S1 AUTOMATED GROUP LEARNING (AGL)
AGL NO. 10 FINANCIAL MANAGEMENT
OF WORKING CAPITAL
DAILY WORK PACK - PART I
Copyright: RGAB/PW 2005/13
AGL
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S2 WELCOME TO THE PROGRAM
a. AGL - two/three days of learning, tested with over 2000
managers in twenty countries around the world.
b. Helps you to understand and use the reports issued
by your finance and accounting division.
c. Provides a controlled learning environment where you
find the answers to all your questions in the groups
and materials provided.
e. Requires hard work, but you have fun and learn a lot.
S3 ABBREVIATIONS
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IND
SG
CSG
MG
ASS
PL
L
D
LRT
CAI
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INDIVIDUAL
SMALL GROUP
COMBINED SMALL GROUP
MAIN GROUP
ACCOUNTING STEP BY STEP
PROGRAM LEARNING
LECTURE
DISCUSSION
LEARNING RECALL TAPE
COMPUTER ASSISTED INSTRUCTION
S4 ASSIGNMENT 1.0 - INTRODUCTION
(30 minutes) 1.1 SPECIFIC OBJECTIVES
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The program provides members with the opportunity to
understand financial management terms, techniques and
reports so that they become more complete managers.
This broadening of knowledge and skills will enable them to
capitalise on business opportunities and to accelerate their
career development.
S5 1.1 SPECIFIC OBJECTIVES
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a.
Understand accounting language and the concepts of
financial management.
b.
Recognize the need for financial forecasting of : cash,
funds, income statements and balance sheets.
c.
Develop practical skills in using financial data to manage
working capital effectively.
d.
Recognize "creative accounting" in financial reporting,
despite IAS (International Accounting Standards) and
motivate further study in the future
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S6 1.2 AUTOMATED GROUP LEARNING
(AGL)
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The AGL method is designed to achieve rapid
individual learning using special materials and the
stimulus of group activity without a formal instructor.
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The groups use the materials to find the answers to
all problems and questions.
S7 1.3 GROUP ARRANGEMENTS
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The work will be done:
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IND - Individually, or in
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SG - Small Group (in small groups of four members
which will change daily), or in
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CSG - Combined Small Group (two small groups
together), or in
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MG - Main Group (for short taped lectures on key
learning points with visual aids).
S8 1.4 SG - SMALL GROUPS
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Group names provided on the flip charts.
Please note the name of your SG and names
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S9 1.5 LEARNING MATERIALS
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(a) Retained by members
Text
Notebook - for recording every key point
Daily Course Diary
Learning Recall Tape
Articles (2)
(b) Used but not retained by members:
Daily work packs including: lectures, cases,
exercises and key learning points.
S10 1.5 LEARNING MATERIALS (continued)
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Use your notebook. Do not mark the Daily Workpack
which must be handed back at the end of each day.
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You receive all the materials in your SG.
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Don't look ahead in the workpack until you are
specifically asked to do so!
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S11 1.6 METHOD
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Try to complete every task in the time allowed.
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A pattern of learning methods will be used including:
• Study notes
• Case analysis
• Lectures
• Quizzes
• Learning patterns
• Homework reading
• Learning Recall Tape (LRT) & CAI
S12 1.7 LEARNING PATTERNS - REVIEW
1. Objectives
Language
Ratios
Concepts
Forecasting
Risk & Return
Working Capital
Creative Accounting
CONFIDENCE
S13 1.7 LEARNING PATTERNS - REVIEW
2. Learning
IND
SG
CSG
MG
S14 1.7 LEARNING PATTERNS - REVIEW
3. Methods
Study Notes
Lectures
Small Groups
Combined Small Groups
Cases & Exercixes
LRT
Main Group
CAI
LEARNING FOR YOU
S15 1.8 INSTRUCTIONS (15 minutes)
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Assemble in SG's to introduce yourself, indicate your past
experience in finance and what you hope to contribute
to and gain from the course.
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Complete the registration sheet in the Daily Course Diary.
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NOTE: Please check that you have a full set of learning
materials now.
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S16 ASSIGNMENT 3.0 - STUDY
(60 MINUTES)
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3.1 INSTRUCTIONS - INDIVIDUAL WORK
a.
Re-assemble in SG and study the lecture and discuss in
SG.
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b.
Record significant points on the flip chart.
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c.
Review the glossary for any difficulties with new words
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Record significant points in your noteboo and ssemble
in MG when the bell rings
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S17 ASSIGNMENT 4.0 - LECTURE ON
FINANCIAL MANAGEMENT
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4.1 METHOD
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Read aloud, listen carefully and respond verbally to
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any questions.
S18 4.2 FINANCIAL MANAGEMENT
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a.
Deals with four major problems:
SIZE - what size should the firm be?
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GROWTH - what rate of growth of sales, assets, cash
flow, profits. etc.?
FINANCING - how should the firm be financed, and
at what risk?
INVESTMENT - what kind of assets should be acquired,
and at what rate?
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S19 4.2 FINANCIAL MANAGEMENT
(continued)
b.
Most important is ... CASH FLOW and SURVIVAL ...
to increase the long term VALUE of the business for ALL
of the "players": customers, shareholders, management,
workers, suppliers, banks, communities, government,
trade unions, environmental groups etc
S19A 4.2
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FINANCIAL MANAGEMENT
(continued)
c. To achieve EVA in a company, the manager of each
division must produce:
OP/NAE X 100% = above CoC
where:
OP = Operating Profit after tax
NAE = Net assets employed (FA & CA & OA less CL)
CoC = Cost of Capital
S19B 4.2 FINANCIAL MANAGEMENT
(continued)
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d. The value of a business or a share may be simply
computed as: OCF/(r-g) which is explained later.
In 1995, shareholders may be powerful pension funds,
insurance companies and mutual funds, who may
REQUIRE management to provide both dividends and
increased share value ... or move over ...
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S20 4.3 FINANCIAL OBJECTIVE,
METHOD AND SKILLS
a.
business with EVA (Economic Value Added) and SVA
(Share Value Added).
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b.
Method - raise money and use it effectively to achieve
standards of financial performance
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Skills - risk evaluation, raising cash, using time effectively,
and maintaining relationships with the “stakeholders”:
customers, employees, owners, bankers, financial
markets. government, auditors, community etc.. by
developing appropriate attitudes towards risk- taking.
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Objective - increase the long term value of the
S21 4.4 SHORT AND LONG TERM
FINANCIAL MANAGEMENT
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a. Diagnosis to determine whether business has a short
term or long term need for funds
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b. Short term:
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1. Investment in cash, receivables (debtors) and inventory
(stock)
2. Finance from payables (creditors). advances. bank
loans etc.
S22 4.4 SHORT AND LONG TERM
FINANCIAL MANAGEMENT (continued)
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c. Long term
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1. Investment in fixed assets, investments, R&D. etc.
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2. Finance by long term loans or equity.
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Note: NET working capital is:
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current assets less current liabilities.
S23 4.5 FINANCIAL ANALYSIS
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Use the LAPP system to evaluate the health
of a business:
Rough Standard
Liquidity (and Gearing):
Quick assets : quick liabilities
1/2 : 1
Current assets : current liabilities
2:1
Equity : debt
2 ; 1 or 1 : 1
ActivityS/A (times turned over)
Cost of goods sold/Inventory
Days of Sales
Days of Purchases
1+
2-50
30-90
30-90
S24 4.5 FINANCIAL ANALYSIS (continued)
Rough Standard
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Proftability:
Gross profit/sales x 100%
Net profit/sales x 100%
Net profit/owners equity x 100%
Operating profit/assets empluyed
improving
improving
improving
greater than CoC
Note:
Rough standards are not adequate!
Relate ratios to industry averages.
Look at past trends, compare with target.
Forecast forward to see the future effect of operations!
S25 4.5 FINANCIAL ANALYSIS (continued)
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Potential:
Sales
Products
Markets
Facilities
Finance
Organization
Research
etc.
S26 4.6 FORECASTING FUNDS
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Funds flow shows source and use of funds.
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Sources are: profit, depreciation, new capital and loans.
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Uses are: fixed assets, dividends, working capital.
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Funds flow statements reveal key management decisions past and future.
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Forecast forward to provide funds as required 1 - 5 years
ahead.
S27 4.7 FORECASTING - CASH
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Arrange now for the cash required in the future.
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Cash flow is cash (received and paid) in the shorter term.
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Continually re-forecast monthly for 12 months ahead to be
sure cash is available when required.
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Some businesses need weekly or even daily cash forecasting
and control due to seasonal fluctuations of the industry.
Review the past cash flows against target, and plan future
cash flows.
S28 4.7 FORECASTING - CASH (continued)
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Look for peak requirement and duration - watch seasonal
and monthly effects.
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Don't keep too much cash in hand earning nothing.
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Debt capacity (equity: debt relationship) is real KEY to
liquidity.
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The quick ratio and current ratio are only part
of the story!
S29 4.8 MANAGEMENT OF
WORKING CAPITAL
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(a) Manage the assets and sources of finance:
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(b) Assets:
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Cash - reduce amount on hand, get it to the bank faster!
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Inventory - reduce inventory or get suppliers to hold it!
Research high values and slow moving items ...,
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S30 4.8 MANAGEMENT OF
WORKING CAPITAL (continued)
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Receivables - reduce by credit control, expediting
payment, cash discounts, change of customers,deposits,
factoring, etc.
Identify the long paying receivables. Research the reasons
why ... Invoice errors? Credit note delays? Documents ?
Forex? Special needs? ...
Get all the managers (marketing, production, finance etc.)
to “own” the WC problem ....
S31 4.8 MANAGEMENT OF
WORKING CAPITAL (continued)
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(c) Liabilities:
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Suppliers - "stretch" but don't miss discounts; get longer credit;
seek alterative suppliers?
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Banks - borrow more from the same or several banks?
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Leasing - lease rather than buy fixed assets, to release cash
for working capital.
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S32 4.8 MANAGEMENT OF
WORKING CAPITAL (continued)
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Management of short term working capital is the
management of CASH FLOW.
Watch out for contingent liabilities for: FOREX, legal and
environmental claims, lease payments etc.
S33 4.8 MANAGEMENT OF
WORKING CAPITAL (continued)
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(d) Cash is vital - so many businesses that go bankrupt
are making a profit - they just run short of cash. Cash
needs vary at different times both within the month
and the season.
(e) Plan for sustainable positive OCF (Operational Cash Flow)
which provides for : increase in working capital needs
and “normal” new capital expenditure, A positive OCF
makes cash available for new profitable investments
that give EVA.
S34 4.8 MANAGEMENT OF
WORKING CAPITAL (continued)
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(f)
"Benchmark" with other companies to set new WC
performance standards,
Get ALL managers (production, marketing and finance)
to "own" the working capital problem!
S35 4.9 CHECK LIST ON
ANNUAL REPORTS
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Be careful with company's annual reports; evaluate
reports using a check list:
(a)
(b)
(c)
(d)
(e)
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(g)
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(h)
Cash, orders and activity
Profitability, prospects and resources
Long term finance
Shareholders and management
Exceptional transactions and notes to the
financial statements
Secret reserves and contingent liabilities for :
leasing, legal, environment, FOREX and INTEREST
DERIVATIVES etc.
Check for reconciliation of net profit with IAS.
S36 4.10 SIMPLIFIED COST OF CAPITAL,
EVA AND SVA
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(a)
In very simple terms, the Cost of Capital is the average
after-tax cost of raising long term funds for the business.
(b) Such funds can come either from long term debt
(liabilties) or equity. Normally debt (say 8%) costs less
than equity (say 16%).
(c) Hence the E:D ratio set by Management (2:1 or 1:1 or
1:2) can affect the average Cost of Captial (say 13.3%
or 12% or 9.3%).
S37
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(d)
4.10 SIMPLIFIED COST OF CAPITAL,
EVA AND SVA (continued)
EVA (Economic Value Added) is produced when the
net assets employed (A-CL) produce an OCF after
tax (say 12%) which is greater than the Cost of
Capital (say 9.3%).
S38
4.10 SIMPLIFIED COST OF CAPITAL,
EVA AND SVA (continued)
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EVA (Economic Value Added) is produced when the net
assets employed (A-CL) produce an OCF after tax (say 11%)
which is greater than the CoC (SAY 9.3%).
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EVA may be simply computed as V = OCF/(r-g), where:
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OCF
r
g
V
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= Operating Cash Flow (say 100)
= Cost of Captal (say 9.3%)
= Growth Rate (say 5.3%)
= 100/(0.93-0.53) = 250
S39 4..10 SIMPLIFIED COST OF CAPITAL,
EVA AND SVA (continued)
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(e)
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(f)
SVA (Share Value Added) is produced when the
sustainable cash flows and dividends lead to
increased short term and long term share value.
Most companies control capital expenditure well
but fail to control investment in WC which is cr is
critical to achieving EVA and SVA.
S40 4.11 OVERALL (continued)
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Plan short term cash and long term needs.
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Set financial management objectives.
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Manage the WC or it will manage itself - very badly!!
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Seek SEVEN alternatives before setting financial policies.
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Ensure that short term plans have good long term effects.
S41 4.11 OVERALL (continued)
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Watch for daily, weekly, monthly and seasonal fluctuations in
cash needs!
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Seek creative not merely routine financial management.
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Always use good financial forecasts 1-3 years ahead ... with
the key underlying assumptions clearly outlined.
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S42
4.11 OVERALL (continued)
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There are always SEVEN alternatives ...
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for every financial problem ...
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so, seek them out ... before ...
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you make that final decision ...
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and ... do a PFD ... before you make the commitment ...
S43 4.12 LEARNING PATTERNS - REVIEW
1. FINANCIAL MANAGEMENT
• SIZE
• GROWTH
• FINANCING
• INVESTMENT ......................... FOR EVA/SVA
S44 4.12 LEARNING PATTERNS - REVIEW
2. W C MANAGEMENT
• SOURCES - P and I
• USES
- C, R and I
S45 4.12 LEARNING PATTERNS - REVIEW
3. FINANCIAL ANALYSIS
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L&G
A
P
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S46 4.13 INSTRUCTIONS (10 MINUTES)
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(a) Reassemble in SG.
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(b) Study the lecture very carefully and record key
points in your notebook.
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(c) Discuss any outstanding questions in SG.
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(d) When the bell rings carry on with the case study
which follows.
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S47 ASSIGNMENT 6.0 LECTURE
PENELOPE TIMBER CO. (PTC)
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6.1 STORY OF THE CASE
PTC an owner operated wholesale timber merchant of good
reputation with two buildings, 20 employees, no sales
representatives and annual staff bonuses of 40% of salaries.
Increased sales lead to increased receivables and inventory
financed by a bank loan and stretching of payables; sales
discounts increase but shortage of cash prevents taking
purchase discounts.
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Should further planned expansion be financed by bank loans
S48 6.2 FINANCIAL HEALTH
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a. Liquidity & Gearing :
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Quick ratio and current ratios below industry average.
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Equity: debt only .5:1 (industry 1:1)
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Bank loan 48,000 insufficient to allow taking purchase
discounts; payables stretched; cash extremely short.
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S49 6.2 FINANCIAL HEALTH
(continued)
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b. Activity:
Sales/assets ratio above average but inventory turnover
weaker;
Receivables 38 days (industry 30 days) and payables 85
days (industry 20 days).
Very active company possibly over trading for its low equity
base.
S50 6.2 FINANCIAL HEALTH
(continued)
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c. Profitability:
Gross profit percentage to sales falling (12.2%) but up to
industry average (12%).
Net profit to owners equity good; very profitable company
even after charging very high staff bonuses!
S51 6.2 FINANCIAL HEALTH
(continued)
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d. Potential:
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Sales potential good, facilities and staff adequate,.
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Management good.
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But finance probably inadequate for the planned
expansion.
S52 6.3 FUNDS FLOW & OCF
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Funds flow indicates key management decisions on sources
and uses of funds; no additional capital.
Very little expended on fixed assets and nothing on
dividends.
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Funds flow confirms the need for further funds to finance a
higher level of activity. Will substantial new fixed assets also
be necessary soon?
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OCF confirms poor EVA focus.
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S53 6.4 EFFECT OF SALES EXPANSION
ON FINANCIAL HEALTH
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Sales increase naturally lead to increase in receivables
and inventory; high sales cash discounts allowed to
get cash quickly.
Increased profits substantially distributed to employees
as bonus leaving relatively little in the business to
finance expansion.
In the past assets were financed equally by equity
and debt (1:1) but in the last year financed mainly by
liabilities (.5:1).
S54 6.4 EFFECT OF SALES EXPANSION
ON FINANCIAL HEALTH (continued)
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Higher leverage and risk of failure!
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Sales and profit expansion has led to high profitability,
high risk and relatively poor financial health.
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Cost of losing purchase discounts of 2% 10 days net
30 days is 2%, for the additional 20 days of credit
i. e. 36% per annum (365/20 x 2%) ...
... but only 4% if the 30 days become 182 days
... 365/182 x 2% = 4% ...
S55 6.5 NEW FORECASTS AND CASH
REQUIREMENTS
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Underlying assumptions may prove to be not valid:
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(a) Gross profit optimistic 14% (last year 12.2%,
industry 12%).
{b) Receivables 30 days (last year 30 days).
(c) Inventory turnover 5 times (last year 4 times).
(d) Bank loan for 48, 000 may not continue.
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NOTE: Forecast shows need of 64,000 but the existing bank
may withdraw, thus creating a need for more than 112, 000.
Can the company afford to give away so much in sales cash
discounts?
S56 6.6 PROVIDING NECESSARY CASH
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(a) Asset Management
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Cash - reduce the minimum cash balance?
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Receivables - reduce by: selecting better paying customers,
expediting more efficiently, billing on time, changing the
cash discount policy, site research visits, error free invoicing,
rapid credit note processing, benchmarking, and getting all
managers to "own" the problem.
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S57 6.6 PROVIDING NECESSARY CASH
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(a) Asset Management (continued}
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Inventory - reduce by: getting suppliers to hold inventory,
cutting back on requirements, standardisation, JIT, site
research visits, benchmarking, and getting all managers
to "own" the problem.
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S58 6.6 PROVIDING NECESSARY CASH
(continued)
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(b) New Sources
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Payables well "stretched' but the discounts lost have cost
about 36% p.a. cheaper to borrow from the bank even at
10%!
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Possible factoring of debtors to get immediate payment for
mounts outstanding!
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Possible bank loan?
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NOTE: Overall, to what extent can planned expansion be
cut back to reduce need for funds?
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S59 6.7 FINANCIAL PROBLEMS AND
ALTERNATIVES
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Difficult to determine whether the problem is short
term or long term without a five year financial forecasts.
Initial forecast shows need for at least 64,000 of
additional funds.
S60 6.7 FINANCIAL PROBLEMS AND
ALTERNATIVES (continued)
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Profits must be retained in the business to reduce reliance on
suppliers (to avoid stretching payables excessively and to
take purchase cash discounts).
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Equity: debt relationship of .5:1 is below industry average and
therefore not healthy.
Could be accepted as a "bridging situation" depending long
term finance from profits or new equity; will further fixed
assets be necessary with the increasing turnover?
S61 6.7 FINANCIAL PROBLEMS AND ALTERNATIVES
(continued)
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Alternatives available: bank, suppliers, factoring, mortgage,
long term loans, new equity, or reduction of assets?
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NOTE: Stretching payables is only cheap after cash discounts
already lost, but rather risky; when equity: debt becomes
very weak.
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Survival may depend more on suppliers than management!
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S62 6.8
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DECISION AND JUSTIFICATION
(a) Decision - depends upon the risk level which Penelope
will accept, his personal objectives for expansion and
the possible need to expand merely to survive.
If sales can be kept to 1,200,000 (not 1,600,000) then
receivables and inventory could be cut back
substantially and very little additional finance needed
either from banks or equity.
S63 6.8 DECISION AND JUSTIFICATION
(continued )
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If, however, business expansion is vital for survival t hen
new funds must finance the increased receivables and
inventory.
Funds from banks or stretching payables is high risk
approach. A lower risk approach to expansion would be to
provide new equity funds thus increasing the equity base
and improving the general financial health.
Bank may refuse new loan and (try to) withdraw existing loan
if PTC goes to another bank.
S64 6.8 DECISION AND JUSTIFICATION
(continued)
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(b) Recommendation : increase the equity base now while
the business is very profitable; alternatively get a
temporary bank loan as "bridging" finance whilst
seeking new equity.
(c) Justification there is no point in taking excessive risks
with a successful business; don't push bank too hard
too soon!
S65 6.8 DECISION AND JUSTIFICATION (continued





Don't pursue sales regardless of financial risk and
requirements.
NOTE: There are several acceptable alternative
solutions; evaluate them in terms of the level of
risk PTC should accept!
S66 6.9 LEARNING POINTS







(a) Health of the business may be determined ln
terms of liquidity (and gearing), activity, profitability
and potential.
(b) Ratios must be compared with industry averages to
determine their significance.
(c) Increased sales lead to increased working capital in
receivables and inventory.
S67 6.9 LEARNING POINTS (continued)



(d) Profits produce funds for financing increased
working capital provided they are not distributed
as dividends.

(e) Working capital may be managed either by
reducing the uses, or increasing the sources,
of funds.

(f)



Must determine whether the financial need is
short term or long term, since the solutions will differ.
S68 6.9 LEARNING POINTS (continued)

(g) Creative financing considers all alternatives before
making a decision.

h)
Cash flow, funds flow and forecasted income
statements and balance sheets help to clarify
financial needs.
(i)
Funds flow reveals key management decisions.




S69 6.9 LEARNING POINTS (continued)


(j) "Bridging" finance is short term money pending
raising of long term funds.

(k) Management must decide the level of risk that
it will accept before deciding upon the expansion
and planning the financing.

(l)



Financing of working capital easier if company
has facilities from more than one bank.
S70 6.9 LEARNING POINTS (continued).

(m) Always seven alternatives ro every finnncial problem.

(n) Cut receivables and inventories in ten ways plus
benchmarking and getting all managers to "own" the
problem.




(o) Research inventory values, turnover, standardisation,
supplier cooperation opportunities.
S71 6.10 LEARNING PATTERNS
1. SALES EXPANSION
– RECEIVABLES +
• INVENTORIES +
• CASH
-
S72 6.10 LEARNING PATTERNS
(continued)
2. SHORT-TERM TO LONG-TERM
PROFIT NOW ..... DISASTER LATER?
S73 6.10 LEARNING PATTERNS
(continued)
3. WORKING CAPITAL
MANAGEMENT
PROBLEM "OWNED" BY ALL
MANAGERS ...
S74 6.11 INSTRUCTIONS

(a) Re-assemble in CSG

(b) Study the lecture and discuss in CSG.


(c) Record significant points in your notebook

(d) Reassemble in MG when the bell rings
S75 ASSIGNMENT 7.0 - STUDY - FINANCING
EXPANSION (75 MINUTES)

7.1 INSTRUCTIONS

(a) Re-assemble in new SG, and study the lecture and
discuss in SG.

(b) Record significant points on the flip chart.

(c) Review the glossary for any difficulties with new words

(d) Record significant points in your notebook and
re-assemble in MG when the bell rings an


S76 ASSIGNMENT 8.0 - LECTURE ON
FINANCING EXPANSION

8.1 METHOD

Read aloud, listen ,,,

and respond verbally ... to any questions.
S77 8.2 PLANNING FOR THE FUTURE

Need to plan the size, growth and profit stability of the
company.

Funds flow is the key to long term financing.

Cash flow is the key to short term financing.

Forecast forward both cash and funds to determine
whether financial needs are short term or long term.

S78 8.3 RISK AND THE CRITICAL FEW

Decide upon "critical few" factors which really make
for profit in the particular business. Analyze the industry,
economy, size of the business and finally the personal
values of the chief executive.

Determine the risk level the company will accept.

Evaluate the risk of various possible disasters.

Set financial policies to deal with the "critical few"
profit-making features at the appropriate risk level.




S79 8.4 EFFECT OF EXPANSION






Expansion of sales leads naturally to expansion
of current assets (receivables, inventory and the
minimum cash balance).
Management of receivables and inventory is the
cheapest "source" of finance, i.e. reduce the
investment.
S80 8.4 EFFECT OF EXPANSION (continued)


Suppliers may provide “cheap finance” with or without
cash discounts.

Loss of cash discounts is costly - i.e. 2% 10 days net 30 days, is
2% for the extra 20 days of credit or 36% per annum!!

Alternative sources of short term finance include: other
suppliers, factoring, loans. customer deposits,banks, etc.



Get suppliers to give 2% 30 days or take 9 months to pay or
change suppliers?
S81 8.5 BANK RELATIONSHIPS








Commercial banks serve customers by financing current
business (not like merchant banks which provide long term
capital)
Key to bank financing is the mutual confidence between
banker and customer.
Bankers like: short term financing which turns over regularly;
they like "accounts" that are actively going from red to
black to red, etc.
S82 8.5 BANK RELATIONSHIPS (continued)

Banks provide a widening range of services today.

Banks believe that "the customer does not have to tell
us all the truth but he must never deliberately lie or be
irresponsible".



Commercial banks have associates that do merchant
banking.
S83 8.6 CRITERIA FOR BANK FINANCE











Commercial banks lend not just against physical security
but on the following criteria:
(a) Personal relationship with banker
(b) purpose
(c) profitability
(d) payback (is it possible?)
(e) security.
Bankers may say "all loans are repayable on demand
if the rules are broken”, but in reality they never demand it ,
unless in danger. Banks hold security in the hope of NEVER
having to use it.
S84 8.6 CRITERIA FOR BANK FINANCE (continued)

Banks give information to each other in a special code which
is discreet and confidential.

Relationship with the bank manager is the key!


Banks sometimes insist that "equity base" be increased as a
condition for further loans.

Banks are normally conservative and tough!

S85 8.7 CONTROL OF WORKING CAPITAL



Frequent (monthly) reporting with reliable financial
statements to all managers (production, marketing,
finance etc,) to get them to “own” the WC problem..

Regular and effective forecasting of peak and duration of
cash needs.

Timely financial data.

Forecast forward the income statements, balance sheets,
cash and funds flow, and then evaluate risk.


S86 8.7 CONTROL OF WORKING CAPITAL
(continued)



Never go to the banker when you need money; go
when you don't need money and arrange to have it
available when you want it.



“I need ECU 500,000. Can you handle it or should I deal
directly with your general manager?"
S87 8.8 CONTROL OF RECEIVABLES









Make frequent aging of receivables to identify slow payers
and assess DOS (days of sales) performance.
For external causes: visit selected customers to identify
the reasons for delay which may include: invoice errors,
order errors, credit claim delays, non-delivery, quality
issues, INCORRECT DOCUMENTATION etc.
For internal causes: investigate, slow invoicing, pricing
complexities, credit note delays, shipment errors, poor
expediting, discount errors, failure to drop poor accounts etc.
S88 8.8 CONTROL OF RECEIVABLES




Benchmark with other companies in collaboration with
marketing, production, quality, finance managers to
jointly: “own” the problem, set targets and monitor
progress.
S89 8.9 CONTROL OF INVENTORY







Make frequent aging of inventories to identify slow moving
high value items and to assess DOP (days of purchases)
and DOS (days of sales) performance.
For external causes: visit selected suppliers to identify
the reasons for high inventory which may include: excess
order quantities, long delivery lead times, poor
standardization, lack of JIT systems etc.
S90 8.9 CONTROL OF INVENTORY
(continued)








For internal causes: investigate delayed usage, excess
storage, lack of standardization, poor design specification,
failure to control high value items daily, excess storage
space/costs, poor standardisation, lack of JIT systems, poor
supplier selection etc.
Benchmark with other companies in collaboration with
marketing, production, quality, finance managers to
jointly: “own” the problem, set targets and monitor progress.
S91 8.10 INFLUENCE OF THE
CHIEF EXECUTIVE








Age. experience, reputation, skills, attitudes and knowledge
of the chief executive are key factors in the decision to
finance expansion by banks. suppliers or merely reduce
the working capital investment.
Overall expansion of sales involves increase in assets
employed in the business; financing of those assets is a
management decision; but there are always many
alternatives.
S92 8.10 INFLUENCE OF THE
CHIEF EXECUTIVE (continued)




"Bridging" of long term needs by short term finance
is cceptable provided the risk is clearly recognized
and there is an achievable long term plan to recover
financial health.
S93 8.10 INFLUENCE OF THE
CHIEF EXECUTIVE (continued)








May accept temporary high risk, and unhealthy financial
position provided: high profits, planned recovery of health
planned reduction of risk to "normal" level.
Note: Before every financial negotiation, always make other
contacts to work out what you could do WITHOUT the other
party ... then negotiate (gently) from strength ... not
weakness ... because you have good alternatives ...
without him/her ...
S94 8.10 INFLUENCE OF THE
CHIEF EXECUTIVE (continued)








Management have a high “ego” priority to use “excess cash”
for expansion and diversfication projects.
By contrast shareholders may have priority for EVA targets
in terms of dividends and SVA.
Thus the sharehiolders may insist that unless new acquisitions
or mergers can achieve EVA then the excess cash is bette
returned to shareholders as dividends or share buy-back
(equity reduction).
S95 8.11 LEARNING PATTERNS - REVIEW
1. BANK FINANCING
PPPP&S
S87 8.11 LEARNING PATTERNS - REVIEW
(continued)
2. CONTROL OF R & I
INTERNAL
EXTERNAL
S88 8.11 LEARNING PATTERNS - REVIEW
(continued)
3. CEO
CHIEF
CUSTOMERS
EXECUTIVE
EMPLOYEES
OFFICER
OWNERS
S89 8.12 INSTRUCTIONS (10 MINUTES)

(a) Reassemble in SG

(b) Study the lecture carefully

(c) Record key points in your notebook

(d) Discuss outstanding questions

(e) When the bell rings, carry on with the case study which
follows

S90 ASSIGNMENT 10.0 LECTURE ON LUMSDEN (A)

10.1 STORY OF THE CASE

Expansion financed by long term bank loan 140,000 capital
expenditure and 160,000 for working capital.




Lumsden commits for increased capital expenditure of about
400, 000 before consulting the bank and thus breaks the
agreement.
S91 10.2 HEALTH OF THE COMPANY

(a) Liquidity & Gearing

Quick ratio is a little weak, although stronger than previous
years; current ratio is strong.




Equity:debt ratio of 2.4: 1 is very strong indeed, both
compared with previous years and the industry.



Overall, fairly liquid and well able to meet its commitments
at the present level of operations.
S92 10.2 HEALTH OF THE COMPANY (continued)

(b) Activity

Turnover of assets and inventories fair.

Receivables better than industry average.

Payables settled with cash discounts; overall, a fairly active
company.

S93 10.2 HEALTH OF THE COMPANY (continued)

(c) Profitability

Gross profit percentage very high in the first seven months
(un-audited!).


Similarly net profit to sales higher than the industry (why?
manipulated?).

Overall return on equity is very good.

Subject to possible manipulation of inventory value (need an
audit), profitability seems very good indeed.


S94 10.2 HEALTH OF THE COMPANY (continued)






(d) Potential
Market potential good; management effective
but a little old and unreliable; production
expanding.
NOTE: Overall a healthy company, with cash and funds flow
adequate to finance current operations.
S95 10.3 FUNDS FLOW & OCF

Funds flow indicates major management decisions regarding
source and use of funds.

Only a small past increase working capital, since profits
mainly used for fixed assets and mortgage repayments.






Funds raised from the bank to finance fixed assets and
working capital expansion. Is this wise?
Substantial increase in assets financed largely by accruals
for taxes; no draining off of profits into dividends. Confirmed
by OCF.
S96 10.4 ORIGINAL BANK LOAN






Criteria for bank finance:
(a) Personal relationship with the bank Lumsden well known
to the bank for some years but a little old (health risk?).
(b) Purpose : expansion to meet outstanding orders;
market seems to warrant such expansion.
(c) Profitability : company very profitable and healthy.
S97 10.4 ORIGINAL BANK LOAN (continued)







(d) Payback no drain.off of profits into dividends;
profitability should enable payback in the time allowed.
(e) Security general security of the business including
property, inventory, etc. seems adequate for the loan.
NOTE: Lumsden well qualified for the original loan of 140, 000
for capital expenditure and 160, 000 for working capital; bank
acted wisely in making loan because it met the criteria.
S98 10.5 BANK AGREEMENT








Lumsden has broken the bank agreement because he has
committed for more than 140, 000 of new capital expenditure;
bank could call in loan immediately.
Bank only committed in Sept last year to 80, 000 outstanding;
could be repaid with no loss to the bank.
The substantial cash balance could be immediately offset
against the loan and Lumsden could get finance from
another bank or financial source.
S99 10.5 BANK AGREEMENT(continued)



New cash needed for fixed assets is 400, 000 and working
capital 160, 000, but no forecasts available for five years to
ensure these amounts will be adequate.

Is the estimate of 400, 000 reliable for a new plant? Will
160, 000 be adequate for working capital if sales increase
from 1 to 3 million?

Probably more money needed.


S100 10.6 FURTHER BANK FINANCE

(a) Criteria for a new loan:

Personal relationship with the bank :

Lumsden broke his agreement once and therefore can he
be relied upon in the future? Is the breach a serious one?
Probably not since only 80, 000 is outstanding at the moment.





Can Lumsden manage bigger plant? Labor problems? Can
he adapt to new scale of operations which is three times
what he is used to? He is quite old and may find it difficult.
S101 10.6 FURTHER BANK FINANCE (continued)




Purpose: additional plant to meet market need; Lumsden
only a "marginal supplier" and the economy might turn down.
Profitability: Lumsden still profitable but no audited
accounts available for last year.
S102 10.6 FURTHER BANK FINANCE (continued)





Payback: larger amount harder to pay back out of profits;
depends upon the general success of Lumsden and good
cash flow from profits.
Security: still fairly strong since the plant could be sold if
necessary; less security for a larger loan than a smaller one.
S103 10.6 FURTHER BANK FINANCE (continued)









NOTE: Overall, Lumsden still a good financial risk, subject to
his ability to work well with the bank and to restrain himself
from excessive expansion and meet new business
management problems!
Total money requirement probably higher because of the
uncertainty; loan terms should tryn to restrict Lumsden's
activities and require very close reporting and control.
Bank policy is to be aggressive in seeking and keeping
clients.
S104 10.6 FURTHER BANK FINANCE (continued)










(b) Alternatives open to Lumsden:
Get the money from another bank
Get loans from suppliers of equipment
Factor receivables
Lease rather than buy the plant
Raise new equity but keep control of the company
Don't expand
Sell out
NOTE: Many opportunities open to Lumsden if the bank
refuses.
S105 10.7 FINANCIAL POLICIES

(a) Lumsden

Recognize the risks involved in such extensive expansion;
play safe by increasing equity base now but keep control of
the company.






Set up alternative financial sources to avoid reliance on
one lender. Consider leasing the plant rather than buying it.
Achieve better relationship with the bank or with several
banks to provide flexibility (and strength!)
S106 10.7 FINANCIAL POLICIES (continued)






Overall accept the loan if offered, but keep to the terms
and seek equity soon while the company is still healthy
and profitable.
NOTE: ALWAYS SET UP ALTERNATIVE FINANCING ... BEFORE ...
NEGOTIATING WITH A BANK ... NEGOTIATE FROM STRENGTH ...
NOT WEAKNESS ...!!!
S107 10.7 FINANCIAL POLICIES (continued)

(b) Bank

Decide if Lumsden can be relied upon to remain a good
client; if not, reclaim the money immediately and seek
business elsewhere.








If Lumsden remains a client, give the loan provided he
also increases the equity base!
Set controls upon him in terms of monthly audited reporting
and inspection of the plant, to ensure that the bank is well
informed of developments in time.
S108 10.7 FINANCIAL POLICIES (continued)





(c) Justification
Expansion by bank finance is "bridging" until more
equity financing can be found.
In the future avoid commitment before providing
financial resources.
S109 10.7 FINANCIAL POLICIES (continued)




NOTE: Always do a PFD before activity major financial
decisions, to check again the underlying assumptions:
economic, marketing, technical, financial, management
etc. and the possible EI ...
S110 10.8


LEARNING POINTS
(a) Criteria for bank lending includes: personal relationship,
purpose, profitability, payback and security.

(b) Breach of a bank loan agreement, gives the bank the
right to reclaim money immediately and to offset all
balances.

(c) Bank confidence in the client is key to bank financing.


S111 10.8 LEARNING POINTS (continued)



(d) Many alternatives for financing of working capital
including reduction of activity, factoring, financing by
supp liers, leasing, etc.

(e) Set up alternative financial plans before negotiating a
final deal, so as to be flexible to negotiate from strength.

(f)



No need to own the whole business and keep all the
profits. Increasing the equity base of the business means
sharing: profits, risks and losses.
S112 10.8 LEARNING POINTS (continued)


(g) Financial control involves regular, reliable and timely
monthly or weekly data, audited when necessary.

(h) "Bridging" finance provides short term resources pending
long term financing arrangements.

(i)


Need financial forecasts for five years ahead to
determine whether problems are short term or long term.
S113 10.8 LEARNING POINTS (continued)





(j)
Unaudited financial statements are not reliable;
they may have been manipulated.
(k) Think creatively about financing problems and
seek out all (SEVEN) alternatives before
making a critical fianancial decision.
S114 10.8 LEARNING POINTS (continued)


(l)
Decide very carefully about the extent and
duration of the risk level to be accepted.

(m) Keep options and relationships open.

(n) Benchmark to help to set better standards for
working capital management.

S115 10.9 LEARNING PATTERNS
1. MAXIMISING GOALS
SALES
PROFITS
CASH FLOW
SVA ...
S116 10.9 LEARNING PATTERNS (continued)
2. INVESTMENT
MUST RETURN ABOVE C. OF C.
FIXED INVESTMENT - WELL CONTROLLED
WC INVESTMENT NOT CONTROLLED ...
S117 10.9 LEARNING PATTERNS (continued)
3. FINANCIAL MANAGEMENT SKILLS
TIMING ...
S118 10.10 INSTRUCTIONS

(a) Re-assemble in CSG

(b) Study the lecture and discuss in CSG.

(c) Record significant points in your notebook

(d) Reassemble in MG when the bell rings.
S119 ASSIGNMENT 11.0 - SUMMARY
LECTURE FOR PART I

11.1 FINANCIAL MANAGEMENT

(a) Deals with four major problems:




1.
2.
3.



4.
Size - what size should the firm be?
Growth - what rate of growth of sales, assets, profits. etc.?
Financing - how should the firm be financed, and at
what risk?
Investment - what kind of assets should be acquired,
and at what rate?
S120 11.1 FINANCIAL MANAGEMENT





(b) Financial health of the business depends upon
both its resources, the environment in which it operates
and its financial policies.
Financial management is dynamic and depends upon
flows or cash and funds not a static situation.
S121 11.1 FINANCIAL MANAGEMENT (continued)





(c) Most important is ... CASH FLOW and SURVIVAL ...
to increase the long term VALUE of the business for ALL
of the "stakeholders": customers, shareholders,
management, workers, suppliers, banks, communities,
government, trade unions, environmental groups etc.
S122 11.1 FINANCIAL MANAGEMENT (continued)







(d) To achieve EVA in a company, the manager of each
division must produce:
OP/NAE X 100% = above CoC
where:
OP = Operating Profit after tax
NAE = Net Assets Employed (FA & CA & OA less CL)
CoC = Cost of Capital
S122A 4.2
FINANCIAL MANAGEMENT
(continued)

(e) The value of a business or a share may be simply
computed as: OCF/(r-g) ,

(f






In quoted companies, shareholders may be powerful
pension funds, insurance companies and mutual
funds, who are highly skilled in finance ; they may
require management to provide both dividends
and increased share value ... or move over ... thus in
1995, SVA is becoming a key financial objective!
S123 11.2 OBJECTIVE, METHOD AND SKILLS

a.
Objective - increase the long term value of the
business with EVA (Economic Value Added) and SVA
(Share Value Added).
b.
Method - raise money and use it effectively to achieve
standards of financial performance
c.
Skills - timing to balance risk and reward





S124 11.3 SHORT TERM/LONG TERM FINANCING









(a) Short term finance used for: cash, receivables,
inventory. prepayments, etc.
(b) Sources of short term finance: suppliers, banks,
factoring, leasing, or reduction of the need for cash,
receivables and inventory.
(c) Long term financing deals with long term assets
and the financing of those assets by proportions
of equity and debt.
S125 11.4 FORECASTING




(a) Cash forecasting used to provide cash resources up
to one year ahead.
Concentrate on the duration and peak need within:
weekly, monthly, yearly, seasonal, etc. periods
S126 11.4 FORECASTING (continued)

Distinguish:

CF

EBIT - earnings before interest and taxes

OCF - operating cash flow - cash flow plus interest, less
working capital changes, less “normal” capital
expenditure. Often called “Free Cash Flow”
because it is cash availble for new profitable
investment opportunities.




- cash flow - net profit plus depreciation
S127 11.4 FORECASTING








(b) Funds flow reveals the key financial decisions of past
and future.
Sources of funds: profit. depreciation. new equity and
long term loans.
Uses of funds: fixed assets, dividends, repaymen
of long term loans and working capital.
Net working capital is:
current assets less current Liabilities.
S128 11.4 FORECASTING (continued)





(c) Forecasted income statements and balance sheets
reveal future financial health.
(d) Materiality is the key - concentrate on large amounts
and long time periods. Don't get involved with the
peanuts ...! Small errors don't matter at all ...!
S129 11.5 BANK RELATIONSHIPS










(a) Relationship with the banker is key to the management
of working capital.
(b) Criteria for bank loans: person, purpose, profitability,
payback, and then security.
(c) Many alternatives available to bank finance (they
may cost more): factoring, deposits. loans, leasing.
stretching creditors, other banks, etc.
(d) Old bank customers normally get better treatment
than new ones. Cultivate a relationship with your
bank manager.
S130 11.6 FINANCIAL ANALYSIS


(a) LAPP system of financial analysis: liquidity (and gearing),
activity, profitability, potential.

(b) Need to forecast cash and funds and provide
adequate flows to finance assets acquired and required.

(c) Be creative in seeking and using financial alternatives.

(d) Avoid "emotional investment"

S131 11.7 CONTROL OF WORKING CAPITAL




Frequent (monthly) reporting with reliable financial
statements to all managers (production, marketing,
finance etc.) to get them ALL to “own” the WC
problem..

Regular and effective forecasting of peak and duration of
cash needs.

Timely financial data.

Forecast forward the income statements, balance sheets,
cash and funds flow, and then evaluate risk.


S132 11.7 CONTROL OF WORKING CAPITAL
(continued)



Never go to the banker when you need money; go
when you don't need money and arrange to have it
available when you want it.



“I need ECU 500,000. Can you handle it or should I deal
directly with your general manager?"
S133 11.8 CONTROL OF RECEIVABLES






Make frequent aging of receivables to identify slow payers
and assess DOS (days of sales) performance.
For external causes: visit selected customers to identify
the reasons for delay which may include: invoice errors,
order errors, credit note claims, non-delivery, quality
issues, incorrect documentation etc.
S134 11.8 CONTROL OF RECEIVABLES (continued)










For internal causes: investigate, slow invoicing, pricing
complexities and errors, credit note delays, shipment errors,
poor expediting, discount errors, failure to drop poor
accounts etc.
Benchmark with other companies in collaboration with
marketing, production, quality, finance managers to
jointly:
1.
2.
3.
“Own” the WC problem
Set targets, and
Monitor progress.
S135 11.9 CONTROL OF INVENTORY







Make frequent aging of inventories to identify slow moving
high value items and to assess DOP (days of purchases)
and DOS (days of sales) performance.
For external causes: visit selected suppliers to identify
the reasons for high inventory which may include: excess
order quantities, long delivery lead times, poor
standardization, lack of JIT systems etc.
S136 11.9 CONTROL OF INVENTORY
(continued)

For internal causes:

Investigate delayed usage, excess storage, poor
standardization, poor design specification, failure to control
high value items daily, excess storage space/costs, lack of
JIT systems, poor supplier selection etc.






Benchmark with other companies in collaboration with
marketing, production, quality, finance managers to
jointly: “own” the problem, set targets and monitor progress.
S137 11.10 SIMPLIFIED COST OF CAPITAL, EVA AND
SVA








(a)
In very simple terms, the Cost of Capital is the average
after-tax cost of raising long term funds for the business.
(b) Such funds can be either from long term debt (liabilties)
or equity. Normally debt (say 8%) costs less than equity
(say 16%).
(c) Hence the E:D ratio set by Management (2:1 or 1:1 or
1:2) can affect the average Cost of Captial (say 13.3%
or 12% or 9.3%).
S138 11.10 SIMPLIFIED COST OF CAPITAL, EVA
AND SVA (continued)

EVA (Economic Value Added) is produced when the net
assets employed (A-CL) produce an OCF (Operating Cash
Flow) (say 11%) which is greater than the CoC (Cost of
Capital) (Say 9.3%).

EVA may be simply computed as V = OCF/(r-g), where:







OCF
r
g
V
=
=
=
=
Operating Cash Flow (say 100)
Cost of Captal (say 9.3%)
Growth Rate (say 5.3%)
100/(0.93-0.53) = 250
S139 11.10 SIMPLIFIED COST OF CAPITAL, EVA
AND SVA (continued)

(e)
SVA (Share Value Added) is produced when the
sustainable cash flows and dividends lead to
increased short term and long term share value.)
(f)
Working capital management is critical to achieving
EVA and SVA.








(g) And thus any INCREASE in working capital is an
INVESTMENT that must be justified, like any other capital
investment or acquisition, by a return, that exceeds the
Cost of Capital.
S140 11.11 DIAGNOSIS AND DECISION





(a) Recognize that every industry and trade and country
has a special tractional environment and standards of
financial management.
(b) Knowledge, attitudes, and skills, force the financial
manager to be creative.
S141 11.11 DIAGNOSIS AND DECISION
(continued)






(c) Diagnosis helps the financial manager to distinguish
short term from long term problems.
(d) Ensure that short term financial policies arc
consistent with long term goals.
(e) Provide for both short term and long term financial
health at appropriate risk levels.
S142 11.11 DIAGNOSIS AND DECISION
(continued)




(f)
Manage the working capital ............ or it will manage
itself - very badly!
(g) Seek all (seven) alternatives before setting financial
policies.
S143 11.11 DIAGNOSIS AND DECISION (continued)

NOTE:

Past attitudes may deter new financial policies for reducing
assets or using increasing NEW sources of finance.

S144 11.12 LEARNING PATTERNS - REVIEW
1. FINANCIAL MANAGEMENT
S, G, F & I ........... CASH FLOW .......... EVA/SVA
S145 11.12 LEARNING PATTERNS - REVIEW
(continued)
2. COST OF CAPITAL
AVERAGE COST OF EQUITY AND DEBT
(LIABILITIES)
HURDLE RATE FOR EVA
S146 11.12 LEARNING PATTERNS - REVIEW
(continued)
3. OPERATING CASH FLOW
PROVIDES CASH FOR:
WC & “NORMAL” CAPITAL INVESTMENT
AND NEW PROFITABLE INVESTMENT
OPPORTUNITIES FOR EVA
INCREASED WC IS AN INVESTMENT!
S147 11.13 INSTRUCTIONS (20 minutes)

Reassemble in SG
Review the Summary Lecture for Part I in the course
 diary and discuss questions arising

To get the best out of Part II of the program, try to
 complete ALL of the following ... homework tonight ...

S148 11.13 INSTRUCTIONS (continued) ...
homework tonight ...

Read the articles on finance

In the ASS text, review the chapter summaries and the
glossary


Do the optional exercises in the course diary and check the
answers

Review the summary lecture for Part I in the course diary

Review your notes for Part I of the course and list outstanding
questions to be resolved in Part II


S149
S20111.13
AUTOMATED
INSTRUCTIONS
GROUP(continued)
LEARNING
Final Note
(AGL)
for Part I ...
AGL NO.
Thank
you 10
for- working so hard
today
....
FINANCIAL MANAGEMENT
Tomorrow .... it’s downhill all the
OF
WORKING
CAPITAL
way ....
DAILY WORK PACK - PART 2
Copyright: RGAB/PW 2005/3
AGL