Notes. CIMA Paper P1. Performance Operations

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1 Chapter 5 extract from our ExPress notes for use with the current video. A full set of P1 ExPress notes can be downloaded free of charge at CIMA Paper P1 Performance Operations For exams in 2011 Notes

2 Chapter 5 Managing Short Term Finance ExPress Notes START The Big Picture The final section of the Paper addresses the short-term elements of the balance sheet and related considerations of cash flow andprofitability. Working Capital This is a core function of management which has day-to-day implications. Working capital definition: Current assets Current liabilities This is an accounting definition. The discussion and analysis of working capital management focuses on the operating elements of current assets and liabilities: Cash Inventory Receivables Payables Page 2

3 Cash Operating Cycle These elements are linked through the Cash conversion cycle, also known as the Cash Operating Cycle. Raw materials received Receipt of cash Payment to supplier Sale of goods Conversion into finished goods The above diagram shows the operating cash flows for a typical manufacturing company converting raw materials into finished goods for sale. The company needs its own cash to pay the supplier and can only recover this from the sale of the finished goods. The cash invested in inventories and receivables represents a cost to the company. This is most directly obvious in opportunity cost terms: the cash could be earning interest, reducing interest-bearing debt, or ultimately find its way into shareholders pockets as a dividend payment. The presence of payables indicates that cash payments (outflows) are delayed; this is beneficial to the company as long as it is not overdue on its payments, as late payment could lead to penalties or damage to the company s reputation (creditworthiness). Managing the individual parts of working capital means managing the whole picture in an optimal way; doing this well can give a firm a significant competitive advantage over its competitors. Ratio Analysis Liquidity ratios The relationship between current assets and current liabilities is used as a measure of liquidity in the firm: Page 3

4 Current ratio = Current assets Current liabilities Quick ratio = Current assets - Inventories Current liabilities Turnover ratios 1. Trade debtors (receivables) Trade Debtors X 365 Sales 2. Inventory turnover Inventory COGS X Trade creditors (payables) Trade Payables COGS X 365 Sales revenue/net working capital ratio Sales Working capital This ratio establishes the link between the level of sales and the amount of working capital a business needs to maintain. It is useful for cash flow forecasting. The ratio need not remain constant as sales grow, but alternate assumptions should usually be based on arguments specific to the business. Economic Order Quantity (EOQ) Within a company, there is a natural temptation to accumulate buffer stocks (raw materials and semi-finished goods) so that production is never interrupted. Similarly, in order to avoid stock-outs, sales managers will insist on maintaining a plentiful level of finished goods. All of this costs money. Page 4

5 The EOQ is a method which seeks to minimize the costs associated with holding inventory. To determine the total costs, the following data is required: Q = order quantity D = quantity of product demanded annually P = purchase cost for one unit C = fixed cost per order (not incl. the purchase price) H = cost of holding one unit for one year The total cost function is as follows: Total cost = Purchase cost + Ordering cost + Holding cost which can be expressed algebraically as follows: TC = P x D + C x D/Q + H x Q/2 It is this total cost function which must be minimized. Recognizing that: PD does not vary; Ordering costs rise the more frequently one places (during the year); and Holding costs rise the fewer times one places orders (due to larger quantities being ordered each time) From the above, one can derive the optimal quantity (Q) to be ordered: EOQ EXAMPLE A trucking company uses disposable carburetor units with the following details: Weekly demand 500 units Purchase price USD 15 / unit Ordering cost USD 40 / order Holding cost 7% of the purchase price Assume a 50 week year. What is the optimal order quantity? Assessing Creditworthiness When assessing the creditworthiness of (potential) clients, companies can use the approach typically employed by banks, referred to (originally) as the 3 C s of credit, later expanded to the 5 C s. They are: Page 5

6 1. Character: Focuses on the reputation of the principals/decision makers at a company; credit checking agencies and bank references assist to this end; 2. Capacity: Examines the company s cash flow generation in the context of management s ability to perform competently and reliably in meeting their obligations, based on an examination of their track record (either directly or via the experiences of others). Financial statement analysis is a major part of the exercise here (and in the next point); 3. Capital: Identifies and assesses the financial staying power and resources of the business; how much of a capital cushion do they have to withstand losses and how much do they have committed at risk in a proposed transaction that incentivizes them to succeed (one can refer to this as the pain factor ); 4. Collateral: Assesses what (if any) security the company is willing to provide in support of the intended transaction. Banks refer to this as providing additional exits ( ways out ) from a transaction. 5. Conditions: This is a general review of the economic environment to appreciate to what extent a customer may be affected by a decline in general business conditions (business cycle influences). EXAMPLE A downturn in housing construction will affect a range of other businesses, from plumbers to building material producers and companies leasing earth-moving equipment. Anyone selling to such businesses needs to keep the big picture in mind so as not to be over-exposed to secondary influences. Early Settlement discounts The objective of granting a settlement discount is to give customers a financial incentive to pay their bills more quickly (before the standard due date). A company granting settlement discounts must ensure that the benefits of doing so will outweigh the costs. Page 6

7 EXAMPLE Redwood Co. currently gives payment terms of 3 months to its customers. If it shortens this to one month by offering a 2% settlement discount, calculate what the impact will be if sales of USD 5m remain unchanged and all customers elect to take advantage of the discount. The company s cost of capital is 15%. Cost of financing receivables for 3 months: 5,000,000 x 3/12 x 15% = 187,500 Cost of financing receivables for 1 month: Cost of settlement discount: 5,000,000 x 1/12 x 15% = 62,500 Savings in financing costs = 125,000 5,000,000 x 2% = 100,000 The discount is worth implementing as the company achieves a net benefit of USD 25,000. Factoring and invoice discounting Note the distinction between factoring and invoice discounting: Invoice discounting is effectively a short-term loan in which a company borrows against its outstanding receivables. The unpaid sales invoices are pledged as collateral to the company (or bank) provides the financing. The borrowing company receives less than the face value of the invoice, the difference being the cost of borrowing, or discount. Factoring involves the administration of debt collection, in which the factor buying a receivable manages the process. The factor may do so on a recourse or non-recourse basis. Recourse: In the event a debt is written-off, the factor has the right to demand payment from the company from which it acquired the debt/receivable; Non-recourse: The factor bears the full credit risk of the debtor s failure to pay. Page 7

8 EXAMPLE Achilles Ltd. is considering whether to engage a factor to assume management of its receivables. Currently, bad debts (write-offs) are running at 1.5%. The factor will charge a fee of 2% of (Achilles ) annual turnover and savings to Achilles are estimated to be USD 1m p.a. Achilles has annual sales of 100m and a cost of capital of 12%. Evaluate the factoring solution. Collection of debts A company must have in place a clear policy on the collection of debts. Even if a good screening/assessment procedure is in place for accepting and reviewing customers, late payments are a fact of life and must be handled pro-actively. Much time can be spent in chasing late payments and if this process is not well-organized, management may come to the conclusion that it is not worthwhile. This is especially true in cases where a company is growing very quickly and celebrates the signing of contracts and issuance of invoices as signs of success. If, however, these invoices are not collected in due time (or at all), then the company is throwing away the rewards of success. Financial implications of different credit policies Evaluating a change in a credit policy requires the identification of relevant cash flows structured as before (the change) and after scenarios. EXAMPLE A company has current annual sales of USD 3,000,000 of which 50% is cash and 50% on 2 month credit terms. The contribution on credit sales is 25% of the selling price. The company is considering reducing its credit terms to 1 month and expects all (credit) customers to accept it with a 2% discount. No change in sales volume is anticipated. The company uses a 15% cost of capital. Analysis: Contribution USD - Before modification of terms: 375,000 (25% x 1.5m) - After modification: 345,000 (23% x 1.5m) Net change: (30,000) Page 8

9 Receivables USD - Financing cost before modification: 37,500 (1.5m x 2/12 x.15) - After modification: 18,750 (1.5m x 1/12 x.15) Net change: 18,750 The change is not worthwhile. Determining working capital needs / funding strategies The level of working capital required in a business depends on the industry it operates in, the length of its working capital cycle and the range of funding options open to it. Retaining flexibility is a key requirement. While overdraft financing is expensive, it does permit spontaneous drawdowns and rapid repayments. Funding strategies are guided by the following considerations: Temporary cash shortages can be funded short-term, while Permanent shortages should be funded long-term The matching principle can be applied to the assets being financed: Fixed assets are generally funded long-term, along with the permanent portion of current assets (e.g. buffer stocks); Current assets of a fluctuating nature can rely on short-term finance (e.g. seasonal upswings in inventories / receivables) Cash surpluses, on the other hand, can be dealt with based on whether they are: Short-term: in this case they may be invested in short-term, low-risk, liquid investments (e.g. Treasury bills or marketable securities); Long-term: Make acquisitions; Reduce debt; Pay extraordinary dividend, etc. (end of ExPress Notes) Page 9

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