Chapter 9 - Sources of short-term finance Flashcards
Why is it important to control/sometimes reduce inventory levels?
The cost of holding inventory includes purchasing goods, storing, insuring and managing them once they are in inventory.
For most businesses, carrying inventory involves a major working capital investment and uses large amounts of finance
that could be used elsewhere in the business. We should note that some companies, such as service companies,
may hold little or no inventory. Inventory levels need to be tightly controlled while retaining the capacity to meet future
demand. Inventory management is balancing those two opposing factors for optimum profitability and cash savings.
Advantages of inventory control
- Carrying low inventory reduces carrying costs of storage (rent, insurance and interest charges).
- It frees up money tied up in inventories.
- It reduces the risk of deterioration, obsolescence and theft.
Disadvantages of inventory control
- Reducing inventories risks the possibility of stock-outs and dissatisfied customers.
- A higher risk of loss of production time.
- Bulk purchase discounts may not be available.
Advantages of delaying payments to trade payables
- Delaying payment to trade payables helps cash retention that can be used for other purposes.
- Trade payables are often viewed as a source of ‘free credit’ and a cheap form of short-term finance.
- ‘Buy now, pay later’: if the business can sell the goods first and pay for them later, there are savings on opportunity
costs if trade payables are paid within the agreed time.
Disdvantages of delaying payments to trade payables
- There may be a reputational cost from loss of goodwill that could damage the company’s credit status.
- Potential loss of suppliers due to breach of the terms of credit and default if their suppliers aren’t paid on time.
- Suppliers may increase prices in future.
- Loss of benefits from suppliers who provide incentives such as settlement discounts on early payments.
Advantages of selling off redundant assets
- It raises finance from assets that are no longer needed – as long as this is clearly identified as being the case.
- No interest charges or dilution of control are associated with this, unlike debt or equity financing.
Disadvantages of selling off redundant assets
- Businesses do not always have surplus assets available for sale.
- Selling off redundant assets is a ‘one off’ source of finance.
- It may not be easy to find potential buyers and can be a slow method of raising finance.
Purpose of cash management
The key objective of cash management is to avoid either a surplus or a deficit of cash by ensuring:
* there are adequate cash balances in times of need;
* surplus cash is invested or used to repay the existing debt to maximise the returns for the company; and
* there should not be a situation where there is deficit of cash due to unnecessary shortage of funds.
Cash management is a trade-off between liquidity and costs.
Keynes theory - 3 reasons for holding cash (MOVE THESE CARDS TO CHAPTER `10)_
- The transaction motive: maintaining enough cash to meet the day-to-day operations such as payments to
vendors, petty expenditure and salaries. Cash is received in the ordinary course of company from debtors (trade
receivables) or investments. Often these inflows and outflows do not match, hence cash is required to meet these
mismatches. - The precautionary motive: holding cash to meet contingencies and unexpected situations, such as providing a
safety net for unexpected events. - The speculative motive: using cash to take advantage of profitable investment opportunities. For example, holding
money will allow cheaper bonds or shares to be bought in the future.
What are capital markets?
A capital market is a market where finance products with maturities of more than one year are traded. These include
long-term debt, bonds or equity-backed securities. This type of market is comprised of both primary and secondary
markets. Broadly, a stock market, derivatives market and a bond market could be collectively called a capital market.
* stock market: for the trading of shares
* bond market: for the trading of bonds/debentures of various companies or the government
* derivatives market: for the trading of complex financial instruments such as futures, forwards, options and so on
(not covered in this module)
2 types of capital market
-
Primary market: new shares and bonds are issued to the public for the first time to raise funds on these markets.
An initial public offering (IPO) takes place on a primary market. An IPO is underwritten by one or more investment
banks, who also arrange for the shares to be listed on one or more stock markets. -
Secondary market: existing securities – shares, stocks and loan stock – are traded after the company has sold all
the stocks and bonds offered on the primary market. Markets such as NYSE and LSE have secondary m
What are money markets
A money market is where instruments with high liquidity and very short maturity (less than one year) are traded, typically
for the financing of working capital and meeting short-term liabilities. These instruments include treasury bills and
commercial paper. They are regarded as being as safe as bank deposits yet provide a higher yield.
Two main instruments trading on money markets
Treasury Bills (T-bills) are short-term debt instruments issued and backed by government (such as the US Treasury
Department). It is essentially money lent to the government and hence considered safe. They have a maturity of less
than one year with no interest payable. They are sold at a discount to their face value but pay the full face value at
maturity.
Commercial paper is an unsecured, short-term debt instrument issued and backed by an issuing bank or company. It is
essentially money lent to the issuing company or bank. They are sold at a discount but pay the full face amount on the
maturity date of no more than 270 days from the date it was issued.
Advantages of private markets
Advantages of private markets
* Selective access to investors and less competition.
* Normally no intermediary between the buyer and the seller.
* Not tightly regulated and hence less compliance costs for the investee.
* Greater probability of providing higher returns.
Disadvantages of private markets
- Investors usually do not have complete information at hand.
- Cannot be sold or purchased easily, making the investments less liquid than public markets.
- Highly risky, as they are essentially unregulated.
