CDA COLLEGECDA COLLEGE

BUS235: PRINCIPLES OF BUS235: PRINCIPLES OF FINANCIAL ANALYSISFINANCIAL ANALYSIS

Lecture 10Lecture 10

Lecturer: Kleanthis Zisimos Lecturer: Kleanthis Zisimos

What is working capital technologyWhat is working capital technology Working capital investmentsWorking capital investments Financing policiesFinancing policies Advantages and disadvantages of short term Advantages and disadvantages of short term

financingfinancing Short term bank loansShort term bank loans The cash conversion cycleThe cash conversion cycle

Lecture Topic ListLecture Topic List

The purpose of this lecture is to explain the The purpose of this lecture is to explain the nature of working capital and the nature of working capital and the importance of it to the financial manager. importance of it to the financial manager. We will also analyze various ratios which We will also analyze various ratios which help the financial manager to understand help the financial manager to understand how working capital is controlled.how working capital is controlled.

Working capital is the name given to net Working capital is the name given to net current assets which are available for day-current assets which are available for day-to-day operating activities.to-day operating activities.

Working capital Working capital = Current assets- current = Current assets- current liabilitiesliabilities

What is Working capitalWhat is Working capital

Working Capital Working Capital = Current assets.= Current assets. Net Working Capital Net Working Capital =Current assets =Current assets

minus current liabilities.minus current liabilities. Current ratio= Current ratio= current assets/ current current assets/ current

liabilitiesliabilities Quick or acid test ratio Quick or acid test ratio =Measures =Measures

liquidly and is found by subtracting stock liquidly and is found by subtracting stock from current assets so the formula is =(CA-from current assets so the formula is =(CA-stock) / CLstock) / CL

Working capital terminologyWorking capital terminology

Working Capital Policy Working Capital Policy = refers to the = refers to the firm’s basic policies regarding (1) targets firm’s basic policies regarding (1) targets levels for each category of current assets levels for each category of current assets and (2) how current assets will be and (2) how current assets will be financed.financed.

Working Capital Management Working Capital Management = = involves the administration, within policy involves the administration, within policy guidelines, of current assets and current guidelines, of current assets and current liabilities.liabilities.

Working capital terminologyWorking capital terminology

Investment policies answer to the question of what is the appropriate level for currents assets. We have three alternative policies:

1.1. Relaxed Current Asset Investment Policy = a Relaxed Current Asset Investment Policy = a policy under which relatively large amounts of policy under which relatively large amounts of cash, marketable securities, and inventories cash, marketable securities, and inventories are carried and under which sales are are carried and under which sales are stimulated by a liberal credit policy, resulting stimulated by a liberal credit policy, resulting in a high level of receivables.in a high level of receivables.

2.2. Restricted Current Asset inv. policy = a policy Restricted Current Asset inv. policy = a policy under which holding of cash and securities are under which holding of cash and securities are minimizedminimized

3.3. Moderate current asset inv policy= a policy Moderate current asset inv policy= a policy that is between the relaxed and restricted that is between the relaxed and restricted policies.policies.

Working Capital Investment Working Capital Investment policiespolicies

Working Capital Financing policiesWorking Capital Financing policies

Working capital financing policy deals with the issue Working capital financing policy deals with the issue of how temporary and permanent current assets are of how temporary and permanent current assets are financed. We have three approachesfinanced. We have three approaches

1.1. Maturity matching approachMaturity matching approach. It matches current . It matches current assets and liabilities maturities .This strategy assets and liabilities maturities .This strategy minimizes the risk that the firm will be unable to pay minimizes the risk that the firm will be unable to pay off its maturity obligations.off its maturity obligations.

2.2. Aggressive Approach Aggressive Approach = it finances fixed assets = it finances fixed assets with long term capital and part of its permanent with long term capital and part of its permanent current assets with short – term debt.current assets with short – term debt.

3.3. Conservative Approach Conservative Approach = Long term capital is = Long term capital is being used to finance all permanent asset being used to finance all permanent asset requirements and also some of the temporary requirements and also some of the temporary current assetscurrent assets

Speed. A short term loan can be Speed. A short term loan can be obtained much faster than a long obtained much faster than a long term loanterm loan

Flexibility is increases in short term Flexibility is increases in short term loansloans

Interest rates are generally lower in Interest rates are generally lower in short term financingshort term financing

Short term financing is riskier than Short term financing is riskier than long termlong term

Advantages and disadvantages of Advantages and disadvantages of short term financingshort term financing

Short – term credit Short – term credit is defined as any is defined as any liability originally scheduled for payment liability originally scheduled for payment within one year.within one year.

The sources of short – term funds which The sources of short – term funds which are: are:

AccrualsAccruals Accounts payable (trade credit)Accounts payable (trade credit) Bank loansBank loans Commercial paper.Commercial paper. FactoringFactoring

Sources of short term financingSources of short term financing

Accruals are the expenses which are not Accruals are the expenses which are not paid on time like wages, taxes social paid on time like wages, taxes social securitysecurity

However, a firm cannot ordinarily control However, a firm cannot ordinarily control its accruals: The timing of wage payments its accruals: The timing of wage payments is set by economic forces and industry is set by economic forces and industry custom, while tax payment dates are custom, while tax payment dates are established by law.established by law.

Thus, firms use all the accruals they can, Thus, firms use all the accruals they can, but they have little control over the levels but they have little control over the levels of these accounts.of these accounts.

AccrualsAccruals

Firms generally make purchases from other Firms generally make purchases from other firms on credit, recording the debt as an firms on credit, recording the debt as an account payableaccount payable. .

Accounts payable, or trade credit, is the Accounts payable, or trade credit, is the largest single category of short term debt, largest single category of short term debt, representing about 40 percent of the current representing about 40 percent of the current liabilities of the average nonfinancial liabilities of the average nonfinancial corporation.corporation.

The percentage is somewhat larger for smaller The percentage is somewhat larger for smaller firms: Because small companies often do not firms: Because small companies often do not qualify for financing from other sources, they qualify for financing from other sources, they rely especially heavily on trade credit.rely especially heavily on trade credit.

Accounts payableAccounts payable

Commercial bank loans Commercial bank loans are second in are second in importance as a source of short term importance as a source of short term financing. The key features of bank loans are:financing. The key features of bank loans are:

MaturityMaturity = Bank loans are frequently written = Bank loans are frequently written as 90 – day notes, so the loan must be repaid as 90 – day notes, so the loan must be repaid or renewed at the end of 90 days.or renewed at the end of 90 days.

Promissory Note Promissory Note = A document specifying = A document specifying the terms and conditions of a loan, including the terms and conditions of a loan, including the amount, interest rate, repayment schedule the amount, interest rate, repayment schedule and collaterals.and collaterals.

Compensating Balances Compensating Balances = A minimum = A minimum checking account balance that a firm must checking account balance that a firm must maintain with a commercial bank, generally maintain with a commercial bank, generally equal to 10 to 20 percent of the amountequal to 10 to 20 percent of the amount of of loans outstanding.loans outstanding.

Short term Bank loansShort term Bank loans

The cost of bank loans varies for The cost of bank loans varies for different types of borrowers at any given different types of borrowers at any given point in time, and for all borrowers over point in time, and for all borrowers over time. time.

Interest rates are higher for riskier Interest rates are higher for riskier borrowers, and rates are also higher on borrowers, and rates are also higher on smaller loans because of the fixed costs smaller loans because of the fixed costs involves in making and servicing loans.involves in making and servicing loans.

Interest rates are calculated in 3 waysInterest rates are calculated in 3 ways1.1. Simple interestSimple interest2.2. Discount interestDiscount interest3.3. Add on interestAdd on interest

Cost of Bank loansCost of Bank loans

Regular or Simple rate Regular or Simple rate is the interest is the interest that is charged on the basis of the amount that is charged on the basis of the amount borrowed; it is paid when the loan ends borrowed; it is paid when the loan ends rather than when it begins.rather than when it begins.

On a 1-year loan the effective annual rate On a 1-year loan the effective annual rate isis

Effective annual rate Effective annual rate = = InterestInterest

Amount receivedAmount received

Simple interestSimple interest

Discount InterestDiscount Interest is the interest that is is the interest that is calculated on the face amount of a loan calculated on the face amount of a loan but is paid in advance.but is paid in advance.

On a 1-year loan the effective annual rate isOn a 1-year loan the effective annual rate is Effective annual rateEffective annual rate = = Interest Interest

Face Value - interestFace Value - interest

Discount interestDiscount interest

Add – On Interest Add – On Interest is the interest that is is the interest that is calculated and added to funds received to calculated and added to funds received to determined the face amount of an determined the face amount of an installment loan.installment loan.

Approximate effective annual rate Approximate effective annual rate ==InterestInterest(Amount received) / 2(Amount received) / 2

Add on interestAdd on interest

Commercial Paper is a type of an unsecured Commercial Paper is a type of an unsecured promissory note issued by large firms, promissory note issued by large firms, usually in denominations of €100,000 or usually in denominations of €100,000 or more and having an interest rate somewhat more and having an interest rate somewhat below the prime rate.below the prime rate.

Maturities vary from one month to nine Maturities vary from one month to nine months. The rates also vary according to months. The rates also vary according to the market but are closed to the stated the market but are closed to the stated prime rates.prime rates.

Commercial paper is never secured, but all Commercial paper is never secured, but all other types of loans can be secured if this is other types of loans can be secured if this is deemed necessary or desirable.deemed necessary or desirable.

Commercial PaperCommercial Paper

FactoringFactoring

Factoring involves the purchase of Factoring involves the purchase of accounts receivable by the lender without accounts receivable by the lender without recourse to the borrower which means recourse to the borrower which means that if the purchaser does not pay then the that if the purchaser does not pay then the lender and not the borrower takes the lender and not the borrower takes the loss.loss.

Since the factoring firm assumes the risk Since the factoring firm assumes the risk of default it must make the credit check of default it must make the credit check and then proceed with the purchase.and then proceed with the purchase.

The rates are higher than the normal rates The rates are higher than the normal rates of the marketof the market

The Cash Conversion Cycle (CCL)is the length of time from The Cash Conversion Cycle (CCL)is the length of time from the payment for the purchase of raw material to the the payment for the purchase of raw material to the collection of accounts receivable generated by the sale of collection of accounts receivable generated by the sale of the final product.the final product.

Inventory Conversion periodInventory Conversion period = = InventoryInventory Sales/360Sales/360

Receivables collection periodReceivables collection period = = ReceivablesReceivables Sales/360Sales/360

Payables deferral periodPayables deferral period = = PayablesPayables credit purchases/360credit purchases/360

CCLCCL= Inventory Conversion period+ Receivables Collection period – Payables Deferral = Inventory Conversion period+ Receivables Collection period – Payables Deferral periodperiod

Cash Conversion cycleCash Conversion cycle