Sabrina Bouter 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 The goal of short term financial management is to manage each of the firms current assets and liabilities to achieve a balance between profitability and risk that contributes positively to overall firm value 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 Ways to Reduce Need for Working Capital Work to reduce inventory Just in time inventory requires improved production efficiency and quality to reduce down time problems Speed up collection of account receivables A Rs Pay payable AP early to obtain discounts Pay AP later if no discount available extra cost if paid past due date Control better which customers get trade credit Account payable 2 10 net 30 Pay invoice in 10 days and get a 2 discount Otherwise pay full amount within 30 days 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 2 10 net 30 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 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 Note 2 3 Cash Conversion Period CCP CCP DIH DSO DPO CCP CashConversion Period DIH Days taken generate A R DSO Days taken get cash firm s A R DPO Daystaken pay A P sale of finished goodsinventory The shorter CCP is the better as it reduces the need for working capital Lambda Lambda is a liquidity measure from a function of the likelihood that a firm will exhaust its liquid reserve It can be used like a z value from the standard normal distribution table It gives an approximation of the probability of a firm running into a liquidity problem As an example a lambda of 3 means that there is only about 1 chance in a thousand that cash needs exceed available cash resources while a lambda of 1 65 signals a 5 chance of running out of cash Sustainable growth rate Sustainable growth rate is a certain sales growth rate that can be supported by the firm s current financial policies without having to issue new external equity 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 In this example it is better to select the credit period extension because the NPV is higher PT payment terms IPL Inventory to production lag PSL Production to sale lag 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 Notes 4 and 5 Economic Order Quantity EOQ 2 approaches to getting EOQ I If the graph of TC is curved 1 The teacher has to provide you with some way of deriving the equation for total cost 2 Take the derivative of the equation with respect to Q FT Q2 H 2 3 Set the derivative equal to zero 0 FT Q2 H 2 4 Solve for Q simplify then plug in given values for F T and H FT Q2 H 2 TC H Q 2 TC F T Q dTC dQ dTC dQ Q2 FT H 2 Q T Totalinventory needed production period F cost per order H holding cost per item inventory Q Economic Order Quantity EOQ II If the graph has a volume discount price 1 Make a table and solve each column T will be given The table is as follows T 500 00 Unit Price P Inventory Cost Q FT Q HQ 2 TC Shown in graph varies T P Shown in graph varies Calc F and T are given Calc H is given Same eqn as in I 0 48 240000 5000 1250 246250 0 40 200000 2000 3125 205125 2000 5000 Optimal Lot Size LS 1 The procedure is the same as for EOQ the equation are the same as well just replacing Q with LS In order to get the optimal you want to find the minimum of the equation TC F T LS H LS 2 2 Take the derivative of the equation with respect to Q FT LS2 H 2 dTC dLS 3 Set the derivative equal to zero 0 FT LS2 H 2 dTC dQ 4 Solve for Q simplify then plug in given values for F T and H FT LS2 H 2 LS2 FT H 2 LS Sales Forecast The sales forecast drives total inventory T values for finished goods inventory and the total inventory T values for finished goods drives T values for raw materials Thus it is important to have a good sales forecast in order for cost minimization to be effective Just In Time Inventory cost is higher 1 Can decrease cash tied up in …