3. Financial Planning and Short-Term Financial Decisions

Question 1

I. In Short-term financial management what should the company management identify correctly?

Answer 1

• Business cycle: AIP (Average inventory period)
• Operating cycle: AIP + ACP (Average Collection Period)
• Cash-Flow cycle: AIP + ACP - APP (Average payment Period)

Note: The operating cycle depends a lot on the industry and product

Question 1

I. Is there an optimal level of current asset investment?

Answer 1

It is a trade-off between carrying costs/Holding costs and shortage costs. The optimal point is the interception of these costs.

• Carrying costs: Costs increasing with the amount of current asset investment (holding costs or Opportunity costs).
• Shortage costs: Costs decreasing with the amount of current asset investment. Related with the non existence of a precautionary reserve (loss of sales/clients, disruption of the production process).

Question 2

I. Name the areas included by short-term financial decisions (working Capital management)

Answer 2

• Liquidity management
• Trade credit and receivables management
• Inventory management
• Short-term financing

Note: Ceteris paribus, as lower the WC the better , without harming the operating profit.

Question 3

II. What is Liquidation Management?

Answer 3

Liquidation Management is the coordination of collection and payment movements and use of financing instruments, in order to ensure the company meets all financial obligations resulting from its business operations.

Question 4

II. Point the main reasons to hold cash and liquid deposits.

Answer 4

1. Transaction motive
   - Ensure payment of salaries, accounts payable, dividends and taxes
   - Some amount of reserves will be needed to cover unexpected obligations
2. Collateral
   - Minimum cash reserve, required by a financial institution in exchange of bank services provided (guarantees, letters of credit or even new loans).
3. Speculative motive
   - Resources available to seize opportunities, to make investments with attractive returns or, benefit from exchange rate fluctuations.
4. Preventive motive
   - Resources to be used as a reserve to offer financial stability (good for managers, bad for shareholders)

Question 5

II. Are there costs or benifits from holding cash and liquid deposits?

Answer 5

Costs: opportunity costs.
Benefits: Saving of transaction costs (sale of tradable securities) or costs of short-term financing to meet immediate obligations.

Note: The optimal amount of cash reserve depends on this trade-off.

Question 6

III. What is Trade Credit and Receivable Management?

Answer 6

Definition of the trade credit conditions to be offered to clients,
in businesses where sales depend on credit granting, in order
to maximize the commercial benefits of trade credit policy
adopted.

Question 7

III. What are the costs of credit?

Answer 7

Direct costs of credit: Financing costs and Opportunity costs.

Indirect cots: Creation of a Collection department
once the company implements a credit policy.

Question 8

III.Name the components of trade credit policy.

Answer 8

1. Terms of sale- usually pre-defined (cash vs. term payment, payment discount?, credit period? )
2. Credit Analysis (credit policy equal to every client?)
   3.Collection policy (collection department vs. outsourcing).

Question 9

III. What factors influence the credit period granted by the company?

Answer 9

Degree of deterioration of goods
- faster deterioration -> weak collateral in case of default

Consumer demand
- Goods of high demand tend to be paid at shorter term

Cost, profitability and standardization
- More standardized products are given shorter credit periods

Credit risk
- Higher the risk -> shorter credit period

Dimension of receivables account
- Smaller receivables amounts -> shorter credit period

Question 10

III. Which factors must be taken into account in credit analysis?

Answer 10

• Effect of credit in cash inflows (volume of sales and price)
• Effect of credit on costs (collection period)
• Cost of short-term financing
• Probability of default
• The value of cash payment discount

Question 11

III. In collection policy a company should consider …

Answer 11

• Collections monitoring: ACP and maturity of receivables Analysis
• Collections Actions: Letters demanding payment overdue receivables, Phone calls, Legal action …
• Factoring

Question 12

IV. Inventory Management consists in…

Answer 12

Defining rules for supply and holding of inventory, to minimize its associated costs (financial costs of
inventory, administrative costs and shortage costs.)

Question 13

IV. Name the types of inventory.

Answer 13

Raw materials
Work in progress
Finished products
Good

Question 14

IV. Identify and explain the main Inventory costs.

Answer 14

• Carrying (holding) costs: Storage, Insurance and taxes, Loss of value due to obsolescence, Opportunity cost.
  -Shortage costs: Ordering costs (supply costs), and Opportunity costs (shortage cost).

Question 15

IV. Name the different methods of inventory management.

Answer 15

Method of economic order quantity (EOQ).
Extensions:
- Safety inventory level (Determined as a function of shortage probability and costs)
- Ordering Point (Determined as a function of delivery time)

Question 16

V. Short-term financing consists in…

Answer 16

Defining a financing supply function for the company, that allows it to use the most efficient financing instruments to meet temporary shortages of liquidity.

Question 17

V. Point the main elements of Long-term vs. Short-term financing differences.

Answer 17

In “normal” conditions:
- Long-term financing should be used to finance investment in fixed assets and in (at least) permanent working capital.
- Short-term financing should be used to support liquidity management and to deal with the instability of cash-flows in the company.

Question 18

V. What are the common traits in long/short- term financing?

Answer 18

• Financing cost evaluation
• Influence of financial innovation, degree of development in monetary markets and Capacity of management to absorb financial innovation.
• The presence of options

Question 19

V. Identify short-term financing instruments

Answer 19

• Bank loans
• Promissory discount
• Current account
• Documentary credit
• Overdraft agreement
• Commercial paper
• Factoring

Question 20

V. How to make a choice about short-term financing instruments?

Answer 20

The decision criteria should be the all-in cost. This is affected by:
- The possibility of using alternatively the banking system and the monetary market
- The relationship of the company with the banking sector (not fall dependent on a reduced number of banks)
- The company should take into account and make use of the flexibility mechanisms available in some of these instruments