Chapter 1-5 CH1 STFM:speeds up 1) conversion inv. into sales 2) collect cash on credit sales 3) optimize timing of cash disbursements. All 3CF. 4) shortens CCC. Responsible for: cash management, external financing, stfm, risk management.Working Capital:Cash&Equivalent, A/R, Inv., A/P, Accruals. CCC:number of days it takes to move funds from inventory to receivables and from receivables to cash, after accounting for the payables period.CCC= impliesLiquidity due toWCR which OCF. Also impliesexternal financing required (borrowing) whichInterest Expense andNI. efficient STFM (-iveCCC: DPO exceeds the OC and payables are funding inventory and A/R) can happen due to generous credit terms offered by supplier.Balance Sheet=>Liquidity Management:Increases in financial working capital assets (cash holdings) increase liquidity as CF is realized and retained. Increases in current operating assets reduce liquidity as more cash resources or external financing are required for funding.Income Statement=>Liquidity Management:Revenue is linked to liquidity through inventory and trade credit policies.Cash Flow Statement=>Liquidity Management:The higher the operating net cash flow, the more liquidity will increase. Financing cash flow allows access of credit lines provides a source of liquidity.Firm Liquidity: firms ability to pay its financial obligations when due despite economic conditions. High working capital in current assets. Liquidity is necessary for firm value maximization.Liquidity: the ease with which an asset can be sold at market value. liquidity=risk,solvent=profitability CH2 Solvency:Degree that current assets provide coverage for current liabilities. Concerned with default risk (creditors like solvency measures).Solvency Measures Inadequate for Evaluating Firm Liquidity:Liquidating noncash current assets to meet current liabilities disrupts operations and strategic objectives. Solvency measures assume equal time-to-cash conversion rates across all current assets. Firm can be solvent but not liquid.Current ratioshows the degree of coverage that current assets provide to short-term creditors. Insolvent <1<solvent.Quick ratio shows the degree of coverage that cash holdings and receivables provide to current liabilities. Insolvent <1<solventNWC= amount firm has to pay its operational expenses and debts.NWC=0; current liabilities fully fund current assets(Matching).+NWC:long term financing is used to fund a portion of current assets (Conservative) Pros:interest rate and refinance risk. Cons: profitability since borrowing ratesfor long-term financing.-NWC:current liabilities fully finance current assets as well as a portion of long term assets (Aggressive) Pros:financing cost for current liability causesinterest expense andprofitability. Cons:financial distress risk. Ex: NWC=5$ indicates that firm requires $5 in additional financing from long-term sources to fund current assets.WCR: amount of external financing needed to cover operating expenses. (WCR=OCF by same amount)+iveWCR=solvency (current operating assets provide enough liquidity to cover accruals and A/P)-iveWCR=solvency (current operating assets don't have enough liquidity to cover accruals and A/P).DIH: average days to turn inventory into revenue. DSO: average days to collect on sales made on credit.DSO: days on average to pay suppliers.
CCC: # of days between cash outflow and cash inflow.Limitations of using CCC to evaluate Firm Liquidity: averages across all goods sold does notreflect the actual time-to-cash conversion rates. Seasonality in operations may lead to inaccurate estimates of the CCC. Possible to get -iveCCC.Net liquid balance (NLB): cash holdings minus current financial liabilities. +iveNLB= current financial liabilities can be covered without exhausting cash holdings. -iveNLB= extent to which future cash inflows or external financing (line of credit) are required to cover current financial liabilities. Ex: NLB= -$400 000 implies Short-term financial liabilities exceed cash holdings by $400,000. WCR:if wcr= 10$ implies $10 in external financing (non- supplier generated financing) is required to fund current operating assets.Days' cash held (DCH):#days firm can cover its CGS with its cash position without receiving liquidity from operations or external financing.ToDCH= firm need tocash holdings orCGS Lambda: captures ongoing changes in liquidity Expected liquid reserve= sum of cash&equivalents, expected daily net cash flow, funding available for credit line.NCF= sd of daily net cash flow. Ex: Lambda=1.5 implies that expected liquid reserveof $x can cover a drop in net cash flow of 1.5 standard deviations without becoming illiquid. Check z-score for %probability staying liquid = 93% and (1-.93)=7% prob of experiencing illiquidity.λ=cash holding,use of credit line,daily cash flow,σNCFComplexities with using Lambda (λ) to Assess Firm Liquidity:λ involves unique data requirements: lines of credit availability and the estimation of expected daily net cash flows. Expected daily NCF and σNCF must be estimated using statistical approaches. The λ methodology assumes that daily net cash flows are normally distributed. CH3 PV and Firm Value: the effect of timing on PV of cash flows motivates managers to monitor timing of inflows and outflows of cash. Strategy that speed up cash receipts increase PV of cash inflows and firm value. Strategy that slow down cash disbursements decrease PV of cash outflows but increase firm value.CCC=earnings andshare price.How? =>ing OCF bying WCR whichexternal financing andinterest expense which in turnEPS.Share price by multiplying higher EPS by P/E multiple. CH4 Inventory: hedges against unpredictability in 1) customer demand 2) timing of deliveries 3) supply of raw material 4) future price changes.Pros:1) Transaction motive: inventory held for customer demand 2) speculative motive: inventory held to take advantage of changing industry 3) precautionary motive: held as a hedge for adverse conditions.Cons:1) insurance premium 2) storage expense 3) taxes 4) financing costs (direct= interest expense, indirect= opp. Cost Tradeoff of inventory: too much=cash andcosts. Too little=sales andcustomer service. 3types of inventory:1) raw material (RMI) 2) Work in process (WIP) 3) Finished Goods (FGI) Economic Order Point (EOQ): inventory quantity that minimizes total costs of inventory. Reorder Point: ex: EOQ=35 and Reorder Point=12 => once inventory is at 12 units, the store should place order for 35 unitsBalance Fraction: proportion % of each month's purchases remaining as inventory at the end of a given month.Inventory balance fraction= improved
inventory management, which in turn =OCF,liquidity,borrowing,interest expense, and profit CH5 Trade credit: buyer acquires goods without immediate cash outflow. Costs of extending trade credit(Cons):1) opportunity cost of funds 2) cash discounts (if buyer pays within period) 3) bad debt expense 4) Administrative costs(Pros):revenue andoperating cost due to uncertain demand.How to Optimize?:1) aggressive policy(revenue by increasing credit periods but carrying cost of receivables) 2) restrictive policy (give credit to only strong credit buyers carrying cost of receivables)Five C's of credit worthiness:Character: refers to a credit applicant's quality of management and overall integrity.Capital: the credit applicant's net worth (or book value of shareholder equity). Higher capital or net worth implies higher creditworthinessCapacity:ability to service financial obligations when due. Proxied by earnings or cash flow.Conditions: general health of the current and projected macro economy as well as that for the credit applicant's specific industry.Collateral:assets pledged by the credit applicant to the creditor as security to back up the requested loan.Invoicing floatis the interval between the delivery of goods or services to the buyer and the buyer's receipt of the invoice. After submitting the invoice and receiving payment, the seller must apply the payment to the outstanding account balance, which is known ascash application.This is done to keep track of buyers paying on time.Tools to monitor receivables: Average past due: Compare DSO to the stated credit period. If DSO exceeds the credit period, then the seller has a collection problem. Ex: if DSO = 90 days and net credit period is 60 days, then the average past due is 30 daysAging schedules: Table that decompose the balance of receivables into current and past-due age brackets.Balance pattern:Table that shows the percentage of monthly credit sales outstanding at the end of the current and future months. These percentages can be used to plan liquidity needs and to benchmark collection efficiencies. /Uncollected receivables: 1) Bad debt expense: An expense shown on the income statement indicating the seller's estimate of the percentage of the period's credit sales that will be uncollectable.bad debt expense bycredit sales and extension of credit to less credit worthy buyers.2) Allowance for doubtful accounts: A contra account that reduces the receivables balance to reflect the potential for defaults on credit sales. Pros of Lending to buyers: 1) Information advantage: Sellers observe buyer payment behavior 2) Control: Control of the supply chain of inputs makes buyers pay on time. 3) Salvage value: Sellers have an improved ability to repossess and resell goods recovered from default. Short Term financing for receivables: Asset-based lending(Seller seeks funds from a bank by putting receivables as collateral) Securitization(Seller issues short-term securities backed by receivables) Private-label financing(A third party operates the credit function in the seller's name) Third-party financing(Seller outsources the credit and receivables management functions to a financial institution) Card payments(Seller accepts payment via card) Trend in DSO: did not change much over the decades. Wholesalers have much bigger DSO than retailers. Low market share, Difficulty assess product quality, cheap access to capital, low level of receivables => extend trade credit =>shareholder return, net profit , return on asset