TOPIC 3 Management of Current Liabilities.pdf

Introduction to management of current liabilities

1. WORKING CAPITAL
MANAGEMENT OF CURRENT
LIABILITIES
Short-term Financing1

2. Management of
Current Liabilities
1.Short term sources of funds which include
accruals, accounts payable, notes payable
and short-term loans (secured and
unsecured)
2.The repayment period is within one year
3.Secured sources involve the pledge of
specific assets as collateral in the event the
borrower defaults in payment of principal or
interest.
4.The primary suppliers are commercial banks,
finance companies and factors. The main
forms of security pledged are accounts
receivable and inventories.
Short-term Financing2

3. Accounts Payable
(Trade Credit)
1.Trade credit is a spontaneous source
of financing that arise from ordinary
credit purchases.
2.It is the most flexible source of short-
term financing for a firm.
3.The objective of the firm is to pay on
the last day of the supplier’s credit
term to allow the maximum use of an
interest-free loan from the supplier
Short-term Financing 3

4. Analyzing
Credit Terms
1.The firm should analyze credit
terms to determine its best
credit strategy.
2.If a cash discount is offered, the
firm has two options- to take
the cash discount or to give it
up.
Short-term Financing4

5. Taking the cash discount
1.If a firm intends to take a cash discount, it should pay on
the last day of the discount period.
2.There is no cost associated with taking a cash discount.
3.Example: WTW Ind., purchased RM1000 worth of goods
from a supplier extending terms of 2/10, net 30 EOM.
4.If the firm takes the cash discount, it will have to pay 98%
x RM1000 = RM980 with a saving of RM20.
Short-term Financing5

6. Giving up the cash discount
1.If a firm choose to give up the cash discount, it should pay
on the final day of the credit period.
2. The cost of giving up a cash discount is the implied rate
of interest paid to delay payment of an account payable
for an additional number of days.
Also known as annualized opportunity cost
Short-term Financing6

7. Giving up cash discount @
annualized opportunity cost
Cost of giving up cash discount = a x 360
(1-a) (c – b)
_% discount __ x 360_________
100% - % discount credit pd –discount pd
Example: Term 2/10 net 30:
Cost = 2% x 360 = 36.73%
100% - 2% 30 – 10

Short-term Financing7

8. Illustration 1
•Determine the cost of not taking cash discounts under each of
the following terms of sale.
–A) 2/10 net 30
–B) 2/10 net 90
–E) 3/15net 60
–F) 6/15 net 60
Short-term Financing8

9. Illustration 2
SuppliersCredit terms
A1/10 net 55
B2/10 net 30
C2/20 net 60
•Required:
a)Determine the annual
interest cost of not
taking the cash discount
from each supplier.
b)Assuming that the firm
needs short-term
financing, recommend
whether it would be
better not to take the
cash discount or to take
the discount and borrow
from a bank at 15%
annual interest. Evaluate each supplier separately,
using your findings in
part (a).
Short-term Financing9
The credit terms for each
of 3 suppliers are shown
in the following table:

10. Short-term Financing10
Bank Credit
1.Short-term bank loans appear on the
balance sheet as Notes Payable and they
are non spontaneous debt and unsecured
short-term credit known as short-term,
self-liquidating loan.
2.Maturities are usually one year or less,
with rates of interest depending on the
creditworthiness of the borrower and the
level of interest rates in the economy as a
whole.
3.Basic forms of bank loans are line of credit
and transaction loans.

11. Short-term Financing11
Line of Credit
1.Informal agreement between the bank
and the borrower in relation to the
maximum amount of credit provided at
any one time.
2.Interest is charged at a certain
percentage above the prime rate of
lending.
3.The borrower will be required to maintain
a minimum balance (10% - 20%) in the
bank throughout the period of the loan
(Compensating balance)

12. Short-term Financing12
Line of Credit
4.The bank has the right to revoke the credit
line if any major changes occur in the firm’s
financial condition.
5.The bank also require an annual cleanup –
which means that the borrower must have a
loan balance of zero for 30-40 day period
during the year
6.Interest rates may be calculated as simple
interest or discount interest.

13. Short-term Financing13
Transaction Loan
•Loans for a specific purpose
•Obtained by signing a promissory
note.
•Similar to line of credit
•Has a maturity of 30 days to 9
months.

14. Cost of Bank loans
5.Interest rates on bank loans are calculated in 2 ways:
1.Simple interest
2.Discount interest
Short-term Financing14

15. Short-term Financing15
Simple Interest Loan
1.The borrower receives the face value of
the loan and repays the principal and
interest at maturity.
2.Interest is charged on the basis of the
amount borrowed.
3.Effective annual rate = Interest
Amount Received
4. AR = AB
5. See pg 158

16. Short-term Financing16
Discount interest loan
1.Interest is calculated on the amount borrowed but
paid when the loan begins.
2.The bank deducts the interest in advance
(discounts the loan). Thus, the borrower receives
less than the face value of the loan. For example,
on a 1-year, RM10,000 loan with 12% rate,
discount basis, the borrower will obtain the use of
only RM10,000 – RM1,200 = RM8,800.
3.The effective annual rate =
Interest
Amount Received
= RM1,200/RM8,800 = 13.64%

17. Short-term Financing17
Discount Interest Loan
Amount borrowed = Amount received
or (face value of loan) 1 - nominal rate
Amount borrowed = RM8,800 = RM1 0,000
(1-0.12)
Effective annual interest = Interest
Amount Borrowed - Interest
AR = AB – I
See pg 159
•The effective cost is higher than simple
interest loan.

18. Short-term Financing18
Simple Interest with compensating
balance
1.The effective cost will increase unless the
firm has idle cash equal to or greater than
the balance required to cover the
compensating balance.
2.Amount Borrowed = Amount received
(1 – CB as a decimal)
3.CB = Principal x Compensating
amount balance stated
as a decimal
4. AR = AB – CB see pg 159, 160

19. Short-term Financing19
Discount Interest with Compensating
Balance
•Amt. Borrowed = Fund required
1- Interest – CB
•Effective cost = Interest
AB – Interest – CB
• AR = AB – I – CB
•See pg 162, 163

20. Short-term Financing20
Commercial Paper
1.Unsecured promissory notes issued only by
firms with high credit standing that are
financially sound.
2.Maturity varies from 30 days to 270 days.
3.Interest charges are usually lower compared
to bank loans.
4.May be issued directly to investors or placed
by dealers.
5.Interest is usually discounted, and a fee is
charged if placed by dealer.
6.See pg 167

21. Short-term Financing21
Advantages of Commercial Paper
1.Interest rates –are generally lower than
rates on bank loans
2.Compensating balance requirement – no
minimum balance requirements are
associated with commercial paper
3.Amount of credit – offers the firms with very
large credit needs a single source for all its
short-term financing.
4.Prestige – signifies credit status since only
the most creditworthy borrowers have
access to the commercial paper.

22. Short-term Financing22
Secured Sources of Loans
1.Accounts Receivable loans
1. Pledging Accounts Receivable
2.Factoring Accounts Receivable
2.Inventory loans
1.Floating lien agreement
2.Chattel mortgage agreement
3.Field warehouse financing agreement
4.Terminal warehouse agreement

23. Short-term Financing23
Pledging Accounts Receivable
1.Under pledging, the borrower simply pledges accounts receivables as collateral for a loan obtained from either a commercial bank or a finance company
2.The amount of the loan is stated as a percentage of the face value of the receivables pledged
3.After investigating the desirability and liquidity of the receivables, lender will normally lend between 50 and 90% of the face value of acceptable receivables.
4.In addition, to protect its interests, the lender files a lien (claim) on the collateral and is made on a non-notification basis. (the customer is not notified)

24. Short-term Financing24
Pledging Accounts Receivable
5.The interest charged is 2% to 5% higher
than bank’s loans. In addition, there is a
handling fee equal to 1% to 2% of
receivables pledged.
6.Look at example on page 168

25. Short-term Financing25
Factoring Accounts Receivable
1.Involves the outright sale of receivables at a
discount to a factor
2.Factor are financial institutions that specialize in
purchasing accounts receivable and may be
either departments in banks or companies that
specialize in the activity.
3.Normally done on a notification basis where the
factor receives payment directly from the
customer. In addition, most sales of accounts
receivable to a factor are made on a
nonrecourse basis. This means that the factor
agrees to accept all credit risk. Thus, if a
purchased account turns to be uncollectible, the
factor must absorb the risk.

26. Short-term Financing26
Factoring Accounts Receivable
4.The factor bears the risk of collection and
services the accounts for a fee.
5.Payments for factored accounts are made after
collection or when credit terms have been met
6.A firm can receive immediate payment for its
factored accounts by borrowing from the factor
using the factored accounts as collateral.
7.The maximum loan that may be obtained from
the factor is the face value of its factored
accounts less the factor’s fee, less the reserve
less the interest on the loan.
8.Look at example on pg 169.

27. Short-term Financing27
Inventory Loans
1.The most important characteristic of
inventory as collateral is its marketability
and perishability of the inventory.
2.Perishable items such as fruits or
vegetables may be marketable, but since
the cost of handling and storage is
relatively high, they are generally not
considered to be a good form of
collateral.
3.Specialized items with limited sources of
buyers are also generally considered not
to be desirable collateral.

28. Short-term Financing28
Methods of using Inventory to secure
short-term loans
1.Floating Lien Agreement.
2.Chattel Mortgage Agreement
3.Field Warehouse Financing Agreement
4.Terminal Warehouse Agreement