Corp Flashcards
Explain “the capital requirement for banks are based on a Value-at-risk calculation”
The capital requirement is based on the maximum credit loss possible in 9999 out of 10000 years. This is a VAR measure given the credit loss distribution with a confidence interval of 99,99%
It is a statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame. This metric is most commonly used by investment and commercial banks to determine the extent and occurrence ratio of potential losses in their institutional portfolios. Risk managers use VaR to measure and control the level of risk exposure. One can apply VaR calculations to specific positions or whole portfolios, or to measure firm-wide risk exposure.
Describe the BUILD-up model for the COST OF EQUITY
The build-up model for estimating the cost of equity has four components:
- Risk-free rate
- A general equity risk premium
- A size premium
- A company specific risk adjustment.
- Possible, an industry adjustment factor
Why should the maturity of the risk free rate be about 10-20 years? (BUILD-UP model)
So that it matches with the duration of equity investments
Companies put specific assets in SPV:s. Mention the most important advantages for this? Use the Structured Finance Model discussed in class.
Better match between risk return profiles of assets and investors. By using an SPV, companies are in a better positions to offer specific assets with specific return profiles to specific investors.
Why is the quality of non-financial corporate issure ratings - from S&P and Moody’s - relativley poor compared to credit scoring models?
TTC methodology (focus on permanent component and prudent migration policy)
What do financial sponsors (PE firms) typically do?
Historically, almost all M&A activity has involved one operating firm aquiring another operating firm. In recent years however, financial sponsors have been growing in importance in aqusition activity. Financial sponsors (PE-firms) typically do:
- Raise large pools of equity capital from investors.
- Bid for and aquire operating firms using this equity capital they invest.
- change the operating companys management incentive scheme to give the management team a much larger than usual share of any shareholder wealth they successfully create.
- Replace operating companys board of directors with the general partners of the private equity firms who have a huge stake in the success of the business.
- Manage the aquired firm for optimum cash flow generation.
- Resell the aquired firm, in three to five years, hopefully for a large capital gain.
Why is bank debt mostly senior, and public debt mostly junior/subordinated?
- Bank is in a better position to take a monitoring role and look after the collateral and more strict covenants for senior debt.
- On public markets investors are mostly dispersed with little negotiating power (“take it or leave it”)
What is Overtrading?
Overtrading – also called undercapitalization, occurs if a company is trying to support too large a volume of trade from too small of a WC base.
Even if a company is operating profitably, overtrading can result in a liquidity crisis, with the company not being able to meet debt payments because the cash has been absorbed by growth I non-current assets, inventory and trade receivables.
Overtrading can be caused by a rapid increase in turnover, perhaps as a result of a successful marketing campaign where funding was not put n place for the necessary associated investment in non-current assets and current assets.
Strategies to deal with overtrading:
- Introduce new capital - likely injection of equity finance raither than debt, since debt payments also pressure liquidity
- Improving WC management - ex chasing overdue accounts
- Reducing musibness ctivity - allow time for its capital base to build up through retained earnings.
Indications that a company may be overtrading:
-Rapid growth in sales over a short period.
-Rapid growth in the amount of current assets, and perhaps non-current assets.
-Deteriorating iventory days and trade receivables days ratio.
-declining liqudity.
-Declining profitability.
Decreasing amount of cash or liquid assets.
There are three reasons why companies choose to hold cash:
- Transactions motive - companies need cash reserve in order to balance ST cash in and out flows.
- Precautionary motive - future cash flows are subject to uncertainty.
- Speculative motive - have cash for potential investments.
Main points of EXAM “Shortt erm finance and working capital management”
- The main objectives of working capital management are profitability and liquidity
- Short term sources of finance include overdrafts, short-term bank loans and trade credit
- Companies may adopt aggressive, moderate or conservative working capital policies regarding the level and financing of working capital
- The CCC can be used to determine the working capital requirement of a company as well as to help managers look for ways of decreasing the cash invest in current assets.
- Overtrading can lead to business failure and must be corrected if found. Corrective measures include introducing new capital, improving working capital management and reducing business activity.
- Because there can be significant amounts of cash tied up in inventories of raw materials, work-in-progress and finished goods, steps must be taken to question both the amount of inventory held and the time it is held for.
- The economic order quantity model can be used to determine an optimum order size and directs attention to the cost of holding and ordering inventory. However, there is a growing trend for companies to minimize the use of inventory.
- Cash may be held for transactions, precautionary and speculative reasons, but companies should optimize holding of cash according to their individual needs.
- Cash flow problems can be anticipated by forecasting cash needs, for example by using cash flow forecasts and cash budgets
- Surplus cash should be invested to earn a return in appropriate short-term instruments
- The effective management of trade receivables requires assessment of credit-worthiness of customers, effective control of credit granted and efficient collection of money due. Effective management of receivables can be assisted by factoring and invoice discounting.
How to invest surplus cash:
- Term deposits - deposit into bankaccount with interest.
- T bills
- Stering commerical paper
- Gilt-edged goverment securities.
What is supply chain finance?
A way to INCREASE working capital and REDUCE supply chain risk; SCF allows businesses to increase supplier payment terms and while giving them the option to get paid early.
Supply chain finance boils down to:
- Supplier submits an invoice.
- Buyer approves the invoice
- Supplier selects invoices for early payment.
- Funder receives and processes request and provides early payment to the supplier - Funder bridges gap.
- Once the invoice has matures, the buyer is instructed to pay funder/supplier.
What is supply chain finance?
Supply chain finance – also known as supplier finance or reverse factoring – is a set of solutions that optimizes cash flow by allowing buyers to extend supplier payment terms. Increasing the time it takes to pay a supplier improves several financial metrics (ex. Days payable outstanding or DPO), and most importantly, frees up cash that would otherwise be trapped inside the supply chain. A buyer can use increased cash flow to invest in operational, competitive and innovation initiatives that will drive additional growth. They can also return cash to shareholders in the form of dividends or stock repurchases.
Simultaneously, SCF offer suppliers a way to mitigate the effect of payment term extensions and to accelerate their own cash flow. Suppliers who participate in a program have the option to get paid early – typically as soon as an invoice has been approved by a buyer. The supplier can accelerate payment on some, all or none of their receivables, depending on their financial position and funding requirements. For those receivables that are paid early, the supplier will pay a small finance charge or discount.
All of this occurs without negatively impacting either companies’ balance sheets. Accounting treatment for SCF, does not count as additional debt for a buyer or supplier.
Furthermore, since the buyer is the obligated party, financing is offered to the supplier at rates that are typically more favorable because they are based on the buyer’s credit history and raiting. For many suppliers, this access to a lower cost of funding is exceptionally important.
SCF thus creates a win-win situation for both buyers and their suppliers. The buyers optimizes working capital because it has more time to pay suppliers. Meanwhile, suppliers can generate additional operating cash flow by getting paid early without affecting their balance sheet.
Two methods of SCF
- The extension of supplier payment terms. The buyer extends payment terms with all of its suppliers – for example from 60 to 120 days. This dramatic slowdown of cash outflow gives the buyer access to more working capital.
- The second tactic in SCF is a counterbalance to the first. The buyers gives selected suppliers the option to get paid early by selling their invoices to financial institutions (or funders). This offsets the negative impact of longer payment terms on suppliers, while still enabling the buyer to meet its cash flow optimization objectives.
SCF fördelar för buyers,supplier och funders
Buyer:
- Improved cashflow
- Stronger supply chain
- Optimized WC needs
Supplier:
- Improved cashflow
- Better visibility into accounts recievbles
- Discounted liquidity
- Off balance sheet funding
Funder:
-Good quality credit
Ratio Analysis - first understanding of the business by looking at financial ratios:
- Profitability ratios
- Efficiency ratios (WC)
- Leverage ratios (capital ratio, healthiness financial structure)
- Liquidity ratios (“running out of cash”)
- Coverage ratios
- Growth %
- Ratios with market value information
How to evaluate Business performance:
- Profitability, efficiency in use of assets
- Find key drivers of sales, cost structure and profitability (time series and cross section, peers)
- Find trends for extrapolation
- Find CA(P) (cross section relative to peers)
how to evaluate Financial performance:
Solvency, liquidity, overage ratios
Ratios only tell a story if:
- Benchmarked with sector peers.
- Compared with historical time series.
Ratios analysis is a first quick and dirty analysis of a company
•Ratios only tell a story IF
-Benchmarked with sector peers
-Compared with historical time series
•Separate out structural and incidental developments
•Be aware of accounting differences/changes in accounting practice
•Risk is (mostly) measured by deviations from sector averages
•Detect inconsistencies!
Profitability avg:
EBIT/TA =10%
NI/TA = 5,5%
EBITDA/TA = 13,5%
The CCC provides
insight in the financing need for working capital
Sectors with longest CCC
- Pharmaceuticals
- Electrical componens and equipment
- Building materials
- industrial diversified
sectors with shortest CCC
- Telecom
- consumer and household services
- oil
- transportation services
CCC =
DIO + DSO - DPO
DIO - Days Inventory Outstanding (hur länge varor är i lager innan de säljs)
DSO - Days Sales Outstanding (antal dagar innan kunder betalar fakturan)
DPO - Days Payable Outstanding (Hur långt innan man betalar sina fakturor)
Liquidity Management definition
“the key issues in liquidity management are how much to invest in each componenet of current assets and current liabilities and how to mange these investments effectively in order to minimize insolvency risk”
6 Liquidity ratios
- Cash ratio - (cash+liquid assets)/TA
- Liquidity level of current assets - Current ratio/Quick ratio
- The financing of WC (long term) - Net working capital
- The cash need in future - Liquidity flow index
- The surviving time period without cash inflow - Surviving time interval
- Probability “running out of cash” - Z-score
Cash ratio =
(cash + Liquid assets) / TA
Relative amount of cash and liquid assets
Current ratio and Quick ratio =
Current ratio = Current assets/Current liabilities
Quick ratio = (Current assets–inventories)/ Current liabilities
Both of these are for the liqudity level of current assets
Net working capital =
Current assets - Current liabilities
The financing of working capital (long term)
Liquidity flow index
=(cash + expected inflow - cash(t+1)) / expected outflow
= 1 - (borrowing need)/ expected outflow
The cash need in the future
Surviving time interval (days) =
(current assets - invetories) / daily cash outflow
The surviving time period without cash inflow
liquidity ratio: Z-score
Probability of “running out of cash”
Trends in WC/TA over time
Non financial companies have become less conservative in net working capital (ST financing risk increases)
- When excluding ST debt, the trend is more stable
- When excluding ST debt & Cash, we can see that WC/TA is a bottom level since 2005
Cash holding and Net WC differences between sectors
Cash/TA (mest och minst):
Industry = 18%
Service = 23,2%
Transport en utility = 6,3%
Net WC/TA(mest och minst):
Heavy industry = 35,2%
Service 24%
transport =5,1%
Cash budgeting (how its done in steps)
Understand the driver of WC before setting up a cash budget.
- Look at current situation - Compute CCC
- Financing - How is WC financed? What is net WC? Look at balance sheet!
- Look at trends - Compute chages in wc accounts and how these changes are financed
- Benchmarking - Compare WC ratios with peer (compareble firms in specific industry)
- Extra analysis - impact investments/reduction in WC on profitability
Formula for spread price for credit risk (from a banking perspective)
Spread = rental income R(L) - Funding costs R(F) Spread = epected loss + costs buffer K + operational costs (K is for unexpected losses) Spread = PD × LGD + K × shareholder expected return + operational costs Spread = PD × LGD + K(Basel I or Basel II) × 15% + operational costs (50bp)
