SHORT-TERM FINANCIAL MANAGEMENT Chapter 7 – Managing Supplier Financing

SHORT-TERMFINANCIAL MANAGEMENT

Chapter 7 – Managing Supplier Financing

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MANAGING SUPPLIER FINANCING

Chapter 7 Agenda

Apply time value of money principles to the payment of accounts payable, decide when the cash discount is optimal, understand ethical issues involved in the payment decision, and assess payables using the balance fraction approach.

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Cash Flow Timeline

The cash conversion period is the time between when cash is received versus paid.

The shorter the cash conversion period, the more efficient the firm’s working capital.

The firm is a system of cash flows. These cash flows are unsynchronized and

uncertain.

Note: The clock typically starts ticking when the order is received, not when the order is placed or the invoice received.

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A/P Timing

In Chapter 4, we studied optimal inventory levels and considered the impact on NPV from quantity and cash discounts. In this chapter, we take it a step further and decide when to pay A/P.

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Managing Supplier Financing

Most firms buy inventory on credit, creating an Accounts Payable.

The inventory is subsequently sold to customers on credit, creating an Accounts Receivable.

In the meantime, the firm incurs expenses (e.g.: salaries, wages, taxes) for which payment has not yet been made, creating an Accrual.

A/P and Accruals are generally due before A/R are received.

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Managing Supplier Financing

A/P (also called Trade Credit) and Accruals represent spontaneous sources of financing for a firm, allowing the working capital cycle to continue without making cash disbursements.

Trade credit is effectively a “free” source of financing.

Firms establish policies on how to manage these accounts.

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Types of Supplier Financing

There are several types of purchase terms: Open Account

Once credit is approved, the firm may repeatedly submit orders without reapplying for credit.

Net Terms vs. Discount Terms Seasonal Dating

Used in seasonal businesses (e.g.: toys). “2/10, net 30, dating 90” allows customers to take the

2% discount within 10 days or pay the invoice in full within 30 days after the 90 day period ends (120 days from purchase date; same as “2/10, net 120”).

Consignment Payment is made only if the item is sold (e.g.: textbook

inventory in college bookstores).

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Supplier Financing

The concept of A/P is the same as A/R, but from the opposite perspective.

Say, a firm receives an invoice from a supplier with the terms 2/10, net 30.

The firm pays $98 per $100 invoiced amount if they pay within 10 days.

Taking the discount requires the firm to part with cash 20 days sooner, but it may deduct 2% from the amount owed.

Should the firm take the discount?

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Modeling A/P Timing

We’ll look at two methods:

NPV

Annualized Cash Discount Rate

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A/P Payment Timing Options

Firm’s establish an A/P policy based on the number of days payment is delayed from the purchase date (DD), choosing from:1. Date of purchase.

DD = 0

2. On or before end of cash discount period (DP). DD < DP

3. On or before end of credit period (CP). DD < CP

4. After credit period ends. DD > CP

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A/P Payment Timing Options

Say, the terms offered are 2/10, net 30:

Firms must determine when to pay invoices.

Like before, we apply TVM principles to the payment timing of A/P, seeking the lowest NPV.

Purchase DP CP >CP

0 Days 10 Days 30 Days > 30 Days

1) (DD=0)

2) DD < DP

3) DD < CP

4) DD > CP

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A/P Decision Models - NPV

Shown are the variables associated with this decision:

Deciding when to pay considers these rates:

Cash discount rate (d)

Annualized investment rate (i)

Annualized borrowing rate (ib)

Annualized late payment rate (fee)

Variables

Terms

Invoice Price (IP )

Days Until Payment is Made (DD)

Discount Period (DP )

Credit Period (CP )

Cash Discount Rate (d)

Annual Opportunity Cost (i)

Annual Borrowing Rate (i b )

Annual Fee / Intangible Cost of Late Payment (fee)

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A/P Decision Models - NPV

There are three Decision Models based on the timing of the delayed payment.

Discount Model

Credit Period Model

Late Payment Model

WE ARE DECIDING THE OPTIMAL TIMING OF DD.

Variables

Terms

Invoice Price (IP )



Credit Period (CP )





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Payment Decision Model #1

Discount Model - Payment made on or before the end of the cash discount period (DD < DP):

PV of discounted invoice price

Variables

Terms

Invoice Price (IP )



Credit Period (CP )





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Credit Period Model - Payment made on or before the end of the credit period (DD < CP):

PV of full invoice price

Variables

Terms

Invoice Price (IP )



Credit Period (CP )





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Late Payment Model - Payment made after the credit period ends (DD > CP):

(IP) [1 +(DD-CP)(fee/365)]NPV = - ---------------------------------- [1 + (DD)(i/365)]

PV of full invoice price plus late fee

Variables

Terms

Invoice Price (IP )



Credit Period (CP )





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Payment Decision Model Example

A firm receives an $100,000 invoice from a supplier with the terms 2/5, net 45. Should the firm:

Take the discount?

Pay within the credit period?

Pay late?

Variables Current Terms (E)

Terms 2/5, Net 45

Invoice Price (IP ) $100,000

Days Until Payment is Made (DD) TBD

Discount Period (DP ) 0-5 Days

Credit Period (CP ) 6-45 Days

Cash Discount Rate (d) 2%

Annual Opportunity Cost (i) 10%

Annual Borrowing Rate (i b ) 12%

Annual Fee / Intangible Cost of Late Payment (fee) 18%

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The invoice is $100,000 with terms of 2/5, net 45:

Discount Model - The check amount for 0-5 days is $98,000…the NPV decreases as time passes.

Credit Period Model - The check amount for 6-45 days is $100,000…the NPV decreases as time passes.

Late Payment Model - The check amount for >45 days is $100,000 plus the late fee…the NPV increases as time passes.

$98,000 mailed to supplier


$100,000 mailed to supplier

$100,000 plus time-based fee mailed to supplier

0

1

2

3

4

5

6

15

20

25

30

35

40

45

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Days Delayed From Invoice Date

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The invoice is $100,000 with terms of 2/5, net 45.

i = 10%

Discount Model[(IP)(1-d)] / [1 + (DD)(i/365)]

[$100,000(1-.02)] / [1+(5)(.10/365)]= $97,866


0 $98,000

1 $97,973

2 $97,946

3 $97,920

4 $97,893

5 $97,866

6 $99,836

15 $99,591

20 $99,455

25 $99,320

30 $99,185

35 $99,050

40 $98,916

45 $98,782

46 $98,804

47 $98,826

48 $98,848


NPV (10% Investment Rate)

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Credit Period ModelIP / [1 + (DD)(i/365)]

$100,000 / [1+(45)(.10/365)]= $98,782



0 $98,000

1 $97,973

2 $97,946

3 $97,920

4 $97,893

5 $97,866

6 $99,836

15 $99,591

20 $99,455

25 $99,320

30 $99,185

35 $99,050

40 $98,916

45 $98,782

46 $98,804

47 $98,826

48 $98,848



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Late Payment Model(IP) [1 +(DD-CP)(fee/365)] / [1 + (DD)(i/365)]

($100,000)[1+(48-45)(.18/365)] / [1+(48)(.10/365)] = $98,848



0 $98,000

1 $97,973

2 $97,946

3 $97,920

4 $97,893

5 $97,866

6 $99,836

15 $99,591

20 $99,455

25 $99,320

30 $99,185

35 $99,050

40 $98,916

45 $98,782

46 $98,804

47 $98,826

48 $98,848



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The invoice is $100,000 with terms of 2/5, net 45: Paying on

the fifth day and taking the discount provides the lowest NPV.

Discount Model[(IP)(1-d)] / [1 + (DD)(i/365)]

[$100,000(1-.02)] / [1+(5)(.10/365)]= $97,866

Late Payment Model(IP) [1 +(DD-CP)(fee/365)] / [1 + (DD)(i/365)]

($100,000)[1+(48-45)(.18/365)] / [1+(48)(.10/365)] = $98,848

Credit Period ModelIP / [1 + (DD)(i/365)]

$100,000 / [1+(45)(.10/365)]= $98,782


0 $98,000

1 $97,973

2 $97,946

3 $97,920

4 $97,893

5 $97,866

6 $99,836

15 $99,591

20 $99,455

25 $99,320

30 $99,185

35 $99,050

40 $98,916

45 $98,782

46 $98,804

47 $98,826

48 $98,848



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What if the investment rate (i) is 20%. Paying late now

has the lowest NPV.

Discount Model

Late Payment Model

Credit Period Model


0 $98,000 $98,000

1 $97,973 $97,946

2 $97,946 $97,893

3 $97,920 $97,839

4 $97,893 $97,786

5 $97,866 $97,732

6 $99,836 $99,672

15 $99,591 $99,185

20 $99,455 $98,916

25 $99,320 $98,649

30 $99,185 $98,383

35 $99,050 $98,118

40 $98,916 $97,855

45 $98,782 $97,594

46 $98,804 $97,590

47 $98,826 $97,585

48 $98,848 $97,581





Terms 2/5, Net 45



Discount Period (DP ) 0-5 Days

Credit Period (CP ) 6-45 Days





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Payment Decision Model - NPV While we calculated many possible dates

before, only three need to be calculated: Last day of discount period. Last day of credit period. Some late date after credit period ends.

In general: A/P should never be paid early.

Pay on the last day of the discount period or the last day of the credit period.

A/P should not be stretched past the credit period.

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Paying Late

If the late payment penalty fee (fee) is less than the firm's investment rate (i), the firm has a financial incentive to pay late. There are consequences to the firm’s

brand for paying late: New orders will not be shipped until the

account is current.

The firm’s reputation and credit rating can be comprised.

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Payment Decision Model - NPV

Since late payments should be avoided, it is the one of the first two models (Discount or Credit Period) with the lower NPV that is selected.

Choose the smaller of: [(IP)(1-d)] / [1 + (DD)(i/365)] IP / [1 + (DD)(i/365)]

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Alternative Decision Model

The reason we would forego the discount is to retain the funds to finance operations or to invest short-term.

The cash discount is not an interest rate; rather, it is a discount off the amount of the invoice.

It can be converted to an interest rate,

and then be compared to i and ib.

So, an alternative approach to calculating NPV is to compare the Annualized Cash Discount Rate (d).

Variables

Terms

Invoice Price (IP )



Credit Period (CP )





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For terms, 2/5, net 45, if we forego the discount, we pay 2% more for the product.

Said another way, we are paying 2% more to simply keep our cash for an extra 40 days.

We can convert that to the annualized equivalent:

Annualized Cash Discount Rate[The first expression is the effective

discount rate (the discount divided by the discounted invoice) and the second

expressions annualizes the rate (the number of times the rate would be

realized in a year).]

If the i < kTC, the firm is

better off taking the discount.

If the i > kTC, the firm

should keep the cash and forego the discount.

)(

365

1 (

DPCP)d-

dkTC

Variables

Terms

Invoice Price (IP )



Credit Period (CP )





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Assuming the firm does not have the cash, but has access to short-term credit, borrowing the money to take the discount might make sense if the annualized borrowing rate

(ib) is less than annualized cash discount rate (kTC), given

by:

ib < = > kTC = [d / (1 – d)] [365 / (CP-DP)]

If the ib < kTC, the firm should borrow to take the discount.

If the ib > kTC, the firm should forego the discount.

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Alternative Decision Example For our decision, the annualized cash

discount rate (kTC) is:

[d / ( 1 – d)] [365/(CP-DP)] [.02/(1-.02)] [365/(45-5)] = 18.62%

In our original analysis, with an i of 10%, the discount rate is the more favorable choice since 10% < 18.62%.

If i = 20%

Here, i > kTC > ib.

20% > 18.62%, so forego discount.

However, since the firm has access to ST credit at 12%, borrowing to take the

discount would make sense since kTC>

ib.

i > kTC > ib

20% > 18.62% > 12%


Terms 2/5, Net 45



Discount Period (DP ) 5 Days

Credit Period (CP ) 45 Days





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Taking The Cash Discount

It almost always make sense to take the discount since the cost is high for not taking the discount.

Research shows that:

51% of firms always take the discount.

40% sometimes take the discount.

9% take the discount regardless of when they pay!

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Managing Payables

Credit Managers watch trends for:

Payables Turnover Ratio

Days Payables Outstanding (DPO)

Balance Fraction Approach

Compares ratio of purchases to payables outstanding by month.

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Accruals

Accruals represent an operating expense that has contributed to firm productivity but for which the expense has not been paid.

A firm has minimal latitude in the timing of paying Accruals.

e.g.: Lengthening accrued wages means delaying payment to your workers.

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SHORT-TERM FINANCIAL MANAGEMENT Chapter 7 – Managing Supplier Financing