CDA COLLEGE
BUS235: PRINCIPLES OF FINANCIAL
ANALYSIS
Lecture 10
Lecturer: Kleanthis Zisimos
Lecture Topic List
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What is working capital technology
Working capital investments
Financing policies
Advantages and disadvantages of short term
financing
Short term bank loans
The cash conversion cycle
What is Working capital
The purpose of this lecture is to explain the
nature of working capital and the importance of
it to the financial manager. We will also analyze
various ratios which help the financial manager
to understand how working capital is controlled.
 Working capital is the name given to net current
assets which are available for day-to-day
operating activities.
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Working capital = Current assets- current liabilities
Working capital terminology
Working Capital = Current assets.
 Net Working Capital =Current assets minus
current liabilities.
 Current ratio= current assets/ current liabilities
 Quick or acid test ratio =Measures liquidly
and is found by subtracting stock from current
assets so the formula is =(CA-stock) / CL
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Working capital terminology
Working Capital Policy = refers to the firm’s
basic policies regarding (1) targets levels for
each category of current assets and (2) how
current assets will be financed.
 Working Capital Management = involves the
administration, within policy guidelines, of
current assets and current liabilities.
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Working Capital Investment
policies
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1.
2.
3.
Investment policies answer to the question of
what is the appropriate level for currents
assets. We have three alternative policies:
Relaxed Current Asset Investment Policy = a
policy under which relatively large amounts of
cash, marketable securities, and inventories
are carried and under which sales are
stimulated by a liberal credit policy, resulting in
a high level of receivables.
Restricted Current Asset inv. policy = a policy
under which holding of cash and securities are
minimized
Moderate current asset inv policy= a policy
that is between the relaxed and restricted
policies.
Working Capital Financing policies
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1.
2.
3.
Working capital financing policy deals with the issue of
how temporary and permanent current assets are
financed. We have three approaches
Maturity matching approach. It matches current
assets and liabilities maturities .This strategy
minimizes the risk that the firm will be unable to pay
off its maturity obligations.
Aggressive Approach = it finances fixed assets with
long term capital and part of its permanent current
assets with short – term debt.
Conservative Approach = Long term capital is being
used to finance all permanent asset requirements and
also some of the temporary current assets
Advantages and disadvantages of
short term financing
Speed. A short term loan can be obtained
much faster than a long term loan
 Flexibility is increases in short term loans
 Interest rates are generally lower in short
term financing
 Short term financing is riskier than long
term
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Sources of short term financing
Short – term credit is defined as any liability
originally scheduled for payment within one
year.
 The sources of short – term funds which are:
 Accruals
 Accounts payable (trade credit)
 Bank loans
 Commercial paper.
 Factoring
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Accruals
Accruals are the expenses which are not paid on
time like wages, taxes social security
 However, a firm cannot ordinarily control its
accruals: The timing of wage payments is set by
economic forces and industry custom, while tax
payment dates are established by law.
 Thus, firms use all the accruals they can, but
they have little control over the levels of these
accounts.
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Accounts payable
Firms generally make purchases from other
firms on credit, recording the debt as an account
payable.
 Accounts payable, or trade credit, is the largest
single category of short term debt, representing
about 40 percent of the current liabilities of the
average nonfinancial corporation.
 The percentage is somewhat larger for smaller
firms: Because small companies often do not
qualify for financing from other sources, they
rely especially heavily on trade credit.
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Short term Bank loans
Commercial bank loans are second in importance
as a source of short term financing. The key
features of bank loans are:
 Maturity = Bank loans are frequently written as 90
– day notes, so the loan must be repaid or renewed
at the end of 90 days.
 Promissory Note = A document specifying the
terms and conditions of a loan, including the
amount, interest rate, repayment schedule and
collaterals.
 Compensating Balances = A minimum checking
account balance that a firm must maintain with a
commercial bank, generally equal to 10 to 20
percent of the amount of loans outstanding.
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Cost of Bank loans
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The cost of bank loans varies for different
types of borrowers at any given point in time,
and for all borrowers over time.
Interest rates are higher for riskier borrowers,
and rates are also higher on smaller loans
because of the fixed costs involves in making
and servicing loans.
Interest rates are calculated in 3 ways
Simple interest
Discount interest
Add on interest
Simple interest
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Regular or Simple rate is the interest that is
charged on the basis of the amount borrowed; it
is paid when the loan ends rather than when it
begins.
On a 1-year loan the effective annual rate is
 Effective annual rate = Interest
Amount received
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Discount interest
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Discount Interest is the interest that is
calculated on the face amount of a loan but is
paid in advance.
On a 1-year loan the effective annual rate is
 Effective annual rate = Interest
Face Value - interest
Add on interest
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Add – On Interest is the interest that is
calculated and added to funds received to
determined the face amount of an installment
loan.
Approximate effective annual rate
=Interest
(Amount received) / 2
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Commercial Paper
Commercial Paper is a type of an unsecured
promissory note issued by large firms, usually in
denominations of €100,000 or more and having
an interest rate somewhat below the prime rate.
 Maturities vary from one month to nine months.
The rates also vary according to the market but
are closed to the stated prime rates.
 Commercial paper is never secured, but all other
types of loans can be secured if this is deemed
necessary or desirable.
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Factoring
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Factoring involves the purchase of accounts
receivable by the lender without recourse to the
borrower which means that if the purchaser
does not pay then the lender and not the
borrower takes the loss.
Since the factoring firm assumes the risk of
default it must make the credit check and then
proceed with the purchase.
The rates are higher than the normal rates of
the market
Cash Conversion cycle
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The Cash Conversion Cycle (CCL)is the length of time from the
payment for the purchase of raw material to the collection of
accounts receivable generated by the sale of the final product.
Inventory Conversion period = Inventory
Sales/360
Receivables collection period = Receivables
Sales/360
Payables deferral period = Payables
credit purchases/360
CCL= Inventory Conversion period+ Receivables Collection period – Payables Deferral period