Chapter 1: Introduction to Corporate Finance

1.1. Corporate Finance and the Financial Manager

The financial manager coordinates the activities of the treasurer and the controller. The controllers
office handles cost and financial accounting, tax payments, and management information systems.
The treasurers office is responsible for managing the firms cash and credit, its financial planning, and
its capital expenditure.
A financial manager must be concerned with three basic types of questions:
- Capital budgeting
what are the long-term investments?
The process of identifying investment opportunities. The value of the cash flow generated by
an asset exceeds the cost of that asset.
Size
(how much cash do we expect to receive)
Timing
( when are we going to receive this)
Risk
( how likely will we receive it)
-

Capital Structure
Where do we get the financial aid from?
Is the specific mixture of long-term debt and equity the firm uses to finance its operations. The
goal is to decide if one structure is better than the other
How much should the firm borrow, by finding the best mixture? (this will effect both the
risk and the value of the firm)
What are the least expensive sources of funds for the firm?
The financial manager has to decide exactly how and where to raise money

Working Capital Management How are you going to manage everyday financial activities?
All the short-term assets and liabilities such as money owed to suppliers
Managing the firms working capital is a day-to-day activity that ensures that the firm has
sufficient resources to continue its operations and avoid costly interruptions.
How much cash and inventory should we keep on hand?
Should we sell on credit? What terms? To who?
How will we obtain needed short-term financing?

1.2. Forms of Business Organization

Three legal forms of business organizations:
Sole Proprietorship A business owned by a single individual
Owned by one person, least regulated form, easy to start, all the profits to owner BUT the
owner has unlimited liability for business debts (personal assets for payment). All business
income is taxed as personal income. The life of a sole proprietorship it limited to the owners
life span. There are limitations which makes it hard for a business to grow because of
insufficient capital.
Partnership
A business formed by two or more individuals or entities.
It is similar to a proprietorship except that there are two or more owners.
General partnership: all the partners share in gains or losses, and all have unlimited
liability for all partnership debts. The way partnership gains and losses are divided is
described partnership agreement. (ownership of a general partnership is not easily
transferred since it requires that a new partnership is formed.)
Limited partnership: one or more general partners will run the business and have unlimited
liability, but there will be one or more limited partners who will not actively participate in the
business. A limited partners liability for business debt is limited to the amount that partner
contributes in the partnership.(a limited partners interest can be sold without dissolving
the partnership)
Corporation
A business created as a distinct legal entity composed of one or more
individuals or entities
A corporation is a legal person separate and distinct from its owners.
It can borrow money and own property, can sue and be sued, can enter into contracts, it can
own stock in another company.
Forming a corporation involves preparing articles of incorporation and a set of bylaws(rules
describing how the corporation regulates its existence)

o
o

Advantages: ownership can be easily transferred (the life of the corporation is not
limited), the stockholders (owners) have limited liability for corporate debt (they can
only loose the investment) it can sell shares
Disadvantages: because it is a legal person, it must pay taxes (dividends is also
taxed double taxation= at the corporate level when they are earned and at personal
level when they are paid out)

LLC limited liability companys goal is to operate and be taxed like a partnership but
retain limited liability for owners (hybrid of partnership and corporation)
IRS Internal Revue Service will consider LLC as a corporation, thereby subjecting it to
double taxation, unless it means certain specific criteria
Another names for corporations: joint stock companies, public limited companies, limited liability
companies.
1.3. The Goal of financial Management
A fundamental question to ask: from the stockholders point of view, what is a good financial
management decision?
The goal of financial management is to maximize the current value per share of the existing
stock
Maximize the market value for the existing owners equity
The financial manager best serves the owners of the business by identifying goods and
services that add value to the firm because they are desired and valued in the free
marketplace
Corporate finance is the study of the relationship between business decisions and the value of
the stock in the business
the act Sarbox is intended to protect investors from corporate abuses.
Requires that each companys annual report must have an assessment of the companys
internal control structure and financial reporting
They must declare that the annual report does not contain any false statements
The annual report must list any deficiencies ininternal controls
It makes management responsible for the accuracy of the companys financial statements
Many public firms have chosen to go dark (the shares are no longer traded on the stock
exchange markets) (AIM - Alternative Investment Market)
1.4. The Agency Problem and Control of the Corporation
The relationship between stockholders and the management is called an agency relationship
Agency problem: the possibility of conflict of interest between the stockholders and
management of a firm
Agency cost refers to the costs of the conflict of interest between stockholders and management.
These cost can be indirect or direct. An indirect agency cost is a lost opportunity
Direct agency costs come in two forms:
Corporate expenditure (benefits management, cost the stockholders)
Expense that arise from the need to monitor management actions
Management may tend to overemphasize organizational survival to protect job security. Also,
management may dislike outside interference, so independence and corporate self-sufficiently may be
important goals.
Whether managers will act in the stockholders interest depends on 2 factors
1. Are managers goals aligned with stockholders goals? (this question relates to the way
managers are compensated)
o Managerial compensation is usually tied to financial performance in general and often
to share value in particular.
o Better performers within the firm will tend to get promoted. Managers who are
successful in pursuing stockholder goals can reap enormous rewards

2. Can managers be replaced if they do not pursue stockholders goals? (this question relates to
control of the firm)
o Control of the firm ultimately rest with stockholders
o Proxy fight is an important mechanism by which unhappy stockholders can act to
replace existing management. (proxy is the authority to vote someone elses stock)
o Another way that managers can be replaced is by takeover. Avoiding a takeover by
another firm gives management another incentive to act in the stockholders interest
Stakeholder: someone other than a stockholder or creditor who potentially has a claim on the cash
flows of the firm (employees, customers, supplies etc). Such groups will also attempt to exert control
over the firm, perhaps to the detriment of owners
1.5. Financial Markets and the Corporation
A financial market is just a way to bring buyers and sellers together.
Financial markets function as both primary and secondary markets for debt and equity securities.

primary markets refers to the original sale of securities by governments and corporations
o
o
o
o

the corporation is the seller, and the transaction raises money for the corporation.
Two types of primary market transactions: public offerings (selling securities to the
general public) and private placements (a negotiated sale involving a specific buyer)
Public offerings of debt and equity must be registered with the Securities and
Exchange Commission (SEC). registration requires the firm to disclose a great deal of
information before selling any securities
Debt and equity are often sold privately to large financial institutions such as life
insurance companies or mutual funds, to avoid regulatory requirements and the
expenses.

Secondary markets are those in which these securities are bought and sold after the original
of sale
o One owner or creditor selling to another (transferring ownership of corporate
securities)
o Investors are much more willing to purchase securities in a primary transaction when
they know that those securities can later be resold if desired.
o Two kinds of markets: auction and dealer (buy and sell for themselves, their own risk)
markets
Dealer markets in stock and long-term debt are called over-the-counter (OTC)
markets (refers to old over the counter buying securities)
An auction market or exchange has a physical location (dealer markets not)
in an auction market to match buyers and sellers. In a dealer market, the dealer
search for buyers and sellers
NYSE New York Stock Exchange
AMEX American Stock Exchange
NASD- National Association of Securities Dealers
TSE Tokyo Stock Exchange
LSE London Stock Exchange
Listing
Stocks that trade on an organized exchange are said to be listed on that exchange. To be listed firms
must meet certain minimum criteria. These differ from one exchange to another.

Chapter 2,Financial Statements and Cash Flow.

2.1 The Balance Sheet
Write-off by a company
The value of the companys assets that has been declined (Reducing net income). It is the reduction of
taxable income as recognition of certain expenses required to produce the income.

The Balance Sheet

Financial statements showing a firms accounting value on a particular date.

1. What a Firms owns
1. (Assets)
left side
2. What a Firms owes
2. (Liabilities) right side
3. The difference between the two
3. (Equity)
right side

1. Assets
Assets are items of Economic Value. The assets are classified as either current or fixed.
Fixed (Long Life)
4. Tangible: truck or a computer
5. Intangible: trademark or patent
Current (Life < 1 year)
6. Will convert to cash within 12 months: inventory, cash, and accounts receivable.
2. Liabilities
The liabilities are either current or long-term.
Current (Life < 1 year)
7. Have to be paid within 12 months: accounts payable
Long-Term
8. Not due in the coming year: a loan that needs to be due in five years.
Bond and bondholders is where companies borrow money from for the long term.
3. Equity (Shareholders-, Common- or Owners Equity)
The differences between Assets and Liabilities
The Balance Sheet Identity

Assets = Liabilities + Shareholders Equity

Net Working Capital

Current assets - Current liabilities.

This is positive in a healthy firm. This means that cash that will become available exceeds the cash
that must be paid over the same period. So basically you are able to pay off your debts.

Liquidity
The speed and ease with which an asset can be converted to cash.
Liquid Assets: Ease of conversion
An asset that can be easily sold has a high liquidity without losing significant loss of value for example
current assets.
Illiquid Assets: Loss of value
An asset that cannot be quickly converted to cash without a price reduction for example fixed assets
like tangible things. Intangible things will never convert to cash but are very valuable.
o

The more liquid a business is, the less likely it is to experience financial distress meaning
being in difficulty in paying debts or buying needed assets.
Downside is that liquid assets are less profitable to hold: cash holdings (just sit there, no
earnings). Therefore there is a trade-off between advantages of liquidity and forgone profits.

Residual portion: the amount left after the creditors are paid. This amount is for the equity holders.
Shareholders Equity

Assets Liabilities
Financial Leverage: the more debt a firm has, the greater is its degree of financial leverage.
It increases the potential shareholders reward, but it also increases the potential distress and
business failure (because you invest your assets).
GAAP: Generally Accepted Accounting Principles
The common set of standards and procedures by which audited financial statements are prepared.
The firms assets are book values (carried on the books) which mean that the balance sheet will show
the historical cost of the asset, not the cost of what it would be worth today.

Current Assets book value and market value might be somewhat similar since they are converted into
cash over a relative short span of time. For fixed assets this would be a purely coincidence.
Balance sheet is important for:
Supplier
size of accounts payable
Potential creditor
examine the liquidity and degree of financial leverage
Manager
can track things like cash and inventory on hand.
Keep in mind that the balance sheet does not show the value of the firm. Things like a good
management team, good reputation, and talented employees are not on there.
Accounting Value
Market Value

= in the books (historical value)

= right now, this moment value. (More interesting!)

2.2 The Income Statement

Income Statement
Financial statement summarizing a firms performance over a period of time (a quarter or year).

Revenues - Expenses = Income

The income statement starts off with the revenues and expenses of the company, followed by other
financial expenses like interest paid or taxes.
End the statement with Net Income (bottom line). Often expressed (EPS) earnings per share.
Earnings per share = Net income/Total Shares Outstanding
Dividends per share= Total Dividends/Total Shares Outstanding
Addition to retained earnings
The differences between net income and cash dividend. This amount is added to the cumulative
retained earnings account.
Matching Principle is first determining revenues and then match the revenues with the cost associated
with producing them.
The revenue is realized at the time of sales. The cost at the time of production.
However, the actual cash outflows may have occurred at some different time.
This means that the revenues and expenses are shown on the income statement may not be
all representative of the actual cash inflows and outflows.
Noncash Items
Expenses charged against revenues that do not directly affect cash flow, such as depreciation.
When a company purchased a new asset and writes it off over a five year period, then every
year an amount will be depreciation. This is just an accounting number, not real cash!
Because the company already paid for it when it purchased the asset.
Differences between accounting income and cash flow:
Accounting Income is the financial figure that you get after deducting all business expenses from
sales.
Cash Flow is the mechanism by which you see net cash generated or absorbed in business from
different activities.
Time and Costs
In the long run, all business costs are variable
In a relative short time horizon, some cost are Effectively fixed they must be paid no matter what
(property, taxes etc.)
2.4 Cash Flow
Cash Flow
The difference between the number of dollars that came in and the number that went out.
Cash Flow Identity

Cash flow from assets (CFA)= Cash flow to creditors (CFC) + Cash flow to stockholders (CFS)

The cash flow from a firms assets is equal to the cash flow paid to suppliers of capital to the firm.
Cash flow from assets
The total of cash flow to creditors and cash flow to stockholders, consisting of the following:
1. Operating Cash Flow cash results from day to day activities of producing and selling.
2. Capital spending net spending on fixed assets.
3. Change in Net Working Capital net change in current assets relative to current
liabilities.
1. Operating Cash Flow (OCF)
Cash generated from a firms normal business activities.
X Do not include depreciation (not cash outflow) and interest (financing expense).
+ Do include taxes.

Earnings before Interest and Taxes (EBIT)

You will add up the depreciation because this was not a cash outflow and you deduct the taxes.
A company uses its operating cash flow to see if its operations are sufficient enough to cover its
everyday cash outflow.
EBIT + Depreciation Taxes = OCF
2. Capital Spending (CAPEX)
Money that is spent on fixed assets less money received from the sale of fixed assets.
Net Capital Spending (NCS)

Ending net fixed assets beginning net fixed assets + depreciation

Net capital spending could become negative if a firm sold off more assets than it purchased.
3. Change Net Working Capital (NWC)
Companies are not only investing in fixed assets but also invest in current assets. Usually when a
company is investing in its current assets its liabilities will also change.
Change in NWC = Ending NWC Beginning NWC
Change in NWC is also called net investment or addition to NWC.
4. Conclusion
Another name for cash flow from assets is free cash flow. The name refers to cash that the firm if free
to distribute to creditors and stockholders because it is not needed for working capital or fixed asset
investment.
CFA = OCF NCS change in NWC
CFA = CFC + CFS
Cash Flow to Creditors and Stockholders
It represents the net payments to creditors and owners during the year.
1. Cash flow to Creditors (CFC)
A firms interest payments to creditors less net new borrowings.
CFC = Interest paid net new borrowing
Cash flow to creditor is also called flow to bondholders
2. Cash flow to Stockholders (CFS)
Dividends paid out by a firm less net new equity raised
CFS = dividends paid net new equity raised

Chapter 3, Working with Financial Statements

Ratios: to get a perspective of the financial position of a company
Firms do two different things:
- Generate Cash and spend it
Cash Flow from Assets = Cash Flow from Creditors + Cash Flow from Owners

Sources of Cash
A firms activities that generate cash
Selling products, assets or a security
Decrease in Assets / Increase in Liabilities
Uses of Cash
A firms activities in which cash is spend. Also called applications of cash
Buying assets (inventory/accounts receivable), payments (debts/notes payable)
Increase in Assets / Decrease in Liabilities
Statement of Cash Flow
A firms financial statement that summarizes the sources and uses of cash over a specified period
3 Categories:
- Operating activities
- Financing activities
- Investment activities
3.2 Standardized financial statements
Due to the fact that you need to have the same standards to make statements, you use standardizing
financial statements (by working with percentage instead of dollars)
Common-Size Statement
A standardized financial statement presenting all items in percentage terms. (easy to compare)
Balance sheet items
percentage of assets
Income statements
percentage of sales
Common-Base Statement
A standardized financial statement presenting all items relative to a certain base year amount
Combined Common-Size and Common-Base Statements
The reason for doing this is that as total assets grow, most of the other accounts must grow as well.
By first forming the common-size statements, we eliminate the effect of this overall growth
3.3 Ratio Analysis
Financial ratios
Relationship determined from a firms financial information and used for comparison purposes.
Another way of avoiding the problems involved in comparing companies of different sizes is to
calculate and compare
After calculating you are left with percentages, multiples, or time periods
Financial ratios are grouped in the following categories
1. Short-term solvency, or liquidity, ratios
2. Long-term solvency, or financial leverage, ratios
3. Asset management, or turnover, ratios
4. Profitability ratios
5. Market value ratios
Short Term Solvency, or Liquidity, Measures
The ratios are intended to provide information about a firms liquidity, and these ratios are
sometimes called liquidity measures.
Liquidity ratios are particularly interesting to short-term creditors
1. Current Ratio
the current ratio is a measure of short-term liquidity. The unit of measurement in either in dollars or
times.
To a creditor
the higher the Current Ratio, the better

 a high current ratio indicates liquidity, but is may also indicate an inefficient
use of cash and other short-term assets
A current ratio of less than 1 would mean that net working capital is negative, which is unhealthy for a
company
Current ratio = Current Assets/Current Liabilities

To a firm

2. The Quick (or Acid-Test) Ratio

The Quick Ratio is computed just like the current ratio, except inventory is omitted:
Quick Ratio = (Current Assets Inventory)/Current Liabilities

Relative large inventories are often a sign of short-term trouble. The firm may have
overestimated sales and overbought or overproduced as a result.
Using cash to buy inventory does not affect the current ratio, but reduces the quick ratio.

3. Other Liquidity Ratios

A very short-term creditor might be interested in the cash ratio
Cash Ratio = Cash/Current Liabilities
Net Working Capital to total Assets = NWC/Total Assets
You can see how long a business can keep running by looking at the Interval measure
Interval Measure = Current Assets/Average Daily Operating Costs
(the daily operating cost is often called the burn rate, meaning the rate at which cash is burned in the
race to become profitable)
Long-Term Solvency Measures
The ratios are intended to address the firms long-term ability to meet its obligations, or, more
general, its financial leverage.
Sometimes called financial leverage ratios or just leverage ratios.
1. Total Debt Ratio
It takes into account all debts of all maturities to all creditors
Total Debt Ratio = (Total Assets Total Equity)/Total assets
Whether this is high or low or whether it even makes any difference depends on whether capital
structure matters.
Debt-Equity Ratio = Total Debt/Total Equity
Equity Multiplier = Total Assets/Total Equity
The Equity Multiplier is equal to 1 + Debt-Equity Ratios
2. Total Capitalization versus Total Assets
Financial analysts are more concerned with a firms long-term debt than its short-term debt because
the short-term debt will constantly be changing. Also, a firms accounts payable may reflect trade
practice more than debt management policy. Long-term ratio
Long-Term Debt Ratio= Long-Term Debt/(Long-Term Debt + Total Equity)
Long-term debt + Total Equity is sometimes called total capitalization
3. Times Interest Earned (TIE)
Another measure of long-term Solvency. The ratio measures how well a company has its interest
obligations covered and it is often called the interest coverage ratio
Times interest earned ratio = EBIT/Interest
4. Cash Coverage
A problem with TIE ratio is that it is based on EBIT, which is not really a measure of cash available to
pay interest, since depreciation has been deducted out. Because interest is definitely a cash outflow
(to creditors) one way to define the cash coverage ratio is:
Cash Coverage Ratio = (EBIT + Depreciation)/Interest
EBIT plus depreciation is often called EBITD( Earnings before interest, taxes, and depreciation)
It is a measure of the firms ability to generate cash from operations, and it is frequently used as a
measure of cash flow available to meet financial obligations.
Asset Management, or Turnover, Measures

The measures in this section are sometimes called asset utilization ratios.
They are intended to describe how efficiently or intensively a firm uses its assets to generate
sales.

1. Inventory Turnover and Days Sales in Inventory

An indicator of how fast we can sell our products
Inventory Turnover = Cost of Goods Sold/Inventory
Days sales in Inventory = 365/Inventory Turnover
2. Receivables Turnover and Days Sales in Receivable
An indicator of how fast we can collect our sales
(also possible for payable turnover)
Receivables turnover = Sales/Accounts Receivables
Days sales in Receivables = 365/Receivables Turnover
This ratio is frequently called average collection period (CPA)
3. Asset Turnover Ratios
Several big picture ratios.
NWC turnover = Sales/NWC
This ratio measures how much work we get out of our working capital (a high value is preferred)
Fixed asset turnover = Sales/Net fixed assets
For every dollar in fixed assets, is generated in sales
Total asset turnover = Sales/Total Assets
For every dollar in assets is generated in sales
Profitability Measured
Intended to measure how efficiently a firm uses its assets and manages its operations (focus
on net income)
1. Profit Margin
All other things being equal, a relatively high profit margin is obviously desirable (low expense ratios
relative to sales)
Profit Margin = Net Income/Sales
A low profit margin does not have to be bad for a company our prices are so low that we lose money
on everything we sell, but we make it up in volume
2. Return on Assets (ROA)
It is a measure of profit per dollar of assets.
Return on Assets = Net Income/Total Assets
3. Return on Equity (ROE)
A measure of how the stockholders fared during the year. Because benefiting shareholders is our goal,
ROE is the true bottom-line measure of performance.
Return on Equity = Net income/Total Equity
ROA en ROE are accounting rates of return. These measures should properly be called return
on book assets and return on equity (ROE is sometimes called return on net worth)
Market Value Measures
The market price per share of stock, is not necessary contained in the financial statements.
These measures can be calculated directly only for publicly traded companies
Earnings per share (EPS) = Net Income/Shares Outstanding
1. PriceEarnings Ratio
It measures how much investors are willing to pay per dollar of current earnings (the higher, the more
potential growth the company has)
PE ratio = Price per Share/Earnings per share
if the firm had no or almost no earnings, its PE would also be quite large.

PEG ratio = PE ratio/expected future earnings growth rates. The idea behind this ratio is that
whether a PE ratio is high or low depends on expected future growth. (high PEG ratios
suggest that the PE is too high relative to growth)

2. PriceSales Ratio
Sometimes, companies will have negative earnings for extended periods, to their PE ratios are not
very meaningful Price-sales ratio
Price-Sales ratio = Price per share/Sales per share
Whether a particular price-sales ratio is high or low depends on the industry involved.
3. Market-to-book Ratio
It compares the market value of the firms investments to their cost. ( a value less than 1 could mean
that the company has not been successful overall in creating value for its stockholders.
Market-to-book ratio = Market value per share/Book value per share
Notice that book value per share is total equity divided by the number of shares outstanding
Because book value is an accounting number, it reflects historical costs.
Another ratio, called Tobins Q ratio, is much like the market-to-book ratio.
Tobins Q = market value of assets/Replacements cost of assets
Tobins Q = market value of equity&debt/Replacements cost of assets
The Q ratio is superior to the market-to-book ratio because it focuses on what the firm is worth today
relative to what it would cost to replace it today.
High Q = attractive investment opportunities/competitive advantage
Market-to-book ratio focuses on historical costs, which are less relevant
Q ratios are difficult to calculate with accuracy.
3.4 The Du Pont Identity
ROA and ROE, the difference between these two profitability measures is a reflection of the use of
financial debt financing, or financial leverage.
A closer look at ROE
Return on Equity = Net Income/Total Equity
Return on equity =

net income
Sales

Sales x
Assets

Assets
Equity

ROE = ROA x Equity multiplier = ROA x (1+ Debt-Equity Ratio)

ROE = profit margin x total asset turnover x equity multiplier
Du Pont Identity
Popular expression breaking ROE into three parts:
1. operating efficiency
(as measured by profit margin)
2. asset use efficiency
(as measured by total asset turnover)
3. financial leverage
(as measured by the equity multiplier)
Weakness in either operating or asset use efficiency (or both) will show up in a diminished
return on assets, which will translate into a lower ROE
ROE could be leveraged up by increasing the amount of debt in the firm (however, this also
increases interest expense, which reduces profit margins, and reduces ROE)
If a companys equity value declines sharply, its equity multiplier rises higher ROE
An Expanded Du Pont Analysis
Du pont can increase its ROE by increasing sales and also by reducing one or more of these costs.
Figure 3.1 Page 68 Fundamentals of Corporate Finance
3.5 Using Financial Statement Information

Why evaluate Financial Statements

The primary reason for looking at accounting information is that we dont have market value
information.
If there is a conflict between accounting and market data, market data should be given
precedence
Internal Uses
Managers and employees are frequently evaluated and compensated on the basis of
accounting measures of performance such as profit margin and return on equity.
(Performance evaluation)
Historical financial statement information is useful for generating projections about the future.
External Uses
Financial statements are imported for short-term and long-term creditors and potential
investors (parties outside the firm)
Financial statements are a prime source of information about a firms financial health
Financial statements are useful in evaluating our main competitor
Financial statement information would be essential in identifying potential targets and deciding
what to offer
Choosing a Benchmark
Time Trend Analysis
Management by exception a deteriorating time trend may not be bad, but it does merit
investigation.
Peer Group Analysis
The second means of establishing a benchmark is to identify firms similar in the sense that they
compete in the same markets, have similar assets, and operate in similar ways. (identify a peer group)
Standard Industrial Classification (SIC) code
a U.S. government code used to classify a firm by its type of business operations.
There are four-digit codes. Firms with the same SIC code are assumed to be similar
o The first digit in a SIC code established the general type of business. (>60 banks or
bank like businesses, >602 commercial banks, >6025 Federal Reserve System)
o It is not appropriate to blindly use SIC code-based averages.
Aspirant group is a group of the top firms in an industry (we aspire to be like them). In this
case a financial statement analysis reveals how far we have to go .
A new classification system: North American Industry Classification System (NAICS) is
intended to replace the old SIC codes.
Problems with Financial Statement Analysis
The basic problem with financial statements analysis is that there is no underlying theory to
help us identity which quantities to look at and to guide us in establishing benchmarks.
Major competitors and natural peer group members in an industry may be scattered around
the globe and financial statements from outside de US (for example) do not necessarily
conform to GAAP.
Different firms use different accounting procedures (difficult to compare statements)
Different firms and their fiscal years at different times (e.g. Seasonal businesses)
For any particular firm, unusual or transient events affect financial performance

Chapter 4 Long-Term Financial Planning and Growth

4.1 what is financial planning?
Long-range planning avoids financial distress and failure.
It is a mean of systematically thinking about the future and anticipating possible problems
before they arrive. Normally focuses on the big picture and concerned about the major
elements of a firms financial and investment policies.

The technique to use this is the percentage of sales approach.

Firms financial policy
Which directly affect its future profitability, need for external financing, and opportunities for growth.
Investment in new assets
Capital Budgeting
Arises from investment opportunities and capital budgeting decision.
Financial leverage
Structure Policy
The amount of borrowing to finance its investments.
Cash
Dividend policy
Amount which is necessary to pay shareholders
Liquidity and working capital
Net Work Capital Decision

Investment and financing policies interact.

Proper Prior Planning Prevents Poor Performance
Financial Planning formulates the way in which financial goals are to be achieved. What is to
be done in the future? It leads to long time implements.
The goal is to increase the market value of the owners equity. If this happens then growth will
usually result. It is a desirable consequence of good decisions making.
The short-range time period: 12 months
The long-range time period: 2-5 years
Planning Horizon: The long-range time period on which the financial planning process
focuses.
It is the first dimension of the planning process that must be established.
Aggregation: the process by which smaller investment proposals of each of a firms
operational units are added up and treated as one big project.
It is the second dimension of the planning process that needs to be determined.
A company always needs to be aware of different future scenarios: (3 years planning horizon)
1. Worst Case
Disaster planning, looking pessimistic towards the future, it would require details about cost
cutting and liquidation.
2. Normal Case
Requires most likely the assumptions about the company and economy.
3. Best Case
Optimistic, new products and expansion, financial details to fund the expansion.
Cyclical Business: businesses with sales that are strongly affected by the overall state of
economy or business cycles.
What will planning accomplish?
- Examining Interactions (where will the financing be obtained from?)
The link between investment proposals and its available financing choices.
- Exploring Options (what is the impact of a new investment?)
Develop, analyze and compare different scenarios.
- Avoiding Surprises (what may happen to the firm?)
The actions of a firm when things go seriously wrong. Goal is to avoid surprises and develop
contingency plans.
- Ensuring Feasibility and Internal Consistency
Specific goals. Financial planning is a way of finding out just what is possible and, by
implication, what is not possible.
4.2 Financial planning models
A financial plan is based on future assumptions which generate predicted values for variables.
-

Sales Forecast
The sales forecast will be used as the driver which means that the user will supply this value
and all other values will be based on this forecast.

The forecast will be given as the growth rate in sales and cannot always be perfect because of
the uncertain future state of economy evaluate alternative scenarios.
Forma (As a matter of form) Statements
The pro formas are the output from the financial planning model and includes a forecast:
Balance sheet
Income statement
Cash flows
The financial statements are the form we use to summarize the different events projected for the
future. (pro forma statements / pro forma the output from the financial planning model)
- Asset requirements
This shows the projected capital spending. It indicates the minimum amount a company must invest in
order to participate in an activity (changes is total fixed assets and net working capital) Affect the
capital budget.
- Financial requirements
Contains the financial agreements about the dividend and debt policy, raise cash by selling new
shares or by borrowing.
- The Plug
After the firm has a sales forecast and an estimate of the required spending on assets, the balance
sheet will no longer balance. Because new financing may be necessary to cover all of the projected
capital spending, a financial plug variable must be selected
The plug is the designated source or sources of external financial needed (EFN) to deal with
any shortfall (or surplus) in financing and thereby bring the balance sheet into balance.
- Economic Assumptions
The plan will have to state explicitly the economic environment in which the firm expects to reside over
the life of the plan. Also, assumptions of the level of interest rates and the firms tax rate have to be
made.
A simple Financial Planning Model
The way the liabilities and owners equity change depends on the firms financing policy and its
dividend policy. Growth in assets requires that the firm decide on how to finance that growth. This is a
strictly managerial decision.
4.3 The Percentage of Sales Approach
The amount of long-term borrowing is something set by management, therefore it does not directly
increase at the same rate as sales.
Percentage of sales approach: a financial planning method in which accounts are varied
depending on a firms predicted sales level
The Income Statement
Dividend payout ratio: the amount of cash paid out to shareholders divides by net income
Dividend payout ratio = cash dividends/Net income
Retention Ratio: the addition to retained earning divided by net income. Also called the plowback
ratio.(equal to 1 the dividend payout ratio)
Retention ratio = addition to retained earnings/Net income
The Balance Sheet
Capital intensity ratio: a firms total assets divided by its sales, or the amount of assets needed to
generate $1 in sales. (the higher the ratio, the more capital intensive the firm is)
Capital intensity ratio = total assets/sales
Long-term debt, common stock, and paid in surplus, are not applicable to the balance sheet since they
wont change automatically with a change is sales. We initially assume no change and simply write in
the original amounts.
How to finance: External Financial Needed (EFN)

- Short-term borrowing;
- Long-term borrowing; OR
- New equity
The choice is up to management.
Capacity Usage
Full-capacity sales = current sales/capacity usage in percentage
Ratio of fixed assets to sales = Fixed Assets/Full-capacity sales
4.4 External Financing and Growth
All other things staying the same, the higher the rate of growth in sales or assets, the greater
will be the need for external financing.
Again, growth is simply a convenient means of examining the interactions between the
investment and financing decisions
EFN and Growth

The need for new assets grows at a

much faster rate than the addition to
retained earnings, so the internal
financing provided by addition to
retained earnings rapidly disappears.
whether a firm runs a cash surplus
or deficit depends on growth.

Financial Policy and Growth

- The internal growth rate
The maximum growth rate a firm can achieve without external financing of any kind
Internal growth rate = ROA x b
1 ROA x b
B = plowback / retention ratio.
- The Sustainable Growth Rate
The maximum growth rate a firm can achieve without external equity financing while maintaining a
constant debt-equity ratio. (no increase in financial leverage)
Sustainable Growth rate =
ROE x b
1 ROE x b
- Determinants of Growth
ROE = profit margin X Total asset turnover X Equity multiplier
ROE will increase the sustainable growth rate by making the top bigger and the bottom smaller.
Increasing the plowback ratio will have the same effect
A firms ability to sustain growth depends explicitly on the following factors:
Profit margin: an increase will increase the firms ability to generate funds internally and
thereby increase its sustainable growth.
Dividend policy: a decrease in the percentage of net income paid out as dividends will
increase the retention ratio. This increase internally generated equity and thus increases
sustainable growth

Financial policy: an increase in the debt-equity ratio increases the firms financial leverage.
Because this makes additional debt financing available, it increases the sustainable
growth rate
Total asset turnover: an increase in the firms total asset turnover increases the sales
generated for each dollar in assets. This decreases the firms need for new assets as
sales grow and thereby increases the sustainable growth rate. (increasing total asset
turnover is the same thing as decreasing capital intensity)

The sustainable growth rate shows the relationship between the firms four major areas of concerns:
- Its operating efficiency as measured by profit margin
- Its asset use efficiency as measured by total asset turnover
- Its dividend policy as measured by the retention ratio
- Its financial policy as measured by the debt-equity ratio.
If sales are to grow at a rate higher than the sustainable growth rate, the firm must increase its profit
margin, increase total asset turnover, increase financial leverage, increase earnings retention, or sell
new shares.
If a firm does not wish to sell new equity and its profit margin, dividend policy, financial policy,
and total asset turnover (or capital intensity) are all fixed, then there is only one possible
growth rate.

Chapter 18,Short-Term Finance and Planning

Short-term financial management is often called working capital management.
18.1 Tracing Cash and Net Working Capital
Current assets
Cash and other assets that are expected to convert to cash within a year.
They are on the balance sheet in order of their accounting liquidity the ease with which they
can be converted to cash and the time it takes to convert them.
Cash, cash equivalents, marketable securities, accounts receivable, and inventories
Current liabilities
Obligations that are expected to require cash payment within one year (or operating period)
Accounts payable, expenses payable (wages & taxes), and notes payable
Net working capital + fixed assets = Long-term debt + equity
Net working capital = (cash + other current assets) liabilities
Cash = Long-term debt + equity + current liabilities current assets other than cash fixed
assets
(cash=LTD + Eq + CL CA (other than cash) FA)
Those activities that increase cash are called sources of cash
Those activities that decrease cash are called uses of cash
18.2 The Operating Cycle and the Cash Cycle
The primary concern in short-term finance is the firms short-run operating and financing activities
The activities create patterns of cash inflows and cash outflows
Defining the Operating and Cash Cycles
- The operating Cycle
The length of time it takes to acquire inventory, sell it, and collect for it.
Operating Cycle = Inventory period + Accounts receivable period
Definitions:
Operating Cycle: the period between the acquisition of inventory and the collection of cash
from receivables.
Inventory period: the time it takes to acquire and sell inventory

Accounts receivable period: the time between sale of inventory and collection of the
receivable
The operating cycle describes how a product moves through the current asset account.

- The Cash Cycle

The number of days that pass before we collect the cash from a sale, measured from when we
actually pay for the inventory
Cash cycle = Operating cycle Accounts payable period
Definitions:
Accounts payable period: the time between receipt of inventory and payment for it
Cash Cycle: the time between cash disbursement and cash collection
Cash flow time line
A graphical representation of the operating cycle and the cash cycle
a gap between short-term inflows and outflows can be filled either by borrowing or by holding
a liquidity reserve in the form of cash or marketable securities.
The gap can be shorted by changing the inventory, receivable, and payable periods.
The Operating Cycle and the Firms Organizational Chart
Table 18.1, Page 584 Fundamentals of Corporate Finance
Calculating the Operating and Cash Cycles
- The Operating Cycle
Inventory turnover = Cost of Goods Sold/Average Inventory
Inventory period = 365/Inventory turnover
Receivables turnover = Credit sales/Average Accounts Receivable
Receivables period = 365/Receivables Turnover

Receivables period is also called the days sales in receivables or the average
collecting period.
- The Cash Cycle
Payables turnover = Cost of Goods Sold/Average payables
Payable period = 365/Payables turnover
* note: average is the beginning and ending divided by
2.
18.3 Some Aspects of Short-Term Financial Policy
The short-term financial policy that a firm adopts will be reflected in at least two
ways:

The size of the firms investment in current assets: this is usually measured relative to the
firms level of total operating revenues. A flexible short-term financial policy would maintain a
relatively high ratio of current assets to sales. A restrictive short-term financial policy would
entail a low ratio of current assets to sale.
The financing of current assets: this measured as the proportion of short-term debt and longterm debt used to finance current assets. A restrictive short-term financial policy means a high
proportion of short-term debt relative to long-term financing, and a flexible policy means less
short-term debt and more long-term debt

The size of the firms Investment in Current Assets

Flexible short-term policies, such actions as:
Keeping large balances of cash and marketable securities
(costly)
Making large investments in inventory
Granting liberal credit terms, which results in a high level of accounts receivable. (stimulates
sales)

Restrictive short-term policies, has actions which are exactly the opposite.
It probably reduces future sales to levels below those that would be achieved under flexible policies.
Carrying costs:
(high in a restrictive policy)
Costs that rise with increases in the level of investment in current assets.
Carrying costs are the opportunity costs associated with current assets.
The rate on return on current assets is very low when compared to other assets.
Shortage costs:
(high in a flexible policy)
Costs that fall with increases in the level of investment in current assets
Shortage costs are incurred when the investment in current assets is low
If a firm runs out of cash, it will be forced to sell marketable securities. (if this is not possible
cash-out it may borrow or default on an obligation
A firm may lose customers if it runs out of inventory or if it cannot extend credit to customers
In general, two kinds of shortage costs:
Trading, or order, costs: order costs are the costs of placing an order for more cash or more
inventory
Costs related to lack of safety reserves: these are costs of lost sales, lost customer goodwill,
and disruption of production schedules.

Alternative financing policy for Current Assets

- An Ideal Case
In an ideal economy, short-term assets can always be financed with short-term debt, and long-term
assets can always be financed with long-term debt and equity. Net Working Capital is always zero.
(sawtooth pattern)
- Different Policies for Financing Current Assets
In the real world, it is not likely that current assets will ever drop to zero.
A growing firm can be thought of as having a total asset requirement consisting of the current assets
and long-term assets needed to run the business efficiently. The total asset requirement may exhibit
change over time for many reasons, like:
(1) A general growth trend
(2) Seasonal variation around the trend
(3) Unpredictable day to day and month-to-month fluctuations.
A firm might consider two strategies to meet its cyclical needs:
The firm could keep a relatively large pool of marketable securities. As the need for inventory
and other current assets began to rise, the firm would sell of marketable securities and use the
cash to purchase whatever is needed. Once the inventory was sold and inventory holdings
begin to decline, the firm would reinvest in marketable securities. (policy F)
The firm could keep relatively little in marketable securities. As the need for inventory and
other assets began to rise, the firm would simply borrow the needed cash on a short-term
basis. The firm would repay the loans as the need for assets cycled back down (policy R)
In the flexible case, the firm finances internally, using it own cash and
marketable securities. In the restrictive case, the firm finances the variation
externally, borrowing the needed funds on a short-term basis
Which financing Policy is the Best
There is no definitive answer. Several considerations must be included in a proper analysis

(1) Cash reserves: the flexible financing policy implies surplus cash and little short-term
borrowing. This policy reduces the probability that a firm will experience financial distress.
Firms may not have to worry as much about meeting recurring, short-run obligations.
However, investments in cash and marketable securities are zero net present value
investments at best.
(2) Maturity hedging: most firms attempt to match the maturities of assets and liabilities. They
finance inventories with short-term bank loans and fixed assets with long-term financing. Firms
tend to avoid financing long-lived assets with short-term borrowing. This type of maturity
mismatching would necessitate frequent refinancing and is inherently risky because short-term
interest rates are more volatile than longer-term rates
(3) Relative interest rates: short-term interest rates are usually lower than long-term rates ,this
implies that it is, on average, more costly to rely on long-term borrowing as compared to shortterm borrowing.
18.4 The cash Budget
Cash budget:
(primary tool in short-run financial planning)
a forecast of cash receipts and disbursements for the next planning period
Sales and Cash Collections
Cash Collections = Beginning accounts receivable + (days or receivable)/90 X sales
> 90 days for a quarterly cash budget
Ending Receivables = Beginning receivables + Sales - Collections
Table 18.2 Page 594 Fundamentals of Corporate Finance
Because beginning receivables are all collected along with half of sales, ending receivables
for a particular quarter will be the other half of sales.
Collections are a source of cash, other sources include: asset sales, investment income, and
receipts from planned long-term financing.
Cash Outflows
The cash disbursement, or payments. Four Basic categories
(1) Payments of account payable: these are payments for goods or services rendered by
suppliers, such as raw materials. Generally, these payments will be made sometime after
purchases.
(2) Wages, taxes, and other expenses: this category includes all other regular costs of doing
business that require actual expenditures. E.g. depreciation, it requires no cash outflow and is
not included as a regular cost of business. (wages, taxes etc. routinely 20 percent of sales)
(3) Capital expenditures: these payments of cash for long-lived assets.
(4) Long-term financing expenses: this category includes, for example, interest payments on longterm debt outstanding and dividend payments to shareholders.
Cash Balance
The predicted net cash flow is the difference between cash collections and cash disbursements.
Table 18.3 / 18.4 / 18.5 page 595/596 Fundamentals of Corporate finance

Chapter 20, Credit and Inventory Management

20.1 Credit and Receivables
Granting credit is making an investment in a customer an investment tied to the sale of a product or
service. This stimulates sales. However:
- There is the chance that the customer will not pay
- The firm has to bear the costs of carrying the receivables.
Therefore, the credit policy decision involves a trade-off between the benefits of increased sales and
the costs of granting credit.
Trade credit are receivables which include credit to other firms (when credit is granted.)
Credit granted consumers are called consumer credit

Components of Credit Policy

If a firm decides to grant credit to customers, then it must establish procedures for extending credit
and collecting. Components of credit policy:
(1) Terms of Sale: the terms of sale establish how the firm proposes to sell its goods and
services. A basic decision is whether the firm will require cash or will extend credit. If the firm
does grant credit to a customer, the terms of sale will specify the credit period, the cash
discount and discount period, and the type of credit instrument
(2) Credit analysis: in granting credit, a firm determines how much effort to expend trying to
distinguish between customers who will pay and the customers who will not pay. The firms use
a number of devices and procedures to determine the probability that customers will not pay;
these are called credit analysis
(3) Collection policy: after credit has been granted, the firm has the potential problem of
collecting cash, for which it must establish a collection policy.
The Cash Flows from Granting Credit

The Cash flow of Granting Credit

One way to reduce the receivables period is to speed up the check mailing, processing, and clearing.
The Investment in Receivables
The investment in accounts receivable for any firm depends on the amount of credit sales and the
average collection period (ACP).
Accounts receivable = average daily sales X ACP
Thus, a firms investment in accounts receivable depends on factors that influence credit sales and
collections.
20.2 Terms of the Sale
The term of sale are made up of three distinct elements:
(1) The period for which credit is granted
(2) The cash discount and the discount period
(3) The type of credit instrument
The Basic Form
Terms such as 2/10, net 60 mean customers have60 days from the invoice date to pay the full
amount; however, if payment is made within 10 days, a 2 percent cash discount can be taken.
Credit terms are interpreted in the following way:
< take this discount off the invoice price>/<if you pay in this many days>
<else pay the full invoice amount in this many days>
The Credit Period
Credit Period: The length of time for which credit is granted
It varies from industry, however it is almost always between 30 and 120 days.
If a cash discount is offered, then the credit period has two components: the net credit period
(length of time the customer has to pay) and the cash discount period (the time during which
the discount is available)
- Invoice date
The invoice date is the beginning of the credit period.

 An invoice is a bill for goods or serviced provided by the seller to the purchaser. It is usually
the shipping date or the billing date, not the date on which the buyer receives the goods or the
bill.
The term of sale might be ROG, receipt of goods. In this case, the credit period starts when
the customer receives the order.
With EOM (end of the month) dating, all sales made during a particular month are assumed to
be made at the end of the month. (MOM is middle of the month)
Seasonal dating is sometimes used to encourage sales of seasonal products during offseason (e.g. suntan oil)
- Length of the Credit Period
two important factors that influence the length of the credit period are the buyers inventory period and
operating cycle. The shorter these are, the shorter the credit period will be.
The operating cycle has two components: the IP and RP.
The buyers inventory period is the time it takes the buyer to acquire inventory, process it, and
sell it. (credit period we offer)
The buyers receivable period is the time it then takes the buyer to collect on sale.
By extending credit, we finance a portion of our buyers operating cycle and thereby shorten
that buyers cash cycle.
If our credit period exceeds the buyers inventory period we also finance part of the buyers
receivables.
The length of the buyers operating cycle is often cited as an appropriate upper limit to the
credit period.
Number of factors that influence the credit period:
(1) Perishability and collateral value: perishable items have relatively rapid turnover and relatively
low collateral value. Credit terms are thus shorter for such goods.
(2) Consumer demand: products that are well established generally have more rapid turnover.
Newer or slow-moving products will often have longer credit periods associated with them to
entice buyers. Also, sellers may choose to extend much longer credit periods for off-season
sales.
(3) Cost, profitability and standardization: relatively inexpensive goods tend to have shorter credit
periods. The same is true for relatively standardized goods and raw materials. These al tend
to have lower markups, and higher turnover rates, both of which lead to shorter credit periods.
(exception: Auto dealers)
(4) Credit risk: the greater the credit risk of the buyer, the shorter the credit period is likely to be.
(5) Size of the account: if an account is small, the credit period may be shorter because small
accounts cost more to manage, and the customers are less important
(6) Competition: when the seller is in a highly competitive market, longer credit periods may be
offered as a way of attracting customers
(7) Customer type: a single seller might offer different credit terms to different buyers. Sellers
often have both wholesale and retail customers, and they frequently quote different terms of
the two types.
Cash Discount
Cash discount: a discount given to induce prompt payment. Also sales discount
Discounts are offered to speed up the collection of receivables the effect of Reducing the
amount of credit being offered, against the cost of the discount
Another reason for discounts is that they are a way of charging higher prices to customers that
have had credit extended to them. ( a convenient way of charging for the credit granted to
customers)
- Cost of the Credit
To see why the discount is important we must calculate the cost to the buyer of not paying early.
(1) We must find the interest rate that the buyer is effectively paying for the trade credit.
E.G.
2/10 net 30
the order cost $1000
Then the interest rate is 20/980= 2.0408%
How many period are there in a year = 365/20= 18.25
The EAR Effective Annual Rate is:

EAR= 1.020408^18.25 1 = 44.6%.

- Trade Discounts
Is some circumstances, the discount is not really an incentive for early payment but is instead a
trade discount a discount routinely given to some type of buyer
The credit period and discount period are effectively the same and there is no reward for
paying before the due date.
- The Cash Discount and the ACP
To the extent that a cash discount encourages customers to pay early, it will shorten the receivables
period and, all other things being equal, reduce the firms investment in receivables.
ACP =Average Collection Period.
New ACP = ..% pays in .. days X .. Days + ..% pays in .. days X ..Days
E.G.
0.5 X 10 days + 0.5 X 30 days = 20 Days
If the firms annual sales are $15 million before discount $15 million/365 = 41.096
Receivables will fall with 41.096 X 10 = $410.960
- Credit Instruments
Credit instruments the evidence of indebtedness.
Open account: the only formal instrument of credit is the invoice, which is sent with the
shipment of goods. The customer must sign as evidence that the goods have been received
Promissory note: a basic IOU and might be used when the order is large, when there is no
cash discount involved, or when the firm anticipates a problem in collections. They can
eliminate possible controversies later about the existence of debt.
Commercial draft: calling the customer to pay a specific amount by a specified date (before
the goods are delivered)
Sight draft: immediate payments are required
Time draft: immediate payments are not required
Trade acceptance: when the draft is presenter and the buyers accept it (promise to pay in the
future)
Bankers acceptance: if the bank accepts the draft, meaning that the bank is guaranteeing
payment
20.3 Analyzing Credit Policy
Granting credit makes sense only if the NPS from doing so is positive
Credit Policy Effects
Five basis factors to consider
(1) Revenue effects: if the firm grants credit, then there will be a delay in revenue collections as
some customers take advantage of the credit offered and pay later. however, the firm may be
able to charge a higher price if it grants credit and it may be able to increase the quantity sold.
Total revenues may thus increase
(2) Cost effects: although the firm may experience delayed revenues if it grants credit, it will still
incur the costs of sales immediately. Whether the firm sells for cash or credit, it will still have to
acquire or produce the merchandise (and pay for it)
(3) The cost of debt: when the firm grants credit, it must arrange to finance the resulting
receivables. As a result, the firms cost of short-term borrowing is a factor in the decision to
grant credit
(4) The probability of nonpayment: if the firm grants credit, some percentage of the credit buyers
will not pay. This can happen, of course, if the firm sells for cash
(5) Time cash account: when the firm offers a cash discount as part of its credit terms, some
customers will choose to pay early to take advantage of the discount
Evaluating a proposed Credit Policy
P =Price per unit
v = variable cost per unit
Q = current quantity sold per month

Q = Quantity sold under new policy

R = monthly required return
- NPV of Switching Policies
Sales = P x Q
Variable cost = v x Q
Cash flow with old policy = (P v)Q
We do not need the fixed cost to calculate this since fixed cost and other components of cash flow are
the same whether or not the switch is made.
Cash flow with new policy = (P v)Q
Incremental cash inflow = (P v)(Q Q)
The incremental cash inflow says that the benefit each month of changing policies is equal to the
gross profit per unit sold, multiplied by the increase in sales.
The present value of the future incremental cash flows is:
PV = [(P v)(Q Q)] / R
now we know how to calculate the benefit of switching, but how to calculate the cost?
- We have to produce more units (Q Q)
- The sales that should be collected this month will not be collected(P x Q)
Cost of switching = PQ + v(Q Q)
NPV Of switching = - [PQ + v(Q Q)] + [(P v)(Q Q) / R
- A break-Even application
We can calculate the break-even point explicitly by setting the NPV equal to zero and solving for (Q
Q):
NPV = 0 = - [PQ + v(Q Q)] + [(P v)(Q Q) / R
Q Q = PQ / [(P v) / R v]
20.4 Optimal Credit Policy
The optimal amount of credit is determined by the point at which the incremental cash flows from
increased sales are exactly equal to the increment cost of carrying the increase in investment in
accounts receivable.
The Total Credit Cost Curve
The carrying costs associated with granting credit come in three forms:
(1) The required return on receivables
(2) The losses from bad debts
(3) The costs of managing credit and credit collections (cost of running the credit department)
These three cost will all increase as credit policy relaxed.
Credit cost curve
A graphical representation of the sum of carrying costs and the opportunity costs of a credit policy
Carrying cost are the cash flows that must be incurred when credit is granted. They are
positively related to the amount of credit extended
Opportunity costs are the lost sales resulting from refusing credit. These costs go down when
credit is granted
All other thing being equal, it is likely that firms with:
- Excess capacity
- Low variable operating cost AND
- Repeat customers

Will extend credit more liberally than other firms

Organizing the Credit Funtion
Factoring
An arrangement in which the firm sells its receivables. (e.g. to contract out the credit department)

The factor may have full responsibility for credit checking, authorization, and collection.
Smaller firms may find such an arrangement cheaper than running a credit department.

Captive finance company

A wholly owned subsidiarity that handles the credit function for the parent company (large firms do this
often)
To separate the production and financing of the firms products for management, financing,
and reporting. This may allow the firm to achieve a lower overall cost of debt than could be
obtained if production and financing were commingled
20.7 Inventory Management
Both credit policy and inventory policy are used to drive sales, and the two must be coordinated to
ensure that the process of acquiring inventory, selling it, and collecting on the sale proceeds smoothly.
Inventory will often exceed 15 percent of assets.
The Financial Manager and Inventory Policy
Inventory management has become an increasingly important specialty in its own right, and financial
management will often only have input into the decision.
Inventory Types
For a manufacturer, inventory is normally classified into one of three categories
- Raw material: what the firms uses as a starting point in its production process
- Work-in-progress: unfinished products. How big this portion of inventory is depends in large
part on the length of the production process
- Finished goods: products ready to ship or sell
Keep in mind three things concerning inventory types:
(1) The names for the different types can be a little misleading (one firms raw materials are
another firms finished goods.
(2) The various types of inventory can be quite different in terms of their liquidity (how easy to turn
into cash)
(3) The demand of inventory item that becomes a part of another item is usually termed derived
or dependent demand because the firms need for these inventory types depends on its need
for finished items. (opposite is independent)
Inventory costs
Carrying costs represent all of the direct and opportunity cost of keeping inventory on hand. These
include:
(1) Shortage and tracking costs
(2) Insurance and taxes
(3) Losses due to obsolescence, deterioration, or theft
(4) The opportunity cost of capital on the invested amount
The sum of these costs can be ranging roughly from 20 to 40 percent of inventory value per year.
The other type of cost associated with inventory is shortage costs. These costs are associated with
having inadequate inventory on hand.
Restocking costs: the cost of placing an order with suppliers or the costs of setting up a
production run.
Costs related to safety reserves: opportunity losses such as lost sales and loss of customer
goodwill that result from having inadequate inventory
A basic trade-off exists in inventory management because carrying costs increase with inventory
levels, whereas shortage or restocking cost decline with inventory levels.
The basic goal of inventory management is to minimize the sum of these two costs.
20.8 Inventory Management Techniques
The goal of inventory management is usually framed as cost minimization.

The ABC Approach

It is a simple approach to inventory management in which the basic idea is to divide inventory into
three groups. The underlying rationale is that a small portion of inventory in terms of quantity might
represent a large portion in terms of inventory value.
The Economic Order Quantity Model (EOQ)
the EOQ model is the best-known approach for explicitly establishing an optimal inventory level.
Inventory carrying cost rise and restocking costs decrease as inventory levels increase.
Minimum cost point is at Q* (figure 20.3 page 663)
The total amount of inventory the firm needs in a given year is dictated by sales. Therefore,
the actual cost of inventory is not included.
- The carrying costs
Carrying cost are normally assumed to be directly proportional to inventory levels
Total carrying costs = average inventory X
Carrying cost per unit
Q/2
X
CC
- The Shortage costs
We will assume that the firm never actually runs short on inventory, so that costs relating to safety are
not important
Restocking costs are normally assumed to be fixed
Total restocking costs =
fixed cost per order X number of orders
F
X
(T/Q)
- The Total Costs
Total costs = Carrying costs +
Restocking costs
(Q/2) X CC + F X (T/Q)
Our goal is to find the value Q, the restocking quantity, that minimizes cost
Carrying costs = Restocking costs
(Q*/2) X CC = F X (T/Q*)
Q*^2 = (2T X F)/CC
Q* = (2T X F)/CC
Economic Order Quantity (EOQ)
The restocking quantity that minimizes the total inventory costs.
Extensions to the EOQ model
Thus far, we have assumed that a company will let its inventory run down to zero and then reorder. In
reality, a company will wish to reorder before its inventory goes down to zero for two reasons:
By always having at least some inventory on hand, the firm minimizes the risk of a stock out
and the resulting losses of sales and customers
When a firm does reorder, there will be some time lag before the inventory arrives.
- Safety Stocks
A safety stock is the minimum level of inventory that a firm keeps on hand. Inventories are reordered
whenever the level of inventory falls to the safety stock level
- Reorder Points
The reorder points are the times at which the firm will actually place its inventory orders. This simply
occur some fixed number of days before inventories are projected to reach zero.
Safety stocks and reorder points together results in a generalized EOQ model in which the
firm orders in advance of anticipated needs and also keeps a safety stock of inventory
Managing Derived-Demand Inventories
Demand for some inventory types is derived from or dependent on other inventory needs.
Materials required planning and just-in-time inventory management are two methods for
managing demand-dependent inventories

- Materials Required planning (MRP)

A set of procedures used to determine inventory levels for demand-dependent inventory types such as
work-in-progress and raw materials.
Production and inventory specialists have developed computer-based systems (MRP) for
ordering and/or scheduling production of demand-dependent types of inventory
Especially important for complicated products for which a variety of components are needed
to create the finished products
- Just-in-time Inventory (JIT)
A system for managing demand-dependent inventories that minimizes inventory holdings.
Minimize inventory Maximizing turnover
It requires a high degree of cooperation among suppliers
Each large manufacturer tends to have its own keiretsu
JIT systems are sometimes called kanban systems (kanban is a signal to a supplier to send
more inventory)
A JIT system is an important part of a larger production planning process