D. Managing cash and working capital Flashcards
Where can entities obtain short term finance?
- commercial and corporate banks
- non-banking fin institutions e.g short term loan providers
- trading partners
What are commercial and corporate banks?
- provide financial products to customers for profit
- accept deposits and provide loans/overdrafts
What are non-financial institutions?
- main operating activity is not to provide finance
- use surplus cash to invest in shares/debentures
How can trading partners help with finance?
- formal trade agreement
- between exporters and importers
- topical for Brexit
What are the main types of short-term finance?
- TP
- factoring or invoice discounting of TR
- bank overdrafts and short-term loans
- financing exports
How can trade payables be used as a source of short-term finance?
- delaying payment
- ‘fund’ inventory through suppliers
- to max benefit, pay as late as possible
- weigh discount against cost of borrowing
Benefits of paying suppliers late?
- alleviated cash flow difficulties
- cash can earn a return
Problems when paying late?
- loss of settlement discount
- poor credit rating
- supplier may stop further supplies
- increase in future selling prices
- legal action
What is one of the benefits of trade credit?
no interest cost
- may charge interest once deadline has passed, unlike banks
- supermarkets use:pay when good is resold
What is factoring?
take on responsibility to collect debt by offering 3 services:
- debt collection:credit control
- financing:funds provided before debt is collected
- credit insurance:take responsibility for irrecoverable debt
What is invoice discounting?
- provided by factoring entity
- sell unpaid invoices to lender
- confidential service
What are the benefits of bank overdrafts as short-term cash requirement?
- flexible
- only pay for what is used, so generally cheaper
What are the disadvantages of bank overdrafts as short-term cash requirement?
- repayable on demand
- may require security
- variable finance costs
What are bank loans?
- contractual agreement for a specific fund, period and interest rate
- less flexible than overdraft
- provide greater security than overdraft
What are some methods available for dealing with the problems of financing exports and controlling the credit risk?
- bills of exchange
- forfaiting
- export factoring
- documentary credits
What are documentary credits?
- letter of credit from issuer
- guarantees payment for exporter, provided exporter complies with certain requirements
- document issued by bank and authorises foreign exporter to withdraw money when conditions are met
What is a bill of exchange/acceptance credit?
- binds one party to pay another on a fixed date
- similar to post-date cheques
- supplier (drawer) can draw a bill of exchange on customer (drawee)
- customer signs and acknowledges the debt exists and commits to paying it
What are the two types of a bill of exchange?
- a slight draft/bill-payable immediately
- a time draft/bill-predetermined date of payment
How can a time draft help with financing?
holder of the bill can use an accepted time draft to pay a 3rd party debt or can discount it to raise cash
What is a significant characteristic of bills of exchange?
- drawee given a period of credit before having to pay a term bill
- drawee/payee can obtain payment earlier than the bill’s maturity date by means of discounting bill
What happens when a bill of exchange is discounted?
- sold to financial markets at a discount to face value
- size of discount reflects the rate of interest that the buyer of the bill required from holding bill to maturity
What is export factoring?
- factoring organisation agrees to factor the client’s export
- factor’s services include admin of the receivables ledger and collecting payment and factor finance
- factor buys overseas receivable for a lump sum < debt
- factor expertise can be helpful, especially for SMEs
What is forfaiting?
- same as export factoring but seller will receive 100% of receivable as a lump sum
- exporter draws up bill of exchange from an importer
- bill of exchange is purchased by forfaiting comp (typically banks) without recourse to exporter
- exporter received total amount owed, forfaiter chases debt directly
- exporter has obtained payment for the goods without risk
What are the key features of forfaiting?
- importer obtains medium-term finance for much of the purchase cost of the goods
- exporter receives immediate payment
- credit risk is accepted by the forfaiting bank, although the risk is reduced by the guarantee of the promissory notes (bille of exchange/acceptance credit)
Why might a business make short-term investments?
- money in day account makes no interest
- can maximise profits if they gain returns
What are some short-term interest-earning investments cash surpluses can be spent on?
- interest-bearing bank accounts
- negotiable instruments
- short-dated government bonds
- other short-term investments
What criteria should be considered when making investment decisions?
- maturity
- return
- risk
- liquidity
- diversification
What is maturity?
short-term investment interest received on ‘maturity’
What is a return?
interest yield on investment
What is risk a business should consider when investing?
-high risk, high return e.g shares
What is liquidity of investment?
how easily investment can be cashed in without significant loss of value
- short term are less liquid than keeping in bank
- art is illiquid and long term investment
How essential is diversification of investments for short term vs long term investments?
-less essential for investing short-term cash surpluses than long-term in equities and bonds
What are the two types of interest bearing accounts?
- bank deposit accounts
- money market deposits
What is a bank deposit account?
- some are instant access, highly liquid
- some allow withdrawal without notice
- some require notice period before withdrawal
What is a money market deposit?
amounts of money deposited through a bank in the money markets
- markets for short term borrowing and lending
- attractive interest yields
- cant be withdrawn until deposit matures
- short term investments should be large amounts to reap benefits
Interest earned calculation?
amount deposited x annualized interest rate x (number of days interest earned/annual day count)
What are negotiable instruments?
financial instruments that may be obtained as investments
-can easily be sold by one person to another
What are some examples of negotiable instruments?
bank notes bearer bonds Certificates of Deposit bills of exchange treasury bills
What are the most negotiable instruments as short-term investments
Certificates of Deposit
Treasury bills
bills of exchange
What is a Certificate of Deposit?
- evidence of a short-term deposit with a bank for a fixed term and earning a specified amount of interest
- amount is 100k<
- holder of the CD at maturity has the right to take the deposit with interest
- present to a bank who will collect it from bank holding instrument
- cant withdraw before maturity
- can sell CD if cash is needed early
What are investment yields on CDs?
- CDs are negotiable instruments
- can be sold unlike money market deposits
- therefore, yields are slightly lower on CDs
Bills of exchange as negotiable instrument?
- discount market is active money market for bills
- investor can buy bills
- eligible bank bills are payable by top quality banks
What are treasury bills?
- maturity of less than a year (most have 3 months)
- used by govt for short-term cash requirements
- have high credit quality, low risk and yield as govt backed
- redeemable at face value
- attractive as they are risk-free and liquid
- there is a large and active secondary market
What are the features of investing in government bonds?
- interest received on the due payment dates
- can liquidate their investment at any time by selling the bonds in the secondary market
- bonds are short-date when purchased, they can hold the bonds to maturity and have them redeemed at par
What are the risks of government bonds?
- price ricks:esp for longer-date bonds
- if market interest rate increases/decrease , value will fall/rise
Which short-term investments are more likely to be purchased by investment institutions rather than by entities with a short-term cash surplus?
corporate bonds commercial paper (CP)
What is a corporate bond?
- bonds issues by an entity
- long-term investments, high risk
- fluctuate with interest rates
- affected by perceived credit risk of issuer
What is a commercial paper (CP)?
- short-dated negotiable debt instruments
- issue by entity
- sold by bank managing entity’s CP programme
- generally negotiable and purchased by large investment institutions and held to maturity
- not suitable for short-term investment of cash surpluses by a trading entity
What is working capital?
capital available for conducting the day-to-day operations of an organisation
-excess of current assets over current liabilities
What is working capital management?
all aspects of both current assets and current liabilities, to minimise the risk of insolvency while maximising the return on assets
What are the costs of investing in working capital?
- cost of funding it
- opportunity cost of lost investment opportunities because cash is tied up and unavailable for other uses
What is the main objective of working capital management?
get the balance of current assets and current liabilities right: cash flow vs profits trade off
What are some consequences of poor working capital management?
- cant pay bills
- demands on cash during periods of growth being too great (overtrading)
- over-stocking or stock-outs
What is the trade off between cash flow and profit?
cash can help with low profit, profit can help with low liquidity
- purchase of NCA for cash
- sale of goods on credit
- timing of tax payment
What is the trade off between profitability and liquidity?
when an entity is able to improve its profitability but at the expense of tying up cash:
- receiving bulk purchase discount for buying unnecessary amount of inventory
- offering customers credit
- early settlement discount to customers
What are the main sources of liquidity?
- cash in the bank
- short-term investments that can be cashed in easily
- cash inflows from normal operations
- overdraft facility
What is the working capital cycle?
length of time between the entity’s outlay on raw materials, wages and other expenditures and the inflow of cash from the sale of goods
-time span between incurring production costs and receiving cash returns
How is the working capital cycle calculated?
cash operating cycle = inventory days + trade receivable days - trade payable days =working capital cycle
If firms can ‘push’ items around cycle, what does this mean for the investment in working capital?
the lower the investment will be
How does the firm’s investment in working capital gradually increase?
first only in raw materials
then in labour and overheads as production progresses
this investment must be maintained until TR
-can reduce investment by taking credit from suppliers
What factors affect the length of the cycle?
- liquidity vs profitability decisions
- management efficiency
- industry norms e.g retail vs construction
What is the optimum level of working capital?
amount that results in no idle cash or unused inventory but does not put a strain on liquid resources
How does the nature of a business affect the length of the working capital cycle?
- supermarket chain will have low or negative cycle as they have few credit customers, high inv turnover and can negotiate long credit periods with suppliers
- construction entity will have long cycle as their projects are and bulk of cash is received at the end of the project
If sales increase and the length of the cycle stays the same, what happens to the funds needed?
increase proportionate to activity
If length of cycle increases and sales stay the same, what happens to the funds needed?
increase proportionate to length of cycle
What are the factors that affect the amount required to invest in working capital?
- industry
- type of products sold:perishables, low inv
- whether products are manufactures or bought in: manu, high raw mat and WIP
- the level of sales:if high, high receivables
- policies towards working capital management:diff strategies
What should entities ensure they have during periods of uncertainty?
minimal level of cash and inventories based on expected revenue plus an additional safety buffer
What factors impact the working capital investment levels?
- nature of business
- uncertainty in supplier deliveries
- overall level of activity of the business
- entity’s credit policy
- length of the working capital cycle
- credit policy of suppliers
What are the 3 possible working capital management policies?
aggressive, conservative, moderate
What is an aggressive working capital management policy?
reduce costs by holding low capital
- produces shorter operating cycle
- greater risk of illiquidity
- greatest returns
- short-term finance sourced
What is a conservative working capital management policy?
- reduce risk through higher levels of cash, inv and rec
- produces long operating cycle
- risk such as stock-outs or liquidity problems are low but costs are increased
What is a moderate capital management policy?
middle ground between aggressive and conservative approaches
What are the benefits of a more conservative approach?
- lower risk
- higher cost in terms of money tied up in working capital
- lower liquidity risk
- can meet changes in demand
- more relaxed credit policy
What was the traditional pattern of current assets?
fluctuating, originally with seasonal pattern
- financed out of short-term credit
- NCAs on long-term credit
- simplistic view
What are the risks to a borrower of short term finance?
renewal problems-continually renegotiated
stability of interest rates-mercy of fluctuations
How does an aggressive policy finance variable and a portion of fixed working capital?
through short term finance
How does a conservative approach finance all permanent and current assets?
long-term financing
-only use short-term financing for fluctuating current assets
What type of finance do moderate policies use?
- short-term finance for fluctuating current assets
- long term finance for permanent current assets and on current assets
What does healthy trading growth lead to?
- increased profitability
- need to increase investment in non-current assets and working capital
What is overtrading?
when a business does not have sufficient capital to fund the increase in profitability or investment
-resources surpassed by activity
What are some indicators of overtrading?
- rapid increase in turnover (revenue)
- rapid increase in the volume of current assets
- most of the increase in assets being financed by credit
- dramatic drop in liquidity ratios