CMA Part 3: Section C Corporate Finance Prepared by:Section C – Corporate FinanceThis section represents approximately 25% of the Part 3 Exam. You should expect somewhere between 26 and 27 questions from Section C.The three Parts to Corporate Finance are:Working Capital Management,Corporate Finance, andRisk and Return.Working CapitalWorking capital is the term for short-term assets that a company uses in its day-to-day operations. Working capital finance concerns the optimal level, mix and use of current assets and current liabilities. Working capital is one of the measures of a company’s short-term solvency, which is its ability to pay liabilities as they become due.
Net working capital is calculated as follows:Net Working Capital = Current Assets – Current Liabilities
Working Capital GoalsWorking capital management is a process of balancing different goals by management. On one hand, every company must be certain that they have enough cash to be able to pay their liabilities as they come due. However, the short-term assets (cash, inventory, receivables) that the company holds provide very little, if any, return.
Therefore, the more short-term assets held by the company, the lower the chance of insolvency, but the lower the return that is earned on company assets. Levels of Working CapitalA conservative working capital policy seeks to minimize liquidity risk by increasing the amount of working capital that it holds. The company gives up the potentially higher returns available from using the additional working capital to acquire long-term assets, but is in a safer position with respect to liquidity and possible insolvency because of the greater amount of working capital. An aggressive working capital policy reduces the current ratio (calculated as current assets ÷ current liabilities) and accepts a higher risk of short-term cash flow problems in exchange for a greater return on investment. The company will have a very low (maybe even negative) level of working capital, but will also have a higher return on its assets. In the short term it is possible to have a negative working capital. In this case, the company is planning to collect additional cash or receive a new source of financing before its current liabilities become due.
Types of Working CapitalBecause a company may have different cash needs throughout the year, it is possible that it will maintain different levels of working capital at different times of the year. Permanent working capital is the minimum amount of working capital that is maintained at all times.The increases that occur from time to time are called temporary working capital.
Changing Levels of Working CapitalA company may increase its net working capital by either: 1) Increasing current assets, or 2) Decreasing current liabilities. Conversely, a company may decrease its net working capital by either: 1) Decreasing current assets, or 2) Increasing current liabilities.
Effect of Other TransactionsTransactions in which one current asset is exchanged for another current asset have no effect on net working capital. An example of this type of transaction is the collection of accounts receivable. When cash received, there will be an equal decrease in account receivable. Another type of transaction that does not affect net working capital is one in which both current assets and liabilities are increased (or decreased). If a company purchases inventory on short-term credit, the current assets of the company will increase, but so will current liabilities. Similarly, the payment of the payable will not have an effect on working capital because both a current asset and a current liability are reduced by an equal amount. Short-Term Liquidity RatiosShort-term liquidity ratios (also called solvency ratios) measure the short-term viability of a business. This is a firm’s ability to continue operating in the short term by paying its obligations as they come due. A company must have enough working capital to finance its daily operations. This working capital, which the company holds, bridges the gap between production (spending money) and sales (collecting money). As discussed earlier, maintaining a comfortable level of working capital is important, and doing so enhances the company’s ability to meet its current liabilities, expand production, and take advantage of business opportunities that may arise. However, maintaining too much working capital can make it difficult for a company to maximize the return from its assets. Current RatioThe current ratio measures working capital as a ratio instead of a dollar amount. It is calculated as:Current AssetsCurrent Liabilities
Again, this number should be more than 1. The specific ‘target’ amount depends on the business and the industry.
Quick RatioThe quick ratio is based on the current ratio, but it does not include inventory in the numerator. This is because the company should not use inventory to pay its liabilities as the company would then have nothing left to sell.
Cash + Cash Equivalents + Receivables + Short-term SecuritiesCurrent Liabilities
This is also called the ‘Acid-test Ratio’Cash RatioThe cash ratio further adjusts the current ratio by not including receivables in the numerator
Cash + Cash Equivalents + Short-term SecuritiesCurrent LiabilitiesCash Flow RatioThe cash flow ratio compares the cash flows from operating activities with the average current liabilities during the period.
Annual Cash Flows from Operating ActivitiesAverage Current Liabilities
Cash ManagementCash management is one of the most critical processes for a company. If there is not enough cash at any one point in time a company will face, at worst, bankruptcy or at least high interest charges to obtain the necessary cash from a bank on short notice. A company must manage cash from both a short-term and a long-term perspective. In the short-term it is essential that the company have enough cash to pay its obligations as they come due.In the long-term, it is critical that the company has enough cash to grow and expand as needed. How Much Cash is Needed?Among these factors that influence how much cash is held are:How much cash will be needed in the near future,The amount of risk a company is willing to take in respect to solvency,The level of other short-term assets that a company holds,The available return on other short-term investments, At what point in its business cycle it is in (if a business is a seasonal business it will have more cash at the peak periods than at the slow periods).
Reasons for Holding CashThe reasons that a company holds cash are many and varied. However, we can break the reasons for holding cash into the following categories:As a medium of exchange. Cash is still needed for some business transactions.As a precautionary measure. Cash may be held for use in unforeseen situations where cash is needed quickly. There is no longer a need to keep cash outside of the bank as a protection against the failure of the bank because bank accounts in the U.S. are guaranteed. For speculation. Cash may be held in order to be able to act quickly on good investment opportunities that arise. Cash may be held as a compensating balance. This occurs when a bank requires that a company maintain a minimum balance in its bank account during the period that a loan is outstanding.
Operating Cycle and Cash CycleThe operating cycle measures the amount of time it takes to convert an investment in inventory back into cash after the collection of the sale. It is calculated as:Days in Inventory + Days of Sales in Receivables
The cash cycle represents the number of days that cash is tied up in the operating cycle of the business. It is:Days in Inventory + Days of Sales in Receivables – Days of Purchases in Payables
Both of these are better if they are shorter.
Timing of Cash FlowsThe main two elements of managing cash are:Collecting cash as quickly as possible (speeding cash inflows), andDisbursing cash as slowing as possible (slowing cash outflows).
Speeding Cash Inflows A company should always endeavor to receive its cash payments as soon as possible in order to maximize its cash management position. The following measures can help to expedite cash inflows and minimize collection float (the collection of receivables):All invoices should be mailed as soon as possible under the terms of the sales agreement so that they can be paid as soon as they are due.The payment terms for credit should be such that they encourage prompt payment. Giving a discount if the invoice is paid before the due date may achieve this. We will look at the calculations related to this in the slowing payments section.Use of electronic data interchange (EDI), electronic funds transfer (EFT) and automated clearinghouses (ACHs).
Speeding Cash Inflows, continuedAccept credit cards (Visa, MasterCard and American Express, for example) can be used as an alternative method of speeding up collection rates. The bank that issued the card charges the seller a fee equal to 1% - 3% of a charge sale, but the funds are instantly available to the seller when a buyer uses a credit card. The responsibility for collection has been transferred to the credit card in exchange for the fee that they charge. Use wire transfers as a means of collection from customer. Utilize a lockbox system. This method will be discussed in greater detail.Lockbox SystemIn a lockbox system, a company maintains special mailboxes in different locations around the country. Customer send their payment to the closest lockbox. This reduces the amount of time the money is in the mail.The company then authorizes a bank to check these mailboxes as often as is reasonable, given the number of payments that will be received. Because the bank is making the collection, the funds that have been received are immediately deposited into the company’s account without first being processed by the company’s accounting system, thereby speeding up cash collection. Benefits of a Lockbox SystemFor a company to benefit from a lockbox system, the interest earned from the additional day(s) on the cash received (because the bank collected it directly and deposited it immediately) must be greater than the cost of the bank fees for providing this service. Having several lockbox locations reduces the time a payment is in the postal system. It also allows concentration banking to be used. This is a system in which a regional bank is responsible for the transfer of lockbox receipts in that region. By also having a disbursement account at each of the regional centers, a company will have faster access to its money because there is no need to wait for the money to be transferred to the central bank account. Calculating the Lockbox BenefitThe calculation of the benefit from a lockbox system is calculated using the following steps:Calculate the amount of cash that is collected each day.Multiply this by the number of days that the collection float will be reduced (this calculates the increase in the cash balance that the company will have for the year).Multiply the increase in the cash balance by the interest rate at which the company can invest their funds. This is the benefit that the company will receive.The final step is to compare the amount of the benefit to the company to the cost that they will need to pay for the new system. If the savings are more than the cost, the company should invest in the new cash management system.
Slowing Cash OutflowsAs opposed to cash inflows, a company should slow its cash disbursements in order to increase the amount of time that it has the cash.Payments should be made as close to deadline requirements as possible. However, it is important to remember that if a company misses the payment date they may incur interest charges or lose the chance to purchase from that supplier again.Payments should be made within the cash discount period, if taking the discount provides a better return than not taking the discount. This will be looked at in more detail later.Slowing Cash Outflows, continuedMaking payments via drafts (check). The advantage to the payer is that there is a delay of time between when the check is presented for payment (this is when the recipient receives the money) and when the money is taken out of the account of the company that wrote the check. This delay (cash taken out of the account) is called the check float. The effect of this delay is an interest free loan for the time that the check has been paid, but not yet deducted from his cash account. There are two types of floats, depending on if the person is making payment or receiving payment by the check. The person paying has what is called the disbursement float and the person receiving the money has what is called the collections float. Slowing Cash Outflows, continuedUsing Payable Through Drafts (PTD) are a specific type of draft that a company can use. It functions largely like a check, except the recipient needs to present the PTD to the company who issued it. Some banks offer zero balancing checking accounts, although a fee may be charged for this service. In a zero-balance account, the account balance is maintained at zero until the bank receives a check for payment. This resulting overdraft (having a negative balance in an account) is then automatically ‘covered’ by the bank by transferring money from another account that the company holds. This other account is one that bears interest and a zero-balance arrangement allows the company to earn interest on its funds for as long as possible. Slowing Cash Outflows, continuedUsing Overdrafts as a method of slowing payment is similar to zero-balance checking accounts except the fact that in an overdraft there is no second account from which to transfer the money. Therefore, the company has a negative balance at the bank and as a result will need to pay various penalties and/or high interest on this amount. Because of the penalties and interest, this should not be a common method used by a company to slow its payments. Calculating compensating balances on an average basis rather than an absolute basis. By using an average daily cash balance for the compensating balance, the company can manage its cash more effectively as it doesn’t always need to keep a minimum balance in the bank as long as the average is the required amount. Taking the Cash DiscountA cash discount is when the company receives a discount if they pay their payable within a certain number of days after it is created. A typical cash discount would be 2/10, n/30. This means that if the company pays within 10 days, they get a 2% discount. If they do not pay within 10 days, the full amount is due in 30 days.Payments should be made within the cash discount period, if taking the discount provides a better return than not taking the discount. Taking the Cash Discount CalculationThe calculation of the cost of not taking the cash discount that is offered for early payment, is calculated as follows:
If this cost of not taking the discount is higher than the cost of capital to the company, they should take the cash discount and pay within the discount period. Marketable Securities ManagementMost companies try to avoid holding large cash balances and prefer to borrow to meet any extraordinary short-term cash needs because holding cash does not provide any return on the cash that is heldMarketable securities provide some return on what is invested. Marketable securities may be purchased so that the maturity periods of the securities will match a time period of low cash balances or higher than usual cash needs. These securities may be used to synchronize the cash inflows and the cash outflows of the business. Marketable Securities Management, continuedThe purpose of a marketable securities portfolio is to provide a store of liquidity. The return on the portfolio is only a secondary objective. Liquidity has two components: time and amount. Marketable securities should be converted into cash quickly (usually in less than 24 hours).The risk of change in value should be very low, meaning that they can be sold without a large discount.
Marketable Securities Management, continuedA firm should choose its investments with a view of the financial (repayment) risks involved with each security. As a result, a higher return may be given up in exchange for greater safety (less chance of default) by placing cash in investments with lower rates of return in exchange for a lower risk profile. Interest rate risk is the change in value of a fixed income security that results from a change in market interest rates. In order to minimize interest rate risk, marketable securities should be investments with short-term maturities. Liquidity is a function of how quickly an asset can be converted into cash, and how safe the investment is from loss of value. Only high quality, short-term debt instruments typically qualify as marketable securities. Tax Issues with Marketable SecuritiesSome marketable securities that are issued by cities, states or the federal government are tax-exempt. This means that the interest earned from this security is exempt from taxation by federal, state and/or other local authorities. These are frequently called “municipal bonds” even though they may not have been issued by a municipality (city).
Because of this tax-exempt status of the interest, the interest rate on a tax-exempt security is less than that from a corporate bond. This is because the tax exemption provides extra compensation to the holder of the security. The higher the tax bracket of the investor, the more attractive the tax-free alternative becomes. Investment PoliciesBecause of the variety of factors that go into the decisions related to marketable securities, it is very helpful if a company has an investment policy statement. This statement provides guidance to the individuals who need to make these decisions and as a result, ensures that the investments that are made throughout the company are in line with its policies. Types of Marketable SecuritiedThere are a number of different types of instruments that may be classified as marketable securities.The main ones that you need to know are:Treasury bills,Certificates of deposits (CDs),Money market accounts, andHigh-grade commercial paper.
Other marketable securities are listed after a discussion of these.Treasury BillsTreasury bills (also called T-Bills) are short-term government debt securities (mature in 30, 90, or 120 days) guaranteed by the full faith and confidence of the U.S. government. The income from T-Bills is exempt from state and local taxes, but not federal taxation. T-Bills differ from obligations of federal agencies, which are guaranteed only by the agency that is issuing the bill and not the U.S. government. T-Bills are sold at a discount, which means you pay less than the face value, and redeem them at par on maturity. The difference is the discount. Treasury Bills – Calculating the DiscountThe calculation of the amount of the discount is: Face value of the Bill - Interest earned while the T-Bill is outstanding = Discounted Basis
The T-Bill interest rate is calculated as follows:Certificates of Deposit (CDs)CDs are a form of savings deposit with a bank that may not be withdrawn before their maturity without a high penalty. CDs usually have a higher rate of interest when compared with other savings instruments because they are for fixed, usually long-term periods. The longer the period of the CD, the higher the interest rate that is paid. A negotiable CD is usually sold with higher denominations ($100,000 and more) and can be freely traded on secondary markets, but fall under the regulation of the Federal Reserve System. The return on a negotiable CD is high, but not as high as the return on commercial paper since the risk is lower than for commercial paper. Money Market AccountsMoney market accounts operate in a manner similar to checking accounts but they pay higher interest rates, generally in line with money market mutual funds. The number of checks that can be written against the account is usually limited although unlimited transfers can be made via ATMs. Balances in the account may be withdrawn at any time without penalty, but in return for this flexibility, the interest rate that is earned is less than on CDs. High-Grade Commercial PaperHigh-grade commercial paper is marketable short-term, unsecured debt that is issued by large companies that have solid credit histories and high credit ratings. These instruments are sold to other large companies and institutional investors. Commercial paper is usually issued in very large denominations ($100,000 or more) and is unsecured. Like T-Bills, commercial paper is sold at a discount, and the face value is paid at maturity. High-grade commercial paper may yield a higher return than CDs because of the higher risks involved with the unsecured debt. Maturities for commercial paper are at most 270 days. Other Marketable SecuritiesOther types of marketable securities that you need to recognize as marketable securities are:Bankers’ acceptances,Federal agency securities,Eurodollars,Money market mutual funds,State and local government securities,Treasury notes and bonds, andRepurchase agreements.
Cash and Marketable Security Models There are 2 models of marketable securities management that both address the need of the company to balance the amounts of cash and marketable securities that they hold.Too much cash (and not enough marketable securities) reduces the return that the company received on their assets.Not enough cash (and too many marketable securities) increases the risk of insolvency.The two models are:Baumol Cash Management Model, andThe Miller-Orr Management Model.The Baumol Cash Management ModelThis model is based off of the same equation that we will see in the calculation of the economic order quantity (EOQ) for inventory. (This is covered in more detail in the inventory section.) In the application of EOQ to cash management, a company is calculating the optimal cash (OC) level to receive every time it converts marketable securities to cash. Another way of looking at this formula is that it determines the amount of cash that should be converted from securities each time a conversion is made in order to minimize the costs of conversion and the opportunity cost that is given up by holding cash instead of marketable securities. The Baumol FormulaIn this formula the assumption is that cash that is not needed in the immediate future by the company are held as marketable securities. To get more cash the company simply needs to convert these marketable securities into cash. However, in order to convert these securities to cash, there is a fixed fee (such as a brokerage fee) that is paid for each conversion. Also, any time that cash is held, the company gives up the interest that was being earned by the marketable securities. This formula balances the cost of converting marketable securities into cash with the interest benefit of holding marketable securities. The Miller-Orr ModelThe Miller-Orr addresses the issue that the demand for cash is not known and is not constant over time. Similarly, the source of cash is not known and not constant. The Miller-Orr Model creates an upper limit and a lower limit for the cash balance that a company holds. As long as the cash balance is between these two levels, there is no need for the company to make any cash transactions to either increase or decrease the balance. As soon as the cash balance moves outside of this corridor, the company needs to do something to bring it back into the corridor.The model also establishes a cash balance that the company will move towards whenever it makes a cash transaction. Accounts Receivable ManagementIn managing accounts receivable a company must balance the amount of receivables outstanding and the amount of bad debts resulting from receivables not collected. The company must balance the trade-off betweenThe rewards of credit sales (additional sales that would not be made if only cash sales were accepted), and The costs of having and collecting the corresponding accounts receivable (these costs include collection costs, foregone interest, bad debt costs, etc). Obviously, it would be best for a company to never have bad debts, but the only way to do this is to never make a credit sale. Credit Policy VariablesThere are three credit policy variables Credit standards – these determine who the company grants credit to. Relaxed terms mean that the company gives credit to more people, and strict terms means that the company gives credit to only those with very low risk of default.Credit terms – the terms of sale, including the payment period, discount for early payment or penalty for late payment, and the size of the discount or penalty.Collection efforts – the amount of time and money spent on collection of past due accounts. Changing Credit Policy ItemsAny action that changes any of these variables will have both costs and benefits. The benefits may be in the form of increased sales revenues, the reduction of opportunity costs due to lower accounts receivable balances, fewer bad debts or lower collection expenses. The costs may include lost sales revenue, increased discounts taken, the opportunity cost of higher accounts receivable balances, higher bad debts or higher collection expensesSome companies use a system called credit scoring in an attempt to manage their credit policies and extend credit policies only to worthy customers. In a credit scoring system, a potential customer is graded against specific criteria and they get points for meeting certain criteria. The ‘score’ that a potential customer receives then determines whether or not it will receive credit. Impact of Credit Policy ChangesIf the credit standards are made softer (changed so that more people are able to obtain credit), there will be:An increase in sales. A corresponding increase in bad debts and collection costs resulting from people with worse credit histories who can borrow money from the company. In other words, as the credit terms are relaxed and more people obtain credit, there is an increase in the default risk. Conversely, a change to more strict credit policies will have the opposite effect. This will cause lower levels of accounts receivables and bad debts, but also lower levels of credit sales. Other Types of ReceivablesIn addition to accounts receivable (called an invoice), a company has other options about how it may make a sale and then collect the money at a later date. Among these other options are:Promissory Note – this is an unconditional promise by one party to pay another party a certain amount of money at a time in the future. Conditional Sales Contract – this is often used for larger cost items and the seller sells the item to the buyer, but retains the actual title to the item until all of the payments have been made. After all payments have been made, title is transferred to the buyer.Commercial Draft – this is a business-to-business order for payment. Credit Cards – credit cards are in a sense another form of a credit sale, but this is much closer to a cash sale because the seller almost immediately collects the money from the credit card company. The credit card company that needs to collect from the buyer. One drawback to this type of sale is that the seller does not receive 100% of the sales price as the credit card company takes a commission on the sale. Accounts Receivable TurnoverLike the Inventory Turnover number, this measures how many times during the period the company collects its receivables.
Annual Credit SalesAverage Annual Accounts Receivable
Days of Sales in ReceivablesThis is the number of sales that are outstanding and not yet collected (held as receivables)
365, 360 or 300 (told in the question)Receivables Turnover
Inventory ManagementInventory management is a critical part of the accounting function of any company that produces or sells a product. If a company is a seller of finished goods or a producer of goods, it is very possible that inventory will be the largest, or one of the largest, items on the balance sheet. Therefore, a small incremental percentage increase or decrease in the cost of inventory will translate into a very large dollar amount of cost when it runs through all of the inventory that is produced or sold. Cost of InventoryAs a result of this potential impact, a firm should minimize its total inventory costs. These are divided into the following three main categories. Ordering Costs,Carrying Costs, andStockout Costs.
Ordering CostsThese are the costs that are incurred every time inventory is ordered. These costs include:The costs of placing an order, The cost of receiving an order,Discounts lost by not ordering enough units, andAny setup costs.
Carrying CostsThese are the costs of keeping one unit of inventory in stock. These costs include the costs of:Storing the inventory, Insuring and securing the inventory, Inventory taxes, Depreciation or rent of facilities, Obsolescence and spoilage, andThe Opportunity cost of inventory investment. This is the cost of capital and it represents the amount of interest that is lost by investing our cash in inventory instead of in some other longer-term investment that returns dividends or interest.
Stockout CostsThese are the costs that are incurred through lost sales when we don’t have inventory available for the customer. It includes both the cash and profit that is lost from not being able to make that individual sale and also the cost of customer ill will. The cash cost of the lost sale is probably a very small amount and not very crucial in the larger picture, but the cost of the customer ill will is potentially very large. Ill will is almost impossible to measure as it can cause the customer to not return for future purchases, and can instigate the spread of negative information about the company in the marketplace. Safety StockThe level of safety stock a company carries is its main protection against stockouts. The safety stock is the amount of inventory the company plans to have on hand when the next shipment of inventory is due to arrive. A high level of safety stock means that even if the inventory is delayed in its receipt, the company will have sufficient levels of inventory to continue to operate while the shipment arrives.The amount of safety stock that a company is required to hold will be affected by: The variability of the lead time, The variability of the demand for the product, andThe cost of stockout.
The Reorder PointThe reorder point is the level of remaining inventory that indicates when the company needs to place the order for inventory. It is calculated as follows:
Expected demand during the lead time + Amount of safety stock = Reorder point
The average inventory that the company holds is calculated by adding together the safety stock and the number of units that is ordered each time an order is placed, and dividing this by two. Economic Order QuantityIn using EOQ, a company calculates the number of units that it should order each time it orders inventory for the purpose of achieving the minimum cost for ordering and holding inventory. This is a traditional inventory management approach and if it is used correctly it can help reduce the inventory costs of a company. The factors that are incorporated into the model are:The annual demand for inventory, The cost to carry one unit of inventory for one year (this includes the interest on funds invested in inventory), andThe cost of placing an order. EOQ AssumptionsFor the EOQ calculation to work, the following assumptions are made:The annual demand for the item is known and constant, The cost per order is known and constant, The unit carrying costs are assumed to be known and constant throughout the period, andThere are no stockout costs included in the EOQ model because it is assumed that demand can be determined and planned for. EOQ CalculationThe EOQ is calculated as follows:
2aD EOQ = k
Where a = Variable cost of placing an order D = Periodic demand k = Carrying cost per unit per period
Just-in-Time Inventory ManagementModern inventory management has departed from the EOQ approach in favor of the JIT approach. JIT inventory systems are based on a manufacturing philosophy that combines purchasing, production and inventory control into one function. This reduces the level of inventory that is held within the company at all stages of production, and thereby also reduces the cost of carrying the inventory. However, this reduced level of inventory carries with it an increased risk of stockout costs. JIT, continuedOne of the main differences between JIT and traditional inventory systems is that JIT is a “pull system” rather than a “push system.” The main idea of JIT is that nothing will be produced until the next process in the assembly line needs it. This means essentially that nothing will be produced until a customer orders it. However, we know that this is not actually possible so production is driven by the expected demand for the product. By contrast, in a push system, a department produces all that it can and sends those units to the next step in the process for further processing. This means that a company is producing something without knowing if it is actually needed or not, resulting in a possibly large, useless stock of inventory. Implementing JITTo implement the JIT approach and to minimize inventory storage, the factory must be reorganized to permit what is known as lean production. Under lean production, the plant layout is arranged by manufacturing cells that each produces a product, or product type. Each worker is able to operate all machines, and also perform support tasks within that cell. This reduces the downtime resulting from breakdowns or employee absences.Because inventory levels are kept low in a JIT system, the company must have a very close relationship with its suppliers to make certain that the supplier makes frequent deliveries of smaller amounts of inventory. It is also critical that the inventory is of the required quality because there is no extra to use in place of any defective units that are delivered. Other Inventory SystemsOther systems that you need to be aware of are:Kanban - Kanban is a Japanese inventory system in which ‘cards’ or ‘tickets’ are used to keep track of inventory and the movement of the inventory. Kanban is an integral part of a JIT system. Computer Integrated Manufacturing (CIM),Materials Requirement Planning (MRP), Manufacturing Resource Planning (MRP-II), andEnterprise Resource Planning (ERP).
Inventory Turnover RatioThis measures the number of times the company sells its inventory. If this number is too low, it may indicate that they have too much inventory and have too much cash invested in inventory.If the number is too high it may indicate that they do not have enough inventory and lose sales from stockouts.
Annual Cost of SalesAverage Annual Inventory
Days of Sale in InventoryThis measures the number of days of sales that are held in inventory, on average. The higher the number, the less risk that there is for a stockout; but the more cash is invested in inventory.
365, 360 or 300 (told in the question)Inventory Turnover
Short-Term FinancingWhen discussing short-term financing, we are focusing on the current liabilities portion of the company’s balance sheet and how these items affect a company’s net working capital.
We will discuss these short-term liabilities now because of the overlap between working capital management and capital structure finance. Sources of Short-Term Financing The two most common forms of short-term financing are:Bank loans, andFactoring receivables.
We will look at these in detail and then at other sources of short-term financing.Bank LoansBanks offer many different types of loans to borrowers and you need to be familiar with what the different terms are and also how the interest is calculated under the different arrangements.The effective interest rate is the percentage that is really paid on the loan based upon the amount of interest paid and the actual amount of funds received. This is what is most important to the company in the decision regarding what financing source to use because it eliminates any distortions caused by compensating balances, withheld interest or other items discussed below. Simple and Compound InterestIn simple interest, the interest is calculated only on the original principal amount.
Simple interest contrasts with compounded interest, in which interest is charged on the principal plus any accumulated, unpaid interest.The effective interest rate of compounded interest is higher than the effective interest rate of simple interest.
Loans with Compensating BalancesIn order to provide some sort of collateral to the loan, a bank may require the borrower to keep some amount of cash in an interest bearing checking account at the bank. This amount of cash may be a percentage of the amount of the loan or a fixed amount. This required amount is called a compensating balance. This raises the effective rate of interest paid by the borrower, since not all of the borrowed funds are available. Loans with Compensating Balances, continuedThe amount held as a compensating balance reduces the amount of the loan received.But, it does not reduce the amount of interest paidInterest is calculated from the full amount of the loan.
This greater interest rate compensates a bank for services provided and results in greater profitability for the financial institution. Often, funds kept as a compensating balance can be withdrawn for short periods of time if a certain average balance is maintained.
Compensating Balances – Effective RateThe effective interest rate on loans requiring compensating balances equals total interest cost divided by the effective amount of total cash received. It is calculated as follows:
Interest Paid – Interest received on Additional Cash Required Amount of the Loan – Amount Required to be added for the Compensating Balance Meeting the Compensating RequirementsAs in the formula above, when there is a compensating balance, the total cash received is calculated as principal amount of the loan minus the amount of cash that is necessary to be added to the normal cash balance in order to maintain the compensating balance. It is very possible that the company already has some cash in the bank and therefore already has some of the compensating balance. Therefore, in the calculation of total cash received, we will subtract only the balance that the company needs to add to its account at the bank in order to meet the compensating balance requirement. Loans with Discounted InterestDiscounted interest is a method whereby the bank deducts interest on the loan in advance. The amount of interest on the loan is not even transferred to the borrower. Having the interest discounted and withheld results in a higher effective rate than simple interest because the borrower receives less than the face value of the loan, but still needs to pay interest on the entire amount. In effect, discounted interest acts similar to a compensating balance in that it reduces the amount of funds that are received by and available to the borrower.Again, this raises the effective rate of interest applied on the loan because the interest is paid on the full amount. Discounted Interest – Effective RateThe effective interest rate is calculated as follows:Interest Paid Borrowed Amount – Interest ‘Withheld’
Because the interest portion of the repayment is guaranteed to the bank, there is a reduction of the overall risk to the lender. Therefore, the lender should offer the funds at a lower stated rate of interest. This arrangement may also benefit the borrower because no payments will need to be made to the lender until the maturity date of the loan. Installment Loans An installment loan requires periodic payments, and each payment includes both the repayment of some of the principal and the interest owed on the outstanding balance. This is essentially an annuity in which the amount borrowed is equal to the present value of all of the payments on the loan.The calculation for installment loans is more complex than others, and it is not presented here because it is not expected that installment loans will be tested with a numerical question. Factoring ReceivablesWhen companies factor their receivables, they are selling the receivables for some amount of money to a bank or other company. They also transfer the risk of not collecting the receivables to the company that bought the receivables. However, because what they are essentially doing is obtaining a loan that is guaranteed by the receivables, they are going to have to pay ‘interest’ on this loan, and they will therefore not receive the face amount of the receivables when they factor them.This is a very common practice in many countries as it enables a company to immediately receive the cash from its receivables and use this money for other purposes. Cash Received from FactoringThe company selling the receivables does not receive the face amount of the receivables when it sells them. There are possibly three things that will reduce the amount of money that is actually received from the factoring of the receivables. Factoring fee,Interest charge, andReserve allowance.The Factoring FeeThe company purchasing the receivables (called the factor) will usually charge a fee for this service. The fee is usually a set percentage of the amount of the receivables. This fee will be higher if the factor determines that there is more risk related to the receivables that are purchased. Interest ChargeThe factor is providing a loan to the seller of the receivables and will collect this loan when the receivables are actually paid. The factor will charge an interest rate on the amount of the loan that is provided to the seller. This interest rate will almost always be higher than the market rate of interest. The interest rate is higher than market because it reflects two ‘costs’ that the factor assumes in this transaction.The costs of collection and the risk of noncollection, andThe time value of the money that is given as a loan to the selling company. This occurs because the factor is giving the money to the seller now, but will not be receiving the cash from the receivables until some point in the future. In essence the factoring of the receivables is similar to getting a loan from the bank with the loan being guaranteed by the receivables. Reserve AllowanceIn addition to the factor fee and the interest charge, sometimes the factor withholds some amount of the money that he owes to the seller as a reserve. This reserve acts as a guarantee against noncollection. If all of the receivables are collected, the reserve will then be paid to the seller. If there are some bad debts that are not received by the factor, then they will be deducted from the reserve before it is paid to the seller. Advantages of FactoringOne of the reasons that a company is willing to enter into the factoring agreement is because the factor is probably able to more effectively and efficiently collect the receivables than the company. Other advantages of factoring for a company are:A reduction of the costs of collection by outsourcing this function. This will enable the company to reduce the time and cost of collections,The factor can often operate more efficiently than its clients because of the specialized nature of its service, andBad debts are eliminated because the risk of noncollection is passed to the factor. However, the company needs to pay a fee to the factor instead. (Also, in the case that the factor withholds a reserve, the risk of bad debts is not eliminated.) Disadvantages of FactoringThe only big disadvantage of using factoring as a source of financing is that the reduction in costs that are received from not having to collect the receivables may not completely offset the fee and interest that is charged by the factor. This is a classic example of cost-benefit decision-making. Cash Received from FactoringThe formula to calculate the cash received from factoring is as follows: Face amount of the receivables - The amount of the reserve (based on face amount of receivables) - The factor’s fee (this is also calculated from the face amount) = Amount that the seller needs to pay interest on - Interest for the time period before the collection of the receivables = Cash to be received by the seller
Other Sources of Short-Term FinancingSeveral other secured and unsecured sources of short-term funds are available to companies. Before looking at these other sources of financing, it is important to draw the distinction between secured and unsecured debts.A secured debt is one that involves an asset that is used as collateral for repayment of the loan should the borrower default. An unsecured debts has no such collateral backing them, and thus, will be more expensive (higher interest rate paid by the borrower) to compensate for the higher default risk.
Secured Sources of FinancingOther sources of secured financing that you need to be aware of are:First and second mortgagesChattel mortgagesFloating liensPledged receivablesWarehouse financingInventory financingUnsecured Sources of FinancingOther sources of secured financing that you need to be aware of are:Trade credit (payables)Repurchase agreementsAccrued expenses (wages payable, for example)Line of creditRevolving line of creditCommercial paperBankers’ acceptances
Net working capital is calculated as follows:Net Working Capital = Current Assets – Current Liabilities
Working Capital GoalsWorking capital management is a process of balancing different goals by management. On one hand, every company must be certain that they have enough cash to be able to pay their liabilities as they come due. However, the short-term assets (cash, inventory, receivables) that the company holds provide very little, if any, return.
Therefore, the more short-term assets held by the company, the lower the chance of insolvency, but the lower the return that is earned on company assets. Levels of Working CapitalA conservative working capital policy seeks to minimize liquidity risk by increasing the amount of working capital that it holds. The company gives up the potentially higher returns available from using the additional working capital to acquire long-term assets, but is in a safer position with respect to liquidity and possible insolvency because of the greater amount of working capital. An aggressive working capital policy reduces the current ratio (calculated as current assets ÷ current liabilities) and accepts a higher risk of short-term cash flow problems in exchange for a greater return on investment. The company will have a very low (maybe even negative) level of working capital, but will also have a higher return on its assets. In the short term it is possible to have a negative working capital. In this case, the company is planning to collect additional cash or receive a new source of financing before its current liabilities become due.
Types of Working CapitalBecause a company may have different cash needs throughout the year, it is possible that it will maintain different levels of working capital at different times of the year. Permanent working capital is the minimum amount of working capital that is maintained at all times.The increases that occur from time to time are called temporary working capital.
Changing Levels of Working CapitalA company may increase its net working capital by either: 1) Increasing current assets, or 2) Decreasing current liabilities. Conversely, a company may decrease its net working capital by either: 1) Decreasing current assets, or 2) Increasing current liabilities.
Effect of Other TransactionsTransactions in which one current asset is exchanged for another current asset have no effect on net working capital. An example of this type of transaction is the collection of accounts receivable. When cash received, there will be an equal decrease in account receivable. Another type of transaction that does not affect net working capital is one in which both current assets and liabilities are increased (or decreased). If a company purchases inventory on short-term credit, the current assets of the company will increase, but so will current liabilities. Similarly, the payment of the payable will not have an effect on working capital because both a current asset and a current liability are reduced by an equal amount. Short-Term Liquidity RatiosShort-term liquidity ratios (also called solvency ratios) measure the short-term viability of a business. This is a firm’s ability to continue operating in the short term by paying its obligations as they come due. A company must have enough working capital to finance its daily operations. This working capital, which the company holds, bridges the gap between production (spending money) and sales (collecting money). As discussed earlier, maintaining a comfortable level of working capital is important, and doing so enhances the company’s ability to meet its current liabilities, expand production, and take advantage of business opportunities that may arise. However, maintaining too much working capital can make it difficult for a company to maximize the return from its assets. Current RatioThe current ratio measures working capital as a ratio instead of a dollar amount. It is calculated as:Current AssetsCurrent Liabilities
Again, this number should be more than 1. The specific ‘target’ amount depends on the business and the industry.
Quick RatioThe quick ratio is based on the current ratio, but it does not include inventory in the numerator. This is because the company should not use inventory to pay its liabilities as the company would then have nothing left to sell.
Cash + Cash Equivalents + Receivables + Short-term SecuritiesCurrent Liabilities
This is also called the ‘Acid-test Ratio’Cash RatioThe cash ratio further adjusts the current ratio by not including receivables in the numerator
Cash + Cash Equivalents + Short-term SecuritiesCurrent LiabilitiesCash Flow RatioThe cash flow ratio compares the cash flows from operating activities with the average current liabilities during the period.
Annual Cash Flows from Operating ActivitiesAverage Current Liabilities
Cash ManagementCash management is one of the most critical processes for a company. If there is not enough cash at any one point in time a company will face, at worst, bankruptcy or at least high interest charges to obtain the necessary cash from a bank on short notice. A company must manage cash from both a short-term and a long-term perspective. In the short-term it is essential that the company have enough cash to pay its obligations as they come due.In the long-term, it is critical that the company has enough cash to grow and expand as needed. How Much Cash is Needed?Among these factors that influence how much cash is held are:How much cash will be needed in the near future,The amount of risk a company is willing to take in respect to solvency,The level of other short-term assets that a company holds,The available return on other short-term investments, At what point in its business cycle it is in (if a business is a seasonal business it will have more cash at the peak periods than at the slow periods).
Reasons for Holding CashThe reasons that a company holds cash are many and varied. However, we can break the reasons for holding cash into the following categories:As a medium of exchange. Cash is still needed for some business transactions.As a precautionary measure. Cash may be held for use in unforeseen situations where cash is needed quickly. There is no longer a need to keep cash outside of the bank as a protection against the failure of the bank because bank accounts in the U.S. are guaranteed. For speculation. Cash may be held in order to be able to act quickly on good investment opportunities that arise. Cash may be held as a compensating balance. This occurs when a bank requires that a company maintain a minimum balance in its bank account during the period that a loan is outstanding.
Operating Cycle and Cash CycleThe operating cycle measures the amount of time it takes to convert an investment in inventory back into cash after the collection of the sale. It is calculated as:Days in Inventory + Days of Sales in Receivables
The cash cycle represents the number of days that cash is tied up in the operating cycle of the business. It is:Days in Inventory + Days of Sales in Receivables – Days of Purchases in Payables
Both of these are better if they are shorter.
Timing of Cash FlowsThe main two elements of managing cash are:Collecting cash as quickly as possible (speeding cash inflows), andDisbursing cash as slowing as possible (slowing cash outflows).
Speeding Cash Inflows A company should always endeavor to receive its cash payments as soon as possible in order to maximize its cash management position. The following measures can help to expedite cash inflows and minimize collection float (the collection of receivables):All invoices should be mailed as soon as possible under the terms of the sales agreement so that they can be paid as soon as they are due.The payment terms for credit should be such that they encourage prompt payment. Giving a discount if the invoice is paid before the due date may achieve this. We will look at the calculations related to this in the slowing payments section.Use of electronic data interchange (EDI), electronic funds transfer (EFT) and automated clearinghouses (ACHs).
Speeding Cash Inflows, continuedAccept credit cards (Visa, MasterCard and American Express, for example) can be used as an alternative method of speeding up collection rates. The bank that issued the card charges the seller a fee equal to 1% - 3% of a charge sale, but the funds are instantly available to the seller when a buyer uses a credit card. The responsibility for collection has been transferred to the credit card in exchange for the fee that they charge. Use wire transfers as a means of collection from customer. Utilize a lockbox system. This method will be discussed in greater detail.Lockbox SystemIn a lockbox system, a company maintains special mailboxes in different locations around the country. Customer send their payment to the closest lockbox. This reduces the amount of time the money is in the mail.The company then authorizes a bank to check these mailboxes as often as is reasonable, given the number of payments that will be received. Because the bank is making the collection, the funds that have been received are immediately deposited into the company’s account without first being processed by the company’s accounting system, thereby speeding up cash collection. Benefits of a Lockbox SystemFor a company to benefit from a lockbox system, the interest earned from the additional day(s) on the cash received (because the bank collected it directly and deposited it immediately) must be greater than the cost of the bank fees for providing this service. Having several lockbox locations reduces the time a payment is in the postal system. It also allows concentration banking to be used. This is a system in which a regional bank is responsible for the transfer of lockbox receipts in that region. By also having a disbursement account at each of the regional centers, a company will have faster access to its money because there is no need to wait for the money to be transferred to the central bank account. Calculating the Lockbox BenefitThe calculation of the benefit from a lockbox system is calculated using the following steps:Calculate the amount of cash that is collected each day.Multiply this by the number of days that the collection float will be reduced (this calculates the increase in the cash balance that the company will have for the year).Multiply the increase in the cash balance by the interest rate at which the company can invest their funds. This is the benefit that the company will receive.The final step is to compare the amount of the benefit to the company to the cost that they will need to pay for the new system. If the savings are more than the cost, the company should invest in the new cash management system.
Slowing Cash OutflowsAs opposed to cash inflows, a company should slow its cash disbursements in order to increase the amount of time that it has the cash.Payments should be made as close to deadline requirements as possible. However, it is important to remember that if a company misses the payment date they may incur interest charges or lose the chance to purchase from that supplier again.Payments should be made within the cash discount period, if taking the discount provides a better return than not taking the discount. This will be looked at in more detail later.Slowing Cash Outflows, continuedMaking payments via drafts (check). The advantage to the payer is that there is a delay of time between when the check is presented for payment (this is when the recipient receives the money) and when the money is taken out of the account of the company that wrote the check. This delay (cash taken out of the account) is called the check float. The effect of this delay is an interest free loan for the time that the check has been paid, but not yet deducted from his cash account. There are two types of floats, depending on if the person is making payment or receiving payment by the check. The person paying has what is called the disbursement float and the person receiving the money has what is called the collections float. Slowing Cash Outflows, continuedUsing Payable Through Drafts (PTD) are a specific type of draft that a company can use. It functions largely like a check, except the recipient needs to present the PTD to the company who issued it. Some banks offer zero balancing checking accounts, although a fee may be charged for this service. In a zero-balance account, the account balance is maintained at zero until the bank receives a check for payment. This resulting overdraft (having a negative balance in an account) is then automatically ‘covered’ by the bank by transferring money from another account that the company holds. This other account is one that bears interest and a zero-balance arrangement allows the company to earn interest on its funds for as long as possible. Slowing Cash Outflows, continuedUsing Overdrafts as a method of slowing payment is similar to zero-balance checking accounts except the fact that in an overdraft there is no second account from which to transfer the money. Therefore, the company has a negative balance at the bank and as a result will need to pay various penalties and/or high interest on this amount. Because of the penalties and interest, this should not be a common method used by a company to slow its payments. Calculating compensating balances on an average basis rather than an absolute basis. By using an average daily cash balance for the compensating balance, the company can manage its cash more effectively as it doesn’t always need to keep a minimum balance in the bank as long as the average is the required amount. Taking the Cash DiscountA cash discount is when the company receives a discount if they pay their payable within a certain number of days after it is created. A typical cash discount would be 2/10, n/30. This means that if the company pays within 10 days, they get a 2% discount. If they do not pay within 10 days, the full amount is due in 30 days.Payments should be made within the cash discount period, if taking the discount provides a better return than not taking the discount. Taking the Cash Discount CalculationThe calculation of the cost of not taking the cash discount that is offered for early payment, is calculated as follows:
If this cost of not taking the discount is higher than the cost of capital to the company, they should take the cash discount and pay within the discount period. Marketable Securities ManagementMost companies try to avoid holding large cash balances and prefer to borrow to meet any extraordinary short-term cash needs because holding cash does not provide any return on the cash that is heldMarketable securities provide some return on what is invested. Marketable securities may be purchased so that the maturity periods of the securities will match a time period of low cash balances or higher than usual cash needs. These securities may be used to synchronize the cash inflows and the cash outflows of the business. Marketable Securities Management, continuedThe purpose of a marketable securities portfolio is to provide a store of liquidity. The return on the portfolio is only a secondary objective. Liquidity has two components: time and amount. Marketable securities should be converted into cash quickly (usually in less than 24 hours).The risk of change in value should be very low, meaning that they can be sold without a large discount.
Marketable Securities Management, continuedA firm should choose its investments with a view of the financial (repayment) risks involved with each security. As a result, a higher return may be given up in exchange for greater safety (less chance of default) by placing cash in investments with lower rates of return in exchange for a lower risk profile. Interest rate risk is the change in value of a fixed income security that results from a change in market interest rates. In order to minimize interest rate risk, marketable securities should be investments with short-term maturities. Liquidity is a function of how quickly an asset can be converted into cash, and how safe the investment is from loss of value. Only high quality, short-term debt instruments typically qualify as marketable securities. Tax Issues with Marketable SecuritiesSome marketable securities that are issued by cities, states or the federal government are tax-exempt. This means that the interest earned from this security is exempt from taxation by federal, state and/or other local authorities. These are frequently called “municipal bonds” even though they may not have been issued by a municipality (city).
Because of this tax-exempt status of the interest, the interest rate on a tax-exempt security is less than that from a corporate bond. This is because the tax exemption provides extra compensation to the holder of the security. The higher the tax bracket of the investor, the more attractive the tax-free alternative becomes. Investment PoliciesBecause of the variety of factors that go into the decisions related to marketable securities, it is very helpful if a company has an investment policy statement. This statement provides guidance to the individuals who need to make these decisions and as a result, ensures that the investments that are made throughout the company are in line with its policies. Types of Marketable SecuritiedThere are a number of different types of instruments that may be classified as marketable securities.The main ones that you need to know are:Treasury bills,Certificates of deposits (CDs),Money market accounts, andHigh-grade commercial paper.
Other marketable securities are listed after a discussion of these.Treasury BillsTreasury bills (also called T-Bills) are short-term government debt securities (mature in 30, 90, or 120 days) guaranteed by the full faith and confidence of the U.S. government. The income from T-Bills is exempt from state and local taxes, but not federal taxation. T-Bills differ from obligations of federal agencies, which are guaranteed only by the agency that is issuing the bill and not the U.S. government. T-Bills are sold at a discount, which means you pay less than the face value, and redeem them at par on maturity. The difference is the discount. Treasury Bills – Calculating the DiscountThe calculation of the amount of the discount is: Face value of the Bill - Interest earned while the T-Bill is outstanding = Discounted Basis
The T-Bill interest rate is calculated as follows:Certificates of Deposit (CDs)CDs are a form of savings deposit with a bank that may not be withdrawn before their maturity without a high penalty. CDs usually have a higher rate of interest when compared with other savings instruments because they are for fixed, usually long-term periods. The longer the period of the CD, the higher the interest rate that is paid. A negotiable CD is usually sold with higher denominations ($100,000 and more) and can be freely traded on secondary markets, but fall under the regulation of the Federal Reserve System. The return on a negotiable CD is high, but not as high as the return on commercial paper since the risk is lower than for commercial paper. Money Market AccountsMoney market accounts operate in a manner similar to checking accounts but they pay higher interest rates, generally in line with money market mutual funds. The number of checks that can be written against the account is usually limited although unlimited transfers can be made via ATMs. Balances in the account may be withdrawn at any time without penalty, but in return for this flexibility, the interest rate that is earned is less than on CDs. High-Grade Commercial PaperHigh-grade commercial paper is marketable short-term, unsecured debt that is issued by large companies that have solid credit histories and high credit ratings. These instruments are sold to other large companies and institutional investors. Commercial paper is usually issued in very large denominations ($100,000 or more) and is unsecured. Like T-Bills, commercial paper is sold at a discount, and the face value is paid at maturity. High-grade commercial paper may yield a higher return than CDs because of the higher risks involved with the unsecured debt. Maturities for commercial paper are at most 270 days. Other Marketable SecuritiesOther types of marketable securities that you need to recognize as marketable securities are:Bankers’ acceptances,Federal agency securities,Eurodollars,Money market mutual funds,State and local government securities,Treasury notes and bonds, andRepurchase agreements.
Cash and Marketable Security Models There are 2 models of marketable securities management that both address the need of the company to balance the amounts of cash and marketable securities that they hold.Too much cash (and not enough marketable securities) reduces the return that the company received on their assets.Not enough cash (and too many marketable securities) increases the risk of insolvency.The two models are:Baumol Cash Management Model, andThe Miller-Orr Management Model.The Baumol Cash Management ModelThis model is based off of the same equation that we will see in the calculation of the economic order quantity (EOQ) for inventory. (This is covered in more detail in the inventory section.) In the application of EOQ to cash management, a company is calculating the optimal cash (OC) level to receive every time it converts marketable securities to cash. Another way of looking at this formula is that it determines the amount of cash that should be converted from securities each time a conversion is made in order to minimize the costs of conversion and the opportunity cost that is given up by holding cash instead of marketable securities. The Baumol FormulaIn this formula the assumption is that cash that is not needed in the immediate future by the company are held as marketable securities. To get more cash the company simply needs to convert these marketable securities into cash. However, in order to convert these securities to cash, there is a fixed fee (such as a brokerage fee) that is paid for each conversion. Also, any time that cash is held, the company gives up the interest that was being earned by the marketable securities. This formula balances the cost of converting marketable securities into cash with the interest benefit of holding marketable securities. The Miller-Orr ModelThe Miller-Orr addresses the issue that the demand for cash is not known and is not constant over time. Similarly, the source of cash is not known and not constant. The Miller-Orr Model creates an upper limit and a lower limit for the cash balance that a company holds. As long as the cash balance is between these two levels, there is no need for the company to make any cash transactions to either increase or decrease the balance. As soon as the cash balance moves outside of this corridor, the company needs to do something to bring it back into the corridor.The model also establishes a cash balance that the company will move towards whenever it makes a cash transaction. Accounts Receivable ManagementIn managing accounts receivable a company must balance the amount of receivables outstanding and the amount of bad debts resulting from receivables not collected. The company must balance the trade-off betweenThe rewards of credit sales (additional sales that would not be made if only cash sales were accepted), and The costs of having and collecting the corresponding accounts receivable (these costs include collection costs, foregone interest, bad debt costs, etc). Obviously, it would be best for a company to never have bad debts, but the only way to do this is to never make a credit sale. Credit Policy VariablesThere are three credit policy variables Credit standards – these determine who the company grants credit to. Relaxed terms mean that the company gives credit to more people, and strict terms means that the company gives credit to only those with very low risk of default.Credit terms – the terms of sale, including the payment period, discount for early payment or penalty for late payment, and the size of the discount or penalty.Collection efforts – the amount of time and money spent on collection of past due accounts. Changing Credit Policy ItemsAny action that changes any of these variables will have both costs and benefits. The benefits may be in the form of increased sales revenues, the reduction of opportunity costs due to lower accounts receivable balances, fewer bad debts or lower collection expenses. The costs may include lost sales revenue, increased discounts taken, the opportunity cost of higher accounts receivable balances, higher bad debts or higher collection expensesSome companies use a system called credit scoring in an attempt to manage their credit policies and extend credit policies only to worthy customers. In a credit scoring system, a potential customer is graded against specific criteria and they get points for meeting certain criteria. The ‘score’ that a potential customer receives then determines whether or not it will receive credit. Impact of Credit Policy ChangesIf the credit standards are made softer (changed so that more people are able to obtain credit), there will be:An increase in sales. A corresponding increase in bad debts and collection costs resulting from people with worse credit histories who can borrow money from the company. In other words, as the credit terms are relaxed and more people obtain credit, there is an increase in the default risk. Conversely, a change to more strict credit policies will have the opposite effect. This will cause lower levels of accounts receivables and bad debts, but also lower levels of credit sales. Other Types of ReceivablesIn addition to accounts receivable (called an invoice), a company has other options about how it may make a sale and then collect the money at a later date. Among these other options are:Promissory Note – this is an unconditional promise by one party to pay another party a certain amount of money at a time in the future. Conditional Sales Contract – this is often used for larger cost items and the seller sells the item to the buyer, but retains the actual title to the item until all of the payments have been made. After all payments have been made, title is transferred to the buyer.Commercial Draft – this is a business-to-business order for payment. Credit Cards – credit cards are in a sense another form of a credit sale, but this is much closer to a cash sale because the seller almost immediately collects the money from the credit card company. The credit card company that needs to collect from the buyer. One drawback to this type of sale is that the seller does not receive 100% of the sales price as the credit card company takes a commission on the sale. Accounts Receivable TurnoverLike the Inventory Turnover number, this measures how many times during the period the company collects its receivables.
Annual Credit SalesAverage Annual Accounts Receivable
Days of Sales in ReceivablesThis is the number of sales that are outstanding and not yet collected (held as receivables)
365, 360 or 300 (told in the question)Receivables Turnover
Inventory ManagementInventory management is a critical part of the accounting function of any company that produces or sells a product. If a company is a seller of finished goods or a producer of goods, it is very possible that inventory will be the largest, or one of the largest, items on the balance sheet. Therefore, a small incremental percentage increase or decrease in the cost of inventory will translate into a very large dollar amount of cost when it runs through all of the inventory that is produced or sold. Cost of InventoryAs a result of this potential impact, a firm should minimize its total inventory costs. These are divided into the following three main categories. Ordering Costs,Carrying Costs, andStockout Costs.
Ordering CostsThese are the costs that are incurred every time inventory is ordered. These costs include:The costs of placing an order, The cost of receiving an order,Discounts lost by not ordering enough units, andAny setup costs.
Carrying CostsThese are the costs of keeping one unit of inventory in stock. These costs include the costs of:Storing the inventory, Insuring and securing the inventory, Inventory taxes, Depreciation or rent of facilities, Obsolescence and spoilage, andThe Opportunity cost of inventory investment. This is the cost of capital and it represents the amount of interest that is lost by investing our cash in inventory instead of in some other longer-term investment that returns dividends or interest.
Stockout CostsThese are the costs that are incurred through lost sales when we don’t have inventory available for the customer. It includes both the cash and profit that is lost from not being able to make that individual sale and also the cost of customer ill will. The cash cost of the lost sale is probably a very small amount and not very crucial in the larger picture, but the cost of the customer ill will is potentially very large. Ill will is almost impossible to measure as it can cause the customer to not return for future purchases, and can instigate the spread of negative information about the company in the marketplace. Safety StockThe level of safety stock a company carries is its main protection against stockouts. The safety stock is the amount of inventory the company plans to have on hand when the next shipment of inventory is due to arrive. A high level of safety stock means that even if the inventory is delayed in its receipt, the company will have sufficient levels of inventory to continue to operate while the shipment arrives.The amount of safety stock that a company is required to hold will be affected by: The variability of the lead time, The variability of the demand for the product, andThe cost of stockout.
The Reorder PointThe reorder point is the level of remaining inventory that indicates when the company needs to place the order for inventory. It is calculated as follows:
Expected demand during the lead time + Amount of safety stock = Reorder point
The average inventory that the company holds is calculated by adding together the safety stock and the number of units that is ordered each time an order is placed, and dividing this by two. Economic Order QuantityIn using EOQ, a company calculates the number of units that it should order each time it orders inventory for the purpose of achieving the minimum cost for ordering and holding inventory. This is a traditional inventory management approach and if it is used correctly it can help reduce the inventory costs of a company. The factors that are incorporated into the model are:The annual demand for inventory, The cost to carry one unit of inventory for one year (this includes the interest on funds invested in inventory), andThe cost of placing an order. EOQ AssumptionsFor the EOQ calculation to work, the following assumptions are made:The annual demand for the item is known and constant, The cost per order is known and constant, The unit carrying costs are assumed to be known and constant throughout the period, andThere are no stockout costs included in the EOQ model because it is assumed that demand can be determined and planned for. EOQ CalculationThe EOQ is calculated as follows:
2aD EOQ = k
Where a = Variable cost of placing an order D = Periodic demand k = Carrying cost per unit per period
Just-in-Time Inventory ManagementModern inventory management has departed from the EOQ approach in favor of the JIT approach. JIT inventory systems are based on a manufacturing philosophy that combines purchasing, production and inventory control into one function. This reduces the level of inventory that is held within the company at all stages of production, and thereby also reduces the cost of carrying the inventory. However, this reduced level of inventory carries with it an increased risk of stockout costs. JIT, continuedOne of the main differences between JIT and traditional inventory systems is that JIT is a “pull system” rather than a “push system.” The main idea of JIT is that nothing will be produced until the next process in the assembly line needs it. This means essentially that nothing will be produced until a customer orders it. However, we know that this is not actually possible so production is driven by the expected demand for the product. By contrast, in a push system, a department produces all that it can and sends those units to the next step in the process for further processing. This means that a company is producing something without knowing if it is actually needed or not, resulting in a possibly large, useless stock of inventory. Implementing JITTo implement the JIT approach and to minimize inventory storage, the factory must be reorganized to permit what is known as lean production. Under lean production, the plant layout is arranged by manufacturing cells that each produces a product, or product type. Each worker is able to operate all machines, and also perform support tasks within that cell. This reduces the downtime resulting from breakdowns or employee absences.Because inventory levels are kept low in a JIT system, the company must have a very close relationship with its suppliers to make certain that the supplier makes frequent deliveries of smaller amounts of inventory. It is also critical that the inventory is of the required quality because there is no extra to use in place of any defective units that are delivered. Other Inventory SystemsOther systems that you need to be aware of are:Kanban - Kanban is a Japanese inventory system in which ‘cards’ or ‘tickets’ are used to keep track of inventory and the movement of the inventory. Kanban is an integral part of a JIT system. Computer Integrated Manufacturing (CIM),Materials Requirement Planning (MRP), Manufacturing Resource Planning (MRP-II), andEnterprise Resource Planning (ERP).
Inventory Turnover RatioThis measures the number of times the company sells its inventory. If this number is too low, it may indicate that they have too much inventory and have too much cash invested in inventory.If the number is too high it may indicate that they do not have enough inventory and lose sales from stockouts.
Annual Cost of SalesAverage Annual Inventory
Days of Sale in InventoryThis measures the number of days of sales that are held in inventory, on average. The higher the number, the less risk that there is for a stockout; but the more cash is invested in inventory.
365, 360 or 300 (told in the question)Inventory Turnover
Short-Term FinancingWhen discussing short-term financing, we are focusing on the current liabilities portion of the company’s balance sheet and how these items affect a company’s net working capital.
We will discuss these short-term liabilities now because of the overlap between working capital management and capital structure finance. Sources of Short-Term Financing The two most common forms of short-term financing are:Bank loans, andFactoring receivables.
We will look at these in detail and then at other sources of short-term financing.Bank LoansBanks offer many different types of loans to borrowers and you need to be familiar with what the different terms are and also how the interest is calculated under the different arrangements.The effective interest rate is the percentage that is really paid on the loan based upon the amount of interest paid and the actual amount of funds received. This is what is most important to the company in the decision regarding what financing source to use because it eliminates any distortions caused by compensating balances, withheld interest or other items discussed below. Simple and Compound InterestIn simple interest, the interest is calculated only on the original principal amount.
Simple interest contrasts with compounded interest, in which interest is charged on the principal plus any accumulated, unpaid interest.The effective interest rate of compounded interest is higher than the effective interest rate of simple interest.
Loans with Compensating BalancesIn order to provide some sort of collateral to the loan, a bank may require the borrower to keep some amount of cash in an interest bearing checking account at the bank. This amount of cash may be a percentage of the amount of the loan or a fixed amount. This required amount is called a compensating balance. This raises the effective rate of interest paid by the borrower, since not all of the borrowed funds are available. Loans with Compensating Balances, continuedThe amount held as a compensating balance reduces the amount of the loan received.But, it does not reduce the amount of interest paidInterest is calculated from the full amount of the loan.
This greater interest rate compensates a bank for services provided and results in greater profitability for the financial institution. Often, funds kept as a compensating balance can be withdrawn for short periods of time if a certain average balance is maintained.
Compensating Balances – Effective RateThe effective interest rate on loans requiring compensating balances equals total interest cost divided by the effective amount of total cash received. It is calculated as follows:
Interest Paid – Interest received on Additional Cash Required Amount of the Loan – Amount Required to be added for the Compensating Balance Meeting the Compensating RequirementsAs in the formula above, when there is a compensating balance, the total cash received is calculated as principal amount of the loan minus the amount of cash that is necessary to be added to the normal cash balance in order to maintain the compensating balance. It is very possible that the company already has some cash in the bank and therefore already has some of the compensating balance. Therefore, in the calculation of total cash received, we will subtract only the balance that the company needs to add to its account at the bank in order to meet the compensating balance requirement. Loans with Discounted InterestDiscounted interest is a method whereby the bank deducts interest on the loan in advance. The amount of interest on the loan is not even transferred to the borrower. Having the interest discounted and withheld results in a higher effective rate than simple interest because the borrower receives less than the face value of the loan, but still needs to pay interest on the entire amount. In effect, discounted interest acts similar to a compensating balance in that it reduces the amount of funds that are received by and available to the borrower.Again, this raises the effective rate of interest applied on the loan because the interest is paid on the full amount. Discounted Interest – Effective RateThe effective interest rate is calculated as follows:Interest Paid Borrowed Amount – Interest ‘Withheld’
Because the interest portion of the repayment is guaranteed to the bank, there is a reduction of the overall risk to the lender. Therefore, the lender should offer the funds at a lower stated rate of interest. This arrangement may also benefit the borrower because no payments will need to be made to the lender until the maturity date of the loan. Installment Loans An installment loan requires periodic payments, and each payment includes both the repayment of some of the principal and the interest owed on the outstanding balance. This is essentially an annuity in which the amount borrowed is equal to the present value of all of the payments on the loan.The calculation for installment loans is more complex than others, and it is not presented here because it is not expected that installment loans will be tested with a numerical question. Factoring ReceivablesWhen companies factor their receivables, they are selling the receivables for some amount of money to a bank or other company. They also transfer the risk of not collecting the receivables to the company that bought the receivables. However, because what they are essentially doing is obtaining a loan that is guaranteed by the receivables, they are going to have to pay ‘interest’ on this loan, and they will therefore not receive the face amount of the receivables when they factor them.This is a very common practice in many countries as it enables a company to immediately receive the cash from its receivables and use this money for other purposes. Cash Received from FactoringThe company selling the receivables does not receive the face amount of the receivables when it sells them. There are possibly three things that will reduce the amount of money that is actually received from the factoring of the receivables. Factoring fee,Interest charge, andReserve allowance.The Factoring FeeThe company purchasing the receivables (called the factor) will usually charge a fee for this service. The fee is usually a set percentage of the amount of the receivables. This fee will be higher if the factor determines that there is more risk related to the receivables that are purchased. Interest ChargeThe factor is providing a loan to the seller of the receivables and will collect this loan when the receivables are actually paid. The factor will charge an interest rate on the amount of the loan that is provided to the seller. This interest rate will almost always be higher than the market rate of interest. The interest rate is higher than market because it reflects two ‘costs’ that the factor assumes in this transaction.The costs of collection and the risk of noncollection, andThe time value of the money that is given as a loan to the selling company. This occurs because the factor is giving the money to the seller now, but will not be receiving the cash from the receivables until some point in the future. In essence the factoring of the receivables is similar to getting a loan from the bank with the loan being guaranteed by the receivables. Reserve AllowanceIn addition to the factor fee and the interest charge, sometimes the factor withholds some amount of the money that he owes to the seller as a reserve. This reserve acts as a guarantee against noncollection. If all of the receivables are collected, the reserve will then be paid to the seller. If there are some bad debts that are not received by the factor, then they will be deducted from the reserve before it is paid to the seller. Advantages of FactoringOne of the reasons that a company is willing to enter into the factoring agreement is because the factor is probably able to more effectively and efficiently collect the receivables than the company. Other advantages of factoring for a company are:A reduction of the costs of collection by outsourcing this function. This will enable the company to reduce the time and cost of collections,The factor can often operate more efficiently than its clients because of the specialized nature of its service, andBad debts are eliminated because the risk of noncollection is passed to the factor. However, the company needs to pay a fee to the factor instead. (Also, in the case that the factor withholds a reserve, the risk of bad debts is not eliminated.) Disadvantages of FactoringThe only big disadvantage of using factoring as a source of financing is that the reduction in costs that are received from not having to collect the receivables may not completely offset the fee and interest that is charged by the factor. This is a classic example of cost-benefit decision-making. Cash Received from FactoringThe formula to calculate the cash received from factoring is as follows: Face amount of the receivables - The amount of the reserve (based on face amount of receivables) - The factor’s fee (this is also calculated from the face amount) = Amount that the seller needs to pay interest on - Interest for the time period before the collection of the receivables = Cash to be received by the seller
Other Sources of Short-Term FinancingSeveral other secured and unsecured sources of short-term funds are available to companies. Before looking at these other sources of financing, it is important to draw the distinction between secured and unsecured debts.A secured debt is one that involves an asset that is used as collateral for repayment of the loan should the borrower default. An unsecured debts has no such collateral backing them, and thus, will be more expensive (higher interest rate paid by the borrower) to compensate for the higher default risk.
Secured Sources of FinancingOther sources of secured financing that you need to be aware of are:First and second mortgagesChattel mortgagesFloating liensPledged receivablesWarehouse financingInventory financingUnsecured Sources of FinancingOther sources of secured financing that you need to be aware of are:Trade credit (payables)Repurchase agreementsAccrued expenses (wages payable, for example)Line of creditRevolving line of creditCommercial paperBankers’ acceptances
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