Part 3. Sources of Capital

Question 1

Internal financing and liquidity from ST operating activities:

Answer 1

• Generating more after-tax operating cash flow.
• Increasing working capital efficiency such as extending company’s payables period, reducing receivables period, or shortening its asset conversion cycle.
• Converting liquid assets such as receivables, inventories and marketable securities to cash.

Question 2

Operating cash flows

Answer 2

The company’s after-tax operating cash flows less interest and dividend payments (adjusted for tax) used to invest in assets, and equal to net income plus depreciation charges minus dividend payments.

Higher value = greater ability to internally finance itself.

Question 3

Accounts payable

Answer 3

The amounts due suppliers of g/s that have not been paid.

Arise from trade credit, financing purchase by delaying date on which payment is made.

Discount from purchase price is allowed if payment received within specified number of days; otherwise full amount is due by specified date.

Question 4

Accounts receivable

Answer 4

The amounts owed by customers.

Business prefer to delay paying what they owe, but prefer to receive what is owed to them as quickly as possible.

The sooner a company can collect what is owed, the lesser its need to finance its operations some other way.

Question 5

Inventory

Answer 5

A current asset on the balance sheet.

Company preference not to put a lot of money into inventory when money could be used for more productive means.

The longer inventory remains unsold, the longer that money is tied up and not usable for other purposes.

i.e. efficient company holds little inventory; just in time inventory system - not sit in storage

Sold inventory, mean purchase amount moves into accounts receivable, and money becomes available once customer makes payment.

Question 6

Marketable securities

Answer 6

Financial instruments such as stocks and bonds, that can be quickly sold, and converted to cash.

Listed as current asset as company intends to liquidate them within a year.

Earn a rate of return greater than what they would earn by holding cash.

Question 7

Uncommitted lines of credit

Answer 7

The least reliable form of bank borrowing, given for an extended period of time, but reserves the right to refuse to honour any request for use of the line.

Very unstable, and only as good as the bank’s desire to offer it.

Question 8

Committed lines of credit

Answer 8

The form of bank line of credit that is more reliable because of bank’s formal commitment, verified through an acknowledgement letter as part of the annual financial audit, footnoted in company’s annual report.

In effect for 364 days, for a year or longer banks require more capital.

Require commitment fee to lender, typically a fractional percent (e.g. 0.5%) of full amount or unused amount of line, depending on bank-company negociations.

Question 9

Revolving credit agreements

Answer 9

The most reliable form of ST bank borrowing; involves formal legal agreements that define the aspects of agreement.

They are often used for much larger amounts than regular line; spread among more than one bank.

Question 10

Secured loans

Answer 10

Loans which lender requires the company to provide collateral in form of asset; such as fixed asset owned by company, high quality receivables and inventory.

• factor arrangement = company shifts the credit granting and collection process to lender or factor.
• assignment of account receivables = use of receivables as collateral for a loan.

Question 11

Web based lenders

Answer 11

Operate primarily on the internet, offering loans in relatively small amounts to small businesses in need of cash.

Question 12

Commercial paper

Answer 12

A ST, unsecured instrument issued by large well-rated companies, with no specific collateral.

These are sold to investors directly and through dealers.

Avoid regulation costs, maturities for CP range from few days up to 270 days.

Low risk investment for investors due to its ST nature, creditworthiness of borrower, and back-up line of credit.

Question 13

Long term debt

Answer 13

This has the maturity of at least one year.

Bonds tend to be risker in IR and credit risk than notes or money market instruments.

Investors (bond lenders) and companies (bond borrowers) agree to bond covenants; detailed contracts specifying the rights of lender and restrictions of borrower.

Covenants regulate the company’s use and disposition of assets, restrict ability to pay dividends and restrict ability to issue add. debt that may dilute value of bond.

Public and private debt are negotiable; but public is approved for sale in open markets.

Question 14

Common equity

Answer 14

This represents ownership in a company, considered a more permanent source of capital.

Receive dividends, and entitles to residual value of assets if company dilutes.

Question 15

Preferred equity

Answer 15

These are hybrid securities issued by companies having characteristics of bonds and common equity.

Dividends on preferred shares are fixed, but can be variable, but not a tax-deductible expense for company.

In business failure, bondholders have seniority over preferred shareholders on assets and cash flows, and seniority over common shareholders.

Question 16

Other hybrid securities

Answer 16

Convertible debt and convertible preferreds; convertible into a fixed number of companies’ common shares.

If share price rises sufficiently, convertible owners may choose to convert their security to common stock, given the appreciation in value of investment.

Question 17

Leasing obligations

Answer 17

The purchase of asset and financing are bundled instead of being separate transactions.

The lease is a debt instrument where asset owners gives another party the right to use the asset; who agrees to make a set of contractually fixed payments.

Question 18

3 dominant sources of external financing:

Answer 18

1. Capital markets
2. Large commercial banks
3. Sovereign state

Question 19

Liquidity

Answer 19

The extent to which a company is able to meet its ST obligations using cash flows and those assets that can be readily transformed into cash.

2 dimensions:

1. the type of asset
2. the speed at which asset can be converted to cash; either by sale or financing.

Question 20

Primary sources of liquidity

Answer 20

• Free cash flow - the firms after-tax operating cash flow less planned ST and LT investments.
• Ready cash balances - cash available in bank accounts resulting from payment collections, investment income, liquidation of near-cash securities, and other cash flows.
• ST funds; include items such as trade credit, bank lines of credit and ST investment portfolios.
• Cash flow management; the company’s effectiveness in its cash management system and practices, and degree of decentralisation of collections or payment processes.

Question 21

Secondary sources of liquidity

Answer 21

This may result in change in companies financial and operating positions:

• Negotiating debt contracts, relieving pressures from high interest payments, or principal repayments, and negotiating contracts with customers and suppliers.
• liquidating assets; depends on level of substantial loss in value.
• filing for bankruptcy protection and reorganisation.

Question 22

Drag on liquidity

Answer 22

When the receipts lag, creating pressure from decreased available funds.

Question 23

Pull on liquidity

Answer 23

This is when disbursements are paid too quickly or trade credit availability is limited, requiring companies to expend funds before they receive funds from sales that could cover liability.

Question 24

Major drags on receipts include:

Answer 24

• Uncollected receivables
• Obsolete inventory
• Tight credit

Question 25

Major pulls on payments include:

Answer 25

• Making payments early
• Reduce credit limits
• Limits on ST lines of credit
• Low liquidity positions

Question 26

Liquidity ratios

Answer 26

Used to measure a company’s ability to meet ST obligations to creditors as they mature or come due.

Focuses on relationship between current assets and current liabilities; and rapidity in which receivables and inventory can be converted into cash during normal business operations.

Question 27

Activity ratios

Answer 27

This measures how well key current assets are managed over time.

Use info from income statement and balance sheet to help tell story of how well a company is managing its liquid assets.

Applications:

• Performance evaluation
• Monitoring
• Creditworthiness assessment
• Financial projections

Ratios only useful when compared; 1) comparisons over time for same company, 2) comparisons over time for the company compared with its peer group.

Question 28

Major objectives of ST borrowing strategy include:

Answer 28

• Ensuring sufficient capacity exists to handle peak cash needs.
• Maintaining sufficient sources of credit to fund ongoing cash needs.
• Ensure rates obtained are cost effective and do not substantially exceed market averages.

Question 29

Factors that will influence companies ST borrowing strategies:

Answer 29

• Size and creditworthiness
• Legal and regulatory considerations - regulated companies such as utilities and banks may be restricted in how much they borrow and kind of borrowing they engage in.
• Sufficient access; diversify borrowing sources
• Flexibility of borrowing options - ability to manage maturities efficiently; no big days when significant amounts of loans mature.

Question 30

Borrowing strategies:

Answer 30

1. Passive

• minimal activity
• reactive in responding to immediate needs of liquidity
• Steady; often routine rollovers of borrowings for same amount of fund each time, without much comparison shopping.
• Borrowing is restricted, limited to 1 or 2 lenders by agreement.

2. Active
   - More flexible and reflect planning, reliable forecasting and comparison pricing.
   - Borrowers more in control, not fall into rollover trap.
   - Matching strategies; loans scheduled to mature when large cash receipts are expected.