Flashcards for Chapter 6 Introduction to Working Capital Management [ ]

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1 Flashcards for Chapter 6 Introduction to Working Capital Management [ ] [Type the abstract of the document here. The abstract is typically a short summary of the contents of the document. Type the abstract of the document here. The abstract is typically a short summary of the contents of the document.]

2 THE CASH CONVERSION OF A BUSINESS Purchase of Materials Payment for Materials Sale of Product Collect Accounts Receivable Days Inventory Days Payables Days Receivable Cash Conversion Cycle 43 What is the Working Capital Cash Conversion Cycle (CCC)? Formula: Cash Conversion Cycle = Days Inventory + Days Receivables Days Payables Cash Turnover = 365/Cash Conversion Cycle Definition: Period of time between disbursement for the A/P and collection of the A/R. Define Days Inventory or Inventory Conversion Period Definition: Manufacturing Average number of days that elapse from purchase/receipt of raw materials until the sale of finished goods. Retail Average length of time that finished goods inventory is held before sale. Service Average length of time that materials are held in inventory until they are used to provide services.

3 Define Days Receivable or Receivables Conversion Period Definition: Manufacturing, Retail, and Service Average number of days required to convert a credit sale into a collection. Define Days Payable or Payables Conversion Period Definition: Manufacturing, Retail, and Service Average number of days between the purchase/receipt of materials or supplies and issuance of payment for them. Compare the two Current Asset Investment Strategies Restrictive Relaxed Investment in raw materials Low High A/R and cash levels Low High Advantages Most profitable strategy as long as liquidity is stable. Low risk profile due to larger liquid asset balance. Disadvantages Risks not meeting customer demand due to low levels of inventory. Results in lower investment returns.

4 Compare the three Current Asset Investment Strategies Use of long-term financing Use of short-term financing Maturity Matching Conservative Aggressive Permanent current assets and fixed assets Fluctuating current assets Permanent current assets, fixed assets, and a portion of fluctuating current assets Remainder of fluctuating current assets All fixed assets, and a portion of permanent current assets Remainder of permanent current assets and all temporary current assets RISK COMPARISON TRADE PAYMENT METHODS Most Commonly Used Methods Most Protection Most Expensive LETTER OF CREDIT DOCUMENTARY COLLECTION OPEN ACCOUNT Least Protection Least Expensive 8 Name the International Trade Payment Methods 1) Open Account 2) Documentary Collection 3) Letter of Credit

5 Define Open Account Terms The buyer may take possession of the goods before issuing payment. The seller issues an invoice indicating when payment is due. Common terms are Net 30, Net 60, Net 90. Used when two trading partners have an existing relationship and essentially trust each other. Trade Credit Policies must clearly define a company s : 1) Credit Standards 2) Credit Terms 3) Discount Terms 4) Collection Policies What are the Five C s of Credit? Character Perceived honesty or integrity of an individual applicant or a corporate applicant s officers. Capacity Current and future financial resources a company or individual has available to pay obligations when they come due. Capital An individual or corporate customer s short and long-term financial resources that could be accessed if the immediate cash flow is insufficient to meet payment obligations. Collateral Available assets or guarantees used to secure an obligation in the event that payment terms are not met. Conditions Existing economic environment that impacts a customer s ability to pay or a company s willingness to grant credit.

6 What ratios are most often used in the Quantitative Credit Analysis of a company? 1) Liquidity and Working Capital Ratios (current, quick, and cash flow to total debt ratios) 2) Debt Management and Coverage Ratios (times interest earned, long-term debt-to-capital, debt-to-total assets, and total liabilities-to-total assets ratios) 3) Profitability Measures (return on sales, return on total assets, and return on equity ratios) What are the most common Terms of Sale? 1) Cash Before Delivery (CBD) Requires buyer to make full and final payment before the shipment or receipt of goods. E.g: Catalogue, telephone, internet orders. 2) Cash on Delivery (COD) Seller ships the goods and buyer pays upon receipt. Seller bears shipping and handling costs if the buyer does not pay and the goods are returned. 3) Cash Terms Generally, buyer has 7 to 10 days to make payment. Frequently used in the sale of perishable items. 4) Net Terms Seller specifies a net due date by which payment must be received in full. E.g: Net 30 from invoice date. 5) Discount Terms A seller may offer a discount on payments made prior to the due date. E.g: Terms of 2/10 net 30 mean that payment is due in 30 days from invoice date, and a 2% discount will be given if buyer pays within 10 days. 6) Monthly Billing Seller issues a monthly statement covering all invoices prior to a cutoff date. E.g: Terms of 1/10 prox. 30, mean that the buyer may take a 1% discount if payment is made by the 10 th day of the following month. 7) Draft/Bill of Lading Also known as Documentary Collection. 8) Seasonal Dating Seller agrees to accept payment at the end of the buyer s selling season. E.g: Toys, greeting cards, text books. 9) Consignment The supplier (consignor) ships goods to another party (consignee) who has no obligation to pay until the goods have been sold.

7 INTERNATIONAL METHODS OF PAYMENT:DOCUMENTARY COLLECTIONS Documents 4 Foreign Collecting Bank 7 Remitting Bank 5 Documents 3 8 Goods 2 Buyer Importer Contract 1 Seller Exporter 1. Buyer and seller agree to a sales contract requiring the use of documentary collections The seller/exporter ships merchandise to the buyer/importer. 3. The seller/exporter delivers the draft documents to the remitting bank. 4. The remitting bank forwards the documents and collection letter to the buyer/importer s bank, the foreign collecting bank. 5. The buyer/importer makes payment to the foreign collecting bank in the case of a sight draft, or accepts a time draft. 6. The foreign collecting bank releases the documents so that the buyer/importer may take delivery of the merchandise. 7. The foreign collecting bank transfers funds to the remitting bank. The remitting bank pays the seller/exporter. Define Documentary Collection Trade payment mechanism that processes the collection of a draft and accompanying shipping documents through international correspondent banks. Banks act as intermediaries between buyer and seller.

8 What information is disclosed in a documentary collection letter? 1) Name of the seller 2) Name and address of the importer 3) Information regarding the collecting bank 4) Details of the documentation accompanying the collection 5) Date, tenor, and value of the collection 6) Details of the bank and other charges to be paid by the exporter, importer or both 7) Recourse procedures in the event of non-acceptance or non-payment 8) Any other terms and conditions INTERNATIONAL METHODS OF PAYMENT: LETTER OF CREDIT Issuing / Opening Bank 8) Any other terms and conditions Documents Advising / Confirming Bank Applicant / Buyer Importer Goods 5 Contract 1 Beneficiary Seller Exporter Buyer and seller agree to a sales contract in which the buyer is required to open an L/C in favor of the seller. 2. Buyer chooses a bank in its country and opens an L/C in favor of the seller. 3. The issuing bank sends this L/C to a bank in the seller s country. The latter becomes the advising bank. 4. The advising bank sends details of the credit to the seller, who is the beneficiary of the credit. 5. Seller ships the merchandise to the buyer. 6. Seller examines and sends the documents to the advising/negotiating bank.

9 7. Advising/negotiating bank examines all documents for accuracy, creates a draft drawing on the L/C, and sends documents and draft to the issuing bank. 8. Issuing bank examines the documents and, if in order, accepts the time draft that draws on the L/C. *The accepted draft now becomes a banker s acceptance (BA). * The BA is returned to the advising/negotiating bank. * At this point the seller may ask its bank to discount the BA, in order to receive funds immediately, or hold the BA until maturity and receive the full amount at that time. 9. Seller receives either full payment at the maturity of the BA or a discounted amount immediately. 10. Issuing bank notifies the buyer that it has received the documents and, after payment terms are settled, releases the documents to the buyer. 11. At the maturity of the BA, the holder presents it to the issuing bank, which honors the BA for the face value. What is a Letter of Credit (L/C)? Document issued by a bank, guaranteeing the payment of a stated amount to named beneficiary, for a specified period, provided that certain conditions are met. In this way, the bank s credit substitutes the buyer s credit, which represents less risk to the seller. Generally, L/Cs are irrevocable, meaning that the L/C cannot be canceled or amended without the agreement of all parties to the transaction (buyer, seller, issuing bank, and confirming bank if applicable). What is a Commercial (Documentary) Letter of Credit? Document issued by a bank as the intended mechanism of payment in relation to a trade transaction, involving the domestic or international shipment of merchandise. The documentary L/C requires presentment of a draft, commercial invoice, and related shipping documents.

10 What roles do bank serve in L/C transactions? 1) Issuing Bank Buyer s (importer s) bank that issues the L/C in favor of the seller. 2) Advising Bank Advises the seller of an L/C issued in its favor. 3) Negotiating Bank Examines the documents presented by the beneficiary (seller), receives payment from the issuing bank, and pays the beneficiary. Frequently, the advising and negotiating banks are the same bank. 4) Confirming Bank If confirmation is requested by the seller, the confirming bank commits to the seller that payment will be made (provided that documents meet the conditions stipulated in the L/C) regardless of the issuing bank s ability to pay. The confirming bank will be the negotiating bank. What is the primary difference between documentary collection and L/C? The bank does not guarantee payment to the seller under a documentary collection, nor does it examine the documents for accuracy. For this reason, documentary collections are less expensive than L/Cs. What is a Standby Letter of Credit? Document issued by a bank to ensure the financial performance of a bank s customer to a named beneficiary. The standby L/C requires the presentation of a sight draft and documentation that supports the beneficiary s claim of non-performance on the part of the issuing bank s customer. In many other countries, these instruments are called guarantees.

11 What is a Banker s Acceptance (BA)? BA s are frequently used in conjunction with L/Cs requiring a time draft drawn on a bank. By accepting the draft, the bank agrees to pay the face value of the obligation if the buyer (the issuer and party who drew on the draft) fails to make payment. The accepting bank assumes the risk of the buyer defaulting. What is Asset Based Lending? A company may borrow on a secured basis, by pledging A/R and in some cases Inventory. The lender evaluates the collateral and determines the eligible A/R and Inventory that may be included in a borrowing base. The lender advances a certain percentage of the eligible A/R and Inventory. The loan is repaid as the company collects the receivables. What is Factoring? The outright sale (without recourse) of A/R to a factor, a company that specializes in the financing and management of A/R. The primary benefit is that the seller can receive funds immediately upon completion of the factoring arrangement. The primary disadvantage is that A/R will be sold at a significant discount.

12 What are the basic elements of Inventory Policy? 1) Reasons for holding inventory 2) Types of inventory held 3) Levels of inventory 4) Costs and benefits associated with holding inventory 5) Financing inventory What is Just in Time Inventory (JIT)? A business philosophy that attempts to minimize inventory levels by reducing the costs and uncertainties that underlie the motives for holding inventory. JIT methodology treats inventory as being undesirable, and recognizes that excess inventory can be a liability rather than an asset. Name the most important regulations related to Consumer Credit Legislation 1) Truth in Lending Act (1968) 2) Fair Credit Reporting Act (1971) 3) Fair Credit Billing Act (1975) 4) Equal Credit Opportunity Act (1975) 5) Fair Debt Collection Practices Act (1978) 6) Credit Card Accountability Responsibility and Disclosure Act (2009)

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