CHAPTER 13
FINANCING CHANGES IN SHORTTERM ASSET INVESTMENTS
ACCOUNTING AND FINANCE
FOR
ENTREPRENEURS
EBD-301
Dr. David P. Echevarria
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1
WHY DO BUSINESSES BORROW MONEY?
• Most frequent reason why businesses borrow is to finance growth
• Finance additional working capital
• Cash
• Increase Receivables
• Acquire more inventory
• Finance additional fixed assets
• Equipment
• Real Estate: land, buildings, rolling stock
Dr. David P. Echevarria
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Slide 2
SOURCES OF SHORT-TERM FINANCING
• Spontaneous
• Trade Credit – Accounts Payable (inventory)
• Accrued Wages & Salaries Payable
• Planned
• Borrowing
• Short-term loans
• Line of credit
• Raising External Capital
• Selling equity
• Selling debt
Dr. David P. Echevarria
All Rights Reserved
Slide 3
FACTORS AFFECTING SHORT-TERM
FINANCING STRATEGY
• Current Cash Position of Business
• Desired levels of Working Capital
• Restrictive Loan covenants (existing debt)
• Economic Conditions
• Nature of Cash Inflows and Outflows
• Seasonal effects
• Efficiency of credit collection
Dr. David P. Echevarria
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Slide 4
WORKING CAPITAL MANAGEMENT
REVISITED
• Short-Term Assets
• Cash
• Accounts Receivable
• Inventory
• Prepaid Expenses
• Short-Term Liabilities
• Accounts Payable (terms for trade credit)
• Accrued Expenses (wages, taxes, etc.)
• Notes Payable (S-T bank loans)
• Efficiency of Cash Conversion Cycle
Dr. David P. Echevarria
All Rights Reserved
Slide 5
OWNER’S WORKING CAPITAL
RISK PREFERENCES
• Working Capital Management Strategy
• Aggressive
• Current and quick ratios close to 1 and < 1, respectively
• Minimal cash on hand
• Middle of the road
• Current and quick ratios close to 2.0 and 1.0, respectively
• Able to pay maturing obligations
• Conservative
• Current and quick ratios close to >>2 and >>1, respectively
• Highly liquid
Dr. David P. Echevarria
All Rights Reserved
Slide 6
SALES GROWTH AND PRODUCT
LIFE CYCLES
• Mature product cycles require resources to develop and replace
aging product lines
• Periods of rapid sales growth will require more cash to finance
receivables and invest in more inventory
• Availability of bank loans and favorable trade credit terms a must
• High percentage of net income must be reinvested in business
Dr. David P. Echevarria
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Slide 7
IMPACT OF LIQUIDITY CONSTRAINTS
• Ability to increase bank borrowing may be restricted by prior loan
covenants
• Required to maintain minimum liquidity ratios
• Need to carefully plan use of trade credit and accrued expenses
• [See Equation (11.1)] : Tying magnitude of change in inventory to
change in Trade Credit (A/P)
• Importance of sensitivity analysis (Figure 11.1)
• Importance of Cash Sales
Dr. David P. Echevarria
All Rights Reserved
Slide 8
FORMS OF COMMERCIAL TRADE CREDIT
• Open Accounts
• Vendor gives its customers the ability to order on credit so long as
the accounts are up to date
• Consignment
• Vendor retains title to the goods it “sells” to the buyer
• Floor Plan Financing
• Manufacturer finances dealer’s inventory
Dr. David P. Echevarria
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Slide 9
SHORT-TERM BANK BORROWING
• Uncollateralized Loans
• Funds lent on basis of good credit history of borrower
• Typically of short duration: less than 3 years
• Collateralized Loans
• By receivables (assignment or pledging)
• By goods (inventory)
• Other assets with a cash value (insurance policy)
• Loan Type
• Regular: principal and accrued interest due at maturity
• Installment: monthly payments of Principal & Interest
Dr. David P. Echevarria
All Rights Reserved
Slide 10
SHORT-TERM BANK BORROWING
• Cost of Add-on Interest Loan
• Rate = Interest $ / Loan Amount
• Cost of Discount Loan
• Rate = Interest $ / (Loan Amount – Interest $)
• Installment Loan: (Approx. Annual Percentage Rate)
• AAPR = (2 x n x Interest Rate) / (m + 1)
• Where: n = number of annual payments and m = total payments.
• Line of Credit: interest charges same as credit card
Dr. David P. Echevarria
All Rights Reserved
Slide 11
FINANCING INTERNATIONAL TRADE
• BANKERS’ ACCEPTANCES
• Bankers’ Acceptances represent a term loan to an importer.
• The bank may retain the loan on its books or sell the acceptance in
the secondary market
• FORFAITING
• Essentially the purchase of foreign receivables by a third party
• Non-recourse is typical
• Goods sold are not used as collateral for a loan to pay the seller
• Financing can be up to 5 years
Dr. David P. Echevarria
All Rights Reserved
Slide 12
HOMEWORK QUESTIONS
•
1. The business has three sources for financing increases in short term assets.
• What are they and how do they impact the current ratio? The quick ratio?
•
2. How does the focus of working capital management differ from the notion of net working
capital management?
•
3. If you where constructing a model of the business’s cash flows, how would you specify the
relationship between inventory and accounts payable in terms of cause and effect?
•
4. How does the description of payables and accruals as spontaneous sources differ from their
description as planned outflows?
• 5. There are three major working capital management strategies; conservative, moderate, and
aggressive. How do they differ in terms of liquidity ratios? Cash ratios? In what marketdemand environments are they most likely to be used in successfully?
Dr. David P. Echevarria
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Slide 13
HOMEWORK QUESTIONS
• 6. Why do some high-growth businesses seem to experience liquidity problems?
•
7. How might businesses anticipating high growth episodes prepare themselves
from a working capital point of view? Where in the product’s life cycle are
businesses most likely to experience high growth rates?
•
8. If you were asked to develop the organizational outline of a cash management
system with built in checks and balances, what kinds of requirements would you
specify?
•
9. What benefits can be derived from good vendor relationships?
•
10. What are the benefits of an open account? Floor plan financing?
Consignment?
Dr. David P. Echevarria
All Rights Reserved
Slide 14