powerpoint to accompany chapter 15 current liabilities management

PowerPoint to accompany

CHAPTER 15

Current liabilities management

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Learning Objectives

• Discuss the firm’s credit terms• See the effect of stretching accounts payable• Describe unsecured types of short term

credit• Describe secured types of short term credit• Explain how to use inventory as collateral

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Spontaneous liabilitiesSpontaneous liabilities are types of

funding that arise from the normal operations of the firm

• two main types- accounts payable- accruals

• advantages- unsecured short term financing (no pledging of

specific assets as collateral involved)- interest-free financing (no borrowing involved)

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Spontaneous liabilities

Accounts payable management involves maximising the time between purchase of supplies and paying the supplier (without damaging credit rating)

eg. if the terms are net 30, the account should be paid 30 days from the beginning of the credit period

result: ‘stretching’ accounts payable allows maximum use of interest-free loan

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Spontaneous liabilities In the CCC demonstration in Ch. 14, MAX Company

had an average payment period of 35 days, resulting in average accounts payable of $467,466.

Thus, the daily accounts payable generated by MAX was $13,356 ($467,466/35).

If MAX pays in 40 days instead of 30, its accounts payable would increase by $66,780 ($13,356 × 5), MAX’s cash conversion cycle would decrease by five days, and the firm would reduce its investment in operations by $66,780.

If this action did not damage MAX’s credit rating, it would be in the company’s best interest.

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Exercise

Now try to do problem 15-1 from the Gitman chapter 15 handout

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Spontaneous liabilities

Analysing credit terms involves choosing whether to pay invoices early or late

eg. if the firm is offered credit terms for N days that include a cash discount (CD), it has two options: to take the cash discount or forgo it

result depends on cost of forgoing cash discount

= CD/(100%-CD) x 365/N

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Analysing credit terms

Taking the cash discount If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no cost associated with taking a cash discount.

Lawrence Industries Ltd purchases $1,000 worth of merchandise on 27 February from a supplier extending terms of 2/10 net 30 End of Month (EOM).

If the firm takes the cash discount, it will have to pay $980 [$1,000 – (0.02 × $1,000)] on 10 March, thereby saving $20.

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Forgoing the cash discount If the firm chooses to forgo, or give up, the cash discount it should pay on the final day of the credit period. There is an implicit cost associated with forgoing a cash discount.

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.

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In the preceding example, Lawrence Industries could take the cash discount on its 27 February purchase by paying $980 on 10 March.

If the cash discount is forgone, payment can be made on 30 March (EOM).

To keep its money for an extra 20 days (from 10 March to 30 March), the firm must forgo an opportunity to pay $980 for its $1,000 purchase - it costs $20 to delay payment for 20 days.

Figure 15.1 shows the payment options open to the company.

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To calculate the cost of forgoing the cash discount, the true purchase price must be viewed as the discounted cost of the merchandise, - $980 for Lawrence Industries.

To delay paying for an extra 20 days, the firm must pay $1,000.

The annual percentage cost of forgoing the cash discount can be calculated using Equation 15.1.1

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where CD = the stated cash discount in percentage terms N = the number of days payment can be delayed by

forgoing the cash discount Substituting the values for CD (2%) and N (20 days) into

Eqn 15.1 results in an annualised cost of forgoing the cash discount of 37.25% [(2% ÷ 98%) × (365 ÷ 20)]

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Mason Products has four possible suppliers, each offering different credit terms. Except for the differences in credit terms, their products and services are identical. Table 15.1 presents the credit terms offered by suppliers A, B, C and D, respectively, and the cost of forgoing the cash discounts in each transaction.

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If the firm needs short-term funds, currently available from its bank at an interest rate of 13%, and if each supplier (A, B, C and D) is viewed separately, which of the suppliers’ cash discounts will the firm forgo?

For supplier A, the firm will take the cash discount. The cost of forgoing it is 37.24%. The firm will borrow the funds it requires from its bank at 13% interest.

With supplier B, the firm will forgo the cash discount. The cost of this is less than the cost of borrowing money from the bank (8.19% vs 13%).

With suppliers C and D, the firm should take the cash discount, since the cost of forgoing the discount is greater than the 13% cost of borrowing from the bank.

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Exercise


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Stretching accounts payable—that is, paying bills as late as possible without damaging its credit rating

Lawrence Industries was extended credit terms of 2/10 net 30 EOM. The cost of forgoing the cash discount, assuming payment on the last day of the credit period, was found to be 37.25 %.

If the firm stretches its account payable to 70 days without damaging its credit rating, the cost of forgoing the cash discount would be only 12.41%.

Stretching accounts payable reduces the implicit cost of forgoing a cash discount

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Exercise


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Do: 15-6 - Credit terms

Answer: a. (i) 1/15 net 45 date of invoice (ii) 2/10 net 30 EOM (iii) 2/7 net 28 date of invoice (iv) 1/10 net 60 EOM b.(i) 45 days (ii) 49 days (iii) 28 days (iv) 79 days

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Spontaneous liabilitiesAccruals are liabilities for services received for which payment

has yet to be made• examples: wages, taxes• eg. delay payment of wages and/or taxes result: interest free loan from workers, government Tenney Coy pays its employees at the end of each working

week. The weekly payroll totals $400,000. If Tenney changes the pay period to fortnightly (that is, one week later), the employees would in effect be lending the firm $400,000 each year.

If the firm could earn 10% annually on invested funds, this strategy would be worth $40,000 per year (0.10 × $400,000). By delaying payment of accrued wages in this way, the firm could save this amount of money.

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Unsecured sources of short term loans

Unsecured types of financing involve no collateral being pledged by the borrower

• bank loans are a common form

- typically in the form of an overdraft

- can be used by small firms and big firms

- provides funding for seasonal peaks

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Bank loan interest rates• prime rate = lowest rate charged by banks to

their best customers• fixed rate loan = loan with constant rate until

maturity (set at a fixed margin above the prime rate)

• floating rate loan = loan with variable rate (set at a flexible margin above the prime rate)

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Bank loan interest rate calculation• nominal rate of interest - equals the contract rate - reflects the borrower’s credit standing• effective rate• = (interest)/(amount borrowed) if interest paid at

maturity• discount loan rate = (interest) / (amount borrowed - interest)

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Calculating interest

Wooster Company wants to borrow $10,000 at a stated rate of 10% interest for one year. If the interest on the loan is paid at maturity, the firm will pay $1,000 (0.10 × $10,000) for the use of the $10, 000 for the year. The effective annual interest rate is 10%

If the money is borrowed at the same stated rate but interest is paid in advance, the firm still pays $1,000 in interest, but receives only $9,000 ($10,000 –1,000).

Thus, the effective annual interest rate in this case is: 1,000/9,000 = 11.1%

Paying interest in advance makes the effective interest rate (11.1%) greater than the stated interest rate (10%).

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Exercise


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Bank loan terminology• ‘overdraft’- a short term self liquidating loan subject to a

pre-determined limit- operates by allowing the borrower’s cheque

account to go into deficit

- may involve an interest charge on the unused portion of the overdraft

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line of credit An agreement between a bank and a business for

ongoing short-term finance by way of overdraft or bill facility

revolving line of credit An extended line of credit provided by a bank subject to

annual review. commitment fee The fee that is normally charged on a revolving credit

agreement. It often applies to the average unused balance of the borrower’s credit line.

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REH Coy has a $2 million revolving credit agreement with its bank. Its average borrowing under the agreement for the past year was $1.5 million. The bank charges a commitment fee of 0.5% on unused funds.

The average unused portion of the committed funds was $500,000 ($2 million – $1.5 million), so the commitment fee for the year was $2,500 (0.005 × $500,000).

REH also pays interest on the actual $1.5 million borrowed. If $160,000 interest was paid on the $1.5 million borrowed, the effective cost of the agreement was 10.83% [(160,000 + 2,500)/$1,500,000].

Although more expensive than a line of credit, a revolving credit agreement can be less risky from the borrower’s viewpoint, because the availability of funds is guaranteed.

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Clemens Cutters recently negotiated a $100,000 overdraft limit with bank A. The interest rate was set at 3% above bank A’s prime rate of 6.5% per annum.

Clemens Cutters overdrew its current account by $80, 000 on the first day of the agreement. The overdraft stayed at $80,000 for 30 days, rose to $98,000 during the next 30 days, fell to $75,000 on the next 30 days and was reduced to zero on day 91.

Bank A’s prime rate stayed at 6.5% for the first 30 days, fell to 6.25% for the next 30 days and rose to 6.75% for the next 30 days.

The unused overdraft limit charged by bank A is 2% per annum. Clemens Cutters would pay the following interest on the overdraft for the first 90 days:

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Overdraft interest: (Prime rate + excess)(period)(amount) Unused fee: (rate x period x unused balance)

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Bank loan terminology• ‘operating change restrictions’ are contractual

regulations the bank imposes on the borrower eg - regular financial statements - notification of major business changes• ‘compensating balances’ is an amount the bank

may require the firm to maintain in its cheque account

• ‘annual clean-ups’ require the borrower to keep a zero overdraft balance for N days per year

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EG borrows $1 million (10% pa interest rate) under a line of credit agreement and must maintain a compensating balance equal to 20% of the amount borrowed, ($200,000), in its cheque account. Thus, it can use only $800,000.

The firm pays interest of $100,000 (0.10 x $1 million). The effective annual rate is 12.5% ($100,000 ÷ $800,000).

If the firm has $200,000 or more in its cheque account, the effective annual rate is 10% because none of the $1 million borrowed is needed for the compensating balance.

If the firm has $100,000 balance in its cheque account, only an additional $100,000 needs to be tied up, leaving it with $900,000 of usable funds. The effective annual rate is 11.1% ($100,000 ÷ $900, 000).

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General formula for interest The general approach to calculating interest on

short-term financing is: Nominal Interest rate/(amount borrowed – all

deductions) = Nominal interest/(net amount received) Eg. A 10%, $1,000 loan with 20% compensating

balance and 0.5 % initiation fee, would be: 100/(1,000 – 200 – 5) = 100/795 = 12.58% Or, 0.1/(1 – 0.2 – 0.005) = 0.1/0.795 = 12.58%

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Bill and note finance• a ‘bill of exchange’ is a written, unconditional order

involving three parties for a specified sum to be paid on a specified date

the drawer is the issuing party (= borrower)

the acceptor agrees to pay ( = bank)

the endorser purchases the bill (= lender)

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Bill and note finance• ‘bank-accepted bills of exchange’ are bills

that have been accepted by a bank

• implications: the bank guarantees the credit risk the bill trades as a low-risk security the bill trades at a low yield the bill is highly liquid

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Bill and note finance

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Bill and note finance• ‘commercial bills of exchange’ are bills not

accepted or endorsed by a bank

• ‘promissory notes’ are short term unsecured commercial loan instruments

note: CBs need to be endorsed when transferred PNs are transferable without endorsement

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Bill and note finance interest calculation interest is determined by the size of the discount (D)

and length to maturity (N days)Example: Bertram Ltd issues $1m worth of P-notes with 90-day maturity at price of $980,000

At maturity, Bertram pays $1,000,000 to the lender

Solution: the 90-day interest rate is 2.04% (=$20,000/$980,000) and the effective annual interest rate is 8.41% = [(1+0.0204)4 -1] if the loan is rolled over each 90 days

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promissory notes normally have a yield of 2% - 4% below the prime bank lending rate. Firms are able to raise funds through the sale of bills and notes more cheaply than by borrowing from a commercial bank

Although the stated interest cost of borrowing through the sale of bills and notes is normally lower than the prime bank lending rate, the overall cost of bills and notes may not be cheaper than a bank loan.

Additional costs include the fees paid by most issuers to obtain the bank line of credit used to back the paper, fees paid to obtain third-party ratings used to make the paper more saleable, and flotation costs

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Secured sources of short term loans

Secured types of financing involve collateral being pledged by the borrower

• a ‘security agreement’ specifies the collateral held against the loan, including:

- nature of asset

- conditions of release

- rights of claim

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Ordinary collateral

lenders try to match collateral duration to loan length

a ‘percentage advance’ is a % of the asset’s book value that constitutes the principal

a service charge will be payable for the lender’s administration expenses

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Accounts receivable as collateral

a ‘pledge of accounts receivable’ involves using the firm’s accounts as security to obtain a loan

the pledging process involves scrutiny by the lender of the quality and value of the accounts

pledges can be on a notification or non-notification basis, depending on whether the account customer is informed their account is being used as collateral

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Factoring accounts receivable involves the outright sale of accounts receivable at

a discount to a bank (called the ‘factor’) in exchange for credit

Invoice discounting is the sale of accounts receivable to a discounter,

where the accounting function is retained by the firm

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Factoring and invoicing discounting agreements

a lender selects accounts for purchase based on acceptable credit risk

usually on a ‘non-recourse’ basis, which is an understanding that the factor accepts all credit risks

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Graber Company discounts its invoices. The discounter provides 80% of value of each invoice discounted to Graber within 48 hours, charges a 2% service fee and charges 1% per month interest (12% per year) on advances.

Graber wishes to obtain an advance on discounted invoices having a book value of $1,000 and due in 30 days. The proceeds to the company are calculated as follows:

The firm receives $772.20 now and the balance when the customer pays the discounter. The method used to calculate the amount advanced depends on the terms of the discounting agreement.

If both the discount service fee of $20 and the interest of $7.80 are included, the annual discounting cost for the transaction would be approximately 43% [($27.80/$772.20) × 12] – see next slide.

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Using inventory as short term collateral seen as second to accounts receivable as

collateral

advantage: inventory has greater market value than its book value

a ‘floating charge over inventory’ is a lender’s claim on the borrower’s inventory

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Prescott needs a loan of $125,000 for 60 days. The company’s bank offers a loan secured under a floating charge over inventory. The annual interest rate would be 14%, 5% above the bank’s prime rate.

The bank advances 40% of the average book value of the secured inventory. The company would have to put up $312,500 in book value of inventory as collateral—the loan required divided by the loan advance ratio ($125,000/0.40).

The cost of this loan is $2,917 ($125,000 × 14% x 2/12) - an effective rate of 2.33% [0.14/(2/12)] for two months ($2,917/$125,000) or the stated 14% rate annually [2.33% × (12/2)], assuming this is a single transaction.

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floor plan inventory loan An agreement under which the lender

advances 80 to 100% of the cost of the borrower’s saleable inventory items in exchange for the borrower’s promise to immediately repay the loan, with accrued interest, on the sale of each item.

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Exercise


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Questions for review• What are the key components of the firm’s credit

terms?• How does stretching accounts payable affect their

cost?• What is the difference between secured and

unsecured funding? What are the basic terms and characteristics of a

bank overdraft? How is interest calculated on amounts borrowed under an overdraft agreement?

• Explain three types of collateral.

powerpoint to accompany chapter 15 current liabilities management

Documents

cash discount cd

discount period

cost of forgoing cash

credit period result

analysing credit termsin

analysing credit termsforgoing

maxs credit rating

damaging credit rating