ACT233-9 Working Capital Policy and Short Term Financing

Short term credit (used to finance current assets and non current assets includes (2)

1. Cash flow Lenders (unsecured) 2. Asset Based Lenders (secured)

Why is working capital important? (3)

1. Firms must have working capital to operate and survive - invest in long term projects- increase sales- increase stock- increase AR 2. Current assets makes up a large percentage of total assets - if working capital isn't effective, too much current assets results in overstock, and spoilage 3. Surveys indicate that most of financial managers time is devoted to day-to-day operations of the firm

Advantages of using short term debt (compared to long term debt) (2)

1. Greater flexibility 2. Interest costs cheaper (because firms incur interest expense, even in seasonal downturns)

Risk is increase from investing in less working capital because... (4)

1. Illiquidity (don't have enough cash to pay off creditors) 2. Stock outs (loss goodwill and customers) 3. Forgoing credit sales (don't have enough funds to support the credit sales 4. Forgoing cash discounts (not enough fund to get cash discount from suppliers

In regards to 'Trade Credit' what are the conditions within the 'credit term'? (4)

1. Length 2. Beginning Date 3. Cash Discount 4. Special Terms - Seasonal dating, get inventory before peak and pay supplier when you have a profit

What are the two types of factoring methods that can be used within 'factoring accounts receivable'

1. Maturity Factoring 2. Advanced Factoring

What two categories can current assets be split into..

1. Permanent Current Assets 2. Fluctuating Current Assets

The operating cycle refers to...

1. Purchasing resources (cash balance) 2. Producing the product (inventories) 3. Selling the product (accounts receivable)

Disadvantages of using short term debt (compared to long term debt)

1. Risk of not being able to refinance short term debt - the more frequently a firm must refinance debt, the greater the risk of not being able to obtain necessary funding) 2. Short term interest rates are more volatile - firms interest expense, EAT are subject to more variation over time

What are three types of Short Term Bank Credit

1. Single Notes 2. Lines of Credit 3. Revolving Credit Agreements

In regard to short term bank loans what are the advantages of 'line credit' vs 'single note'

1. The firm doesn't have to negotiate with the bank every time funds are required 2. The firm can plan for its future short term requirements without having to anticipate exactly how much to borrow each month

What are the three types of spontaneous sourced for short term credit

1. Trade Credit 2. Accrued Expenses 3. Deferred Income (Unearned Revenue)

The levels of working capital investment depends on (6)

1. Type of Product 2. Length of Operating Cycle 3. Sales level 4. Inventory Policies 5. Credit policies 6. How efficiently a firm manages current assets

How do firms main liquidity?

By cashing working capital

Define the term "Fluctuating Current Asset"

CA affected by seasonal or cyclical nature of the companies sales

Define the term "Permanent Current Asset"

CA held to meet the companies minimum long term needs 'safety stock'

Commercial Paper is a unsecured short term loan that...

Cannot be paid until maturity, even if the firm no longer needs funds from the commercial paper, it must pay interest costs - Sold at discount (because of interest fees taken off the original amount - Incurs placements fees to pay commercial paper deal for arranging the sale of the issue

What are the disadvantages of taking a cash discount?

Forgoes the credit offered by a supplier (AP) beyond the end of the accounting period = the shorter the distance (duration) between the discount period and payment limit, the higher the cost of credit.

In regard to 'levels of working capital investment' from a aggresive perspective you will have ______ amount of risk

Higher

In regard to 'levels of working capital investment' from a aggressive perspective you will have ______ amount of current liabilities

Higher

In regard to 'levels of working capital investment' from a aggressive perspective you will have ______ amount of profitability

Higher

In regard to 'levels of working capital investment' from a conservative perspective you will have ______ amount of Long Term Debt

Higher

In regard to 'levels of working capital investment' from a conservative perspective you will have ______ amount of current assets

Higher

In regard to 'levels of working capital investment' from a conservative perspective you will have a _____ liquidity

Higher

Its important to take into accounting, when regarding the matching/ hedging principle that...

No one combination of short term and long term debt is necessarily optimal for all firms

Definition of Deferred Income

Payments received for goods and services that the firm has agreed to deliver at some future date They constitute an interest-free source of financing

What does 'stretching accounts payable' refer to?

Rather than paying suppliers within the credit period, a firm can postpone payment of the amount due BEYOND the end of the credit period

In regard to an inventory loan, what specific type of inventory is considered acceptable to use as collateral?

Raw Material and finished goods

In regard to the short term loan 'pledging accounts receivable' the firm..

Remains title to the receivables and continues to carrying them on its balance sheet

Definition of Accrued Expenses

Represents the liabilities for services rendered to the firm, that have not yet been paid for by the firm. e.g. Wages, Taxes, Interest They constitute an interest-free source of financing

In regard to Bank Credit 'line of credit' a protective covenant

Restrictions used to maintain the NWC, when a company borrows from a bank. I.e. limit on lease financing

Are revolving credit agreements a secured or unsecured form of short term funds

Secured

In regard to 'short term collateral, an inventory loan is a...

Short term loan where inventory is used as collateral because it is fairly liquid

Define spontaneous financing

Trade credit and other accounts payable which arise 'spontaneously' in the firms day-to0day operations. Examples include wages and salaries payable, accured interest and accured taxation

In regards to 'Trade Credit', what does the 'cost of trade credit' refer to?

Trade credit is spontaneous source of financing because it normally expands as the volume of a company's purchases expand If a company wait till the last day of the credit period to make payments is AP (trade credit) will automatically increase by the purchase proportion

What is the main issue in regard to using inventory loans

The products perishability

In regard to 'Short Term Bank Credit' the term 'prime rate' means...

The rate banks historically have charged on credit worthy customers (cheaper than rates offered to other customers)

Definition of 'Term Structure of Interest Rates'

The relationship among interest rates of debt, that differ in their lengths of time due to maturity e.g. longer bonds will have higher interest rates

The receivables conversion period takes place between..

The selling of the product on credit and when the firm receives the cash

Are lines of credit a secured or unsecured form of short term funds?

Unsecured

In regards to 'Trade Credit' what does the term "promissory note" refer to?

Used as an alternative to "open account arrangement" This specific the amount pay and due date. = It formally recognises an obligation to repay the credit

Regarding the Matching Principle, a conservative approach to asset financing would suggest..

Using more long term debt suggest to cover some of the fluctuating assets (resulting in smaller amount of short term debt recommended to cover the Fluctuating assets)

Regarding the Matching Principle, a aggressive approach to asset financing would suggest..

Using more short term debt financing to cover permanent current assets (than is recommended) (resulting in a smaller amount of long term debt recommended to cover the permanent assets)

Define temporary financing

Various sources of short-term debt including secured and unsecured bank loans, bank bills, loan secured by accounts receivable and loans secured by inventories

In refer to Pledging AR the term 'non notification basis' refers to..

When the customer is not notified that the receivable has been pledged by the firm. The customer continues to make payments directly to the firm

The cash conversion period takes place between

When the firm pays for the resources and when the firm receives cash from the customers

The payable deferral period takes place between

When the resources are purchased and the payment for the resources purchased

The inventory conversion period takes place between...

When the resources are purchased by the firm and when they are sold to a customer

Definition of Trade Credit

Whenever a business receives a merchandise order from a supplier and then is permitted to wait a specified period of time before having to pay it

Lines of Credit is a category of 'Short Term Bank Credit' which permits

a company to borrow funds up to a predetermined limit any time during the life of the agreement. - Bank usually feels morally obligated to honor a line of credit agreement. If the company's financial position had deteriorated or if the bank lacks sufficient loanable funds to satisfy all its commitments

What is the definition of a spontaneous source of short term credit

'spontaneous' means that they increase instantly and proportionately in regard to the firms day-to-day operations

In regards to a single note (Short Term Bank Credit) The interest payments are...

- Paid at maturity - Discount Loan is deducted at the start, so the user doesn't receive the full loan amount

In regards to a single note (Short Term Bank Credit) The compensating balance...

Is a percentage of loan balance that the borrower keeps on deposit with a bank as a requirement of the loan made by the bank The compensated balance needs to be deducted from the loan amount to calculate the usable funds

Discuss the risk-return relationship that related to working capital management

* Assuming other factors to remain constant, the greater the firms investment in current assets, the greater the liquidity, however these asset investments earn little return. Therefore a firm can reduce its risk of illiquidity only be reducing its overall return on invested funds and vice versa

In regards to 'Trade Credit' what does the term "extended on an open account basis" refer to?

A firm sends a purchase order to a supplier who then evaluates the firms creditworthiness, using various information sources and decision criteria

Short Term Bank Credit uses...

A promissory note specifying the amount of the loan, interest rate being charged and the due date

In regard to Bank Credit 'line of credit' a clean up period refers to...

A provision requiring that the company have no loans outstanding for a certain period, since they are for short durations

Definition of liquidity

Ability to meet cash obligations as they come due

Definition of an unsecured cash flow lender

Investors look upon borrowers future cash flows as the primary source of the loan payments and borrowers assets as a secondary source of repayment. FCF= EAT + Dept + Initial payment

Why do you need to prepare an operating cycle analysis?

Because the cash inflows and outflows are unsynchronized and uncertain

Why is pleading AR subject to fraud?

Because they may pledge non-existing accounts, therefore the firm is subject to a periodic audit

Definition of secured Asset-Based Lenders

Borrower place greater emphasis on the value of the borrowers collateral (CA and PPE) as a source of loan payments * Tend to make riskier loans

In regard to the short term loan 'factoring accounts receivable' the firm..

Involves the outright sale of the firm's receivables to a financial institution known as a 'factor' When receivables are factored the title is transferred to the factor and the receivables no longer appear in the balance sheet

In regard to 'Levels of Working Capital Investment' Increases profitability results from (three flow on effects from main point)

Investing in less working capital... because 1. Reduce Opportunity Costs - don't hold as much inventory, therefore less funds tied up 2. Reduce warehousing, admin costs and insurance costs 3. Reduces the danger of stock becoming obsolete

What happens if a firm fails to have sufficient liquidity?

It may incur costs associated with a deteriorated credit credit rating, which will force the company into possible bankruptcy

In regard to 'inventory loan' a 'floating liens

Lender receives a security interest (general claim) on all of the firms inventory.

In regard to 'levels of working capital investment' from a conservative perspective you want have ______ amount of current liabilities

Lower

In regard to 'levels of working capital investment' from a conservative perspective you will have ______ amount of profitability

Lower

In regard to 'levels of working capital investment' from a conservative perspective you will have ______ amount of risk

Lower

What does the term 'Non Recourse Basis' Mean in reference to 'Factoring Accounts Receivable'

The factor assumes the risk of default firm is not responsible if customers don't pay because AR sold to another company

What is the benefits of 'stretching accounts payable'?

The firm gets additional short term financing

In regard to 'Factoring Accounts Receivable' maturity factoring refers to

The firm receives the payment from the factor at the normal collection

In regard to 'Factoring Accounts Receivable' advanced factoring refers to

The firm want to receive the funds prior to the normal collection period

Define temporary asset investments

The firm's investment in current assets that will be liquidated and not replaced within the current year

In regard to 'inventory loan' the major disadvantage of a 'floating lien' is..

Specific items of inventory are not identified. Therefore it doesn't offer the lender protection against losses, fraud or bankruptcy

In regards to 'Trade Credit' what does the term "Credit Terms" refer to?

Specifies the conditions under which a business is required to repay the credit that a supplier has extended it to.

In regard to 'Short Term Bank Credit' LIBOR refers to

The interest rate at which banks in the eurocurrency market lend each other - Only large firms can borrow short term credit in the eurocurrency market, at subprime rates

The receivables conversion period refers to...

The length of time required to collect the sales receipts

The inventory conversion period refers to...

The length of time required to produce and sell the product

The payables deferral period refers to

The length of time the firm is able to defer payments on its various resource purchases

Define Matching/ Hedging Principle

The maturity structure of the firm's liabilities is made to correspond exactly to the life of its assets i.e. finance short term needs with short term sources

The cash conversion cycles represents

The net time interval between the collection of cash receipts from product sales and the cash payments for resources puchased

What are the disadvantages (cost) of forgoing a cash discount

The opportunity cost, of the yearly savings, you can make from discount which can be invested

Unsecured short-term credit refers to...

The Firm's obtains credit without having to pledge any specific collateral; the lender depends upon the cash generating ability of the firm to pay the debt

What is the calculation to work out usable funds

The Loan taken out - compensating balance = usable funds

What is the definition of a negotiated source of short term credit

The amount of borrowing has to be determined before hand, unlike spontaneous sources of credit which will increases instantly

The levels of working capital investment refers to...

The appropriate level of current assets to maximise profit, based on the investing and financial decision

As the risk of working capital policies decreases

The associated profitability decreases

As the risk of working capital policies increases...

The associated profitability increases

Revolving Credit Agreement is a category of 'Short Term Bank Credit' in which

The bank is legally committed to making loans to a company up to the predetermined credit limit specified in the agreement The company is normally required to pay a commitment fee to the bank on unused proportion

In a pledging AR who assumes the default risk?

The borrower (firm) and the lender has recourse back to the borrower

Secured short-term credit refers to...

The borrower pledges assets (AR, loans, inventory and NCA) as collateral

Whats the disadvantages of 'stretching accounts payable'?

The cost of forgoing the discount + increased risk (due to the deterioration of the credit rating i.e default risk)

Define a permanent investment

in an asset that the firm expects to hold for a period longer than one year

The optimal level of working capital investment, is one that..

increases shareholders wealth. However no single policy is optimal for all firms

Single notes is a category of 'Short Term Bank Credit' that...

it used to finance a particular short term need

In regard to 'levels of working capital investment' from a aggresive perspective you will have ______ amount of Long Term Debt

lower

In regard to 'levels of working capital investment' from a aggressive perspective you will have ______ amount of current assets

lower

In regard to 'levels of working capital investment' from a aggressive perspective you will have ______ liquidity

lower

Is a commercial paper a secured or unsecured short term loan?

unsecured