Presentation is loading. Please wait.

Presentation is loading. Please wait.

PowerPoint Presentation prepared by Traven Reed Canadore College.

Similar presentations


Presentation on theme: "PowerPoint Presentation prepared by Traven Reed Canadore College."— Presentation transcript:

1 PowerPoint Presentation prepared by Traven Reed Canadore College

2 chapter 17 Working Capital Management and Short-Term Financing

3 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Corporate Valuation and Working Capital Management

4 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Topics in Chapter Cash conversion cycle Alternative net operating working capital policies Cash budget Short-term financing policies Trade credit Bank loans and their costs

5 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Basic Definitions (Gross) working capital: total current assets used in operations Net working capital: current assets - current liabilities. Net operating working capital (NOWC): Operating CA – Operating CL = (cash + inventories + accounts receivable) – (accruals + accounts payable)

6 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Cash Conversion Cycle The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales: Cash Conversion = Cycle Inventory Conversion + Period Receivables Collection - Period Payables Deferral Period

7 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Cash Conversion Cycle

8 CH17 Cash Conversion Cycle CCC = inventory period (73) + receivables period (24) – accounts payable period (30) = 67 days = Where sales = $10m, inv = $2m, cost of goods sold = $8m, A/R = A/P = $657,534 Net delay = cash inflow delay – payment delay = ( ) – 30 = 67 days Copyright © 2011 by Nelson Education Ltd. All rights reserved Payables COGS/365 Inventory sales/365 Receivables sales/365 +-

9 CH17 Shortening Cash Conversion Cycle CCC can be improved: –By processing and selling goods quickly (ICP↓) –By speeding up collections (DSO↓) –By slowing down payments (PDP↑) Without increasing costs or depressing sales, firms should make their CCC as little as possible Copyright © 2011 by Nelson Education Ltd. All rights reserved. 17-9

10 CH17 Benefits from shortening CCC ∆NOWC = -$268,493 (improvement) Copyright © 2011 by Nelson Education Ltd. All rights reserved OriginalImproved Annual sales$10,000,000 Cost of goods sold (COGS)8,000,000 Inventory conversion period73 days65 days Receivables collection period24 days23 days Payable deferral period(30) days(31) days Cash conversion cycle67 days57 days Inventory$2,000,000$1,780,82 Receivables657,534630,137 Payables(657,534)(679,452) Net operating working capital$2,000,000$1,731,507

11 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Definitions Net operating working capital management includes both establishing policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable. NOWC policy deals with: –The level of each current asset. –How current assets are financed.

12 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Net Working Capital Policies Relax working capital policy: firms hold relatively large amounts of each type of current asset. Restricted working capital policy: firms would hold minimal amounts of these item. Each dollar of NOWC is forced to “work harder”. Moderate working capital policy: between the two extremes.

13 CH17 Permanent vs. temporary NOWC Permanent net operating working capital is the NOWC that the firm holds even during slack times. Temporary NOWC is the additional NOWC needed during seasonal or cyclical peaks. In reality, NOWC never drops to zero. Copyright © 2011 by Nelson Education Ltd. All rights reserved

14 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Working Capital Financing Policies Self-liquidating Approach: Match the maturity of the assets with the maturity of the financing. Aggressive Approach: Use short- term financing to finance permanent assets. Conservative Approach: Use permanent capital for permanent assets and temporary assets.

15 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Years $ Perm NOWC Fixed Assets Temp. NOWC Lower dashed line, more aggressive. } S-T Loans L-T Fin: Stock & Bonds, Moderate Financing Policy

16 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Conservative Financing Policy Fixed Assets Years $ Perm NOWC L-T Fin: Stock & Bonds Marketable Securities Zero S-T debt

17 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Illustration: Selected Ratios for SKI SKIIndustry Current1.75x2.25x Quick0.83x1.20x Debt/Assets58.76%50.00% Turnover of Cash16.67x22.22x DSO(365-day year) Inv. Turnover4.82x7.00x F.A. Turnover11.35x12.00x T.A. Turnover2.08x3.00x Profit Margin2.07%3.50% ROE10.45%21.00% Payables deferral

18 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved How does SKI’s NOWC policy compare with the industry? Working capital policy is reflected in a firm’s current ratio, quick ratio, turnover of cash and securities, inventory turnover, and DSO. These ratios indicate SKI has large amounts of working capital relative to its level of sales. Thus, SKI is following a relaxed policy.

19 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Is SKI inefficient or just conservative? A relaxed policy may be appropriate if it reduces risk more than profitability. However, SKI is much less profitable than the average firm in the industry. This suggests that the company probably has excessive working capital.

20 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Cash Budget: The Primary Cash Management Tool Purpose: Uses forecasts of cash inflows, outflows, and ending cash balances to predict loan needs and funds available for temporary investment. Timing: Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management.

21 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Cash Budget: Inputs Sales forecast. Information on collections delay. Forecast of purchases and payment terms. Forecast of cash expenses: wages, taxes, utilities, etc. Initial cash on hand. Target cash balance.

22 CH17 Cash Budget: Output A cash budget is used mainly for planning purposes. There are three major sections of a cash budget –Collections and purchases worksheet –Cash gain or loss over the period –Loan requirement or cash surplus Copyright © 2011 by Nelson Education Ltd. All rights reserved

23 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved SKI’s Cash Budget for January and February Net Cash Inflows JanuaryFebruary Collections$67,651.95$62, Purchases44, , Wages6, , Rent2, Total Payments$53,794.31$44, Net CF$13,857.64$18,311.85

24 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Cash Budget (cont’d) JanuaryFebruary Cash at start if no borrowing $3,000.00$16, Net CF (previous slide) 13, , Cumulative cash$16,857.64$35, Less: target cash1, Surplus$15,357.64$33,669.49

25 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Implications for Cash Surplus Cash budget indicates the company probably is holding too much cash. Company could improve its EVA by either investing its excess cash in more productive assets or by paying it out to the firm’s shareholders. A company may choose to hold large amounts of cash if it does not have much faith in its sales forecast, or if it is very conservative. The excess cash may be there, in part, to fund a planned fixed asset acquisition.

26 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Cash Budget Issues #1 Should depreciation be explicitly included in the cash budget? No. Depreciation is a noncash charge. Only cash payments and receipts appear on cash budget. However, depreciation does affect taxes, which do appear in the cash budget.

27 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Cash Budget Issues #2 What are some other potential cash inflows besides collections? Proceeds from fixed asset sales. Proceeds from stock and bond sales. Interest earned. Court settlements.

28 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Cash Budget Issues #3 How can interest earned or paid on short- term securities or loans be incorporated in the cash budget? Interest earned: Add line in the collections section. Interest paid: Add line in the payments section. Found as interest rate x surplus/loan line of cash budget from preceding month. Note: Interest on any other debt would need to be incorporated as well.

29 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Cash Budget issue #4 How could bad debts be worked into the cash budget? Collections would be reduced by the amount of bad debt losses. For example, if the firm had 3% bad debt losses, collections would total only 97% of sales. Lower collections would lead to lower surpluses and higher borrowing requirements.

30 CH17 Short-term Financing The relative amount of short-term credit used is critical for a financing policy. Advantages: –Low cost-- yield curve usually slopes upward. –Can get funds relatively quickly. –Can repay without penalty. Disadvantages: –Higher risk. The required repayment comes quicker, and the company may have trouble rolling over loans. Copyright © 2011 by Nelson Education Ltd. All rights reserved

31 CH17 Accruals Accruals arise when payments are not yet made, but the services have been performed. Accruals increase automatically as a firm’s operations expand Firms use all the accruals they can, but they have little control over the levels and timing of these accounts. Copyright © 2011 by Nelson Education Ltd. All rights reserved

32 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved What is trade credit? Trade credit is credit furnished by a firm’s suppliers. Trade credit is often the largest source of short-term credit, especially for small firms. Spontaneous, easy to get, but cost can be high.

33 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Illustration: Find free and costly trade credit A firm buys $506,985, on terms of 1/10, net 30, and pays on Day 40. Net daily purchases = 506,985/365 = $1,389 Annual gross purchases = $506,985/(1-0.01) =$512,106 List price = true price + finance charge

34 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Gross/Net Breakdown Company buys goods worth $506,985 That’s the cash price. They must pay $5,121 more if they don’t take discounts. Think of the extra $5,121 as a financing cost similar to the interest on a loan. Want to compare that cost with the cost of a bank loan.

35 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Payables level if don’t take discount: Payables = $1,389(40) = $55,560 Total trade credit= $55,560 Free trade credit= 13,890 Costly trade credit= $41,670 Free and Costly Trade Credit Payables level if take discount: Payables = $1,389(10) = $13,890

36 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Nominal Cost of Costly Trade Credit But the $5,121 is paid all during the year, not at year-end, so EAR rate is higher. Firm loses 0.01($512,106) = $5,121 of discounts to obtain $41,670 in extra trade credit, so: r Nom = = = 12.29% $5,121 $41,670

37 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Nominal Annual Cost Formula: 1/10, net 40 Interpretation: Pays 1.01% times per year. r Nom = Discount % 1 - Discount % × 365 days Days Taken Discount Period - = 1 99 × = × = = 12.29%

38 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Effective Annual Rate, 1/10, net 40 Periodic rate = 0.01/0.99 = 1.01%. Periods/year = 365/(40 – 10) = EAR= (1 + Periodic rate) n – 1.0 = (1.0101) – 1.0 = 13.01%

39 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Short Term Bank Loans Loan application. Interest rates. Maturity. Collateral. Covenants. Line of credit. Commercial paper.

40 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Assessing Loan Application Historical financials. Pro forma financials. Income and EBITDA. Types of assets.

41 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Interest Rates Prime rate is the lowest interest rate at which a bank lend money to its best customers. Prime rate differs from Bank rate although they are highly correlated Rates on loans are generally scaled up from the prime rate, e.g. P+2% Interest rate can be fixed or floating

42 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Collateral The short term loan is secured by a specific collateral item (asset). Banks usually have a “General Security Agreement” written into the agreement that covers all of the lender’s asset The collateral is registered under the Personal Property Security Act (PPSA).

43 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Covenants Designed to protect the lender. Specific terms written into the loans that the borrower must adhere to for the loan to remain in good standing. Examples of covenants: –Better current ratio –Minimum interest payment coverage –Minimum cash balance

44 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Line of Credit One year operating loan designed to finance seasonal working capital requirements. Interest rate floats based on prime. Interest is only paid when funds are borrowed. Revolving line of credit has 3- or 4- year of maturity.

45 CH17 Copyright © 2011 by Nelson Education Ltd. All rights reserved Commercial Paper (CP) Short term unsecured notes issued by large, strong companies. Small firms cannot issue CP. CP trades in the market at rates just above T-bill rate. CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes.

46 CH17 Bankers’ Acceptances Significant source used to finance goods sold with long payment terms such as exports and imports BA is a firm’s time draft that has been accepted by a bank This means the bank guarantees payment of the amount stated on the draft when it matures Copyright © 2011 by Nelson Education Ltd. All rights reserved

47 CH17 Calculating Financing Costs The cost of bank loans varies widely depending upon the terms of the loan. For illustrative purposes, consider a $10,000, 2-month (60days) loan with a nominal interest rate of 10%. Copyright © 2011 by Nelson Education Ltd. All rights reserved

48 CH17 Regular (Simple) Interest Calculation Cost involved is interest Amount of financing is $10,000 Interest charge for period = (days in period) × (rate per day) × (amount) = (60) × (0.1/365) × ($10,000) = $ Copyright © 2011 by Nelson Education Ltd. All rights reserved

49 CH17 Discount Interest Calculation In a discount loan, bank deducts the interest in advance. Cost involved is interest = $ Amount of financing is $10,000 – interest = $10,000 - $ = $9, Copyright © 2011 by Nelson Education Ltd. All rights reserved

50 CH17 Compensating Balances Calculation Cost involved is interest. Amt of financing is $10,000 – compensate balance + normal balance. Given: 30% compensating balance and firm always keeps $1,500. Copyright © 2011 by Nelson Education Ltd. All rights reserved

51 CH17 Installment Loans Calculation Lenders typically charge add-on interest on installment loans. Interest cost = $ The payment is ($10,000+$164.38)/2 = $5,082. Copyright © 2011 by Nelson Education Ltd. All rights reserved

52 CH17 Secured Short-Term Financing Secured Loans: a company will offer assets as security. –A/R financing –Inventory financing Weaker firms can obtain financing by pledging accounts receivable as security against a loan or by factoring (selling) the receivables to a finance company Depending on the firm’s credit-worthiness, an inventory blanket lien, a trust receipt, or warehouse receipt financing methods may be used. Copyright © 2011 by Nelson Education Ltd. All rights reserved


Download ppt "PowerPoint Presentation prepared by Traven Reed Canadore College."

Similar presentations


Ads by Google