Reading 39 Los's

Question 1

LOS 39a: Describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position

Answer 1

Liquidity management refers to the ability of a company to generate cash when required. Sources of liquidity can be classified as:

• Primary Sources, which are readily available resources such as cash balances and short-term funds
• Secondary Sources, which provide liquidity at a higher cost than primary sources. They include negotiating debt contracts, liquidating assets, or filing for bankruptcy

A drag on liquidity occurs when there is a delay in cash coming into the company. Major drags include

• uncollected receivables: The longer receivables are outstanding, the greater the risk that they will not be collected at all
• Obsolete inventory: If inventory remains unsold for a long period, it might indicate that it is no longer usable
• Tight credit: Adverse economic conditions can make it difficult for companies to arrange short-term financing

A pull on liquidity occurs when cash leaves the company too quickly. Major pulls inlcude:

• Making payments early instead of waiting until the due date to make them
• Reduced credit limits as a result of a history of not being able to make payments on time
• Limits on short-term lines of credit : These can be mandated by the government, market-related, or company-specific
• Low existing levels of liquidity

Question 2

LOS 39b: Compare a company’s liquidity measures with those of peer companies

Answer 2

The following liquidity ratios are used to evaluate a company’s liquidity management

Current Ratio = Current Assets / Current Liabilities

• A higher current ratio means that a company is better positioned to meet its short-term obligation
• A current ratio of less than 1 implies negative working capital, which might mean the company faces a liquidity crisis

Quick Ratio = Cash + Short term marketable investments + receivables /

Current liabilities

• Higher quick and current ratios indicate greater liquidity. However, in order to gauge whether a given quick or current is good or bad, we must look at the trend in ratios and how they compare to competitors

Accounts Receivable Turnover = Credit Sales / Average receivables

• this measures how many times, on average, accounts receivable are created by credit sales and collectedover a given period
• Its desirable to have a turnover close to the industry average

Number of Days Receivables = Accounts Receivables / (Sales on credit/ 365)

• this measures how many days it takes, on average, to collect receivables from customers.
• desirable to be around industry average
• (Sales on credit / 365) = average day’s sales on credit
• A collection period that is too high might imply that customers are too slow in making payments and too much of the company’s capital is tied up in accounts receivable
• A collection period that is too low might suggest that the company’s credit policy is too strict

Inventory Turnover = COGS / Average inventory

• An inventory TO ratio that is too high might indicate that the company has too little stock on hand at any given point
• a low inventory TO ratio might suggest that the company has too much liquidity tied up in inventory, possibly because units are obsolete

Number of days of inventory = Inventory / (COGS/365) or average days COGS

• tells us the length of the period that inventory remains with the firm before being sold

Accounts payables turnover = Purchases / Average trade payables

• This measures how many times the company theoretically pays off creditors over a period
• A high payables turnover might indicate that the company is not making full use of available credit facilities
• A low ratio could suggest that the company has trouble making payments on time

Number of Days of payables = Accounts Payable / (Purchases/ 365)

• this measures how long the company takes to pay its suppliers
• The amount of purchases might not be explicity listed but can be calculated as so - Purchases = Ending Inventory + COGS - beginning inventory

Question 3

LOS 39c: Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles, and compare the company’s effectiveness with that of peer companies

Answer 3

The operating cycle measures the time needed to convert raw materials into cash from sales

Operating Cycle = Number of days of inventory + No. Days of receivables

The cash conversion cycle or the net operating cycle is the length of the period from paying suppliers for materials to collecting cash from sales to customers. It can also be calculated as the operating cycle minus the number of days payables

Net operating = No. Days of inventory + No. days of receivables - No. days payables

usually shorter cycles are desirable. A cycle that is too long suggests that the company has too much invested in working capital

Question 4

LOS 39d: Describe how different types of cash flows affect a company’s net daily cash position

Answer 4

Most companies prefer keeping a minimum cash balance to run their operations smoothly. If a company sets aside to much money, it will lose out on investment income. It a company sets aside too little, it will incur higher costs to raise funds quickly. Examples of cash flows follows:

Inflows:

• Receipts from operations
• Funds transfer from subsidiaries, joint ventures, and third parties
• Maturing investments
• debt proceeds
• other income items

Out Flows:

• Payables and payroll disbursements
• funds transfers to subsidiaries
• investments made
• debt repayments
• tax payments
• interest and dividend payments

Investing Short-term Funds

A company maintains a daily cash balance to make sure that it has the necessary funds to carry on its day to day acitivites. Short-term invesments represent temporary store for funds that are not needed to financing daily operations. Typically these will be of low risk and high liquidity ( ex. CDs, T-bills, Repos, Commercial Paper)

Question 5

LOS 39e: Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines

Answer 5

Discount instruments are purchased at less than face value, and pay back face value at maturity

Interest-bearing securities differ from discounted securities in that the investor pays the face value to purchase the security and receives that face value plus interest at maturity

Yields on Short-Term Investments

Money Market Yield = [(face value- price)/ price] x (360/days)

Bond equivalent yield = [(face value- price)/ price] x (365/days)

Discount basis yield =[(face value- price)/ face value] x (360/days)

• [(face value- price)/ price]= holding period yield
• [(face value- price)/ face value] = % discount

Cash management investment strategies

Short term strategies can be categorized as passive or active

• A passive strategy involves a limited number of transactions, and is based on very few rules for making daily investments. The focus is simply on reinvesting funds as the mature with little attention paid to yields
• An active strategy involves constant monitoring to exploit profitable opportunities in a wider array of investments. This calls for more involvement, more study, evaluations, and forecasts
  
  • Matching strategies involve matching the timing of cash outflows with investment maturities
  • Mismatching strategies involve intentionally mismatching the timing of cash outflows with investment maturities. This strategy is riskier and requries very accurate and reliable cash forecasts
  • laddering strategies involve scheduling the maturities of portfolio investments such that maturities are spread out equally over the term of the ladder

Cash Management Investment Policy

An investment policy has the basic structure:

• the purpose of the investment policy states reasons for the existence of the portfolio and describes its general attributes, such as the investment strategy to be follow
• it identifies the authorities who supervise the portfolio managers and details the actions that must be undertaken if the policy is not followed
• It describes the types of investments that should be considered for inclusion in the portfolio. The policy also contains restrictions on the max proportion of each type of security in the portfolio

The investment policy statement should be evaluated on the basis of how well it meets the goals of short-term investments

Question 6

LOS 39f: Evaluate a company’s management of accounts receivable, inventory, and accounts payable over time and compared to peer companies

Answer 6

Managing Customer Receipts

A good collection system should accelerate payments along with their information content. This can be done through an electronic collection network, or through a bank lockbox service

Companies may measure the performance for check deposits by calculating the float factor, which gives the number of days it takes deposited checks to clear

• Float factor = average daily float/ average daily deposit
• where average daily deposit = total amount of check deposited/ no. of days

Evaluating Management of Accounts Receivables

An aging schedule classifies accounts receivables according to the length of time that they have been outstanding.

We can better evaluate the firm’s ability to collect its receivables by calculating the weighted average collection period, which measures how long it takes a company to collect cash from its customers irrespective of the changes in sales and the level of sales.

The only drawback is that it requires more info than is normally presented

Evaluating Inventory Management

The main goal of inventory management is to maintain a level of inventory that ensures smooth delivery of sales without having more than necessary invested in inventory

Companies may have a variety of motives for holding inventory including:

• The transaction motive - inventory is just kept for the planned manufacturing activity
• The precautionary motive- Inventory is kept to avoid stock-out losses
• The speculative motive - inventory is kept to ensure its availability in the future when prices are expected to increase

Two basic approaches for managing inventory levels are:

1. Economic order quantity is the order quantity for inventory that minimizes its total ordering and holding costs. Companies typically use the economic order quantity - reorder point (EOQ - ROP) method, which minimizes inventory costs. This method relies on expected demand
2. The just-in-time method reduces in-process inventory and associated carrying costs through evaluation of the entire system of delivery of materials and production

We can evaluate a company’s inventory management by analyzing the inventory turnover ratio and the nuber of days of inventory

Evaluating Management of Accounts Payable

Companies shold consider a variety of factors for managing their accounts payable effectivey. These include:

• Financial organization centralization - the management of a company’s payables is affected by the degree to which its core financial system is centralized or decentralized
• Number, size, and location of vendors- The sophistication of a company’s payables system is affected by its supply chain and how dependent the company is on its trading partners
• trade credit and cost of borrowing or alternative cost- The standardization of a company’s payables procedures is dependent on the importance of credit to the company and its ability to evaluate trade credit opportunities
• Control of disbursement float- the disbursement float allows companies to use their funds longer than if they had to fund their checking accounts on the day the checks were mailed
• Inventory management - newer management techniques and systems are required to process the increased volume of payments generated through newer inventory control techniques
• E-commerce and electronic data interchange (EDI) - Making payments electronically may be more efficient and cost-effective than making payments through checks

Evaluating Trade Discounts

An early payment discount must be availed if the savings from paying suppliers are greater than the returns tha could have been earned by investing the funds instead or greater than the firm’s cost of borrowing

• Cost of trade credit = [1+ (discount/ (1-discount))]^{[365/ # of days beyond discount per.]- 1}

Question 7

LOS 39g: Evaluate the choices of short-term funding available to a company and recommend a financing method

Answer 7

Bank sources of credit

• Uncommitted lines of credit a bank offers a line of credit to the company for a certain period of time, but reserves the right to refuse to lend. This makes it the weakest and least reliable
• Committed lines of credit (regular lines of credit) These are stronger than uncommitted lines of credit as they require a formal commitment from the bank. Further, they are unsecured and are pre-payable without penalty
• Revolving credit agreements These are the strongest form of short-term borrowing facilities. They are similar to regular lines of credit with respect to borrowing rates, compensation, and being unsecured.

Nonbank Sources

These include nonbank finance companies and commercial paper. Some companies take secured short-term loans, which are known as asset-based loans. These loans are collateralized by current assets of the company.

Approaches to short-term Borrowing

• Ensure that there is sufficient capacity to handle peak cash needs
• Maintain sufficient sources of credit to be able to fund ongoing cash requirements
• Ensure that the rates obtained for these borrowings are cost effective
• Diversify to have abundant options and not be too reliant on one lender or form of lending
• Have the ability to manage different maturities in an efficient manner

Computing the Cost of borrowing

Line of credit cost = (interest + commitment fee) / loan amount

bankers acceptance cost = interest / net proceeds= interest/(loan amount- interest)

Cost of commercial paper = Interest + Dealer’s comission+ backup cost/

Loan amount - interest