Exam 1 Short Term Financial Management 1 The Main problem in short term financial management is managing the timing problem between cash inflows accounts receivables and cash outflows accruals and payables The longer that resources remain idle in inventory receivables or collection float the more value is lost A firms cash outflow is greater or equal to cash inflows at most points in time even though over time inflows exceed outflows and lead to positive profits A Working capital Cash Inflow CA Cash Outflow CL Positive leading to short term investment of excess funds Negative requiring bank borrowing or liquidating S T assets B Quick Ratio CA Inventory CL or Solvency TA TL A firm is solvent when its assets exceed its liabilities It is liquid when it can pay its bills on time without undue cost C This can affect solvency because short term solvency includes liquidity Also if long term assets are paying for short term liabilities this makes a cash flow problem because long term assets take longer to liquidate than short assets This is why the more liquid firm is the most solvent one If CA CL then some L T debt is financing some CA and this is safer for the firm since CL is reduced relative to CA If CA CL then some L T assets are supporting some CL bu L T assets are not easily liquidated to cover CL 2 Firm has A P invoice of 100 000 received on September 1 2 10 net 30 Firm s choice 1 Pay early by day 10 and obtain 2 discount 2 000 Pay only 98 000 on day 10 2 Pay full amount 100 000 on day 30 expect A R by then Depends on firm s opportunity cost Can liquidate S T investments earning 8 Can borrow 98 000 from bank at 10 for 20 days Liquidate S T investments 8 opportunity cost 98 000 x 08 365 x 20 days 430 Borrow from bank 10 opportunity cost 98 000 x 10 365 x 20 days 537 Implied annual return from a 2 discount 98 000 x X 365 x 20 days 2 000 X 37 2 Clearly firm should liquidate 98 000 in S T investments to pay early and save 2 000 net savings 2 000 430 1 570 3 CCP DIH DSO DPO Days Inventory Held FG CGS 365 Days Sales Outstanding Receivables Sales 365 Days Payable Outstanding Payables CGS 365 A Cash Conversion Period is a liquidity measure that measures the difference in time from when cash is received from credit customers and when cash is paid to suppliers The length of time from when cash is paid out for purchases and when cash is received from collections on credit sales The shorter this cash conversion period is the more effecient the working capital policies are and the less value is lost due to working capital management activities B Sustainable growth rate is a certain sales growth rate that can be supported by the firms current financial policies without having to issue new external equity If a firm is not generating sufficient cash flow from operations to support the additions of new debt then the firm will have to change is target financial policies As a company experiences a growth in sales it must finance the purchase of additional assets to support the higher level of sales Firms that grow faster than the sustainable rate must support that growth through cash generated from investing or financing activities C Problems associated with just in time inventory are stock out costs cost of excess inventory and ordering costs 4 Change in credit policy from A R in 30 days to A R in 60 days Firm will have to self finance the extra 30 days so easier credit terms often leads to a rise in bad debt expense If estimated new profits are positive then implement the credit change Given Daily sales 100 000 COGS Sales 65 10 bank firm financing cost Raw materials A P due in 30 days PV revenue 100 000 100 000 98 118 28 inflow 1 10 70 days 1 019178 365 PV COGS 100 000 x 65 65 000 64 470 11 outflow 1 10 30 days 1 00822 365 33 648 17 NPV 3 000 more in expected daily sales Wait 30 more days to be paid going from 70 to 100 days PV revenue 100 000 1 03 103 000 inflow 1 10 100 days 1 02740 365 PV COGS 100 000 1 03 65 66 950 66 404 21 outflow 1 10 30 days 1 00822 365 100 253 33 33 849 12 NPV NPV of net 60 policy 33 849 12 New credit policy has possible NPV of net 30 policy 33 648 17 gain of 200 95 per day NPV of net 60 policy 33 849 12 New credit policy has possible NPV of net 30 policy 33 648 17 gain of 200 95 per day However if past bad debts are 1 of sales then benefit 29 20 day Need look only at bad debt 3 000 01 bad debt 1 02740 29 20 Sensitivity Analysis If sales only rise by 2 not 3 then lose 127 68 day If sales only by 2 5 not 3 then gain is 36 64 day which is offset by 1 bad debt loss of 29 20 so net benefit 0 here 5 Economic Order Quantity the order quantity that minimizes the total cost of managing inventory Also it is the quantity of inventory items that should be ordered each time an order is placed Total Cost F X T Q H X Q 2 Fixed cost per order delivery of orders holding cost Avg Inventory held delivery T Total inventory units demanded Q Order quantity F Fixed order cost per order H Holding cost per inventory unit Minimum Cost Q LS Lot size is the total minimum cost for finished goods TC set up costs holding cost output needed holding cost fixed cost x for sales per unit of x lot size per set up lot size per inventory 2 set up F x T LS H x LS 2 Types raw materials work in progress finished goods Use for production later processing for sales Q Economic Order Quantity EOQ Inventory cost ordering delivery cost holding cost fixed cost average per order of orders holding cost inventory delivery held F x T Q H x Q 2 C A good sales forecast fit into this problem because the sales forecast determine the amount of inventory need to meet forecasted sales 6 A The credit scoring model is the evaluation approach which weights variables depending on their helpfulness in discriminating between good and bad applicants based on past payment histories These models are developed with the assistance of computerized statistical techniques such as multiple dicriminant analysis B Firms use the credit scoring model to determine if the should give trade credit to some buyers and not others by managing three areas Aggregate investment in A R credit standards applied when determing which customers to give trade credit to and adjustment of …