1FI3300Corporation Finance 010Spring Semester 2010Dr. Isabel TkatchAssistant Professor of Finance1Learning objectives☺ Discuss working capital management☺ Identify the effect of seasonality on monthly cash flows ☺ Explain the purpose of long-term financial planning2☺ Use the percent of sales method to construct pro-forma financial statements☺ Identify spontaneous assets and liabilities, internally generated funds and financing decision variables ☺ Compute ‘Outside (External) Funds Needed’Responsibilities of theFinancial Manager 1. Managing theworking capital2 E ti ti th Financial Manager 32. Estimating the seasonal fund needs3. Long-term financial planning: forecasting long-term fund requirementsWorking Capital on the Balance SheetASSETS LIABILITIES and EQUITYCurrent Assets:CashNet Accounts ReceivableItiCurrent Liabilities:Notes PayableAccounts PayableAd E4InventoriesAccrued ExpensesCurrent Portion of LT DebtNet Fixed AssetsLong-Term DebtEquityTotal Assets Total Liabilities and EquityNet Working Capital (NWC)Net Working Capital (NWC) represents the investment needed to maintain the cash, credit and inventory necessary for operations – varies over timeNet Working Capital (NWC) =Current Assets Current Liabilities5Current Assets -Current LiabilitiesEfficient management of current assets and current liabilities reduces the investment in NWCRelated liquidity ratios:Current assetsCurrent ratio =Current liabilitiesWorking Capital - Cash1. Determining minimum cash requirements, maintaining the checking account and managing the cash balanceR l d li idi i6Related liquidity ratios:Related financial statement:Statement of Cash Flows (operating activities)Current assets - InventoriesQuick ratio =Current liabilities2Working Capital - Credit2. Setting credit policy (for customers) and managing the collection of accounts receivableRelated activity ratios:7Related activity ratios:Book example 5.1-5.6 (page 135): Cost benefit analysis of a new credit policyAccount receivableAverage collection period = × 360Annual credit salesWorking Capital - Inventory3. Establishing inventory target levels and managing inventory turnoverRelated activity ratios:8Related activity ratios:InventoriesInventory conversion period = × 360Cost of goods soldCost of goods soldInventory turnover ratio =InventoriesWorking Capital – ST Debt4. Establishing and maintaining banking relations to ensure access to short-term (ST) funds☺ Short term funds offset effects on cash flow 9(CF) volatility:☺ Predictable / expected events: seasonality☺ Surprise / unexpected events: accidentsSeasonality and Cash Budgets☺ Most firms experience seasonality in sales:☺ Weather☺ HolidaysSli i l ld h fl 10☺Seasonality in sales leads to cash flow problems whenever(cash balance + cash inflow) < cash outflow☺ Financial managers must plan in advance and secure funds to cover shortfallsWorking Capital - Credit5. Negotiating and monitoring trade credit terms and managing supplier relationshipsRelated activity ratios:11Account payablePayables period = × 360Cost of goods soldDiscount percentEffective annual cost = × 360Extra days if not take discountWorking Capital - Interest6. Monitoring and evaluating operating expenses, interest and taxes, and maintaining efficient payment patterns12Related debt utilization ratios:Operating incomeTimes Interest Earned =Interest expense3Long-term financial planningWhy do we need long-term financial planning?To make sure that funds are available to support firm’s growth!13to support firm s growth!Long-term financial planningIf the firms is not operating at full capacityÆ find ways to use assets more efficientlyIf the firm is operating at full capacity (maximum efficiency - no idle assets)14Æ increase investment in assets to support LT growth:Current assets (cash, inventory, A/R ) Fixed assets (plant & equipment)Æ The financial manager must find additional funding sources to support assets growth and decide:How much is needed? What sources of funding are available?Three sources of funds1. “Spontaneous” liabilities:☺ Accounts payable☺ Accruals 2 Internally generated funds:These liabilities usually increase as the firm buys more inventory and incurs additional expenses 2. Internally generated funds:☺ Addition to retained earnings3. External funds (financing decision variables): ☺ Notes payable (credit line – short-term debt)☺ Long-term debt (issue new bonds, bank loan)☺ Common stock (issue new stock - equity)15Pro-forma financial statements☺ To determine if and how much outside (external) funding is needed, financial managers construct pro-forma financial statements☺ We will use the percent of sales methodto construct pro-forma financial statementsTextbook example: pages 142-147 (Coffy’s coffee Shop)16Percent of sales methodStarting point: assume sales growth rate = gStep 1:Each assets account on the balance sheet grows at the same rate as sales (g) 17Note: we assume that the growth rates of gross fixed assets, accumulated depreciation and net fixed assets are also gStep 2:Each “spontaneous” liabilities account on the balance sheet grows at same rate as sales (g):1. Accounts payable2. AccrualsPercent of sales methodStep 3:(3a) Compute the expected net income for the projected period(3b) Find the addition to retained earnings:18Addition to retained earnings =net income – dividends(3c) Use it to determine the retained earnings account on your pro-forma balance sheet:Retained earnings (t+1) =retained earnings (t) + Addition to retained earnings4Percent of sales methodStep 4:Copy all the financing decision variables from the previous statement (BS):1Notes Payable191.Notes Payable2. Long Term Debt3. Common StockResult: Total Assets ≠ Total Liabilities & EquityOutside funds neededStep 5: Holding the financing decision variables constant, calculate outside funds needed:Outside Funds Needed (OFN)= Total Assets Total Liabilities & Equity20= Total Assets –Total Liabilities & EquityNext Step: Determine financing sources1. Increase Notes Payable (ST debt)2. Borrow or issue new LT Debt3. Issue new stock (equity)Outside funds needed - FormulaAn alternative way to calculate the OFNOutside Funds Needed = 21+ Change in Total Assets - Change in Spontaneous Liabilities - Change in Retained EarningsOutside funds needed - FormulaChange in Total Assets =(total assets on current BS) x gChange in Spontaneous Liabilities = (spontaneous liabilities on current