Short Term Financial Management

Short-Term Financial Management

TVU Reading CollegeMBA Managerial Finance Lecture 3

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BasicsWorking Capital Basics The assets/liabilities that are required

to operate a business on a day-to-day basis Cash Accounts Receivable Inventory Accounts Payable Accruals

These assets/liabilities are short-term in nature and turn over regularly

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Working Capital, Funding Requirements, and the Current Accounts

Gross Working Capital (GWC) represents the investment in assetsWorking Capital Requires Funds Maintaining a working capital balance

requires a permanent commitment of funds Example: Your firm will always have a

minimum level of Inventory, Accounts Receivable, and Cash—this requires funding

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Working Capital, Funding Requirements, and the Current Accounts

Spontaneous Financing Your firm will also always have a

minimum level of Accounts Payable—in effect, money you have borrowed Accounts Payable (and Accruals) are

generated spontaneously Offset the funding required to support

assets Net working capital is Gross Working Capital –

Current Liabilities (or spontaneous financing) Reflects the net amount of funds needed

to support routine operations

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Objective of Working Capital Management

To run the firm efficiently with as little money as possible tied up in Working Capital Involves trade-offs between easier

operation and the cost of carrying short-term assets Benefit of low working capital

Able to funnel money into accounts that generate a higher payoff

Cost of low working capital Risky

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The Cash Conversion Cycle

time = 0

Purchase rawmaterials on account

Operating cycle

Sell finished goodson account

Collect accountsreceivable

Average Collection PeriodAverage Age of Inventory

Average paymentperiod

Cash Conversion Cycle

Time

Payment mailed

Operating cycle

• Time from the beginning of the production to the time when cash is collected from sale

• Financing the operating cycle is costly, so firms have an incentive to shrink it. Cash

conversion cycle

• Operating cycle less the average payment period on accounts payable

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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 costsOpportunity cost of fundsCash and marketable securities

Operating Assets

Cost 2 * Shortage Costs(cost of holding too little of operating asset)

Cost 1(holding cost)

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Cost Trade-offs in Short-Term Financial Management

Trade-off of Short-Term Financial Costs

Account Balance

Co

st

Cost 1

Cost 2

Total Cost

Inventory Management

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Inventory ManagementMismanagement of inventory has the potential to ruin a companyInventory is not the direct responsibility of the finance department Usually managed by a functional area

such as manufacturing or operations However, finance department has an

oversight responsibility for inventory management Monitor level of lost of obsolete inventory Supervise periodic physical inventories

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Benefits and Costs of Carrying Adequate Inventory

Benefits Reduces stockouts and backorders Makes operations run more smoothly, improves

customer relations and increases sales

Costs Interest on funds used to acquire inventory Storage and security Insurance Taxes Shrinkage Spoilage Breakage Obsolescence

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Inventory Control and ManagementInventory management refers to the overall way a firm controls inventory and its cost Define an acceptable level of

operating efficiency with regard to inventory

Try to achieve that level with the minimum inventory cost

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Economic Order Quantity (EOQ) ModelEOQ model recognizes trade-offs between carrying costs and ordering costs Carrying costs increase with the

amount of inventory held Ordering costs increase with the

number of orders placed

EOQ minimizes the sum of ordering and carrying costs

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EOQ (Q*)Total costs = Ordering costs + Carrying costsTotal costs = (number of orders per year Cost per order) + (Avg. INV Annual carrying cost per unit)Total costs = (D/Q S) + (Q/2 C)EOQ

CSD

Q2*

365

**

DQ

T D

Q*365oror

• Optimal length of one inventory cycle

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Safety Stocks, Reorder Points and Lead Times

Safety stock provides a buffer against unexpectedly rapid use or delayed delivery An additional supply of inventory that is

carried at all times to be used when normal working stocks run out

Rarely advisable to carry so much safety stock that stockouts never happen Carrying costs would be excessive

Ordering lead time is the advance notice needed so that an order placed will arrive at the needed time Usually estimated by the item’s supplier

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Tracking Inventories—The ABC SystemSome inventory items warrant a great deal of attention Are very expensive Are critical to the firm’s processes or to

those of customers

Some inventory items do not warrant a great deal of attention Commonplace, easy to obtain

An ABC system segregates items by value and places tighter control on higher cost (value) pieces

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Just In Time (JIT) Inventory SystemsSuppliers deliver goods to manufacturers just in time (JIT)Theoretically eliminates the need for factory inventoryA late delivery can stop a factory’s entire production lineJIT works best with large manufacturers who are powerful with respect to the supplier Supplier is willing to do almost anything to

keep the manufacturer’s business

Management of Accounts Receivable

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Accounts Receivable Management

• Determine its credit standards.

• Set the credit terms.• Develop collection policy.• Monitor its A/R on both

individual and aggregate basis.

If a company decides to offer trade credit, it

must:

Credit standards

• Apply techniques to determine which customers should receive credit.

• Use internal and external sources to gather information relevant to the decision to extend credit to specific customers.

• Take into account variable costs of the products sold on credit.

Credit selection

techniques

Five C’s of Credit

Credit scoring

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Five C’s of Credit

– Character: The applicant’s record of meeting past obligations; desire to repay debt if able to do so

– Capacity: The applicant’s ability to repay the requested credit

– Capital: The financial strength of the applicant as reflected by its ownership position

– Collateral: The amount of assets the applicant has available for use in securing the credit

– Conditions: Refers to current general and industry-specific economic conditions

Framework for in-depth credit analysis that is typically used for high-value credit requests:

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Credit Scoring

Uses statistically-derived weights for key credit characteristics to predict whether a credit applicant

will pay the requested credit in a timely fashion.

Used with high volume/small dollar credit requests Most commonly used by large credit card operations, such as

banks, oil companies, and department stores.

• An example…

ABC Co Ltd uses credit scoring to make credit decisions. Decision rule is:• Credit Score > 75: extend standard credit terms• 65 < Credit Score < 75: extend limited credit (convert

to standard credit terms after 1 year if account is properly maintained)

• Credit Score < 65: reject application

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Credit Scoring of a Consumer Credit Application by ABC Co

83.251.00

8.500.1085Years on job

9.000.1090Years at address

20.000.2580Payment history

18.750.2575Income range

15.000.15100Home ownership

12.000.1580Credit references

Weighted Score

[(1) X (2)](3)

Predetermined Weight

(2)

Score(0 to 100)

(1)

Financialand Credit Characteristics

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Changing Credit Standards

• Increase in sales and profits (if positive contribution margin), but higher costs from additional A/R and additional bad debt expense.

Credit standards relaxed

• Reduced investment in A/R and lower bad debt, but lower sales and profit.

Credit standards tightened

An example…YMCc wants to evaluate the effects of a relaxation of its credit standards:

• YMCo sells CD organizers for £12/unit. All sales are on credit. YMC expects to sell 140,000 units next year.

• Variable costs are £8/unit and fixed costs are £200,000 per year.

• The change in credit standards will result in:• 5% increase in sales; average collection period will

increase from 30 to 45 days; increase in bad debt from 1% to 2%.

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Effects of Changes in Credit Standards for YMCo

Cost Variable - Price Sales Margin on Contributi Sales Marginal profit fromincreased sales

28,000 £8/un) - (£12/un un £7000

return required investment additional Cost of marginalinvestment in A/R

receivable accounts ofturnover

sales annual ofcost variabletotalAverage investment in

accounts receivable (AIAR)

Additional profit contribution from sales

Cost of the marginal investment in accounts receivables

To compute additional investment, use the following equations:

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cost/unit variable salesunit annual Total variable cost of annual sales (TVC)

£1,120,000 £8/un un 140,000TVCCURRENT

£1,176,000 £8/un un 147,000TVCPROPOSED

(ACP) period collection average

365Turnover of account

receivable (TOAR)

r times/yea2.12days 30

365

ACP

365TOAR

CURRENTCURRENT

r times/yea1.8days 54

365

ACP

365TOAR

PROPOSEDPROPOSED

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£91,803.2812.2

£1,120,000TOARTVC

AIARCURRENT

CURRENTCURRENT

8£145,185.18.1

£1,176,000TOARTVC

AIARPROPOSED

PROPOSEDPROPOSED

return required investment additional Cost of marginalinvestment in A/R

£6,406 return required AIAR- AIAR( CURRENTPPROPOSED )

Compute additional investment and, assuming a required return of 12%, compute cost of marginal

investment in A/R.

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Cost of Marginal Bad Debt Expense

£35,2800.02£1,764,000 rate expensedebt bad )SalesBDE PROPOSEDPROPOSED (

£16,8000.01£1,680,000 rate expense debt bad )SalesBDE CURRENTCURRENT (

£18,480£16,800-35,280 £Cost of marginal bad debt expense

Net profit for the credit decision

Marginal profit from increased

sales

Cost of marginalinvestment in A/R

Cost of marginal

bad debts= - -

= £28,000 - £6,406 - £18,480 = £3,114

3. Cost of marginal bad debt expense

Subtract the current level of bad debt expense (BDECURRENT) from the expected level of bad debt expense (BDEPROPOSED).

4. Net profit for the credit decision

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Credit Monitoring

Credit monitoring

• The ongoing review of a firm’s accounts receivable to determine if customers are paying according to stated credit terms

Techniques for credit

monitoring

• Average collection period• Ageing of accounts receivable• Payment pattern monitoring

dayper sales average

receivable accounts period collection Average

Average collection period: the average number of days credit sales are outstanding

Ageing of accounts receivable: schedule that indicates the portions of total A/R balance

outstanding

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Credit Monitoring

Payment pattern: the normal timing within which a firm’s customers pay their accounts

• Percentage of monthly sales collected the following month

• Should be constant over time; if payment pattern changes, the firm should review its credit policies

• An example…• DJM Manufacturing determined that:

• 20% of sales collected in the month of sales, 50% in the next month and 30% two months after the sale.

• Can use payment pattern to construct cash receipts from the cash budget:• If January sales are £400,000, DJM expects to collect

£80,000 in January, £200,000 in February, and £120,000 in March.

Management of Cash

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Cash Management

Cash management: the collection, concentration, and disbursement of funds

Cash manager

responsible for

• Cash management• Financial relationships with banks• Cash flow forecasting• Investing and borrowing• Development and maintenance of

information systems for cash management

Float: funds that have been sent by the payer but not yet usable funds to the company

Mail float Processing float

Availability float

Clearing float

Time

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Costs of Holding Cash

Opportunity Costs

Trading costs

Total cost 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.

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The Baumol Model

C* Size of cash balance

FT

KC

C2

cost Total

FT

C

Trading costs

The optimal cash balance is found where the opportunity costs equals the trading costs

FK

TC 2*

Opportunity Costs KC 2

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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

FC

TK

C 2

FTKC 2

2

K

FTC

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K

TFC

2*

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Implications of the Miller-Orr Model

To use the Miller-Orr model, the manager must do four things:

1. Set the lower control limit for the cash balance.

2. Estimate the standard deviation of daily cash flows.

3. Determine the interest rate. 4. Estimate the trading costs of buying and

selling securities.

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Implications of the Miller-Orr Model

The model clarifies the issues of cash management: The best return point, Z, is positively

related to trading costs, F, and negatively related to the interest rate K.

Z and the average cash balance are positively related to the variability of cash flows.

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Cash Position Management

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

• Bank provides report to its customers to show recent activity in firms’ accounts.

• Banks cannot pay interest on corporate Current (checking) account balances.

• Firms use earnings credit for balances to offset charges.

Management of short-term investing if the company has a surplus of funds and borrowing arrangements if company has a temporary deficit of funds

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Collections

Primary objective: speeding up collections

Collection systems: function of the nature of the business

Field-banking system

• Collections are made over the counter (retail) or at a collection office (utilities).

Mail-based system

• Mail payments are processed at companies’ collection centers.

Electronic payments

• Becoming increasingly popular because they offer advantages to both parties.

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Collections

Lockbox system(USA)

• Speeds up collections because it affects all components of float.

• Customers mail payments to a post office box.

• Firm’s bank empties the box and processes each payment and deposits the payments in the firm’s account.

• Lockboxes reduce mail and clearing time.

Perform cost-benefit analysis to determine if lockbox system worth using

where,cos ) - LC r (FVR t) t (Net benefi a• FVR = float value reduction in dollars

• ra = cost of capital

• LC = annual operating cost of the lockbox system

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Funds Transfer Mechanisms

Depository transfer checks(USA)

• Unsigned check drawn on one of the firm’s bank accounts and deposited in another of the firm’s bank accounts

Automated direct debit

transfers

• Preauthorized electronic withdrawal from the payer’s account

• Settle accounts among participating banks. Individual accounts are settled by respective bank balance adjustments.

• Transfers clear in one day.

BACS / Chaps/ Swift

transfers

• Electronic communication that, via bookkeeping entries, removes funds from the payer’s bank and deposits the funds in the payee’s bank.

• Bacs – bankers automated clearing system (4 days)

• Chaps Clearing Houses Automated payment system (Same day transfers)

• Swift – International Payments Mechanism

Managing Accounts Payable

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Accounts Payable Management

Management of time from purchase of raw materials until payment is placed in the mail

Accounts payable

functions

• Examine all incoming invoices and determine the amount to be paid.

• Control function: cash manager verifies that invoice information matches purchase order and receiving information.

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.

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Disbursements Products and MethodsZero-balance accounts (ZBAs): disbursements accounts that always have end-of-day balance of zero

Allows the firm to maximize the use of float on each cheque, without altering the float time of its suppliers

Keeps all cash in interest-bearing accounts

Controlled disbursement: Bank provides early notification of cheque presented

against a company’s account every day.

Positive pay: Company transmits to the bank a cheque-issued file to the bank when cheques are issued.

Cheque-issued file includes cheque number and amount of each item.

Used for fraud prevention

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Developments in Accounts Payable and Disbursements

Integrated (comprehensive) accounts payable: outsourcing of accounts payable or

disbursements operations

Purchasing/procurement cards: increased use of credit cards for low-dollar

indirect purchases

Imaging services: Both sides of the cheque, as well as

remittance information, is converted into digital images.

Useful when incorporated with positive pay services

Financing Working Capital

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Sources of Short-term FinancingSpontaneous financing Accounts payable and accruals

Unsecured bank loansCommercial paperSecured loans

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Spontaneous FinancingAccruals Money you owe employees, for example, for

work performed but for which they have not yet been paid Tend to be very short-term

Accounts payable (AKA trade credit) Money you owe suppliers for goods you

bought on credit Credit Terms: Terms of trade specify when you

are to repay the debt Example of terms of trade: 2/10, net/30

You must pay the entire amount by 30 days If you pay within 10 days, you will receive a 2%

discount

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Spontaneous FinancingThe prompt payment discount Passing up prompt payment discounts

is generally a very expensive source of financing

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Spontaneous FinancingAbuses of Trade Credit Terms Trade credit, while originally a service

to a firm’s customers, has become so commonplace it is now expected Companies offer it because they have to

Stretching payables is a common abuse of trade credit Paying payables beyond the due date

(AKA: leaning on the table) Slow paying companies receive poor

credit ratings in credit reports issued by credit agencies

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Unsecured Bank LoanRepresent the primary source of short-term loans for most companiesPromissory note (AKA Notes Payable) Note signed promising to repay the

amount borrowed plus interest Bank usually credits the amount to

borrower’s checking account

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Unsecured Bank LoansLine of credit Informal, non-binding agreement between

bank and firm that specifies the maximum amount firm can borrow over a specific time frame (usually a year) Borrower pays interest only on the amount borrowed

Revolving credit agreement Similar to a line of credit except bank

guarantees the availability of funds up to a maximum amount (effectively a binding agreement) Borrower pays a commitment fee on the

unborrowed funds (whether they are used or not)

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Unsecured Bank LoansCompensating balances A minimum amount by which the

borrower’s bank account cannot drop below (therefore it is unavailable for use)

Increases the effective interest rate on a loan

Typically between 10% and 20% of amounts loaned

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Unsecured Bank LoansClean-Up Requirements Theoretically a firm can constantly

roll-over its short-term debt Borrow on a new note to pay off an old

note Risky for both the firm and the bank

Banks require that borrowers clean up short-term loans once a year Remain out of short-term debt for a

certain time period

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Commercial PaperNotes issued by large, financially-strong firms and sold to investors Basically a short-term corporate bond

Unsecured (usually) Buyers are usually other institutions (insurance

companies, mutual funds, banks, pension funds) Maturity is less than 270 days Considered a very safe investment, therefore

pays a relatively low interest rate Rather than paying a coupon rate, interest is

discounted Commercial paper market is rigid and formal—no

flexibility in repayment terms

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Short-Term Credit Secured by Current Assets

Debt is secured by the current asset being financedMore popular in some industries than in others Common in seasonal businesses

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Receivables Financing: Accounts receivable represent money that is

to be collected in the near future Banks recognize that this money will be

collected soon are are willing to lend money based on this soon-to-be-collected money Invoice discounting: firm sells AR to lender but

retains control of control of the accounts AR are now paid directly to lender to a specified

account Factoring AR: firm sells AR to lender (at a) and

the lending firm (factor) takes control of the accounts

AR are now paid directly to lender Lender assumes responsibility for credit control &

collection

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Pledging Accounts Receivable (US Variant of Invoice Discounting) Firm promises to use the money paid from the

collected accounts to pay off bank loan Accounts Receivable still belong to firm which

still collects the accounts If firm doesn’t repay, lender has recourse to borrower

Lender can provide General line of credit tied to all receivables

Lender likely to advance at most 75% of the balance of accounts

Specific line of credit tied to individual accounts receivable

Evaluates based on creditworthiness of account Lender likely to advance as much as 90% of the

balance of accepted accounts

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Factoring Accounts Receivable Firm sells Accounts Receivable to lender (at

a severe discount) and the lending firm (factor) takes control of the accounts Accounts Receivable are now paid directly to

lender Factor usually reviews accounts and only

accepts accounts it deems creditworthy Factors offer a wide range of services

Perform credit checks on potential customers Advance cash on accounts it accepts or remit cash

after collection Collect cash from customers Assume the bad-debt risk when customers don’t

pay

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Inventory Financing (Common in USA) Use a firm’s inventory as collateral for a short-term

loan Popular but subject to a number of problems

Lenders aren’t usually equipped to sell inventory Specialized inventories and perishable goods are difficult

to market Types of methods used

Blanket liens—lender has a lien (claim) against all inventories of the borrower but borrower remains in physical control of inventory

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)

Warehousing—collateralized inventory is removed from borrower’s premises and placed in a warehouse (borrower’s access controlled by third party)

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Short-Term Financial ManagementLength of cash conversion cycle determines the amount of resources the firm must invest in its operations.Cost trade-offs apply to managing cash and marketable securities, accounts receivable, inventory and accounts payable.Objective for account receivable: collect accounts as quickly as possible without

losing sales.

Objective for accounts payable: pay accounts as slowly as possible without

damaging firm’s credit.

Working Capital Finance Principle is to Match Length of Finance with Asset

Economy & Finance

Short Term Financial Management