COFIB3 - Week 2 - Current Asset Management.pptx

Financial Management

1. Financial Management 3B COFIB3-44 Eduvos (Pty) Ltd (formerly Pearson Institute of Higher Education) is registered with the Department of Higher Education and Training as a private higher education institution under the Higher Education Act, 101, of 1997. Registration Certificate number: 2001/HE07/008

2. Questions / Notes for Discussion Let’s Get Ready & Week 1 Review:

3. Week 2: Lesson 3 – CURRENT ASSET MANAGEMENT Learning Outcomes and Assessment Criteria: Learning Outcome 1: Discuss the objectives of financial statement analysis; calculate and interpret commonly used financial ratios. In this lesson, we will focus on the following Acs (The rest should be self-studied): 3.1 Explain the concepts relating to credit policy, creditworthiness, collection policy, and cash discounts.AC 3.2: Calculate the impact of a change in credit policy on profitability. AC 3.3: Analyse the impact of a change in credit policy: NPV analysis. AC 3.5: Calculate the level of working capital investment in current assets and discuss the key factors determining this level. AC 3.6: Calculate the economic order quantity and the optimal level of safety inventory. AC 3.7: Identify the types of short-term finance. AC 3.8: Determine the cost of trade credit in terms of foregone discounts. AC 3.11 Determine the cost of bankers’ acceptances (bank bills). Class exercises: Questions 12.17, 12.23, 12.24, 12.26 and 12.29.

4. CHAPTER 12 CURRENT ASSET MANAGEMENT AND SHORT-TERM FINANCING

5. 5 Credit Policy What are the costs associated with selling on credit? The cost of bad debts The cost of financing debtors The administrative costs of managing debtors In contrast: An optimal credit policy can enhance sales and maximise net profits in relation to relevant risks Credit sales reduce finished goods inventory and create accounts receivable Sales are pivotal to greater turnover and increase in profitability Some controllable factors of sales are: the quality of the product, the pricing and credit policy The credit policy involves making decisions regarding: creditworthiness Collection policy and Settlement discounts

6. 6 Creditworthiness The credit manager, in assessing the creditworthiness of a potential customer needs to consider the customer ’ s: Character_Attitude and commitment Credit history Cash Flow_Financial position Collateral_Security offered Capital_Equity Conditions_The environment in which the customer operates The state of the general economy will also impact on the decision. Why? The creditworthiness of any customer is enhanced when the economy is doing well and the customer’s business is performing well.

7. 7 Setting the Collection Policy The procedure for collection of overdue accounts could affect : sales, collection period, losses arising from bad debts and the percentage of customers taking discounts

8. 8 Setting Settlement Cash Discount Policy The use of settlement discounts encourages early payment The policy is determined by: Cost of discount -vs.- benefit of cash flow The benefits to this system are : It attracts customers who perceive discounts as price reductions It reduces the average collection period

9. 9 Analysing the Impact of a Change in Credit Policy on Profitability (net income) Management is primarily concerned with the balance between risk and return A change in credit policy would affect the following: The turnover of the firm and its gross profit The amount of receivables outstanding As credit quality has changed, there is likely to be a change in bad debt losses If there is a change in the discount policy , there will be a change in the cost of discounts

10. 10 Example: Analysis of a Change in Credit Policy The terms of the formula may be positive or negative All terms in this formula need not be used in a particular analysis e.g. a change in credit policy may increase the cost of a discount but have no impact on bad debts

11. 11 Analysis of a Change in Credit Policy Orix Ltd is changing its credit terms from : 3/15 net 30, to 5/10 net 60. All sales are on credit – 70% of customers currently take advantage of the 3% cash discount Under new credit policy: 60% of customers to take advantage of the cash discount and the average collection period to increase from 20 days to 30 days. Sales are to increase from R240m to R270m . Gross profit margin remains unchanged at 20% . Bad debts losses = 2% of sales. Opportunity cost = 10% per annum. The increase in gross profit will be : 20% x R30 000 000 = R6000 000

12. 12 Example 12.1 (continued) Increase in incremental investment–new and existing sales Expected incremental investment relating to existing sales=Increase in average collection period x existing turnover ÷ no of days in the year. The investment in relation to new sales will be the investment required to cover the cost of sales. Total = R6 575 342 + R1 972 603 = R8 547 945 Cost of carrying receivables = 10% x 8 547 945 = R854 795 Cost of bad debts = R720 000 [270m x 0.4 x 2% - 240m x 0.3 x 2% ] Cost of discounts = R3 060 000 [(270m x 60% x 5%) – (240m x 70% x 3%) ] Change in net income = R6 000 000 - R854 795 - R720 000 - R3 060 000 = + R1 365 205 Existing Sales New Sales

13. 13 Analysing the Impact of a Change in Credit Policy: NPV analysis Many firms evaluate credit policy on basis of changes in profitability The NPV analysis provides greater precision in analysing change in credit policy It is also important to analyse the cash flow effects of any change in policy

14. 14 Change in Credit Policy – Net Present Value Analysis Change in profitability as change occurs over a few months. Use NPV analysis for a greater precision of the effect of any change on the value of the firm. Example: Change to credit sales which will increase sales from 40000 to 48000 units per month. Selling price remains at R150 per unit. Variable cost is R100 per unit. Interest rate = 1% per month. No bad debts expected. Payment in 60 days.

15. 15 Change in Credit Policy – Net Present Value Analysis Change in annual profitability = R3 075 520 [refer to textbook for example]

16. 16 Accounts Receivable Management Management of accounts receivable starts with the decision to grant credit This is the responsibility of the credit manager who needs an effective accounts receivable control system An accounts receivable control system monitors the credit policy application. It helps prevent; the build up of receivables, the decline of cash flows, and increases in bad debts The total amount of accounts receivable is determined by: The volume of credit sales The average length of time between sales and collections Accounts receivable = credit sales per day x collection period

17. 17 Accounts Receivable Management: Aging Analysis Comparison of the average collection period to the credit terms Use Aging schedule to analysis status of debtors

18. Making money from offering credit What if the firm charges interest on overdue accounts? The business model of companies such as Truworths and Edgars depends on customers taking credit Income from sales and high interest rates charged to customers Offering credit means firms can increase gross profit margins, sales and interest income and increase customer loyalty 18

19. 19 Inventory Management Inventories consist of: raw materials, work in progress, and finished goods Inventory levels are influenced by sales and other factors such as the competitive environment and the industry sector The object of inventory management is to balance a set of costs: Inventory holding costs increase with larger inventory holdings Inventory ordering costs decrease with larger order sizes

20. 20 Inventory Management What are examples of inventory holding costs? Warehousing costs – rent & security Interest on funds invested in inventory Insurance Obsolescence Shrinkage What are examples of ordering costs? Transport costs per order Order initiation costs Receiving and management costs Quality control and verification costs Planning and production management due to smaller orders Sourcing costs

21. 21 Inventory Management Excessive inventories affect profitability: they have substantial carrying costs erode profit margins, and reduce the asset-turnover ratio Alternatively: minimal levels of raw material and work-in-progress inventories could disrupt the production process Adequate inventory levels of finished goods ensures that demand is met rapidly An accurate information system is important : computerised point-of-sales terminals

22. 22 Inventory Models The Economic Order Quantity( EOQ) model assumes that two types of costs exist: The holding cost - increases as order size gets larger The ordering cost – decreases as order size gets larger If carrying costs are added to ordering costs, the sum= total ordering and holding costs The intersection point = minimal total cost which is the EOQ The main assumptions of EOQ are: Sales can be forecasted perfectly Sales are evenly distributed throughout the year Orders are received with no unexpected delays

23. 23 EOQ Formula

24. 24 EOQ Graph

25. 25 Inventory Control Systems EOQ model establishes the optimum ordering quantity and the level of inventory An inventory ordering and control system is essential. Re-order points are determined by demand patterns Physical methods for re-order points can be used - bin/reserve bin system Computerised inventory-control systems automatically update inventory records Bar coding by means of an optical scanner updates inventory records Management should concentrate on high value items- 10% physical quality = 90% of value

26. 26 Inventory Management

27. 27 Inventory Management Example: “Keep-fit” books. Selling price is R400 and cost is R200 per book. The ordering cost is R125 per unit and the carrying cost is R50 per unit per year. Annual demand is 2 000 units per year. EOQ Average inventory is 100/2 = 50 units Total cost at EOQ is;

28. 28 ABC Inventory System Items are evaluated on their costs, frequency of usage, seriousness of being out of inventory, order lead time Category A: expensive, frequently used, long order lead times (monthly) Category B : less important and less frequently used Category C : unimportant and least frequently used

29. 29 Just-in-Time (JIT) Inventory Management Delivery of materials and components from suppliers just as they are required for production A business using JIT inventory system does not require warehousing and other storage facilities and holding costs are minimised. Efficiency and quality A small number of reliable suppliers - to deliver frequently and guarantee quality The aim of JIT is to reduce the total cycle time from raw material to sale

30. 30 Just-in-Time continued…the risks JIT has resulted in improvements in quality and reduction of costs But there are risks : the system is fully optimised, interdependencies are compounded and there are higher risks of shutdown companies should not rely on only one supplier for any component or material increases in insurance premiums and transportation costs higher risks of business disruption , increase in insurance risk and higher levels of inventory volatility of input pricing Hold inventories of components and materials that are critical, purchased from one supplier, and at a higher risk of disruption of supply.

31. 31 Cash Management Cash on hand = an opportunity cost as it earns low returns and results in a low asset turnover. Reasons for a firm to hold cash: Transactions Precautionary Speculative Loan covenants

32. 32 Cash Budgets The cash budget: A report showing a firm’s projected cash inflows and outflows over a specified period. Budgets can be monthly, weekly or daily The cash budget represents a forecast with expected values rather than actual values

33. 33 Cash Budget See Example 12.5 in the textbook

34. 34 Cash Budget Closing Bank Balances

35. 35 Cash Budgeting What is happening in our example? Company’s Sales But Cash Flow Growing firms often fail because they cannot manage the cash flow demands of growth.

36. 36 Working capital management relates to the investment in current assets and financing of current assets. Benefits, costs and risks of short-term finance ACCRUALS Accruals are continual recurring short-term liabilities – accrued wages, accrued taxes, accrued interest Accruals increase with increased turnover No interest is paid on funds raised through accruals Accruals are the result of external factors and depend on the level of production and turnover Financing Current Assets

37. 37 Financing Current Assets TRADE CREDIT Firms usually purchase from suppliers on credit. Trade credit= a spontaneous source of credit from business transactions. If sales double, then financing from creditors would probably double. If company purchases R100 000 per day, on terms net 30 days, then average accounts payable = R100000 x 30 = R3m. If credit terms are extended from 30 to 40 days, then we will raise R1m of finance. Trade credit- has no cost associated with it or has it? There is no interest cost unless overdue, but what about foregone discounts ?

38. Cost of Trade Creditor Finance 38

39. 39 Cost of Trade Creditor Finance Example: Orix Ltd purchases under terms of 2/10 net 30, but can delay payment for a further 17 days without penalty. Effective cost of trade credit is the cost of the foregone discount which is; D/(100-D) x 365/t 2/98 x 365/37 = 20.13% per year What is the cost of alternative financing. It may be optimal to borrow at a lower rate to take advantage of the discount. We assumed that the first 10 days of credit is available whether we take the discount or not, so the cost refers to the additional days credit if the discount is foregone.

40. 40 Cost of Trade Creditor Finance If the creditors adhere to 2/10, net 30 then cost is; 2/98 x 365/20 = 37.24% p.a. The cost above is determined by convention. What is the annual effective cost? Effective cost = [(2/98) (365/20) – 1] = 44.59%

41. 41 Factoring and Invoice Discounting Factoring means the company “sells” its accounts receivable to a factoring firm which effectively converts a credit sale, at a cost, into cash. The sale is either with or without recourse to the company. What does this mean? The factoring firm does the administration, collection and credit checking for the company. Costs include; service facility cost, finance cost and the factoring firm may hold a retention, say 20%, of the accounts receivable balance. Costs need to be set off against the savings in administration and collection costs that the firm will experience by factoring its debtors.

42. 42 Advantages of Factoring Expertise to evaluate credit risk of customer Proficiency in managing accounts receivable will mean a reduction in bad debts. Cost savings relating to administration, collection and legal expenses. Management is freed from managing debtors and can focus on operations. Company is no longer forced by circumstances to offer expensive cash discounts if the company is unable to obtain normal bank borrowings. Factor will evaluate the credit risk of the customer rather than the firm and this is useful if a company has large low credit risk customers such as Woolworths. Seasonality effects and staffing costs Note: A credit card is a form of factoring.

43. 43 Invoice Discounting Invoice discounting is similar to factoring except that the management of accounts receivable remains with the company. This means that the customer will not know that the accounts have been sold. Companies receive up to 80% of the value of the debtors with discounting but costs are lower than factoring.

44. 44 Bankers’ Acceptances (bank bills) The company will sell the bill at a discount to its maturity value. Ex. Co. issues bill for R1m, payable in 90 days and discounts this in the market for R0.986m. This is a discount yield. Cost = 14000/986000 x (365/90) = 5.76% Formula: PV = F(1+R(N/365)) Interest rate = (F/PV – 1)(365/N) Cost is lower than bank loans if company has a high credit rating.

45. Revolving credit facility Line of credit that company can access as required – up to an agreed limit Flexibility – only borrow as company needs funds thereby reducing the cost of finance Long-term or short-term facility Overdrafts and credit cards are two examples 45

46. Revolving credit example Example 46

47. 47 Short-term Financing: Advantages Lower cost Fast Lower credit checks and formalities No loan covenants and pre-payment penalties Flexibility & matching

48. Short-term Financing: Disadvantages Volatility of interest rates Risk that the banks will not extend the loan facility when it comes up for renewal 48

49. What Happens Next? To be completed before the next lecturer-led session (self-directed learning and assessments): Lessons 3’s Practice activities Read Lesson 4’s Notes What will be covered in the next lecturer-led session: Lesson 4 : Dividends and share buy-backs Assessments : Quiz 1: 14-16 October. Covers Weeks 0 – 2