ShortTerm Financial Management

1
Short-Term Financial Management

• TVU Reading College
• MBA Managerial Finance
• Lecture 3

2
Basics

• Working 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

3
Working Capital, Funding Requirements, and the
Current Accounts

• Gross Working Capital (GWC) represents the
  investment in assets
• Working 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
  Cashthis requires funding

4
Working Capital, Funding Requirements, and the
Current Accounts

• Spontaneous Financing
• Your firm will also always have a minimum level
  of Accounts Payablein 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

5
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

6
The Cash Conversion Cycle
7
Cost Tradeoffs in Working Capital Accounts
8
Cost Trade-offs in Short-Term Financial Management
9
Inventory Management
10
Inventory Management

• Mismanagement of inventory has the potential to
  ruin a company
• Inventory 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

11
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

12
Inventory Control and Management

• Inventory 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

13
Economic Order Quantity (EOQ) Model

• EOQ 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

14
EOQ (Q)

• Total costs Ordering costs Carrying costs
• Total 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

• Optimal length of one inventory cycle

15
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 items supplier

16
Tracking InventoriesThe ABC System

• Some inventory items warrant a great deal of
  attention
• Are very expensive
• Are critical to the firms 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

17
Just In Time (JIT) Inventory Systems

• Suppliers deliver goods to manufacturers just in
  time (JIT)
• Theoretically eliminates the need for factory
  inventory
• A late delivery can stop a factorys entire
  production line
• JIT works best with large manufacturers who are
  powerful with respect to the supplier
• Supplier is willing to do almost anything to keep
  the manufacturers business

18
Management of Accounts Receivable
19
Accounts Receivable Management
20
Five Cs of Credit
Framework for in-depth credit analysis that is
typically used for high-value credit requests
21
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.

22
Credit Scoring of a Consumer Credit Application
by ABC Co
23
Changing Credit Standards
24
Effects of Changes in Credit Standards for YMCo
Additional profit contribution from sales
Marginal profit from increased sales
Cost of the marginal investment in accounts
receivables
To compute additional investment, use the
following equations
25
Cost of the marginal investment in accounts
receivables
Total variable cost of annual sales (TVC)
26
Cost of the marginal investment in accounts
receivables
Compute additional investment and, assuming a
required return of 12, compute cost of marginal
investment in A/R.
Cost of marginalinvestment in A/R
27
Cost of Marginal Bad Debt Expense
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).

Cost of marginal bad debt expense
4. Net profit for the credit decision
28
Credit Monitoring
Ageing of accounts receivable schedule that
indicates the portions of total A/R balance
outstanding
29
Credit Monitoring
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
32
Costs of Holding Cash
Costs of holding cash
Trading costs increase when the firm must sell
securities to meet cash needs.
The investment income foregone when holding cash.
C
Size of cash balance
33
The Baumol Model

• F The fixed cost of selling securities to raise
  cash
• T The total amount of new cash needed
• K The opportunity cost of holding cash, a.k.a.
  the interest rate.

Time
1 2 3
34
The Baumol Model

• F The fixed cost of selling securities to raise
  cash
• T The total amount of new cash needed
• K The opportunity cost of holding cash, a.k.a.
  the interest rate.

As we transfer C each period we incur a trading
cost of F each period.
Time
1 2 3
35
The Baumol Model
C
Size of cash balance
The optimal cash balance is found where the
opportunity costs equals the trading costs
36
The Baumol Model
The optimal cash balance is found where the
opportunity costs equals the trading costs
Opportunity Costs Trading Costs
Multiply both sides by C
37
The Miller-Orr Model

• The firm allows its cash balance to wander
  randomly between upper and lower control limits.

When the cash balance reaches the upper control
limit H cash is invested elsewhere to get us to
the target cash balance Z.
When the cash balance reaches the lower control
limit, L, investments are sold to raise cash to
get us up to the target cash balance.
Time
38
The Miller-Orr Model Math

• Given L, which is set by the firm, the Miller-Orr
  model solves for Z and H

• where s2 is the variance of net daily cash flows.
• The average cash balance in the Miller-Orr model
  is

39
Implications of the Miller-Orr Model

• To use the Miller-Orr model, the manager must do
  four things
• Set the lower control limit for the cash balance.
• Estimate the standard deviation of daily cash
  flows.
• Determine the interest rate.
• Estimate the trading costs of buying and selling
  securities.

40
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.

41
Cash Position Management
Cash position management collection,
concentration, and disbursement of funds on a
daily basis

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

Smaller companies set target cash balance for
their current (Checking) accounts.
42
Collections
Primary objective speeding up collections
Collection systems function of the nature of the
business
43
Collections
Perform cost-benefit analysis to determine if
lockbox system worth using
44
Funds Transfer Mechanisms

• Electronic communication that, via bookkeeping
  entries, removes funds from the payers bank and
  deposits the funds in the payees bank.
• Bacs bankers automated clearing system (4 days)
• Chaps Clearing Houses Automated payment system
  (Same day transfers)
• Swift International Payments Mechanism

BACS / Chaps/ Swift transfers
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.
47
Disbursements Products and Methods

• Zero-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 companys 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

48
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

49
Financing Working Capital
50
Sources of Short-term Financing

• Spontaneous financing
• Accounts payable and accruals
• Unsecured bank loans
• Commercial paper
• Secured loans

51
Spontaneous Financing

• Accruals
• 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

52
Spontaneous Financing

• The prompt payment discount
• Passing up prompt payment discounts is generally
  a very expensive source of financing

53
Spontaneous Financing

• Abuses of Trade Credit Terms
• Trade credit, while originally a service to a
  firms 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

54
Unsecured Bank Loan

• Represent the primary source of short-term loans
  for most companies
• Promissory note (AKA Notes Payable)
• Note signed promising to repay the amount
  borrowed plus interest
• Bank usually credits the amount to borrowers
  checking account

55
Unsecured Bank Loans

• Line 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)

56
Unsecured Bank Loans

• Compensating balances
• A minimum amount by which the borrowers 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

57
Unsecured Bank Loans

• Clean-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

58
Commercial Paper

• Notes 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 formalno
  flexibility in repayment terms

59
Short-Term Credit Secured by Current Assets

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

60
Short-Term Credit Secured by Current Assets

• 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

61
Short-Term Credit Secured by Current Assets

• 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 doesnt 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

62
Short-Term Credit Secured by Current Assets

• 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 dont pay

63
Short-Term Credit Secured by Current Assets

• Inventory Financing (Common in USA)
• Use a firms inventory as collateral for a
  short-term loan
• Popular but subject to a number of problems
• Lenders arent usually equipped to sell inventory
• Specialized inventories and perishable goods are
  difficult to market
• Types of methods used
• Blanket lienslender has a lien (claim) against
  all inventories of the borrower but borrower
  remains in physical control of inventory
• Chattel mortgage agreementcollateralized
  inventory is identified by serial number and
  cant be sold without lenders permission (but
  borrower remains in physical control of
  inventory)
• Warehousingcollateralized inventory is removed
  from borrowers premises and placed in a
  warehouse (borrowers access controlled by third
  party)

64
Short-Term Financial Management

• Length 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 firms credit.
• Working Capital Finance Principle is to Match
  Length of Finance with Asset