FINS2615 Intermediate Business Finance
Intermediate Business Finance
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FINS2615 Intermediate Business Finance
1How the Story of Corporate Finance will be explained:
Cash
Flows
Discount
rate
(Risk & Return)
Financial Mathematics
Cash Flow Forecasting
Working capital
management
Capital Asset Pricing Model
Cost of capital
Capital structure
Week 01
Week 02
Weeks 03 and 04
Week 05
Week 07
Week 08
Week 09
Types
of CF
Debt
Equity
= �
=1
1 + − 0
Important: As you take this course, clarify how to connect the different parts of the story!
Week 10:
Payout policy
2• Learning Objectives
• Overview of Working Capital
• Trade Credit
• Receivables Management
• Payable Management
• Inventory Management
• Cash Management
Contents of lecture
3Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Overview of Working Capital
5Review: What is Net Working Capital?
Net Working Capital includes all the materials and services you need to run the daily operations of the firm.
From Finance perspective, these include:
• Current Assets: Cash (excluding excess cash not needed in daily operations)
Inventory, Accounts Receivable (A/Rec)
• Current Liabilities: Accounts Payable (A/Pay)
• NWC = Current Assets – Current Liabilities
• Increases in NWC Cash Outflow
• Decreases in NWC Cash Inflow
Industry Inventory A/Rec A/Pay
Retail supermarkets High Low High
Pharmaceuticals High High High
Airlines Low Low-Med High
Consumer white goods High High High
NWC composition depends on industry characteristics
Affect firm valuation
6Operating Cycle vs. Cash Conversion Cycle
=
=
=
Components of Working Capital can be measured in DAYS:
The number of days it takes to use up the inventory and turn it into sales
• The more days, the longer it takes to sell existing inventory
• Is the firm operating efficiently as it should be? Can inventory be reduced?
The number of days it takes for customers to pay you cash for credit sales
• The more days, the longer it takes to receive customers’ cash payments
• Is the firm offering trade credit terms that are too generous? Should it change?
The number of days for your firm to pay suppliers in cash
• The more days, the longer it takes you to pay suppliers
• Is the firm paying too early or too late? Both can be bad! How do we know?
= 365
= 365
7Operating Cycle vs. Cash Conversion Cycle
Cash Conversion Cycle = Inventory Days + Accounts receivable days – Accounts Payable Days
= Average days from the time cash goes out to the time cash comes in
Operating Cycle = Inventory Days + Accounts receivable days
= Average days from purchasing inventory to receiving cash for goods/services
With the Working Capital components measured in days, we define:
From a finance perspective, investors need to fund the Cash Conversion Cycle!
The longer the cycle, the more capital is tied up, the greater the funding cost.
A Poll Question:
Which is better from a finance
perspective:
A short CCC or long one?
Poll
8Berk Example 19.1 Calculating Cash Conversion Cycle
Woolworths partial Income Statement
& Balance Sheet:
Using the following information, calculate the CCC for Woolworths
Sales 58,276
Cost of Good Sold 42,677
Total Accounts Receivable 519
Total Inventory 4,559
Total Accounts Payable 6,266
=
= 4559
116.9 = 39.0 days
A/Rec days =
= 519
159.7 = 3.2 days
A/Pay days =
= 6266
116.9 = 53.6 days
=
365
= 42677
365
= 116.9 $/days
=
365
= 58276
365
= 159.7 $/day
Cash Conversion Cycle = Inventory Days + Accounts receivable days – Accounts Payable Days
Woolworths’ CCC = 39 + 3.2 – 53.6 = -11.4 days
Woolworths has a NEGATIVE CCC!
• It’s customers on average pay in cash 11 days BEFORE it pays its suppliers in cash!
• This accounts for its market dominance in offering low price guarantees
9Working capital needs depend on industry characteristics
A/Rec
A/Pay
Invent.
Airlines
Qantas
Customers pay up-front
before starting trip
Firm pays suppliers many
days after trip is finished
Very little. Only sufficient
inventory for a trip (fuel, tray
meals, drinks, movies!)
Remark Main expense is depreciation of aircraft and labour costs
White goods
Harvey Norman
To commit customers, firm
offers interest-free purchases
or financing
Firm will get suppliers to help
finance customers’ purchases,
stretching out payments
Hold inventory in showrooms
for customers to give variety
and choice
Large holding costs
Pharmaceuticals
CSL
Customers (pharmacies, labs,
hospitals) pay on credit after
receiving goods
Firm pays suppliers later than
it receives payment from
customers, stretching paymt
Batch manufacturing means
holding large inventories that
are sold seasonally
Special handling and storage.
Main cost is R&D expense.
In the Team Assignment, analyse your Stock’s industry characteristics or norms to understand
the effect on Working Capital Requirements. Compare with major competitors.
For example, we compare and contrast the Working Capital Needs of three industries:
10
Firm value and managing working capital
We know that Changes in NWC affect cash flows because:
• FCF = EBIT(1 – T) + Depr – Chg NWC – Capex
• Decrease in NWC increase in FCF increase in firm value
• BUT BY HOW MUCH VALUE?
Berk Example 19.2
Expected FCF Improvement
Net Profit (earnings) 20 000
+ Depreciation +5 000
- Capital Expenditure -5 000
- Incr in working capital -1 000 Reduce by 20%
= FCF = 19 000
A firm next year expects the following FCF but wants to investigate the
impact of improvements it can make to its need for more working capital.
If the cost of capital is 12% and the working capital is projected to
grow at 4% annually, what impact would a one-time 20%
permanent reduction in its annual working capital requirement
have to the stock’s valuation?
New FCF
20 000
+5 000
-5 000
-800
= 19 200
0 = −
0 = 190000.12 − 0.04 = 237 500 000
0 = 192000.12 − 0.04 = 240 000 000
Current stock price:
New price if WC reduced
by one-time 20%:
Conclusion: A one-time $200K permanent reduction in Working Capital
does not affect earnings, but results in a $2.5 million increase in stock price!
In $ thousands
11
Team Assignment: Questions for Reflection
A firm that manages well its Work Capital requirements generates enormous value for customers!
Especially permanent decreases in Working Capital requirements.
Is working capital management a strategic advantage for firms in the same industry as your target company?
If so, how well does your Team’s company manage its Work Capital requirements compared with competitors?
As an investor in the company, can you suggest changes that it could make to increase its competitiveness in
Working Capital Management?
We have seen that:
Questions for Reflection in your Team Assignment Target Company:
12
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Trade Credit
14
Berk 19.2 Trade Credit
When a firm allows a customer to purchase on credit is said to “extend their customer trade credit”.
• The firm and customer respectively generate entries in accounts receivable and accounts payable.
• Note: a customer purchase on credit does NOT mean purchasing with their credit card or BNPL account! Why?
When a firm buys on credit from suppliers, each respectively generates accounts payable and receivable entries.
• The net difference between a firm’s a/rec and a/pay is the “capital required by trade credit”.
To find optimal credit policies, financial
managers analyze trade credit according to:
1. Trade credit terms
2. Trade credit market frictions
3. Float management
Let’s look at this first
Examples of Trade Credit Terms:
• Supplier offers customer “Net 30”
• Or maybe “2/10, Net 30”
Means “Pay the full amount within
30 calendar days”
Say “Two - ten, Net 30”
Means “Get a 2% discount on the full amount if
paid within 10 days, otherwise pay in full within 30
calendar days”
10 days is
“discount period”
30 days is
“credit period”
Day
10
Day
30
$100
purchase
Discount period
Pay $98 for $100 purchase
Net credit period
Must pay $100 by Day 30
1. Trade credit terms
15
Berk 19.2 Trade Credit
Day
10
Day
30
$100
purchase
Discount period Net credit period
2. Trade Credit Market Frictions
For example, “2/10, Net 30”
If customer decides to take the 2% discount offer,
what benefit interest rate is the customer getting?
• Trade credit is essentially a loan from the supplier to customer.
• If like a loan, what is the trade credit interest rate?
Pay nothing now and repay $100 loan at end (day 30)
Get $2 discount and pay $98 now (day 10)
By taking the $2 discount, the customer is
tying up $98 in funds that could be used
elsewhere. This is an opportunity cost.
• $2 / $98 is the interest rate over 20 days
Think: “A cost of $2 ties up $98 for 20 days”
• i.e., 2.040816% over 20 days
• What rate is this over 365 days?
• i.e., what is the Effective Annual Rate?
• 365/20 = 18.25 20-day periods in one year
• = 1 + − 1= 1 + 2.040816% 36520 − 1= 44.59%
• By taking the discount, the customer is
getting a benefit interest rate of 44.6%!
This would be hard to get anywhere!
• What are the benefits of trade credit?
1. Trade credit is simple and convenient to access.
- Often standard terms, little paperwork involved
- Few things to negotiate
- Flexible arrangement
2. Lower cost of fund compared with alternative sources
- For customer, lower than getting a bank loan
- Collateral on trade credit are the goods provided
- Often the only source of funding for the customer
• What market frictions does Trade Credit overcome?
1. Provides cheaper prices to selected customers
- Trade credit helps a firm discriminate between
customers, providing favourable ones better terms
2. Provides a check on customer credit quality
- Trade credit is built on trust and information sharing
between a firm and its customer. This relationship is
perhaps of better quality in gauging credit worthiness.
16
Berk 19.2 Trade Credit
3. Trade Credit Float Management
• A significant friction in trade credit is the management of collection float.
• Collection float is the amount of time it takes for a firm to be able to use
the funds after a customer has paid for its goods or services. The longer
the collection float, the greater is the need to invest in working capital.
• Collection float is determined by three factors: mail float, processing
float, and availability float
Because of financial technologies, direct customer bank transfers
to supplier bank have significantly speeded up these processes
and even eliminated them.
17
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Receivables Management
19
Berk 19.3 Receivables Management
When a firm allows a customer to purchase on credit, it generates accounts receivable.
But before it does so,
the firm should determine a credit policy by:
• Establishing credit standards
• Establishing credit terms
• Establishing a collection policy
To whom will credit be extended? Everyone? Select customers? Based on what?
- On credit worthiness? Past volume of sales? Potential sales? Repeat customer?
- Potentially higher sales margin?
Establishing standards is about getting the right balance between High margin
Receivables vs. High volume of Receivables
How long to extend credit for? E.g. Net 20? Net 30? Or Net 40?
Offer a discount? Over what discount period? E.g., 1/15, Net 40 or 2/10, Net 20, etc
Are your credit terms comparable with other companies in the same industry?
What do you do if the customer begins delaying payment?
- Do nothing? (probably not)
- Send a reminder?
- Start charging interest or a late fee?
- Threaten legal action?
- Sell delinquent receivables to a collection agency for $0.50 for each $1 of receivable?
As an analyst or consultant, you need to ask these questions to find out the appropriateness of the client’s credit policy