Chapter 10 - Introduction to Working Capital Flashcards
1
Q
Four Types of Operating Cash Flows
A
- Cash Outflow
- Cash Inflow
- Internal Liquidity Management Flow
- External Liquidity Management Flow
2
Q
Cash Flow Timeline’s Three Stages
A
Procure-to-Pay Period
Inventory Period
Order-to-Cash Period
3
Q
Procure-to-Pay Timeline
A
The time between when raw materials are purchased and the point at which funds leave the firm’s bank account
4
Q
Inventory Timeline
A
Turn raw materials into a finished product and then sell the good
5
Q
Order-to-Cash Timeline
A
Sourcing customers through conversion of inventory to sales to the collection of cash
6
Q
How is the Procure-to-Pay Timeline connected to the Inventory Timeline connected to the Order-to-Cash Timeline?
A
P2P –> Inventory = Receive goods and invoice to raw materials
Inventory –> O2C = Finished goods to send invoice
7
Q
Entire Cash Flow Timeline Float Period
(When does it start and when does it end?)
A
Purchase of raw materials to payment received by customers
8
Q
What is usually the biggest driver of float?
A
- Manual processes
- Inefficiencies
- Waiting on someone else to take action
Payment float is the least time-consuming portion of float
9
Q
Unique corporate payment terms will always result in what with relation to working capital management?
A
Float
10
Q
Payment Float for Seller/Payee
A
Time between when the invoice is sent to the buyer and the time that the payee’s account is credited
11
Q
Payment Float for Buyer/Payor
A
Time between when invoice is received and account is debited
12
Q
Collection Float
A
Time interval between the time the buyer/payor initiates payment and the time the seller payee receives good funds
13
Q
Three Types of Collection Float
Mail Float
Processing Float
Availability Float
A
Mail float – interval between when the payment is mailed and when it is received
Processing float – interval between receiving payment and deposit is made
Availability float - interval between the day when a payment is deposited and the day when the payee’s account is credited with collected funds
14
Q
What is the primary cost that should be considered with collection float and use of funds?
A
Opportunity cost of using that cash
15
Q
Can float be applicable to electronic payments?
A
Yes
16
Q
Disbursement Float
A
Time between when a payment is initiated and when it is debited from the account
17
Q
Does prefunding ACH transactions impact float?
A
Yes
18
Q
Invoicing Float
A
Interval between when the customer places an order and the day the customer receives an invoice
19
Q
Payment Float
A
Interval between invoice being sent/received and the day the payment is credited to the biller’s bank account
20
Q
What is usually the largest driver of Payment Float?
A
A customer’s payables policy
21
Q
Information Float
A
Lack of knowledge about the funds and their availability
22
Q
What are two examples of approaches or strategies that reduce overall float for working capital considerations?
A
JIT Inventory
Supply chain management
23
Q
If a customer is using JIT Inventory or Supply Chain Management, they will likely do what with regards to paying and receiving?
A
Everything will be electronic as this outweighs the prior benefits of slowing payments and speeding up collections
24
Q
Collection Float for the supplier is known as what for the buyer?
A
Disbursement float
25
Which float time interval is longer: (a) the seller’s payment float or (b) the buyer’s payment float?
Seller’s payment float because it starts when the invoice is sent, not received
26
In its simplest form, the CCC is the time period between what?
Disbursement for A/P and collection of A/R
Turning a cash outflow into a cash inflow
27
Days Inventory (DI)
Interval between purchase of raw materials and sale of finished goods
28
Days Receivable (DR)
Number of days required to collect on credit
29
Days Payables (DP)
Days between when purchase is made and when payment is made
30
Benefits of expanding Days Payable?
Reduce debt
Invest cash on a short-term basis
Make other purchases
31
If a purchaser has trade terms of net 30, will the Days Payable number usually be higher or lower?
Higher
32
A higher cash turnover ratio means a company is more or less efficient?
More efficient
33
Will changes in CCC related items impact the income statement or the overall sales process?
No
34
Will shortening the CCC increase or decrease NI?
| Why?
Increase NI and lower inventory carrying costs
35
CCC changes will be short-lived if the following occur...
| (Review Only)
What does it encourage heavy reliance upon for financing?
* Lost sales due to overly strict credit and collection standards
* Production stoppages attributable to inadequate raw materials
* Payables stretched beyond the due date
* Forgone cost-saving trade discounts
* Higher prices assessed by suppliers because individual orders are smaller or payment is slower
* Refusal to sell to customers that are good credit risks, but occasionally slow in paying
* Excessive reliance on A/P in lieu of a stable base of short-term bank credit
36
Is WACC generally a good measure of opportunity cost of working capital considerations?
No, it is generally focused on long-term financing
37
Alternative to WACC for the opportunity cost rate as a net borrower?
Short-term borrowing rate
38
Alternative to WACC for the opportunity cost rate as a net investor?
Short-term investment rate
39
Current asset and current liability accounts that fluctuate with sales amounts are known as being...
| (single adjective)
Spontaneous
40
Increase in noncash current assets must be supported by reducing [XXXXXXX] and increasing [XXXXXXX]?
Cash
Debt and other liabilities
41
What may increase in the short-term when sales slow?
Inventory
42
The total net increase in working capital represents what that the company must do?
Fund it using debt or equity
43
Two questions that Treasury should be concerned about regarding working capital:
1. What is the appropriate level of working capital
2. The methods required to finance the working capital
44
Restrictive vs. Relaxed Current Asset Investment Strategy
* **Restrictive**
Lower current assets
More volatile
Higher potential profitability
Issues with suppliers, credit acceptance, and running out of cash
* **Relaxed**
Higher current assets
Reduces investment returns
Issues with higher level of current assets should sales levels fall
45
Are creditors influenced by a company’s current asset strategy?
| (What two things will it impact?)
Yes, will determine interest rates and risk
46
Companies with high gross profits may have what type of current asset investment strategy?
Relaxed
47
What is the concept of permanent current assets?
Minimum amount of current assets required to do business
Serves as the foundation, with fluctuating fixed assets on top
48
Three Approaches for Current Asset Financing Strategies
Maturity-Matching
Conservative Financing Strategy
Aggressive Strategy
49
Maturity Matching Current Asset Financing Strategy
Funding permanent current assets and fixed assets with long-term financing and fluctuating currents assets with short-term debt
50
Conservative Current Asset Financing Strategy
* Funding permanent current assets, fixed assets, and a portion of fluctuating currents assets with long-term financing
* Highest financing costs – mitigated with fixed long-term borrowings and variable rate interest on short-term borrowings
51
Aggressive Current Asset Financing Strategy
* All fixed assets with long-term financing, but finances only a portion of permanent current assets with long-term financing
* Short-term rates are generally lower, but can fluctuate and also leaves the entity prone to more risk during uncertain times
* Liquidity risk with rollover
* May need to renegotiate the credit lines with higher fees
52
What is the annual cleanup period for a lender?
Short-term borrowers must completely pay off or clean up the outstanding balance at least once a year to prove it isn’t being used for long-term financing
53
A relaxed current asset investment policy and a conservative current asset funding strategy will result in what with regards to liquidity?
| (What additional risk does this present for the firm?)
Excess liquidity at a higher cost
May be viewed as takeover targets
54
Three items to consider to help to determine which current asset financing strategy is best for the firm:
| (think about what drives cost of financing)
Current interest rates
Future interest rates
Risk appetite of management
55
Two key considerations when developing trade credit standards
| (if credit standards are too ....)
If credit standards are too strict, potentially good customers may be lost
If credit standards are too lenient, the firm may take on unacceptable credit risk
56
Establishing trade credit standards is a two step process that involves what?
Creating the acceptance criteria
Credit limit for each applicant must be determined
57
What is the downside to relying just on external ratings for determining credit risk?
Sample used by ratings agency may be small or inaccurately represent the applicant’s payment history
58
The Five C’s of Credit
**Character** – perceived honesty / integrity of the buyer
**Capacity** – current and future financial resources that are available to repay; uses liquidity ratios and forecasts
**Capital** – short-term and long-term financial resources that could be utilized
**Collateral** – available assets or guarantees
**Conditions** – macroeconomic environment’s impact on ability to pay and willingness of lender to grant credit
59
Ratios most commonly used for quantitative credit analysis
Liquidity and working capital ratios
Debt management and coverage ratios
Profitability measures
60
Which types of businesses extensively use quantitative credit scoring models?
Major issuers of retail credit, like department stores
61
4 Step Process of Credit Scoring
| (key concept tested in practice questions)
1. Differentiating standard and high-risk accounts based on monthly income, outstanding obligations, and employment history
2. Weighting the characteristics of applicants that fit into each category to establish credit worthiness
3. Setting cutoff scores for clear approval or denial
4. Further analysis to applicants whose scores fall between the cutoff points
62
Are quantitative credit scoring models used extensively in B2B?
No, but it is becoming more popular
Difficulty finding a large enough database and difficulty getting financials from private companies
Impact of one commercial customer is bigger than an individual retail customers
63
What is an example of a credit policy constraint that a treasurer might be concerned about as it relates to covenants?
Changing A/R balances will change working capital ratios
64
Financing considerations related to granting credit
| (what to do with the A/R balances)
A/R must be financed as it is a deferral in cash collection
A/R can also be used as collateral, can be used to securitize debt, or can be factored
65
Income and Expenses related to Granting Credit
**Income**
Interest earned from installment payments
Late fee penalties
**Expenses**
Shot-term borrowing cost or WACC vs. bad debt (primary cost)
Overhead cost of credit department
66
What is the primary cost that should be considered when contemplating the cost of bad debt?
Short-term borrowing cost
67
If discounts are offered, what must be offered as it relates to eligibility?
The benchmark eligibility (postmark date or date funds are received)
68
How can management reduce the impact of bad debt?
Insurance offerings are available, but the cost would need to be factored in
69
4 Types of Credit Extension
**Open account**
* billed for each transaction or monthly (most common form)
**Installment credit**
* requires customer to make equal periodic payments (principal and interest)
* popular for high-value consumer durables
* contract must be signed
* automatically liquidating
**Revolving credit**
* grants credit without requiring specific transaction approval so long as it is below the limit
* interest assessed if no longer current
* not automatically liquidating since it fluctuates
**Letter of Credit**
* most complex
* financial institution guarantees payment on behalf of the purchaser
* import/export
70
Three-Way Match
| (also, will it increase or decrease float?)
Matching invoice to PO to receiving statements
May increase float due to minor discrepancies needing investigation
71
Two tools being used to decrease invoice and payment float
Electronic bill presentment and payment (EBPP)
Electronic invoice presentment and payment (EIPP)
72
Open Item System
| (Cash Application)
Most commonly used in B2B
Applying payments towards individual invoices (manual or automated)
73
Balance-Forward System
| (Cash Application)
Most common for individual retail customers
Focus on overall balance, not a specific tracking of payment against transactions
74
Escheatment and Considerations
Turning over unclaimed property to the state
Criteria are driven by each state
Must file annually with each relevant state where their customers are located
75
Cash Before Delivery
| (Payment Terms)
Prepayment terms
Reduces credit risk
Popular for B2C
May also look at substantial prepayment instead of complete prepayment
| Could use something like a certified check to make payment
76
Cash on Delivery
| (Payment Terms)
If not paid, goods are returned and seller must pay the shipping and handling costs
77
Cash Terms
| (Payment Terms)
Translates to 7 to 10 days to make payment
Used for perishable items or no credit history
78
Net Terms
| (Payment Terms)
Net due date when payment in full is due
79
Proximo
Pay be a specified date in the next month
80
How would you interpret "1/10 prox 30"
1% discount if paid within 10 days into the next month
Full payment due by the 30th day of the following month
81
Monthly Billing
| (Payment Terms)
Monthly statement using a specific cutoff date
82
Documentary Collection
Collects payment through banking channels
Title documents are exchanged in return for payment by the customer
Not guaranteed
83
Seasonal Dating
| (Payment Terms)
Will accept payment at the end of the buyer’s selling season
84
Consignment
| (Payment Terms)
Consignee has no obligation to pay for the goods until they are sold
Commissions or fees are deducted from amount paid to consignor
85
Incoterms
| (Payment Terms)
International Chamber of Commerce terms
International commercial terms used for international trade
86
What is securitization as it relates to
A/R financing?
Bundling and issues securities that are backed by receivables and paid off as the receivables are collected
| (must be an investor)
87
Benefits of using a captive financial company for credit operations and for A/R financing?
Enhances parent company’s liquidity and provides access to capital at a lower cost
88
What is third-party financing for A/R?
Selling firms collects the information to complete the credit application and forward it to a financial institution to decide
Removes control of credit decisions from company
Usually used for big-ticket items such as production machinery
89
Pros and Cons of Credit Card Acceptance
**Pros**
* No direct costs of running credit department
* No financing of A/R
* Bad debt shifts to issuer
* Sales typically increase
* Paid quicker
**Cons**
* Seller relinquishes control over the credit decision
* Seller incurs discount costs and transaction fees
* Charge-backs
* Credit card compliance
90
What does factoring without recourse mean?
The buyer must absorb any losses
91
A/R Factoring
Selling to a third party
Requires notification basis as third party will directly collect
Must account for the discount, which may be factored into the sales price if used extensively
92
Invoice Discounting
Similar to factoring, but the company retains A/R management
Interest charges and an arrangement fee are arranged
93
Private Label Financing
Third party operates the credit function, but does so in the name of the company
Customer will never know it is through a third party
94
Supply Chain Finance
Reverse factoring where organization uses strong credit rating to allow its suppliers to finance their receivables
Managed by bank on behalf of the strong credit rating company
Supplier can choose when to receive payment at a discount
Advantageous for suppliers with weaker credit profiles
Bank line of credit to accelerate payment to the suppliers
95
A company's credit terms, sales and collection patterns are a determinant of its level of what?
Accounts Receivable
96
Stock Out Costs
Lost sales due to lack of sufficient inventory
97
Benefits of Holding Inventory
Meet customer demand
Competitive advantage and customer goodwill
Hedge potential price increases in required inputs
98
Costs of Holding Inventory
**Holding Costs** – physical storage and handling costs, insurance, taxes, opportunity cost
**Obsolescence and Spoilage Costs** – written off, sold at discount
99
What type of model is usually used to determine optimal levels of inventory?
Economic Order Quantity (EOQ)
100
How would a firm manage inventory of finished goods for generic items vs. customized items?
Limit the inventory for the customized items
101
Scrap vs Spoilage
Scrap is a normal by-product of the manufacturing process
102
Stores & Supplies Inventory
Indirect purchases
Support the production process (glue, oil, etc.)
103
Just-In-Time (JIT) Technique
Inventory is seen as a liability
Not simply an inventory management system as it is a wider business philosophy
104
Material Planning System (MPS)
Arrange with suppliers to provide continuous level of production materials on short-notice
Often coupled with JIT
105
Supplier-Managed Replenishment Program
| (also, when is title transferred?)
Supplier tracks and maintains its inventory
Billed as the inventory is used
Supplier can more efficiently track and manage the inventory
Title is transferred at the shipping dock
106
Paid-On-Production Process
Similar to supplier-managed replenishment program, but payment records are based on usage rather than shipment
Title is transferred during the manufacturing process rather than at the shipping dock
107
Inventory Financing Alternatives
1. Trade Credit
2. Supply Chain Finance
3. Collateralized Loans
4. Asset-Based Loans
5. Floor Planning
**Trade Credit** – lease expensive, but terms should be negotiated rather than always delaying payment
**Supply Chain Finance**
**Collateralized Loans** – cash flows are primary repayment source, inventory as secondary; lien on inventory
**Asset-Based Loans** – based on the value of the inventory rather than general financial strength; public warehouse may be used where control can be used in case of default
**Floor Planning** – asset-based lending for high-value durable goods; loans made against each individual item
108
Dominion of Funds Agreement
Lender assumes control of company’s A/R process and decides when to distribute collected funds back to the company
109
Which risk does the JIT technique not decrease?
The risk of backorders given minimal inventory
110
Excess inventory indicates what under the JIT technique?
* Poor inventory planning
* Poor inventory location and movement problems
* Inferior supplier quality
* Unbalanced production processes
111
Invoice Vouchering
Reviewing and authorizing the invoice for payment
112
Two Critical Areas of Coordination for Treasury and A/P Management
Communication from A/P to treasury regarding the invoices vouchered for payment
Communication from treasury to A/P regarding reconciliation of cleared items
113
The net costs of making payments include what?
Opportunity costs
Administrative costs of managing A/P and disbursements
114
Four Considerations for an A/P and Disbursement System
**Information Access** – status of disbursement accounts and disbursement clearings
**Fraud prevention** – written policies and controls
**Relationship maintenance with payees** – timely payments; consider invoice upload
**Timing of payments** – timely payments, consider scheduling payments
115
Centralized A/P and Disbursement Systems
| (Advantages & Disadvantages)
Headquarters or centralized processing center
**Advantages**
* Easier to maintain control and ensure compliance
* Obtain information
* Concentrate excess cash
* Improve forecasting accuracy
* Treasury can control disbursements
**Disadvantages**
* Negative impact on payee relationships for disputes
* Delayed payments and lost discounts
116
Decentralized A/P and Disbursement Systems
| (Advantages & Disadvantages)
Local or regional level processing
Local or regional banks
**Advantages**
* Greater autonomy to field managers
* Improved relationships and ability to manage disputes
* Can take local discounts
**Disadvantages**
* Loss of control over information
* Lost opportunity to concentrate funds
* Increased risk for fraud
* Redundant systems
* Difficult to determine consolidated metrics for vendors
117
Decentralized A/P and Disbursement Systems with Centralized Clearing
Mixes both approaches and allows for local authorization but centralized disbursement bank
Invoices can be received locally or at a centralized location
May use integrated payables or shared services center
May utilize payments on behalf of approaches (POBO)
118
Which groups should be involved with the management of accounts payable?
Treasury and Accounts Payable
119
Multicurrency Account’s 4 Stipulations
Based currency in which the account is denominated
Portfolio of currencies accepted
Spread over spot used for exchanging currencies within the account
Value date to apply credits and debits for each transaction type and currency
120
If you have inflows and outflows in the same foreign currency, should you use an MCA or a dedicated FCA?
FCA will be less expensive
121
International netting will result in what benefits?
Reduced number of intercompany cross-border payments and FX transactions among the firm’s units
Enhanced natural hedging
122
International netting is impacted by what on a country-by-country basis?
National restrictions on netting due to tax consequences
Central bank or government approval is often required
123
Bilateral Netting
Purchases between two subsidiaries of the same firm are periodically netted against each other
Does not require the creation of a new entity or centralized center
124
Multilateral Netting
Similar to bilateral netting but it involves more than two entities
Utilizes centralized treasury management center
Center will help determine common currency and helps to perform any required FX transactions
125
Three Benefits of Using a Netting System
Reduction in the number of cross-border and FX transactions
More favorable FX rates due to consolidation
Improved cash and currency exposure forecasting
126
Can netting still be beneficial to entity groups with few cross-border payments?
Yes, it still helps to instill discipline
127
Leading and lagging are tied to which global working capital management approach?
Netting
128
Leading vs. Lagging Payments
**Leading** is used to accelerate the payment before the intended settlement date
**Lagging** is used to delay the payment until after the intended settlement date
129
Leading or lagging payments may also be considered what by local authorities?
An intercompany loan
130
When would you implement a leading strategy and when would you implement a lagging strategy as it relates to changes in foreign exchange risks?
| (from the perspective of the local currency as payor)
**Leading Strategy:** domestic currency is expected to weaken against the foreign currency you need to pay
**Lagging Strategy:** domestic currency is expected to strengthen against the foreign currency
131
Re-Invoicing
Creates re-invoicing center as a company-owned subsidiary
Re-invoicing center facilitates invoicing between itself and the exporting subsidiary and then itself and the importing subsidiary, all in each of their own currencies
Shipment of goods is sent directly between subsidiaries, but title transfers through re-invoicing center
Requires local government and tax approval, along with tax approval in all involved countries regarding the re-invoicing center
132
Benefits of Re-Invoicing
| (which one is primary?)
**Centralizing FX exposures**
Flexibility in inter-subsidiary payments
Eases the implementation of leading and lagging arrangements
Improves export trade financing and collections
Reduces bank fees
Minimizes FX risk
**Facilitates advantaged FX rates through bigger trades**
Reduces payment costs
133
Internal Factoring
Similar to re-invoicing, but instead of taking title, the centralized center will purchase the A/R from the exporting entity and collect from the importing entity
134
Is internal factoring done with or without recourse?
| (usually)
Usually with recourse
135
In-House Banking
Treasury or standalone legal entity becomes the main provider of banking services for all entities
Each legal entity holds an account with the IHB, with all intragroup transactions routed through those accounts
Most operate using a network of virtual accounts, where the IHG holds a single physical bank account per currency with an external bank and each subsidiary holds on or more virtual accounts
May facilitate POBO or COBO/ROBO for all member entities to centralize all cash
136
Benefits from IHBs
Centralized FX management
Individual transactions can be aggregated, netted, and processed in bulk
Improved visibility and control
Easier to report items related to tax, with some countries providing for tax advantages for in-house banking
137
IHB Responsibilities
Investments/debt or intercompany loans
Netting
Pooling
POBO and COBO/ROBO
Re-invoicing
FX transactions and FX risk management
138
Export Credit Agency (ECA)
Entity established to provide export loans, guarantees, or a combination of both
Many are nationally-based, but some are international
139
Example of ECA in the US?
Export-Import Bank (EXIM) of the United States
140
Advantages and Disadvantages of Export Credit Agencies
**Advantages**
* Interest rate is likely lower and fixed for longer
* Indirect government involvement can provide some protection against appropriation of interference
**Disadvantages**
* Additional lead time to get approvals
* Currency exposure depending on how loan is denominated
141
The decision to accept credit cards does what for the seller as it relates to financing A/R?
It eliminates the need to finance since settlement is made so quickly
142
Which of these invovles actually transferring the title of goods?
Re-Invoicing
Internal Factoring
Only Re-Invoicing
143
When working capital decreases, why would net income increase?
Interest expense for financing the working capital would decrease
144
For those vendors that use three-way match or “auto-match” processes, what is the best strategy to reduce invoice float?
| (missed concept reinforcement)
Ensure invoices contain clearly stated payment terms and remittance instructions
145
What is the win-win approach for reducing float?
| (missed concept reinforcement)
Instead of focusing on the end of the operating cycle (sale of goods through collection), companies are now shifting focus on the beginning of the process (purchase of resources through sale of goods) as this provides focus on the areas that would contribute to the greatest cycle reduction times
JIT technique and supply chain management are examples of this
