Financial Leverage (trading on the equity) – use of debt to finance assets and operations.

Solvency – the firm’s financial ability to pay long-term obligations and survive in the long-term

Key ingredients;

1. Capital structure – sources of financing

a. Equity (risk capital of the firm) – ownership interest I the firm
b. Debt – interest of creditors in the firm

Notes to Financial Statements

Information typically disclosed in the notes includes;

 Details of the inventory costing and depreciation methods used

 Contingent liabilities and pending lawsuits
 Long term leases, if any
 Terms of executive employment contracts, profit sharing programs, pension plans and stock options granted to
employees

Limitations of Financial Statement Analysis

 Financial ratios serve only as an attention-directing device.

 Several factors make financial analysis difficult;
o Variations in accounting methods
o Timing

Therefore, financial statement analysis must be interpreted as a whole, co-relating its weaknesses and strengths rather
individual ratios.

WORKING CAPITAL AND CASH MANAGEMENT

Short-term financial management

 Primarily concerned with the commitments of funds to various activities within the business and with best possible combination
of types of financing.
 Participates in planning, organizing, administration and control of company towards profit goals.
 Mainly with where to get cash and how such cash be used for the benefit of the company.

Principles for managers to effectively manage working capital

1. Hedging Principle (rule of self-liquidating debt)

- Provides the basis for firm’s working capital decisions.
- Permanent asset investments are finance with permanent sources and temporary asset investments are financed with
temporary sources of financing.
- Attempts to match temporary needs for funds with short-term sources of financing and permanent needs with long-term
needs.
2. Permanent Investment
- One which the firm expects to hold for a period of more than one year.
- Involve current or fixed assets
3. Temporary Investment
- The firm’s investment in current assets that will be liquidated and not to be replaced during the year.
4. Spontaneous sources
 - All those sources that are available upon demand such as trade credits or accounts payable
- Those that arise naturally as a part of doing business such as wages, interest and taxes payables.
5. Temporary sources
- All forms of current or short-term financing not categorized as spontaneous such as bank loans, commercial papers, and
financing company loans.
6. Permanent sources
- All long-term sources such as dent having a maturity of more than one year such as preferred stock, common stock or long-
term bonds.

Working Capital Management

- Or short-term financial management

- Refers to the administration and control of the more liquid resources to make sure that they are sufficient to cover day to day
business operations including anticipated contingencies
- Deals with managerial decisions regarding current assets and how they are financed.

Current assets

 Cash
 Account receivables
 Inventories
 Marketable securities

Current Liabilities

 Notes payable
 Accruals
 Accounts payable

Working Capital

- CURRENT ASSET MINUS CURRENT LIABILITIES

- It is analyzed as the ability to meet current obligations as they come due using current ratio analysis.

Usually, the firm’s goal is to minimize net working capital. This could be achieved by;

1. Faster collection of cash from sales or service revenues

2. Increasing inventory turnovers
3. Slowing down disbursements to suppliers or securing longer credit terms

Uses and Importance of Working Capital

- Made to support day to day operations and sales activities. These include;
1. Amount of cash on hand and in bank to be maintained
2. Amount of credit to be extended to customers
3. Number of days extended to credit customers
4. Amount and type of inventories on stock to be maintained
5. Amount of securities or temporary investments to be made
- Working capital is an important topic for several reasons;
1. Largest portion of most financial managers’ time is devoted to the day to day internal operations of the firm
 2. Current assets represent a large proportion of total assets in most companies. It fluctuates with sales and sales vary over
time. thus, managing current assets is a dynamic process and it requires the financial manager to;
a. Closely monitor sales
b. To anticipate changing levels of sales
c. To ensure that assets on hand us sufficient in quantities to meet sales and production targets
3. Working capital management is particularly important for small firms because they have relatively limited access to the
long-term capital markets, they must rely on heavily in trade credit and short-term bank loans, both of which affect
working capital by increasing current liabilities.
4. The relationship between the sales growth and the need to invest in current assets is close and direct. As sales grow, the
firm must increase receivables and inventories and it may need to increase its cash balance as well. A sales increase
would also produce an immediate need for additional inventories and perhaps, for more cash. Any increase in an account
on the left side of the balance sheet must be matched by an increase on the right side. Therefore, it is imperative that the
financial manager be aware of sales trends and their effects on the firm’s working capital needs.

Objectives of Working Capital Management

1. To generate additional income for the business

2. To reduce the amount of investment needed to support sales and production

Generally affected by the following factors:

1. The general nature of the business

2. The cost and length of the operating process
3. Product or service competitive conditions and seasonal variations
4. Government regulations
5. Self-imposed internal policies and commitments
6. Operational efficiencies

Advantages of Adequate Working Capital

1. Solvency of the business

2. Goodwill
3. Easy loans
4. Cash discounts
5. Regular supply of raw material
6. Regular payment of salaries, wages and other day to day commitments
7. Ability to face crisis
8. Quick and regular return on investments
9. Exploitation of favorable market conditions
10. High morale

Disadvantages of Excessive Working Capital

1. Excessive working capital means idle funds which earn no profits for business and hence business cannot earn a proper rate
of return
2. When there is a redundant working capital it may lead to unnecessary purchasing and accumulation of inventories causing
more chances of theft, waste and losses.
3. May result into overall inefficiency in organization
4. Due to low rate of return on investments, the value of shares may also fall
5. The redundant working capital gives rise to speculative transaction
6. When there is excessive working capital, relations with banks and other financial institutions may not be maintained.
Disadvantages of Inadequate Working Capital

1. Inability to pay short-term liabilities in time

2. It cannot buy its requirements in bulk and cannot avail of discounts
3. It becomes difficult for firm to exploit favorable market conditions and undertake profitable projects due to lack of working
capital
4. The rate of return on investments also falls with shortage of working capital
5. The firm cannot pay day to day expenses of its operations and it created inefficiencies increases costs and reduces the profits
of business.

Net Working Capital Fundamentals: Trade-off between profitability and Risk

Profitability

o The relationship between revenues and costs generated by using the firm’s assets both current and fixed, in
productive activities.

Risk (of insolvency)

o Probability that a firm will be unable to pay its bill as they come due.

Ratio Change Effect on Profit Effect on Risk

Current Assets Increase Decrease Decrease
Total Assets Decrease Increase Increase
Current Liabilities Increase Increase Increase
Total Assets Decrease Decrease Decrease

Cash Conversion and Operating Cycle

Operating Cycle

- Time from the beginning of the production process, collection of cash from the sale of the finished product.

OC = Average Selling Period + Average Collection Period

Cash Conversion Cycle

- Length of time required for a company to convert cash invests in its operations to cash received as a result of its operations.
- Average payment period – time it takes to pay the accounts payable, measured in days

CCC = Operating Cycle – Average Payment Period

Or

CCC = (ASP + ACP) - APP

Cycle Turnover = 365 / Accounts receivable turnover

Investment in Inventory = (COGS / 365) x (ASP + Collection Period, end)

Investment in AR = (Net Sales / 365) x Collection Period, beg

Accounts Payable = (COGS / 365) x ASP

Net Financing = (Investment in Inventory + Investment in AR) – Accounts Payable

Permanent Funding Requirement

- A constant investment in operating assets resulting from constant sales over time.

Seasonal Funding Requirement

- An investment in operating assets that varies over time as a result of cyclic sales.

Aggressive Funding Strategy

- A funding strategy under which the firm funds its seasonal requirements with short-term debt and its permanent requirements
with long-term debt.
- Seek to increase profit as possible but increase risk because its operates with minimum net working capital, which could
become negative.

Conservative Funding Strategy

- A funding strategy under which the firm funds both seasonal and its permanent requirements with long-term debt.
- Results in relatively low profit, but less risk

Management of Cash

Cash

- Non-earning assets in the sense that cash itself or commercial checking account earn no interest or very little interest.
- Needed to pay for labor, raw materials, taxes, debts or dividends and to buy fixed assets.

Cash Management

- Refers to the most effective way of handling cash or its equivalent in a manner intended to result in its most efficient use.

A Financial Officer must always have in mind;

1. Cash is the most important and challenging resource to manage

2. The optimal cash level is influenced by a subjective factor
3. Effective management of the cash collection cycle can both reduce the demand for cash and increase its supply
4. The normal operating cycle begins with cash, thus the normal operating cycle is cash-to-cash cycle.
5. Sound cash management techniques are based on a thorough understanding of the cash flow process.
6. Trying to have an acceptable balance between holding too much cash and holding too little cash
7. That a large cash investment minimizes insolvency but sacrifices profitability.

Motives of Holding Cash Balances

1. Transaction motive – transactions balances allow the firm to make payments that arise in the ordinary course of doing
business.
2. Precautionary motive – precautionary balances provide a buffer stock of liquid assets that can be drawn if there are
unexpected demands for cash.
3. Speculative motive – speculative balances permit the economic unit to take advantage of future income producing activities.

Possible Placements of Cash

1. Savings and/or current accounts – bank placements with no holding period. The interests earned are lower than interest
earned in time deposits.
 2. Time deposits – placements with holding period. Normally taxed at 20% of the interest income. Earn a higher interest than the
savings account.
3. Stocks – shares of stock traded in the formal stock exchange and are brought from stockbrokers. Entail costs which include
broker’s commission, government taxes and documentary stamp tax
4. Treasury bills – short-term obligations issued by the government. Offered with a maturity of 91 days, however there are that
mature in more than 91 days but less than a year. It is unique because it is traded on a discount basis that is it earns interest
until the maturity date.
Profit earned for investing TB = maturity value less discounted value
5. Commercial papers – unsecured promissory notes issued by the firms with high credit standings. Interest earned normally
higher than that from the savings account. No collateral is offered by firms that issued the commercial papers because of the
firm’s good track record of cash inflows.

Management Responsibilities Relating to Cash

1. To prevent losses from fraud or theft

2. To provide accurate accounting of cash receipts, cash payments and cash balances
3. To maintain enough cash at all times to make necessary payments plus reasonable balances for emergencies
4. To prevent unnecessary large amounts of cash from being held idle in bank accounts which produce no revenue

Management Techniques in Controlling Cash Flows

Float Management

- Involves in controlling the collection and disbursement of cash.

- Float refers to funds that have been dispatched by a payer but not yet in form that van be spent by payee.a delay between
when funds are sent by a payer to payee.
- Collection float is the time between when a payer sends payments and the funds are credited to the payee’s bank account.
- Disbursement float is the time lag between when a payer sends payments and when the funds are deducted from the payer’s
bank account.
- Negative float exists when book balance exceeds the bank balance which means that there is more cash tied up in a
collection cycle and it earns a 0% rate of return
- Positive float happens when the firm’s bank balance exceeds its book balance
- Mail float refers to the delay between the time when payer places payment in the mail and when it is receives the payee
- Processing float is the delay between the receipts of a check by the payee and the deposit of it in the firm’s account.
- Clearing float means the delay between the deposit of a check by the payee and the actual availability of funds.

Speed-up Collections

1. Bill customers promptly

2. Offer cash discounts for prompt payment
3. Use lockbox system – customers mail their payments to a post office in a specific city. The local bank collects the checks from
this box and deposits them in the firm’s account.
4. Establish local collection office
5. Request customers to make direct payment to the firm’s depository bank
6. Use of automatic fund transfer or Electronic Fund Transfer

Concentration Banking

- Collection procedure in which payments are made to regionally dispersed collection centers and then deposited in local banks
for quick clearing thus reducing collection float by shortening mail and clearing float.

Lockboxes
 - Collection procedure in which payers sends their payments to a nearby post office box that is emptied by the firm’s bank
several times daily.

Direct Sends

- Collection procedure in which the payee presents the payment checks directly to the banks in which they are drawn, thus
reducing clearing float

Slowing Down Disbursement

Controlled disbursing

- Strategic use mailing points and bank account to lengthen mail float and clearing float respectively by;
o Stretching payables
o Maintaining zero-balance accounts
o Less frequently payroll and scheduled issuance of checks to suppliers

Reduce the need for precautionary cash balance with the following techniques
o More accurate cash budgeting
o Have ready lines of credit
o Invest idle cash in highly liquid short-term investments instead of holding idle precautionary cash balances.

Playing the float

- A method of consciously anticipating the resulting float associated with the payment process and using it to keep funds in an
interest-bearing form for as long as possible

Estimating Cash Balance

1. Baumol Model
- Treats cash as inventory item
- This model assumes a constant rate of use of cash, hypothetical assumption
- William J Baumol suggested a model for determining optimum balance of cash based upon carrying costs of cash
- Carrying cost refers to the cost of the holding cash
- Transaction cost refers to the cost involved in getting the marketable securities converted into cash

ECQ =  2 x conversion cost x demand for cash / opportunity cost (in decimal form)

ECQ – economic conversion quantity (cost-minimizing quantity in which to convert marketable securities to cash)

Conversion cost – the fixed cost of placing and receiving an order for cash in the ECQ

Demand for cash – cash outlays for upcoming year

Opportunity cost – interest earnings per dollar given u during specified time period as result of holding funds in a non-interest
cash account rather than having them invested in interest-earning marketable securities

Total cost of cash – sum of the total conversion and total opportunity costs.

Total conversion cost – cost per conversion times the number of conversions per period

Total cost = (Cost per conversion x No. of conversions) + (opportunity cost x Average Cash balance)

2. Miller-Orr Model
 - Argues that changes in cash balance over a given period are random in size as well as in direction
- This model assumes out of the two assets, the latter has a marginal yield, and transfer of cash to marketable securities and
vice versa, is possible without any delay but of course of at some cost.
- Specified two control limits for cash balance, an upper limit , H, beyond which cash balance need not be allowed to go and a
lower limit, L, below, which the cash level is not allowed to reduce.
- Superiority over Baumol’s model

Return point = Lower limit + (1/3 x Spread)

Spread = 3 (3/4 x (Transaction cost x variance of cash flow / interest rate)^1/3

Variance = (standard deviation)^2

Difference of the two models

Baumol model assumes constant need and constant rate of use of funds, the Miller-orr model on the other hand is more realistic
and maintains that the actual cash balance may fluctuate between higher and the lower limits

RECEIVABLE MANAGEMENT