Unit 8: Activity Measures and Financing Flashcards
1
Q
Activity Ratios
(Definition)
A
- Activity ratios measure how quickly two major noncash (inventories and receivables?) assets are converted to cash
- The term can include several ratios that can apply to how efficiently a company is employing its capital or assets.
2
Q
Receivables
(Accounts Receivable Turnover
&
DSO)
A
-
Accounts Receivable Turnover
- FORMULA : Net credit sales (NET CREDIT SALES=ACHTUNG ON QUESTIONS) / Average Accounts Receivable
- A higher turnover implies that customers may be paying their accounts promptly, and VICE VERSA.
-
Days sales outstanding
-
FORMULA (D/S = T): Days in year (360 ,365, etc) / accounts receivable turnover
- Days’s sales can be compared with credit terms to see if client is paying within the payment terms.
-
FORMULA (D/S = T): Days in year (360 ,365, etc) / accounts receivable turnover
3
Q
Inventory Measures (Inventory Turnover)
A
-
INVENTORY
-
Inventory Turnover
- Formula: COGS / Average Inventory
- A high turnover implies strong sales or that the firm may be carrying low levels of inventory, and VICE VERSA (obsolete inventory).
- Spoilable items should have a higher inventory turnover over other commodities.
-
Days sales in inventory
- FORMULA: Days in year (360 ,365, etc) / inventory turnover
-
Inventory Turnover
4
Q
Payable (Accounts Payable Turnover)
A
-
Accounts Payable Turnover
- FORMULA : Net purchases / Average Accounts Payable
- A higher turnover implies that firm is taking less time to pay suppliers and may indicate that firm is taking advantage of discounts.
-
Days purchases in accounts payable
-
FORMULA: Days in year (360 ,365, etc) / accounts receivable turnover
- Days’s s can be compared with average credit terms to see if company is paying invoices on a timely basis.
-
FORMULA: Days in year (360 ,365, etc) / accounts receivable turnover
5
Q
Operating and Cash Cycle
A
-
Operating Cycle
- Amount of time that passes between the acquisition of inventory and the collection of cash on the sales of that same inventory.
- FORMULA: Days of sales outstanding in receivable + Days sales in inventory
-
Cash Cycle
- Portion of operating cycle that is not accounted for by days’ purchases in accounts payable = portion of cycle when the cash is tied up in the form o inventory or accounts receivable.
- FORMULA = Operating cycle – days purchase in accounts payable
6
Q
Other Activity Concepts
(Fixed Assets Turnover
Total Assets Turnover)
A
-
Fixed Assets Turnover Ratio
- Formula: Net Sales / Avg net property , plant, and equipment
- A high turnover implies effective use of net property, plant and equipment to generate sales.
-
Total Assets Turnover Ratio (already covered)
- Formula: Net Sales / Avg total assets
- A high turnover implies effective use of net assets to generate sales.
- Certain assets, for example, investments, do not relate to total net sales. Their inclusion decreases the ratio.
7
Q
Natural Business Year (definition)
A
A natural business year is the period of 12 consecutive months (or 52-53 consecutive weeks) ending at a low point of an organization’s activities.
8
Q
Short Term Fin: Spontaneous Form of Financing
A
-
Trade credit in the accounts payable is the largest source of credit for small firms. It is created when a firm is offered credit terms by its suppliers.
- Trade credit allows a customer to purchase goods on account (not using cash), receive the goods and pay the supplier at a later date (30,60,90).
- Trade credits are usually given as 2/10, net 30.
- Accrued expenses, such as salaries, wages, interest, dividends and tax payables are other sources.
- Trade credit allows a customer to purchase goods on account (not using cash), receive the goods and pay the supplier at a later date (30,60,90).
9
Q
Costs of not taking discount (annualized)
A
-
Discount % / (1 – Discount %) * Days in year / (Total payment period – discount period)
- First term is the additional payment cost in percentage of total discounted cost.
- Second term annualizes it according to incremental period gain of not taking discount.
10
Q
Short-term bank loans
(Term loan and line of credit)
(Disadvantages)
A
- Commercial banks offer term loans and lines are second only to spontaneous credit.
-
Bank loans (term loan and line of credit):
-
Disadvantages:
- Increased risk of insolvency.
- The risk that short-term loans may not be renewed
- The imposition of contractual restrictions, such as compensating balance requirement.
- A term loan, such as a note, must be repaid by a certain date.
-
Disadvantages:
-
A line of credit is an informal borrowing arrangement, generally for a 1-year period. It allows the debtor to reborrow amounts up to a maximum, as long as certain minimum payments are made each month (similar to a consumer credit).
- A major disadvantage is that is not a legal commitment, thus, it might not be renewed. A second is that a bank might require the borrower to “clean up” its debt for a certain period during the year, e.g., for 1 or 2 months.
- Advantage is that is often an unsecured (no collateral needed) loan, and is self-liquidating = the assets acquired provide the cash to pay the loan.
11
Q
Effective vs Stated Rate (and Prime Rate)
A
- Effective interest rate = net interest expenses / usable funds
- Effective rate on discounted loan (without dollar ammount) = Stated rate / (1-stated rate)
“In other words, the interest earned in each quarter will increase the interest earned in subsequent quarters. By the end of the year, the power of quarterly compounding would give you a total of $1,103.80. So, although the stated annual interest rate is 10%, because of quarterly compounding, the effective rate of return is 10.38%.”
- Prime rate is the interest rate that a bank charge to its best (usually least risky) customers.
12
Q
Simple Interest Loans
and
Discounted Loans
(Formulas)
A
-
Simple interest loans
- Is the one where interest is paid at the end of the loan.
- With simple interest loans, the loan amount is equal to the amount of usable funds actually received by the borrower (since he will only pay at end). ALSO, THEREFORE, STATED RATE IS EQUAL TO NOMINAL RATE SINCE THERE IS NO DISCOUNT ON THE VALUE.
- FORMULA: interest expense = loan * stated rate
-
Discounted loans
- Require the interest to be paid in the beginning. This means that the amount of usable funds actually received by the borrower is the loan amount minus interest.
- Loan amount = Usable funds / (1- stated rate)
- Require the interest to be paid in the beginning. This means that the amount of usable funds actually received by the borrower is the loan amount minus interest.
13
Q
Loans with Compensating Balance
A
-
Loans with Compensating balances
- Loan amount = Usable funds* (1-compensating balance %)
- Effective rate with comp.balance = Stated rate / (1 – compensating balance)
-
Loan with discounted basis AND with a compensating balance requirement:
- Effective rate = stated rate / (1 – stated rate – compensating balance)
14
Q
Lines of Credit with Commitment Fees
A
-
Lines of credit with commitment fees
- A line of credit is the right to draw cash at any time to a specific maximum. A line of credit may have a definite term or it may be revolving (the borrower can continuously pay off and reborrow from it). Sometimes a bank charges commitment fees on the unused portion (to incentivize user to use the whole credit or assure it in the future)
- Annual cost = Interest expense on average balance + committed fee on use portion
- A line of credit is the right to draw cash at any time to a specific maximum. A line of credit may have a definite term or it may be revolving (the borrower can continuously pay off and reborrow from it). Sometimes a bank charges commitment fees on the unused portion (to incentivize user to use the whole credit or assure it in the future)
= (average balance * stated rate) +[(credit limit – average balance)*commitment] fee%)]
15
Q
Market – based instruments
(Banker’s acceptance)
(Commercial Paper)
(Secured Financing:
Trust Receipt
Chattel mortgage
Floating Lien)
(Maturity Matching)
A
-
Bankers’ acceptances:
- After acceptance, the drawer is no longer primary responsible party and can sell the instrument to an investor at a discount
- Once the instrument’s term is reached, after for example, 90 days, the investor presets it to the accepting bank and demands payment.
-
At that time, the drawer must have sufficient funds on deposit at the bank to cover it.
- In this way, the drawer obtained a financing for 90 days.
- Bankers acceptance are sold on a discount basis. The difference between the face amount and the proceeds received from the investor is interest expense to the drawer.
-
Commercial paper
- Consists of short term, unsecured notes payable issued in large denominations (>100k) by LARGE corporations (NOT USUALLY THROUGH INVESTMENT BANKING DEALERS) with HIGH credit ratings to other corporations and institutional investors (pension, funds, banks and insurance companies). Maturities are at most 270 days (MAX 270 days)
-
The annualized rate of commercial paper:
- FORMULA: (FACE VALUE- NET PROCEEDS)/NET PROCEEDS * # OF TERMS PER YEAR
- Commercial paper is a lower-cost source of funds than bank loans. It is usually issued at below the prime rate.
- No general secondary market exists for commercial paper.
-
Advantages:
- Provide broad and efficient dx
- Provides a great amount of funds
- Avoids costly financial arrangements
-
Disadvantages:
- It is an impersonal market
- The total amount of funds available is limited to the excess liquidity of big corporations.
-
Secured financing
-
Loans can be secured by pledging receivables: committing the proceeds of the receivables to paying of the loan.
- A bank often lends up to 80% of outstanding receivables.
- A TRUST RECEIPT is an instrument issued by a borrower that provides inventory as collateral.
- The inventory is held in trust for the lender
- Any proceeds of sale are to be paid to the lender
-
A chattel mortgage is a lowan secured by personal property (MOVABLE property like equipment or livestock)
- A floating lien is a loan secured by property, such as inventory, the composition of which may be constantly changing.
-
Loans can be secured by pledging receivables: committing the proceeds of the receivables to paying of the loan.
-
Maturity matching
-
Equalized the life od an acquired asset with the debt instrument used to finance it. Because it mitigates financial risk, maturity matching is a hedging approach to financing.
- For instance, a debt due in 30 days should be paid with funds currently invested in a 30-day marketable security, not with proceeds from a 10-year bond issue.
- In general, as a company increases the amount of short-term financing relateive to long-term financing, the greater the risk that it will be unable to meet principal and interest payments. An increase in the proportion of short-term financing DOES NOT IMPACT A BORROWER’S DEGREE OF LEVERAGE, but risk is increased because of the need of constant refinancing.
-
Equalized the life od an acquired asset with the debt instrument used to finance it. Because it mitigates financial risk, maturity matching is a hedging approach to financing.
