Corporate Finance Short-Term Decisions

Corporate Finance
8. Financial Planning and Short-Term

Financial Decisions
Short-Term versus Long-Term Financial

Decisions
Long-Term Financial Decisions
Short-Term Financial Decisions
Not continuous, segregated by

projects and subject to a previous
valuation analysis.
A continuous process, giving way to a

permanent succession of current
assets (assets easily convertible in
cash).
Based on contracts carefully designed

(as complete as possible), preventing
unwanted transfers of value between
shareholders and creditors.
Although they may take a contractual

form (a loan contract), they will be
based
on
a general financing
agreement kept for a certain period.
Follow a determined strategic

orientation, in the company business,
as well in its capital structure.
Intimately associated with business

dynamics,
depending
of
its
characteristics and requiring financial
planning.
MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management
Short-Term versus Long-Term Financial

Decisions
At
Short-term
financing
Ac
At = total assets
Af
Long-term
financing
Ac = current assets
Af = fixed assets
Time
Summary
I.
Short-Term Financial Management
II. Liquidity Management
III. Trade Credit and Receivables Management

IV. Inventory Management
V.
Short-Term Financing
I. Short-Term Financial Management

Questions to be answered by short-term financial management
What amount of cash (or equivalent) should the company keep?
What amount (and period) of credit should the company grant to its clients?
How much short-term financing should the company raise?
In brief:
What is the optimal investment in working capital?

In order to answer these and other questions, company management
should identify correctly:
Business cycle
AIP
Operational cycle
AIP + ACP
Cash-flow cycle
AIP + ACP - APP
AIP = average inventory period;
ACP = average collection period;
APP = average payment period

Cash-flow cycle
Examples
Power supply companies

Health care equipment
Paper products
Restaurants
AIP
ACP
18
46
39
5
41
73
38
10
Operational
Cycle APP
59
119
77
15
31
17
26
14
Cash-flow
Cycle
28
102
51
1
Central values; study published by CFO magazine (2007)

Is there an optimal level of current asset investment?
Trade-off between:
Costs increasing with the amount of current asset investment (carrying costs)
Opportunity cost (usually, the return on these assets is lower than the required
cost of capital);
Holding costs;
Costs decreasing with the amount of current asset investment (shortage costs)
Trading costs: resulting from the need to sell assets in order to obtain liquidity;
Costs related with the non existence of a precautionary reserve: loss of sales; loss
of clients; disruption of the production process.

Total costs
Holding costs
Shortage costs
CA*
Current assets

It changes from one company to another
Companies with High Current

Asset Investments
Companies with Low Current

Asset Investments
Many growth opportunities
Little investment opportunities
High risk investments
Low risk investments
Small dimension
Big dimension
Low rating
High rating
Opler, Pinkowitz, Stulz and Williamson, The Determinants
and Implications of Corporate Cash Holdings, JFE (1999)
10

It changes from one company to another
Companies with High Current

Asset Investments
Total costs
Companies with Low Current

Asset Investments
Total costs
Shortage costs
Holding costs
Shortage costs
Holding costs
CA*
CA 0
CA*
CA
11

How should current assets be financed?
Seasonal variation of current assets
Permanent current assets
Total assets
Fixed assets (long-term)
12

Restrictive strategy
Short-term financing
Long-term financing
13

Flexible strategy
Investment in liquid assets
Long-term financing
14

The choice of strategy should take into account:
Big cash reserves:
They reduce the liquidity risk;

High opportunity cost;
Different maturities of assets and financing contracts:

Financing permanent assets with short-term debt increases interest rate risk,
because short-term rates are more volatile and short-term financing contracts can
be withdrawn at shorter notice.
Time structure of interest rates:
Long-term rates tend to be higher than short-term rates.
15

Short-term financial decisions (working capital management) include
the following areas:
Liquidity management;
Trade credit and receivables management;

Inventory management;
Short-term financing.
16
Summary
I.

V.
17
Coordination of collection and payment movements and use of
financing instruments in such a way to preserve the capacity of

the company to meet all financial obligations resulting from its
business operations.
18

For a better liquidity management, it is necessary:
Calculate, study and manage the business cycle and the cash cycle of the
company;
Understand every characteristic of the company business and its effect on

cash movements and on the formation of current assets (trade credit and
inventory).
19

To make liquidity management effective, it is necessary:
1. Ensure adequate liquidity levels of the company:
Effective matching of cash inflows and cash outflows;
Constitution of cash reserves (or else, negotiation of credit facilities);
2. Control daily cash-flows:
Monitor collections and process payments;
Monitor cash and bank deposit balances;
Exercise options included in credit facilities.
3. Ensure the prompt use of all excess cash resources.
20

4. To activate efficient short-term financing solutions, with respect to:
Cost of capital;
Flexibility of financing raising solutions;
Activation of funds.
5. Measure and control risks, namely liquidity risk and interest rate risk, what is
once again related with flexible contractual solutions.
21

6. Prepare cash-flow budgets:
Cash forecasts (for different time horizons) which allow the anticipation of liquidity
shortages and the activation of solution for those difficulties.
7. Gradually build balanced contractual relationships with providers of funding,

namely by establishing a network of banking relationships which proves
favourable to the company.
8. Systematically gather relevant information about every movements around

all classes of current assets and short-term debts.
22

Reasons to hold cash and liquid deposits:
Speculative motive:
Resources available to seize opportunities to buy goods and services for a lower price,
to make investments with attractive returns or, in the case of international

companies, take benefit of exchange rate fluctuations.
Preventive motive:
Resources to be used as a reserve to offer financial stability.
These motives may justify the holding of a given level of liquidity but not
necessarily under the form of cash or liquid deposits.
23

Reasons to hold cash and liquid deposits:
Transaction motive:
To ensure the payment of salaries, accounts payable, taxes and dividends;
As far as cash inflows (collections or new financing) might not be perfectly matched,
some amount of reserves will be necessary to meet unexpected obligations;
When unexpected obligations become recurrent, the company should consider the
possibility of raising new long-term financing.
Collateral
Minimum cash reserve, required by a financial institution in exchange of bank
services provided (guarantees, letters of credit or even new loans).
24

Costs from holding cash and liquid deposits
Opportunity cost:
Returns forgone by the company from the best alternative uses of its cash resources,
i.e., investments in highly liquid tradable securities.
Benefits from holding cash and liquid deposits

Saving of transaction costs (sale of tradable securities) or costs of short-term
financing go meet immediate obligations, sach as salaries and accounts
payable.
The optimal amount of cash reserve depends on this trade-off.
25

Situations to take into account in the application of excess cash and
liquid deposits holdings:
Maturity of investments interest rate risk;
Default risk;
Liquidity;
Taxes
26
Summary
I.

V.
27
Definition of the trade credit conditions to be offered to clients,

in businesses where sales depend on credit granting, in order
to maximize the commercial benefits of trade credit policy
adopted and contain the costs associated with it within the

limited defined by sales gross margin.
28

The components of trade credit policy:
Terms of sale:
Cash or term payment?
Cash payment discount? How much and for how long?
Which credit period? Which credit instrument?
Credit analysis:
Credit policy equal to every client or previous credit analysis to determine the risk of
default?
Collection policy:
Collection department? Outsourcing to a specialized company??
29

Terms of sale:
Usually pre-defined:
Cash payment discount (usually: 2-3%)
Period of discount (usually: 5-10 days after invoice)

Period of credit (usually: 60-90 days)
30

Terms of sale
Actual cost of cash payment discount
Example: 2% cash payment discount if payment is done within 10 days, or else total
invoice payment within 60 days
98
D + 10
100
D+60
50 dias
r (actual cost of cash payment discount):
98
100
(1 r )
50
365
r = 15,89%
The same represents the effective cost of credit for the client if he chooses to take
credit.
31

Terms of sale
Duration of credit period
Factors affecting the credit period granted by the company:
Degree of deterioration of goods
Goods of rapid deterioration (fresh fish, for example) represent a weak
collateral in case of default; in these cases, credit period tends to be short;
Consumer demand
Goods of high demand tend to be paid at shorter term, while new products tend
to be given longer credit periods, in order to attract clients;
Cost, profitability and standardization
Products relatively standardized, of low price and little profitability tend to be
given shorter credit periods (cars, for example).
32

Terms of sale
Duration of credit period
Factors affecting the credit period granted by the company:
Credit risk
The higher the credit risk the shorter the credit period;
Dimension of receivables account
The smaller the receivables amounts, the shorter the credit period, because
credit management costs become (proportionally) higher;
Competition
In more competitive markets, credit period tends to be longer;
Nature of clients
Different types of clients may mean different credit periods.
33

Terms of sale
Credit instruments
Invoice / delivery document
The company maintains a an account with the client where the invoice or the
delivery document prove that the goods have been delivered.
Promissory;
Letter of credit
Term or at demand.
34

Credit analysis
Factors to take into account:
Effect of credit in cash inflows (volume of sales and price);
Effect of credit on costs (collection period);

Cost of short-term financing;
Probability of default;
The value of cash payment discount.
35

Credit analysis
The cost / revenue trade-off model
Effect on the value of the company from offering one month credit period:
Revenue
(P v) x Q - (P v) x Q = (P v) x (Q Q)
PV [(P v) x (Q Q)] = (P v) x (Q Q) / R
Costs
P x Q + v x (Q-Q)
P = price per unit
v = variable cost per unit

Q = present monthly sales
NPV = [(P v) x (Q Q) / R] [P x Q + v x (Q-Q)] Q = new sales (after new

credit policy)
NPV = 0 (Q Q) = P x Q / [(P v)/R v]
R = required rate of return

(monthly)
36

Collection policy
Collections monitoring
Analysis of ACP;
Analysis of maturity of receivables;
Collection actions:
Letters demanding payment overdue receivables;
Phone calls;
Contracting a collection agent;

Legal action;
Factoring.
37
Summary
I.

V.
38
Defining rules for supply and holding of inventory, which

minimize its associated costs, namely financial costs of
inventory, administrative costs and shortage costs.
39

Types of inventory:
Raw materials;
Work in progress;
Finished products;
Goods.
40

Costs
Carrying (holding) costs
Storage;
Insurance and taxes;
Loss of value due to obsolescence;
Opportunity cost.
Shortage costs
Ordering costs (supply costs);
Opportunity costs (shortage cost)
Related to loss of sales, of clients or disruptions in production.
41

Methods of inventory management
The ABC method
Break down the stock into 3 (or more) groups
A 10% of products (per unit) representing the biggest amount of inventory;

C 50% of products (per unit) representing the lowest amount of inventory;
B the class in between;
Goods in group A are permanently monitored and their inventory levels are kept low;
Goods in group C are ordered in great quantities and their inventory levels are kept
high.
42

Method of economic order quantity (EOQ)
To minimize storage and ordering costs
Let:
Q quantity to order;
ka cost of storage per unit;
F fixed cost per order;
T sales per year;
Storage cost = Q/2 x ka
Ordering cost = F x (T/Q)
Minimum cost : Q*: Q*/2 x ka = F x (T/Q*)
Q* 2TxF
ka
43

Extensions
Safety inventory level
Determined as a function of shortage probability and costs
Minimum inventory
Safety inventory
0
Time
44

Extensions
Ordering point
Determined as a function of delivery time
Ordering point
Time
0
Delivery time
45

The special case of inventory dependent on the needs of other inventory
Material Requirements Planning (MRP)
Capacity to determine the inventory needs at early stages of the production

process, based on expected demand of final product;
Just-in-time (JIT)
Little inventory or no inventory;
Small quantities orders but very often;
It requires close cooperation with suppliers.
46
Summary
I.
III. Trade Credti and Receivables Management

V.
47
V. Short-Term Financing
Defining a financing supply function for the company, which

allows it to use the most efficient financing instruments to meet
eventual temporary shortages of liquidity.
48
In normal conditions:
Long-term financing should be used to finance investment in fixed assets and
in permanent working capital.

Short-term financing should be used to support liquidity management and to
deal with the instability of cash-flows in the company.
In practice:
Short-term financing has been too often used (in Portugal) as a surrogate of
long-term financing (in a system of roll-over), because of a believed easier
access to this type of financing (recently contradicted by reality).
49
Short-term financing does not differ from long-term financing with
respect to:
Financing cost evaluation (all-in);
Influence of:
Financial innovation;
Degree of development of the monetary markets;
Capacity of management to absorb financial innovation;
The presence of options.
50
Short-term financing instruments:
Bank loans;
Promissory discount;
Current account;
Documental credit;
Overdraft agreement;
Commercial paper;
Factoring.
The use of these instruments must be based on financial planning,
namely on a cash budget.
51
The choice of short-term financing instruments
The decision criteria should be the all-in cost. This is affected by:
The possibility of using alternatively the banking system and the monetary market
(using the latter requires better financial planning);
The relationship of the company with the banking sector
The company should not fall dependent on a reduced number of banks;
The company should take into account and make use of the flexibility
mechanisms available in some of these financing instruments.
52

Corporate Finance Short-Term Decisions

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Corporate Finance Short-Term Decisions

Uploaded by

Copyright:

Available Formats

Corporate Finance

8. Financial Planning and Short-Term

Short-Term versus Long-Term Financial

Short-Term Financial Decisions

Not continuous, segregated by

A continuous process, giving way to a

Based on contracts carefully designed

Although they may take a contractual

Follow a determined strategic

Intimately associated with business

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

Short-Term versus Long-Term Financial

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

Short-Term Financial Management

II. Liquidity Management

III. Trade Credit and Receivables Management

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. Short-Term Financial Management

What is the optimal investment in working capital?

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. Short-Term Financial Management

AIP = average inventory period;

ACP = average collection period;

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

APP = average payment period

I. Short-Term Financial Management

Power supply companies

Central values; study published by CFO magazine (2007)

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. Short-Term Financial Management

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. Short-Term Financial Management

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. Short-Term Financial Management

Companies with High Current

Companies with Low Current

Many growth opportunities

Little investment opportunities

High risk investments

Low risk investments

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. Short-Term Financial Management

Companies with High Current

Companies with Low Current

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. Short-Term Financial Management

Seasonal variation of current assets

Permanent current assets

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

Fixed assets (long-term)

I. Short-Term Financial Management

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. Short-Term Financial Management

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. Short-Term Financial Management

They reduce the liquidity risk;

Different maturities of assets and financing contracts:

Long-term rates tend to be higher than short-term rates.

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

I. Short-Term Financial Management

Trade credit and receivables management;

MIF/ME/MIM 2014/2015: Corporate Finance/Financial Management

Short-Term Financial Management