Note. Corporate Finance Fundamentals. FN1 Module 8. Operating Decisions: Working Capital Management

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1 Corporate Finance Fundamentals FN1 Module 8 Operating Decisions: Working Capital Management Lectures and handouts by: Ruth Heathcote 1 FN1 Module 8 FN1 Module 8 Part 1: Net Working Capital Part 2: Cash Management Part 3: Optimal A/R levels Part 4: Optimal Inventory and A/P levels Part 5: Short-term debt and NWC cycles Part 6: Past exam questions 2 FN1 Module 8 Note The textbook readings are fundamental, and may not be repeated in the Module Notes. The details of the marginal analysis used in Examples 24-1 to 24-3 of Section 24.2 are not critical, but you should understand what components of NWC would change when trade credit terms are altered. 3 FN1 Module 8 1

2 Part 1 Net Working Capital 4 FN1 Module 8 Introduction You should understand: Why the management of net working capital is critical for the survival of the firm How managing receivables, inventory, and payables is related in an integrated approach to net working capital management How the financing and current asset investment decisions interact to determine a company s overall working capital position 5 FN1 Module 8 Introduction You should understand: How to manage individual asset items, such as cash, receivables, and inventory The nature of the major sources of short-term financing, such as trade credit, bank loans, factoring arrangements, and money market securities The fact that in evaluating current asset and current liability decisions, the final decision rests on the standard problem of trading off expected benefits and potential costs 6 FN1 Module 8 2

3 Working Capital Defined Net Working Capital is defined as current assets minus current liabilities Net Working Capital is an investment of capital that is necessary, but not profitable in its own right. 7 FN1 Module 8 Current Assets Include: Cash Marketable Securities Accounts Receivable Inventory 8 FN1 Module 8 Current Liabilities Include: Accounts payable (trade and other) Bank and other short-term loans Taxes payable 9 FN1 Module 8 3

4 Working Capital Management The way in which a firm manages both its current assets and its current liabilities. Some elements are out of financial executive s control Examples: A/R, inventory, A/P, taxes payable Financial executive s role regarding these elements is to ensure all costs are considered, and accounts are paid or received on a timely basis. 10 FN1 Module 8 Good Working Capital Management Characterized by: 1. The maintenance of optimal cash balances 2.The investment of any excess liquid funds in marketable securities that provide the best return possible, considering any liquidity or default-risk constraints 3. Proper management of accounts receivable 4. An efficient inventory management system 5. Maintaining an appropriate level of short-term financing, in the least expensive and most flexible manner possible. 11 FN1 Module 8 Objective of NWC Management Theoretical objective: A firm should increase NWC until the marginal benefits from additional investments equal the marginal costs of carrying this investment. 12 FN1 Module 8 4

5 Objective of NWC Management Example: Optimal Accounts Receivable balance If a firm does not offer terms comparable to the competition, sales will suffer. But, if a firm extends credit terms to attract a larger customer base and/or is not diligent in following up on delinquent accounts, earnings will suffer 13 FN1 Module 8 Objective of NWC Management Example: Optimal inventory levels If a firm does not carry sufficient inventory, lost sales will ensue due to stock-outs. If a firm carries too much inventory, costs increase due to warehousing, handling, insurance, as well as obsolescence, spoilage. 14 FN1 Module 8 Objective of NWC Management Operational objective: Maximize the firm s investment in NWC subject to its operational needs. Have just enough capital invested in NWC to ensure day-to-day obligations can be met. 15 FN1 Module 8 5

6 Objective of NWC Management Operational needs include: Sufficient cash to facilitate trade with customers and suppliers Accounts Receivable based on trade terms competitive with the firm s competitors Inventory sufficient to not exceed a maximum allowable probability of running out of stock and losing potential sales 16 FN1 Module 8 Working Capital Management Firms can run out of liquid financial resources in a number of ways: Rapid growth in production and sales, can cause the firm to use up all of its cash pursuing growth, leaving it invested in illiquid assets such as inventories, accounts receivable and net fixed assets. Continuing to produce inventory in the face of falling sales revenue. Selling products/services for less than their variable cost to produce. 17 FN1 Module 8 An Integrated Approach to Net Working Capital Management Knowledge of the cash flow cycle of a firm gives the manager an awareness of the dynamics involved in working capital management. The cash flow cycle helps the manager visualize the impact of changes in variables on the cash account: How increasing sales requires additional investment in inventory How increasing accounts receivable reduces cash How delaying payables preserves cash How speeding collections on A/R improves the cash position 18 FN1 Module 8 6

7 Use of Ratios in Working Capital Management Ratios are commonly used to assess or to summarize a firm s working capital management. The focus of such an assessment is: Liquidity management The firm s efficiency in asset utilization Current liability management 19 FN1 Module 8 Working Capital Management Liquidity Ratios Ratios used to assess the firm s liquidity include the current and quick ratios: Current Ratio = Current Assets (CA) Current Liabilities (CL) Quick Ratio = Cash + Marketable Securities + A/R Current Liabilities 20 FN1 Module 8 Working Capital Management Liquidity Ratios Excessive liquidity will reduce ROI and ROE. It can also mean the firm is too lenient in terms of credit policy, or may have excessive inventories that may be subject to technological obsolescence. 21 FN1 Module 8 7

8 Working Capital Management Working Capital Ratios [ 23-7] 22 FN1 Module 8 Working Capital Management Working Capital Ratios Changes in these ratios can indicate growing problems with credit policy and/or a need to improve collections efforts. [ 23-7] The shorter the collection period, the lower the cash sensitivity to changes in sales. 23 FN1 Module 8 Working Capital Management Working Capital Ratios 24 FN1 Module 8 8

9 Working Capital Management Working Capital Ratios CGS is not likely to be comparable across different firms, so alternative is to use Sales in the numerator as illustrated in Equation The higher the inventory turnover, the lower the sensitivity of cash to changes in sales. 25 FN1 Module 8 Working Capital Management Working Capital Ratios 26 FN1 Module 8 Working Capital Management Working Capital Ratios Dividing 365 days by inventory turnover (IT) gives ADSI (Average days sales in inventory): The higher IT the lower ADSI showing more efficient inventory management and a reduced sensitivity of cash to changes in sales. 27 FN1 Module 8 9

10 Working Capital Management Working Capital Ratios On the liability side of the balance sheet management ratios include Payables turnover (PT), and average days sales in payables (ADSP): PT shows how many times a year a firm pays off its suppliers on average. ADSP shows how long a firm defers payments to its suppliers. 28 FN1 Module 8 Working Capital Management Working Capital Ratios 29 FN1 Module 8 Cash Conversion Cycle (CCC) Cash cycle is the time between cash disbursement and cash collection. An estimate of the average time between when a firm pays cash for its inventory purchases and when it receives cash for its sales; the average number of days of sales that firm must finance outside the use of trade credit. 30 FN1 Module 8 10

11 Cash Conversion Cycle (CCC) Operating and Cash Conversion Cycles Cash Conversion Cycle = Inventory conversion period + Receivables conversion period - Payables deferral period Management of the cash cycle can make an important difference in the amount of financing required, assets employed to generate a given level of sales...and therefore, can affect ROA and ROE. 31 FN1 Module 8 Cash Flow Time Line Operating and Cash Conversion Cycles Inventory sold Cash received Inventory purchased Inventory period Accounts payable period Cash paid for inventory Accounts receivable period Time Operating cycle (OC) Cash Conversion Cycle (CCC) 32 FN1 Module 8 FN1 Module 8 End: Next Part 1: Net Working Capital Part 2: Cash Management Part 3: Optimal A/R levels Part 4: Optimal Inventory and A/P levels Part 5: Short-term debt and NWC cycles Part 6: Past exam questions 33 FN1 Module 8 11

12 Part 2 Cash Management 34 FN1 Module 8 Objectives of Cash Management The three objectives of cash management are: 1. Reduce the opportunity cost of holding idle cash 2. Ensure that all obligations are paid on time 3. Collect money owed as soon as it becomes due 35 FN1 Module 8 Importance of Cash Flow Management Management of the firm s cash flow is one of the greatest challenges facing the financial manager: Exhaustion of liquid resources can leave the firm unable to pay it s maturing obligations as they come due (a state of technical insolvency an Act of Bankruptcy) 36 FN1 Module 8 12

13 Cash and Marketable Securities Reasons for Holding Cash 1. Transactions motive 2. Precautionary motive 3. Finance motive 4. Speculative motive 37 FN1 Module 8 Transactions motive The cash that is required for a firm s normal operations. To pay bills as they come due 38 FN1 Module 8 Precautionary motive The cash that may be required to pay for unanticipated required outlays of cash Example, unexpected repairs on equipment 39 FN1 Module 8 13

14 Finance motive The cash that firms will accumulate in anticipation of any major outlays Example lump-sum loan repayments, dividend payments 40 FN1 Module 8 Speculative motive The cash firms may keep available to take advantage of unexpected bargains Example the opportunity to purchase raw materials very cheaply 41 FN1 Module 8 Minimum cash balance Primary factors that determine the minimum cash balance are: The expected cash needs for the day The degree of uncertainty about the daily cash flow The cost of acquiring a new cash holding 42 FN1 Module 8 14

15 Minimum cash balance Benefit of holding cash: Cash facilitates transactions Cost of hold cash: Foregone earnings from possible alternative investments. Appropriate level when marginal benefit = marginal cost. Have just enough cash 43 FN1 Module 8 Determining the Optimal Cash Balance The optimal cash balance is the amount of cash that balances the risks of illiquidity against the sacrifice in expected return that is associated with maintaining cash. Differs substantially across firms Firms with predictable cash flows will have lower optimal cash balance requirement Firms with excess borrowing capacity (unused line of credit for example) can hold less cash. 44 FN1 Module 8 Cash Management Techniques Speed up cash inflows: Bill clients earlier each month Increase cash sales through incentives Encourage customers to pay using electronic payments systems such as direct deposit, automatic debit, debit card, rather than cheque. Delay outflows: Arrange with suppliers for more liberal trade credit terms (net 40 rather than net 30 for example) Paying employees once a month rather than twice. 45 FN1 Module 8 15

16 Cash Management Float Float is the time that elapses between the time the paying firm initiates payment, and the time the funds are available for use by the receiving firm. It has three major sources: 1.The time it takes the cheque to reach the firm after it is mailed by the customer. 2.The time it takes the receiving firm to process the cheque and deposit in an account, and 3.The time it takes the cheque to clear through the banking system so that the funds are available to the firm. 46 FN1 Module 8 Cash Management Float Float can be reduced or eliminated through: Debit cards Preauthorized payments Electronic funds transfer (EFT) and electronic data interchange (EDI) systems. 47 FN1 Module 8 Cash Management Float Disbursement float (positive float) = the time lag between the firm s payment of bills and the date the cheque is deducted from the firm s bank balance Collection float (negative float) = the time lag between the customer s payment of bills and the date the cheque is added to the firm s bank balance The financial executive is concerned with net float (the difference between disbursement and collection float) 48 FN1 Module 8 16

17 Class Example See Class Example 1, Handout #1 49 FN1 Module 8 Determining the Optimal Cash Balance Question: How does a firm determine how much cash is enough? Answer: By developing a cash budget. The cash budget is a necessary tool for NWC analysis and planning. 50 FN1 Module 8 Cash Budget A major planning tool for NWC management A planning document to provide insight into future cash flow and needs 51 FN1 Module 8 17

18 Importance of Cash Flow Planning to have cash available to pay bills of the business as they become due is a critical aspect of business survival it is a management skill. Understanding the cash flow cycle of a firm can help you manage those elements that are critical to ensuring you can pay your bills. Cash flow forecasting through a cash budget provides important information to you and to your potential funding partners about your operating financial needs and most particularly, the timing and magnitude of any projected cash deficits or surpluses. 52 FN1 Module 8 The Cash Budget The purpose of the cash budget is to forecast the timing and magnitude of expected cash deficits and surpluses so that, before the fact, you (the manager) can arrange appropriate financing or plan an appropriate investment strategy. 53 FN1 Module 8 Cash Budget The cash budget will highlight months were there are anticipated cash shortages and cash surpluses. Indicates how much cash should be borrowed, and for how long the loan is necessary. Indicates how much excess cash is expected to be available, and for how many months this surplus will be available 54 FN1 Module 8 18

19 Cash Budgets Dealing with Forecast Surpluses Knowing the timing, magnitude and duration of cash surpluses allows management to choose the most appropriate management response: Small Amount of Surplus available for a short period of time (ie. less than $100,000) Keep in current account Small Sum available for a long period time Consider dispersing as cash dividends Potentially retire debt 55 FN1 Module 8 Cash Budgets Dealing with Forecast Surpluses Large Sum available for a short period of time days (ie. greater than $100,00) Invest in money market securities such as T-bills Large Sum available for a long period time Consider dispersing excess funds as cash dividends Alternatively invest in longer-time, higher yielding investments 56 FN1 Module 8 Cash Budgets Dealing with Forecast Deficits Knowing the timing, magnitude and duration of cash deficits allows management to choose the most appropriate management response: Small deficit persisting for a short period of time (ie. less than $100,000) Delay purchases, speed collections and try to synchronize cash flows to eliminate or minimize, or Negotiate an operating line of credit with the financial institution Small deficit available for a long period time Explore more permanent solutions to the underfunding 57 FN1 Module 8 19

20 Cash Budgets Dealing with Forecast Deficits Large deficit forecast to last a short period of time days (ie. greater than $100,00) Operating line of credit, or Seek longer term permanent capital solutions if large cash flow deficits are likely to reoccur. Large Sum deficit for a long period time Seek permanent capital increases in the form of debt, equity or combination. 58 FN1 Module 8 Cash Budget A cash budget summarizes the following data: Key assumptions regarding sales, production, tax rates, salaries, other operating expenses, and capital expenditures. Sales are converted to cash inflows by month Production is converted to cash outflow for purchases Monthly cash disbursements covering all regular cash expenses plus expected dividend payments and tax payments Cash disbursements for capital expenditures 59 FN1 Module 8 Class Example See Class Example 2, Handout #1 60 FN1 Module 8 20

21 FN1 Module 8 End: Next Part 1: Net Working Capital Part 2: Cash Management Part 3: Optimal A/R levels Part 4: Optimal Inventory and A/P levels Part 5: Short-term debt and NWC cycles Part 6: Past exam questions 61 FN1 Module 8 Part 3 Optimal A/R levels 62 FN1 Module 8 Accounts Receivable The financial executive s role: Advise on the economic desirability of terms of trade credit. (benefit/cost quantitative analysis) Monitor accounts receivable and manage the collection process 63 FN1 Module 8 21

22 Accounts Receivable 1. The decision to extend credit to customers has significant cash flow and credit risk implications for the firm. Firms often don t have a choice, if the availability of credit is an important factor in the customer s purchase decision process (if competitors offer credit, then the firm must at least match those credit terms, and then choose to compete on another basis.) 64 FN1 Module 8 Accounts Receivable 2. The second decision (once the firm has decided to extend credit) is to determine which customers will be granted credit. 3. The credit terms must be established. 4. The collection process must be determined. 65 FN1 Module 8 Accounts Receivable The decision to extend credit is determined by: Nature of the product sold, The industry Practices of competitors. 66 FN1 Module 8 22

23 Accounts Receivable Credit Analysis Variables that are weighed in the credit analysis process: Capacity the customer s ability to pay Character the customer s willingness to pay Collateral the security that could be seized to satisfy payment Conditions the state of the economy. 67 FN1 Module 8 Accounts Receivable Credit Analysis Q. In what way might a change in credit standards affect a firm s profits? A. A lowering of credit standards will usually result in higher sales, but may also produce increased costs and bad debts. Decision Rule: Lower credit standards if the profits from increased sales exceeds the opportunity cost of the investment in A/R and write-offs for bad debts. 68 FN1 Module 8 Accounts Receivable The firm must choose what terms of credit to offer its customers. Terms of credit include: The due date The discount amount (if any) Options include: Cash on delivery (COD) Cash before delivery (CBD) Net 30, net 40 - no incentive for early payment 2/10 net 30 - a 2% discount for early payment 69 FN1 Module 8 23

24 Accounts Receivable The Collection Process The firm must monitor outstanding A/R by customer and by category. The firm must then determine what action it will take when late payments occur. Charge interest on outstanding balances Notify customer of arrears ( , mail, telephone) 70 FN1 Module 8 Accounts Receivable The Collection Process Actions on unpaid amounts: Allow no further purchases on credit Choose from a number of additional options to collect: 1.Take legal action 2.Sell receivable to a collection agency 3.Write off the debt as uncollectible. 71 FN1 Module 8 Accounts Receivable Factoring It may not be cost-effective for a firm to manage the collection process itself. Factoring arrangements are the sale of a firm s receivables, at a discount, to a financial company called a factor, which specializes in collections, or the out-sourcing of the collections to a factor. 72 FN1 Module 8 24

25 Factoring (Selling) A/R legally binding agreement between the seller of the goods and the financial institution. the factoring institution receives a credit approval slip...the institution does a credit check...if approved, shipment is made and the buyer is instructed to make payment directly to the factoring company. 73 FN1 Module 8 Factoring (Selling) A/R the factor - credit check - lends - bears risk - in the process of performing these functions, the firm that sells its receivables to a factor, eliminates the need for an accounts receivable department and receives a net amount of cash immediately following the sale...these funds are advanced by the factor. 74 FN1 Module 8 Factoring (Selling) A/R the factor is compensated for its services and protects its interests by charging interest, charging a commission and maintaining a hold-back (reserve) in the case of disputes between buyer and seller over damaged goods, returns, etc. once this arrangement is in place - the financing is spontaneous. 75 FN1 Module 8 25

26 Accounts Receivable When extending more lenient credit terms the firm hopes to increase revenues through the sale of more units, and perhaps even charge higher prices. These benefits are offset by financing costs and the increased risk of non-payment. Financing costs arise because more cash is tied up in receivables, and the firm may have to borrow cash to meet day to day obligations. 76 FN1 Module 8 Accounts Receivable Evaluation of these decisions can use an NPV framework: 77 FN1 Module 8 Accounts Receivable CFo = incremental investment in receivables, if credit terms are extended, CFo = cash inflow from receivables, if credit terms are tightened (shortened) CFi = incremental operating net revenues increased bad debts, discounted at an appropriate discount rate 78 FN1 Module 8 26

27 Financing cost The hurdle rate or financing cost commonly used when evaluating alternative credit policies is the interest rate on short-term loans. WHY? Receivables are generally a low risk investment, and should be discounted at a discount rate that reflects this low risk. If you are only given WACC in the given information, then you must use this discount rate. 79 FN1 Module 8 Accounts Receivable The implications of changing credit terms can be analyzed using the equation: AR = ACP X CSPD AR = Accounts Receivable ACP = average collection period (in days) CSPD = credit sales per day 80 FN1 Module 8 Past Exam Question ZZ Ltd. Is contemplating a change in its credit policy from net 15 to net 60. Currently, the firm sells 400,000 units at a price of $1.10 and an average cost of $0.85 per unit. With the credit extension, management believes that sales will increase to 500,000 units and that, as a result of the increased volume, average cost will drop to $0.80 per unit. The firm s cost of capital is 12%. What is the opportunity cost associated with the increased investment in accounts receivable? Assume all sales are on credit. 81 FN1 Module 8 27

28 Solution Step 1: Identify incremental cash flows If all sales are on credit, then the new average balance in A/R will be: AR = ACP X CSPD Where: ACP = 60 Credit sales/day = 500,000*1.10 = 550, AR new = 60 * 550,000 = $90, FN1 Module 8 Solution Step 1: Identify incremental cash flows If all sales are on credit, then the old average balance in A/R is: AR = ACP X CSPD Where: ACP = 15 Credit sales/day = 400,000*1.10 = 440, AR old = 15 * 440,000 = $18, FN1 Module 8 Solution The incremental cash flow is the difference in the relevant cash flows (90, ,082.19) = 72, The opportunity cost is the benefit given up by investing in A/R in this case, WACC Opportunity cost = 72, * 0.12 = $8, FN1 Module 8 28

29 Solution Opportunity cost = 72, * 0.12 = $8,679 What is the benefit? The benefit is the increased profit margin, both due to increased sales and decreased unit costs (unit costs decrease from 0.85/unit to 0.80/unit). 85 FN1 Module 8 Changing credit terms Increase in discount rate offered: Sales volume will increase Profit margin will decrease (per unit) Accounts Receivable will decrease due to decrease in ACP Accounts Receivable will increase due to increase in daily credit sales 86 FN1 Module 8 Changing credit terms Increase in due date for payment: Sales will increase Accounts Receivable will increase ACP will increase 87 FN1 Module 8 29

30 Class Example See Class Example 3, Handout #1 88 FN1 Module 8 FN1 Module 8 End: Next Part 1: Net Working Capital Part 2: Cash Management Part 3: Optimal A/R levels Part 4: Optimal Inventory and A/P levels Part 5: Short-term debt and NWC cycles Part 6: Past exam questions 89 FN1 Module 8 Part 4 Optimal Inventory and A/P levels 90 FN1 Module 8 30

31 Inventory The level of inventory a firm holds is a trade off between benefits and costs Inventory levels are influenced by sales and productions schedules The financial executive s role is limited to advising on the cost of holding inventory 91 FN1 Module 8 Inventory Benefits of Holding Inventory: Take advantage of large-volume discounts Reduce the probability of production disruptions because of lack of inventory Minimize lost sales because of stock-outs 92 FN1 Module 8 Inventory Costs of Holding Inventory: Financing costs associated with inventory investment Storage, handling, insurance, spoilage and obsolescence costs. 93 FN1 Module 8 31

32 Optimal Inventory Levels Major determinants: The cost of restocking the inventory The rate of demand for the product The cost of holding a unit of inventory The degree of uncertainty about future demand for the product. The financial executive is concerned with the cost of holding a unit of inventory. 94 FN1 Module 8 The cost of holding a unit of inventory Cost = SC*(1-T) + [(1+r) t 1]*COGS Where: SC = storage costs T = tax rate r = WACC t = time, in fraction of a year determined by inventory holding period COGS = unit cost of finished inventory 95 FN1 Module 8 Example Past Exam Question What is the after-tax cost of holding a unit of inventory under the following conditions: physical storage costs are $6 per unit, a unit stays in inventory for an average of 2 months, the cost of goods sold for a unit of inventory is $30, the firm s weighted average cost of capital (WACC) is 15%, and the tax rate is 40% 96 FN1 Module 8 32

33 Solution Using the equation: C = SC*(1-T) + [(1+r) t 1)]*COGS C = 6*(1-0.4) + [(1.15) 1/6 1)]*30 = $ FN1 Module 8 Question If interest rates go up and other things remain the same, how would you expect general inventory levels to be affected? 98 FN1 Module 8 Answer An increase in interest rates increases the cost of carrying inventory (opportunity cost concept) and so will provide an incentive to reduce inventories. It will be more beneficial to order more frequently and carry less inventory. 99 FN1 Module 8 33

34 Short-Term Financing Considerations Trade Credit Often a very important source of short-term financing. Offers a number of advantages: Readily available Convenient Flexible Usually does not entail any restrictive covenants or pledges of security. 100 FN1 Module 8 Trade financing Decision Rule: A firm should take offered purchase discounts if the interest rate on alternative short-term loans (example, bank loans) is less than the annualized discount rate from the purchaser. 101 FN1 Module 8 Trade Credit There is usually a high implicit cost to a firm that forgoes discounts on early payment. Example: assume (2/10 net 30) For a purchase of $100, either you can pay $98 on the 10 th day, or $100 on the 30 th day. Basically, if you wait until the 30 th day, you have borrowed $98 for 20 days at a cost of $ FN1 Module 8 34

35 Short-Term Financing Considerations To estimate the annual effective rate of return or cost (k) of any financing alternative: textbook formula 103 FN1 Module 8 Short-Term Financing Considerations To estimate the annual effective rate of return or cost (k) of any financing alternative: module notes formula: Cost of missed discount = [1/(1-d)] n 1 Where: d = percentage discount offered for early payment n = 365/#days between the 2 payment dates 104 FN1 Module 8 Cost of missed discount Determine the cost of the missed discount for the terms 2/10, net 30 Using the text equation: N-day financing cost = 2 Purchase price = 98 N = 20 days K = (1 + 2/98) 365/20 1 = 44.59% 105 FN1 Module 8 35

36 Cost of missed discount Determine the cost of the missed discount for the terms 2/10, net 30 Using the module notes equation: d = 2% N = 365/20 = K = (1 /.98) 365/20 1 = 44.59% 106 FN1 Module 8 Class Example See Class Example #4, Handout #1 107 FN1 Module 8 FN1 Module 8 End: Next Part 1: Net Working Capital Part 2: Cash Management Part 3: Optimal A/R levels Part 4: Optimal Inventory and A/P levels Part 5: Short-term debt and NWC cycles Part 6: Past exam questions 108 FN1 Module 8 36

37 Part 5 Short-term debt and NWC cycles 109 FN1 Module 8 Short-Term Financing Considerations Investment in current assets tend to rise and fall with the volume of activity. Accruals and accounts payable (trade credit) are spontaneous liabilities. Other sources of financing must be negotiated and before using, the firm must evaluate the cost effectiveness of alternative financing mechanisms. 110 FN1 Module 8 The Cash Budget Use The Cash Budget: Allows management to change plans before they are implemented to produce a more favourable cash result Allows management to choose the most correct investment option in the case of forecast surpluses Allows management to arrange the most appropriate financing solution in the case of forecast deficits. 111 FN1 Module 8 37

38 Short-term Credit Advantages of short-term credit: short-term loans can be secured much more quickly than long-term credit short-term credit is generally more flexible low flotation costs generally no prepayment penalties fewer restrictive covenants with an upward sloping yield curve - short-term credit is normally less expensive than long-term debt 112 FN1 Module 8 Short-term Credit Disadvantage of short-term credit: short-term credit may be more risky than long-term debt: interest rate risk exposure renegotiation risk 113 FN1 Module 8 Sources of Short-term Financing Bank Loans types: operating loans line of credit revolving credit agreement 114 FN1 Module 8 38

39 Short-term Debt The 3 main reasons to use short-term debt: Finance temporary needs Interest rate advantage Stop gap financing 115 FN1 Module 8 Finance temporary needs The cash flow budget may show a short-term cash deficit match term of loan to cash needs This may arise due to seasonality of sales production levels required that do not match sales Widely accepted approach is to match the maturities of assets and liabilities (short-term financing for current assets and current liabilities) 116 FN1 Module 8 Interest rate advantage Assuming an upward sloping yield curve (most common shape), short-term debt is cheaper than long-term debt. Short-term debt may be less costly to obtain Short-term debt is riskier than long-term debt, however. WHY? Short term interest rates change with prevailing interest rates, long-term debt has fixed interest rate for term of loan 117 FN1 Module 8 39