C Spreadsheet Flashcards by Nick Duley

Techniques to managing trade receivables

By assessing the creditworthiness of new customers. In order to do this, the company needs to review information from a range of sources. These sources include trade, bank and credit references

Make sure that its credit customers abide by the terms of trade agreed when credit was granted following credit assessment. Aged receivables analysis can provide info on overdue accounts

Credit customers will pay on time and no need to chase late payers. Credit control staff must assess whether payment is likely wen payment is overdue

Encourage its credit customers to settle outstanding amounts by offering an early settlement discount. This will offer a reduction in the outstanding amount (the discount) in exchange for settlement before the due date

A service whereby a third party, usually a factor, pays a percentage of the face value of a collection of high value invoices

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Why a company may benefit from services of a factoring company

Experts at getting customers to pay promptly and may be able to achieve payment periods and bad debt levels which clients could not achieve themselves

Factor will advance up to 80% of the value of invoices raised, allowing a company quicker access to cash from sales

Factoring can free up management time and allow them to focus on more important tasks

Since administration of trade receivables would be taken over by the factor, administration costs of the company would decrease over time

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Factors that determine level of a company’s investment in working capital

Some businesses have long production processes which inevitably lead to long working capital cycles and large investments in working capital (e.g. housebuilding requires large investment in capital)

Some companies take a conservative approach to working capital investment, offering long periods of credit to customers (to promote sales), high levels of inventory (to prevent stockouts) and prompt payments to suppliers (to maintain good relationships)

If management of the components of working capital is neglected, investment in working capital can increase (e.g. bad credit control results in high level of AR)

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Assumptions of Baumol

Cash needs are steady and predictable and funded by the sale of short-term investments

Constant annual demand for cash

Constant interest rates

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Miller-Orr Model Assumptions

A minimum acceptable cash balance, the lower limit

Changes in daily cash balance are random (normally distributed)

Surplus cash can be invested in interest-earning marketable securities

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Miller-Orr Weaknesses

Subjectivity in setting a lower limit

The complexity of estimating future volatility of cash flows

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Risk associated with Foreign Accounts Receivable

Government actions like trade restrictions, contract breaches, currency devaluation

Performing the same creditworthiness assessment processes on foreign credit customers as those used with domestic credit customers

Challenges in documentation, time zones, cultural norms, and internal processes delay

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What determines level of current assets

Companies with a longer operating cycle compared to others in same industry sector, require higher ivnestment in current assets

A company with generous credit terms compared to other companies in industry will require higher investment in current assets

Aggressive approach has lower level of current assets. Conservative approach has higher level of current assets

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Characteristics when forming a working capital policy

If the cost of financing trade credit is high, there will be pressure to reduce the amount of credit offered and to reduce the period for which credit is offered

In order to compete effectively, a company will need to match the terms offered by its competitors

Where the need for liquidity is relatively high, a company may choose to accelerate cash inflow from credit customers by using invoice discounting or by factoring

Expertise in the assessment of creditworthiness and the monitoring of customer accounts is not a sufficiently high standard

Scope to generate some extra cash by reducing working capital

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Factors in determining working capital funding strategies

Distinguish between permanent and fluctuating current assets. Permanent current assets represent the core level of current assets needed to support normal levels of business activity

Relative cost of short-term and long-term finance. The normal yield curve suggests that long-term debt finance is more expensive than short-term debt finance

Managerial attitudes to risk can lead to a company preferring one working capital funding policy over another

Organisational size can be an important factor in relation to, for example, access to different forms of finance in support of a favoured workingcapital funding policy

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How can company reduce cash operating cycle

Improved credit control in relation to chasing up overdue debt

Raw material holding should be reduced, maybe introducing JIT

Increasing the amount of time to pay suppliers

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Ways Factoring Affects Account Receivable

Factoring involves a company turning over administration of its sales ledger to a factor, which is a financial institution with expertise in this area

The factor will also offer finance to a company based on invoices raised for goods sold or services provided. This is usually up to 80% of the face value of invoices raised

If factoring is without recourse, the factor rather than the company will carry the cost of any bad debts that arise on overdue accounts

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Working Capital Investment Policy

Working capital investment policy is concerned with the level of investment in current assets, with one company being compared with another

Proposed changes in working capital can be measured by the revenue/current assets ratio, revenue/net working capital ratio

(Aggressive, conservative) are used to indicate the comparative level of investment in current assets on an inter-company basis

Conservative: High levels of inventory, offers generous credit terms, pay suppliers promptly

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Working Capital Financing Policy

Concerned with the relative proportions of short-term and long-term finance used by a company

Working capital financing policy uses an analysis of current assets into permanent current assets and fluctuating current assets (Not necessary in an ivnestment policy)

Matching principle holds that long-term assets should be financed from a long-term source of finance (Not necessary in an investment policy)

An aggressive financing policy means that fluctuating current assets and a portion of permanent current assets are financed from a short-term finance source

Ratios: Increase in short-term and long-term funds

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Aggressive Financing Policy

An aggressive financing policy will be more profitable than a conservative financing policy because short-term finance is cheaper than long-term finance

An aggressive financing policy means that fluctuating current assets and a portion of permanent current assets are financed from a short-term finance source

An aggressive financing policy will be riskier than a conservative financing policy because short-term finance is riskier than long-term finance

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Working Capital Funding Policy

A conservative funding policy will use long-term funds to finance permanent current assets and a proportion of fluctuating current assets

An aggressive funding policy will use short-term funds to finance fluctuating current assets and a proportion of permanent current assets

A matching funding policy would apply the matching principle in using short-term funds to finance fluctuating current assets and using long-term funds to finance permanent current assets

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JIT Prerequisites

Sufficiently flexible suppliers and internal workforce to expand and contract output at short notice

The factory design and layout must facilitate JIT deliveries to all areas

Significant investment by suppliers, who will require long-term agreements

Close working relationships with suppliers and, if possible, geographical proximity for immediate deliveries

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JIT Benefits

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Lower level of investment in working capital, since inventory levels have been minimised

A reduction in materials handling costs, due to improved materials flow through the production process

lower reworking costs due to the increased emphasis on the quality of supplies

Cash Operating Cycle (or Working Capital Cycle)

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Average length of time it takes for a business togenerate cash having paid for an item of inventory.

It is calculated by adding the average inventory holding period and the average trade receivables collection period and then subtracting the average trade payables payment period

The cash operating cycle is effectively measuring the business’ liquidity in terms of cash generation

The relationship of the cash operating cycle with the investment in working capital is that higher levels of investment will generally increase the cash operating cycle

Conflict between Liquidity and Profitability in Management of Working Capital

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One objective is to earn profits in order to provide satisfactory returns for its investors and contribute towards the maximisation of shareholder wealth

Another is to generate enough cash to allow the business to meet its short-term financial commitments, such as wages, salaries, accounts payable, interest and tax.

increase profitability, a firm may increase its inventory levels in order to be able to offer customers prompt delivery

increasing inventory levels the company ties up more cash in inventory, thus decreasing its ability to meet its short-term commitments

Pressuries customers to pay faster may improve liquidity as cash resources increase

Same time sales might fall as customers switch to a different supplier with better terms

Companies which take long periods of credit from suppliers may find their liquidity improves

Can be deteriment of profits as settlement discounts may be lost and supplier relationships damaged

Investment in Working Capital (High)

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High investment in working capital: More liquid but less profitable

Investment in Working Capital (Low)

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Low investment in working capital: Less liquid but more profitable

Overtrading

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Overtrading occurs when a company tries to support a large volume of trade from a small working capital base

Indicators of overtrading: Delining liquidity, rapidly increasing revenue, increase in inventory and receivables, decreasing profit

If a business suffers from liquidity problems due to overtrading, the aim will be to reduce the length of the cash operating cycle

Determining Optimum Level of Inventory

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The average level of daily sales (adjusted for seasonal variations)

Reliability of suppliers

Cost of reordering inventory

Storage and security costs

Reasons for Holding Inventory

To meet demand by acting as a buffer when consumption is unusually high. This reduces the risk of "stock-outs" To ensure continuous production Take advantage of quantity discounts

Assumption of EOQ

Constant purchase price per unit Constant demand Order costs are independent

Centralised Treasury Management Advantages

Management by specialised staff with appropriate qualifications, expertise and experience Increased negotiating power with banks, as the amounts borrowed or deposited would be more substantial as a group Economies of scale (e.g. less staff required), as specialists are employed centrally, reducing duplication

Reasons for Holding Cash

Transactions motive, where cash is held to provide sufficient liquidity to meet current day-to-day financial obligations Precautionary motive, where a cash reserve is held as a “cushion” against unplanned expenditure, like buffer inventory Speculative motive, where cash is held to take advantage of potential investment opportunities quickly

Payment Methods for Foreign Accounts Receivable

Bill of exchange – a document drawn by the exporter and sent to the customer, who signs to accept responsibility to pay the amount specified on the stated date. Forfaiting involves a bank discounting a series of bills of exchange without recourse to the exporter if the customer does not pay Countertrade: In a countertrade arrangement, goods or services are exchanged for other goods or services instead of for cash Export factoring: factors buy the trade receivables from the exporter and charge a commission on the transaction

Documentary Letters of Credit

The purchaser (importer) and the seller (exporter) agree terms and conditions The importer’s bank issues a letter of credit in the exporters’s favour The goods are dispatched to the importer, and the shipping documentation is sent to the importer's bank The bank then issues a banker’s acceptance

Documentary Letters of Credit Advantages

Advantage: Letters of credit provide a high level of payment assurance for the seller. Once Ts & Cs are met, the seller is guaranteed to receive payment Advantage: Sellers can negotiate favourable payments such as shorter payment periods to improve cash flow

Documentary Letters of Credit Disadvantages

Disadvantage: Set up can be complex and take a significant amount of time before the sale occurs Disadvantage: Minor discrepancies in rigid Ts & Cs can lead to delays or even non-payment

Invoice Discounting

Selling of selected sales invoices to a third party for a discounted cash sum, while retaining full control over the receivables ledger A finance company will provide a cash advance as a percentage of the outstanding sales invoices – usually in the region of 80%

Invoice Discounting Advantages

Advantage: Improved cash flow: the business receives a significant proportion of invoice amounts upfront. Advantage: Business can choose which invoices to discount, accessing funds when needed

Invoice Discounting Disadvantages

Disadvantage: Fees and interest charges make it an expensive form of financing compared to an overdraft or bank loan Disadvantage: As the finance company has a legal charge over the receivable balances, the business has fewer assets to secure other borrowings.

Debt Factoring

Accounting and collection – the company is paid by the factor as customers settle their invoices or after an agreed settlement period Credit control – the factor is responsible for chasing the customers and speeding up the collection of debts Finance against sales – the factor advances a percentage (e.g. typically between 50% and 85%) of the sales value immediately on invoicing

Debt Factors Advantages

Advantage: Reduced administrative burden: outsourced debt collection saves time and effort Advantage: Improved cash flow - conversion of receivables into immediate cash

Debt Factors Disadvantages

Disadvantage: Cost: factoring fees can be relatively high Disadvantage: Damage to customer relationships: loss of control over customer interactions and factor’s “vigour” may damage customer relationships/goodwill

Factoring with recourse

Factoring with recourse – bad debts remain the company's problem (i.e. the supplier bears the risk of non-payment)

Factoring with non-recourse

Non-recourse factoring – bad debts are the factor's problem. In effect, the company is insured against bad debts. Fees are higher for non-recourse factoring

Baumol model drawbacks?

Unlikely to be possible to predict future amounts accurately Assumes constant transaction costs No buffer inventory is allowed for

Benefits of Miller-Orr model?

Takes into account uncertainty by allowing cash to fluctuate between upper and lower limit If reaches upper limit, firm buys securities to return to a normal level If reaches lower limit, firm sells securities to return to a normal level

Difference between "reduced to" and "reduced by"

"Reducted to" get diference from receivables balances "Reduced by" no difference

C Spreadsheet Flashcards

(43 cards)