introduction to working capital management

INTRODUCTION TO WORKING CAPITAL

MANAGEMENT

Outline

• Working Capital Defined• Goals of working capital management• Cash Conversion Cycle• Working capital policies

WORKING CAPITAL MANAGEMENT

Net Working Capital = Current Assets - Current Liabilities

Assets LiabilitiesCash 10 Accounts Payable 30Accounts Receivable 20 Short-term Bank Loan 20Inventory 40 Current Liabilities 50Current Assets 70 Long-term Loan 20Fixed Assets 30 Shareholders Equity 30Total Assets 100 Total Liabilities and Shareholders Equity 100

Doug's Distributors Inc.

December 31, 2002Balance Sheet


Goals of Working Capital Management:

1. Stimulate sales by offering customers credit (accounts receivable) and ready goods for sale (inventory) Increase Profits

2. Minimize costs by balancing production and sales levels through inventory Increase Profits

3. Secure low cost financing Increase Profits4. Reach above 3 goals but never run out of cash

by having enough cash and marketable securities on hand and/or by limiting use of short-term debt


Issues to Study:

1. What types and amounts of current assets should a firm hold?

2. What types and amounts of short-term financing should a firm employ?

3. How do firms ensure they have enough cash to meet on-going obligations?

4. How do firms forecast their cash needs?

Cash Conversion Cycle for a Manufacturing Firm

Purchase of RawMaterials

Sale onCredit

Cash Received From Credit Sale

InventoryConversion Period

AverageCollection Period

Operating Cycle

Cash Conversion CyclePayable

Deferral Period

Cash Outlay

MANAGEMENT OF CASH CONVERSION CYCLE

Cash Conversion Cycle = (Operating Cycle) - (Accounts Payable Deferral Period)

1. Operating Cycle = The time between ordering or raw materials and receiving cash from credit sales

2. Inventory conversion period = time required to order, produce and sell final products on credit

3. Average collection period = time required to collect cash from credit sales

4. Accounts payable deferral period = time firm is able to delay payment for raw materials, wages and other accounts

5. Cash conversion cycle = time between payments for raw materials and and labour (resources) and cash collection from sales

OPERATING AND CASH CYCLES FOR DOUG’S DISTRIBUTORS INC.

(In this example, we use average balance but could also use year-end figures for inventory, accounts receivable and accounts payable)

1. Inventory Conversion Period- Assume that beginning of year inventory balance was $30 and cost of goods sold was $350

days

SoldGoodsofCostentoryAverageInv

5.36365350$2

)4030($

365


2. Receivables Conversion Period or Average Collection Period

- Assume 100% of sales are on credit

- Assume that beginning of year accounts receivable was $20 and sales was $500

days

SalesCreditceivablesAverage

25.18365500$2

)3020($

365Re


3. Payables Deferral Period - assume beginning of Year accounts payable was$20

4. Operating Cycle= Inventory Conversion Period + Receivables Conversion Period= 36.50 days + 18.25 days= 54.25 days

5. Cash Cycle = Operating Cycle - Accounts Payable Deferral Period = 54.25 days – 26.07 days = 28.18 days

days

SoldGoodsofCostPayablesAccountsAverage

07.26365350$2

)3020($

365

Working Capital Policies and the Current Ratio

• Current Ratio is a measure of the extent to which current Assets are financed by current liabilities

• Current Ratio = Current Assets / Current Liabilities

• Doug’s Distributors has a current ratio of 70/50 or 1.4

• A current ratio of 1.40 means that for every $1.40 of current assets there is one dollar of current liabilities

Working Capital Policies(Relative to Industry)

Working Capital Policy

Levels of Current Assets

How Current Assets are Financed

Current Ratio

Operating and Cash Cycles

Trade-off Between Profitability and Risk

Conservative High With Long-term Debt and Equity

Higher than Industry Average

Longer than Industry Average

Lower Profits / Lower Risk

Aggressive Low With Short-term Debt

Lower than Industry Average

Shorter than Industry Average

Higher Profits / Higher Risk

How a Conservative Working Capital PolicyLowers Profitability and Risk

(Vice-versa for Aggressive Policy)

Impact Higher Level of Cash and Marketable Securities

Higher Level of Accounts Receivable

Higher Level of Inventory

Less Short-term Debt /Greater Long-term Liabilities and Equities

Lower Return

Liquid assets earn lower returns than less liquid assets

Greater cost of financing and possibly more write-offs.

Higher carrying costs and higher obsolescence

With upward-sloping yield curve, interest costs are higher. Equity costs are normally higher

Less Risk

Less Risk Because Cash is Readily Available

Won’t miss a potentially profitable sale.

Fewer Stock-outs

Less short-term debt payments to meet.

Working Capital PoliciesUnderstanding Liquidity

• To understand how well a company can meet its ongoing cash obligations (its liquidity), you need to understand whether the firm is using or generating cash flow

• To help you understand the nature of cash flows, you need to know how to develop and interpret a statement of cash flows

• Before developing a statement of cash flows, let us review how the balance sheet and income statements are created

Summary

• Working Capital = Short-term Assets – Short-term liabilities

• Cash Conversion Cycle– Operating cycle– Cash cycle

• Policies– Aggressive– Conservative

Statement of Cash Flows

Understanding Cash Flows

Outline

• Preparation of balance sheet and income statement from transactions

• Statement of Cash Flows

Preparing Pro Forma: Supplementary Review of Financial Statement Preparation

• A balance sheet is a “snap shot” of a company’s affairs; it shows what the company owns (its assets), what it owes (its liabilities) and how much shareholders have invested in the firm (equity)

• Assets = Liabilities + Equity• An income statement shows how much the

company sells (its revenue), what it costs to operate the business (its expenses) and how much is left over for shareholders (profit)

Preparation of the Balance Sheet and Income Statement: A step-by-step example

Step 1: Initial Investment in BusinessSylvia invests $20,000 in her new business, a clothing retailer,named Sylvia's Satins. The firm establishes an overdraftfacility with a bank for $20,000.

Sylvia's Satins Balance Sheet (Figures in 000's)Assets LiabilitiesCash $20 Overdraft $0

Shareholders EquityCurrent Assets $20 Common Shares 20Total Assets $20 Total Liabilities and Shareholders' Equity $20


Step 2: Accounting for Set-up costs of businessSylvia spends $5,000 to pay for legal feesfor setting up business

Sylvia's Satins Balance Sheet (Figures in 000's)Assets LiabilitiesCash $15 Overdraft $0 Shareholders EquityCurrent Assets $15 Common Shares 20Intangibles 5 Total Assets $20 Total Liabilities and Shareholders' Equity $20


Step 3: Accounting For leasehold improvementsSylvia enters into a lease and spends $5,000 on leasehold improvements

Sylvia's Satins Balance Sheet (Figures in 000's)Assets LiabilitiesCash $10 Overdraft $0 Shareholders Equity Current Assets $10 Common Shares 20Leasehold Improvement 5 Intangibles 5 Total Assets $20 Total Liabilities and Shareholders' Equity $20


Step 4: Accounting for fixed asset purchaseSylvia buys equipment for $10,000.

Sylvia's Satins Balance Sheet (Figures in 000's)Assets LiabilitiesCash $0 Overdraft $0 Shareholders Equity Current Assets $0 Common Shares 20Equipment 10 Leasehold Improvement 5 Intangibles 5 Total Assets $20 Total Liabilities and Shareholders' Equity $20


Step 5: Accounting for purchase of inventorySylvia's firm buys $60,000 of shirts from a supplier on credit

Sylvia's Satins Balance Sheet (Figures in 000's)Assets LiabilitiesCash $0 Overdraft $0 Accounts Payable 60Inventory 60 Shareholders Equity Current Assets 60 Common Shares 20Equipment 10 Leasehold Improvement 5 Intangibles 5 Total Assets $80 Total Liabilities and Shareholders' Equity $80


Step 6: Accounting for salesSylvia's firm sells $30,000 of inventory for $40,000 on credit

Sylvia's Satins Balance Sheet (Figures in 000's)Assets LiabilitiesCash $0 Overdraft $0Accounts Receivable 40 Accounts Payable 60Inventory 30 Shareholders Equity Current Assets $70 Common Shares 20Equipment 10 Retained Earnings $10Leasehold Improvement 5 Intangibles 5 Total Assets $90 Total Liabilities and Shareholders' Equity $90

Income Statement of Sylvia's SatinsRevenue $40Cost of Goods Sold 30Gross Margin $10


Step 7: Accounting for payments to suppliersSylvia pays off $20,000 of payables

Sylvia's Satins Balance Sheet (INCOME STATEMENT UNCHANGED)Assets LiabilitiesCash $0 Overdraft $20Accounts Receivable 40 Accounts Payable 40Inventory 30 Shareholders Equity Current Assets $70 Common Shares 20Equipment 10 Retained Earnings 10Leasehold Improvement 5 Intangibles 5 Total Assets $90 Total Liabilities and Shareholders' Equity $90


Step 8: Account for collection of accounts receivableSylvia receives $10,000 of cash from customers in collecting accounts receivable

Sylvia's Satins Balance Sheet (INCOME STATEMENT UNCHANGED)Assets LiabilitiesCash $0 Overdraft $10Accounts Receivable 30 Accounts Payable 40Inventory 30 Shareholders Equity Current Assets $60 Common Shares 20Equipment 10 Retained Earnings 10Leasehold Improvement 5 Intangibles 5 Total Assets $80 Total Liabilities and Shareholders' Equity $80


Step 9: Account for payment of interestCompany Is charged $1,000 of interest and bank charges related to overdraft.

Sylvia's Satins Balance Sheet (Figures in 000's)Assets LiabilitiesCash $0 Overdraft $11.0Accounts Receivable 30 Accounts Payable 40Inventory 30 Shareholders Equity Current Assets $60 Common Shares 20Equipment 10 Retained Earnings 9Leasehold Improvement 5 Intangibles 5 Total Assets $80.0 Total Liabilities and Shareholders' Equity $80.0

Sylvia Satin's Income StatementRevenue $40.0Cost of Goods Sold 30.0Gross Margin $10.0Interest 1.0Net Income Before Tax $9.0


Step 10: Account for depreciation and amortizationCompany depreciates equipment on straight-line basis over 5 years (useful life of equipment) and over 10 years (lease term) for leasehold improvements

Sylvia's Satins Balance Sheet (Figures in 000's)Assets LiabilitiesCash $0 Overdraft $11Accounts Receivable 30 Accounts Payable 40Inventory 30 Current Assets $60 Shareholders Equity Equipment 8 Common Shares 20Leasehold Improvement 4.5 Retained Earnings 6.5Intangibles 5 Total Assets $77.5 Total Liabilities and Shareholders' Equity $77.5

Sylvia Satin's Income StatementRevenue $40.0Cost of Goods Sold 30.0Gross Margin $10.0Interest 1.0Depreciation 2.0Amortization 0.5Net Income Before Tax $6.5


Step 11: Accounting for TaxesThe income tax rate is 40%. We will ignore deferred taxes.Company won't pay taxes until after year end.Sylvia's Satins Balance Sheet (Figures in 000's)Assets LiabilitiesCash $0 Overdraft $11.0Accounts Receivable 30 Accounts Payable 40Inventory 30 Taxes Payable 2.6 Current Assets $60Equipment 8 Common Shares 20Leasehold Improvement 4.5 Retained Earnings $3.9Intangibles 5 Total Assets $77.5 Total Liabilities and Shareholders' Equity $77.5

Sylvia Satin's Income StatementRevenue $40.0Cost of Goods Sold 30.0Gross Margin $10.0Interest 1.0Depreciation 2.0Amortization 0.5Net Income Before Tax $6.5Taxes 2.6Net Income After Tax $3.9

Importance of Cash Flows: Liquidity

• Although Sylvia’s firm is profitable, it is important to understand how it was able to generate enough cash to meet its obligations. In other words, how liquid is Sylvia’s Satins?

• Liquidity is a critical aspect of a company’s financial performance. The payroll must be met. Before a firm can get a loan from a bank or credit from a supplier, it must show itself to be liquid.

• To assess liquidity, we need to understand the factors affecting firm’s on-going ability to generate cash.

Statement of Cash FlowsSales- Cost of Goods Sold- Selling, General and Administration Expenses Net Income- Interest- Income Taxes+Non-cash expenses e.g.depreciation= Cash Flows From Operating Activities- Increase in Accounts Receivable- Increase in Inventory Change in Net Working Capital+ Increase in Accounts Payable- Purchases of Fixed Assets Net Capital Expenditures + Sales of Fixed Assets- Payments to Owners of Business= Cash Generated (Used) By Business Available for Repayment of Debts

Statement of Cash Flowsfor Sylvia’s Satins

Sales $40.0 - Cost of Goods Sold 30.0= Gross Profit $10.0 - Selling, General and Administration Expenses 2.5 - Interest 1.0 - Income Taxes 2.6=Net Income $3.9+ Non-cash Expenses (depreciation, amortization) $2.5=Cash Flows from Operating Activities $6.4- Increase in Accounts Receivable $30.0- Increase in Inventory 30.0+ Increase in Accounts Payable and other Payables 42.6- Purchases of Fixed Assets and other Capital Expenditures 20.0+ Sales of Fixed Assets 0.0- Payments to Owners of Business Other than Salary 0.0Cash Generated (Used) By Business Available for Repayment of Debts -$31.0

Financing Cash Flow Deficiencies

• If Sylvia’s Satins used up $31,000 cash in its on-going operations, how was this financed?Opening Cash Balance $20,000Less: Cash Used$31,000Cash Surplus (Deficiency) - $11,000

• Deficiency was financed by bank overdraft

Cash Flow Drivers

Eleven Key Cash Flow Drivers Relationship with Cash Flow

1. Sales Growth Usually negative2. Gross Margin % (Gross Profit/Sales) positive3. Selling, General and Administration

(SGA) as % of Sales negative 4. Interest Expense negative5. Non-cash Expenses positive6. Income Tax Rate negative7. Average Collection Period (ACP) negative 8. Inventory Conversion Period negative9. Accounts Payable Period positive10. Net Capital Expenditures negative11. Owner’s Withdrawals from Firm negative

Relationship of Expenses to Cash Flow

• Companies with higher profit margins (firms with low cost of goods sold and low SGA as % of sales) generate more cash

• Conversely, firms that incur losses generally use up cash and will encounter problems repaying loans if losses are not stemmed. LOANS SHOULD NOT BE GRANTED TO FUND SUSTAINED LOSSES OF BORROWERS.

• Significant non-cash expenses provide some relief but only where regular capital expenditures are not required

Relationship of Average Collection Period to Cash Flow

• Average Collection Period (ACP) is calculated as: Accounts Receivable Sales/365

• In case of Sylvia’s Satins, ACP is $30/($40/365) or 274 days• One can estimate Accounts Receivable as:

Sales * ACP 365

• If sales double to $80 and ACP remains unchanged, then Accounts Receivable would also double i.e. ($80*274)/365 = $60

• If ACP decreases in half to 137 days, ending Accounts Receivable would equal ($40*137)/365 = $15 and firm would generate $15 more cash in the year

Relationship of Inventory Conversion Period to Cash Flow

• Inventory Conversion Period is calculated as: Inventory Cost of Goods Sold/365

• In case of Sylvia’s Satins, Inventory Conversion Period is $30/($30/365) or 365 days

• One can estimate Inventory as:Cost of Goods Sold * Inventory Conversion Period 365

• If cost of goods sold doubles to $60 and Inventory Conversion Period remains unchanged, then Inventory would also double i.e. ($60*365)/365 = $60

• If Inventory Conversion Period decreases in half to 183 days, ending inventory would equal ($30*183)/365 = $15 and firm would generate $15 more cash in the year

Relationship of Accounts Payable Period to Cash Flow

• Payables Deferral Period = (Payables)/(Cost of Goods Sold + Other Operating Expenses) X 365

• In case of Sylvia’s Satins, Payables Deferral Period is ($40)/($30/365) or 487 days

• One can estimate Accounts Payable as:Cost of Goods Sold * Accounts Payable Period 365

• If cost of goods doubles and Payables Deferral Period remains unchanged, then Accounts Payable would also double i.e. ($60*487)/365 = $80

• If company pays its suppliers in half the time, ending accounts payable would equal ($30*243)/365 = $20 and firm would use up $20 more cash in the year

Relationship of Sales Growth to Cash Flow

• If a company is selling on credit, an increase in sales usually uses up cash as the firm buys/builds more inventory, sells it and then has to wait to get paid by its customers i.e. there is an increase in both inventory and accounts receivable.

• Even for firms that strictly sell on a cash basis, an increase in sales still means that it needs to increase its inventory.

• In most cases, the cash required to build-up inventory and receivables more than offsets payables increase as well as the increased cash flow from operations

Impact of Doubling of Sales of Sylvia’s Satins on Cash Flow of Firm

Sales $80.0 - Cost of Goods Sold 60.0= Gross Profit $20.0 - Selling, General and Administration Expenses (SGA) 2.5 - Interest 3.0 - Income Taxes 5.8=Net Income $8.7+ Non-cash Expenses (depreciation, amortization) $2.5=Cash Flows from Operating Activities $11.2- Increase in Accounts Receivable $60.0- Increase in Inventory 60.0+ Increase in Accounts Payable (includes Taxes Payables) 85.8- Purchases of Fixed Assets and other Capital Expenditures 20.0+ Sales of Fixed Assets 0.0- Payments to Owners of Business Other than Salary 0.0Cash Generated (Used) By Business Available for Repayment of Debts -$43.0

Sales, gross profit, A/R, inventory, payables all double / SGA and non-cash expenses don’t increase with sales / interest increases to $3 with more borrowing / income taxes equal 40% of ($20-2.5-3.0) or $5.8

Relationship of Sales Growth to Cash Flow

• With increased sales, Sylvia’s Satins would increase its profit from $3,900 to $8,700 but experience an increase in cash outflow from -$31,000 to -$43,000 and therefore end the year with a higher bank overdraft

• Situation would be worse where firm experiences substantial growth and is capital intensive i.e. it needs more capital expenditures to facilitate expansion

• These expenditures place greater pressure on the cash flow of the firm

Relationship of Profitability and Liquidity

• Most often, clients who strive to be more profitable usually improve their liquidity as higher profit margins and better cost controls enhance cash flows

• Furthermore, a more profitable business makes it easier for the firm to attract other sources of credit as well as outside equity

• However, as shown in the last example, sometimes firms seek to expand their businesses to increase or at least preserve profitability. This puts the client’s desire for profitability at odds with the need to maintain liquidity

Relationship of Capital Expenditures and Liquidity

• Most firms periodically need to make substantial capital expenditures, at the very least to maintain their operations or to keep up with the competition– Grocery stores need to replace freezers– Fashion retailers need new fixtures– Delivery firms need to replace vans

• These expenditures place a heavy drain on cash flow and consequently:– Clients should extend life of their fixed assets through preventative

maintenance– Clients should acquire assets with strong warranties and insurance

protection

Relationship of Capital Expenditures and Liquidity

• Financing of Capital Expenditures should be structured so that the period of the repayment of principal matches the life of the asset– Term financing or lease arrangement for equipment– Long-term mortgage for real estate

• Excessive use of short-term debt creates too much demand on cash flows in the period when the asset is first acquired

Identifying Trends in Cash Flow Drivers: Case of a company losing to competition

2000 2001 2002 Possible Concern (Direct Impact on Cash Flow)Sales Growth 5% -9% -10% Losing sales to competition Gross Margin % 30% 29% 27% Lower margins because of more competitionSGA % 18% 20% 21% Costs mainly fixed -- increase as % of salesInterest Expense $1,000 $1,200 $1,400 More borrowing increases interest paidIncome Tax Rate 35% 35% 0% Effective rate falls as losses increaseAverage Collection Period 45 days 49 days 52 days More credit-seeking customersInventory Conversion Period 34 days 38 days 45 days Unsold inventory buildsAccounts Payable Period 35 days 43 days 53 days Greater reliance on supplier creditNet Capital Expenditures 12,000 1,000 600 Decreased sales lessens need for CAPEXOwner's Withdrawals from Firm 25,000 35,000 40,000 Owner tries to preserve personal wealth

Possible Steps to Improve Cash Flows: Limit owner’s withdrawals from firmReview profitability of product mixReview possible cost-cutting measuresMore Closely Monitor A/R, Inventory and Payables Levels

Identifying Trends in Cash Flow Drivers: Case of a company expanding sales at expense of lower gross profit margins

2000 2001 2002 Possible Concern (Direct Impact on Cash Flow)Sales Growth 5% 10% 15% Aggressively sellingGross Margin % 30% 28% 25% Lower prices to attract customersSGA % 18% 17% 16% Costs mainly fixed -- decrease as % of salesInterest Expense $1,000 $1,200 $1,400 Bigger overdraft increases interest paidIncome Tax Rate 35% 35% 35%Average Collection Period 45 days 49 days 52 days Easier credit to attract customersInventory Conversion Period 34 days 33 days 32 days Inventory moves fasterAccounts Payable Period 35 days 43 days 53 days Greater reliance on supplier creditNet Capital Expenditures 12,000 25,000 35,000 Expansion requires increase in CAPEXOwner's Withdrawals from Firm 25,000 30,000 35,000 Owner thinks bigger firm

entitles him to bigger compensation

Possible Steps to Improve Cash Flows:Limit owner’s withdrawals from firmReview profitability of expansion plansMore Closely Monitor A/R and Payables LevelsIncrease use of term debt or other long-term financing e.g. equity

Signs of Liquidity Problems

• Decline in daily or weekly cash inflows

• Profitability and Operating Cash Flow Squeeze -- Increased costs that the firm is unable to pass on to customers

• Unexpected build-up of Accounts Receivable

• Unexpected build-up of Inventory

• Decline in firm’s net working capital, current ratio or an increase in its short-term and total debt ratios (Short-term Debt/ Total Assets and Total Debt/ Total Assets)

Cash Budgets & Pro Forma Statements

Forecasting Cash Flows

Outline

• Why forecast cash flows?• Cash budget• Pro Forma

– Income Statement– Balance Sheet

• Percent of sales method

Managing Liquidity and the Need to Forecast Cash Flows

• Companies need to plan for their cash needs to ensure they have sufficient cash to:– Meet on-going obligations such as the payroll– Meet contingencies such as an increased need for working capital

(sensitivity analysis is especially important)– Be able to invest when attractive opportunities arise

• They need to project a cash budget that forecasts cash inflows and outflows on a monthly basis.

• Cash budgeting is especially important in seasonal and growing businesses.

• Cash budgets should tie in with pro forma income statements and balance sheets.

Preparing Comprehensive Pro Forma Financial Statements

Sales Forecast Production Forecast

Cash Flow Forecast

Pro Forma Income Statement

Pro Forma Balance Sheet

Sales, production and cash flow forecasts are usually done ona monthly basis whereas pro forma income and balance sheets are done an annual basis

EXAMPLE OF CASH BUDGET AND PRO FORMA FINANCIAL STATEMENTS Key Assumptions for Gadget Company

(Startup Business)Sales• Monthly sales of 10,000 units• First month of sales is February 2003• Based on contract with distributorCash Budget• A/R - ½ sales collected within one-month

following sale and the other ½ collected two months following sale

Cash Collections from SalesMonth January February March April

Sales of Gadget Company

$0 $15,800 $15,800 $15,800

Cash Inflows fromAR Collection:During Month After Sale

$7900 $7900

During 2nd Month After Sale

$7900

Total Collections 0 0 $7,900 $15,800

Key Assumptions: Company will sell 10,000 units a month @$1.58 each.

Half of accounts receivable will be collected one month after sale.

Half of accounts receivable will be collected two months after sale.

Cash Collections and Accounts ReceivableMonth October November December Total for

YearSales of Gadget Company

$15,800 $15,800 $15,800 $173,800

Cash Inflows fromAR Collection:During Month After Sale

$7900 $7900 $7900 $79,000

During 2nd Month After Sale

$7900 $7900 $7900 $71,100

Total Collections $15,800 $15,800 $15,800 $150,100

Key Assumptions: Company sold $173,800 of goods but received only $150,100.

The difference of $23,700 represents the increase in accounts receivable during year. Of the $23,700 in accounts receivable at year end, December sales represent $15,800 and half of November sales represent $7,900.

Cash Payments to SuppliersMonth January February March April

Purchases of Gadget Company

$10,000 $10,000 $10,000 $10,000

Cash Payment to Suppliers

$10,000 $10,000 $10,000

Key Assumptions: Company will purchase one month in advance of sales.

- Month-end inventory will equal the current month’s purchases.

Each unit costs $1.00 to purchase.

Supplier will be paid one month after purchase.

Cash Payments and Accounts PaymentsMonth October November December Total for

YearPurchases of Gadget Company

$10,000 $10,000 $10,000 $120,000

Cash Payments to Suppliers

$10,000 $10,000 $10,000 $110,000

Key Assumptions: Company purchased $120,000 of goods but paid for only $110,000 by year end.

The difference of $10,000 represents the increase in accounts payable during year. The $10,000 accounts payable at year end is for December purchases.

Key Assumptions for Gadget CompanyCash Budget• General and administration costs =

$3,750 per month• Interest is charged on previous month’s

loan balance at an annual rate of 12%. The monthly rate is 12%/12 or 1%.

• $10,000 opening cash balancePro Forma Income Statement• Depreciation = $250 per month• no accrual is made for interest expense

at year end

Cash BudgetMonth January February March April

Total Collections 0 0 $7,900 $15,800

Cash Outflows:Cash Payment to Suppliers

$10,000 $10,000 $10,000

General Expenses $3,750 $3,750 $3,750 $3,750

Interest Expense 0 0 75 134Total Cash Outflows $3,750 $13,750 $13,825 $13,884

Net Operating Cash Flow ($3,750) ($13,750) ($5,925) $1,916

Beginning Cash Balance (Borrowing)

$10,000 $6,250 ($7,500) ($13,425)

Ending Cash Balance (Borrowing)

$6,250 ($7,500) ($13,425) ($11,509)

Cash BudgetMonth October November December Total for

YearTotal Collections $15,800 $15,800 $15,800 $150,100

Cash Outflows:Cash Payment to Suppliers

$10,000 $10,000 $10,000 $110,000

General Expenses $3,750 $3,750 $3,750 $45,000

Interest Expense 16 0 0 606Total Cash Outflows $13,766 $13,750 $13,750 $155,606

Net Operating Cash Flow

2,034 2,050 2,050 (5,506)

Beginning Cash Balance (Borrowing)

(1,639) $394 $2,444 $10,000

Ending Cash Balance (Borrowing)

$394 $2,444 $4,494 $4,494

J an Feb Mar April May June JulySales Forecast 15,800 15,800 15,800 15,800 15,800 15,800Cash Inflows From Collections 7,900 15,800 15,800 15,800 15,800Purchases From Suppliers 10,000 10,000 10,000 10,000 10,000 10,000 10,000Cash Outflows to Suppliers 10,000 10,000 10,000 10,000 10,000 10,000General & Admin Expenses 3,750 3,750 3,750 3,750 3,750 3,750 3,750Depreciation 250 250 250 250 250 250 250Interest 0 0 75 134 115 96 76Taxes 0 0 0 0 0 0 0Net Cash Flow -3,750 -13,750 -5,925 1,916 1,935 1,954 1,974Beginning of Month Cash 10,000 6,250 -7,500 -13,425 -11,509 -9,574 -7,620End of Month Cash 6,250 -7,500 -13,425 -11,509 -9,574 -7,620 -5,646

0 2002 Jan Feb Mar April May June JulySales 0 0 15,800 15,800 15,800 15,800 15,800 15,800Cost of Goods Sold 0 0 10,000 10,000 10,000 10,000 10,000 10,000Gross Margin 0 0 5,800 5,800 5,800 5,800 5,800 5,800General Sales & Administrative Expenses 0 3,750 3,750 3,750 3,750 3,750 3,750 3,750Depreciation 0 250 250 250 250 250 250 250Interest Expenses 0 0 0 75 134 115 96 76Profit Before Taxes 0 -4,000 1,800 1,725 1,666 1,685 1,704 1,724Taxes 0 0 0 0 0 0 0 0Profit After Taxes 0 -4,000 1,800 1,725 1,666 1,685 1,704 1,724

2002 Jan Feb Mar April May June JulyCash 10000 6,250 0 0 0 0 0 0Accounts Receivable 0 0 15,800 23,700 23,700 23,700 23,700 23,700Inventory 0 10,000 10,000 10,000 10,000 10,000 10,000 10,000

10000 16,250 25,800 33,700 33,700 33,700 33,700 33,700Net Fixed Assets 28500 28,250 28,000 27,750 27,500 27,250 27,000 26,750Total Assets 38500 44,500 53,800 61,450 61,200 60,950 60,700 60,450

Accounts Payable 0 10,000 10,000 10,000 10,000 10,000 10,000 10,000Bank Loan 0 0 7,500 13,425 11,509 9,574 7,620 5,646

0 10,000 17,500 23,425 21,509 19,574 17,620 15,646Shareholders’ Equity 38500 34,500 36,300 38,025 39,691 41,376 43,080 44,804

38,500 44,500 53,800 61,450 61,200 60,950 60,700 60,450

Aug Sept. Oct Nov Dec 2003Sales Forecast 15,800 15,800 15,800 15,800 15,800 173,800Cash Inflows From Collections 15,800 15,800 15,800 15,800 15,800 150,100Purchases From Suppliers 10,000 10,000 10,000 10,000 10,000 120,000Cash Outflows to Suppliers 10,000 10,000 10,000 10,000 10,000 110,000General & Admin Expenses 3,750 3,750 3,750 3,750 3,750 45,000Depreciation 250 250 250 250 250 3,000Interest 56 37 16 0 0 606Taxes 0 0 0 0 0 0Net Cash Flow 1,994 2,013 2,034 2,050 2,050 -5,506Beginning of Month Cash -5,646 -3,653 -1,639 394 2,444End of Month Cash -3,653 -1,639 394 2,444 4,494

0 2002 Aug Sept. Oct Nov Dec 2003Sales 0 15,800 15,800 15,800 15,800 15,800 173,800Cost of Goods Sold 0 10,000 10,000 10,000 10,000 10,000 110,000Gross Margin 0 5,800 5,800 5,800 5,800 5,800 63,800General Sales & Administrative Expenses 0 3,750 3,750 3,750 3,750 3,750 45,000Depreciation 0 250 250 250 250 250 3,000Interest Expenses 0 56 37 16 0 0 606Profit Before Taxes 0 1,744 1,763 1,784 1,800 1,800 15,194Taxes 0 0 0 0 0 0 0Profit After Taxes 0 1,744 1,763 1,784 1,800 1,800 15,194

2002 Aug Sept. Oct Nov Dec 2003Cash 10000 0 0 394 2,444 4,494 4,494Accounts Receivable 0 23,700 23,700 23,700 23,700 23,700 23,700Inventory 0 10,000 10,000 10,000 10,000 10,000 10,000

10000 33,700 33,700 34,094 36,144 38,194 38,194Net Fixed Assets 28500 26,500 26,250 26,000 25,750 25,500 25,500Total Assets 38500 60,200 59,950 60,094 61,894 63,694 63,694

Accounts Payable 0 10,000 10,000 10,000 10,000 10,000 10,000Bank Loan 0 3,653 1,639 0 0 0 0

0 13,653 11,639 10,000 10,000 10,000 10,000Shareholders’ Equity 38500 46,547 48,311 50,094 51,894 53,694 53,694

38,500 60,200 59,950 60,094 61,894 63,694 63,694

Gadget Company: Projected Income Statement for Year Ended December 31, 2003

Sales $ 173,800Cost of Goods Sold:Purchases 120,000Less: Ending Inventory 10,000

110,000Gross Profit 63,800General Expenses 45,000 Depreciation 3,000 Interest 606

48,606Net Profit $15,194

Gadget Company: Pro Forma Balance Sheet December 31,

2003Actual Projected Actual Projected

2002 2003 2002 2003Current Assets LiabilitiesCash $10,000 4,494 Accounts Payable $0 $10,000Accounts Receivable 0 23,700 Bank Indebtedness 0 0Inventory 0 10,000 $0 $10,000

$10,000 $38,194Equipment Shareholders EquityCost $28,500 $28,500 Common Stock $38,500 $38,500Less: Accum. Dep. 0 3,000 Retained Earnings 0 15,194

$28,500 $25,500 $38,500 $53,694Total Liabilities and

Total Assets $38,500 $63,694 Shareholders Equity $38,500 $63,694

% of Sales Method: Pro Forma Model Ingredients

Sales Forecast Drives the model

Pro Forma Statements The output summarizing different projections

Asset Requirements Investment needed to support sales growth

Financial Requirements Debt and dividend policies

The “Plug”” Designated source(s) of external financing

Economic Assumptions State of the economy, interest rates, inflation

Historical Financial Statements for St. Dilbert Pharmaceuticals

Income StatementSales $500

Costs 235 47% of Sales

Depreciation 120 20% of Net Fixed Assets

Interest 40 10% of last period’s Debt

Taxable Income 105

Taxes 36 34% of Taxable Income

Net Income $69

Retained $23

Dividends $46 67% of Net Income

Balance SheetCurrent assets $400 Total Debt $450

Net fixed assets 600 Owner’s Equity 550

Total Assets $1,000 Total Liabilities $1,000

• Total Assets are 200% of sales. ($2 of assets for every $1 of sales.)• Fixed assets are 60% of total assets, or 120% of sales.

Pro Forma Financial Statements Using % of Sales Method

• Assume that sales grow by 20% to $600 Income StatementSales $600


Depreciation n.a. 20% of Net Fixed Assets

Interest n.a. 10% of last period’s Debt

Taxable Income n.a.

Taxes n.a. 34% of Taxable Income

Net Income n.a.

Retained n.a.

Dividends n.a. 67% of Net Income

Balance SheetCurrent assets $480 Total Debt n.a.

Net fixed asset 720 Owner’s Equity n.a.


• Firms needs $2 of assets for every $1 of sales. • Fixed assets are 60% of total assets.

Filling in the Blanks

• Depreciation– Firm needs $2 of assets for every $1 of sales (total asset turnover is 0.5 or total

assets are 200% of sales) • Total Assets must rise to $1,200 to support $600 of sales• Fixed Assets are 60% of Total Assets• Current Assets are 40% of Total Assets• Depreciation is 20% of Fixed Assets

Depreciation = 0.2 * (0.6 * $1,200) = $144• This depreciation calculation wrong, but close and simple!

– Should calculate depreciation as % of additions to gross fixed assets plus % of last year’s net.

• Interest– Based on the last end-of-period Debt level (short and long-term).– Interest = 0.1 * $450 = 45

Pro Forma Financial Statements Using % of Sales Method

Income StatementSales $600


Depreciation 144 20% of Net Fixed Assets

Interest 45 10% of last period’s Debt

Taxable Income 129

Taxes 44 34% of Taxable Income

Net Income 85

Retained $28

Dividends $57 67% of Net Income

Balance Sheet

Current assets $480 Total Debt $450



Equity is the plug variable

Financial Planning

• Equity is the plug variable. • Equity rises from $550 to $750, but $28 of this is from retained earnings.• The difference, $172, is additional equity income necessary to support the

increase in sales.• Debt could also be the plug. Firm could borrow $172 and Debt could rise to

$622.• If new capital not available, then can’t finance sales increase.

Balance Sheet with Debt as PLUG

Current assets $480 Total Debt $622



Cash & Marketable Securities

Overview of How Companies Maintain Liquidity

• By holding cash and marketable securities• By having ready access to sources of

financing– Access to equity (not always possible or

attractive)– Access to debt through prior commitments

from lender e.g. line of credit

Criteria in Selection of Marketable Securities1. Liquidity – the security should be easy to sell before maturity

and the costs involved in selling (transaction costs) should be minimal

2. Default Risk – when investing in bonds, there should be little chance the borrower will not repay principal and interest (usually stick with high-grade borrowers)

3. Market Risk – there should be little risk that the security’s price will decrease before maturity because of changes in overall market conditions (levels of interest rates and stock market indices); this means that securities are usually short-term, fixed income securities (not long-term bonds and not equities)

4. Attractive Return – firms will accept more of the above three risks in order to higher return

5. Tax Implications – return is considered on after-tax basis

Criteria in Selection of Marketable SecuritiesLiquidity Default Risk Market Risk Yield

(Feb. 14, 2003)

T-bills Highest Lowest /obligation of Federal Government

Lowest 2.82% (3-month t-bill)

Banker’s Acceptance

High Low / guaranteed by a bank

Low 2.87% (highest rated)

Commercial Paper

High to Medium

Low to Medium / depends on risk of corporate borrower

Low to Medium / corporate borrower may be affected by stock market conditions

2.87% (highest rated)Yield is higher on lower rated paper

Other Short-term Investments Used for Liquidity Purposes

• Overnight loans (large firms lend money on an overnight basis)

• Certificates of Deposits (interest-bearing rather than discount instruments issued by banks and trust companies)

• Negotiable Certificates of Deposit (can be sold before maturity in market)

• Money Market Mutual Fund (pool of short-term money market instruments)

Effective Interest Rate on a Short-term Discount Instrument

• Effective rate over life of instrument

• Effective annual interest rate

M atu rity P rice C urren t P riceC u rren t P rice

1 1

M atu rity P rice C u rren t P riceC u rren t P rice

3 6 5

D ays to M a tu rity

Effective Interest Rate on a Short-term Discount Instrument

• Example of effective annual interest rate calculation

• T-bill has 90 days to maturity; maturity price is $1,000 but it currently sells for $990

10 0 0

1 4 1 6 %

$ 1 9 90$ 9 9 0

3 6 5

90,.

Approximate Annual Yield Short-term Discount Instrument

M atu rity P rice C u rren t P riceC u rren t P rice D ays to M atu rity

3 6 5

X

$ 1 $ 9 9 0$ 9 9 0 9 0

36 5,.

0 0 04 1 0 %

X

In the case of t-bills, the approximate yield is referred to as the bond equivalent yield. The bond equivalent yield on the 90-day t-bill is shown below.

Accounts Receivable

Outline

• Terms• Extending Credit to New Accounts• 5 C’s of credit• Monitoring Accounts Receivable through

Aging of Accounts

Accounts Receivable Decisions

• Key Decisions to Make1. Terms and conditions of credit sales2. Credit analysis3. Credit decision. Whether to extend credit to

a customer?4. Collection policy

Accounts Receivable and Credit Terms

• Terms and conditions of credit decisions– No terms – cash on delivery– Typical Credit Terms – 2/10 net 30; this

means that payment is due 30 days following date of invoice and if customer pays by day 10, he/she receives a 2% discount off invoiced price (an incentive to make customers pay early)

Accounts Receivable and Choice of Credit Terms

• Choice of Credit Terms– A longer net term means

• More sales and gross profitBut it also means,• Higher bad debt• Increased credit department costs given need

to check new applicants• Increased investment in accounts receivable

and potentially inventory

Accounts Receivable and Credit Analysis

• Example of Impact of Extending Credit to a New Set of Customers– The new set of customers could increase sales by $60,000. The gross

profit margin is 25% and bad debt is estimated to be 3%. Credit department costs are expected to be $3,000 annually. The average collection period is expected to be 4 months. Given an income tax rate of 40%, what is the after-tax rate of return on providing credit to the new set of customers?

Change in after-tax profit = ($60,000*(25%-3%) –3,000)*(1-0.40) = $6,120

Investment needed = $60,000*4/12*(1-25%)=$15,000Rate of return = $6,120/$15,000 = 40.8%The after-tax rate of return on providing credit to the new set of customers is

40.80%

Exercise #1

• A new set of customers could increase sales by $100,000. The gross profit margin is 10% and bad debt is estimated to be 5%. Additional credit department costs are expected to be $3,000 annually. The average collection period is expected to be 3 months. Given an income tax rate of 40%, what is the after-tax rate of return on providing credit to the new set of customers?

Solution

• Change in after-tax profit = ($100,000*(0.10 - 0.05) –3,000)*(1-0.40)= $1,200

• Investment = $100,000*3/12*(1-.10)=$22,500• Rate of return = $1,200/$22,500 = 5.3%• The after-tax rate of return on providing credit

to the new set of customers is 5.3%

Exercise #2

• You have been approached by your sales staff about selling $100,000 of goods on credit to a new customer. The cost of goods sold on your firm’s products is 80%. Credit department costs are expected to be $2,000 annually to handle this account. The average collection period is expected to be 3 months. The income tax rate is 20%. If you want to earn a 15% after-tax rate of return on providing credit to the new customer, what will be the maximum bad debt expense that can be tolerated?

Solution• Let BD be bad debt expense as % of sales• Gross Margin = 100% -80% =20%.• Change in after-tax profit = ($100,000*(20%-BD) –2,000)*(1-0.20)• Investment needed = $100,000*3/12*(80%)=$20,000

• We need to solve for BD with equation,• Rate of return = (($100,000*(20%-BD) –2,000)*(1-0.20))/$20,500 = 15%• (($100,000*(20%-BD) –2,000)*(1-0.20))=$3,075• ($100,000*(20%-BD) –2,000)= $3,844• $100,000*(20%-BD)=$5,844• 20%-BD=5.844%• BD=14.156%• The maximum bad debt expense is 14.156%

THE 5 C’S OF CREDIT ANALYSIS

Character of Owner/Manager

Capacity to Repay Financial Forecast Business Plan Income or Profits

Collateral Liquidation Value Enforceability Liquidity

Credit Conditions Ability to Access New

Financing Credit Checks Terms of Loan

Capital Adequate Amount of

Long-Term FundsEspecially Equity

SCHEDULE OF AGE OF RECEIVABLES

Age Days Amount (000) Percent of Total0 – 30 $200 46.51%31 – 60 150 34.88%61 – 90 50 11.63%Over 90 30 6.98%Total $430 100%

Trade-off Between Non-Collection and Stringent andExpensive Collection Methods as well as Loss of CustomerGoodwill

Inventory

Financial Overview of Inventory Management

• Benefits of Increased Inventory– quantity discounts for purchasing– avoids stock outs– lessens ordering costs

• Costs of Increased Inventory– Higher carrying costs (Financing, storage,

insurance, etc.)– Potential obsolescence

Short-Term Financing

Outline

• Selection Criteria• Covenants• Effective Annual Rate of Borrowing

Instruments– Line of Credit

• Cost of Trade Credit

Short-term Financing Sources

A ccou n tsP ayab le

R eg ula rIn te re st

D isco u n tIn te re st

V ar iab le -R a teIn te re st

T ermL oan

R eg u la rIn te re st

V ar iab le -R a teIn te re st

L in e o fC red it

B a nkL oa ns

C o m m e rcia lP ap er

F a cto r ing

Criteria in Selecting Short-term Finance• Lowest effective net cost considering

– interest – fees – offsetting benefits in reduced administrative costs– net amount borrowed

• Flexibility of Repayment Terms• Amount of Credit Available• Conditions of Credit e.g. collateral, covenants

etc.

CREDITPACKAGE

InterestRate

Fees Application Administration

Covenants

Collateral

Structure IncludingRepayment Schedule

Guarantees Personal Related Company Third Party

Amount

PRIVATE & CONFIDENTIAL

Victoria Main Office1225 Douglas StreetVictoria, B.C.V8W 2E6

Bank of Montreal is pleased to offer the following lines of credit to upon and subject to the following terms and conditions. Loan TypesAll loans are payable on demand, subject to periodic review by the Bank not less frequently than annually, unless otherwise indicated. Interest Rates For the purpose of this Offer, "Prime Rate" is the floating annual rate of interest established from time to time by the Bank of Montreal as the base rate it will use to determine rates of interest on Canadian dollar loans to customers in Canada and designated as Prime Rate. Prime Rate is currently 6.25%Loan Structure1) First Bank Cash Management Account (FCMA) $2,750,000.

cont’d

September 8th, 1992

Purpose: Operating assistance. Interest Rate: Prime plus 1/4% Repayment: Interest only, payable monthly. Exact dollar borrowing. Above operating line includes: Maximum $100,000 Letter of Credit facility to cover periodic import of food stuffs. Maximum $250,000 overdraft facility to cover periodic settlement of U.S. payables. Margin Conditions:• Operating advances contained within 66.6% eligible accounts receivable (60 days and under) plus 50% inventory at cost as indicated by monthly signed Inventory Declarations, Eligible receivables to include current 30/60 day accounts that have formal repayment program established for any over 61 day payments. Estimate of Priority Payables to be provided on monthly Inventory Declaration.Secondary Margin• Operating advances are not to exceed eligible receivables.

cont’d

Information Requirements: Monthly aged Account Receivable Listings, Inventory and Account Payable

Declarations signed by company Signing Officer. By October 15th, 1992 ‑ In-house Balance Sheet and Income Statements as at

July 31st, 1992. 2) Commercial Mortgage $1,990,000. (Approx. Balance) Purpose: Refinance existing Commercial Mortgage $1,671,000 with

additional $329,000 to repay Demand Loan, Non-Revolving $300,000 balance $29,000 to company current account.

Interest Rate: 11.00%, 3 Year Term due October 1st, 1994 (25 year amortization).Repayment: Monthly blended payments $19,300, 25 year amortization.

Security ‑ Already In Place ‑ Debenture security providing overall Fixed Charge $3,500,000 over property

and various company owned vehicles/equipment along with Floating Charge over all other company assets.

Debenture Restrictive Covenants: Not to declare or pay dividends without Bank approval. Company not to provide Guarantee to any other financial institution without

Bank approval.

cont’d

‑ Standard Mortgage Clause Fire/All Perils Insurance. ‑ Assignment of Book Debts. ‑ Subrogation of shareholder loans signed by ‑ Subrogation of loan by Holdings Ltd. ‑ Corporate Letter of Undertaking re: Financial Test Covenants (To be replaced - replacement letter attached). ‑ First Commercial Mortgage $2,000,000 providing Fixed Charge over Victoria warehouse complex, including charge over company's freehold and leasehold interest in the subject property. ‑ General Assignment of Rents. ‑ Priority Agreement over existing Bank of Montreal Debenture charges. Security ‑ To Be Obtained ‑ Revised Corporate Letter of Undertaking, detailed as follows: 1) Maintain debt/equity ratio maximum 2.75:1 as determined by Fiscal 1993 year end Financial Statements with equity defined as Shareholder Loans, Retained Earnings and net tax Bonus Payable. cont’d

2) Achieve Working Capital ratio minimum 1.25:1. (Current liabilities to exclude Directors Wages after tax). 3) Restrict Annual Capital Expenditures to $1,500,000 as detailed in Controller prepared Fiscal 1993 Capital Expenditure Summary.Please note Capital Expenditures at $1,500,000 level are approved in principle in that the Bank will be reviewing the anticipated and resultant financing requirements with you in the near future.‑ Revised FCMA Agreement.‑ Insurance Waiver.Given the scale and complexity of company financial operations, we would appreciate the opportunity to revisit the need for provision of Annual Audited year end Financial Statements.

cont’d

We are pleased to be of assistance to you. We shall be grateful if you will sign and return copy of this Offer of Credit to the undersigned. Congratulations on your strong Revenue and Profit performance. With best wishes for a successful year.

J. CashCorporate Manager

JC/eg THE UNDERSIGNED HEREBY ACCEPTS THE ABOVE OFFER, ITS TERMS AND CONDITIONS AND AGREES TO BE BOUND THEREBY. DATED AT VICTORIA, IN THE PROVINCE OF BRITISH COLUMBIA THIS ___ DAY OF SEPTEMBER 1992.

Example of Typical Bank Loan Covenants for Closely Held Company

• Gordon Manufacturing is 100% owned by Sam Gordon• Minimum Current Ratio of 1.25 to ensure liquidity• Minimum Adjusted Net Worth of $2 million to ensure

solvency• Adjusted Net Worth equals

Shareholders Equity from Balance Sheet plus Loans from Shareholder/Related Companiesless Loans to Shareholder/Related Companiesless Goodwill

Effective Annual Cost of Short-term Financial Instrument

• Effective before tax rate over life of instrument

• Effective before-tax annual interest rate

In terest F ees S av in gsN et A m o u n t B o rro w ed

1In terest F ees S av in gsN et A m o u n t B o rro w ed

1

3 6 5

D ays to M atu rity

Effective Annual Interest Rate on Regular Interest Term Loan

• Example: A bank charges a 5% annual regular interest rate on a $100,000 91-day term loan. There is an annual fee of 1%.

Solution:Interest paid is 5%* $100,000*91/365 or $1,247Fee is 1%*$100,000*91/365 or $249Net amount borrowed is $100,000 – 1,000 or $99,000Effective annual interest rate equals

10

10 0 ,0 0 01 = 6 .21 %

36 5

9 0

1 2 4 7 2 4 9,

Effective Annual Interest Rate on Discount Interest Term Loan

• Example: A bank charges a 5% annual discount interest rate on a $100,000 91-day term loan. There is an annual fee of 1%.

Solution:Interest paid is 5%* $100,000*91/365 or $1,247 Fee is 1%*$100,000*91/365 or $249 Net amount borrowed is $100,000 – 1,247 or $98,753Effective annual interest rate equals

10

98 ,7 5 31 = 6 .2 9 %

3 6 5

9 0

1 2 4 7 2 4 9,

Line of Credits• Used to finance seasonal fluctuations in working capital. • Firm can borrow up to a maximum level over a specified

time period. • Repayment obligation varies (e.g., 3% of principal per

month), although balance must be zero by termination of the loan agreement.

• Borrowing firm may withdraw as need requires up to a preset maximum.– Committed means bank obliged (written loan agreement) -- fee on

unused balance about 1%. (Commitment fee)– Uncommitted means bank not obliged -- no fee on unused balance.

• Bank usually has option to terminate.

Line of Credits• Assume interest calculated on average balance of

loan used over period.• Assume commitment fee calculated similarly.

Calculating Effective Interest Rate on Line of Credit

• Example: A bank charges a 5% interest rate on a $100,000 line of credit for amounts used and a commitment fee of 1% for amounts available but not used. The fee is calculated based on the average unused balance during the period. If average loan balance was $40,000 for 180 days , what was effective interest rate on line of credit?Solution:

Interest Expense = 5%*$40,000*180/365 or $986Commitment Fee = 1%*60,000*180/365 or $296 Net Amount Borrowed = $40,000 Effective Annual Interest Rate equals

10

4 0 ,0 0 01 = 6 .6 1 %

36 5

18 0

98 6 2 9 6

Exercise #1• Example: A 120-day $200,000 line of credit. The line of credit would have

an annual interest rate of 5% and an annual commitment fee of 1% of the unused balance. During the first 60 days the loan is outstanding, $50,000 will be borrowed. During the last 60 days, $150,000 will be borrowed.

• Interest Expense = 5%*$50,000*60/365 + 5%*$150,000*60/365 = $1,644Commitment Fee = 1%*$150,000*60/365 + 1%*$50,000*60/365 = $329Net Amount Borrowed = $50,000*60/120 + $150,000*60/120 = $100,000Effective Annual Interest Rate equals

6.12%1000,100

329644,11 120365

Exercise #2• Example: A 180-day $300,000 line of credit. The line of credit would have

an annual interest rate of 6% and an annual commitment fee of 0.5% of the unused balance. During the first 100 days the loan is outstanding, $100,000 will be borrowed. During the last 80 days, $250,000 will be borrowed.

• Interest Expense = 6%*$100,000*100/365 + 6%*$250,000*80/365 = $4,932Commitment Fee = 0.5%*$200,000*100/365 + 0.5%*$50,000*80/365 = $329Net Amount Borrowed = $100,000*100/180 + $250,000*80/180 = $166,667Effective Annual Interest Rate equals

6.50%1667,166

329932,41 180365

Additional Exercises• For additional exercises on lines of

credit, try problems 24.6 and 24.7 and Davis and Pinches

Calculating Effective Cost of Deferring Payment on Accounts Payable

• Example: A company has 2/10 n45 terms with its supplier. If the company currently pays within 10 days and receives the 2% discount, what is the effective annual cost of delaying payment until day 45?Solution:Rather than paying 98% of face value on day 10, company gets to pay 100% of face value on day 45. This is equivalent to borrowing a discount interest loan equal to 98% of face value on day 10 and repaying loan back on day 45.

Interest Expense = 2% (discount foregone) Net Amount Borrowed: = 98% of face value of payablesEffective Annual Interest Rate equals

198 %

1 = 23 .4 5 %

36 5

4 5-10

2%

Factoring Receivables

• Selling receivables to a factor (Finance company) for discounted cash value (with advance factoring) without recourse to the seller (borrower)

• Factor bears risk (where no recourse) and collection expenses

• Fees are fairly high in factoring arrangements; in most industries, factoring is one of the most expensive methods of short-term borrowing

Factoring: Example• Don’t Pay for One Full Year!• Salesperson screens client for credit eligibility with

Citifinancial on site using Citi’s in-store computer system. Citi controls credit quality. Bad risks are not offered credit.

• Citi pays Leon’s the discounted value of the purchase price immediately.

• Citi collects full payment from client at end of year. If client can’t pay, then Citi starts charging interest.

Advantages of Factoring Over Pledging of Accounts Receivables

• Allows Companies to Avoid Credit Checking, Bookkeeping and Collection Costs

• With Advance Factoring, Firms can Shorten Cash Conversion Cycle

• With Non-Recourse Factoring, the Financial Institution Absorbs Bad Debt Losses

Effective Annual Interest Rate of Advance Factoring• Example: A company has $200,000 or accounts receivable. A finance company

charges a 1% commission on all receivables factored. The finance company will loan an amount equal to 70% of the receivables factored and will charge a 12% annual interest rate on this amount. However, credit department costs will be reduced by $750 a month. The average collection period is 60 days (2 months). What is effective annual cost of factoring?

Solution:Fee is $200,000*1% or $2,000Net amount borrowed is $200,000*70% or $140,000Annual interest paid is 12%* $200,000*70%*60/365 or $2,762Savings over 2 months = $750*2 =$1,500Effective annual interest rate equals

114 0 ,0 00

1 = 1 5 .0 4 %

36 5

6 0

2 76 2 2 00 0 1 5 00,

XYZ Corp. currently has monthly receivables of $83,333. It advance factors all receivables to Bank. Receivables typically collected on 25th of month, so term = 25 days. Bank lends 75% of receivables, charges 1.5% commission and 3% above Prime (Prime=6%). XYZ Corp, saves $1,000 a month on book-keeping and collection expenses. What is the net cost to XYZ?

Commission = 0.015 * 83,333 = $1,250Savings = -$1,000Interest = 0.09*0.75*$83,333*(25/365) = $385.27

Total = $635.27

15.91%1$62,499.75

$635.271k25

365

EAR

Exercise #1

Beamscope monthly receivables of $400,000. It advance factors all receivables to Bank. Receivables typically collected at the end of each month, so term = 1 month. Bank lends 70% of receivables, charges 0.5% commission and 2% above Prime (Prime=9%). Beamscope, saves $1,000 a month on book-keeping and collection expenses. What is the net cost?

Commission = 0.005 * 400,000 = $2,000Savings = -$1,000Interest = (0.09/12)*0.7*400,000 = $2,567Total = $3,567

16.41%1$280,000$3,5671k

12

EAR

Exercise #2

Ratio Analysis

Outline

• Ratios• Du Pont Analysis

Ratio Analysis

• Financial ratios show relationships among financial statement accounts.

• Investors predict future earnings and dividends of firm in order to value shares

• Creditors predict likelihood of default by firm on claim

• Management decides upon investment in short and long-term asset and establish amount and type of credit financing

Ratio Analysis

Steps:

Type:

1. Decide on ratios that are appropriate2. Calculate ratios3. Compare ratios to industry norms4. Evaluate reasons for discrepancies from industry norms5. Identify trends in ratios over time6. Evaluate reasons for trends7. If discrepancies arose because of underlying problems, evaluate alternative solutions to problems.I. LiquidityII. Asset Management RatiosIII. Debt Management RatiosIV. Profitability RatiosV. Market Value Ratios

II. Asset Management Ratios- measures how effectively management is utilizing the company’s assets

Turnover Measures

1) Inventory Utilization = Sales/InventoryToo “high” Too “low”- loss of profitable sales - obsolescence from stock outs - warehousing constraints-costs from excessive - financing and insurance reordering costs are excessive

2) Average Collection Period = Receivables____ Average Sales per Day

Too “low” Too “high”- loss of profitable sales from - bad debt tight credit terms - financing costs

3) Fixed Asset Utilization = Sales/Net Fixed Assets

4) Total Asset Utilization = Sales/Total Assets

III. Debt Management (Leverage) Ratios

- measures extent to which non-equity financing is used

1) Total Debt/Total Assets

2) Total Debt/Total Equity

3) Long-term Debt/Common Equity

- measures ability of company to meet fixed financing charges with operating income

1) Times Interest Earned = Earnings Before Interest and Taxes (EBIT)

Interest Charges

2) Fixed Charge Coverage Ratio

Leverage

- creditors will charge higher financing rates to firms which are highly levered

1) Greater likelihood of bankruptcy because of added interest costs

2) Loss of creditors upon liquidation of firm is likely higher because amount of debt increases but liquidation value of assets does not.

3) Common shareholders have smaller stake in firm that is financed by debt rather than solely by equity - may lead them to misappropriate firm assets or take excessive risks especially where firm is nearing bankruptcy.

if firms are too highly leveraged, they may be unable to obtain financing from creditors.

Advantages to Shareholders from Leverage

1) leverage allows firms to experience higher returns in “good” times (but lower returns in “bad” times) - generally expected EPS increases to compensate for greater risk with higher leverage

2) existing shareholders can maintain control by borrowing debt rather than issuing new common shares esp. important for shareholders who are also managers - leverage buy outs

3) tax advantages - interest charges are deductible from taxable income while dividends are not

IV. Profitability Ratios

- measure combined effect of liquidity, asset management and leverage on operating results

1) Gross Profit Margin on Sales = Gross Margin/Sales

2) Net Profit Margin on Sales = Net Income Available to Common Shareholders/ Sales

3) Basic Earning Power Ratio = EBIT/Total Assets

4) Return on Total Assets = Net Income Available to Common Shareholders/ Total Assets

5) Return on Equity = Net Income/Common Equity

- Profitability analysis often focuses on means to improve the gross margin through new pricing policies, changes in product lines and methods to reduce the cost of goods sold.

V. Market Value Ratios

- measures the stock market’s evaluation of liquidity, asset management, debt management and profitability

1) Price Earnings Ratio = Price per share/EPS

2) Market/Book Ratio = Stock Price /Book Value Per Share

Book Value Per Share = Shareholders’ Common Equity / Shares Outstanding

The Dupont equation Highlights relationship between financial ratios

ROE

ROA

Net profit margin

Asset turnover

x

x

1+ debt/equity

The DuPont System

EquityDebt*t turnovertotal assein t m net profiROE

nover asset turin * totalt m net profiROA AssetsSales

SalesNet Income

SalesSales

AssetsNet Income ROA

AssetsNet Income ROA

EquityDebtROA

EquityAssetsROAROE

EquityAssets

AssetsNet Income

AssetsAssets

EquityNet Income ROE

EquityNet Income ROE

1arg

arg

1

AutoParts

BuildingMaterials

Gold andPreciousMetals

Food andBeverage

Technology Pipelines

Liquidity

Current 2.69 1.96 10.17 2.76 2.47 0.71

Quick 1.60 1.10 9.67 1.57 1.82 0.51

AssetManagement

Days SalesOutstanding

44.7 59.9 21.2 35.9 70.6 46.5

InventoryTurnover

7.66 11.15 7.76 11.01 34.52 26.22

Long-termAsset Ratio

5.03 3.84 0.59 6.40 9.85 0.89

DebtManagement

Total Debt toTotal Assets

0.30 0.36 0.25 0.49 0.35 0.67

Times InterestEarned

62.37 8.14 (76.08) 9.00 23.35 1.97

Average Industry Ratios

Average Industry Ratios (Continued) Auto

Parts Building Materials

Gold and Precious Metals

Food and Beverage

Technology Pipelines

Profitability

Margin (%)

5.96

5.27

(72.71)

5.96

(2.01)

5.03

Return on Assets (%)

8.36

7.28

(19.52)

7.61

0.09

6.18

Return on Equity (%)

14.29

11.06

(25.68)

12.09

(0.83)

12.28

Market

Average P/E

18.7

29.8

50.2

16.2

26.0

15.1

Dividend Yield (%)

1.24

0.71

0.25

1.72

0.39

4.20

Source: Industry Reports (July 5, 1998) The Financial Post Datagroup.

Capstone Case: Working Capital and Financial Statement Analysis

Beamscope Canada

Capstone Case: Working Capital and Financial Statement Analysis

The chart below shows the price of the stock of Beamscope, a distributor of electronics products in Canada and South America, from 1997 to 2001.

Beamscope’s Working Capital Management

Ratio 1996 1997 1998 1999 2000Current 1.93 1.61 1.70 1.35 1.01Quick 1.38 1.06 1.06 0.58 0.44Average Collection Period 62 84 80 54 50

Days Inventory 29 46 53 64 66Days Payable 53 71 69 47 49Operating Cycle 91 131 133 118 115

Cash Cycle 38 60 64 71 67

Three major problems occurred with working capital in 1997-1998:

1. Company couldn’t cope with growth in managing inventory & AR

2. Company didn’t properly process goods returned from customers.

3. Company didn’t have an adequate returns policies with suppliers.

Beamscope’s Debt Management

Ratio 1996 1997 1998 1999 2000Total Debt/Total Assets 0.48 0.59 0.57 0.71 0.77Total Debt/Equity n.a. 0.43 0.33 1.29 1.37Short-term Debt/Equity n.a. 0.23 0.18 1.07 1.36

Times Interest Earned n.a. 9.69 8.50 -5.24 -2.62

Increased Debt Levels Relative To Equity

1. Increase in Accounts Receivable and Inventory needed to be financed.

2. Company wrote off Uncollectible Accounts Receivable and Overvalued Inventory in 1999.

Lower Debt Servicing Ability because of higher interest and lower profits.

Beamscope’s Profitability

Ratio 1996 1997 1998 1999 2000Gross Profit Margin 9.8% 9.6% 9.2% 2.4% 4.1%Net Profit Margin 2.0% 1.5% 1.7% -3.4% -2.8%

Sales/Total Assets 3.6 2.3 2.4 2.5 2.4

Return on Assets 7.2% 3.5% 4.1% -8.5% -6.7%

Total Assets/Equity 1.93 2.45 2.35 3.41 4.35 Return on Equity 13.9% 8.6% 9.6% -29.0% -29.1%

Company became very unprofitable in 1999

1. Both gross and net profit margins shrunk because of writeoffs in that year.

2. DuPont analysis reveals that the lack of operating profitability after 1998 is major reason for low return.

introduction to working capital management

Economy & Finance