CFA Level 1 Corporate Finance E Book - Part 3

CFA - Corporate Finance E-book 3 of 7
Corporate Finance E-Book

Part 3 of 7
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Working Capital Management
1. Managing And Measuring Liquidity.

Working capital management involves the relationship between a firm's short-term assets and its shortterm liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. Liquidity management refers to the ability of the company to meet its short-term financial obligations. There are two sources of liquidity. The main difference between the two sources is if it is going to affect the companys normal operations or not.
1.
2.
Primary sources of liquidity include cash, short-term funds and cash flow management. They represent funds that are readily accessible at relatively low cost. Secondary sources include negotiating debt contracts, liquidating assets, and filing for bankruptcy and reorganization. They provide liquidity at a higher price and may impact a companys financial and operating positions.
Measuring Liquidity
Almost all liquidity measures are covered in Reading 33 [Understanding the Balance Sheet] and Reading 33 [Financial Analysis Techniques] of Study Session 8. Operating cycle = Number of days in inventory + Number of days of receivables. Net operating cycle (cash conversion cycle) = Number of days in inventory + Number of days of receivables - Number of days of payables. Example Average accounts receivable: $25,400. Average inventory: 48,290. Average accounts payable: 37,510 Credit Sales: 325,700 Cost of goods sold: 180,440.
How many days are in the operating cycle? How many days are in the cash cycle? 1. The receivable turnover rate tells you the number of times during the year that money is loaned to customers. Credit sales / Average accounts receivable = 325,700 / 25,400 = 12.8228. Receivables period = 365 days / 12 8228 = 28 46 days It tells you that it takes customers Receivables period 365 days / 12.8228 28.46 days. It tells you that it takes customers an average of 28.46 days to pay for their purchases.
2.
The inventory turnover rate tells you the number of times during the year that a firm replaces its inventory. COGS / Average inventory = 180,440 / 48,290 = 3.7366. Inventory period = 365 days / 3.7366 = 97.68 days. This means inventory sits on the shelf for 97.68 days before it is sold. That's ok for a furniture store but you should be highly alarmed if a fast food restaurant has a 98 day inventory period.
The accounts payable is matched with COGS to compute the turnover rate because these accounts are valued based on the wholesale, or production, cost of each item. Payables turnover = COGS / Average accounts payables = 180,440 / 37,510 = 4.8105 Payables period = 365 / 4.8105 = 75.88 days. On average, it takes 75.88 days to pay its suppliers.
3.
The operating cycle begins on the day inventory is purchased and ends when the money is collected from the sale of that inventory. This cycle consists of both the inventory period and the accounts receivable period. Operating cycle = 97.68 + 28.46 = 126.14 days.
The cash cycle is equal to the operating cycle minus the payables period. It is the number of days for which the firm must finance its own inventory and receivables. During the cash cycle, the firm must have sufficient cash to carry its inventory and receivables.
Cash cycle = 126.14 - 75.88 = 50.26 days.
In this example, the firm must pay for its inventory 50.26 days before it collects the payment from selling that inventory. Controlling the cash cycle is a high priority for financial managers.
2. Managing The Cash Position.

Managing short-term cash flows involves the minimizing of costs. The two major costs are carrying costs, the return forgone by keeping too much invested in short-term assets such as cash, and shortage costs, the cost of running out of short-term assets. The objective of managing short-term finance and doing short-term financial planning is to find the optimal trade-off between these two costs. The starting point for good cash flow management is developing a cash flow projection. To forecast short term cash flows, a financial manager needs to 1. 2. 3. Determine minimum cash balances. Identify typical cash inflows and outflows of the company. Develop a cash forecasting system.
Monitoring cash uses and levels means keeping a running score on daily cash flows. o o o o The most important task is to collect cash flow information on a timely basis. Establish a target cash balance for each bank. Use short-term investments and borrowings to help with cash position management. Consider other factors such as seasonal factor, upcoming mergers and acquisition, etc.
3. Investing Short-term Funds.

Cash does not pay interest. Companies should invest funds that are not necessarily needed in a company's daily transactions. Short-term investment is discussed in the reading. Nominal rate: a rate of interest based on a security's face value. For a non-zero-bond, the coupon rate is the nominal rate. A yield is the actual return on the investment if it is held to maturity. o Money market yield and bond equivalent yield. Refer to Reading 6 [Discounted Cash Flow Applications] of Study Session 2. Discount-basis yield (also referred to as the investment yield basis) is often quoted in the context of U.S. T-securities: [(Face value - Purchase price) / (Face value)] x (360 / Number of days to maturity).
Strategies
Short-term investment strategies can be grouped into two types:
Passive strategy. o One or two decision rules for making daily investments. o Safety and liquidity first. o Passive strategies must be monitored and the yield should be benchmarked against a comparable standard such as a T-bill.
Active strategy. o More daily involvement and a wider choice of investments. o Matching / mismatching: the timing of cash inflows and outflows. o A laddering strategy is a strategy in which a bond portfolio is constructed to have approximately equal amounts invested in each maturity within a given range, to reduce interest rate risk.
A company should have a formal, written investment policy or guideline that protects a company and its investment managers.
4. Evaluating Accounts Receivable, Inventory And Accounts Payable Management.

Accounts Receivable
The most popular measures to evaluate receivables are receivable turnover and number of days of receivables. Example Build It Right, Inc. sells 5,500 curio cabinets a year at a price of $2,000 each. The credit terms of the sale are 2/10, net 45. Eighty percent of the firm's customers take the discount. What is the amount of the firm's accounts receivable? If 80% of the customers pay in 10 days, then the other 20% must pay in 45 days. How much does the firm sell each year? 5,500 x $2,000 = $11,000,000. The average collection period: [0.80 x 10] + [(1 - 0.80) x 45] = 8 + 9 = 17 days. The accounts receivable turn over: 365 / 17 = 21.470588 The average receivables balance: $11,000,000 / 21.470588 = $512,328.77.
Inventory
Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash resources of a business. Insufficient stocks can result in lost sales, delays for customers etc. Inventory management is to identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow. Just In Time (JIT) is an inventory strategy implemented to improve the return on investment of a business by reducing in-process inventory and its associated costs. Economic order quantity (also known as the EOQ Model) is a model that defines the optimal quantity to order that minimizes total variable costs required to order and hold inventory.
To evaluate inventory management analysts compute the inventory turnover ratio and the number of days of inventory. These measures are covered in Study Session 8.
Accounts Payable
Two countering forces should be considered to manage accounts payable:
Paying too early is costly unless the company can take advantage of discounts. Postponing payment beyond the end of the net (credit) period is known as "stretching accounts payable" or "leaning on the trade." Possible costs are:
o o o Cost of the cash discount (if any) forgone. Late payment penalties or interest. Deterioration in credit rating.
Trade discounts should be evaluated by computing the implicit rate of return:

Cost of trade credit = [1 + Discount / (1 - Discount)](365 / number of days beyond discount period)- 1
Example
Today, June 10, you purchased $5,000 worth of materials from one of your suppliers. The Today, June 10, you purchased $5,000 worth of materials from one of your suppliers. The terms of the sale are 3/15, net 45. Discounted price: $5,000 x (1 - 0.03) = $4,850. Last day to receive discount: June 10 + 15 days = June 25. Days credit: 45 - 15 = 30. Implicit interest: 0.03 x $5,000 = $150. Cost of credit (effective annual rate): (1 + 0.03/0.97)365/30 - 1 = 44.86%. Analysts often use the number of days of payables and payables turnover to evaluate accounts payable management. Payables turnover = Cost of goods sold / Accounts payables Number of days of payables = # of days in period / Payables turnover = Accounts payable / Average day's purchase
5. Managing Short-term Financing.

There are two sources of short-term financing:
Bank Sources
Unsecured Loans -- A form of debt for money borrowed that is not backed by the pledge of specific assets.
Line of credit (L/C). o A bank provides a letter of credit, for a fee, guaranteeing the investor that the company's obligation will be paid. It is a promise from a bank for payment in the event that certain conditions are met. o It is frequently used to guarantee payment of an obligation. o Committed lines of credit are stronger than uncommitted because of the bank's formal commitment.
Revolving credit agreement: A formal, legal commitment to extend credit up to some maximum amount over a stated period of time.
Bankers' acceptance. They are short-term promissory trade notes for which a bank (by having "accepted them") promises to pay the holder the face amount at maturity. They are used to facilitate foreign trade or the shipment of certain marketable goods. Secured Loans -- A form of debt for money borrowed in which specific assets have been pledged to guarantee payment. Factoring accounts receivable. Factoring is the selling of receivables to a financial institution, the factor, usually "without recourse." o Factor is often a subsidiary of a bank holding company. o Factor maintains a credit department and performs credit checks on accounts. o Allows firm to eliminate their credit department and the associated costs. o Contracts are usually for 1 year, but are renewable. Inventory-backed loans. Loan evaluations are made on marketability, price stability, perish ability, and difficulty and expense of selling for loan satisfaction. Floating Lien - A general, or blanket, lien against a group of assets, such as inventory or receivables, without the assets being specifically identified. Trust Receipt - A security device acknowledging that the borrower holds specifically identified inventory and proceeds from its sale in trust for the lender. Terminal Warehouse Receipt - A receipt for the deposit of goods in a public warehouse that a lender holds as collateral for a loan.
Nonbank Sources
Commercial paper. o Short-term, unsecured promissory notes, generally issued by large corporations (unsecured corporate IOUs). o Cheaper than a short-term business loan from a commercial bank. o Dealers often require a line of credit to ensure that the commercial paper is paid off. Nonbank finance companies.
The best mix of short-term financing depends on: Cost of the financing method. Availability of funds. Timing. Flexibility. Degree to which the assets are encumbered.
Cost of Borrowing
The fundamental rule is to computer the total cost of borrowing and divides that by the net proceeds.
Collect basis: interest is paid at maturity of the note. o Example: $100,000 loan at 10% stated interest rate for 1 year. o $10,000 in interest / $100,000 in usable funds = 10.00%.
Discount basis: interest is deducted from the initial loan. o Example: $100,000 loan at 10% stated interest rate for 1 year. o $10,000 in interest / $90,000 in usable funds = 11.11%.
Compensating balances: demand deposits maintained by a firm to compensate a bank for services provided, credit lines, or loans. o Example: $1,000,000 loan at 10% stated interest rate for 1 year with a required $150,000 compensating balance. o $100,000 in interest / $850,000 in usable funds = 11.76%.
Commitment fees: The fee charged by the lender for agreeing to hold credit available is on the unused portions of credit.
Example
$1 million revolving credit at 10% stated interest rate for 1 year; borrowing for the year was $1 million revolving credit at 10% stated interest rate for 1 year; borrowing for the year was $600,000; a required 5% compensating balance on borrowed funds; and a .5% commitment fee on $400,000 of unused credit. What is the cost of borrowing?
Interest: ($600,000) x (10%) = $60,000

Commitment Fee: ($400,000) x (0.5%) = $2,000 Compensating Balance: ($600,000) x (5%) = $30,000 Usable Funds: $600,000 - $30,000 = $570,000
Cost = ($60,000 in interest + $2,000 in commitment fees) / $570,000 in usable funds = 10.88%.
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CFA Level 1 Corporate Finance E Book - Part 3

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CFA - Corporate Finance E-book 3 of 7

Corporate Finance E-Book

CFA - Corporate Finance E-book 3 of 7

Working Capital Management

1. Managing And Measuring Liquidity.

CFA - Corporate Finance E-book 3 of 7

CFA - Corporate Finance E-book 3 of 7

CFA - Corporate Finance E-book 3 of 7

CFA - Corporate Finance E-book 3 of 7

2. Managing The Cash Position.

CFA - Corporate Finance E-book 3 of 7

3. Investing Short-term Funds.

CFA - Corporate Finance E-book 3 of 7

CFA - Corporate Finance E-book 3 of 7

Short-term investment strategies can be grouped into two types:

4. Evaluating Accounts Receivable, Inventory And Accounts Payable Management.

CFA - Corporate Finance E-book 3 of 7

CFA - Corporate Finance E-book 3 of 7

CFA - Corporate Finance E-book 3 of 7

Two countering forces should be considered to manage accounts payable:

Trade discounts should be evaluated by computing the implicit rate of return:

CFA - Corporate Finance E-book 3 of 7

5. Managing Short-term Financing.

CFA - Corporate Finance E-book 3 of 7

CFA - Corporate Finance E-book 3 of 7

CFA - Corporate Finance E-book 3 of 7

CFA - Corporate Finance E-book 3 of 7

CFA - Corporate Finance E-book 3 of 7

Interest: ($600,000) x (10%) = $60,000

For FREE Resources

CFA - Corporate Finance E-book 3 of 7

Corporate Bridge Blog

For Online Finance Courses

For any other enquiry / information

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