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.


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


I. Short-Term Financial Management

II. Liquidity Management

III. Trade Credit and Receivables Management

IV. Inventory Management

V. Short-Term Financing

Summary



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?



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



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)



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.


0 Current assets CA*

Shortage costs

Holding costs

Total costs






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)




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


How should current assets be financed?

0 t

Fixed assets (long-term)

Permanent current assets

Seasonal variation of current assets

Total assets





Restrictive strategy

0 t

Long-term financing

Short-term financing




Flexible strategy

0 t

Long-term financing

Investment in liquid assets




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.



Short-term financial decisions (working capital management) include

the following areas:

Liquidity management;

Trade credit and receivables management;

Inventory management;

Short-term financing.







Summary



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.



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).



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.




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.




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.



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.



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).



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.



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







Summary



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.



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??



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)



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



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).



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.



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.



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.



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)



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.







Summary



Defining rules for supply and holding of inventory, which

minimize its associated costs, namely financial costs of

inventory, administrative costs and shortage costs.



Types of inventory:

Raw materials;

Work in progress;

Finished products;

Goods.



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.



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.




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*





Extensions

Safety inventory level

Determined as a function of shortage probability and costs

Q

0 Time

Safety inventory

Minimum inventory





Extensions

Ordering point

Determined as a function of delivery time

Q

0 Time

Delivery time

Ordering point




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.




III. Trade Credti and Receivables Management



Summary



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.



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).



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.



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.



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.

lecture short-term financial decisions

Documents

company management

inventory management

liquidity management

financial planning

receivables management

shortterm financing

current assets af

liquidity costs