1. C HAPTER 11 F INANCING C HANGES IN S HORT - T ERM A SSET I NVESTMENTS A CCOUNTING AND F INANCE FOR E NTREPRENEURS EBD-301 Dr. David P. EchevarriaAll Rights Reserved1

2. W HY D O B USINESSES B ORROW M ONEY ? Most frequent reason why businesses borrow is to finance growth Finance additional working capital Cash Increase Receivables Acquire more inventory Finance additional fixed assets Equipment Real Estate: land, buildings, rolling stock Dr. David P. EchevarriaAll Rights Reserved Slide 2

3. S OURCES OF S HORT - TERM F INANCING Spontaneous Trade Credit – Accounts Payable (inventory) Accrued Wages & Salaries Payable Planned Borrowing Short-term loans Line of credit Raising External Capital Selling equity Selling debt Dr. David P. EchevarriaAll Rights Reserved Slide 3

4. F ACTORS A FFECTING S HORT - TERM F INANCING S TRATEGY Current Cash Position of Business Desired levels of Working Capital Restrictive Loan covenants (existing debt) Economic Conditions Nature of Cash Inflows and Outflows Seasonal effects Efficiency of credit collection Dr. David P. EchevarriaAll Rights Reserved Slide 4

5. W ORKING C APITAL M ANAGEMENT R EVISITED Short-Term Assets Cash Accounts Receivable Inventory Prepaid Expenses Short-Term Liabilities Accounts Payable (terms for trade credit) Accrued Expenses (wages, taxes, etc.) Notes Payable (S-T bank loans) Efficiency of Cash Conversion Cycle Dr. David P. EchevarriaAll Rights Reserved Slide 5

6. OWNER’S WORKING CAPITAL RISK PREFERENCES Working Capital Management Strategy Aggressive Current and quick ratios close to 1 and < 1, respectively Minimal cash on hand Middle of the road Current and quick ratios close to 2.0 and 1.0, respectively Able to pay maturing obligations Conservative Current and quick ratios close to >>2 and >>1, respectively Highly liquid Dr. David P. EchevarriaAll Rights Reserved Slide 6

7. SALES GROWTH AND PRODUCT LIFE CYCLES Mature product cycles require resources to develop and replace aging product lines Periods of rapid sales growth will require more cash to finance receivables and invest in more inventory Availability of bank loans and favorable trade credit terms a must High percentage of net income must be reinvested in business Dr. David P. EchevarriaAll Rights Reserved Slide 7

8. I MPACT OF L IQUIDITY C ONSTRAINTS Ability to increase bank borrowing may be restricted by prior loan covenants Required to maintain minimum liquidity ratios Need to carefully plan use of trade credit and accrued expenses [See Equation (11.1)] : Tying magnitude of change in inventory to change in Trade Credit (A/P) Importance of sensitivity analysis (Figure 11.1) Importance of Cash Sales Dr. David P. EchevarriaAll Rights Reserved Slide 8

9. F ORMS OF C OMMERCIAL T RADE C REDIT Open Accounts Vendor gives its customers the ability to order on credit so long as the accounts are up to date Consignment Vendor retains title to the goods it “sells” to the buyer Floor Plan Financing Manufacturer finances dealer’s inventory Dr. David P. EchevarriaAll Rights Reserved Slide 9

10. SHORT-TERM BANK BORROWING Uncollateralized Loans Funds lent on basis of good credit history of borrower Typically of short duration: less than 3 years Collateralized Loans By receivables (assignment or pledging) By goods (inventory) Other assets with a cash value (insurance policy) Loan Type Regular: principal and accrued interest due at maturity Installment: monthly payments of Principal & Interest Dr. David P. EchevarriaAll Rights Reserved Slide 10

11. SHORT-TERM BANK BORROWING Cost of Add-on Interest Loan Rate = Interest $ / Loan Amount Cost of Discount Loan Rate = Interest $ / (Loan Amount – Interest $) Installment Loan: (Approx. Annual Percentage Rate) AAPR = (2 x n x Interest Rate) / (m + 1) Where: n = number of annual payments and m = total payments. Line of Credit: interest charges same as credit card Dr. David P. EchevarriaAll Rights Reserved Slide 11

12. F INANCING I NTERNATIONAL T RADE B ANKERS ’ A CCEPTANCES Bankers’ Acceptances represent a term loan to an importer. The bank may retain the loan on its books or sell the acceptance in the secondary market F ORFAITING Essentially the purchase of foreign receivables by a third party Non-recourse is typical Goods sold are not used as collateral for a loan to pay the seller Financing can be up to 5 years Dr. David P. EchevarriaAll Rights Reserved Slide 12

13. HOMEWORK QUESTIONS 1. The business has three sources for financing increases in short term assets. What are they and how do they impact the current ratio? The quick ratio? 2. How does the focus of working capital management differ from the notion of net working capital management? 3. If you where constructing a model of the business’s cash flows, how would you specify the relationship between inventory and accounts payable in terms of cause and effect? 4. How does the description of payables and accruals as spontaneous sources differ from their description as planned outflows? 5. There are three major working capital management strategies; conservative, moderate, and aggressive. How do they differ in terms of liquidity ratios? Cash ratios? In what market-demand environments are they most likely to be used in successfully? Dr. David P. EchevarriaAll Rights Reserved Slide 13

14. HOMEWORK QUESTIONS 6. Why do some high-growth businesses seem to experience liquidity problems? 7. How might businesses anticipating high growth episodes prepare themselves from a working capital point of view? Where in the product’s life cycle are businesses most likely to experience high growth rates? 8. If you were asked to develop the organizational outline of a cash management system with built in checks and balances, what kinds of requirements would you specify? 9. What benefits can be derived from good vendor relationships? 10. What are the benefits of an open account? Floor plan financing? Consignment? Dr. David P. EchevarriaAll Rights Reserved Slide 14