Chapter 24 & 25 Flashcards
EAR of supplier financing formula
What are the ways a company can decrease its CCC?
Decreasing inventories and receivables
OR
Increasing payables.
Total Working Capital Formula
Current Assets - Current Liabilities
Net Working Capital
current assets
(except cash and marketable securities)
−
current liabilities
(excluding short-term and current debt)
An increase in the CCC is a reduction in what?
It reduces issuers liquidity
drag on liquidity
Drag on liquidity occurs when cash inflows lag (Increase in DOH, DSO)
This can occur when excess inventory builds up or inventory becomes obsolete.
(DOH increases - Days of inventory on hand ),
or
when collections are slow or receivables become uncollectible.
(DSO increases - days sales outstanding).
days of inventory on hand
number of days it takes for a company to sell its inventory
days sales outstanding
the number of days it takes for the company to collect payment from its customers
Current Ratio Formula and what does it mean when its greater than 1?
current assets /
current liabilities
Greater than 1 means company has sufficient current assets to meet its current liabilities.
Quick Ratio formula and what does it exclude?
Excludes Inventory because tis least liquid current assets.
Also excludes payables
Cash Ratio formula and what does it exclude?
Cash Ratio > 1 suggests what?
Most Conservative
Cash ratio > 1 suggest the co could cover all its ST obligations w/o needing to wait to sell inventory or collect receivables.
pull on liquidity
A pull on liquidity occurs when cash outflows accelerate. (reduce credit terms)
This can occur when suppliers reduce credit lines or demand faster payments (DPO decreases)(days payable outstanding)..
Features of conservative approach to working capital management.
Pros and Cons
- Hold higher amt of ST assets
- Finance the WC using LT sources like LT debt and Equity
- High WC as % of sales
Pros:
- Using more permanent capital with less need for roll over
- Greater flex during mrk disruptions,
- High probability of meeting ST obligations
Cons:
- Higher costs and lower profitability
- LT lenders may impose constraints like min interest coverage ratio.
Aggressive approach to WC and its Pros and Cons
- Low WC as % of sales
- lower levels of ST assets and finance WC using ST debt.
Pros: lower cost
Cons: The risk is failing to meet business obligations and vulnerability to mrk disruptions.
Moderate approach to WC
PERMANENT current assets are funded using LT sources of capital.
While VARIABLE/SEASONAL current assets are funded using ST sources
Corporate governance
Corporate governance is the system of internal controls and procedures by which individual companies are managed.
It includes a framework that defines the rights, roles, and responsibilities of various groups within an organization.
The objective is to manage and minimize conflicts of interest between stakeholders of the company.
Reduced risk of default is among the benefits of effective corporate governance. Risks from poor corporate governance include related-party transactions by managers and opportunities for some stakeholder groups to gain an advantage at the expense of others.
Stakeholder management
Stakeholder management refers to the management of company relations with stakeholders and is based on having a good understanding of stakeholder interests and maintaining effective communication with stakeholders.
Stakeholder theory focuses on the conflicts of interest among owners and several groups that have an interest in a company’s activities, including creditors.
With respect to the company’s relationship with shareholders, there are standard practices. These practices are required by corporate laws and are similar in many jurisdictions
Primary Sources of Liquidity
Cash and Mrk Securities on hand
Bank Loans
Cash generated from business
EAR Example:
A supplier offers 2/10 net 30 terms. The bank interest rate is 8%. Which source of financing should the company prefer?
A company receives an invoice of $150,000 for machine tools with terms of “1.5/15 net 40.” The cost to the company of delaying payment of this receivable is most appropriately described as $2,250 for the use of:
The terms indicate that the company can pay
$150,000(1 − 0.015) = $147,750 on day 15 (after the invoice date)
or
pay $150,000 on day 40—effectively gaining the use of $147,750 for 25 days at a cost of $2,250.
A supplier offers 4/30 net 90 terms. The bank interest rate is 6.5%. Which source of financing is the cheapest?
The EAR of supplier financing = (1 + 0.04 / 0.96)365/60 – 1 = 28.2%.
The cost of implicit supplier financing is much higher than the cost of explicit bank financing of 6.5%.
Buildup Design, Inc., expects a 20% reduction in its days payable outstanding from 50 to 40 days, while its days of inventory on hand and days sales outstanding would remain unchanged. What would be the most likely impact on the cash conversion cycle (CCC)?
The CCC would increase by 20%.
The CCC is calculated by adding the days of inventory on hand and the days sales outstanding, and subtracting the days payable outstanding.
A shorter days payable outstanding implies less generous credit terms by suppliers, where the company must pay its suppliers in a shorter time period. This would increase the CCC by 10 days.
Current Ratio
Quick Ratio
Cash Ratio
And exclusions
Cash Conversion Cycle
Operating Cycle
Cash Conversion Cycle
Definition
Formula
Interpretation
Shortening CCC Methods
Calculating CFs
Which conservative ratio should we look for liquidity?
