1.9.Financial Management (1)

Study Notes Financial Management - FM Inventory Management Inventory Costs Holding Costs Ordering costs Stock out costs Cost of inventory Warehousing and Ordering costs Contribution from lost Purchase Cost handling costs sales Deterioration cost Delivery costs Extra cost of emergency inventory Obsolescence cost Freight Charges Insurance cost Reputation loss Pilferage cost Economic Order Quantity 2×annual demand × per order cost/Holding cost per unit EOQ focuses on two costs Holding costs = Holding cost per unit × order quantity/2 Ordering Costs = per order cost × Annual demand/order quantity EOQ Example  Example: Annual demand is 200,000 units Per order cost is 20$ Holding cost is 0.2$ per unit Purchase price is 1$/unit Current order quantity= 50,000 units  What is the total cost if order quantity remains at 50,000 ? Purchase cost =1$×200,000=$200,000 Ordering cost=20$×200,000/50,000=80$ Holding cost=0.2×50,000/2=$5000 Total cost= $205080 99

Study Notes Financial Management - FM EOQ Example (Continued)  What is the total cost of inventory if company follows EOQ model ? EOQ=2×200,000×20/0.2 =60325 Ordering cost=20$×200,000/6325=632$ Holding cost=0.2×6325/2=$632 Total cost= $201,264  Supplier has offered 1% discount if order quantity is at least 30,000 units What is the total cost if company accept the supplier’s offer.? Purchase cost =1$× 200,000×0.99=$198,000 Ordering cost=20$×200,000/30,000=133$ Holding cost=0.2×30,000/2=$3000 Total cost= $201,133 Assumptions of using EOQ The following assumptions are applicable in EOQ which limits its applicability:  Demand and lead time are assumed to remain constant.  Purchase price is also assumed to remain  No buffer inventory  Holding costs are assumed to be constant. Other formulas to remember  Re-order level = Maximum usage x Maximum lead time  Maximum inventory level = Re-order level + re-order quantity – (minimum usage x minimum lead time)  Buffer safety inventory = Re-order level – (average usage x average lead time)  Average inventory level = Buffer safety inventory + Re-order amount 2 JIT (Just-in-Time) Procurement  Just-in-time procurement is a term which describes a policy of obtaining goods from suppliers at the latest possible time, so avoiding the need to carry any inventory level.  The objective is zero inventory level which results in zero holding costs. Advantages Disadvantages Reduction in inventory holding costs Just-in-time manufacturing system is vulnerable to unexpected disruptions in supply chain. A production Reduced manufacturing lead times line can quickly come to a halt if essential parts are Improved labor productivity unavailable Reduced scrap/rework/warranty costs. JIT can only be implemented in case of reliable suppliers that are located close 100

Study Notes Financial Management - FM Accounts Receivable Management Major roles of credit control department/Receivable management. To formulate credit policies  Lenient policy  Strict policy  Early settlement discount Assess credit worthiness of customers Collection of debt from customers efficiently Collection of overdue debt Receivable as sources of finance  Factoring  Invoice discounting Foreign receivable management Cost of Receivable o Administrative cost to record and collecting debts o Cost of irrecoverable debts (Sales X % of bad debt) o Cost of early Settlement Discount = (Sales X % of discount X % of customers taken the discount) o Finance Cost (Average Receivable X % of interest rate) Advantages and Disadvantages of using different polices for Receivables Management Lenient Policy Strict policy Advantages Increase in contribution Decrease in potential bad debt Decrease in administration cost Less overdraft cost Disadvantages Increase in potential bad debt Decrease in contribution High overdraft cost Increase in administration cost 101

Study Notes Financial Management - FM How to tackle in Exam Proposed policy Current Policy Cost of receivables=(Credit sales x ������������������������������������ ������������������������ )× Cost of receivables=(Credit sales x ������������������������������������ ������������������������ )× ������������������ ������������������ OD Interest rate OD Interest rate Contribution =Sales × C/S ratio% Contribution =Sales × C/S ratio% Bad debt = sales × % of bad debt Bad debt = sales × % of bad debt Admin cost Admin cost Total cost/Benefit Total cost/Benefit Early Settlement Discount Proposed Policy Current Policy Cost of receivables=(Credit sales x ������������������������������������ ������������������������ )× OD Cost of receivables availing discount ������������������ =(Credit sales x ������������������������������������ ������������������������ )× % of availing discount x Interest rate ������������������ Contribution = Sales × C/S ratio% OD Interest rate Bad debt=sales×% of bad debt Cost of receivables not availing discount Admin cost =(Credit sales x ������������������������������������ ������������������������ )× % of not availing Total cost ������������������ discount x OD rate Discount allowed= Sales × % of discount × % of availing discount Contribution = Sales × C/S ratio% Bad debt = sales × % of bad debt Admin cost Total cost Cost of Early Settlement Discount The percentage cost of early settlement discount to the company offering the discount can be calculated by the following formula Cost of early settlement discount= ( 100 )^365/t -1 100−������ Where  d = discount offered  t = reduction in payment period in days that is necessary to obtain early payment discount 102

Study Notes Financial Management - FM ASSESSING CREDITWORTHINESS methods  Trade reference This is obtained from another company who has  Bank reference dealings with your potential customer/customer. Due While a bank reference can be fairly easily to the litigious nature of society these days, it may not obtained, it must be remembered that the be so easy to obtain a written reference. However, you other company is the bank’s customer and may be able to call contacts you have in the trade and so a bank reference will stick to the facts. It obtain an informal oral reference is most unlikely to raise any fears the bank may have about the company ASSESSING CREDITWORTHINESS methods  Financial Statements Financial statements of a company are publicly available  Credit rating/reference agency information and can be quickly and easily obtained. While These agencies’ professional business is an analysis of the financial statements may indicate to sell information about companies whether or not a company should be granted credit, it and individuals. Hence, they will be must be remembered that the financial statements keen to give you the best possible available could be out of date and may have suffered from information, so you are more likely to manipulation. For larger companies, an analysis of their return and use their services again accounting information can generally be found through various sources on the internet ASSESSING CREDITWORTHINESS methods  Visit Visiting a potential new customer to discuss their exact  Information from the financial media needs is likely to impress the customer with regard to your Information in the national and local desire to provide a good service. At the same time, it gives press, and in suitable trade journals and you the opportunity to get a feel for whether or not the on the internet, may give an indication of business is one which you are happy to give credit to. While the current situation of a company. For it is not a very scientific approach, it can often work quite example, if it has been reported that a well, as anyone who runs their own successful business is large contract has been lost or that one likely to know what a good business looks, feels and smells or more directors has left recently, then like! this may indicate that the company has problems 103

Study Notes Financial Management - FM Collection of Receivables Collection of overdue debt Collection of funds efficiently  Instituting reminders or final demands  Chasing payment by telephone  The customer is fully aware of the terms  Making a personal approach  The invoice is correctly drawn up and  Notifying debt collection section  Handling over debt collection to specialist debt issued promptly.  They are aware of any potential quirks in collection section  Instituting legal action to recover the debt the customer’s system  Hiring external debt collection agency to recover debt.  Queries are resolved quickly  Monthly statements are issued promptly Debt Factoring Factoring is an arrangement to have debts collected by a factor company, which advances a proportion of the money it is due to collect. Factoring can be used to help short-term liquidity or to reduce administrative costs. Aspects of Factoring The main aspects of factoring include the following  Administration of the client’s invoicing, sales accounting and debt collection service.  Credit protection for the client’s debts, whereby the factor takes over the risk of loss from bad debts ad so insures the client against such losses. This is knows as non-recourse service.  Making payments to the client in advance of collecting the debts. This is referred to as ‘factor finance’ Applying Debt Factoring After factoring Before Factoring Cost of receivables=(Credit sales x ������������������������������������ ������������������������ )× Cost of Factor advance =(Credit sales x ������������������������������������ ������������������������ )× % ������������������ ������������������ OD Interest rate of factor advance x Factor Interest rate Bad debt = sales × % of bad debt Cost of remaining receivable =(Credit sales x ������������������������������������ ������������������������ )× % of remaining finance x ������������������ OD Interest rate Factor fee = Sales × % of fee Bad debt = sales × % of bad debt ( if with recourse) Admin cost Admin cost Total cost Total cost 104

Study Notes Financial Management - FM Example of Debt Factoring A company makes annual credit sales of $1,500,000. Credit terms are 30 days, but its debt administration has been poor and the average collection period has been 45 days with 0.5% of sales resulting in bad debts which are written off. A factor would take on the task of debt administration and credit checking, at an annual fee of 2.5% of credit sales. The company would save $30,000 a year in administration costs. The payment period would be 30 days. It is assumed that the factor would advance an amount equal to 80% of the invoiced debts, and the balance 30 days later. The factor would also provide an advance of 80% of invoiced debts at an interest rate of 14% (3% over the current base rate). The company can obtain an overdraft facility to finance its accounts receivable at a rate of 2.5% over base rate. Required: Should the factor's services be accepted? Assume a constant monthly turnover. Solution (a) The current situation is as follows, using the company’s debt collection staff and a bank overdraft to finance all debts. Credit sales $1,500,000 pa Average credit period 45 days The annual cost is as follows: $ 45/365 x $1,500,000 x 13.5% (11% + 2.5%) 24,966 Bad debts 0.5% x $1,500,000 7,500 Administration costs 30,000 Total cost 62,466 Solution (b) The cost of the factor. 80% of credit sales financed by the factor would be 80% of $1,500,000 = $1,200,000. For a consistent comparison, we must assume that 20% of credit sales would be financed by a bank overdraft. The average credit period would be only 30 days. The annual cost would be as follows. Factor’s finance 30/365 x $1,200,000 x 14% $ Overdraft 30/365 x $300,000 x 13.5% 13,808 3,329 Cost of factor’s services: 2.5% x $1,500,000 17,137 Cost of the factor 37,500 54,637 105

Study Notes Financial Management - FM Solution (c) Conclusion. The factor is cheaper. In this case, the factor’s fees exactly equal the savings in bad debts ($7,500) and administration costs ($30,000). The factor is then cheaper overall because it will be more efficient at collecting debts. The advance of 80% of debts is not needed, however, if the company has sufficient overdraft facility because the factor’s finance charge of 14% is higher than the company’s overdraft rate of 13.5%. Advantages & Disadvantages Disadvantages  Factoring is likely to be more costly than an Advantages efficiently run internal credit control department.  Business can pay its suppliers on time and so be  Customers may not like to deal with factors. able to take advantage of early payment  Company loses control to decide to whom to grant discounts. credit period and the length of credit period for each  Optimum inventory level can be maintained because management will have enough cash. customer  Once a company hires a factor, it is difficult to go  Growth can be financed through sales rather than injecting new capital back to an internal credit control system again.  Factoring may have a bad reputation for the  The cost of running sales ledger department is over. company. It may indicate that the company has  Business can use the expertise of debtor financial issues. management that the factor specializes.  Management time is saved because managers don’t have to spend their time on debtor management.  Business gets its finance linked to its volume of sales Invoice Discounting Invoice discount is the purchase of trade debts at a discount by the providers of the discounting service. Invoice discount and factoring are linked and mostly factors also provide invoice discounting service too. It involves the purchase of a selection of invoices by the factor at a discount but the invoice discounter doesn’t take over administration of the client’s sales ledger.  Confidential invoice discounting is an arrangement whereby a debt is assigned to the factor confidentially and the client’s customer will only become aware of the arrangement if he doesn’t pay his debt to client.  Non-confidential invoice discount is an arrangement whereby the client’s customer is aware of the relationship of factor to client and acknowledges its liability towards factor. Managing Foreign Accounts Receivables  REDUCING INVESTMENT IN FOREIGN ACCOUNTS RECEIVABLE  FORFAITING  LETTER OF CREDIT  COUNTERTRADING 106

Study Notes Financial Management - FM  EXPORT CREDIT INSURANCE  EXPORT FACTORING Managing Foreign Accounts Receivables REDUCING INVESTMENT IN FOREIGN ACCOUNTS RECEIVABLE  A company can reduce its investment in foreign accounts receivable by asking for full or part payment in advance of supplying goods. However this may be resisted by consumers, particularly if competitors do not ask for payment up front. Forfaiting  Forfaiting involves the purchase of foreign accounts receivable from the seller by a forfaiter.  The forfaiter takes on all of the credit risk from the transaction (without recourse) and therefore the forfaiter purchases the receivables from the seller at a discount.  The purchased receivables become a form of debt instrument (such as bills of exchange) which can be sold on the money market.  The non-recourse side of the transaction makes this an attractive arrangement for businesses, but as a result the cost of forfaiting is relatively high. LETTER OF CREDIT This is a further way of reducing the investment in foreign accounts receivable and can give a business a risk-free method of securing payment for goods or services. There are a number of steps in arranging a letter of credit:  Both parties set the terms for the sale of goods or services  The purchaser (importer) requests their bank to issue a letter of credit in favor of the seller (exporter)  The letter of credit is issued to the seller’s bank, guaranteeing payment to the seller once the conditions specified in the letter have been complied with  The goods are dispatched to the customer and the shipping documentation is sent to the purchaser’s bank  The bank then issues a banker’s acceptance Letter of Credit (Continued)  The seller can either hold the banker’s acceptance until maturity or sell it on the money market at a discounted value  It takes significant amount of time and therefore are slow to arrange.  The use of letters of credit may be considered necessary if there is a high level of non-payment risk.  Customers with a poor or no credit history may not be able to obtain a letter of credit from their own bank. Letters of credit are costly to customers and also restrict their flexibility:  Collection under a letter of credit depends on the conditions in the letter being fulfilled. Collection only occurs if the seller presents exactly the documents stated in the conditions. COUNTERTRADING In a countertrade arrangement, goods or services are exchanged for other goods or services instead of for cash. The benefits of countertrading include the fact that it facilitates conservation of foreign currency and can help a business enter foreign markets that it may not otherwise be able to. 107

Study Notes Financial Management - FM Disadvantage  The value of the goods or services received in exchange may be uncertain.  It includes complex negotiations and logistical issues, particularly if a countertrade deal involves more than two parties. EXPORT CREDIT INSURANCE Export credit insurance protects a business against the risk of non-payment by a foreign customer. Exporters can protect their foreign accounts receivable against a number of risks which could result in non-payment. Export credit insurance usually insures insolvency of the purchaser or slow payment, insures against certain political risks, for example war, and riots. Disadvantages include the relatively high cost of premiums and the fact that the insurance does not typically cover 100% of the value of the foreign sales. EXPORT FACTORING An export factor provides the same functions in relation to foreign accounts receivable as a factor covering domestic accounts receivable and therefore can help with the cash flow of a business. However, export factoring can be more costly than export credit insurance and it may not be available for all countries, particularly developing countries. GENERAL POLICIES FOR FOREIGN ACCOUNTS RECEIVABLE None of the methods detailed above would allow the selling company to escape from the basic fact that credit should only be given to customers who are creditworthy. Managing Accounts Payable There are three main objectives of accounts payable management.  Seeking satisfactory credit terms from suppliers.  Extending credit period during periods of cash shortage.  Maintaining good relationships with suppliers. Trade Credit The cost of lost cash discount can be calculated by the following formula Cost of early settlement discount= ( 100 ) ^365/t -1 100−������ Example: Product Q The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product at $1 per unit on 60 days credit. The supplier has offered an early settlement discount of 1% for settlement of invoices within 30 days. Plot Co finances working capital with short-term finance costing 5% per year. Assume that there are 365 days in each year. Calculate the net value in dollars to Plot Co of accepting the early settlement discount for Product Q. 108

Study Notes Financial Management - FM Managing Cash Objective of holding Cash: John Maynard Keynes identified three reasons for holding cash.  Transactions Motive: Every business needs cash to meet its regular commitments of paying its accounts payable like employee wages, taxes, annual dividends …  Precautionary motive: There is a need to maintain a ‘buffer of cash for unforeseen contingencies.  Speculative Motive: Sometimes businesses hold surplus cash as a speculative asset in the hope that interest rates will rise in future. Problems associated with cash flows:  Making losses If a business is continually making losses, it will eventually have cash flow problems.  Inflation Even if a business is making a profit, it can still face cash flow problems in during period of inflation.  Growth During periods of growth, business has an ever increasing need for more non-current assets and for its increasing working capital  Seasonal business When a business has seasonal or cyclical sales, it may have cash flow difficulties at certain times during the year.  One-off items of expenditure Sometimes, a single non-recurring item of expenditure may create a cash flow problem. Managing Cash Flow Problems Cash flow problems can be eased by taking a number of steps  Postponing capital expenditure: Some capital expenditures can be postponed for a year or so without serious effect on company’s long term performance.  Accelerating cash inflows: Business can encourage its account receivables to pay early through discounts on early payments.  Reversing past investments: Some assets that are not crucial for business survival can be sold during period of severe cash flow problem  Negotiations with accounts payable:  This involves the following  Longer credit can be taken from suppliers 109

Study Notes Financial Management - FM  Loan repayments can be rescheduled through negotiations with bank  Dividend payment can be reduced Cash Flow Forecasts 12 3 4 Months Cash Inflows XX X X Receivable Collection XX X X Dividends Received XX X X Sale of non-current assets Cash Outflow (X) (X) (X) (X) Trade payable payment (X) (X) (X) (X) Purchase of non-current assets (X) (X) (X) (X) Wages XX X X Net Cash Flows XX X X Opening Balance XX X X Closing Balance Treasury Management Treasury management can be defined as  Corporate handling of all financial matters,  The generation of external and internal funds for business,  The management of currencies and cash flows,  The complex strategies,  Policies and procedures of corporate finance Treasury department can be centralized or decentralized in an organization depending on its needs. Both have certain advantages associated with them. Advantages of Centralized Treasure Department  Large volume of cash is available to invest, leading to better short-term investment opportunities.  Borrowing can be arranged in bulk at lower interest rate.  Foreign exchange risk management will be improved through matching foreign currency income earned by one subsidiary with expenditure in the same currency by another subsidiary.  Treasure management will be efficient because a centralized treasury department can employ experts.  Liquidity management will be improved through centralized treasury department  It avoids having a mix of cash surpluses and overdrafts in different localized banks  It facilitates bulk cash flow which will result in less transaction costs. 110

Study Notes Financial Management - FM Advantages of Decentralized Treasury Management  Greater autonomy will be given to subsidiaries  A decentralized treasury function may be more responsive to the needs of individual operating units.  Sources of finance will be diversified Objective of holding Cash: John Maynard Keynes identified three reasons for holding cash.  Transactions Motive: Every business needs cash to meet its regular commitments of paying its accounts payable like employee wages, taxes, annual dividends …  Precautionary motive: There is a need to maintain a ‘buffer of cash for unforeseen contingencies.  Speculative Motive: Sometimes businesses hold surplus cash as a speculative asset in the hope that interest rates will rise in future Cash Management (The Baumol model) The Baumol model is based on the idea that an optimum cash balance is like deciding an optimum inventory level. It uses the same EOQ formula that is used to calculate the optimum inventory level Q = 2CS I Where Q = Optimum amount of cash to be raised S = Amount of cash to be used in each time period C = Cost per sale of securities I = Interest cost of holding cash or near cash equivalents (Interest rate on new borrowings – interest earned on cash investment) EXAMPLE Finder Co faces a fixed cost of $4,000 to obtain new funds. There is a requirement for $24,000 of cashover each period of one year for the foreseeable future. The interest cost of new funds is 12% per annum; the interest rate earned on short-term securities is 9% per annum. Required: How much finance should Finder raise at a time? Solution The cost of holding cash is 12% - 9% = 3% The optimum level of Q (the ‘recorder quantity) is: 2 x 4,000 x 24,000 = $80,000 0.03 The optimum amount of new funds to raise is $80,000. This amount is raised every 80,000 ÷ 24,000 = 31/3 years. 111

Study Notes Financial Management - FM Advantages & Disadvantages Disadvantages  It is unlikely to be possible to predict amounts required Advantages  The Baumol model enables companies over future periods.  No buffer inventory of cash is allowed. to find out their desirable level of cash  There may be a number of other costs associated with balance under certain assumed conditions. holding cash  It recognizes the cost of holding extra cash. The Miller-Orr Model The miller-Orr model focuses on an optimum amount of cash that a company should held which is called return point. The model then sets an upper and lower limit of cash balances which should not be crossed. If a company reaches an upper limit, it should buy market securities to return to the “return point” and if it reaches lower limit, it should sell some securities to reach to the “return point”. Calculating the Return Point  Spread = 3 ( 3 x transaction cost x variance of cash flows )1/3 4 Interest rate  Return point = Lower limit + ( 1 x Spread) 3 112

Study Notes Financial Management - FM Example The following data applies to a company.  The minimum cash balance is $8,000.  The variance of daily cash flows is 4,000,000, equivalent to a standard deviation of $2,000 per  The transaction cost for buying or selling securities is $50. The interest rate is 0.025 per cent day. Required: You are required to formulate a decision rule using the Miller-Orr model. Solution The spread between the upper and the lower cash balance limits is calculated as follows. Spread = 3 ( 3x transaction cost x variance cash flows)1/3 4 interest rate = 3 ( 3x 50 x 4,000,000)1/3 = 3 x (6 x 1011)1/3 = 3 x 8,434.33 4 0.00025 = $25,303, say $25,300 The upper limit and return point are now calculated. Upper limit = Lower limit + $25,000 = $8,000 + $25,300 = $33,300 Return point = lower limit + 1/3 x spread = $8,000 + 1/3 x $25,300 = $16,433, say 16,400 The decision rule is as follows. If the cash balance reaches $33,300, buy $16,900 (= 33,300 – 16,400) in marketable securities. If the cash balance falls to $8,000, sell $8,400 of marketable securities for cash. Working Capital Investment Policy A company can adopt a working capital strategy for managing its working capital depending on the important risks associated with working capitals. It can choose from three different working capital strategies. These strategies are as follows:  Conservative Approach  Aggressive Approach  Rate Approach Conservative Approach “A conservative working capital management policy aims to reduce the risk of system breakdown by holding high levels of working capital”  Customers are allowed generous payments terms to stimulate demand,  Finished goods inventories are high to ensure availability for customers,  Raw material and work in progress are high  Suppliers are paid promptly to ensure their goodwill. 113

Study Notes Financial Management - FM Aggressive & Management Approach Moderate Approach A moderate working capital management policy is a Aggressive Approach middle way between the aggressive and conservative “An aggressive working capital management approaches. policy aims to reduce financing cost and increase profitability:  by cutting inventories to kept it at minimum level.  speeding up collections: Customers are allowed a limited payment period and discounts are given for prompt payment  delaying payments to supplier. Working Capital Financing Policy Assets can be divided into three types in order to understand different working capital management strategies  Non-current assets: These are long term assets from which an organization expects to derive benefit over a number of periods. For example, plant and machinery  Permanent current assets: This is the amount required to meet minimum long-term needs and sustain normal trading activity. For example, inventory and average receivables…  Fluctuating current assets: These are current assets which vary according to normal business activity. Example include fluctuate in working capital due to seasonal variations Conservative Approach Policy A can be characterized as a conservative approach to finance working capital where all non-current assets, permanent current assets and part of fluctuating current assets are financed by long-term funding 114

Study Notes Financial Management - FM Aggressive Approach Policy B can be characterized as an aggressive approach to finance working capital where non-current assets and some part of permanent current assets are financed through long-term borrowings while fluctuating current assets and part of permanent current assets are financed through short-term sources Moderate Approach Policy C describes a balance between risk and return which might be best achieved by moderate approach. In this case, long-term sources of finance are used to finance permanent current assets while short-term sources of finance are used to finance fluctuating current assets. 115