LDP 4.3 Discovering Borrowing Causes and Repayment Sources Flashcards
Borrowing cause vs. potential source of repayment
In the simplest terms, any increase in an asset or decrease in a liability or net worth account is a use of funds (borrowing cause), and any decrease in an asset or increase in a liability or net worth account is a source of funds (potential source of repayment)
Identifying sources of funds as permanent or temporary is important because it allows you to:
- Evaluate the risk of repayment because risk increases with time
- Structure realistic repayment periods
Borrowing Causes
1) Asset Inefficiency
2) Sales Growth
3) Fixed-Asset Expenditures
4) Change in Trade Credit
5) Decrease in Net Worth
1) Asset Inefficiency - Borrowing cause
- Determine: if efficiency has declined
- if the decline is temporary or long-lasting
- realistic sources of repayment
Estimating Increases in A/R and Inventory Due To Asset Inefficiency
Increase in Days’ Sales in A/R x Average Daily Sales = Increase in A/R: 5 x 20,000 = $100,000
Increase in Days’ COGS in Inventory x Average COGS = Increase in Inventory: 3 x 15,000 = $45,000
2) Sales Growth - Borrowing cause
When sales increase, typically a company’s current assets, especially accounts receivable and inventory, increase.
Estimating the Effect of an Increase in Sales - On accounts receivable
On accounts receivable:
Sales in Current Year / Sales in Prior Year
= Sales Growth Factor
Sales Growth Factor x Previous Receivables = Effect of Sales Change
Effect of Sales Change – Previous Level of Receivables = Suggested Sales-Related Change
Actual A/R Change – Suggested Sales-Related Change = Nonsales-Related Change
Estimating the Effect of an Increase in Sales - On Inventory
On inventory:
COGS in Current Year / COGS in Prior Year
= COGS Growth Factor
COGS Growth Factor x Previous Inventory = Effect of COGS (and generally, Sales) Change
Effect of COGS (and Sales) Change – Previous Amount of Inventory = Suggested Sales-Related Change
Actual Inventory Change – Suggested Sales-Related Change = Nonsales-Related Change
3) Fixed-Asset Expenditures - Borrowing cause
Lending to finance fixed-asset acquisitions often involves large sums and long repayment periods.
Fixed-asset expansions often trigger related but unanticipated additional borrowing needs, such as:
- Set-up and installation of new equipment
- Out-of-pocket costs and lost production time when moving to a new building
- Distraction of management from other tasks - Increase in inventory
- Capacity increases that lead to sales increases
- Increased property maintenance expense
4) Change in Trade Credit - Borrowing cause
- Changes in terms offered by trade creditors can be either permanent or temporary, requiring long- or short-term sources of funding. However, most changes in trade terms are permanent.
- A reduction in terms usually happens too quickly to permit a company to replace the payables with internally generated funds.
- A company may choose to permanently shorten its accounts payable payment time to take advantage of suppliers’ discounts.
For manufacturers, measure the number of days’ purchases in accounts payable:
Accounts Payable x 365 / Purchases
= Days’ Purchases in Payables
For wholesalers, distributors and retailers, measure the number of days’ COGS in accounts payable:
Accounts Payable x 365 / COGS
= Days’ COGS in Payables
5) Decrease in Net Worth - Borrowing cause
Loans caused by decreases in net worth carry additional risks for three reasons:
- Decreases in net worth diminish a company’s resources, which may damage a company’s capacity to generate repayment. They do not “reverse” or carry the seeds of their own repayment.
- Repayment usually depends on change rather than continuation of a trend.
- Replacing net worth with debt has a double impact on leverage. The increase in leverage weakens the lender’s margin of protection in asset values.
Repayment Sources
1) Improving Asset Efficiency
2) Leveling-off of Growth, or Sales Decline
3) Sale of Noncurrent Assets
4) Increase in Trade Credit
5) Increase in Net Worth
