FINANCIAL MANAGEMENT

CASH CONVERSION CYCLE

CASH CONVERSION CYCLE- is the average length of time a peso is tied up in current assets. It runs from
the date the company makes payment of raw materials to the date company
receives cash inflows thru collection of accounts receivable. It is also known
as the cash flow cycle

Inventory Conversion period Inventory ÷ CGS* per day

+ Receivable Collection period Receivables ÷ Sales per day
- Payable deferral period Payables ÷ Purchases per day
CASH CONVERSION CYCLE

* Alternatively, sales per day may be also used to compute conversion period.
The intention is to use an amount in proportion to unit sales.

The firm’s goal should be to shorten its cash conversion cycle without hurting operations. The longer the
cash conversion cycle, the greater the need for external financing ( hence, the more cost of financing) .

CASH MANAGEMENT STRATEGIES

1. Accelerating collections (e.g., lockbox system)
2. Slowing disbursements (e.g., playing the floats)
3. Reducing precautionary idle cash (e.g., zero-balance accounts)

THE CONCEPT OF FLOAT

FLOAT - generally defined as the difference between the cash balance per BANK and the cash
balance per BOOK as of a particular period, primarily due to outstanding checks or other
similar reasons.

Types of Float:
 POSITIVE (Disbursement) Float: Bank balance > Book balance
EXAMPLE: Outstanding checks issued by the firm that have not cleared yet.
 NEGATIVE (Collection) Float: Book balance > Bank balance
EXAMPLES:
1. MAIL Float – Amount of customer’s payments that have been mailed by customers but not
yet received by the seller-company.
2. PROCESSING Float - Amount of customer’s payments that have been received by the seller
but not yet deposited.
3. CLEARING Float - Amount of customer’s checks that have been deposited but have not
cleared yet

Good cash management suggests that positive float should be maximized (negative float minimized).

MARKETABLE SECURITIES – short-term money market instruments that can easily be converted to cash
 CERTIFICATES of DEPOSITS (CD) – savings deposits at financial institutions (e.g., time deposit)
 MONEY MARKET FUNDS – shares in a fund that purchases higher- yielding bank CD’s, Commercial
paper, and other large-denomination, higher-yielding securities.
 GOVERNMENT SECURITIES
 Treasury bills - debt instruments representing obligation of the National Government issued
by the Central Bank and usually sold at a discount through competitive bidding.
 CB Bills or Certificates of Indebtedness (CBCIs) - represent indebtedness by the central Bank.
 COMMERCIAL PAPERS- unsecured short-term promissory notes issued by corporations with very
high credit standing

FACTORS INFLUENCING THE CHOICE OF MARKETABLE SECURITIES (MS)

1. RISK
• Default Risk - refers to the chances that the user may not be able to pay the interest or
principal on time or at all.
• Interest Rate Risk - refers to fluctuations in MS prices caused by changes in market interest
rates.
• Inflation Risk - refers to the risk that inflation will reduce the relevant value of the
investment.
2. RETURNS – The higher the MS’s risk involved, the higher its required return. While MS must consist
of highly liquid short-term investments, the company should not sacrifice safety for higher rates of
return.
3. MATURITY - Maturity dates of MS’s held should coincide, whenever possible, with the date at
which the firm needs cash, or when the firm will no longer have cash to invest.
4. MARKETABILITY - refers to how quickly a security can be sold before maturity date without a
significant price concession.
FINANCIAL MANAGEMENT

EXERCISE; CASH & MS MANAGEMENT

1. OPTIMAL CASH BALANCE

KAS Corporation is expecting to have total payments of P 1, 800, 000 for one year, cost per transaction
amounted to P 25, and the interest rate of marketable securities is 10%.

REQUIRED:
A) What is the company’s optimal initial cash balance that minimizes total costs?
B) What is the total number of transaction or cash conversions that will be required per year?
C) What will be the average cash balances for the period?
D) How much is the total cost of maintaining cash balances?
(Adopted: Principles of Managerial Finance by Lawrence J. Gitman)

2. MINIMUN CASH BALANCE

Cashy Corporation’s cost of goods sold per year is P 4, 500, 00. Annual operating expenses are
estimated at P 1,200, 000, inclusive of depreciation and other non-cash expenses of P 300,000.

REQUIRED:
How much must the corporation’s minimum cash balance be if it is to be equal to 30 days’ requirement?
(Use 300 - day year)
(Adopted: Principles of Corporate Finance by Brealey, et.al.)

3. CASH CONVERSION CYCLE

Mapera Corporation purchases merchandise on 20-day term . Goods are sold, on the average, 15 day
after they are received. The average age of accounts receivable is 45 days. Mapera pays its payable on
due date.

REQUIRED:
A) How long is the company’s normal operating cycle?
B) How long is the company’s cash conversion cycle?
C) What is the number of cash conversion cycles in one year (360days)?
(Adopted: Theory and Practice in Financial Management by Brigham, et.al)

4. FLOAT & LOCKBOX SYSTEM

It usually takes Kwarta Corporastion 8 calendar days to receive and deposit customer remittances.
Kwarta is considering to adopt a lockbox system that will reduce the float time to 5 days. Average daily
cash receipts are P 220,000. The rate of return is 10 percent .

REQUIRED:
A) How much is the reduction of float in cash balances associated with implementing the system?
B) What is the amount of return associated with the earlier receipt of the funds?
C) If the lockbox costs P 7,500 per month to implement, should the system be implemented?
a. Yes, savings is P 24,000 per year c. No, loss is P 14,500 per year
b. Yes, savings is P 82,500 per year d. No, loss is P 24,00 per year
(Adopted: Financial Management Principles and Applications by Keown, et.al.)

5. MARKETABLE SECURITIES
Datung Corporation has P 20,000 excess cash that it might invest the marketable securities. It considers
investing the money for a holding period of 3 months. The transaction fee arising from this is P 300.

REQUIRED: What is the break-even yield (annual basis) for the three-month holding period?

SOLUTION: Break-even yield is the interest rate at which the income from investment equals the
transaction costs incurred. Hence, based on P x R x T : 20,000 (x) 3/12 = 300 x = 6%

ACCOUNT RECEIVABLE (AR) MANAGEMENT

AR MANAGEMENT- involves the determination of the amount and terms of credit to extend to customers
and monitoring receivables from credit customers.

OBJECTIVE: To collect AR as quickly as possible without losing sales from high pressure collection techniques.
Accomplishing this goal encompasses three topics: (1) credit selection and standards, (2) credit
Terms, and (3) collection and monitoring program.

Consider this trade-off:

Offering liberal and relaxed credit terms attracts more customers while it would entail more
Cost of AR such as collection, bad debts and interests ( opportunity costs).
FINANCIAL MANAGEMENT

FACTORS TO CONSIDER FOR AR POLICY

1. CREDIT STANDARD
Who (customers) will be granted credit? How much is the credit limit?
Factors to consider in establishing credit standard – The Five C’s of credit
 Character - customers’ willingness to pay
 Capacity - customers’ ability to generate cash flows
 Capital - customers’ financial sources (i.e., net worth)
 Conditions - current economic or business conditions
 Collateral – customers’ asset pledged to secure debt.
2. CREDIT TERMS
This defines the credit period and discount offer for customers’ prompt payment. The following cost
associated with the credit terms must be considered : cash discounts, credit analyst and collections
costs, bad debt losses and financing costs.

3. COLLECTION PROGRAMS
Shortening the average collection period may preclude too much investment in receivable (low
opportunity costs ) too much loss due to delinquency and defaults. The same could also results to
loss of customers if harshly implemented.

EXERCISE: AR MANAGEMENT

1. AVERAGE INVESTMENT IN ACCOUNTS RECIEVABLE

King Corporations sells on terms of 2/10, n/30. 70% of customers normally avail of the discounts.
Annual sales are P 900,000, 80% of which is made on credit . Cost is approximately 75% of sales.

REQUIRED:
A) Average balance of accounts receivable.
B) Average investments in accounts receivable.

2. ACCELERATING COLLECTION
Queen Corporation makes credit sales of P 2, 160, 000 per annum. The average age of accounts
receivable is 30 days. Management considers shortening credit terms by 10 days. Cost of money is 18%.

REQUIRED: How much will the company save from financing charges? (Assume 360- day year)

3. DISCOUNT POLICY
Jack Company presents the following information:
 Annual credit sales: P 25,200,000
 Collection period: 3 months
 Trade credit term: n/30
 Rate of return : 18%

The company considers to offer a credit term of 4/10, n/30 . It expects 30% of its customers will take
advantage of the discount while sales would remain constant . As a result , the collection period is expected
to decrease to two months.

REQUIRED:
What is the net advantage (disadvantage) of implementing the proposed discount policy ?

4. CREDIT POLICY – RELAXATION

The Ace Corporation reports the following information :
Selling price per unit P 10
Variable cost per unit P 8
Total fixed cost P 120,000
Annual credit sales 240 000 units
Collection period 3 months
Rate of return 25%

Ace consider to relax its credit standards by granting extension of credit terms. The following are
expected to result : ( 1 ) sales will increase by 25% ; collection costs will increase by P 40, 000 ; (3 ) bad
debts losses are expected to be 5% on the incremental sales; and ( 4 ) collection period will increase to 4
months.

REQUIRED:
Should the proposed relaxation in credit standards be implemented ?
a. Yes, savings is P 30,000 per year c. No, loss is P 14,500 per year
b. Yes, savings is P 50,000 per year d. No, loss is P 30,000 per year
FINANCIAL MANAGEMENT

INVENTORY MANAGEMENT

INVENTORY MANAGEMENT - refers to the process of formulation and administration of plans and policies
to efficiently and satisfactorily meet production and merchandising
requirements and minimize costs relative to inventories .

OBJECTIVE: To maintain inventory at a level that best balance the estimates of actual savings , the cost of
carrying additional inventory , and the efficiency of inventory control.

INVENTORY MANAGEMENT TECHNIQUES

INVENTORY PLANNING - involves determination of the quality and quantity and location of inventory , as
well as the time of ordering , in order to minimize costs and meet future
business requirements
Examples: Economic Order Quantity ; Reorder Point; Just-in Time (JIT) system

INVENTORY CONTROL - involves regulation of inventory within predetermined level; adequate stocks
should be able o meet business requirements, but the investment in inventory
should be at the minimum.

SYSTES OF INVENTORY CONTROL

 JUST- IN TIME PRODUCTIO system - a “demand full” (driven by demand ) system in which each
component of a finished good is produced when needed by
the next production stage .
 FIXED ORDER QUANTITY system - an order for a fixed quantity is placed when the inventory level
reaches the reorder point. This is consistent with EOQ concept
 PERIODIC REVIEW OR REPLACEMENT system - orders are made after a review of inventory level
has been that at regular intervals .
 OPTIONAL REPLENISHMENT system - combination of fixed order and replacement systems.
 MATERIALS REQUIREMENT PLANNING (MRP)
MRP is a push through system that is designed to plan and control materials used in production
based on a computerized systems that manufactures finished goods based on demands forecast.
 MANUFACTURING RESOURCE PLANNING (MRP-11)
A closed loop system that integrates various functional areas of manufacturing company(e.g.,
inventories, production, sales and cash (flows). It is developed as an extension of MRP.
 ENTERPRISE RESOURCE PLANNING (ERP)
ERP integrates information system of all functional areas in a company . Every aspect of
operations is interconnected as the company is connected with its customers and suppliers.
 ABC Classification system – inventories are classified for selective control
A items - high value requiring highest possible control
B items - medium cost items requiring normal control
C items - low cost items requiring the simplest possible control

SHORT-TERM CREDIT FINANCING

WORKING CAPITAL FINANCE - refers to optimal level , mix and use of current assets and current liabilities

WORKING CAPITAL FINANCING POLICIES

A) AGGRESSIVE FINANCING SRATEGY - operations are conducted with minimum amount of
working capital . This is also known as restricted policy.
B) CONSERVATIVE FINANCING SRATEGY - a company seeks to minimize liquidity risk by increasing
working capital . This is also known as relaxed policy
C) MODERATE FINANCING SRATEGY - also known as semi- aggressive or semi- conservative financing
strategy . Under this strategy, working capital maintained as relatively not too high (conservative )
nor too low (aggressive ). This is also known as balance policy.
D) MATCHING POLICY - This is achieved by matching the maturity of financing source with an
asset’s useful life . This is also known as self -liquidating policy or hedging policy.
 Short-term assets are financed with short-term liabilities .
 Long- term assets are funded by long-term financing sources.

TOTAL FINANCING REQUIREMENT FIXED AND LONG- TERM ASSETS

PERMANENT financing requirements •

(Minimum operation requirement)
PERMANENT CURRENT ASSETS
TEMPORARY financing requirement
(Seasonal operation requirement)
FINANCIAL MANAGEMENT

EXERCISE: AGGRESSIVE VS CONSERVATIVE FINANCING STRATEGIES

Yahweh’s Corporation’s permanent financing requirement is P 300,000 per quarter , composed of P
200, 000 for fixed assets , and P 100, 000 for current assets. However, the financing requirements for
current assets are expected to increase by P 30, 000 in the first quarter , P 20,000 in the second quarter, P
40, 000 in the third quarter , and P 10, 000 in the fourth quarter .

REQUIRED: Determine the amount working capital to maintain under :

A) Aggressive financing strategy ( Answer: P 100,000)
B) Moderate financing strategy (Answer: P 125, 000 – approximate )
C) Conservative financing strategy ( Answer: P 140, 000)

SOURCES OF SHORT-TERM FUNDS

 UNSECURED CREDITS (Accruals, trade credit and commercial papers )
 SECURED LAONS (Receivable financing – pledging and factoring)
(Inventory financing - blanket lien , trust receipts, warehouse receipts )
 BANKING CREDITS (Loan, line of credit , revolving credit agreement )

FACTORS OF CONSIDERATIONS IN SELECTING SOURCES OF SHORT-TERM FUNDS

 COST: The effective cost of various credit sources .
 AVAILABILITY: The readiness of credit as to when needed and how much is needed.
 INFLUENCE: The influence of use of one credit source and availability of other sources of financing .
 REQUIREMENT: The additional covenants unique to various sources of financing (e.g., loans).

COST OF SHORT-TERM CREDIT

 Cost of TRADE CREDIT with supplier * ;
Discount Rate 360 days
COST = X
100% - Discount Rate Credited period – Discount period

*This type of financing cost is caused by foregoing cash discount (opportunity cost).

 Cost of BANK LOANS ( EFFECTIVE ANNUAL RATE )

 Without compensating balance:
If not discounted (cash proceeds normally equal face value ) :
Interest
COST =
Amount Received ( Face )
If discounted (cash proceeds is net of interest deducted in advance ):
Interest
COST =
Face value – Interest

 With compensating balance (CB) :

If not discounted:
Interest Nominal %
COST = COSTOR
=
Face value - CB 1000% - CB%

If discounted:
Interest Nominal %
COST = COST =
Face value – Interest - CB 1000% - Nominal % - CB%

 Cost of COMMERCIAL PAPERS

Interest + Issue cost 360 days
COST = Face Value - Interest – Issue Cost s X Term

EXCERCICE: SHORT – TERM CREDIT FINANCING

1. COST OF TRADE CREDIT

CPL Trading Co. purchases merchandise for P 200, 000 , 2/10 , n/30

REQUIRED:
A) The annual cost of trade credit .
B) The annual cost of trade credit if term is changed to 1/15, n/20.
FINANCIAL MANAGEMENT

3 COST OF COMMERCIAL PAPER

CPL Co. plans to sell a 180 –day commercial paper amounting P 100, 000, 000 , which it expects to pay
a discounted interest of 12% per annum . CPL expects to incur P 100, 000 in dealer placement fees and
paper issue costs.

REQUIRED:
Determine the effective cost of CPL ‘s credit.

4 COST OF FACTORING RECIEVABLES

CPL Co. has P 200, 000 in receivable that carries 30- day credit term , 2% factor ‘s fee , 6% holdback
reserve , and an interest of 12% per annum on advances.

REQUIRED:
A) Cash proceeds from factoring receivable
B) Effective annual financing cost of factoring the receivable

LONG-TERM FINANCING DESCISIONS

LONG-TERM FINANCING DESCISIONS – primarily aimed in determining the best mix of the permanent
source of fund used by a firm in a manner that will achieve the
optimal capital structure.

CAPITAL STUCTURE - refers to mix of the long term sources of fund used by the firm. It is composed
of long term- debt , preferred stock and common stockholders’ equity

FINANCIAL STRUCTURE - refers to the mix of all the firms assets.

Capital Structure = Financial Structure (Total Assets) – Current Liabilities

OPTIMAL STRUCTURE - refers to the mix of the long term sources of fund that will minimize the
firm’s overall cost of capital , at which the stock price is at the maximum .

OBJECTIVE: To maximize the market value of the firm through an optimal mix of long term sources of funds.

CAPITAL REQUIREMENTS : ADDITIONAL FUNDS NEEDED (AFN)

Financial management requires thorough analysis of the firm’s capital requirements . Generally, the
additional (external ) fund needed can be determined by using the following formula:

Requires increase in asset in Sales x (Assets/ Sales)

-Spontaneous increase in liabilities in Sales x (Liability/Sales)
-Increase in retained earnings* Earnings after tax - Dividend payment
ADDITIONAL FUNDS NEEDED

*Alternative Computation: increase in retained earnings = ( Expected sales x profit margin ) x retention ration

FACTORS INFLUENCING LONG-TERM FINANCING DESCISIONS

 BUSINESS RISK - uncertainty inherent in projections of future returns on assets . The greater the
business risk , the less debt should be included in its capital structure
 TAX POSITON - generally , the higher the firm’s tax rate , the more debt it should include in its capital
structure . Reason : Interest expense is tax deductible.
 FINANCIAL FLEXIBILITY - The firm’s ability to raise capital on reasonable term even under adverse
conditions.
 MANAGERIAL AGGRESIVENESS - refers to non f inancial managers’ inclination to
use more debt to
Boost profit

EXERCISE : ADDITIONAL FUND S NEEDED & CAPITAL STRUCTURE

1. ADDITIONAL FUNDS NEEDED
Ryu Corporation’s sales are expected to increase from P 5,000,000 in 2013 to P 6,000,000 in 2014. Its
assets totaled P 3, 000,000, at the end of 2013 . Ryu has full capacity , so it assets must grow in proportion
to projected sales . At the end of 2013 , current liabilities are P 1, 000,000 ( of which P 200,000 are accounts
payable, P 500, 000 notes payable and P 300, 000 accruals) . The after tax profit margin is projected to be
10% . The forecasted pay out ratio is 75%

REQUIRED:
Determine the additional funds needed from external source .
FINANCIAL MANAGEMENT

SOLUTION GUIDE

Increase in assets
-) Increase in Liabilities ( )
-) Increase in retained earnings ( )
Additional Funds Needed

Key financial ratios

 Capital intensity ratio = assets ÷ sales
 After – tax profit margin = after tax profit ÷ sales
 Dividend payout ratio = dividends per share ÷ earnings per share
 Retention ratio = 100% - dividend payout ratio

2. TARGETED CAPITAL STRUCTURE

Omega Company has the following capital structure :

Debt (16%) P 750, 000, 000

Preferred stock (12.5% , P 100 par) 300,000,000
Common stock (10 par ) 1,000,000,000,000
Retained earnings 450,000,000
TOTAL P 2, 500, 000, 000

Omega Company considers the following options for the financing of its planned expansion that requires
additional external financing for P 300,000,000 :

OPTION A

 60% borrowing at 18%

 The balance through the issuance of common shares at P 15 per share .

OPTION B

 20% borrowing at 18%

 15% preferred stock at 12. 5 to be issue at par
 65 % common to the end to be sold at P 15 per shares

Corporate tax rate is 35%

The project is likely to generate earnings before interest and taxes of P 230, 000, 000 .

REQUIRED:
Between option A an B, which option shall be selected to achieve the higher EPS?
OPTION A OPTION B
EBIT 230,000,000 230,000,000
Less: Interest expense *(152,400,000) ** (130,800,000)
Income before taxes 77,600,000 99,200,000
Less: Income Taxes(35%) (27,160,000) (34,720,000)
Net income 50,440,000 64,480,000
Less: Preferred Dividends (37,500,000) ***(43,125,000)
Income common stockholders 12,940,000 21,355,000

Number of common shares 180, 000,000 113,000,000

EARNINGS PER SHARE 0.12 0.19

Current Fixed Financing Charges :

 Annual Interest 750,000 ,000 (16%) = 120, 000, 000
 P/S Dividends = 300,000,000 (12.5%) = 37, 500, 000

Option A
 Debt (60%) = 180 ,000,000 (18%) = 32, 400,000 *
 Common Stock (40%) = 120 ,000,000 / 15 (per share) 8,000,000 shares

Option B
 Debt (20%) = 60,000,000 (18%) = 10,800,000 **
 Common Stock (65%) = 195,000,000 / 15 (per share ) 13,000,000 shares
  Preferred Stock (15%) = 45,000,000 (12.5%) = 5,625,000 ***

FINANCIAL MANAGEMENT

SOURCE OF INTERMIDIATE AND LONG-TERM FINANCING

1) INTERNAL Sources:
 Operations ( Retained Earnings)
Earning s available after the payment of interest , taxes and preferred stock dividends may be
used to either pay common , cash dividends or be plowed back into the company in the form of
additional capital investments .
Advantages of internal financing :
1. The after-tax opportunity cost is lower than for newly issued common stock.
2. Financing with retained earnings leaves the present control structure inact.
2) EXTERNAL Sources:
 DEBT (Bond) FINANCING
Basic Types of bonds or Long –term Debt :
A) Debenture Bonds - unsecured loan; issued by the companies with good credit ratings.
B) Mortgage Bonds - secured loan with pledge of certain assets, such as real property .
C) Income Bonds - pay interest only if the issuing company has earnings.
D) Serial Bonds - bonds with staggered maturities .
E) Floating Bonds - bonds with varying interest rates.
 EQUITY (Common Stock ) FINANCING
The sale of common stock is frequently more attractive to investors than debt, because it grows
in value with the success of the firm . The higher the common stock value, the more
advantageous equity financing is over debt financing .
 HYBRID FINANCING
These are sources of funds that possess a combination of features ; these include preferred
Stock, leasing , and option securities as warrants and convertibles .
 PREFERRED STOCK - a hybrid security because some of its characteristics are similar to
those of both common stocks and bonds. Legally, like common stock , it represents a part
of ownership or equity in affirm. However , as in bonds , it has only a limited claim on a
firms’’ earning a and assets.
 LEASE FINANCING
Lease - a rental agreement that typically requires a series of fixed payments that extend
over several periods .
Leasing vs. Borrowing - leasing represents an alternative to borrowing . The lease
payments are very similar to loan amortization ,with part of payment applied to
principal, and part of interest . Like loan agreements , lease contracts usually
contain restrictive covenants like the requirement to maintain minimum debt-
equity ratios of minimum level of liquid assets. Basic difference : ownership of
the asset
Leasing Benefits
 Increased Flexibility – in some cases, lease can be cancelled or replaced with a new
one depending on the need of the firm .
 Tax Savings – the tax shield generated by lease payments usually exceeds that from
depreciation if the asset were purchased .
Types of Leases :
1. OPERATING LEASES - usually short -term and cancelable ; obligations is not
Is not shown in the balance sheet , maintenance and upkeep of asset is usually provided
By the lessor ; lease payment is treated as rent expense .

2. CAPITAL OR FINANCIAL LEASE - non-cancelable , long - term lease that fully

amortizes the lessor ‘s cost of the asset ; service and maintenance are usally
provided by the lessee.
3. SALES AND LEASEBACK - Assets that are already owned by a firm are purchase by
the lessor and are subsequently leaseback to the firm .
 CONVERTIBLE SECURITIES - preferred stock or bond issue that can be exchanged for a
specified number of shares of common stock at the will of the owner . These are generally
considered hybrid securities because they provide the stable income associated with
preferred stocks and bonds in addition to the possibility of capital gains associated with
common stocks .
 WARRANT - an option granted by the corporation to purchase a specified number of shares
of common stock at a stated price exercisable until some time in the future called the
expiration date. Usually , it is attached to debt instruments as a incentive for investors to
buy the combined issue at a lower interest rate .
 OPTION - it is a contract that gives its holders the right to buy (or sell) stocks at some
predetermined price ( usually less than stocks ‘s market prices ) within a specified period of
time.