower’s inventory. </li></ul><ul><li>Trust receipt: An instrument that acknowledges goods held in trust for the lender. A specific registration number is needed. Automobile dealer financing is a widely used example. </li></ul><ul><li>Warehouse receipt: Uses inventory as security. </li></ul><ul><li>Form used depends upon type of inventory and situation at hand. Provides flexible financing. </li></ul>
    100. 100. Public Vs. Field Warehouse <ul><li>Public Warehouse is an independent third party engaged in the business of storing goods. </li></ul><ul><li>Field Warehouse may be established at the borrower’s place of business </li></ul><ul><ul><li>Physical Control of inventory - e.g. canned peaches </li></ul></ul><ul><ul><li>Public notification </li></ul></ul><ul><ul><li>Supervision by custodian of Field Warehouse company </li></ul></ul>
    101. 101. Inventory Financing Costs <ul><li>Minimum of $5,000 plus 1 to 2 % of amount of credit extended </li></ul><ul><li>Interest charges typically set at 2% to 3% above prime </li></ul><ul><li>But, necessity for warehouse control may improve warehouse practices </li></ul>
    102. 102. What Is “securitization” and Why Is It Used? <ul><li>Pension funds and mutual funds have money to lend, but they typically don’t make short term loans. </li></ul><ul><li>Companies like GM and Ford can bundle up their receivables, use them as security for a low-risk bond, and sell the bond to pension funds, etc. </li></ul><ul><li>This is “securitization,” and its purpose is to get funds at a low cost. However, the risk is substantial for the final investor. </li></ul>
    103. 103. Sequential Method for Managing Current Debt <ul><li>List all the potential sources from the lowest effective rate to the highest </li></ul><ul><li>Start with the cheapest and proceed sequentially (typically) to the more expensive source </li></ul>
    104. 104. Working Capital Management <ul><li>Working Capital Policies </li></ul><ul><li>Cash Management </li></ul><ul><ul><li>Short-Term Investments </li></ul></ul><ul><li>Inventory Management </li></ul><ul><li>Accounts Receivable Management </li></ul><ul><li>Short-Term Financing </li></ul><ul><ul><li>Trade Credit </li></ul></ul><ul><ul><li>Bank Loans </li></ul></ul><ul><ul><li>Commercial Paper </li></ul></ul><ul><ul><li>Secured Loans </li></ul></ul>