Finance 4412 Short Term Financial Management Topic Outline for First Exam 1 Be able to explain the main problem that short term financial management is trying to solve for a firm Given balance sheet information for two firms be able to a compute measures of the two firm s liquidity e g net working capital b determine which firm is more liquid and c how this can affect solvency Also what is implied for long term or short term assets and liabilities when net working capital is or and is one situation less risky than the other Why Firms purchase inputs before they produce and sell outputs Payments for inventory purchased occurs before the firm sells output and receives revenue Key Problem A firm s cash outflow is cash inflows at most points in time even though over time inflows exceed outflows and lead to positive profits The need for working capital is a timing problem Four things to manage inventory receivables payables and electronic commerce Working Capital for US firms is 40 50 of total assets A Liquidity Firm is liquid when it can pay its bills on time without undue cost a subjective concept since in practice liquidity differs among assets B Net working capital CA CL Net Working Capital Requirement WRC A R Inventory Prepaid Expenses A P Revenue sales C Short term Solvency CA CL Any reduction in firm expenses reduces the need for working capital while any rise in firm costs increases the need for working capital Thus any change in a firm s cash inflow or outflow affects working capital NWC Positive leading to sort term investment of currently excess funds If CA CL then L T debts are financing some of the CA This is ok Negative requiring bank borrowing or liquidating S T assets If CA CL L T Assets are financing some of the CL This is risky 2 Given the value of a firm s account payable its short term bank borrowing rate and the payment terms of the payable e g 2 10 net 30 be able to determine if the firm should pay the payable early and what the implied rate of return is for an early payment Firm should pay early when the following holds where k d 1 d x 365 CP DP eq 7 5 p 239 k opportunity cost 08 for liquidating S T investment d discount rate when pay early 2 CP credit period 30 days DP discount period 10 days If 08 02 1 02 x 365 30 10 implied rate of return 08 372 therefore pay early 3 Be able to determine the cash conversion period and what it implies for a firm s working capital needs What is Lambda and how is it used to assess the probability of a purchasing firm to pay the A Ps of a supplying firm In addition be able to explain what a sustainable growth rate is and the logic behind how it is derived and what it implies compared to a firm s desired versus actual sales growth rate Good indicators of firm liquidity look at cash flows Cash Conversion Net cash flow from operations Profits CCE Efficiency Revenues sales Sales CCP Cash Conversion Days finished Days sales Days Period goods inventory outstanding payables held outstanding CCP DIH DSO DPO The shorter is CCP the better as this reduces the need for working capital Actual Measures DIH finished goods inventory cost of goods sold 365 DSO receivables outstanding sales 365 DPO payables outstanding cost of goods sold 365 Lambda Cash Anticipated Cash is like Xi X Z statistic Std Dev of Cash i Lambda Z statistic both reflect number of standard deviations from X Lambda used to estimate the confidence interval about the calculated CCP Shows the probability that a firms realized CCP is close to the calculated value 1 68 covered so 1 68 32 Pr of being outside covered area in 2 tailed test Only interested in uncovered 1 tail when Cash Ant Cash 1 or Pr of 16 2 95 and 3 99 so Pr of liquidity problem is less at 2 5 and 0 5 See Slides 8 and 9 in class notes 3 ppt for example Sustainable growth rate in order to grow sales assets need to grow as well A sustainable growth rate is one that allows the firm to grow without new borrowing outside funding Assets debt equity therefor the assets grow in direct relation to the debt and equity internal funding End Result estimated sustainable growth rate g from internal funding E and debt D keeping debt equity ratio constant so only generate new debt from normal sources To grow sales by 10 M the firm needs new assets A gS desired growth in sales 10 M g is growth rate A current assets 13 535 M S current sales 31 168 M A S asset sales ratio 43426 gS x A S 10M x 43426 need 4 3 M in new assets to be able to produce 10M in new output and hence new sales gS x A S E D E 1 D E 4 3M in new new sales will new sales also generates assets for 10M generate new an expansion of debt but in new sales internal funding keep the D E ratio constant 4 Be able to assess the effect on net present value NPV of a change in a firm s account receivable credit policy payment terms similar to that shown in pages 66 70 in the text This was discussed in the class notes as well NPV with current 30 day Credit policy Given Daily sales 100 000 COGS Sales 65 10 bank firm financing cost Raw materials A P due in 30 days Good sold A R on day 40 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 NPV with new 60 day credit policy and 3 increase in sales 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 outflow 1 10 30 days 1 00822 365 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 33 849 12 NPV 100 253 33 66 404 21 5 Given the necessary information be able to determine the Economic Order Quantity EOQ for a firm s inventory of raw material inputs Also be able to determine the optimal lot size LS of a production run associated with producing an inventory of finished goods prior to their sale Be able to illustrate your comparison with a graph so that your answer is clear How does a good sales forecast fit into this problem What are the problems associated with adopting just in time inventory …