FIRE654 Oct 3 Mid-term Review

FIRE654: Short Term Financial Management Ceyed Baiju, Fall 2012VCU School of Business 1

Present Value and Future ValueC0 CT

PV0

Present Value at Time = 0FVT

Future Value at Time = T

r = Nominal Interest Raten = Number of periods interest will be paid in an year


• Different Compounding Methods– No Compounding: FV = C0 * (1 + r*T)

– Discrete Compounding: FV = C0 * (1+r/n)n*T

– Continuous Compounding: FV = C0 * er*T

• Effective Annual Interest Rate


Net Present Value (NPV)

C0

C1 C1 C2 C3 C4 CT

r = discount rate (interest rate) for each period

Discount Rate at which NPV = 0 is called Internal Rate of Return (IRR)


AnnuityC C C C C FVCPV

PV and FV of an Annuity

r = Interest Rate for the periodT = # of periods


PV of Perpetuity = C / rC C C C C…………………………………………………………………………PV

PV of a Growing Perpetuity = C / (r – g)

C C*(1+g) C*(1+g)2PV C*(1+g)3


Cash Flow Timeline

Purchase Order Released

Inventory Received

Goods Sold AR Created

Payment Received

Payment Sent

Cash Received

Cash Disbursed

AP Created

Inventory

Accounts Payable

Accounts Receivable Collection Float

Payment Float

Time

Cash Conversion Period = Lag time between Cash Received and Cash Paid

• Longer Cash Conversion Period indicates financing problem• Shorter Cash Conversion Period indicates efficient working capital management


Profit and Cash Flow Relationship

• Maintain a cost structure that results in required profit

• Manage Working Capital accounts (Accruals, Payables, Receivables and Inventory) so that an adequate amount of liquidity is maintained


Accrual to Cash basis Income StatementIncome Statement Account Adjustment Account Cash Flow Account

Sales – Change in Accounts Receivable = Cash collected from Customers

Cost of Goods Sold – Change in Accounts Payable+ Change in Inventory = Cash paid to Suppliers

Operating Expenses – Change in Operating Accruals– Depreciation = Cash paid for operating expenses

Interest – Change in Accrued Interest = Cash paid to Creditors

Taxes – Change in Accrued Tax– Change in Deferred Tax = Cash paid for Taxes

Cash collected from Customers– Cash paid to Suppliers– Cash paid for Operating Expenses– Cash paid to Creditors– Cash paid for taxes= Cash Flow from Operations


Profit and Cash Flow RelationshipBALANCE SHEET June 1 June 2 June 30 July 1 July 15 July 31Cash 1,000 400 325 125 (175) 525Accounts Receivable 700 700 700 0Inventory 300 0 0 0 0Fixed Assets 600 600 600 600 600

Less: Accumulated Dep. (100) (100) (100) (100)Total 1,000 1,300 1,525 1,325 1,025 1,025

Accounts Payable 300 300 300 0 0Operating Accruals 200 0 0 0Debt 500 500 500 500 500 500Stockholders Equity 500 500 500 500 500 500Retained Earnings 25 25 25 25Total 1,000 1,300 1,525 1,325 1,325 1,025

INCOME STATEMENT Jun 1-30 Jun 1–Jul 15 Jun 1–Jul 31Sales 700 700 700COGS (Cost of Goods Sold) 300 300 300Gross Profit 400 400 400Operating Expenses:

SGA (Selling/Gen/Admin) 200 200 200Depreciation 100 100 100

Operating Profit 100 100 100Interest 50 50 50Tax 25 25 25Net Profit 25 25 25Dividends 0 0 0Added to Retained Earnings (RE) 25 25 25


INCOME STATEMENT (ACCRUAL) Jun 1 – Jun 30 Jun 1 – Jul 15 Jun 1 – Jul 31Sales 700 700 700COGS (Cost of Goods Sold) 300 300 300Gross Profit 400 400 400Operating Expenses:

SGA (Selling/Gen/Admin) 200 200 200Depreciation 100 100 100

Operating Profit 100 100 100Interest 50 50 50Tax 25 25 25Net Profit 25 25 25

INCOME STATEMENT (CASH) Jun 1 – Jun 30 Jun 1 – Jul 15 Jun 1 – Jul 31Cash Collected from Customers 0 0 700– Cash Paid to Suppliers 0 300 300– Cash Paid for Operating Expenses 0 200 200– Cash Paid to Creditors 50 50 50– Cash Paid for Taxes 25 25 25= Cash Flow from Operations (75) (575) 125

Accrual to Cash basis Income Statement


Working Capital policies of a firm impact Solvency, Liquidity and Financial Flexibility

• Solvent if the firm’s assets exceed liabilities

• Liquid if the firm can meet its obligations on time

• Financially flexible if the firm’s financial policies are consistent with respect to growth


Solvency and Liquidity Ratios

Current Ratio =Current Assets

Current Liabilities

Quick Ratio =Current Assets – Inventories

Current Liabilities

Net Working Capital = Current Assets – Current Liabilities

Net Working Capital (NWC) = Working Capital Requirements (WCR) + Net Liquid Balance (NLB)

WCR = Current Operating Assets – Current Operating LiabilitiesWCR = AR + Inv + Prepaids + Other Cur. Assets – (AP + Oper. Accruals + Other Cur. Liabilities)

NLB = Current Financing Assets – Current Financing LiabilitiesNLB = Cash + Mkt Securities – (Notes Payable + Current Maturities of LT Debt)


Dell Inc. Balance Sheet, Income Statement and Common RatiosBALANCE SHEET ($M) 1999 2000 2001 2002 2003 INCOME STATEMENT ($M) 1999 2000 2001 2002 2003Cash + Equivalents 3,181 4,132 5,438 3,914 4,638 Sales 18,243 25,265 31,888 31,168 35,404Account Receivables 2,481 2,678 2,895 2,269 2,586 Cost of Goods Sold (COGS) 14,304 19,891 25,205 25,422 28,844Inventories 273 391 400 278 306 Gross Profit 4,209 5,374 6,683 5.746 6,560Prepaid Expenses 0 0 0 0 0 Selling Gen Adm Exp (SGA) 2,060 2,761 3,675 3,236 3,505Other Current Assets 404 480 758 1,416 1,394 Depreciation 103 156 240 239 211Total Current Assets 6,339 7,681 9,491 7,877 8,924 Operating Profit 2,046 2,457 2,768 2,271 2,844Plant, Property, Eqpt (PPE) 775 1,140 1,534 1,438 1,662 Interest Expense 26 34 47 29 17Accumulated Depreciation (252) (375) (538) (612) (749) Net Oper. Income/(Expense) 64 222 578 231 200Other Assets 15 3,025 2,948 4,832 5,633 Special Items 0 (194) (105) (742) 0Total Assets 6.877 11,471 13,435 13,535 15,470 Net Income before Tax (NIBT) 2,084 2,451 3,194 1,731 3,027LT Debt due in one year 0 0 0 0 0 Income Taxes 624 785 958 485 905Notes Payable 0 0 0 0 0 Net Income after Tax (NIAT) 1,460 1,666 2,236 1,246 2,122Accounts Payable 2,397 3,538 4,286 5,075 5,989 Extraordinary Items 0 0 (59) 0 0Taxes Payable 0 0 0 5 54 Adjusted NIAT 1,460 1,666 2,177 1,246 2,122Accrued Expenses 355 337 428 1,127 1,458Other Current Liabilities 943 1,317 1,829 1,312 1,432Total Current Liabilities 3,695 5,192 6,543 7,519 8,933Long-Term Debt 512 508 509 520 506Other Liabilities 349 463 761 802 1,158Total Liabilities 4,556 6,163 7,813 8,841 10,597Stockholders Equity 1,781 3,583 4,795 5,605 6,018Retained Earnings 540 1,725 827 1,338 3,394Less: Treasury Stock 0 0 0 2,249 4,539Total Stockholders Equity 2,321 5,308 5,622 4,694 4,873Total Liabilities + Equity 6,877 11,471 13,435 13,535 15,470

Current Ratio 1.72 1.48 1.45 1.05 1.00Quick Ratio 1.64 1.40 1.39 1.01 0.96Net Working Capital ($M) 2,644 2,489 2,948 358 (9)Net Liquid Balance ($M) 3,181 4,132 5,438 3,914 4,638WCR ($M) (537) (1,643) (2,490) (3,556) (4,647)WCR/Sales (0.03) (0.07) (0.08) (0.11) (0.13)Cash flow from Operations ($M) 2,436 3,926 4,195 3,797 3,538Operating Profit Margin 11.2% 9.7% 8.7% 7.3% 8%Net Profit Margin 8.0% 6.6% 6.8% 4.0% 6.0%Cash Conversion Efficiency 13.4% 15.5% 13.2% 12.2% 10.0%Days Inventory Held (DIH) 7.1 7.2 5.8 4.0 3.9Days Sales Outstanding (DSO) 49.6 38.7 33.1 26.6 26.7Days Payable Outstanding (DPO) 62.3 64.9 62.1 72.3 75.8Cash Conversion Period (5.6) (19.1) (23.1) (42.3) (45.3)


Cash Flow Activities Classification

Operating Activities

Investing Activities

Financing Activities

Proceeds from issuing securityProceeds from issuing debt

Payments of dividendsPayments to repurchase stockPayments of debt

Receipts against receivablesDividends from ST securities

Payment to suppliersPayment to employeesPayments of interestPayments of tax

Payment to acquire PPELoans made to other businessesLoans purchased from businessesPayments to acquire security

Receipts from sale of PPEReceipt from loansReceipts from loan salesReceipts from sale of security

Cash Inflow Cash Outflow


Cash Conversion Period measures Liquidity from the perspective of a firm’s “going-concern”


Inventory Received

Goods Sold AR Created

Payment Received

Payment Sent

AP Created

Inventory

Accounts Payable

Accounts ReceivableTime

Days Inventory Held Days Sales Outstanding

Days Payables Outstanding Cash Conversion Period

Days Inventory Held =Inventory

Cost of Goods Sold/365

Days sales outstanding =Receivables

Sales/365

Cash Conversion Efficiency =Cash Flow from Operations

Sales


Cash Conversion Period measures Liquidity from the perspective of a firm’s “going-concern”

Days Inventory Held =Inventory


Days sales outstanding =Receivables

Sales/365

Days Payables outstanding =Payables


Operating Cycle = Days Inventory Held + Days Sales Outstanding

Cash Conversion Period = Operating Cycle – Days Payables Outstanding

Cash Conversion Period = DIH + DSO – DPO


Management of inventory plays an important role in the management of cash flow timeline

• Smaller inventory balance means less idle investment

– Increases the probability of inventory shortage

• Larger inventory balance means more idle investment

– Reduces the probability of inventory shortage

Inventory acts as the shock absorber between product demand and supply


Investment in Inventory is based on demand, cost of holding and cost of ordering

• Increase in cost of holding leads to stocking less inventory

• Increase in cost of ordering leads to more items per order


Total cost of managing inventory is the sum of ordering and holding costs

Total Cost = (F x T/Q) + (H x Q/2)Ordering Cost Holding Cost

T – Total Inventory units demandedQ – Order QuantityF – Fixed Ordering Cost per OrderH – Holding Cost per Inventory unit


Optimal trade-off between ordering cost and holding cost will lead to Economic Order Quantity

Holding Costs

Order Costs

Total Costs

Order Quantity

Dolla

r Cos

t

EOQ =2 x T x F

H


EOQ Example

T = 500,000 tonsF = $20 per OrderH = $1.25 per tonPeriod = 375 days

EOQ = Sqrt(16,000) = 4,000Average Inventory Bal = 2,000Number of orders = 125Usage Rate = 1,333 tons per dayDelivery Time = 2 daysReorder Point = Usage Rate x Delivery TimeReorder Point = 2,666 tons

0

1,333

2,666

4,000

1 2 3 4 5 6 7 8 9

Reorder point


Basic EOQ model can be extended based on the concepts of safety stock and discounts

• Safety Stock concept should be added whenever sales are not stable or production/delivery is uncertain– Average Inventory Balance = EOQ/2 + Safety Stock– Reorder Point = Usage Rate x Delivery Time + Safety Stock

• Total Costs analysis should be considered whenever the supplier offers quantity discount for volume purchases– Total Cost = (F x T/Q) + (H x Q/2) + Purchase Cost (Variable)


EOQ Example Revisited based on Total Cost

T = 500,000 tonsF = $20 per OrderH = $1.25 per ton

Quantity Cost per Unit0 – 999 $0.501,000 – 2,999 $0.483,000 – 4,999 $0.455,000+ $0.40

Quantity # Order Purchase Cost Order Cost Holding Cost Total Cost

500 1,000 250,000 20,000 313 270,313

1,000 500 240,000 10,000 625 250,625

1,500 333 240,000 6,667 938 247,604

2,000 250 240,000 5,000 1,250 246,250

2,500 200 240,000 4,000 1,563 245,563

3,000 167 225,000 3,333 1,875 230,208

3,500 143 225,000 2,857 2,188 230,045

4,000 125 225,000 2,500 2,500 230,000

4,500 111 225,000 2,222 2,813 230,035

5,000 100 200,000 2,000 3,125 205,125

5,500 91 200,000 1,818 3,438 205,256

6,000 83 200,000 1,667 3,750 205,417


Time Value analysis helps making decisions on quantity discounts

Scenario 1T = 1,000Q = 200C = $10F = $5H = $2.5D = 100

Scenario 2T = 1,000Q = 500C = $9.5F = $5H = $2.5D = 100

Discount Rate = 15%

Demonstrate Calculation using Excel in Class


Constant monitoring of inventory balance ensures proper investment in inventory

• Inventory Control Systems– Information based integrated systems

• Inventory Turnover Approach– Inventory Turnover Ratio = COGS / Inventory Balance– Days Inventory Held = Inventory Balance / COGS per day

• Balance Fraction Approach– Convert Inventory Balance as a fraction of Inventory Purchase


Even though investment in Receivables are the highest asset percentage, firms lack proper receivables and credit policies

• Finance managers can add value by influencing:

– Aggregate investment in Receivables

– Its Credit Terms

– Its Credit Standards


NPV analysis helps to decide whether to allow a credit extension (allow deferred payment to a customer)

NPV =S – EXP (S)

1 + r– VCR (S)

S = Dollar Amount of Credit SaleEXP = Expense for Credit Administration and Collection per $1 of SalesVCR = Variable Cost Ratio per $1 of Salesr = Interest rate for the collection period of the Sale

If NPV > 0 Extend creditIf NPV = 0 Probably extend credit (marginally acceptable)If NPV < 0 Do not extend credit


Key Financial Ratios for Credit Analysis

Current RatioNet Working CapitalQuick RatioCash Flow to DebtCash Flow from OperationsCash Conversion PeriodCash TurnoverNet Liquid BalanceDefensive Interval

Times Interest EarnedLong-term Debt to CapitalTotal Liabilities to Total Assets

Return on EquityProfit Margin on SalesReturn on Assets

Debt ManagementLiquidity Performance


Companies develop various Credit Scoring Models to decide extending Credit

• Weighted Score

• Probability Weighted


NPV Analysis helps to evaluate changes in Credit Policy

• Loosening Credit Standards

• Lengthening Credit Period

• Offering Cash Discount


NPV Valuation: Loosening Credit Standard

Decision: Whether to extend Credit to Marginal Customers

Annual Sales 100.00 $MIncremental Annual Sales 10.00 $MVariable Cost Ratio 0.65 per $ SalesBad Debt Losses 4%DSO 45 daysWeighted Average Cost of Capital 15%


NPV Valuation: Lengthening Credit Period

Decision: Whether to change terms from Net 30 to Net 60

Annual Sales 30.00 $MIncremental sales 5.00 $MVariable Cost Ratio 0.70 per $ SalesBad Debt Losses at Net 30 5.0%Bad Debt Losses at Net 60 6.0%DSO Net 30 45 daysDSO Net 60 68 daysCredit + Collection Expenses Net 30 2.0% SalesCredit + Collection Expenses Net 60 2.5% SalesWeighted Average Cost of Capital 14%


NPV Valuation: Offering Cash Discount

Decision: Whether to offer 2/10 Net 30 instead of Net 30

Annual Sales 20.00 $MIncremental sales 3.0%Variable Cost Ratio 0.60 per $ SalesBad Debt Losses at Net 30 3.0%Bad Debt Losses at 2/10 Net 30 2.5%DSO Net 30 35 daysDSO Net 2/10 10 daysCredit + Collection Expenses Net 30 4.0% SalesCredit + Collection Expenses 2/10 Net 30 4.0% SalesWeighted Average Cost of Capital 12%


When a firm’s working capital cycle begins with purchase of Inventory, an Accounts Payable balance is initiated

• As the firm continues its operation to convert Inventory to Finished Goods, Expenses are accrued in the form of Salaries, Wages etc

• Payables and Accrued Expenses are paid some time in the future generally before converting Receivables to Cash

Firms get in to cash flow problems when more cash is needed to pay Creditors and Suppliers than collected from Sales


Spontaneous Financing is one that occurs automatically as a result of operations

• Trade credit such as Accounts Payable and Accrued Expenses perform as spontaneous financing

• Materials and Services obtained this way will facilitate sales without actually paying for them

• Collections from sales can be used to pay off Payables and Accruals

Payment terms against Payables are dependent on the type of Industry the firm belongs to


Cash Flow Timeline and Accounts Payable


Inventory Received

AP Created

• Normally payment is delayed till the last date of the credit period• If payment is missed, the usual penalty is 1% to 1.5% per month until payment is made• Delinquency on payment results in firms not sending items on future orders

Discount Date Payment Due

NPV Analysis helps to make the decision when to pay on Payables


Finance Manager has several Payment Options• Pay on date of purchase

• Pay before discount period expires

• Pay before credit period expires

• Pay with penalty after credit period expires

Key considerations by Finance Manager:

• Payable should never be paid until the last day of the discount period or at the end of the credit period

• A discount should be taken only when the NPV is positive at the opportunity cost

• A payable should not be stretched past the credit period


NPV Analysis on making payment against Payable

Decision: Whether to make the payment

Invoice Value $10,000Term 2/5 Net 45Firm’s Investment Rate 10%Firm’s Cost of Borrowing 12%Annualized Late payment Rate 18%

Days from Invoice Date NPV @ 10% NPV @ 20%

0 9,800 9,800

1 9,797 9,795

2 9,795 9,789

3 9,792 9,784

4 9,789 9,779

5 9,787 9,773

10 9,973 9,946

15 9,959 9,918

20 9,946 9,892

25 9,932 9,865

30 9,918 9,838

35 9,905 9,812

40 9,892 9,786

45 9,878 9,759

46 9,880 9,759

47 9,883 9,759

48 9,885 9,758

49 9,887 9,758

50 9,889 9,757


Delayed Payment Fee has both tangible and intangible impacts

• Late fee indicates the tangible impact of paying past the credit period

• Ill will generated by constantly paying late indicates the intangible impact of paying past the credit period

Even though NPV Analysis helps to identify the most beneficial time to pay considering penalties and invest opportunity rates,

Payments should be stretched beyond the credit period only if the firm is financially unable to make the payment


Constant monitoring of Payables balance ensures proper investment in Payables

• Payables Turnover Approach– Payables Turnover Ratio = Purchases (COGS) / Payables Balance– Days Payables Outstanding = Payables / Purchase (COGS) per day

• Balance Fraction Approach– Convert Payables Balance as a fraction of Purchase

The greater the DPO (Days Payable Outstanding) is, the slower the Payables Turnover and the longer the firm is taking to pay its suppliers

As we discussed in Inventory Management, Balance Fraction Approach gives a consistent monitoring of Payables Management


Two forms of Accruals provide a short-term financing for the firm

• Accrued Wages and Salaries

– Service rendered by employees without an immediate payment

– Bi-weekly or monthly payment instead weekly payments

• Accrued Taxes

– Government requires firms pay taxes quarterly

– Firms have 3-month financing from Tax dollars

Documents

FIRE654 Oct 3 Mid-term Review