Lecture Short-Term Financial Decisions

Corporate Corpora te Finance 8. Financial Planning and Short-Term Financial Decisions

Short-Term versus Long-Term Financial Decisions Long-Term Financial Decisions

Short-Term Financial Decisions

Not continuous, segregated by projects and subject to a previous prev ious valuation analysis.

A continuous process, giving way to a permanent succession of current assets (assets easily convertible in cash).

Based on contracts carefully designed (as complete as possible), preventing unwanted transfers of value between shareholders and creditors.

Although they may take a contractual form (a loan contract), they will be based on a general financing agreement kept for a certain certain period.

Follow a determined strategic orientation, in the company business, as well in its capital structure.

Intimately associated with business dynamics, depending of its characteristics and requiring financial planning.

Short-Term versus Long-Term Financial Decisions Long-Term Financial Decisions

Short-Term Financial Decisions

Not continuous, segregated by projects and subject to a previous prev ious valuation analysis.

A continuous process, giving way to a permanent succession of current assets (assets easily convertible in cash).

Based on contracts carefully designed (as complete as possible), preventing unwanted transfers of value between shareholders and creditors.

Although they may take a contractual form (a loan contract), they will be based on a general financing agreement kept for a certain certain period.

Follow a determined strategic orientation, in the company business, as well in its capital structure.

Intimately associated with business dynamics, depending of its characteristics and requiring financial planning.

Short-Term versus Long-Term Financial Decisions

€

At

Short-term financing

Ac

At = total assets

Af

0

Long-term financing

Ac = current assets Af = fixed assets

Time

Summary I.

Short-Term Financial Management

II.

Liquidity Management

III. Trade Credit and Receivables Management IV. Invent Inventory ory Management M anagement V.

Short-Term Financing

I. ShortSh ort-T Term Financial Fi nancial Manage Management ment •

Questions to be answered by short-term financial management •

What amount of cash (or equivalent equivalent)) should the company keep?

•

What amount (and period) of credit should the company grant to its clients?

•

How much short-term financing should the company raise?

•

In brief:

What is the optimal invest investment ment in working capital?

I. Short-Term Financial Management •

In order to answer these and other questions, company management should identify correctly: •

Business cycle •

•

Operational cycle •

•

AIP

AIP + ACP

Cash-flow cycle •

AIP + ACP - APP

AIP = average inventory period;

ACP = average collection period;

APP = average payment period


Cash-flow cycle •

Examples

Power supply companies Health care equipment Paper products Restaurants

AIP

ACP

18 46 39 5

41 73 38 10

Operational Cycle APP 59 119 77 15

31 17 26 14

Cash-flow Cycle 28 102 51 1

Central values; study published by CFO magazine (2007)


Is there an optimal level of current asset investment? •

Trade-off between: •

Costs increasing with the amount of current asset investment (carrying costs) •

•

•

Opportunity cost (usually, the return on these assets is lower than the required cost of capital); Holding costs;

Costs decreasing with the amount of current asset investment (shortage costs) •

•

Trading costs: resulting from the need to sell assets in order to obtain liquidity; Costs related with the non existence of a precautionary reserve: loss of sales; loss of clients; disruption of the production process.


Is there an optimal level of current asset investment? €

Total costs Holding costs

Shortage costs

0

CA*

Current assets



It changes from one company to another Companies with High Current Asset Investments

Companies with Low Current Asset Investments

Many growth opportunities

Little investment opportunities

High risk investments

Low risk investments

Small dimension

Big dimension

Low rating

High rating Opler, Pinkowitz, Stulz and Williamson, “The Determinants and Implications of Corporate Cash Holdings”, JFE (1999)



It changes from one company to another Companies with High Current Asset Investments

€

Total costs

Companies with Low Current Asset Investments € Total costs

Shortage costs

Holding costs Shortage costs

Holding costs 0

CA*

CA 0

CA*

CA


How should current assets be financed?

Seasonal variation of current assets € Permanent current assets

Total assets

0

Fixed assets (long-term)

t


How should current assets be financed? •

Restrictive strategy Short-term financing

€

Long-term financing

0

t



Flexible strategy Investment in liquid assets

€

Long-term financing

0

t



The choice of strategy should take into account: •

•

Big cash reserves: •

They reduce the liquidity risk;

•

High opportunity cost;

Different maturities of assets and financing contracts: •

Financing permanent assets with short-term debt increases interest rate risk, because short-term rates are more volatile and short-term financing contracts can be withdrawn at shorter notice.

•

Time structure of interest rates: •

Long-term rates tend to be higher than short-term rates.


Short-term financial decisions (working capital management) include the following areas: •

Liquidity management;

•

Trade credit and receivables management;

•

Inventory management;

•

Short-term financing.

Summary I.


II.


III. Trade Credit and Receivables Management IV. Inventory Management V.


II. Liquidity Management

Coordination of collection and payment movements and use of financing instruments in such a way to preserve the capacity of the company to meet all financial obligations resulting from its business operations.

II. Liquidity Management •

For a better liquidity management, it is necessary: •

Calculate, study and manage the business cycle and the cash cycle of the company;

•

Understand every characteristic of the company business and its effect on cash movements and on the formation of current assets (trade credit and inventory).


To make liquidity management effective, it is necessary: 1. Ensure adequate liquidity levels of the company: •

Effective matching of cash inflows and cash outflows;

•

Constitution of cash reserves (or else, negotiation of credit facilities);

2. Control daily cash-flows: •

Monitor collections and process payments;

•

Monitor cash and bank deposit balances;

•

Exercise options included in credit facilities.

3. Ensure the prompt use of all excess cash resources.


To make liquidity management effective, it is necessary: 4. To activate efficient short-term financing solutions, with respect to: •

Cost of capital;

•

Flexibility of financing raising solutions;

•

Activation of funds.

5. Measure and control risks, namely liquidity risk and interest rate risk, what is once again related with flexible contractual solutions.


To make liquidity management effective, it is necessary: 6. Prepare cash-flow budgets: •

Cash forecasts (for different time horizons) which allow the anticipation of liquidity shortages and the activation of solution for those difficulties.

7. Gradually build balanced contractual relationships with providers of funding, namely by establishing a network of banking relationships which proves favourable to the company. 8. Systematically gather relevant information about every movements around all classes of current assets and short-term debts.


Reasons to hold cash and liquid deposits: •

Speculative motive: •

Resources available to seize opportunities to buy goods and services for a lower price, to make investments with attractive returns or, in the case of international companies, take benefit of exchange rate fluctuations.

•

Preventive motive: •

•

Resources to be used as a reserve to offer financial stability.

These motives may justify the holding of a given level of liquidity but not necessarily under the form of cash or liquid deposits.


Reasons to hold cash and liquid deposits: •

Transaction motive: •

To ensure the payment of salaries, accounts payable, taxes and dividends;

•

As far as cash inflows (collections or new financing) might not be perfectly matched, some amount of reserves will be necessary to meet unexpected obligations;

•

When unexpected obligations become recurrent, the company should consider the possibility of raising new long-term financing.

•

Collateral •

Minimum cash reserve, required by a financial institution in exchange of bank services provided (guarantees, letters of credit or even new loans).


Costs from holding cash and liquid deposits •

Opportunity cost: •

Returns forgone by the company from the best alternative uses of its cash resources, i.e., investments in highly liquid tradable securities.

•

Benefits from holding cash and liquid deposits •

Saving of transaction costs (sale of tradable securities) or costs of short-term financing go meet immediate obligations, sach as salaries and accounts payable.

•

The optimal amount of cash reserve depends on this trade-off.


Situations to take into account in the application of excess cash and liquid deposits holdings: •

Maturity of investments – interest rate risk;

•

Default risk;

•

Liquidity;

•

Taxes

Summary I.


II.




III. Trade Credit and Receivables Management

Definition of the trade credit conditions to be offered to clients, in businesses where sales depend on credit granting, in order to maximize the commercial benefits of trade credit policy adopted and contain the costs associated with it within the limited defined by sales gross margin.

III. Trade Credit and Receivables Management •

The components of trade credit policy: •

•

Terms of sale: •

Cash or term payment?

•

Cash payment discount? How much and for how long?

•

Which credit period? Which credit instrument?

Credit analysis: •

•

Credit policy equal to every client or previous credit analysis to determine the risk of default?

Collection policy: •

Collection department? Outsourcing to a specialized company??


Terms of sale: •

Usually pre-defined: •

Cash payment discount (usually: 2-3%)

•

Period of discount (usually: 5-10 days after invoice)

•

Period of credit (usually: 60-90 days)


Terms of sale •

Actual cost of cash payment discount •

Example: 2% cash payment discount if payment is done within 10 days, or else total invoice payment within 60 days 98

D

•

•

D + 10

100

D+60

50 dias

r (actual cost of cash payment discount):

98 

100 (1  r )

50

365

r = 15,89%

The same represents the effective cost of credit for the client if he chooses to take credit.


Terms of sale •

Duration of credit period •

Factors affecting the credit period granted by the company: •

Degree of deterioration of goods •

•

Consumer demand •

•

Goods of rapid deterioration (fresh fish, for example) represent a weak collateral in case of default; in these cases, credit period tends to be short;

Goods of high demand tend to be paid at shorter term, while new products tend to be given longer credit periods, in order to attract clients;

Cost, profitability and standardization •

Products relatively standardized, of low price and little profitability tend to be given shorter credit periods (cars, for example).


Terms of sale •

Duration of credit period •

Factors affecting the credit period granted by the company: •

Credit risk •

•

Dimension of receivables account •

•

The smaller the receivables amounts, the shorter the credit period, because credit management costs become (proportionally) higher;

Competition •

•

The higher the credit risk the shorter the credit period;

In more competitive markets, credit period tends to be longer;

Nature of clients •

Different types of clients may mean different credit periods.


Terms of sale •

Credit instruments •

Invoice / delivery document •

The company maintains a an account with the client where the invoice or the delivery document prove that the goods have been delivered.

•

Promissory;

•

Letter of credit •

Term or at demand.


Credit analysis •

Factors to take into account: •

Effect of credit in cash inflows (volume of sales and price);

•

Effect of credit on costs (collection period);

•

Cost of short-term financing;

•

Probability of default;

•

The value of cash payment discount.


Credit analysis •

The cost / revenue trade-off model •

Effect on the value of the company from offering one month credit period: •

•

Revenue •

(P – v) x Q’ - (P – v) x Q = (P – v) x (Q’ – Q)

•

PV [(P – v) x (Q’ – Q)] = (P – v) x (Q’ – Q) / R

Costs •

P x Q + v x (Q’ -Q)

P = price per unit v = variable cost per unit Q = present monthly sales

•

NPV = [(P – v) x (Q’ – Q) / R] – [P x Q + v x (Q’ -Q)]

Q’ = new sales (after new credit policy)

•

NPV = 0 → (Q’ – Q) = P x Q / [(P – v)/R – v]

R = required rate of return (monthly)


Collection policy •

•

•

Collections monitoring •

Analysis of ACP;

•

Analysis of maturity of receivables;

Collection actions: •

Letters demanding payment overdue receivables;

•

Phone calls;

•

Contracting a collection agent;

•

Legal action;

Factoring.

Summary I.


II.




IV. Inventory Management

Defining rules for supply and holding of inventory, which minimize its associated costs, namely financial costs of inventory, administrative costs and shortage costs.

IV. Inventory Management •

Types of inventory: •

Raw materials;

•

Work in progress;

•

Finished products;

•

Goods.


Costs •

•

Carrying (holding) costs •

Storage;

•

Insurance and taxes;

•

Loss of value due to obsolescence;

•

Opportunity cost.

Shortage costs •

Ordering costs (supply costs);

•

Opportunity costs (shortage cost) •

Related to loss of sales, of clients or disruptions in production.


Methods of inventory management •

The ABC method •

Break down the stock into 3 (or more) groups •

A – 10% of products (per unit) representing the biggest amount of inventory;

•

C – 50% of products (per unit) representing the lowest amount of inventory;

•

B – the class in between;

•

Goods in group A are permanently monitored and their inventory levels are kept low;

•

Goods in group C are ordered in great quantities and their inventory levels are kept high.



Method of economic order quantity (EOQ) •

To minimize storage and ordering costs •

Let: •

Q – quantity to order;

•

ka – cost of storage per unit;

•

F – fixed cost per order;

•

T – sales per year;

•

Storage cost = Q/2 x k a

•

Ordering cost = F x (T/Q)

•

Minimum cost : Q*: Q*/2 x k a = F x (T/Q*) →

Q*  2TxF k a




Extensions •

Safety inventory level •

Determined as a function of shortage probability and costs

Q

Minimum inventory Safety inventory 0

Time




Extensions •

Ordering point •

Determined as a function of delivery time

Q

Ordering point

Time

0 Delivery time



The special case of inventory dependent on the needs of other inventory •

Material Requirements Planning (MRP) •

Capacity to determine the inventory needs at early stages of the production process, based on expected demand of final product;

•

Just-in-time (JIT) •

Little inventory or no inventory;

•

Small quantities orders but very often;

•

It requires close cooperation with suppliers.

Summary I.


II.


III. Trade Credti and Receivables Management IV. Inventory Management V.


V. Short-Term Financing

Defining a financing supply function for the company, which allows it to use the most efficient financing instruments to meet eventual temporary shortages of liquidity.

V. Short-Term Financing •

In “normal” conditions: •

Long-term financing should be used to finance investment in fixed assets and in permanent working capital.

•

Short-term financing should be used to support liquidity management and to deal with the instability of cash-flows in the company.

•

In practice: •

Short-term financing has been too often used (in Portugal) as a surrogate of long-term financing (in a system of roll-over), because of a believed easier access to this type of financing (recently contradicted by reality).


Short-term financing does not differ from long-term financing with respect to: •

Financing cost evaluation (all-in);

•

Influence of:

•

•

Financial innovation;

•

Degree of development of the monetary markets;

•

Capacity of management to absorb financial innovation;

The presence of options.


Short-term financing instruments: •

Bank loans;

•

Promissory discount;

•

Current account;

•

Documental credit;

•

Overdraft agreement;

•

Commercial paper;

•

Factoring.

The use of these instruments must be based on financial planning, namely on a cash budget.

Lecture Short-Term Financial Decisions

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