Professional Documents
Culture Documents
Permanent
Current Assets
Long-term
Fixed Assets
Fixed assets should be financed long-term, either equity or long-term debt, since
the assets are long-lived and need financing for a long period of time. The current
assets can be broken down into two portions, permanent current assets and fluctuating
current assets. The permanent current assets represent base levels of inventories,
receivables, etc., that will always be on hand. The fluctuating current assets represent
the seasonal build-ups that occur, such as inventories before Christmas and receivables
after Christmas. The fluctuating current asset levels should be financed short-term since
we dont want to pay financing charges all year if we only need the money for a fourmonth period.
While the permanent current assets are, individually, short-lived assets, as a
category they are always there (hence, permanent) and will always need to be financed.
Thus, the permanent current assets should also be financed long-term, just like the fixed
assets. While it is possible to finance some of our permanent needs using short-term
debt, it is risky to do so. (Such financing is described as an aggressive working capital
financing policy in your text aggressive being associated with risky.) The risk of
financing permanent needs with short-term financing is twofold: first, short-term interest
rates fluctuate much more than long-term interest rates. Rolling over short-term debt
year after year will subject you to greater fluctuation in your financing costs as a result.
Probably a bigger risk is the inability to roll over the short-term debt every year. You may
have a bad year and find that lenders are unwilling to refund the debt (forcing you to
default).
While cash is necessary to cover the transactions motive, the precautionary and
speculative motives can be covered with the near money (or near cash) of marketable
securities.
In order to maximize your cash balances, you can do one of two things; either
accelerate the inflow of funds (ask for an advance on your salary) or delay the outflow of
funds (postpone paying the phone bill until next month). But why would we want to
maximize our cash holdings if it is the least productive asset? Because idle cash, either
sitting in a checking account or tied-up in accounts receivable is extremely costly.
For example, suppose we have a client who owes us payment of $1,000,000 that
is due. The opportunity cost of not collecting is the interest we could earn on the money.
$1,000,000
5%
Receivable due
Treasury bill rate
Anticipation notes
Anticipation notes are issued by municipalities and school districts. Since
their revenues come from tax sources, the notes are in anticipation of
future tax receipts.
Commercial paper
Commercial paper is the promissory notes of a major national firms. Most
of the firms that issue commercial paper sell it directly to investors
(insurance companies, money market funds, pension funds) although
sometimes it will be sold through investment bankers. Commercial paper
is a substitute for bank debt, but at a rate of interest that is one-fourth to
on-half of a percent higher than t-bills (currently about 4.3%) but
significantly less than what banks would charge (prime is currently about
8.5%).
Bankers Acceptances
A bankers acceptance is a time draft that evolves from international
export/import financing. An exporter is paid by a time draft issued by a
foreign bank. Since the draft is not payable until some future date (1-3
months, typically) the company that receives it will often sell it to its local
bank at a discount. The local bank bundles the discounted drafts
(bankers acceptances) and then resells them in the money markets.
Accounts Receivable
Accounts receivable are generated when a firm offers credit to its customers.
The first thing that needs to be addressed when establishing a credit policy is to set the
standards by which a firm is judged in determining whether or not credit will be
extended. There is whats known as the 5 Cs of credit:
Competitors will respond very quickly to a change in price. How many times
have we seen the claims that We will meet or beat any advertised price? A change in
credit policy, on the other hand, is a more subtle means of competing for customers and
one that the competition will not necessarily respond to. In fact, many firms base their
business on easy credit. How many times have we seen the advertisements where they
tell us Good credit? Bad credit? No credit? We dont care! Of course, these firms will
have larger bad debt expenses and larger financing costs, etc. Obviously, they will also
need to have higher prices (higher gross profit margins) in order to cover these costs.
Inventories
Inventories (raw materials, work-in-process, finished goods) make up a large
portion of most firms current assets, and for many, total assets. As such, the extent to
which a firm efficiently manages its inventories can have a large influence on its
profitability. Thus, keeping abreast of inventory policy is critical to the profitability (and
value) of the firm.
Several factors influence the amount of inventory that a firm maintains. The most
important of these include
Level of sales typically, the more sales a firm has, the more inventory it
holds
Length of time and technical nature of the production process The longer it
takes to produce finished goods inventories from raw materials, the larger the
amount of finished goods that a firm will typically hold (a safety stock). Also,
if the production process is highly technical, requiring that retooling be
performed prior to each production run in order to assure that production is
meeting specifications, larger amounts of inventory will be produced with
each production run in order to minimize the set-up costs associated with
retooling.
Durability vs. Perishability If an inventory item is highly perishable, such as
fresh vegetables, a small amount will be held. Similarly, fashions of clothes
and car styles are perishable and will result in smaller inventories than
durable goods such as tools and hardware.
Costs Cost of holding inventories as well as costs of obtaining inventories
will influence inventory sizes.
Ordering Costs
1.
Fixed costs stocking, clerical
2.
Shipping costs often fixed
3.
Missed quantity discounts an opportunity cost
B.
Carrying Costs
1.
Time value of money tied-up in inventories
2.
Warehousing costs
3.
Insurance
4.
Handling
5.
Obsolescence, breakage, shrinkage
C.
Stock-out Costs
1.
Lost sales
2.
Loss of goodwill
3.
Special shipping costs
Ideally, we want to balance these costs against each other so that our total costs
are minimized.
Short-term Financing
Trade Credit
The major source of short-term financing for firms is that of trade credit. While it
is an account payable on our balance sheet, it is an account receivable on the balance
sheet of our supplier.
The terms of credit can vary quite a bit:
2% 360days
*
36. 7%
98% 20days
Of course, if you miss payment by day 10 for taking the discount, dont pay the full
amount of day 11 or you have paid
2%*360 = 720%
Do banks charge 36% interest on loans? Not in Texas or most states. It is a violation of
the usury laws. Then why do many companies forego the discounts if the cost is so
high? It is the only source of funding that they can get. To reduce the effective cost,
firms will often stretch payment out past the due date. Of course, this subjects the firm
to risk of its credit being completely cut off by the supplier and possibly damages the
credit reputation since other suppliers will often request references before extending
credit themselves.
Some firms will offer post-dated billing, typically in a seasonal industry. For
example, if a manufacturers primary sales are to retailers for the Christmas season they
may encourage retailers to order in June and July rather than waiting until September.
The encouragement is that if an order is placed in June or July, the manufacturer will not
bill them until September and even then regular credit terms will apply. The advantage
here is that it allows the manufacturer to smoothe out sale and thus production. The
manufacturer can then save on overtime with employees as well as not incur many of
the carrying costs associated with holding the inventories since the retailer takes
possession and ownership earlier.
$100,000 loan
20,000 compensating balance
$ 80,000 net proceeds
At the end of one year, the firm repays the bank $88,000. $8,000 is interest on the loan
and the other $80,000 (with the $20,000 in the compensating balance for a total of
$100,000) is the principal. Thus, the firm has effectively paid $8,000 interest on the use
of $80,000 for an annual rate of interest of 10%.
Alternatively, the bank may offer a discounted loan where the interest is deducted
up-front. Using our same example,
Less:
$100,000 loan
8,000 interest
$ 92,000 net proceeds
At the end of the year, the firm repays the $100,000 of principal (since the interest was
paid up-front). Effectively, the firm paid $8,000 of interest for the use of $92,000 of funds
for a rate of interest of 8.7% on the loan.
12 months
As an approximation, the amount of the loan that was outstanding during the
year was, on average, only $50,000. The $8,000 of interest thus represents an
approximately 16% rate of interest on the average amount of the loan.
More precisely, this loan appears as
0
100,000
1 - - - - - - - - - - - - - - - - - 11
12
(9,000) - - - - - - - - - - - - - - (9,000)
(9,000)
Of course, if you were the bank, the cash flows would be the same, only the
signs would be reversed. So as a bank officer, how would you determine the rate of
interest that you were earning on this investment?
The true cost of debt of any loan is the internal rate of return between what you
receive and what you have to pay back. Suppose we use our calculators and determine
the IRR of this interest add-on loan. We determine that the IRR is 1.2%. But remember
that his is 1.2% per month. Using simple interest, 1.2%*12 = 14.4% annual rate of
interest.
Security for Bank Loans
Banks like some sort of collateral for loans to ensure repayment of the loan, at
least in part. The preferred collateral for bank loans is accounts receivable. The reason,
of course, is that collecting money is what banks do. Typically, a bank will loan up to 7580% of the receivables that are not over 60 days. There are two ways to obtain
financing with receivables:
Pledging of Accounts Receivable This is the most common form. A lender will
loan up to 80% of the amount of the invoice. Upon payment, the borrower has pledged
to use the proceeds to reduce the amount of the loan. If the customer does not pay the
invoice, the borrower is still obligated to repay the loan.