Explain foundational finance theories
FIN 3301, Financial Management 1
Course Learning Outcomes for Unit VII Upon completion of this unit, students should be able to:
1. Explain foundational finance theories. 1.1 Discuss methods of maintaining positive cash flow.
2. Analyze a financial forecast using relevant data.
2.1 Determine investment value of a firm based on its cash position and cash balance. 2.2 Examine the use of short-term financing for a company.
4. Apply measures of risk in financial analysis.
4.1 Discuss whether investing in a specific company is a good financial decision.
5. Prepare preliminary financial statements and ratio analyses.
6. Evaluate stock and bond valuation. Required Unit Resources Chapter 15: Managing Working Capital Chapter 16: Short-Term Business Financing Unit Lesson In Unit VII, we will examine working capital and short-term financing. We will study the importance of working capital management, and we will learn about a firm’s operating cycle and cash conversion cycle. Further, we will evaluate the use of a cash budget and its impact on accounts receivable management and inventory management. Finally, we will explore different sources of short-term financing, and we will assess strategies for financing working capital.
Working Capital and Short-Term Financing Working capital consists of the current assets that are used and replaced in the course of the year to support the short-term business activities of the company. Net working capital (NWC) consists of the current assets minus the current liabilities, which can be used to support operations (Brigham & Houston, 2015). Positive net working capital exists when the current assets exceed the current liabilities. Working capital represents the portion of the company’s available investment that circulates through different forms during the course of the year such as cash, inventories, and receivables (Gitman et al., 2009). The following sections discuss several aspects of working capital and short-term financing, including the cash conversion cycle, cash budgets, account receivables management, inventory management, and sources of short-term financing.
Operating and Cash Conversion Cycle The operating cycle is the term given to the period of time from the purchase or manufacture of a product for inventory and the collection of money from the sale of the product (Porter & Norton, 2010). The collection of money can occur either at the time of sale for cash transactions or at some point in the future when the receivable for the sale is collected for credit transactions. The steps in the operating cycle are the use of working capital to purchase or manufacture a product, which is followed by the sale of the product. The next
UNIT VII STUDY GUIDE Working Capital and Short-Term Financing
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step involves the collection of payment, which creates cash for working capital. The cash can then be used to again purchase and manufacture inventory. The cash conversion cycle is the amount of time that a company’s resources are tied up in the operating cycle (Gitman et al., 2009). The cash conversion cycle includes the average age of inventory (AAI), the average collection period (ACP), which is the average amount of time necessary to collect receivables, and the average payment period (APP), which is the average amount of time necessary to pay the accounts payable
to suppliers. The amount of days in the cash conversion cycle is found by AAI+ ACP-APP. Sometimes, the measures for the cycle are days inventory outstanding, days sales outstanding, and days payable outstanding. The measure is useful for determining if the company has enough working capital to support operations throughout the cycle or needs to obtain short-term financing to increase working capital.
Cash Budgets
The cash budget assists companies in forecasting cash flows and the possible need for additional working capital well before the need actually arises (Brigham & Houston, 2015). The cash budget is sometimes called the cash flow forecast because it helps predict future cash flow needs. The cash budget can be set for any period of time, but most companies prepare the cash budget on a monthly basis. The budget focuses on cash flows. It includes information on forecasted sales, receivable receipts, and amounts that are likely to be due to creditors. When securing a short-term loan, banks or other creditors like to review the cash budget to ensure the company will have sufficient cash flow to cover the loan. The cash budget is a pro-forma document that is based on the expected forecasts. The cash budget contains three sections. The cash receipts shows anticipated cash inflows from all sources including sales of products, services, and sale of investments. The cash disbursement shows all expenditures including overhead, labor, and cost of materials. The financing section shows anticipated borrowing and the repayment of borrowing plus interest (Weygandt et al., 2010). If the assumptions in the budget forecasts are changed, however, the budget can be used to predict cash flow needs in different scenarios such as a 10% decrease in sales or a 10% increase in sales.
Accounts Receivables Management
Most companies extend credit to their customers, which is a practice intended as a means of increasing sales. The amount of sales on credit comprises the accounts receivable of the company. The company has to manage accounts receivables effectively because it represents the income portion of the cash conversion cycle. The credit policy of the company is a key factor for managing the accounts receivable because it establishes the standard terms for payment for customers (Porter & Norton, 2010). An approach to credit policy that is often used is extension of credit on term of 2% 10 net 30. The customer can deduct 2% if the invoice is paid within 10 days with the full amount due in 30 days. The credit policy of companies varies according to industry. A credit policy that is too lax can create cash flow problems because customers are likely to delay payment as long as possible. In this type of situation, the company may have to finance working capital, which is essentially borrowing money to support customers. Conversely, a credit policy that is too strict can lead to cash flow problems from lower sales. Managers have to maintain an appropriate credit policy to balance sales and the collections necessary to maintain the cash conversion cycle necessary to support operations.
AAI + ACP – APP
The amount of days in the cash conversion
The three sections of a cash budget.
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Managers can use metrics such as average collection period and comparison to peers to help determine if the credit policy is too lax or too strict.
Inventory Management Inventory management is also important for company operation because standing inventory ties up working capital. Each item in inventory has a cost for the company in the form of purchased materials, labor, and the overhead associated with storing the inventory. Nonetheless, a company can face stockout costs if the company does not have enough inventory on hand to meet customer needs, forcing the customers to purchase products elsewhere (Mowen et al., 2012). The working capital covers the costs of inventory for the company with excessive amounts of inventory representing a drain on working capital. The optimal amount of inventory on hand depends on factors such as historic sales patterns, the overall state of the economy, and the type of industry. In general, however, companies want to turn over inventory as fast as possible to maximize their cash flow (Gitman et al., 2009). Measures such as the inventory turnover rate or the average age of inventory can be helpful for managers to determine if the company has too little or too much inventory on hand. The measures can also be helpful for determining whether the company has obsolete inventory on hand. In addition, the use of inventory management approaches such as just-in-time supply chain management in which supplies are purchased and products are produced just before they are needed. The approach can be used to minimize the amount of inventory on hand and reduce the negative effect of on hand inventory on working capital management.
Strategies for Financing Working Capital Companies have several strategic options for financing working capital. One approach is to control inventory and credit policy to speed the cash conversion cycle to the point at which cash flows into the company at a rate faster than the rate of cash outflows to pay for supplies, overhead, labor, and other short-term expenses. The effectiveness of the strategy depends on the ability of the company to manage inventory, receivables, and purchasing, which may depend on the type of industry and the general economic conditions. Many companies could have difficulty with improving management of the cash conversion cycle during periods of seasonal fluctuation in demand for products. Another strategy for financing working capital is through short-term borrowing from a bank, another type of financial institution, or private creditors. Working capital loans are short-term loans made to a company to finance operations when the company does not have enough current cash flow to cover its operating expenses (Brigham & Houston, 2015). The expectation of the lender is that that the loans will be paid in a relatively short period of time when cash flow becomes available for the company. The disadvantage of working capital loans is the cost associated with loan fees and interests, which reduce profitability.
Providers of Short-Term Financing Banks are a major source of short-term financing for companies. Banks are willing to provide unsecured short-term financing for companies they believe are solvent and will have the ability to repay the loan. Banks often use overdraft agreements with companies intended to allow the company to carry the company through seasonal peaks during which inventory and receivables are higher than normal (Gitman et al., 2009). Banks also provide a revolving line of credit that a company can access as needed without a formal loan application and pay back in stated time frames. It is also possible for the company to issue debentures that are basically long-term bonds, with the general public providing the funding.
Non-Bank Short-Term Financing Sources A company’s suppliers can be considered a short-term financing source. If a supplier has a credit policy that allows its customers to extend payment over a long period of time, the company can delay paying its suppliers until inventory has been sold and receivables can be collected. Another non-bank source of short- term financing is the sale of receivables at a discount to face value. The company obtains immediate cash inflows but the company will no longer have the future cash flows that would have occurred from the receivables. A company can also increase the amount of discount for early payment to its customers to encourage them to make payment as rapidly as possible. A company that pays a dividend can also eliminate the dividend to conserve cash, which is an internal source of additional working capital.
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Summary
In summary, we studied working capital and short-term financing. We examined the importance of working capital management, and we learned about a firm’s operating cycle and cash conversion cycle. Further, we evaluated the use of a cash budget and its impact on accounts receivable management and inventory management. Finally, we explored different sources of short-term financing, and we assessed strategies for financing working capital.
References Brigham, E. F, & Houston, J. F. (2015). Fundamentals of financial management. Cengage. Gitman, L., Juchau, R., & Flanagan, J. (2009). Principles of managerial finance. Pearson. Mowen, M. M., Hansen, D. R., & Heitger, D. L. (2012). Cornerstones of managerial accounting. South-
Western. Porter, G. A., & Norton, C. L. (2010). Financial accounting: The impact on decision makers. South-Western. Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2010). Managerial accounting. Wiley. Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. How well do you know the unit material? Take the Unit VII Knowledge Check Quiz to find out! (PDF of Unit VII Knowledge Check Quiz)
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