Dox 8 - Lecture notes 8 PDF

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Today we are going to talk about this short-term financing. So, for this lecture we have mainly forecast long term capital budgeting or financing both in terms of longterm financing. Today, we are going to focus mainly on short-term financing, and we have two parts of today's lecture; working Capital Management and short-term financial planning, from chapter 26 and chapter 27. So, if we can recall that in MM’s world, that is, in a perfect market, these financing actually doesn't matter; whether you take from debt or equity, whether it is short term or long term, it is just different pieces same pizza, when you put together it becomes the total value of firm. But in reality, what we have seen that due to the friction like tax, transaction cost, information asymmetry, that thing doesn't work, as a result, what happens these actually choosing the correct source and managing these things efficiently, will add value to the company and that’s the main purpose or focussing into this specific topic which is short term financing. So, when we talk about short term financing, what we are mainly dealing with, working capital. And what is working capital, we have seen week 2. That is, current asset minus current liability, what we get is working capital or sometimes referred net working capital, same thing. Now, what is that What is this working capital? the amount these companies needs for the day to day operations. It varies from industry to industry, amount of required working capital. It varies from company to company, that is, nature of business, you can think of grocery store, they usually do have high working capital requirement. They have to keep lots of inventories. On the other hand, if you think about an airline, they do not need much inventories. Rather, they mostly invest on those aeroplanes which are not short term, rather long term, that is, property plant and equipment. So, it varies from company to company, industry to industry, business to business, regarding the working Capital Management. So, we just cannot follow strict rule and policy to manage these things efficiently, rather we have to use this based on judgement, on case to case basis. Now, in the working capital as I was saying, how do we get it? current assets minus current liability, and the main components are these accounts receivable, accounts payable, cash and inventory. So, basically in the first half of today's lecture, we are going to see how to manage these 4 main components. So, before that we have to understand the basic process of a business. So, what happens when a company first needs raw materials? they place order. So, the firm buys inventory. The moment they

are placing the order, it is recorded as accounts payable, because the world is running on credit, they do not pay cash immediately. So, it is recorded as in account payable and the raw material is recorded as inventory. Now, they may get a credit 40 days or 45 days, after which they pay the cash, and in the mean time they start processing their production, the finish goods goes back to the warehouse that is also part of inventory. Now, the time they will sell, similarly the sell on credit and after that credit term, can be 30 days, 40 days, 45 days they get the cash. So, the total process is known as the operating cycle, that is, the period starting from when they place order for inventory till the process they actually received cash. So, that full period is known as operating cycle, but for working Capital Management, the main item that we need to look for is cash cycle, which is the actual impact on cash inflow and cash outflow. And what is that length; how long the company is actually out of cash. That is, the time they are paying out cash to their suppliers and the time they are actually receiving cash from there buyers, that period of time is critical, because that is the time they are most of the time out of the cash. They need these working capital mainly because of that period of time.

So, now next question is how do we measure it? Practitioners came up with some easy formula that we can use and they usually measure it using cash conversion cycle. And in order to get the cash conversion cycle, we need to do 3 calculations, that is, we need to know how to get the inventory days, how to get account receivable days and once we have them, we add them and deduct the accounts payable days. So, we can actually get this from that particular chart in previous slide. Now, these are quite simple calculations and in the numerator, say for example, in inventory days these are the average amount of inventory throughout the period. Usually one year. In one year period what was the average balance of the inventory, and we did divide that with the average daily cost of goods sold. Now, there are different ways to reflect it. In some places you may see they do it average inventory divided by average cost of good sold for the entire period. Then they multiplied with 365, you should get the same thing, doesn't matter which one you follow. The idea is, how we get this inventory days, account receivable days, and account payable days. and once we have these 3, you can just easily plugin into this relationship to get the

cash conversion cycle, which actually will help you to determine what you working capital needs are. So, thats quite straight forward.

Now, as I was saying that it varies from industry industry, business to business, this is just an example to show you that. So, for example you can think of this airlines or groceries, look at their account receivable. Very low account receivable days, maybe they have account receivable high amount, but that number of days it takes to recover is low, because what happens when you buy an airline ticket, you straight away pay with credit card or doing grocery with credit card or cash. So, using credit card for a business is considered as cash, because maybe you are paying to your back after 45 days or 50 days, but these retailers the moment they claims with your receipts, they get it instantly from bank. So, these are considered as good as cash. And that's why you’ll see they have account receivable days of very low, like these airlines, restaurants or grocery stores. On the other hand, say this Tiffany; luxury goods, jwellaries, look at their inventory days, 546. That is they need keep inventory for a very long time. In other words, lots of cash for these companies are tied up, as a result, definitely their working capital requirement is higher. Similarly, once we calculate the cash conversion cycle, what you can see for Tiffany, it is 497 days. That is, it takes more than one year, that is, the length of out of cash they are. So, that is quite long period of time. Similarly, what you can see, another interesting thing is negative cash conversion cycle. Say, they airlines, restaurants, they have negative conversion cycle. What is that? which means they receive cash from their customers earlier than they pay their suppliers. And that’s why they have negative cash conversion cycle. It varies from business to business, and the company your analysing, which industry they are operating in. so, we need to keep that in mind.

Now, ultimate goal in this unit, that is, whatever we are doing are related to value of a company. And working Capital Management adds value. How? Same concept what we have seen in capital structure, that is, if you can make a permanent debt, you can easily calculate present value tax shield, and that is the amount by which your company value goes up. same logic applies here. In your working Capital Management, with your efficiency, definitely you cannot eliminate the working capital

requirement, but you can minimize it. If you can minimize and say 50,000 a year permanently, you are reducing your working capital requirement, your company value is going up by the present value of that 50,000. So, eficient working Capital Management increase the value of the company. That’s why we study in Corporate finance. Now this is an example for those who actually may think that working capital, How do we adjust in our statements? Fine, working capital; we check cash at the beginning of a project we recovered it at the end, that is how the working capital works. And the problem is that is true, but you should look into the time value of money for a 10 year project or 15 year project, you are using say, 500,000 as working capital, which means at the beginning of the project you are inserting cash 500,000 and at the end of 10 or 15 years you are getting back your 500,000 without any interest. So, you are losing time value of money. Now, with efficient management if you can at least half that requirement, instead of 500,000 now you require only 250,000, that will add value to the company. And that is what examples trying to show you. That is, if you can reduce the requirement by your management by half, then how it will affect the firm’s value.

So the bottom line is, efficiency management of working capital will maximize firm’s value. Now we understand that why we need short term financial management or working Capital Management. Now, let's look into some quotations, that is, how actually they are quoted. We know in any business they want cash settlement, but due to the competition they actually cannot do that. That is, you always offering your customer some credit period, that is 40 day or 45 days, depending on the Norm in the industry, just to keep in the same level with competetors, otherwise you will lose your customers. Now, how do they quote it? Usually you will find that in invoice. You will find it’s written net 40/ net 45, if it is net 30, all it means that you don't have to pay anything for 30 days. On the 30th, you must pay full amount. That’s the latest. Now, some companies may prefer to offer some discount for early payment. In that case, they will quote it as 2/10 net 30 for example. That is, if you pay within 10 days, you will get 2% discount. If you dont take that discount, you must pay the full amount. So, its quite simple. Now, in terms of cost, the company who is offering this trade credit, what is their cost? their cost is the discount. That is, you are selling things on credit with this discount option, which means, if your selling $100 product with 2% discount

in 10 days or 20 days and if your customer avails it, you're not getting $100 back, you are getting only $98 back. So, that 2% discount is actually the cost for the company who is providing the credit. Now, in terms of the receiver of this credit, do they have a cost? Say, this 2/10 net 30, for first 10 days there is no cost , its free for them. The cost starts if they do not take the discount, or if they take the discount. What does it mean, say 2/10 30 for the customer, if you take up that discount, you are playing $98 in 10 days time out of your 100. If you don't do that, you will pay $100 at the end of 30 days. In other words, you are borrowing 98 for 20 days if you don't take up discount. If you take the discount, you can pay 98 dollars today. If you don't take the discount you’re paying at the 30th day. That is, you're borrowing $98 at the rate of 2% for 20 days. That is the cost. And how do you calculate? So, in the calculation you see actually you are borrowing $98 at the rate of 2.04% for 20 days. Now, if you know how to calculate the equivalent annual rate, that we include as 44.6%. that is, if you do not take the discount that’s bad for you in this scenario. If you do not take the discount, which means you are taking the opportunity to use $98 for 20 days and pay an annual interest of 44.6%, which is very high. Now, in outside from the bank or other source if you can get it for 15%, you should go for it. Take the $98 from them, give it your supplier. You are saving money, you’re maximising shareholder's wealth; You are adding value to the company. So, from this perspective this is cost for the buyer, that is, who actually is taking the loan or is not taking the loan. That is, availing the credit or not availing the credit. So, for the company who is offering, the cost is that 2%; the discount. But the company actually purchased, for their perspective it is more critical to analyse whether they should take up the discount or they should not. And that’s how they take decision.

This is another example that is, your company purchases goods from supplier on terms of 1/15 40 net, what is the effective annual cost to your firm, if it chooses not to take that advantage? So, In other words, all it means if you pay within 15 days you will get 1% discount. So, if it is say, $100, essentially you are boring $99 for 40 -15 = 25 days. So, now you calculate equivalent annual rate, which is 15.8%, compare with your outside source. If you can get it cheaper outside, you should take up this discount. If you see the market rate is 20%, just avail that facility. don't pay anything till 40 days, on the 40th day, pay your $100.

Now, some attractive features. Why? Because, one thing is what are the benefits? The benefit is, its very easy to use convenient. That is, you can think of it as a loan. If you compare it with any other loan, lots of paperworks and application you have to do. But, in this case, a trade credit; its automatic. You get it with your invoice, that’s fine. Its a benefit and attraction. You take it or you leave it, your choice. It is flexible source of funds and can be used as needed. Whenever you need you can avail it if not you won’t. it is sometimes the only source of funding available to a firm. In some companies whose who has got very high credit risk, may have some past bad records; banks will not finance them. But, these suppliers, maybe they are the regular customs they are happy to extend. So ion some cases, exceptional cases companies find that's the only source of fund for them availing trade credit depending on the situation. Now why should we offer or why should a company offer trade credit? You may think they are not banks, offering credit is something banks do. Why should a company should do that? so these are the reasons. That is, providing financing at below market rate. That is, an indirect way tlo lower prices. You can think of automobile manufacturer. So, if you want to increase their sale, what do they have to do is, reduce the price all their cars in general. Instead of doing that, what they can do? They can actually identify specific customers, they make their credit terms customise for different customers. And some customers who actually are not in a good position to afford, if you offer them very good trade credit, maybe they'll take the offer. And as a result, your purpose is served. Your sale is going up, your company value is going up. So, they can actually customise, and that will add benefit. That is one reason why they should offer. Another is because, supplier may have an ongoing business relationship. So, as I was saying that most of the cases these supplier do not change. The customer relationship is based on trust, and when you are doing business for last 5 years with the same company, for some reason in one particular year the company made a loss, you will not stop giving them. But the bank will stop lending them. So, that is another reason they found, that because of this relationship and long-term knowing of each other and they know they actually are quite regular in pay, even if there financial difficulties they will come up with some alternatives. So, in that case they will do it. And if the buyer default, supplier may be able to cease the inventory. So, again it is for those regular business, so in that is what happens if you

default, you will not get your next supply from them. And for a company not getting inventory is a big problem, they will not be able to conduct their production. So, these are some reasons why companies should actually offer trade credit.

Now, one factor that contributes to the length of this account receivable, account payable, is the timing, even though its very minimal, the timing of when a company is paying and other company is receiving the cash in actual term. And that is actually known as this collection float. This collection float is for accounts receivable, that is, when you have account receivable which means you're expecting money from your customers. This collection float is, how long days after they actually paid, and you actually received the cash, and you can use it. Maybe, 2-3 days that period is actually the collection float. Now, this collection float depends on 3 further things; Mail float, processing float and availability float. What is Mail float? It is those who actually settle transaction, using check. Now, it depends whether you have done business Inter-state, Inter-country or in the same city. Depending on that, this Mail float will vary. So, all they’re trying to say is, you the buyer is actually issuing the check and mailing it, how long it takes to reach you, that is what Mail floated. What is processing float? Once, you received the check, how long it takes for you to actually deposit it and get the cash. Now, what happens in companies medium to large size companies, they receive various check during everyday or throughout the week. So, it is not efficient for them to go to bank every one hour with the cheques and deposit. So, some company may have policy, that they do it twice a week. So, in that case, a check is sitting in your office for 2-3 days, before it is going to the bank. So, that is processing float. How long it take for your company to do the process. and what we have availability float, that is how long it takes a bank to give a company credit, that is, even when you submit the check to the bank, that actually you do not get credit in your account instantly. It needs to go through the clearing house, it need to be cleared and only then you will get the amount into your account. So, it is basically a collection of various factors all these different float on which the collection float is dependent and this collection float actually has some impact on the length of account receivable day, which has impact in your working capital management. So, that’s all we are trying to say here. And from the table’s prospective, they do have this disbursement float, that is, the moment you’re sending the check, how long it takes

your balance to go down in that account. So, sometimes it may take 1 or 2 days or even more unless and until the receiver submit the cheque to the bank. So it varies from day to day. But the terminologies for that is this disbursement float. But, in recent times, because of this electronic cheque processing these collection float, disbursement float has actually considerably gone down. And if you take these electronic transfer as payment, in that case you can eliminate most of these issues. So, it varies from company practice. The market, whether it is a developed country or not. So, there are lots of additional things that actually makes this collection and disbursement float longer or shorter.

Now, we've got the general idea. let's look into the specific item. We have seen in working capital key four components. Accounts receivables, the account payable, inventory and cash. And now we are going to look into some basic Management policy and tools to use out there to manage each of the four. So, let's start with this receivable management. So, first step or one of the main thing is you have to determine the policy, what type of credit policy you are going to set for your customers. And for that, the first step is, establishing the standard. What do you mean by standard? Are you going to give credit to all your customs, or you want selective customers to avail this credit. That is what you set in this credit standard. Now, if you decide you are not going to give it to each and every customer; selective. Or, it is each and every customer, what you have to do? you have to asess the individual customs. Their credit rating or their credit risk, past credit performance and then you set a policy, that customers with this particular capability will access the credit or we will offer credit to only such fir,s who fulfill these requirements,. ...