Download 1320771_bus106_lec_8_2015_cash_flow

BUS106
Lecture #8
Cash Flow Management
Prepared by
Simon Lenthen
University of Western Sydney
Presented by
Sarah Andrew
Managing net working capital
• Working capital: funds invested in current
assets
• Current assets: assets the entity expects to
convert to cash within the next 12 months
e.g., cash, debtors
• Net working capital: current assets minus
current liabilities
• Current liabilities: debts to be paid within next
12 months
e.g., creditors
2
Managing net working capital
continued
• Effective management of net working capital
involves
1. maintaining liquidity (i.e. ease of converting an
asset into cash)
2. the need to earn the required rate of return on
assets for investors (working capital that is too
high reduces return on equity)
3. the cost and risk of short-term funding (current
liabilities)
3
Deciding the appropriate level of
net working capital
• To achieve an appropriate level of net working
capital many firms use the hedging principle
• This means matching the maturity of the
source of funding with its use or cash flows
• To make the hedging principle more useful, it
is useful to think in terms of different 3
different sources of funding
4
Deciding the appropriate level of
net working capital continued
• Permanent sources
– funding with maturities > I year
e.g. long term debt, leases, shares
• Temporary sources
– short term finance
e.g. bank loans, commercial bills
• Spontaneous sources
– unplanned or unstructured funding
e.g. trade creditors, accrued expenses
5
Deciding the appropriate level of
net working capital continued
• Principles for using the various sources of
financing are:
– Permanent assets should be financed with
permanent and spontaneous sources of funding
– Temporary assets should be financed with
temporary sources of funding
6
Managing cash
• Entities manage cash in relation to the
following issues:
– the need to have sufficient cash to meet financial
obligations
– the timing of cash flows
– the cost of cash
– the cost of not having enough cash
7
The need for sufficient cash
• Need to have sufficient cash to meet financial
obligations
• Paying debts when they are due avoids
insolvency
• Managers face a trade-off between risk and
return when contemplating how much cash to
hold
• Cost may be minimised by holding as little
cash as possible, but risk is increased
8
The timing of cash flows
•
•
•
•
•
•
Cash Inflows
cash sales
credit sales, when the
debtors eventually pay
their accounts
sales of used or
unwanted assets
capital injections
short-term loans
long-term loan funding
•
•
•
•
Cash Outflows
purchase of inventories
purchase of labour,
materials and other
services
purchase of assets
(fixed or intangible)
payment of taxes.
9
The timing of cash flows
• The timing of most cash flows is normally
variable, the only exceptions probably being
the payment by the entity of wages and taxes
• Entities can plan the timing of the purchase
and sale of assets, and the requirements for
capital injections, to suit their needs.
• Similarly, in contracting for loans or placing
funds in the short-term money market, an
entity can negotiate timing that best suits its
own needs
10
The cost of cash
• Cost of holding cash:
– opportunity cost of holding currency or cash
deposits, rather than short-term securities
– cost of ensuring physical security of currency
• Electronic alternatives
– have reduced the amounts of currency handled by
entities
– but has increased costs elsewhere
11
The cost of not having enough
cash
• Not having enough cash at the required time
may result in the loss of the business
• A deficit in cash has the potential to become a
permanent condition — insolvency
• Temporary cash shortages may be overcome
by arranging emergency loans
• However, as a general rule, the more
desperate the need, the higher the cost of
emergency funds
12
Managing debtors: Benefits and costs of
granting credit
Benefits
Costs
• Increasing sales:
– new customers from
cash-only suppliers
– bring planned purchases
forward
– impulsive purchases
– customers who would
not otherwise have
purchased
• Reducing the cost of making
sales (eg., counter staff)
• Opportunity cost of funds
being tied up
• Cost of slow payers, bad
debts, specialist collection
services
• Cost of administering the
system
13
Determinants of the
level of debtors
• The level of debtors is determined by total
sales, credit policies and collection policies
• Total sales
The greater the total sales, the greater
the credit sales and the greater the
value of debtors.
14
Determinants of
the level of debtors
• The level of debtors is determined by total
sales, credit policies and collection policies
• Credit Policies
Credit policies may be broken up conveniently
into four aspects, all of which must be
managed.
• deciding to offer credit or not
• selecting suitable creditworthy
customers
• setting credit limits
• deciding payment terms.
15
Determinants of the
level of debtors
• The level of debtors is determined by total
sales, credit policies and collection policies
• Collection Policies &
Procedures
A decreasing average collection period (ACP)
may indicate more effective collection processes.
Conversely, an increasing ACP may indicate less
effectiveness in collections, too little
expenditure, or too lenient a credit policy.
16
Managing inventories
• Inventories or stock are normally a component
of current assets for most entities involved in
manufacturing or the sale of goods
• Types of inventories
– Raw materials
– Work in progress (WIP)
– Finished goods
17
Benefits and costs of holding
inventories
Benefits
Costs
• Sales are made and profits
gained
• Cross-sales are made and
profits gained
e.g lotto and card sales in a
newsagency
• Goodwill built up
• No-stock costs are avoided
• Ordering costs
– compounded if a large
number of small orders
• Holding costs
– Storage and display costs
– Insurance costs
– Deterioration and
obsolescence
– Wholesale price changes
– Theft
– Financing costs
18
Management techniques
1. Maintaining a minimum level of stock
– Either explicit or implicit level
2. Average inventory turnover period (ITP)
– Manages can decide on a number of days of
inventory to be held as optimum for the firm
Inventory turnover = Average inventory x 365 = x days
Cost of sales
19
Management techniques continued
– The need to reduce the funds tied up in inventory
over long periods of time is especially relevant to
‘just-in-time’ (JIT)
20
Sources of short-term finance
• The most common sources of short-term
finance for entities are:
– accrued wages and taxes
– trade credit
– bank overdrafts
– commercial bills and promissory notes
– factoring or debtor/invoice/trade finance
– stock/inventory loans or floor-plan finance
21
Calculating Creditor Turnover
• First, we must find the average trade creditors value
for each available year.
• We can now substitute into the equation and
compute the average settlement periods for the four
years, as follows
22
Sources of long-term debt finance
• Long-term debt finance is supplied to
borrowers through financial institutions
– acting as intermediaries, or
– directly by the debt markets
23
Intermediated finance
• Australian entities tend to first look to
financial institutions as suppliers of
intermediated finance
• Most financial institutions offer
– Fixed-rate business loans
– Variable-rate business loans
– Instalment loans
– Interest-only loans
– Fully drawn advances
– Lease finance
24
Intermediated finance continued
• Leasing is a significant form of finance for
entities
• Leasing options and products include:
– Novated leases
– Hire-purchase agreements
– Finance leases
– Operating leases
25
Debt finance from the Australian
market
• Entities wanting to raise debt finance from the
Australian market have the following methods
to choose from:
– Corporate bonds (unsecured)
– Notes (unsecured)
– Debentures (secured)
26
Equity finance
• At certain times, owners of entities may wish
to expand their businesses or liquidate some
or all of their ownership by selling ownership
rights or shares to other investors
• This is performed through selling
– ordinary shares (most common)
– preference shares
27
Ordinary shares
• No fixed maturity date – but they can be
consolidated or split
• Payments attached to ordinary shares are
called dividends – decided by directors out of
profits
• Ranked last in the event of the company
winding up
28
Preference shares
• Hybrid form of capital, but lean more towards
equity than debt
• Usually have a fixed dividend
• Rank ahead of ordinary shares in the event
that company winds up
• Owners cannot buy them partly paid (like
ordinary shares) and owners have no voting
rights
29
Rights and options
• Rights issue — issue of new shares to existing
shareholders
• They are either:
– Renounceable (i.e. investors are free to sell their
rights to subscribe on the market) or
– Non-renounceable (cannot sell their rights)
• Options confer the right to subscribe to shares
in the future at a price and time which are
pre-determined
30
Hybrid finance
• Hybrid debt securities are securities that have
characteristics of both debt and equity
• The principal hybrid securities are
– convertible notes (pay interest)
– convertible preference shares (pay dividends)
• Both convert to ordinary shares at maturity
31
International sources of funding
• Australia relies heavily on overseas capital as a
source of funds to assist in our development
• Foreign investment in Australian industry
occurs when overseas investors make
– direct equity investments (lend directly), or
– portfolio investments in equities or debt
32
International sources of funding
continued
• Direct investment
– Capital invested in an enterprise by an investor
that has significant influence over the key policies
of the enterprise
• Portfolio investment
– Where the investor has no control over the key
policies of the enterprise
33
Summary
• Working capital consists of funds invested in
current assets
• Entities must manage their cash, debtors and
inventory as these are their most liquid assets
• Firms have a large number of short term
finance options
• Long-term debt may be borrowed through
financial institutions as intermediaries or
directly by the debt market
34
Summary continued
• Equity finance instruments consist of ordinary &
preference shares, rights & options
• Hybrid debt securities are securities that have
characteristics of both debt and equity with the
principal hybrid securities being
– convertible notes
– convertible preference shares
• Countries like Australia and New Zealand have
traditionally relied heavily on overseas capital as
a source of funds to assist in their development
35
Summary continued
• Equity finance instruments consist of ordinary &
preference shares, rights & options
• Hybrid debt securities are securities that have
characteristics of both debt and equity with the
principal hybrid securities being
– convertible notes
– convertible preference shares
• Countries like Australia and New Zealand have
traditionally relied heavily on overseas capital as
a source of funds to assist in their development
36
Homework
• Chapter 13
• CQ: 13.1, 13.3
• SAP: 13.24, 13.30
37