1 working capital policy. 2 learning objectives understand the importance of working capital....

1

Working CapitalPolicy

2

Learning Objectives

Understand the importance of working capital.

The liquidity-profitability trade-off. Determining the optimal level of

current assets. The risk and return implications of

alternative approaches to working capital financing policy.

3

The Importance of Managing and Accumulating Working Capital

Working capital is the amount of the firm’s current assets: cash, accounts receivable, marketable securities, inventory and prepaid expenses.

Managing the level and financing of working capital is necessary:– to keep costs under control (e.g.

storage of inventory)– to keep risk levels at an appropriate

level (e.g. liquidity)

4

Managing Current Assets & Liabilities Net Working Capital

= Current Assets - Current Liabilities Determining the “Correct” level of

Working Capital– Balance Risk & Return– Benefits of Working Capital

Higher Liquidity (Lowers Risk)– Costs of Working Capital

Lower Returns - $$ invested in lower returning securities rather than production.

5

Firm 1ST Debt 100

LT Debt 400

Common Stock 500

Total Liabilities&Equity 1000

Firm 1Marketable Securities 0Other Current Assets 200Fixed Assets 800Total Assets 1000

Firm 1 Operating Earnings 150Interest Earned 0EBT 150Taxes (40%) -60Net Income 90

Example: Risk-Return Trade-offCompare the 2 following companies

Current Assets Current Liabilities

Current Ratio =

200100

=

= 2Current Ratio 2

6

Firm 1ST Debt 100

LT Debt 400

Common Stock 500

Total Liabilities&Equity 1000

Firm 1Marketable Securities 0Other Current Assets 200Fixed Assets 800Total Assets 1000

Firm 1 Operating Earnings 150Interest Earned 0EBT 150Taxes (40%) -60Net Income 90

Current Ratio 2

Return on Assets = Net Income

Assets

90 1000

=


= .09 = 9%

ROA 9%

7

Firm 2:

$200 Marketable Securities Financed with Common Stock

200 x 4% = $8 interest earned

Firm 1 Firm 2Marketable Securities 0 200Other Current Assets 200 200Fixed Assets 800 800Total Assets 1000 1200

Firm 1 Firm 2ST Debt 100 100LT Debt 400 400Common Stock 500 700Total Liabilities&Equity 1000 1200

Firm 1 Firm 2Operating Earnings 150 150Interest Earned 0 8EBT 150 158Taxes (40%) -60 -63Net Income 90 95

Current Ratio 2ROA 9%


8




Current Ratio 2 ROA 9%

400100

=

Current Ratio = CACL


= 44

9




Current Ratio 2 4ROA 9%

95 1200

=


=.079 = 7.9%

7.9%

Return on Assets = NI

Assets

10

Firm 1Higher ROALess LiquidRiskier

Firm 2Lower ROAMore LiquidLess Risky





Current Ratio 2 4ROA 9% 7.9%

11

Time

Total Assets

Assume ZERO Long-term Growth

$5M

Variation in assets over time

FixedAssets}

12

Time

Total Assets

FixedAssets

PermanentCurrent Assets}

}$5M

$7M


13

Temporary Current Assets


Time

Total Assets

FixedAssets


}$5M

$7M

$10M

14

Different Approaches to Financing

Conservative Approach– Finance all fixed assets, permanent current

assets, and some temporary with LT debt or equity. ST financing is used for the remaining temp. current assets.

– Lower risk, lower return

15

Financing Current Assets:Conservative Approach


Time

Total Assets

FixedAssets


}$5M

$7M

$10MTemporary Current Assets

Time

Total Assets

FixedAssets


}$5M

$7M

$10M

Short-termSources

Lo

ng

-te

rmS

ou

rce

s

16

Different Approaches to Financing Conservative Approach

– Finance all fixed assets, permanent current assets, and some temporary with LT debt or equity. ST financing is used for the remaining temp. current assets.

– Lower risk, lower return Moderate Approach (Maturity Matching)

– Finance fixed assets and permanent current assets with LT funds and temporary current assets with ST funds.

– Moderate risk, moderate return

17

Financing Current Assets:Moderate Approach


Time

Total Assets

FixedAssets


}$5M

$7M


Time

Total Assets

FixedAssets


}$5M

$7M

$10ML

on

g-t

erm

So

urc

es

18

Financing Current Assets:Moderate Approach

Short-termSources


Time

Total Assets

FixedAssets


}$5M

$7M


Time

Total Assets

FixedAssets


}$5M

$7M

$10ML

on

g-t

erm

So

urc

es

19

Different Approaches to Financing

Conservative Approach– Finance all fixed assets, permanent current assets,

and some temporary with LT debt or equity. ST financing is used for the remaining temp. current assets.

– Lower risk, lower return Moderate Approach (Maturity Matching)

– Finance fixed assets and permanent current assets with LT funds and temporary current assets with ST funds.

– Moderate risk, moderate return Aggressive Approach

– Finance all temporary current assets, permanent current assets, and some fixed assets with ST debt. LT financing is used for the remaining fixed assets.

– Higher risk, higher return

20

Long-term Sources

Financing Current Assets:Aggressive Approach


Time

Total Assets

FixedAssets


}$5M

$7M


Time

Total Assets

FixedAssets


}$5M

$7M

$10M

Short-termSources

21

Managing (WARM, SOFT) Cash

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How much cash should a firm keep on hand? Managers must keep enough cash

to make payments when needed. (Minimum balance)

But since cash is a non-earning asset, managers should invest excess returns and keep just the amount of cash that is necessary.(Maximum balance)

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The size of the minimum cash balance depends on: How quickly and cheaply a firm

can raise cash when needed. How accurately managers can

predict cash requirements. How much precautionary cash the

managers need for emergencies.

Link to Dun & Bradstreet

http://www.dnb.com/

25

The firm’s maximum cash balance depends on: Available (short-term) investment

opportunities– e.g. money market funds, CDs, commercial

paper Expected return on investment

opportunities (opportunity cost)– If high expected return, firms are quick to

invest excess cash Transaction cost of withdrawing cash

and making an investment

Link to Bureau of Economic Analysis

http://www.bea.doc.gov/

http://www.bea.doc.gov/

26

Choosing the Optimum Cash Balance

Days of the Month

| | | | | | | | | | | | | | | | | | | | | | | | | | | |

Do

llars

in th

e C

ash

Acc

oun

t

Cash Balances in a Typical Month

28Days of the Month

| | | | | | | | | | | | | | | | | | | | | | | | | | | |

Do

llars

in th

e C

ash

Acc

oun

t



Sell Securities toobtain cash

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The Miller - Orr Model

The Miller-Orr Model provides a formula for determining the optimum cash balance, the point at which to sell securities (lower limit) and when to invest excess cash (upper limit).

Depends on: – transaction costs of buying or selling

securities– variability of daily cash – return on short-term investments

30

The Miller-Orr Model- Target Cash Balance

(Z)

3 x TC x V 4 x r

Z = + L3

where: TC = transaction cost of buying or selling securities

V = variance of daily cash flows r = return on short-term

investments L = minimum cash requirement

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Example: Suppose that short-term securities yield 5% per year (r) and it costs the firm $50 each time it buys or sells securities (TC). The variance of cash flows is $100,000 (V) and your bank requires $1,000 minimum checking account balance (L).


(Z)

32


(Z) Example

3 x 50 x 100,000 4 x .05/365

Z = + $1,000

= $3,014 + $1,000 = $4,014

3

33

The Miller-Orr Mode- Upper Limit

The upper limit for the cash account (H) is determined by the equation:

H = 3Z - 2Lwhere:Z = Target cash balanceL = Lower limit

In the previous example:H = 3 ($4,014) - 2($1,000) =

$10,042

34

Forecasting Cash Needs

- Cash Budget Used to determine monthly needs and

surpluses for cash during the planning period

Examines timing of cash inflows and outflows i.e. when checks are written and when deposits are made.

Payments to suppliers are typically made some time after shipment is received.

Receipts from credit customers are received some time after sale is recorded.

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Cash Budget - Problem

Rocky Mountain Climbing, Inc. (RMC) has the following information:

Previous Sales November 2007 130,000December 2007 125,000

Forecast Sales January 2008 120,000February 2008 260,000March 2008 140,000April 2008 140,000

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Rocky Mountain Climbing, Inc. (RMC) has the following information:Previous Sales: November 2007 130,000

December 2007 125,000Forecast sales for: January 2008 120,000

February 2008 260,000March 2008 140,000April 2008 140,000

Collections : 30% of customers pay cash 50% pay in month after sale 20% pay 2 months after sale

37


Other information for RMC Cash Budget:

Purchases of inventory are 75% of salesand are made 2 months before saleand are paid for 1 month after delivery

Other expenses $14,000 per monthTaxes $10,000 due in March

Cash Balance (Dec. 31, 2007) = $28,000Minimum balance required by bank = $25,000(ST borrowing rate = 6% annually)

38

Steps in the Cash Budget Forecast of monthly collections

and other cash inflows Forecast of purchases and other

cash outflows Summarize the effect on net

monthly cash flows and determine borrowing needs or surpluses.

39

Cash Budget - Collections In each month RMC will collect cash from

sales that have occurred in that month and in the preceding two months.

In January, sales are 120,000

Collections:– 30% x $120,000 (January sales) =

36,000– 50% x $125,000 (December sales) = 62,500– 20% x $130,000 (November sales) = 26,000

Total cash collected in January =$124,500

40

Collection of January Sales

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

36,000

Cash Budget - CollectionsSales made in January will not be fullycollected until March.

120,000 x .30120,000 x .30

41

Sales made in January will not be fullycollected until March.

Cash Budget - Collections


Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

36,000

120,000 x .30120,000 x .30

60,000

120,000 x .50120,000 x .50

42

Sales made in January will not be fullycollected until March.



Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

36,000

120,000 x .30120,000 x .30

60,000

120,000 x .50120,000 x .50

24,000

120,000 x .20120,000 x .20

43

Calculate collections for other months.


Cash BudgetRMC, Inc.

Sales 130,000 125,000 120,000 260,000 140,000Collections:Month of Sale (30%) 36,000 78,000 42,000First Month (50%) 62,500 60,000 130,0002nd Month (20%) 26,000 25,000 24,000Total Collections 124,500 163,000 196,000

Nov Dec Jan Feb Mar

44

Payments for January Purchases

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

75% of January Sales Purchased in November

75% of January Sales Purchased in November

Purchases are made 2 months prior to sale and are paid for 1 month later.

Cash Budget - Purchases/Payments

90,000

45


Payments for January Purchases

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

90,000 90,00075% of January Sales Purchased in November, Paid for in December

75% of January Sales Purchased in November, Paid for in December

Purchases are made 2 months prior to sale and are paid for 1 month later.

46

Calculate payments for all months. Note that in order to do a cash budget,you will need forecasts of sales for April.



Sales 130,000 125,000 120,000 260,000 140,000 140,000Purchases 195,000 105,000 105,000Payments 195,000 105,000 105,000

Nov Dec Jan Feb Mar Apr

47

Jan Feb Mar


Cash Collections 124,500 163,000 196,000Material Payments 195,000 105,000 105,000

Summary of Previous CalculationsSummary of Previous Calculations

48

Jan Feb Mar


Cash Collections 124,500 163,000 196,000Material Payments 195,000 105,000 105,000Other Payments:Other Expenses 14,000 14,000 14,000Tax Payments 0 0 10,000

Remaining Cash OutflowsRemaining Cash Outflows

49

Jan Feb Mar


Cash Collections 124,500 163,000 196,000Material Payments 195,000 105,000 105,000Other Payments:Rent 2,000 2,000 2,000Other Expenses 12,000 12,000 12,000Tax Payments 0 0 10,000Net Monthly Change (84,500) 44,000 67,000

50

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow)Needed (Borrowing)Loan RepaymentInterest CostEnding Cash BalanceCumulative Borrowing

Analysis of Borrowing Needs

51

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow) (56,500)Needed (Borrowing)Loan RepaymentInterest CostEnding Cash BalanceCumulative Borrowing


52

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow) (56,500)Needed (Borrowing)Loan RepaymentInterest CostEnding Cash Balance 25,000Cumulative Borrowing

Target Ending BalanceTarget Ending Balance


53

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow) (56,500)Needed (Borrowing) 81,500Loan Repayment 0Interest Cost 0Ending Cash Balance 25,000Cumulative Borrowing


Borrowing Required to cover Minimum Balance and Deficit

Borrowing Required to cover Minimum Balance and Deficit

56,500+25,000

54

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow) (56,500)Needed (Borrowing) 81,500Loan Repayment 0Interest Cost 0Ending Cash Balance 25,000Cumulative Borrowing 81,500


55

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500Loan Repayment 0Interest Cost 0Ending Cash Balance 25,000Cumulative Borrowing 81,500


56

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500 0Loan Repayment 0Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500


Interest Incurred on PriorMonth Borrowing


81,500 x .005

57

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500


Amount that can be repaid from monthly surplus

Amount that can be repaid from monthly surplus

69,000 - 408 - 25,000=$43,592

58

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500

New Loan BalanceNew Loan Balance

81,500 - 43,592=$37,908


37,908

59

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908


60

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908




37,908 x .005

190

61

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0 0Loan Repayment 0 43,592Interest Cost 0 408 190Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908


Repay Outstanding Loan Balance

Repay Outstanding Loan Balance

37,908

62

Jan Feb Mar


Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0 0Loan Repayment 0 43,592 37,908Interest Cost 0 408 190Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908 0


Ending Cash BalanceEnding Cash Balance

$53,902-$25,000=$28,902 Surplus

53,902

63

Jan Feb Mar


Ending Cash Balance 25,000 25,000 53,902Cumulative Borrowing 81,500 37,908 0

RMC needs to raise $81,500 in short-term debt in January, would probably take out a short-term bank loan. In March RMC has a 28,902 surplus. It would probably invest in marketable securities at this point

in time.


64

Managing Cash Inflows and Outflows Generally managers try to

increase the amount of cash flowing into a business during any given time period.

They also try to slow down cash outflows.

Collect early and Pay late (but not too late).

65

Managing Cash Flows Can increase cash inflows (or speed

them up) by:– Increasing cash sales– Increasing credit sales collections

Can decrease cash outflows (or slow them down) by:– Cutting costs– Taking full advantage of time allowed to

pay obligations

66

Managing Cash Flows Can speed up inflows by:

– Tightening up credit policy (as long as savings from reduced bad debts and collection costs exceed sales that may be lost)

– Obtaining computerized fund transfers from customers

– Using collection centers– Using a lockbox system

Can slow down cash outflows by:– Delaying the payment of bills– Using remote disbursement banks

67

Accounts Receivableand Inventory

68

Learning Objectives

How and why firms manage accounts receivable and inventory.

Computation of optimum levels of accounts receivable and inventory.

Alternative inventory management approaches.

How firms make credit decisions and create collection policies.

69

Why do firms accumulate accounts receivable and inventory? Given that accounts receivable and

inventory are assets that do not provide an explicit rate of return, it is important to understand why firms might still want to have these investments.

Granting credit is often an essential business practice and can enhance sales. (But also will increase costs.)

Holding adequate inventory is necessary to avoid loss of sales due to stock-outs.

70

Finding the Optimum Level of Accounts Receivable Firm’s managers must review the

firm’s credit policies and evaluate the impact of any proposed changes in policies based on the NPV of incremental cash flows due to the change.

This is similar to the method we used in determining the best capital budgeting projects to undertake.Link to Hoover’s Online

http://www.hoovers.com/

71

Accounts Receivable Management The terms of sale are generally

stated in the form X / Y, n Z This means that the customer can

deduct X percentage if the account is paid within Y days; otherwise, the account must be paid within Z days.

Example: 2/10 n 30– The company offers a 2% discount if

account paid in 10 days. – Balance due in 30 days.

72

Effects of Tightening Credit Policy Raise credit standards

– Fewer credit customers (could reduce sales)

– Lower accounts receivable Shorten net due period

– Fewer credit customers (could reduce sales)

– Accounts paid sooner– Lower accounts receivable

Reduce discount percentage– Fewer credit customers (could reduce

sales)– Fewer take the discount

Shorten discount period– Same as above

73

Average Collection Period (ACP) Old Policy; 2/10, n30

– 35% of customers pay in 10 days– 62% of customers pay in 30 days– 3% of customers pay in 100 days– ACP=(.35x10)+(.62x30)+(.03x100)=25.1

days New Policy; 2/10, n40

– 35%of customers pay in 10 days– 60% of customers pay in 40 days– 5% of customers pay in 100 days– ACP=(.35x10)+(.60x40)+(.05x100)=32.5

days

74

Analysis of Accts. Receivable Changes Develop pro forma financial

statements for each policy under consideration.

Use the pro formas to estimate incremental cash flows by comparing forecasts to current policy cash flows.

Use the incremental cash flows to estimate the NPV of each policy change.

Choose the policy change that maximizes the value of the firm (highest NPV).

75

Example:ABC Corporation is considering a credit policy change from offering no credit to offering 30 days credit with no discount (n 30).

Why might they do this?-Increase sales-Increase market share

What costs will the firm incur as a result?-Cost of carrying accounts receivable-Potential increase in bad debts-Credit analysis and collection costs

Analysis of Accts. Receivable Changes

76


Assume the Net Incremental Cash Flows associated with ABC’s new credit policy are as follows:

External financing (Init. Investment) = $28,000 t=0– Increase in sales = $30,000

t=1,2...– Increase in COGS = $15,000 – Increase in Bad Debts = $3,000– increase in Other Expenses = $5,000– Increase in Interest Expense = $500– Increase in Taxes = $2,600– Total Incr. Operating Cash Flow =

$3,900/yr.

77


Calculate the NPV of the change (k = 12%): PV of the expected inflows of $3,900 per

year from t = 0 to infinity (perpetuity)

=$3,900 / .12 =$32,500

NPV = PV of inflows - initial investment

= $32,500 - $28,000 = $4,500

Since NPV > 0, ABC should undertake the credit policy change, assuming that the assumptions are valid and that the projected cash flows are accurate.

78

How Firms Make Credit Decisions The Five Cs of Credit: Character is the borrower’s willingness to pay

based on past payment patterns. Capacity is the borrower’s ability to pay

based on forecasts of future cash flows. Capital is how much wealth the borrower has

to fall back on. Collateral is what the lender gets if the

borrower fails to pay. Conditions faced by the borrower in the

business marketplace are also considered.Link to Credit Scoring

http://www.ftc.gov/bcp/conline/pubs/credit/scoring.htm

79

Methods of Collection

Send reminder letters. Make telephone calls. Hire collection agencies. Sue the customer. Settle for a reduced amount. Write off the bill as a loss. Sell accounts receivable to

factors.

Most firms use some of the following:

80

Inventory Management

Typically, inventory accounts for about four to five percent of a firm's assets.

In order to effectively manage the investment in inventory, two problems must be dealt with: how much to order and how often to order.

The economic order quantity (EOQ) model attempts to determine the order size that will minimize total inventory costs.

81


Determining Optimal Inventory– Economic Order Quantity (EOQ)

TotalInventory

Costs=

TotalCarrying

Costs

TotalOrdering

Costs+

Link to Bloomberg.com

http://www.bloomberg.com/

82

Time

OrderQuantity

Q

InventoryLevel

(units)

The EOQ Model assumes the firm orders a fixed amount Q at equal intervals.

83Time

OrderQuantity

Q

InventoryLevel

(units)

The EOQ Model

Average Inventory = Order Quantity2

Q2

84

=Total

InventoryCosts

( ) CC + ( ) OCOQ2

S OQ

Where:OQ = Order Size (order quantity)S = Annual Sales VolumeCC = Carrying Cost per UnitOC = Ordering Cost per Order

TotalInventory

Costs=

TotalCarrying

Costs

TotalOrdering

Costs+

85Order Size (units)

Cost($)

Ordering Costs

= ( )OC S OQ

Ordering Costs

86

Carrying Costs

Order Size (units)

Cost($)

Carrying Costs = ( ) CC OQ 2

= ( )OC S OQ

Ordering Costs

87

Total Costs = Carrying Costs + Order Costs

Order Size (units)

Cost($)

Carrying Costs = ( ) CC OQ 2

= ( )OC S OQ

Ordering Costs

88


– The economic order quantity that minimizes the total costs of inventory.

Determining Optimal Inventory

EOQ =2 x S x OC

CC

89


– Economic Order Quantity (EOQ)Example:Awesome Autos expects to sell 1,200 new automobiles in the next year. It currently costs $26 per order placed with the manufacturer. Carrying costs amount to $75 per auto. How many autos should they order each time they place an order?

=

= 28.84 29 cars

2(1200)2675

Determining Optimal Inventory

EOQ =2 x S x OC

CC

90

Inventory Management Determining Optimal Inventory

– Economic Order Quantity (EOQ)

EOQ autos in each order

Place 1,200/ 29 = 41.4 orders each year

Example:Awesome Autos expects to sell 1,200 new automobiles in the next year. It currently costs $26 per order placed with the manufacturer. Carrying costs amount to $75 per auto. How many autos should they order each time they place an order?

91

Inventory Management with Safety Stock- Order before inventory is at zero.

EOQ

Depleted StockDuring Delivery

Inventory Order Point

Actual Delivery Time

SafetyStock

Time

InventoryLevel

(units)

92

Time

OrderQuantity

Q

InventoryLevel

(units)

93

ABC Inventory Classification System Tool to reduce inventory carrying costs:

classify different types of inventory according to value.

Example:– Class A: Expensive items are assigned a

serial number and are checked daily. Replaced only as sold.

– Class B: Moderately priced items are assigned a serial number but are checked less often (monthly) and managed according to EOQ.

– Class C: Small inexpensive items. Check inventory annually and reorder by visual check.

94

Just In Time Inventory Control (JIT) Developed in Japan. Reduce raw material inventory

carrying costs by making deals with suppliers that require them to deliver the raw materials as needed.

Carrying costs are passed on to suppliers.

Can result in higher costs if delivery is delayed: shut down of whole production line.

95

Short Term Financing

96

Learning Objectives

The need for short-term financing. The advantages and disadvantages of

short-term financing. Three types of short-term financing. Computation of the cost of trade

credit, commercial paper, and bank loans.

How to use accounts receivable and inventory as collateral for short-term loans.

97

Why Do Firms Need Short-term Financing? Profits may not be sufficient to keep up

with growth-related financing needs. Firms may prefer to borrow now for

their needs rather than wait until they have saved enough.

Short-term financing instead of long-term sources of financing due to:– easier availability– usually lower cost

98

Sources of Short-term Financing Short-term loans.

– borrowing from banks and other financial institutions for one year or less.

Trade credit.– borrowing from suppliers

Commercial paper. – only available to large credit- worthy

businesses.

99

Types of short-term loans: Promissory note

– A legal IOU that spells out the terms of the loan agreement, usually the loan amount, the term of the loan and the interest rate.

– Often requires that loan be repaid in full with interest at the end of the loan period.

Self-liquidating loan– The proceeds of the loan are used to

acquire assets that generate cash to repay the loan (e.g. inventory).

100

Types of short-term loans: Line of Credit

– The borrowing limit that a bank sets for a firm.

– May include many promissory notes that the firm has taken out at different times and with overlapping payment periods.

– Usually informal agreement and may change over time

Revolving credit agreement– Formal agreement with bank to extend

credit to a firm for a period of time (can be more than one year).

101

Trade Credit

Trade credit is the act of obtaining funds by delaying payment to suppliers.

Even though it is obtained by simply delaying payment, it is not always free.

The cost of trade credit may be some interest charge that the supplier charges on the unpaid balance. More often, it is in the form of a lost discount that would be given to firms who pay earlier.

Credit has a cost. That cost may be passed along to the customer as higher prices, borne by the seller as lower profits, or some of both.

102

Estimation of Cost of Short-Term Credit

Calculation is easiest if the loan is for a one year period:

Effective Interest Rate is used to determine the cost of the credit to be able to compare differing terms.

Effective Interest Rate

Interest you pay Amount you get to use

=

Example: You borrow $10,000 from a bank and must pay $1,000 interest at the end of the year

Your effective rate is the same as the stated rate= $1,000/$10,000 = .10 = 10%

103

Variations in Loan Terms A discount loan requires that

interest be paid up front when the loan is given.

This changes the effective cost in the previous example since you only get to use:

($10,000 - $1,000) = $9,000. Effective cost = $1,000/$9,000

= .1111 = 11.11%.

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Variations in Loan Terms Sometimes lenders require that a

minimum amount, called a compensating balance be kept in your bank account.

If your compensating balance requirement is $500, then the amount you can use is reduced by that amount.

Effective cost for a $10,000 simple interest 10% loan with a $500 compensating balance = $1,000/($10,000-$500) = .1053 = 10.53%.

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Cost of Short-Term CreditFor Periods Less Than One Year

When loans are for less than one year, we must convert the cost to annual terms for comparison.

e.g. A 1 month $10,000 loan requires that interest of $90 be paid: the monthly rate = 90/10,000 = .0090 = .9%.

Use the following formula to equate:

EffectiveAnnual = Rate

1 + -1$ Interest$ you get to use

(Periods/yr)( )

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Cost of Short-Term CreditFor Periods Less Than One Year

$10,000 loan for 1 month with monthly interest equal to $90. What is the effective annual interest rate?

Effective annual rate = (1.009)12 - 1 = .1135 =11.35%

Link to CNNfn

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107

Cost of Short-Term CreditFor Periods Less Than One Year What if the loan is a discount loan?

Must pay the interest up front so that reduces the dollars available to use.

$10,000 loan with .9%monthly interest:

K=(1+90

10,000 - 90 )12

-1 = .1146

k = 11.46%

Effective annual rate

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Sources of Short Term Credit Cost of Trade Credit

– Typically receive a discount if you pay early.

– Stated as: 2/10, net 60 Purchaser receives a 2% discount if

payment is made within 10 days of the invoice date, otherwise payment is due within 60 days of the invoice date.

– The cost is the form of the lost discount.

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Cost of Trade Credit 2/10 net 60 Assume your purchase is $100

list. If you take the discount, you pay

$98. If you don’t take the discount, you pay $100.

Therefore, you are paying $2 for the privilege of borrowing $98 for the additional 50 days. (Note: the first 10 days are free in this example).

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The formula for cost of trade credit is similar to the previous equations.

The exponent is the number of times per year the firm can take 50 days of credit.

The cost of trade credit for this example:[1 +(2/98)])7.3 -1 = .1589 = 15.89%.

Cost of Trade Credit 2/10 net 60

Costof Credit

Discount %100-Discount%

1 + -1365

days to pay - disc. pd.( )=( (

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Computing the Cost of Trade CreditAnother Example Effective Annual Cost, k, of

Passing Up a Discount; 2/10, n40

K =(1+2

100 - 2 )( 365

40 – 10 )-1 = .2786

k = 27.86%

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Commercial Paper

Commercial paper is quoted on a discount basis so discount yield must be converted to effective annual interest rate for comparison.

Compute the discount from face value (D)– D = (Discount yield x par x DTG)/360– DTG = days to go (to maturity)

Compute the price = Par - D Compute Effective Annual Rate

= (par/price)(365/DTG) - 1

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Cost of Commercial Paper Example

$1 million issue of 90 day c.p. quoted at 4% discount yield.

Step 1: Calculate D = .04 x $1 mill. x 90 360

= $10,000

Step 2: Calculate price = $1,000,000 - $10,000 = $990,000

Step 3: Calculate effective rate = (1,000,000 / 990,000)

(365/90) -1

= 4.16%

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Accounts Receivable as Collateral A pledge is a promise that the

borrowing firm will pay the lender any payments received from the accounts receivable collateral in the event of default.

Since accounts receivable fluctuate over time, the lender may require certain safeguards to ensure that the value of the collateral does not go below the balance of the loan.

Accounts receivable can also be sold outright. This is known as factoring.

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Inventory as Collateral

A major problem with inventory financing is valuing the inventory.

For this reason, lenders will generally make a loan in the amount of only a fraction of the value of the inventory. The fraction will differ depending on the type of inventory.

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Inventory as Collateral

Blanket Lien: A general claim against the borrowers inventory if there is a default

Trust Receipt: A legal document that identifies specific inventory as security for a loan

Warehousing: Inventory pledged as collateral is removed from the control of the borrower (either in an on-site or public warehouse)

1 working capital policy. 2 learning objectives understand the importance of working capital....

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