CIMA F3 Course Notes c Chapter 3 Short term finance Personal use only - not licensed for use on courses 31
1. Conservative, Aggressive and Matching strategies There are three over-riding approaches to short term financing: conservative, matching and aggressive. Conservative financing This involves financing both long term assets (non-current assets) and short term assets using long term financing, such as equity or long term loans. This is a safe way of managing debt as there is little risk of non-repayment in the short term. On the other hand it is more expensive as equity and long term debt tends to be more expensive due to the higher risk being taken by these investors compared with short term lenders. Matching financing Matching aims to link closely the short and long term nature of investments with the short and long term nature of finance used to support them. For example: Using long term funding (e.g. equity or long term debt) for long term projects and assets. The aim is to use the long term returns from these projects/assets to pay back the long term debt. If returns are not due for 4-5 years then debt repayment should be delayed until that point or after. Short term funding to match against short term needs o E.g. Leasing for short term equipment use o E.g. Overdrafts for short term cashflow shortages Matching aims to balance risk and financing costs. Aggressive financing Aggressive financing is the funding of part of long term assets and all current assets using short-term funds. Short term funds are usually less expensive due to he lower risks being taken by lenders, so this can be the cheapest approach to financing. However risks to the company are higher as the repayment will need to be made in the short term, which could put the company in cash flow Personal use only - not licensed for use on courses 32
difficulties if it is not able to generate cash through sales or raise further funds from another source. These are best suited to companies with a strong credit position and good access to short term funds, and companies which are highly cash generative with a short working capital cycle (e.g. a supermarket or restaurant). 2. Working capital management What is working capital management? Working capital is the difference between current assets and current liabilities. The higher the level of working capital then the greater the funds which are readily available in the short term (current assets) to cover the short term liabilities (current liabilities) and the lower the risk that creditors will not be able to be paid. Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. Goal of working capital management The goal of corporate finance is the maximisation of shareholder value. In the context of long term, capital investment decisions, firm value is enhanced through appropriately selecting and funding positive Net Present Value (NPV) investments. These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of Working capital management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational expenses. 3. Management of working capital Management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows are available to pay debts as they fall due. Personal use only - not licensed for use on courses 33
Cash management Cash flow forecasting identifying the expected cash balances over coming weeks and months. It enables prediction of peaks and troughs in the cash balance and so helps with planning how much and when to borrow and how much available cash will be available to meet payments due to suppliers or other creditors. Often a bank will ask for cashflow forecasts prior to considering a loan as it helps to give them assurance that both the interest payments and the capital amount will be paid. Working capital (or cash operating) cycle The most widely used measure of cash flow is the working capital (or operating) cycle. This represents the time difference between cash payment for raw materials and cash collection for sales. The longer the operating cycle the longer that the payment for raw materials is tied up before income is earned from it. The operating cycle can vary depending on the type of industry the company is in. In some businesses, such as manufacturing, the operating cycle is naturally longer. Where this is the case there is a greater need for careful management of working capital to ensure enough cash is available to meet debts as they fall due. Other industries generate cash soon after purchase (e.g. restaurants and supermarkets). In these businesses working capital management is often comparatively less important. Calculating the working capital cycle Working capital cycle = Inventory days + Receivable days Payable days Inventory management Inventory management is the management of stocks of raw materials and finished goods. Inventory days measures the average number of days that inventory is in stock. The longer the inventory days the more stock is available to meet customers needs, but the more capital is tied up in stock and the greater the likelihood of obsolescence and wastage. Personal use only - not licensed for use on courses 34
Inventory x365days Total operating costs (or cost of sales if op. costs not available) Receivables (debtors) management Receivables are the amounts due at any one point in time from customers. From a working capital perspective the quicker debtors repay debts the better. It shortens the working capital cycle and ensures cash is available to pay debts as they fall due. However this needs to be balanced against the needs of the business to generate sales. The longer the credit period given to customers the more likely that customers will buy from the company compared with their competitors. The aim is to identify the appropriate credit policy which will offer the customer attractive credit terms (and so encourage greater sales) whilst reducing the total time for which debtors have access to this free finance and so ensuring cash is available to pay debts as they fall due. Discounts can be made for early payment, and this can be a good, simple practical method of receiving cash earlier when cash is needed in the short term. Bad debts are another consideration, and appropriate credit checks should be used with customers to reduce the risk of default. It should also be noted that the longer the credit period given to customers the greater the chance of default, so good management of receivables is also useful as a way to reduce bad debts. Accounts receivable days measures the average number of days before customers pay debts. Receivables x 365days Revenue Payables management Payables are the amounts due to suppliers. The longer the company are able to take to pay suppliers the longer the working capital cycle and the less pressure there is on cash availability. Longer payables also help to keep financing costs down as it credit from customers is usually at no cost. Personal use only - not licensed for use on courses 35
The downside of taking longer to pay suppliers is the risk of worsening relationships with them. Like with receivables management, a balance needs to be struck. Accounts payable days are the average number of days it is taking to pay creditors. Payables Total operating costs (or cost of sales if available) x 365days Using the ratios For specific examples of each of these ratios see the chapter on financial analysis. 4. Short term financing methods Methods of short term financing include: Overdrafts An overdraft is a highly flexible source of short term funds provided by a bank up to a set limit. It can be useful a useful method of providing for short term cash requirements. It can be drawn on at any time and is most useful for day-to-day expenses. An overdraft is a relatively expensive way of borrowing short term, as the bank charges more due to the flexibility provided and lack of security on the debt. Advantages Flexible - borrow as needed (which may make it cheaper than a loan if the total is only borrowed for a short period of time) Quick to arrange Disadvantages Arrangement fees for setting up or extending overdrafts Charges for exceeding overdraft limits without authorisation The bank has the right to ask for repayment of overdrafts at any time Only available at the company s own bank The interest rate applied is nearly always variable, making it difficult to accurately calculate borrowing costs Personal use only - not licensed for use on courses 36
Short term loans A short term loan provides a loan for a specific period of time for a specific amount of money. Advantages Known date for repayment Availability of full amount of funds for agreed time Disadvantages Lack of flexibility o May be a fee for early repayment o May borrow funds not needed on which interest is still paid May require security Factoring Factoring is where a business sells its accounts receivable (i.e. invoices) to a third party (called a factor) at a discount. When used for funding purposes advance factoring is undertaken where the factor provides financing to the seller of the accounts in the form of a cash advance often 70-85% of the invoice amount. The balance of the purchase price is paid, net of the factor's discount fee (commission) and other charges, upon collection. E.g. Accounts receivable are 100,000. An agreement is made with a factor that 80% ( 80,000) is paid now at a 5% fee. Upon receipt of the debt, 5,000 is kept by the factor and the remaining 15,000 paid over to the company. Other points: There are many factoring companies, so a company can negotiate with a number to find the best rates. The company can protect from bad debts by taking the nonrecourse factoring service, although the factor charges more for this due to the risk taken. Cash is released as soon as orders are invoiced helping to fund future payments to suppliers. Factors will credit check customers which can help reduce bad debt risk. Internal costs of managing a sales ledger and credit control can be reduced. Personal use only - not licensed for use on courses 37
On the downside, factoring can suggest cash flow problems to customers, and there is a loss of control over methods used to chase up debts. As such it may worsen the company s reputation with its customers. Invoice discounting Invoice discounting is very similar to factoring. When a business enters into an invoice discounting arrangement, the finance company allow the business to draw down a percentage of the outstanding sales invoices - usually in the region of 80%. As customers pay their invoices, and new sales invoices are raised, the amount available to be advanced will change so that the maximum drawdown remains at 80% of the sales ledger. The finance company will charge a monthly fee for the service, and interest on the amount borrowed against sales invoices. In addition, the finance company may refuse to lend against some invoices, for example if it believes the customer is a credit risk, sales to overseas companies, sales with very long credit terms, or very small value invoices. The lender will require a floating charge over the book debts (trade debtors) of the business as security for the funds it lends to the business under the invoice discounting arrangement. The difference between invoice discounting and factoring where that with factoring the debt is sold to the factor who processes the debt while with invoice discounting the responsibility for raising sales invoices and for credit control stays with the business. An advantage of invoice discounting over factoring is that it can be arranged confidentially, so that customers are unaware that the business is borrowing against sales invoices. Selective Invoice Discounting Selective Invoice Discounting allows the company to select individual invoices to discount and so receive funding on an invoice-by-invoice basis. This provides greater flexibility, particularly where the company has a small number of large invoices, or only has seasonal sales, and only needs additional funds for certain periods. Fees for selective invoice discounting are higher, but it can be more costeffective as the company does not need to process all invoices through the factor. Personal use only - not licensed for use on courses 38
Advantages As with invoice discounting the company retains management of sales and collections and can maintain business relationships Flexibility Quick funding Open contracts without long term ties No leaving fees for ending an agreement Export factoring Export factoring is essentially the same as factoring, but for overseas sales. Key points The company can choose to invoice in one currency and be paid in another. This helps to manage foreign exchange risk as if payment is made immediately there is protection against currency fluctuations. The cost of export factoring is usually slightly higher than the cost of domestic factoring due to the increased currency and credit risks being faced by the factor. Bad debt risk can be reduced by purchasing credit protection from the factor 5. Over-trading Over-trading is where fast growing companies aim to grow without sufficient capital to support trading activities. This tends to be a problem where there is a long working capital cycle where payments to creditors are due long before receipts from customers (E.g. manufacturing businesses). So how can growing too quickly become a problem? A fast growing company also has the problem of increasing needs for cash to pay for higher levels of raw materials and a greater number of employees. If the working capital cycle is long receipts from debtors are now being paid from a sales made a few months earlier when sales levels were at a much lower volume (as the business is growing quickly) so the cash received from those sales may not be sufficient to pay the much higher current levels of purchases and wages. This can result in unpaid suppliers refusing to sell to them until paid, or only selling for cash in the future, and the business grinding to a halt, and in some cases failing not because of any problem with the underlying business, but instead because of a lack of cash to pay creditors. Growing companies in particular need to plan for increasing cash requirements during the growth period, for which a cash-flow forecast will Personal use only - not licensed for use on courses 39
be useful, and may need to raise longer term finance well in advance of running out of cash to avoid over-trading. Personal use only - not licensed for use on courses 40
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