Midterm #1 Flashcards
What is the short-term financial management area of corporate finance and the objective?
ensures firm liquidity by optimizing cash flows and monitoring variability.
Objective- speed up the conversion of revenues into cash flow and optimize cash disbursements
Short-Term Financial Management definition
the utilization of the firm’s current assets and liabilities to maximize shareholder wealth
Current accounts include (also known as working capital)
(1) Financial assets
(2) ST operating assets
(3) ST operating liabilities
cash management
Monitoring and reporting of daily cash receipts and disbursements and forecasting future short term cash flows
Liquidity management
management of daily cash flows to ensure that the firm has the ability to meet its financial obligations when they are due.
*Liquidity is a necessary condition for firm value maximization.
How do we determine the firm’s liquidity and what is it?
(1) cash conversion process
(2) timing of inflows and outflows of cash from operation
* cash position must be carefully maintained to ensure liquidity
Cash conversion cycle
metric to gage efficiency of cash conversion process
A firm is solvent when
when assets exceed liabilities meaning they have positive equity or net worth
Solvency is important to creditors due to
concerned with the ability of borrowers to raise enough cash from the liquidation of assets to meet their liabilities if negative cash flow shocks were to occur
-useful due to being concerned with default risk ( bank giving line of credit to firm)
Current Ratio
is the degree of coverage that CA provide to short term creditors
Quick Ratio
degree of coverage for CL provided by cash holdings and receivables
Net working capital provides
provides insights on financing strategy, is related to LT financing
WCR = Working Capital Requirement
examines solvency from the perspective of spontaneously generated sources and uses of funds
cash conversion cycle CCC is
avg number of days it takes to make and collect on a sale after accounting for the spontaneous financing from A/P
-Longer CCC => less efficient ST financial management and increased reliance on external financing to fund operations
Long Cash conversion cycle affect
- reduces firm liquidity
- depend more on external financing to fund operations due to taking 105 days to collect sale
- leads to higher interest expense ( borrowing on credit line)
Using cash conversion cycle to evaluate liquidity drawbacks
- averages across all goods sold
- Does not reflect actual time-to-cash conversion rates for each good sold
- May deviate substantially from the average
- negative CCC is possible
Days’ Cash Held (DCH)
how long a firm can cover its daily costs without receiving liquidity from operations or external financing
Lambda (λ)
- Matches cash disbursements with cash receipts
- dynamic measure capturing on going changes in liquidity.
Lambda facts
- number of standard deviations in daily net cash flow that the expected liquid reserve can withstand
- As lambda increases liquidity risk drops
- std captures both positive and negative deviations
- Higher dispersion around the mean=more variability
- used to estimate the likelihood that the firm will remain liquid.
Lambda λ is a tool
- to determine the liquid reserve required to decrease liquidity risk to an acceptable level
- Managing liquidity by increasing the availability on corporate lines of credit: management wants an expected liquid reserve to cover three standard deviation movements in daily net C/F
Complex aspects when it comes to assessing firms liquidity with Lamdba
- involves unique data requirements
- assumes daily net cash flows are normally distributed
- Data typically suffers skewness or kurtosis
Main concept with cash conversion cycle (CCC) when positive
the longer the CCC the more financing is required for inventory and receivables; a lengthening cycle could signal liquidity issues.
banks provide
- Safety and soundness of financial system
- Financial Market Confidence
- Consumer Protection
- Bank have Federal or State Charter
BankingAct (1933) Glass-Steagall Act (after Great Depression)
-prohibited banks from underwriting commercial securities and prohibited securities firms from taking deposits and traditional banking activities
this created limitations to scope lead to fragmentation of banking sectored) investment banks and credit unions
(1) Financial Institutions Reform, Recovery and Enforcement Act (FIRREA, 1989)
(2) Financial Services Modernization Act (FSMA, 1999) Gramm- Leach-Billey Act
(3) McFadden Act (1927)
(1) FIRREA -allowed bank holding companies to buy savings and loans associations
(2) FSMA - allowed banks to affiliate with investments and insurance firms which allowed banks to conduct insurance and securities activities through financial subsidiaries.
(3) McFadden Act- allowed a national bank to operate branches to the extent permitted by state governments or state banks in each state.
(1) Bank Holding CompanyAct (1956)
(2) St.Germain Depository Institutions Act(1982)
(3) Interstate Banking and Branching EfficiencyAct (IBBEA, 1994)
(1) bank holding- prohibited interstate acquisitions by holding companies ( with exception)
(2) reduces the cost of Government bailouts of troubled institutions and allowed for interstate acquisitions of failed or failing banks or thrifts
(3) permitted bank holding companies to acquire banks located in any state (interstate banking) and permitted bank mergers across state lines
DDA: Demand Deposit Account def
Checking account allows account holders to deposit collected funds as well as make disbursements
Corporate was able to receive earnings on credit allowance or interest income in demand deposit accounts- this used to be prohibited in regulation Q of 1933 banking act
how was it repealed?
Repealed in Wall Street Reform and Consumer Protection Act (2010) the Dodd-Franck Accord
Times deposit accts and concurrent accts
money market accounts and certificates of deposit
What is a FX service?
-Firms engage in international B2B tranactions
1-Transfers of payments FX in DDAs (cheq)
2- Facilitate FX deposits held in other currencies or location 3-Allow multi-currency account payments in different countries
What is a financial derivatives?
reduces the adverse effects of changes in financial market conditions ex) futures and options in order to counter FX risk or variable rate debt
Commercial letters of credit
- importer’s bank guarantees that payment is made in full and on time.
- documentary collections and commercial letters of credit reduce risk aversion associated with new trade relationships with non-domestic partners
When choosing a banking partner you need to consider- (3)
(1) Counterparty risk- risk that the counter party to a contract will not meet it’s obligation on a timely basis = therefore if bank fails, then it is the only bank of your firm.
(2) Operational risk- losses from procedures and policies ex) fraud
(3) Financial risk- liquidity shortages of insolvency
Once you choose a bank- documentation phase begins (4)
(1) account resolution- contract between firm and bank (who can open and close acct
(2) signature card
(3) service agreements
(4) statements of beneficial ownership ( monitor client transactions and conduct due diligence)
account analysis statement
periodic bill for the treasury products and services purchased by the firm from banks.
RRR = Reserve requirement rate
portion of deposits that Fed Reserve mandates the bank must hold for liquidity purposes
- reduces earnings on deposits
- low RR- more money available for lending
The Fed provides several services ( for US)
(1) lending to banks through the discount window and serving as lender of last
(2) regulating and supervising banks,
(3) facilitating payments mechanisms.
Depository institutions Deregulation and Monetary Control Act 1980 (DIDMC A)
- Being a member of the Fed is a requirement for all national banks
- Required a reserve amount ( around 10%)
Organization of fed
(1) 7-member Board of Governors appointed by the President and confirmed by the Senate
(2) Fed encompasses 12 district banks: Federal Reserve Banks
Association of financial professionals (AFP) (6)
- Average ledger balance (daily ending per month)
- Deposit Float
- Collected Balance
- reserve requirement ratio for liquidity
- Earnings credit rate
- Service charges
Why is inventory important?
- Inventory is essential for revenue generation and market share growth
- when organizations decrease inventory- shorter CCC and reduces expenses
Inventory management definition
seeks to balance the costs and benefits of carrying inventory (occurs outside the finance department)
3 types of inventory- each inventory component would reduce the likelihood of delays in production or sales:
(1) Raw Materials RMI- Goods required for the initial production process (ex scrap metal to make automobile frames)
(2) Work-In-Process WIP- Not yet completed, one is input to in product line ex-car engine is WIP
(3) Finished Goods FGI- Ready for sale or transit ex) completed automobiles
Why would companies hold inventory?
(1) Transaction Motives- To meet customer daily expected customer demand
(2) Speculative Motives- To take advantage of changes in competitive conditions within the industry
(3) Precautionary motives- variability in the price of inputs or supply or Price of raw materials is variable in the future (holding extra inventory just incase)
costs of holding inventory?
- Inventory is held to meet unpredictable customer demand.
- costly ex) storage expenses, interest payments or can be damaged before its sold
What are the two direct costs associated with inventory levels?
(1) Ordering Costs - receipt, inspection, returns, processing,
shipping/delivery/transportation
(2) Holding (Carrying) Costs – Opportunity cost, interest expense, labor, tracking, storage insurance, utilities, security, taxes, etc
What is the economic order quantity model?
helps firms determine the optimal inventory level that minimizes total costs.
Inventory decisions should be based on:
• The cost of ordering and holding inventory
• Try to find the optimal balance between higher quantities or decreased number of orders placed but higher holding cost
what is balance fraction?
- Approach to monitor inventory
- it shows the proportion of each month’s purchases remaining as inventory at the end of a given month
- lower value= more efficient
what is trade credit?
- the provision of goods (or services) by a seller to a buyer on delayed payment terms.
- essential source of ST-financing
- strategic tool to attract buyers from rivals BUT it is costly for the supplier
what is the opportunity cost of funds?
- Extension of trade credit results in higher interest expense
- Seller cannot use the cash from credit sales to repay ST debt or purchase ST securities
types of costs (4)
(1) Cash discount- Credit terms: 2/15 net 60 which means
Receive a 2% discount taken from the invoice value if cash payment is made within 15 days, otherwise pay full invoice within 60 days
(2) Cash discount
(3) bad debt expense- report on income statement which is an estimate of the proportion of credit sales that are considered uncollectable
(4) administrative costs
what are the benefits of extending trade credit?
- Buyer demand increases because:
(1) Marketing: trade credit promotes awareness of seller’s goods and services
(2) Liquidity: buyers with cash or financial constraints allows sales otherwise not possible
(3) Quality guarantee: buyer can assess the goods received before making payment
how do we optimize trade policy?
(1) Aggressive policy: Seller attempts to increase revenues by lengthening credit periods and granting credit to less creditworthy buyers.
(2) Restrictive policy: Lowers the carrying costs of receivables. (more sales can be lost this way)
what do cash discounts offer
- Offer cash discount to customers in exchange for earlier PMT.
- improves sellers liquidity and reduces the opportunity cost
When choosing a credit policy, we need to determine-
(1) Minimum credit standards
(2) Maximum credit limits
(3) Optimal credit terms
(1) min- the minimum level of creditworthiness required by a credit applicant to receive trade credit
(2) credit limit- the amount
(3) terms- specify credit terms
What are the 5C’s of credit?
(1) Character
(2) Capital
(3) Capacity
(4) Conditions
(5) Collateral
what are the tools for monitoring receivables
DSO, aging schedules and balance pattern
ST financing instrument for receivables
1) Asset-based lending
2) Securitization: issue ST securities backed by receivables
3) Captive Finance Company: establish a subsidiary that obtains financing for receivables of credit sales
4) private label financing- third party source
5) third party financing- financing with financial institution\
6) card PMT
7) Factoring- getting immediate PMT
8) supply chain finance-
4 steps in the payment process
1) Providing payment instructions
(2) Generating a payment
3) Clearing the payment
4) Settlement of funds:
Paper check clearing process
1- Federal Reserve System: (most popular)
2- Correspondent Banking
3- Clearinghouse: representatives meet at a central location to settle balances collectively
4- Direct Presentment: deliver checks to payor bank by courier, most expensive
ledger balance vs collected balance
Ledger Balance= all credits and debits posted to an account at a certain point in time (including provisional credit items)
Collected Balance= funds that the payee can spend without over drafting the account
Deposit Float= diff between Ledge and Collected Balance
Disadvantages and advantages of the automatic clearing house (ACH)
- lowers processing costs and provide additional payment-related information and enhances liquidity
Disadvantages: up-front investment in information technology
real-time gross settlement system RTGS
- Offer immediate and irrevocable value transfer between payor and payee
- Banks of payor and payee are simultaneously debited and credited
- also known as wire transfer
Pull payment (wire)
reversing wire transfer
what is a letter of credit used for
-finance purchases
-a guarantee of payment by the buyer’s bank
• The bank(s) becomes a bridge between the buyer and seller assuring that various parties fulfill their obligations
-provider of LOC is the issuing bank
most common associated with ST
treasury
least likely controlled by treasury
purchasing
motives for holding cash refers to managers’ ability to take advantage of unexpected positive NPV investments as they arise
speculative motive
Restrictive assumptions used to develop and use the basic EOQ model include all of the following except:
A. a constant cost of holding each unit of inventory
B. an accurate inventory demand forecast
C. a constant rate of inventory usage
D. a variable order cost per order
d
Which of the following are advantages that credit sellers have over banks?
A. Control advantage
B. Information advantage
C. Information advantage and control advantage
D. None of the given choices
c
_______________ is NOT an electronic means to transfer payments.
Time drafts
EDTs
ACH
Wire transfers
time drafts
