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CHAPTER 11FINANCING CHANGES IN SHORT-

TERM ASSET INVESTMENTS

ACCOUNTING AND FINANCE

FOR ENTREPRENEURS

EBD-301

Dr. David P. Echevarria

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WHY DO BUSINESSES BORROW MONEY?

• 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. Echevarria

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SOURCES OF SHORT-TERM FINANCING

• Spontaneous

• Trade Credit – Accounts Payable (inventory)

• Accrued Wages & Salaries Payable

• Planned

• Borrowing

• Short-term loans

• Line of credit

• Raising External Capital

• Selling equity

• Selling debtDr. David P. Echevarria

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FACTORS AFFECTING SHORT-TERM FINANCING STRATEGY

• 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. Echevarria

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WORKING CAPITAL MANAGEMENT REVISITED

• 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 CycleDr. David P. Echevarria

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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 liquidDr. David P. Echevarria

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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. Echevarria

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IMPACT OF LIQUIDITY CONSTRAINTS

• 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 SalesDr. David P. Echevarria

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FORMS OF COMMERCIAL TRADE CREDIT

• 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. Echevarria

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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 & InterestDr. David P. Echevarria

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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. Echevarria

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FINANCING INTERNATIONAL TRADE

• BANKERS’ ACCEPTANCES

• 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

• FORFAITING

• 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. Echevarria

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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. Echevarria

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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. Echevarria

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