Lecture Short-Term Financial Decisions
-
Upload
olessya-vorontsova -
Category
Documents
-
view
220 -
download
3
description
Transcript of Lecture Short-Term Financial Decisions
-
Corporate Finance 8. Financial Planning and Short-Term Financial Decisions
-
2 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
Short-Term versus Long-Term Financial Decisions
Not continuous, segregated by projects and subject to a previous valuation analysis.
A continuous process, giving way to a permanent succession of current assets (assets easily convertible in cash).
Long-Term Financial Decisions Short-Term Financial Decisions
Based on contracts carefully designed (as complete as possible), preventing unwanted transfers of value between shareholders and creditors.
Although they may take a contractual form (a loan contract), they will be based on a general financing agreement kept for a certain period.
Follow a determined strategic orientation, in the company business, as well in its capital structure.
Intimately associated with business dynamics, depending of its characteristics and requiring financial planning.
-
3 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
At = total assets
Ac = current assets
Af = fixed assets
0 Time
At
Af
Ac
Short-term financing
Long-term financing
Short-Term versus Long-Term Financial Decisions
-
4 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
II. Liquidity Management
III. Trade Credit and Receivables Management
IV. Inventory Management
V. Short-Term Financing
Summary
-
5 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
Questions to be answered by short-term financial management
What amount of cash (or equivalent) should the company keep?
What amount (and period) of credit should the company grant to its clients?
How much short-term financing should the company raise?
In brief: What is the optimal investment in working capital?
-
6 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
In order to answer these and other questions, company management
should identify correctly:
Business cycle
AIP
Operational cycle
AIP + ACP
Cash-flow cycle
AIP + ACP - APP
AIP = average inventory period; ACP = average collection period; APP = average payment period
-
7 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
Cash-flow cycle
Examples
ACP AIP
Operational
Cycle APP
Cash-flow
Cycle
Power supply companies 41 18 59 31 28
Health care equipment 73 46 119 17 102
Paper products 38 39 77 26 51
Restaurants 10 5 15 14 1
Central values; study published by CFO magazine (2007)
-
8 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
Is there an optimal level of current asset investment?
Trade-off between:
Costs increasing with the amount of current asset investment (carrying costs)
Opportunity cost (usually, the return on these assets is lower than the required cost of capital);
Holding costs;
Costs decreasing with the amount of current asset investment (shortage costs)
Trading costs: resulting from the need to sell assets in order to obtain liquidity;
Costs related with the non existence of a precautionary reserve: loss of sales; loss of clients; disruption of the production process.
-
9 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
0 Current assets CA*
Shortage costs
Holding costs
Total costs
Is there an optimal level of current asset investment?
I. Short-Term Financial Management
-
10 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
Is there an optimal level of current asset investment?
It changes from one company to another
Many growth opportunities Little investment opportunities
Companies with High Current Asset Investments
Companies with Low Current Asset Investments
High risk investments Low risk investments
Small dimension Big dimension
Low rating High rating
Opler, Pinkowitz, Stulz and Williamson, The Determinants and Implications of Corporate Cash Holdings, JFE (1999)
-
11 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
Is there an optimal level of current asset investment?
It changes from one company to another
Companies with High Current Asset Investments
Companies with Low Current Asset Investments
0 CA CA*
Shortage costs
Holding costs
Total costs
0 CA CA*
Shortage costs
Holding costs
Total costs
-
12 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
How should current assets be financed?
0 t
Fixed assets (long-term)
Permanent current assets
Seasonal variation of current assets
Total assets
I. Short-Term Financial Management
-
13 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
How should current assets be financed?
Restrictive strategy
0 t
Long-term financing
Short-term financing
-
14 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
How should current assets be financed?
Flexible strategy
0 t
Long-term financing
Investment in liquid assets
-
15 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
How should current assets be financed?
The choice of strategy should take into account:
Big cash reserves:
They reduce the liquidity risk;
High opportunity cost;
Different maturities of assets and financing contracts:
Financing permanent assets with short-term debt increases interest rate risk,
because short-term rates are more volatile and short-term financing contracts can
be withdrawn at shorter notice.
Time structure of interest rates:
Long-term rates tend to be higher than short-term rates.
-
16 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
Short-term financial decisions (working capital management) include
the following areas:
Liquidity management;
Trade credit and receivables management;
Inventory management;
Short-term financing.
-
17 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
II. Liquidity Management
III. Trade Credit and Receivables Management
IV. Inventory Management
V. Short-Term Financing
Summary
-
18 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
II. Liquidity Management
Coordination of collection and payment movements and use of
financing instruments in such a way to preserve the capacity of
the company to meet all financial obligations resulting from its
business operations.
-
19 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
II. Liquidity Management
For a better liquidity management, it is necessary:
Calculate, study and manage the business cycle and the cash cycle of the
company;
Understand every characteristic of the company business and its effect on
cash movements and on the formation of current assets (trade credit and
inventory).
-
20 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
II. Liquidity Management
To make liquidity management effective, it is necessary:
1. Ensure adequate liquidity levels of the company:
Effective matching of cash inflows and cash outflows;
Constitution of cash reserves (or else, negotiation of credit facilities);
2. Control daily cash-flows:
Monitor collections and process payments;
Monitor cash and bank deposit balances;
Exercise options included in credit facilities.
3. Ensure the prompt use of all excess cash resources.
-
21 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
II. Liquidity Management
To make liquidity management effective, it is necessary:
4. To activate efficient short-term financing solutions, with respect to:
Cost of capital;
Flexibility of financing raising solutions;
Activation of funds.
5. Measure and control risks, namely liquidity risk and interest rate risk, what is
once again related with flexible contractual solutions.
-
22 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
II. Liquidity Management
To make liquidity management effective, it is necessary:
6. Prepare cash-flow budgets:
Cash forecasts (for different time horizons) which allow the anticipation of liquidity shortages and the activation of solution for those difficulties.
7. Gradually build balanced contractual relationships with providers of funding,
namely by establishing a network of banking relationships which proves
favourable to the company.
8. Systematically gather relevant information about every movements around
all classes of current assets and short-term debts.
-
23 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
II. Liquidity Management
Reasons to hold cash and liquid deposits:
Speculative motive:
Resources available to seize opportunities to buy goods and services for a lower price,
to make investments with attractive returns or, in the case of international
companies, take benefit of exchange rate fluctuations.
Preventive motive:
Resources to be used as a reserve to offer financial stability.
These motives may justify the holding of a given level of liquidity but not
necessarily under the form of cash or liquid deposits.
-
24 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
II. Liquidity Management
Reasons to hold cash and liquid deposits:
Transaction motive:
To ensure the payment of salaries, accounts payable, taxes and dividends;
As far as cash inflows (collections or new financing) might not be perfectly matched,
some amount of reserves will be necessary to meet unexpected obligations;
When unexpected obligations become recurrent, the company should consider the
possibility of raising new long-term financing.
Collateral
Minimum cash reserve, required by a financial institution in exchange of bank
services provided (guarantees, letters of credit or even new loans).
-
25 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
II. Liquidity Management
Costs from holding cash and liquid deposits
Opportunity cost:
Returns forgone by the company from the best alternative uses of its cash resources,
i.e., investments in highly liquid tradable securities.
Benefits from holding cash and liquid deposits
Saving of transaction costs (sale of tradable securities) or costs of short-term
financing go meet immediate obligations, sach as salaries and accounts
payable.
The optimal amount of cash reserve depends on this trade-off.
-
26 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
II. Liquidity Management
Situations to take into account in the application of excess cash and
liquid deposits holdings:
Maturity of investments interest rate risk;
Default risk;
Liquidity;
Taxes
-
27 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
II. Liquidity Management
III. Trade Credit and Receivables Management
IV. Inventory Management
V. Short-Term Financing
Summary
-
28 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
III. Trade Credit and Receivables Management
Definition of the trade credit conditions to be offered to clients,
in businesses where sales depend on credit granting, in order
to maximize the commercial benefits of trade credit policy
adopted and contain the costs associated with it within the
limited defined by sales gross margin.
-
29 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
III. Trade Credit and Receivables Management
The components of trade credit policy:
Terms of sale:
Cash or term payment?
Cash payment discount? How much and for how long?
Which credit period? Which credit instrument?
Credit analysis:
Credit policy equal to every client or previous credit analysis to determine the risk of default?
Collection policy:
Collection department? Outsourcing to a specialized company??
-
30 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
III. Trade Credit and Receivables Management
Terms of sale:
Usually pre-defined:
Cash payment discount (usually: 2-3%)
Period of discount (usually: 5-10 days after invoice)
Period of credit (usually: 60-90 days)
-
31 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
III. Trade Credit and Receivables Management
Terms of sale
Actual cost of cash payment discount
Example: 2% cash payment discount if payment is done within 10 days, or else total
invoice payment within 60 days
r (actual cost of cash payment discount): r = 15,89%
The same represents the effective cost of credit for the client if he chooses to take
credit.
D + 10 D D+60 50 dias
98 100
36550
)1(
10098
r
-
32 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
III. Trade Credit and Receivables Management
Terms of sale
Duration of credit period
Factors affecting the credit period granted by the company:
Degree of deterioration of goods
Goods of rapid deterioration (fresh fish, for example) represent a weak collateral in case of default; in these cases, credit period tends to be short;
Consumer demand
Goods of high demand tend to be paid at shorter term, while new products tend to be given longer credit periods, in order to attract clients;
Cost, profitability and standardization
Products relatively standardized, of low price and little profitability tend to be given shorter credit periods (cars, for example).
-
33 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
III. Trade Credit and Receivables Management
Terms of sale
Duration of credit period
Factors affecting the credit period granted by the company:
Credit risk
The higher the credit risk the shorter the credit period;
Dimension of receivables account
The smaller the receivables amounts, the shorter the credit period, because credit management costs become (proportionally) higher;
Competition
In more competitive markets, credit period tends to be longer;
Nature of clients
Different types of clients may mean different credit periods.
-
34 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
III. Trade Credit and Receivables Management
Terms of sale
Credit instruments
Invoice / delivery document
The company maintains a an account with the client where the invoice or the
delivery document prove that the goods have been delivered.
Promissory;
Letter of credit
Term or at demand.
-
35 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
III. Trade Credit and Receivables Management
Credit analysis
Factors to take into account:
Effect of credit in cash inflows (volume of sales and price);
Effect of credit on costs (collection period);
Cost of short-term financing;
Probability of default;
The value of cash payment discount.
-
36 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
III. Trade Credit and Receivables Management
Credit analysis
The cost / revenue trade-off model
Effect on the value of the company from offering one month credit period:
Revenue
(P v) x Q - (P v) x Q = (P v) x (Q Q)
PV [(P v) x (Q Q)] = (P v) x (Q Q) / R
Costs
P x Q + v x (Q-Q)
NPV = [(P v) x (Q Q) / R] [P x Q + v x (Q-Q)]
NPV = 0 (Q Q) = P x Q / [(P v)/R v]
P = price per unit
v = variable cost per unit
Q = present monthly sales
Q = new sales (after new credit policy)
R = required rate of return (monthly)
-
37 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
III. Trade Credit and Receivables Management
Collection policy
Collections monitoring
Analysis of ACP;
Analysis of maturity of receivables;
Collection actions:
Letters demanding payment overdue receivables;
Phone calls;
Contracting a collection agent;
Legal action;
Factoring.
-
38 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
II. Liquidity Management
III. Trade Credit and Receivables Management
IV. Inventory Management
V. Short-Term Financing
Summary
-
39 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
IV. Inventory Management
Defining rules for supply and holding of inventory, which
minimize its associated costs, namely financial costs of
inventory, administrative costs and shortage costs.
-
40 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
IV. Inventory Management
Types of inventory:
Raw materials;
Work in progress;
Finished products;
Goods.
-
41 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
IV. Inventory Management
Costs
Carrying (holding) costs
Storage;
Insurance and taxes;
Loss of value due to obsolescence;
Opportunity cost.
Shortage costs
Ordering costs (supply costs);
Opportunity costs (shortage cost)
Related to loss of sales, of clients or disruptions in production.
-
42 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
IV. Inventory Management
Methods of inventory management
The ABC method
Break down the stock into 3 (or more) groups
A 10% of products (per unit) representing the biggest amount of inventory;
C 50% of products (per unit) representing the lowest amount of inventory;
B the class in between;
Goods in group A are permanently monitored and their inventory levels are kept low;
Goods in group C are ordered in great quantities and their inventory levels are kept
high.
-
43 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
IV. Inventory Management
Methods of inventory management
Method of economic order quantity (EOQ)
To minimize storage and ordering costs
Let:
Q quantity to order;
ka cost of storage per unit;
F fixed cost per order;
T sales per year;
Storage cost = Q/2 x ka
Ordering cost = F x (T/Q)
Minimum cost : Q*: Q*/2 x ka = F x (T/Q*) ak
TxFQ 2*
-
44 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
IV. Inventory Management
Methods of inventory management
Method of economic order quantity (EOQ)
Extensions
Safety inventory level
Determined as a function of shortage probability and costs
Q
0 Time
Safety inventory
Minimum inventory
-
45 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
IV. Inventory Management
Methods of inventory management
Method of economic order quantity (EOQ)
Extensions
Ordering point
Determined as a function of delivery time
Q
0 Time
Delivery time
Ordering point
-
46 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
IV. Inventory Management
Methods of inventory management
The special case of inventory dependent on the needs of other inventory
Material Requirements Planning (MRP)
Capacity to determine the inventory needs at early stages of the production
process, based on expected demand of final product;
Just-in-time (JIT)
Little inventory or no inventory;
Small quantities orders but very often;
It requires close cooperation with suppliers.
-
47 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
I. Short-Term Financial Management
II. Liquidity Management
III. Trade Credti and Receivables Management
IV. Inventory Management
V. Short-Term Financing
Summary
-
48 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
V. Short-Term Financing
Defining a financing supply function for the company, which
allows it to use the most efficient financing instruments to meet
eventual temporary shortages of liquidity.
-
49 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
V. Short-Term Financing
In normal conditions:
Long-term financing should be used to finance investment in fixed assets and
in permanent working capital.
Short-term financing should be used to support liquidity management and to
deal with the instability of cash-flows in the company.
In practice:
Short-term financing has been too often used (in Portugal) as a surrogate of
long-term financing (in a system of roll-over), because of a believed easier
access to this type of financing (recently contradicted by reality).
-
50 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
V. Short-Term Financing
Short-term financing does not differ from long-term financing with
respect to:
Financing cost evaluation (all-in);
Influence of:
Financial innovation;
Degree of development of the monetary markets;
Capacity of management to absorb financial innovation;
The presence of options.
-
51 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
V. Short-Term Financing
Short-term financing instruments:
Bank loans;
Promissory discount;
Current account;
Documental credit;
Overdraft agreement;
Commercial paper;
Factoring.
The use of these instruments must be based on financial planning,
namely on a cash budget.
-
52 MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
V. Short-Term Financing
The choice of short-term financing instruments
The decision criteria should be the all-in cost. This is affected by:
The possibility of using alternatively the banking system and the monetary market
(using the latter requires better financial planning);
The relationship of the company with the banking sector
The company should not fall dependent on a reduced number of banks;
The company should take into account and make use of the flexibility
mechanisms available in some of these financing instruments.