2. Chapter 6,7&8 Short-term Financing

3. Introduction  Long-term financing is normally used to fund plant and equipment acquisition or other long- term investments.  Short-term financing is required because we need working capital  An efficient current asset management helps to reduce the amount of working capital and thus the reliance on short-term financing

4. Today’s Agenda  Working Capital  Current Asset Management  Sources of Short-term Financing

5. Working Capital  What is working capital ?  Example - a manufacturing company  When the production plant (factory) and the necessary equipment (machine) are ready, the firm has to order raw materials, hire employees, manufacture goods, finished goods transferred to inventory and eventually sold

6. Working Capital cont’  The amount of capital involved in the above process (excluding plant and equipment investments) is called working capital  Once the goods are sold, the working capital will be recovered  (In addition, a small portion of the plant and equipment investment may be recovered)

8. Need for Financing  Time lag between receipt of payment from customers and the need to pay suppliers and employees  For manufacturing firms, they have to pay their suppliers and employees before they receive payment from their customers  Hence, there is a need for short-term financing(proceed of sales are coming)

9. Need for Financing cont’  If financing is not available, suppliers will stop supplying raw material and employees will leave  The longer the time lag, the greater the need for short-term financing  The larger the amount of working capital, the greater the need for short-term financing

10. Need for Financing cont’  Excess financing occurs when we fund the short-term needs with long-term funds  Long-term funds are normally more expensive - term structure of interest rates - the longer the period, the higher the rate e.g. home mortgage

11. Figure 6-11(2) A Normal yield curve

12. Short-Term vs. Long-Term Financing  Short-term financing is less expensive but riskier –lower interest rates –short-term rates are volatile –risk of default if sales slow down –risk that bank may not extend / renew loans  Long-term financing is more expensive but less risky –usually higher interest rates, –you may pay interest on funds you don’t always need –you have capital at all times  Firm must decide the appropriate “mix”

13. Working Capital & Current Asset  As firms grow, sales increase leads to the need for more working capital which in turn will also increase the demand for current assets: - higher cash to pay employees’ wages - higher inventories - higher levels of A/R

14. Current Asset (CA) Management  Efficient CA management helps to reduce the required amount of working capital  Current assets include: cash, marketable securities, accounts receivable and inventory  CA management = management of cash, marketable securities, A/R and inventory

15. Principle in managing CA  The lower the level of current assets, the lower the firm’s liquidity, the greater the risk of being caught short of cash and inventories  To increase liquidity (reduce risk), the firm may invest additional capital in current assets  However, current assets earn no or low returns  Hence, investment in current assets is a balance between risk and return

16. Cash Management  Cash is a necessary but low earning asset  Minimize cash balance, yet keep sufficient amount to meet obligations  Invest excess cash  Cash flow is determined by customers’ payment pattern, amount of credit sales, credit terms, checks clearing time, inventory turnover and production cycle

17. Cash Management cont’  To minimize cash balance, speed up cash receipts (e.g. debit cards and preauthorized payments) and slow down payments  Use electronic transfer of funds and/or lock-box system (both are serviced by banks), checks can be cleared immediately  Remote disbursement (longer mailing time) to slow down payments to suppliers, etc

18. Cost and Benefit  The primary benefit of speeding up inflows or slowing outflows is the earnings generated from the freed up balances  The benefit must be weighed against the cost of installing the collection and payment systems

19. Invest Excess Cash in Marketable Securities  Play the Float  The Float is the difference between bank book and the firm’s accounting book  By investing the float for a day or two, the firm may generate a higher return  Example on the next slide shows a float of + $300,000

20. Play the Float

22. Account Receivable Management  Account receivable is the result of credit sales. Credit policy has 4 components - credit period, cash discounts, credit standards and collection policies  Credit period – time customers can take to pay for goods without penalty - involves a trade-off: longer periods better for customers but worse for the selling firm (raise financing needs and bad debt risk)

23. A/R Management cont’  Cash discount – encourage early payment by customers e.g. 2/10 net 30 means customers get 2% discount if paid within 10 days, else full amount is due within 30 days  Credit standards – refer to the credit assessment standards usually done by a third party e.g. Dun & Bradstreet

24. A/R Management cont’  Collection policy with regard to average collection days, ratio of bad debts to credit sales and aging of accounts receivables  Inventory management SKIP - DONE IN 42.230* (p 243-249)

25. Short-Term Financing  Sources: –Trade credits, –bank financing, –Commercial paper, –Banker's acceptance, –pledging or factoring of A/R, –inventory financing, –Other types of collateral financing (personal, chattel mortgage)  In all cases, the issues are the cost of financing (effective interest rate), time horizon, collateral, and availability

26. Trade Credit  Costs: We can forego the discount and pay on the final date due. Costs are high 2/10 net 30 = 2/98* 365/(30-10) (simple) or = (1+2/98) 365/(30-10) - 1 (compounding) = effective rate of 37.2% (simple) or 44.6%(compound) – usually, the cost of foregoing the discount is high

27. Bank Loans  many choices and terms and types –Operating loan or Line of credit, –bridge loan, –unconfirmed or stand by LOC, –Promissory note (transaction loan) –Term Loans  Fees: –commitment fee, –stand-by fee, –compensating balances (rare in Canada) usually total of fees is about 1 percent of loan can be negotiated and waived - discount interest loan: pay interest upfront

28. Bank Loan cont’  A bank offers you a 10% discount interest loan of $1,000,000 for a year  The effective annual rate (EAR) = (1+100000/900000)^1-1 = 11.1%  If the bank also requires a 15% compensating balance, the EAR = (1+100000/750000)^1-1 = 13.3%

29. Commercial Paper  Unsecured promissory notes sold by large companies e.g. GM; –generally short term; –interest slightly higher than the t-bill rate, depends upon the supply and demand  Canadian market intentionally created by Bank of Canada and some large Canadian firms

30. Banker's Acceptances  Bank guarantees payment when due to the seller of the goods.  The seller of the goods may then sell the bank acceptances to his bank  His bank then p ays a discounted value to him less a fee (handling charge & interest).

31. A/R and Inventory Financing  Accounts Receivable –once pledged, up to 75% of the face value of A/R can be the borrowed amount  Inventories: –Used inventories as collateral to borrow money

32. Summary  Short-term financing is required for the provision of Working Capital  Current Asset Management as a mean to reduce the reliance on short-term financing  Sources of Short-term Financing