INTRODUCTION TO

WORKING CAPITAL
MANAGEMENT
Outline
Working Capital Defined
Goals of working capital management
Cash Conversion Cycle
Working capital policies

WORKING CAPITAL
MANAGEMENT
Net Working Capital = Current Assets - Current Liabilities

Assets Liabilities
Cash 10 Accounts Payable 30
Accounts Receivable 20 Short-term Bank Loan 20
Inventory 40 Current Liabilities 50
Current Assets 70 Long-term Loan 20
Fixed Assets 30 Shareholders Equity 30
Total Assets 100 Total Liabilities and Shareholders Equity 100
Doug's Distributors Inc.
December 31, 2002
Balance Sheet
WORKING CAPITAL
MANAGEMENT
Goals of Working Capital Management:

1. Stimulate sales by offering customers credit
(accounts receivable) and ready goods for sale
(inventory) Increase Profits
2. Minimize costs by balancing production and
sales levels through inventory Increase Profits
3. Secure low cost financing Increase Profits
4. Reach above 3 goals but never run out of cash by
having enough cash and marketable securities on
hand and/or by limiting use of short-term debt

WORKING CAPITAL
MANAGEMENT
Issues to Study:

1. What types and amounts of current assets should
a firm hold?

2. What types and amounts of short-term financing
should a firm employ?

3. How do firms ensure they have enough cash to
meet on-going obligations?

4. How do firms forecast their cash needs?


Cash Conversion Cycle for a
Manufacturing Firm
Purchase of Raw
Materials
Sale on
Credit
Cash Received
From Credit Sale
Inventory
Conversion Period
Average
Collection Period
Operating Cycle
Cash Conversion Cycle
Payable
Deferral Period
Cash Outlay
MANAGEMENT OF CASH
CONVERSION CYCLE
Cash Conversion Cycle = (Operating Cycle) - (Accounts
Payable Deferral Period)
1. Operating Cycle = The time between ordering or raw
materials and receiving cash from credit sales
2. Inventory conversion period = time required to order,
produce and sell final products on credit
3. Average collection period = time required to collect cash
from credit sales
4. Accounts payable deferral period = time firm is able to
delay payment for raw materials, wages and other
accounts
5. Cash conversion cycle = time between payments for raw
materials and and labour (resources) and cash collection
from sales
OPERATING AND CASH CYCLES FOR
DOUGS DISTRIBUTORS INC.
(In this example, we use average balance but could also use year-end
figures for inventory, accounts receivable and accounts payable)

1. Inventory Conversion Period

- Assume that beginning of year inventory balance
was $30 and cost of goods sold was $350










days
Sold Goods of Cost
entory AverageInv
5 . 36 365
350 $
2
) 40 30 ($
365
=
+
=
=
OPERATING AND CASH CYCLES FOR
DOUGS DISTRIBUTORS INC.

2. Receivables Conversion Period or Average Collection Period

- Assume 100% of sales are on credit

- Assume that beginning of year accounts
receivable was $20 and sales was $500


days
Sales Credit
ceivables Average
25 . 18 365
500 $
2
) 30 20 ($
365
Re
=
+
=
=
OPERATING AND CASH CYCLES FOR
DOUGS DISTRIBUTORS INC.
3. Payables Deferral Period
- assume beginning of
Year accounts payable was
$20


4. Operating Cycle
= Inventory Conversion Period +
Receivables Conversion Period
= 36.50 days + 18.25 days
= 54.25 days
5. Cash Cycle = Operating Cycle - Accounts
Payable Deferral Period
= 54.25 days 26.07 days
= 28.18 days
days
Sold Goods of Cost
Payables Accounts Average
07 . 26 365
350 $
2
) 30 20 ($
365
=
+
=
=
Working Capital Policies and the Current Ratio
Current Ratio is a measure of the extent to which
current Assets are financed by current liabilities

Current Ratio = Current Assets / Current Liabilities

Dougs Distributors has a current ratio of 70/50 or 1.4

A current ratio of 1.40 means that for every $1.40 of
current assets there is one dollar of current liabilities
Working Capital Policies
(Relative to Industry)
Working
Capital
Policy
Levels of
Current
Assets
How
Current
Assets are
Financed
Current
Ratio
Operating
and Cash
Cycles
Trade-off
Between
Profitability
and Risk
Conservative High With Long-
term Debt
and Equity
Higher
than
Industry
Average
Longer
than
Industry
Average
Lower
Profits /
Lower Risk
Aggressive Low With
Short-term
Debt
Lower
than
Industry
Average
Shorter
than
Industry
Average
Higher
Profits /
Higher Risk
How a Conservative Working Capital Policy
Lowers Profitability and Risk
(Vice-versa for Aggressive Policy)
Impact Higher Level
of Cash and
Marketable
Securities
Higher Level
of Accounts
Receivable
Higher
Level of
Inventory
Less Short-term
Debt /Greater
Long-term
Liabilities and
Equities
Lower
Return
Liquid assets
earn lower
returns than
less liquid
assets
Greater cost
of financing
and possibly
more write-
offs.
Higher
carrying
costs and
higher
obsolescence
With upward-
sloping yield curve,
interest costs are
higher. Equity costs
are normally higher
Less
Risk
Less Risk
Because Cash
is Readily
Available
Wont miss a
potentially
profitable
sale.
Fewer
Stock-outs
Less short-term
debt payments to
meet.
Working Capital Policies
Understanding Liquidity
To understand how well a company can meet its
ongoing cash obligations (its liquidity), you need
to understand whether the firm is using or
generating cash flow
To help you understand the nature of cash flows,
you need to know how to develop and interpret a
statement of cash flows
Before developing a statement of cash flows, let us
review how the balance sheet and income
statements are created

Summary
Working Capital = Short-term Assets
Short-term liabilities
Cash Conversion Cycle
Operating cycle
Cash cycle
Policies
Aggressive
Conservative
Statement of Cash Flows
Understanding Cash Flows
Outline
Preparation of balance sheet and income
statement from transactions
Statement of Cash Flows
Preparing Pro Forma: Supplementary Review
of Financial Statement Preparation
A balance sheet is a snap shot of a companys
affairs; it shows what the company owns (its
assets), what it owes (its liabilities) and how much
shareholders have invested in the firm (equity)
Assets = Liabilities + Equity
An income statement shows how much the
company sells (its revenue), what it costs to
operate the business (its expenses) and how much
is left over for shareholders (profit)
Preparation of the Balance Sheet and Income
Statement: A step-by-step example
Step 1: Initial Investment in Business
Sylvia invests $20,000 in her new business, a clothing retailer,
named Sylvia's Satins. The firm establishes an overdraft
facility with a bank for $20,000.
Sylvia's Satins Balance Sheet (Figures in 000's)
Assets Liabilities
Cash $20 Overdraft $0
Shareholders Equity
Current Assets $20 Common Shares 20
Total Assets $20 Total Liabilities and Shareholders' Equity $20
Preparation of the Balance Sheet and Income
Statement: A step-by-step example
Step 2: Accounting for Set-up costs of business
Sylvia spends $5,000 to pay for legal fees
for setting up business
Sylvia's Satins Balance Sheet (Figures in 000's)
Assets Liabilities
Cash $15 Overdraft $0

Shareholders Equity
Current Assets $15 Common Shares 20
Intangibles 5
Total Assets $20 Total Liabilities and Shareholders' Equity $20
Preparation of the Balance Sheet and Income
Statement: A step-by-step example
Step 3: Accounting For leasehold improvements
Sylvia enters into a lease and spends $5,000 on leasehold improvements
Sylvia's Satins Balance Sheet (Figures in 000's)
Assets Liabilities
Cash $10 Overdraft $0

Shareholders Equity
Current Assets $10 Common Shares 20
Leasehold Improvement 5
Intangibles 5
Total Assets $20 Total Liabilities and Shareholders' Equity $20
Preparation of the Balance Sheet and Income
Statement: A step-by-step example
Step 4: Accounting for fixed asset purchase
Sylvia buys equipment for $10,000.
Sylvia's Satins Balance Sheet (Figures in 000's)
Assets Liabilities
Cash $0 Overdraft $0

Shareholders Equity
Current Assets $0 Common Shares 20
Equipment 10
Leasehold Improvement 5
Intangibles 5
Total Assets $20 Total Liabilities and Shareholders' Equity $20
Preparation of the Balance Sheet and Income
Statement: A step-by-step example
Step 5: Accounting for purchase of inventory
Sylvia's firm buys $60,000 of shirts from a supplier on credit
Sylvia's Satins Balance Sheet (Figures in 000's)
Assets Liabilities
Cash $0 Overdraft $0
Accounts Payable 60
Inventory 60
Shareholders Equity
Current Assets 60 Common Shares 20
Equipment 10
Leasehold Improvement 5
Intangibles 5
Total Assets $80 Total Liabilities and Shareholders' Equity $80
Preparation of the Balance Sheet and Income
Statement: A step-by-step example
Step 6: Accounting for sales
Sylvia's firm sells $30,000 of inventory for $40,000 on credit
Sylvia's Satins Balance Sheet (Figures in 000's)
Assets Liabilities
Cash $0 Overdraft $0
Accounts Receivable 40 Accounts Payable 60
Inventory 30
Shareholders Equity
Current Assets $70 Common Shares 20
Equipment 10 Retained Earnings $10
Leasehold Improvement 5
Intangibles 5
Total Assets $90 Total Liabilities and Shareholders' Equity $90
Income Statement of Sylvia's Satins
Revenue $40
Cost of Goods Sold 30
Gross Margin $10
Preparation of the Balance Sheet and Income
Statement: A step-by-step example
Step 7: Accounting for payments to suppliers
Sylvia pays off $20,000 of payables
Sylvia's Satins Balance Sheet (INCOME STATEMENT UNCHANGED)
Assets Liabilities
Cash $0 Overdraft $20
Accounts Receivable 40 Accounts Payable 40
Inventory 30
Shareholders Equity
Current Assets $70 Common Shares 20
Equipment 10 Retained Earnings 10
Leasehold Improvement 5
Intangibles 5
Total Assets $90 Total Liabilities and Shareholders' Equity $90
Preparation of the Balance Sheet and Income
Statement: A step-by-step example
Step 8: Account for collection of accounts receivable
Sylvia receives $10,000 of cash from customers in collecting accounts receivable
Sylvia's Satins Balance Sheet (INCOME STATEMENT UNCHANGED)
Assets Liabilities
Cash $0 Overdraft $10
Accounts Receivable 30 Accounts Payable 40
Inventory 30
Shareholders Equity
Current Assets $60 Common Shares 20
Equipment 10 Retained Earnings 10
Leasehold Improvement 5
Intangibles 5
Total Assets $80 Total Liabilities and Shareholders' Equity $80
Preparation of the Balance Sheet and Income
Statement: A step-by-step example
Step 9: Account for payment of interest
Company Is charged $1,000 of interest and bank charges related to overdraft.
Sylvia's Satins Balance Sheet (Figures in 000's)
Assets Liabilities
Cash $0 Overdraft $11.0
Accounts Receivable 30 Accounts Payable 40
Inventory 30
Shareholders Equity
Current Assets $60 Common Shares 20
Equipment 10 Retained Earnings 9
Leasehold Improvement 5
Intangibles 5
Total Assets $80.0 Total Liabilities and Shareholders' Equity $80.0
Sylvia Satin's Income Statement
Revenue $40.0
Cost of Goods Sold 30.0
Gross Margin $10.0
Interest 1.0
Net Income Before Tax $9.0
Preparation of the Balance Sheet and Income
Statement: A step-by-step example
Step 10: Account for depreciation and amortization
Company depreciates equipment on straight-line basis over 5 years (useful life
of equipment) and over 10 years (lease term) for leasehold improvements
Sylvia's Satins Balance Sheet (Figures in 000's)
Assets Liabilities
Cash $0 Overdraft $11
Accounts Receivable 30 Accounts Payable 40
Inventory 30
Current Assets $60 Shareholders Equity
Equipment 8 Common Shares 20
Leasehold Improvement 4.5 Retained Earnings 6.5
Intangibles 5
Total Assets $77.5 Total Liabilities and Shareholders' Equity $77.5
Sylvia Satin's Income Statement
Revenue $40.0
Cost of Goods Sold 30.0
Gross Margin $10.0
Interest 1.0
Depreciation 2.0
Amortization 0.5
Net Income Before Tax $6.5
Preparation of the Balance Sheet and Income
Statement: A step-by-step example
Step 11: Accounting for Taxes
The income tax rate is 40%. We will ignore deferred taxes.
Company won't pay taxes until after year end.
Sylvia's Satins Balance Sheet (Figures in 000's)
Assets Liabilities
Cash $0 Overdraft $11.0
Accounts Receivable 30 Accounts Payable 40
Inventory 30 Taxes Payable 2.6

Current Assets $60
Equipment 8 Common Shares 20
Leasehold Improvement 4.5 Retained Earnings $3.9
Intangibles 5
Total Assets $77.5 Total Liabilities and Shareholders' Equity $77.5
Sylvia Satin's Income Statement
Revenue $40.0
Cost of Goods Sold 30.0
Gross Margin $10.0
Interest 1.0
Depreciation 2.0
Amortization 0.5
Net Income Before Tax $6.5
Taxes 2.6
Net Income After Tax $3.9
Importance of Cash Flows: Liquidity
Although Sylvias firm is profitable, it is important to
understand how it was able to generate enough cash to
meet its obligations. In other words, how liquid is
Sylvias Satins?
Liquidity is a critical aspect of a companys financial
performance. The payroll must be met. Before a firm
can get a loan from a bank or credit from a supplier, it
must show itself to be liquid.
To assess liquidity, we need to understand the factors
affecting firms on-going ability to generate cash.
Statement of Cash Flows
Sales
- Cost of Goods Sold
- Selling, General and Administration Expenses Net Income
- Interest
- Income Taxes
+Non-cash expenses e.g.depreciation
= Cash Flows From Operating Activities
- Increase in Accounts Receivable
- Increase in Inventory Change in Net Working Capital
+ Increase in Accounts Payable
- Purchases of Fixed Assets Net Capital Expenditures
+ Sales of Fixed Assets
- Payments to Owners of Business
= Cash Generated (Used) By Business Available for Repayment of
Debts
Statement of Cash Flows
for Sylvias Satins
Sales $40.0
- Cost of Goods Sold 30.0
= Gross Profit $10.0
- Selling, General and Administration Expenses 2.5
- Interest 1.0
- Income Taxes 2.6
=Net Income $3.9
+ Non-cash Expenses (depreciation, amortization) $2.5
=Cash Flows from Operating Activities $6.4
- Increase in Accounts Receivable $30.0
- Increase in Inventory 30.0
+ Increase in Accounts Payable and other Payables 42.6
- Purchases of Fixed Assets and other Capital Expenditures 20.0
+ Sales of Fixed Assets 0.0
- Payments to Owners of Business Other than Salary 0.0
Cash Generated (Used) By Business Available for Repayment of Debts -$31.0
Financing Cash Flow Deficiencies
If Sylvias Satins used up $31,000 cash in
its on-going operations, how was this
financed?
Opening Cash Balance $20,000
Less: Cash Used $31,000
Cash Surplus (Deficiency) - $11,000
Deficiency was financed by bank overdraft
Cash Flow Drivers
Eleven Key Cash Flow Drivers
Relationship with Cash Flow
1. Sales Growth Usually negative
2. Gross Margin % (Gross Profit/Sales) positive
3. Selling, General and Administration
(SGA) as % of Sales negative
4. Interest Expense negative
5. Non-cash Expenses positive
6. Income Tax Rate negative
7. Average Collection Period (ACP) negative
8. Inventory Conversion Period negative
9. Accounts Payable Period positive
10. Net Capital Expenditures negative
11. Owners Withdrawals from Firm negative
Relationship of Expenses to Cash Flow
Companies with higher profit margins (firms with
low cost of goods sold and low SGA as % of sales)
generate more cash
Conversely, firms that incur losses generally use up
cash and will encounter problems repaying loans if
losses are not stemmed. LOANS SHOULD NOT
BE GRANTED TO FUND SUSTAINED LOSSES
OF BORROWERS.
Significant non-cash expenses provide some relief
but only where regular capital expenditures are not
required
Relationship of Average Collection
Period to Cash Flow
Average Collection Period (ACP) is calculated as:
Accounts Receivable
Sales/365
In case of Sylvias Satins, ACP is $30/($40/365) or 274 days
One can estimate Accounts Receivable as:
Sales * ACP
365
If sales double to $80 and ACP remains unchanged, then Accounts
Receivable would also double i.e. ($80*274)/365 = $60
If ACP decreases in half to 137 days, ending Accounts Receivable would
equal ($40*137)/365 = $15 and firm would generate $15 more cash in the
year
Relationship of Inventory Conversion
Period to Cash Flow
Inventory Conversion Period is calculated as:
Inventory
Cost of Goods Sold/365
In case of Sylvias Satins, Inventory Conversion Period is $30/($30/365)
or 365 days
One can estimate Inventory as:
Cost of Goods Sold * Inventory Conversion Period
365
If cost of goods sold doubles to $60 and Inventory Conversion Period
remains unchanged, then Inventory would also double i.e. ($60*365)/365
= $60
If Inventory Conversion Period decreases in half to 183 days, ending
inventory would equal ($30*183)/365 = $15 and firm would generate $15
more cash in the year
Relationship of Accounts Payable Period
to Cash Flow
Payables Deferral Period
= (Payables)/(Cost of Goods Sold + Other Operating Expenses) X 365

In case of Sylvias Satins, Payables Deferral Period is ($40)/($30/365) or
487 days
One can estimate Accounts Payable as:
Cost of Goods Sold * Accounts Payable Period
365
If cost of goods doubles and Payables Deferral Period remains
unchanged, then Accounts Payable would also double i.e. ($60*487)/365
= $80
If company pays its suppliers in half the time, ending accounts payable
would equal ($30*243)/365 = $20 and firm would use up $20 more cash
in the year
Relationship of Sales Growth to Cash
Flow
If a company is selling on credit, an increase in sales
usually uses up cash as the firm buys/builds more
inventory, sells it and then has to wait to get paid by
its customers i.e. there is an increase in both
inventory and accounts receivable.
Even for firms that strictly sell on a cash basis, an
increase in sales still means that it needs to increase
its inventory.
In most cases, the cash required to build-up
inventory and receivables more than offsets
payables increase as well as the increased cash flow
from operations

Impact of Doubling of Sales of Sylvias Satins on Cash Flow of Firm
Sales $80.0
- Cost of Goods Sold 60.0
= Gross Profit $20.0
- Selling, General and Administration Expenses (SGA) 2.5
- Interest 3.0
- Income Taxes 5.8
=Net Income $8.7
+ Non-cash Expenses (depreciation, amortization) $2.5
=Cash Flows from Operating Activities $11.2
- Increase in Accounts Receivable $60.0
- Increase in Inventory 60.0
+ Increase in Accounts Payable (includes Taxes Payables) 85.8
- Purchases of Fixed Assets and other Capital Expenditures 20.0
+ Sales of Fixed Assets 0.0
- Payments to Owners of Business Other than Salary 0.0
Cash Generated (Used) By Business Available for Repayment of Debts -$43.0
Sales, gross profit, A/R, inventory, payables all double / SGA and non-cash
expenses dont increase with sales / interest increases to $3 with more
borrowing / income taxes equal 40% of ($20-2.5-3.0) or $5.8
Relationship of Sales Growth to Cash
Flow
With increased sales, Sylvias Satins would increase
its profit from $3,900 to $8,700 but experience an
increase in cash outflow from -$31,000 to -$43,000
and therefore end the year with a higher bank
overdraft
Situation would be worse where firm experiences
substantial growth and is capital intensive i.e. it
needs more capital expenditures to facilitate
expansion
These expenditures place greater pressure on the
cash flow of the firm

Relationship of Profitability and
Liquidity
Most often, clients who strive to be more profitable
usually improve their liquidity as higher profit
margins and better cost controls enhance cash flows
Furthermore, a more profitable business makes it
easier for the firm to attract other sources of credit
as well as outside equity
However, as shown in the last example, sometimes
firms seek to expand their businesses to increase or
at least preserve profitability. This puts the clients
desire for profitability at odds with the need to
maintain liquidity


Relationship of Capital
Expenditures and Liquidity
Most firms periodically need to make substantial
capital expenditures, at the very least to maintain
their operations or to keep up with the competition
Grocery stores need to replace freezers
Fashion retailers need new fixtures
Delivery firms need to replace vans
These expenditures place a heavy drain on cash
flow and consequently:
Clients should extend life of their fixed assets through
preventative maintenance
Clients should acquire assets with strong warranties and
insurance protection

Relationship of Capital
Expenditures and Liquidity
Financing of Capital Expenditures should be
structured so that the period of the repayment of
principal matches the life of the asset
Term financing or lease arrangement for equipment
Long-term mortgage for real estate
Excessive use of short-term debt creates too much
demand on cash flows in the period when the asset
is first acquired

Identifying Trends in Cash Flow Drivers:
Case of a company losing to competition
2000 2001 2002 Possible Concern (Direct Impact on Cash Flow)
Sales Growth 5% -9% -10% Losing sales to competition
Gross Margin % 30% 29% 27% Lower margins because of more competition
SGA % 18% 20% 21% Costs mainly fixed -- increase as % of sales
Interest Expense $1,000 $1,200 $1,400 More borrowing increases interest paid
Income Tax Rate 35% 35% 0% Effective rate falls as losses increase
Average Collection Period 45 days 49 days 52 days More credit-seeking customers
Inventory Conversion Period 34 days 38 days 45 days Unsold inventory builds
Accounts Payable Period 35 days 43 days 53 days Greater reliance on supplier credit
Net Capital Expenditures 12,000 1,000 600 Decreased sales lessens need for CAPEX
Owner's Withdrawals from Firm 25,000 35,000 40,000 Owner tries to preserve personal wealth
Possible Steps to Improve Cash Flows:
Limit owners withdrawals from firm
Review profitability of product mix
Review possible cost-cutting measures
More Closely Monitor A/R, Inventory and Payables Levels
Identifying Trends in Cash Flow Drivers:
Case of a company expanding sales at
expense of lower gross profit margins
2000 2001 2002 Possible Concern (Direct Impact on Cash Flow)
Sales Growth 5% 10% 15% Aggressively selling
Gross Margin % 30% 28% 25% Lower prices to attract customers
SGA % 18% 17% 16% Costs mainly fixed -- decrease as % of sales
Interest Expense $1,000 $1,200 $1,400 Bigger overdraft increases interest paid
Income Tax Rate 35% 35% 35%
Average Collection Period 45 days 49 days 52 days Easier credit to attract customers
Inventory Conversion Period 34 days 33 days 32 days Inventory moves faster
Accounts Payable Period 35 days 43 days 53 days Greater reliance on supplier credit
Net Capital Expenditures 12,000 25,000 35,000 Expansion requires increase in CAPEX
Owner's Withdrawals from Firm 25,000 30,000 35,000 Owner thinks bigger firm
entitles him to bigger compensation
Possible Steps to Improve Cash Flows:
Limit owners withdrawals from firm
Review profitability of expansion plans
More Closely Monitor A/R and Payables Levels
Increase use of term debt or other long-term financing e.g. equity
Signs of Liquidity Problems
Decline in daily or weekly cash inflows

Profitability and Operating Cash Flow Squeeze -- Increased
costs that the firm is unable to pass on to customers

Unexpected build-up of Accounts Receivable

Unexpected build-up of Inventory

Decline in firms net working capital, current ratio or an
increase in its short-term and total debt ratios (Short-term
Debt/ Total Assets and Total Debt/ Total Assets)
Cash Budgets & Pro Forma
Statements
Forecasting Cash Flows
Outline
Why forecast cash flows?
Cash budget
Pro Forma
Income Statement
Balance Sheet
Percent of sales method
Managing Liquidity and the Need to Forecast
Cash Flows
Companies need to plan for their cash needs to ensure they
have sufficient cash to:
Meet on-going obligations such as the payroll
Meet contingencies such as an increased need for working capital
(sensitivity analysis is especially important)
Be able to invest when attractive opportunities arise
They need to project a cash budget that forecasts cash
inflows and outflows on a monthly basis.
Cash budgeting is especially important in seasonal and
growing businesses.
Cash budgets should tie in with pro forma income
statements and balance sheets.

Preparing Comprehensive Pro
Forma Financial Statements
Sales Forecast Production Forecast
Cash Flow Forecast
Pro Forma Income
Statement
Pro Forma Balance Sheet
Sales, production and cash flow forecasts are usually done on
a monthly basis whereas pro forma income and balance sheets
are done an annual basis
EXAMPLE OF CASH BUDGET AND PRO
FORMA FINANCIAL STATEMENTS
Key Assumptions for Gadget Company
(Startup Business)
Sales
Monthly sales of 10,000 units
First month of sales is February 2003
Based on contract with distributor
Cash Budget
A/R - sales collected within one-month following
sale and the other collected two months following
sale

Cash Collections from Sales
Month January February March April
Sales of Gadget
Company
$0 $15,800 $15,800 $15,800
Cash Inflows from
AR Collection:
During Month
After Sale


$7900

$7900
During 2nd Month
After Sale
$7900
Total Collections 0 0 $7,900 $15,800
Key Assumptions: Company will sell 10,000 units a month @$1.58 each.
Half of accounts receivable will be collected one month after sale.
Half of accounts receivable will be collected two months after sale.
Cash Collections and Accounts Receivable
Month October November December Total for
Year
Sales of Gadget
Company
$15,800 $15,800 $15,800 $173,800
Cash Inflows from
AR Collection:
During Month
After Sale
$7900 $7900

$7900

$79,000
During 2nd Month
After Sale
$7900 $7900 $7900 $71,100
Total Collections $15,800 $15,800 $15,800 $150,100
Key Assumptions: Company sold $173,800 of goods but received only $150,100.
The difference of $23,700 represents the increase in accounts receivable during
year. Of the $23,700 in accounts receivable at year end, December sales represent
$15,800 and half of November sales represent $7,900.
Cash Payments to Suppliers
Month January February March April
Purchases of
Gadget Company
$10,000 $10,000 $10,000 $10,000
Cash Payment to
Suppliers
$10,000 $10,000 $10,000
Key Assumptions: Company will purchase one month in advance of sales.
- Month-end inventory will equal the current months purchases.
Each unit costs $1.00 to purchase.
Supplier will be paid one month after purchase.
Cash Payments and Accounts Payments
Month October November December Total for
Year
Purchases of
Gadget Company
$10,000 $10,000 $10,000 $120,000
Cash Payments to
Suppliers
$10,000 $10,000 $10,000 $110,000
Key Assumptions: Company purchased $120,000 of goods but paid for only
$110,000 by year end.
The difference of $10,000 represents the increase in accounts payable during year.
The $10,000 accounts payable at year end is for December purchases.
Key Assumptions for Gadget Company
Cash Budget
General and administration costs = $3,750 per
month
Interest is charged on previous months loan
balance at an annual rate of 12%. The
monthly rate is 12%/12 or 1%.
$10,000 opening cash balance
Pro Forma Income Statement
Depreciation = $250 per month
no accrual is made for interest expense at year
end
Cash Budget
Month January February March April
Total Collections 0 0 $7,900 $15,800
Cash Outflows:
Cash Payment to
Suppliers
$10,000 $10,000 $10,000
General Expenses $3,750 $3,750 $3,750 $3,750
Interest Expense 0 0 75 134
Total Cash Outflows $3,750 $13,750 $13,825 $13,884
Net Operating Cash Flow ($3,750) ($13,750) ($5,925) $1,916
Beginning Cash Balance
(Borrowing)
$10,000 $6,250 ($7,500) ($13,425)
Ending Cash Balance
(Borrowing)
$6,250 ($7,500) ($13,425) ($11,509)
Cash Budget
Month October November December Total for
Year
Total Collections $15,800 $15,800 $15,800 $150,100
Cash Outflows:
Cash Payment to
Suppliers
$10,000 $10,000 $10,000 $110,000
General Expenses $3,750 $3,750 $3,750 $45,000
Interest Expense 16 0 0 606
Total Cash Outflows $13,766 $13,750 $13,750 $155,606
Net Operating Cash
Flow
2,034 2,050 2,050 (5,506)
Beginning Cash
Balance (Borrowing)
(1,639) $394 $2,444 $10,000
Ending Cash Balance
(Borrowing)
$394 $2,444

$4,494 $4,494
Jan Feb Mar April May June July
Sales Forecast 15,800 15,800 15,800 15,800 15,800 15,800
Cash Inflows From Collections 7,900 15,800 15,800 15,800 15,800
Purchases From Suppliers 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Cash Outflows to Suppliers 10,000 10,000 10,000 10,000 10,000 10,000
General & Admin Expenses 3,750 3,750 3,750 3,750 3,750 3,750 3,750
Depreciation 250 250 250 250 250 250 250
Interest 0 0 75 134 115 96 76
Taxes 0 0 0 0 0 0 0
Net Cash Flow -3,750 -13,750 -5,925 1,916 1,935 1,954 1,974
Beginning of Month Cash 10,000 6,250 -7,500 -13,425 -11,509 -9,574 -7,620
End of Month Cash 6,250 -7,500 -13,425 -11,509 -9,574 -7,620 -5,646
0 2002 Jan Feb Mar April May June July
Sales 0 0 15,800 15,800 15,800 15,800 15,800 15,800
Cost of Goods Sold 0 0 10,000 10,000 10,000 10,000 10,000 10,000
Gross Margin 0 0 5,800 5,800 5,800 5,800 5,800 5,800
General Sales & Administrative Expenses 0 3,750 3,750 3,750 3,750 3,750 3,750 3,750
Depreciation 0 250 250 250 250 250 250 250
Interest Expenses 0 0 0 75 134 115 96 76
Profit Before Taxes 0 -4,000 1,800 1,725 1,666 1,685 1,704 1,724
Taxes 0 0 0 0 0 0 0 0
Profit After Taxes 0 -4,000 1,800 1,725 1,666 1,685 1,704 1,724
2002
Jan Feb Mar April May June July
Cash 10000 6,250 0 0 0 0 0 0
Accounts Receivable 0 0 15,800 23,700 23,700 23,700 23,700 23,700
Inventory 0 10,000 10,000 10,000 10,000 10,000 10,000 10,000
10000 16,250 25,800 33,700 33,700 33,700 33,700 33,700
Net Fixed Assets 28500 28,250 28,000 27,750 27,500 27,250 27,000 26,750
Total Assets 38500 44,500 53,800 61,450 61,200 60,950 60,700 60,450
Accounts Payable 0 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Bank Loan 0 0 7,500 13,425 11,509 9,574 7,620 5,646
0 10,000 17,500 23,425 21,509 19,574 17,620 15,646
Shareholders Equity 38500 34,500 36,300 38,025 39,691 41,376 43,080 44,804
38,500 44,500 53,800 61,450 61,200 60,950 60,700 60,450
Aug Sept. Oct Nov Dec 2003
Sales Forecast 15,800 15,800 15,800 15,800 15,800 173,800
Cash Inflows From Collections 15,800 15,800 15,800 15,800 15,800 150,100
Purchases From Suppliers 10,000 10,000 10,000 10,000 10,000 120,000
Cash Outflows to Suppliers 10,000 10,000 10,000 10,000 10,000 110,000
General & Admin Expenses 3,750 3,750 3,750 3,750 3,750 45,000
Depreciation 250 250 250 250 250 3,000
Interest 56 37 16 0 0 606
Taxes 0 0 0 0 0 0
Net Cash Flow 1,994 2,013 2,034 2,050 2,050 -5,506
Beginning of Month Cash -5,646 -3,653 -1,639 394 2,444
End of Month Cash -3,653 -1,639 394 2,444 4,494
0 2002 Aug Sept. Oct Nov Dec 2003
Sales 0 15,800 15,800 15,800 15,800 15,800 173,800
Cost of Goods Sold 0 10,000 10,000 10,000 10,000 10,000 110,000
Gross Margin 0 5,800 5,800 5,800 5,800 5,800 63,800
General Sales & Administrative Expenses 0 3,750 3,750 3,750 3,750 3,750 45,000
Depreciation 0 250 250 250 250 250 3,000
Interest Expenses 0 56 37 16 0 0 606
Profit Before Taxes 0 1,744 1,763 1,784 1,800 1,800 15,194
Taxes 0 0 0 0 0 0 0
Profit After Taxes 0 1,744 1,763 1,784 1,800 1,800 15,194
2002 Aug Sept. Oct Nov Dec 2003
Cash 10000 0 0 394 2,444 4,494 4,494
Accounts Receivable 0 23,700 23,700 23,700 23,700 23,700 23,700
Inventory 0 10,000 10,000 10,000 10,000 10,000 10,000
10000 33,700 33,700 34,094 36,144 38,194 38,194
Net Fixed Assets 28500 26,500 26,250 26,000 25,750 25,500 25,500
Total Assets 38500 60,200 59,950 60,094 61,894 63,694 63,694
Accounts Payable 0 10,000 10,000 10,000 10,000 10,000 10,000
Bank Loan 0 3,653 1,639 0 0 0 0
0 13,653 11,639 10,000 10,000 10,000 10,000
Shareholders Equity 38500 46,547 48,311 50,094 51,894 53,694 53,694
38,500 60,200 59,950 60,094 61,894 63,694 63,694
Gadget Company: Projected Income Statement for Year
Ended December 31, 2003
Sales
$ 173,800
Cost of Goods Sold:
Purchases 120,000
Less: Ending Inventory 10,000
110,000
Gross Profit 63,800
General Expenses 45,000
Depreciation 3,000
Interest 606
48,606
Net Profit $15,194
Gadget Company: Pro Forma
Balance Sheet December 31,
2003
Actual Projected Actual Projected
2002 2003 2002 2003
Current Assets Liabilities
Cash $10,000 4,494 Accounts Payable $0 $10,000
Accounts Receivable 0 23,700 Bank Indebtedness 0 0
Inventory 0 10,000 $0 $10,000
$10,000 $38,194
Equipment Shareholders Equity
Cost $28,500 $28,500 Common Stock $38,500 $38,500
Less: Accum. Dep. 0 3,000 Retained Earnings 0 15,194
$28,500 $25,500 $38,500 $53,694
Total Liabilities and
Total Assets $38,500 $63,694 Shareholders Equity $38,500 $63,694
% of Sales Method: Pro Forma Model
Ingredients
Sales Forecast
Drives the model
Pro Forma Statements
The output summarizing different projections
Asset Requirements
Investment needed to support sales growth
Financial Requirements
Debt and dividend policies
The Plug
Designated source(s) of external financing
Economic Assumptions
State of the economy, interest rates, inflation
Historical Financial Statements for St.
Dilbert Pharmaceuticals
Income Statement
Sales $500
Costs 235 47% of Sales
Depreciation 120 20% of Net Fixed Assets
Interest 40 10% of last periods Debt
Taxable Income 105
Taxes 36 34% of Taxable Income
Net Income $69
Retained $23
Dividends $46 67% of Net Income

Balance Sheet
Current assets $400 Total Debt $450
Net fixed assets 600 Owners Equity 550
Total Assets $1,000 Total Liabilities $1,000
Total Assets are 200%
of sales. ($2 of assets
for every $1 of sales.)
Fixed assets are 60%
of total assets, or 120%
of sales.
Pro Forma Financial Statements Using % of
Sales Method
Assume that sales grow by 20% to $600
Income Statement
Sales $600
Costs 282 47% of Sales
Depreciation n.a. 20% of Net Fixed Assets
Interest n.a. 10% of last periods Debt
Taxable Income n.a.
Taxes n.a. 34% of Taxable Income
Net Income n.a.
Retained n.a.
Dividends n.a. 67% of Net Income

Balance Sheet
Current assets $480 Total Debt n.a.
Net fixed asset 720 Owners Equity n.a.
Total Assets $1,200 Total Liabilities $1,200
Firms needs $2 of assets
for every $1 of sales.
Fixed assets are 60% of
total assets.
Filling in the Blanks
Depreciation
Firm needs $2 of assets for every $1 of sales (total asset turnover is 0.5 or total
assets are 200% of sales)
Total Assets must rise to $1,200 to support $600 of sales
Fixed Assets are 60% of Total Assets
Current Assets are 40% of Total Assets
Depreciation is 20% of Fixed Assets
Depreciation = 0.2 * (0.6 * $1,200) = $144
This depreciation calculation wrong, but close and simple!
Should calculate depreciation as % of additions to gross fixed assets plus
% of last years net.

Interest
Based on the last end-of-period Debt level (short and long-term).
Interest = 0.1 * $450 = 45
Pro Forma Financial Statements Using % of
Sales Method
Income Statement
Sales $600
Costs 282 47% of Sales
Depreciation 144 20% of Net Fixed Assets
Interest 45 10% of last periods Debt
Taxable Income 129
Taxes 44 34% of Taxable Income
Net Income 85
Retained $28
Dividends $57 67% of Net Income

Balance Sheet
Current assets $480 Total Debt $450
Net fixed assets 720 Owners Equity 750
Total Assets $1,200 Total Liabilities $1,200
Equity is the plug
variable
Financial Planning
Equity is the plug variable.
Equity rises from $550 to $750, but $28 of this is from retained earnings.
The difference, $172, is additional equity income necessary to support the
increase in sales.
Debt could also be the plug. Firm could borrow $172 and Debt could rise to
$622.
If new capital not available, then cant finance sales increase.

Balance Sheet with Debt as PLUG
Current assets $480 Total Debt $622
Net fixed assets 720 Owners Equity 578
Total Assets $1,200 Total Liabilities $1,200
Cash & Marketable Securities
Overview of How Companies
Maintain Liquidity
By holding cash and marketable securities
By having ready access to sources of
financing
Access to equity (not always possible or
attractive)
Access to debt through prior commitments
from lender e.g. line of credit
Criteria in Selection of Marketable Securities
1. Liquidity the security should be easy to sell before
maturity and the costs involved in selling
(transaction costs) should be minimal
2. Default Risk when investing in bonds, there should
be little chance the borrower will not repay principal
and interest (usually stick with high-grade
borrowers)
3. Market Risk there should be little risk that the
securitys price will decrease before maturity because
of changes in overall market conditions (levels of
interest rates and stock market indices); this means
that securities are usually short-term, fixed income
securities (not long-term bonds and not equities)
4. Attractive Return firms will accept more of the
above three risks in order to higher return
5. Tax Implications return is considered on after-tax
basis
Criteria in Selection of Marketable Securities
Liquidity Default Risk Market Risk Yield
(Feb. 14, 2003)
T-bills Highest Lowest
/obligation of
Federal
Government
Lowest 2.82% (3-month
t-bill)
Bankers
Acceptance
High Low /
guaranteed
by a bank
Low 2.87% (highest
rated)
Commercial
Paper
High to
Medium
Low to
Medium /
depends on
risk of
corporate
borrower
Low to Medium /
corporate
borrower may be
affected by stock
market conditions
2.87% (highest
rated)
Yield is higher
on lower rated
paper
Other Short-term Investments
Used for Liquidity Purposes
Overnight loans (large firms lend money on an
overnight basis)
Certificates of Deposits (interest-bearing rather
than discount instruments issued by banks and
trust companies)
Negotiable Certificates of Deposit (can be sold
before maturity in market)
Money Market Mutual Fund (pool of short-term
money market instruments)
Effective Interest Rate on a
Short-term Discount Instrument
Effective rate over life of instrument


Effective annual interest rate
Maturity Price Current Price
Current Price

|
\

|
.
|
1 1 +

|
\

|
.
|

(

Maturity Price Current Price
Current Price
365
Days to Maturity
Effective Interest Rate on a
Short-term Discount Instrument
Example of effective annual interest rate
calculation
T-bill has 90 days to maturity; maturity
price is $1,000 but it currently sells for $990
1
000
1 416% +

|
\

|
.
|

(
=
$1 990
$990
365
90
,
.
Approximate Annual Yield
Short-term Discount Instrument
Maturity Price Current Price
Current Price Days to Maturity
365

|
\

|
.
| X
$1 $990
$990 90
365
,
.
000
410%

|
\

|
.
| = X
In the case of t-bills, the approximate yield is referred to as the bond
equivalent yield. The bond equivalent yield on the 90-day t-bill is
shown below.
Accounts Receivable
Outline
Terms
Extending Credit to New Accounts
5 Cs of credit
Monitoring Accounts Receivable through
Aging of Accounts
Accounts Receivable Decisions
Key Decisions to Make
1. Terms and conditions of credit sales
2. Credit analysis
3. Credit decision. Whether to extend credit to
a customer?
4. Collection policy
Accounts Receivable and Credit Terms
Terms and conditions of credit decisions
No terms cash on delivery
Typical Credit Terms 2/10 net 30; this
means that payment is due 30 days
following date of invoice and if customer
pays by day 10, he/she receives a 2%
discount off invoiced price (an incentive
to make customers pay early)

Accounts Receivable and Choice
of Credit Terms
Choice of Credit Terms
A longer net term means
More sales and gross profit
But it also means,
Higher bad debt
Increased credit department costs given need
to check new applicants
Increased investment in accounts receivable
and potentially inventory

Accounts Receivable and Credit Analysis
Example of Impact of Extending Credit to a New Set of
Customers
The new set of customers could increase sales by $60,000.
The gross profit margin is 25% and bad debt is estimated
to be 3%. Credit department costs are expected to be
$3,000 annually. The average collection period is
expected to be 4 months. Given an income tax rate of
40%, what is the after-tax rate of return on providing
credit to the new set of customers?
Change in after-tax profit = ($60,000*(25%-3%) 3,000)*(1-
0.40)
= $6,120
Investment needed = $60,000*4/12*(1-25%)=$15,000
Rate of return = $6,120/$15,000 = 40.8%
The after-tax rate of return on providing credit to the new set of
customers is 40.80%
A
Exercise #1
A new set of customers could increase sales by
$100,000. The gross profit margin is 10% and bad
debt is estimated to be 5%. Additional credit
department costs are expected to be $3,000
annually. The average collection period is
expected to be 3 months. Given an income tax rate
of 40%, what is the after-tax rate of return on
providing credit to the new set of customers?
Solution
Change in after-tax profit
= ($100,000*(0.10 - 0.05) 3,000)*(1-0.40)
= $1,200
Investment = $100,000*3/12*(1-.10)=$22,500
Rate of return = $1,200/$22,500 = 5.3%
The after-tax rate of return on providing credit
to the new set of customers is 5.3%
Exercise #2
You have been approached by your sales staff
about selling $100,000 of goods on credit to a new
customer. The cost of goods sold on your firms
products is 80%. Credit department costs are
expected to be $2,000 annually to handle this
account. The average collection period is expected
to be 3 months. The income tax rate is 20%. If you
want to earn a 15% after-tax rate of return on
providing credit to the new customer, what will be
the maximum bad debt expense that can be
tolerated?
Solution
Let BD be bad debt expense as % of sales
Gross Margin = 100% -80% =20%.
Change in after-tax profit = ($100,000*(20%-BD) 2,000)*(1-0.20)
Investment needed = $100,000*3/12*(80%)=$20,000

We need to solve for BD with equation,
Rate of return = (($100,000*(20%-BD) 2,000)*(1-0.20))/$20,500 = 15%
(($100,000*(20%-BD) 2,000)*(1-0.20))=$3,075
($100,000*(20%-BD) 2,000)= $3,844
$100,000*(20%-BD)=$5,844
20%-BD=5.844%
BD=14.156%
The maximum bad debt expense is 14.156%
THE 5 CS OF CREDIT ANALYSIS
Character of Owner/Manager
Capacity to Repay
Financial Forecast
Business Plan
Income or Profits
Collateral
Liquidation Value
Enforceability
Liquidity
Credit Conditions
Ability to Access New
Financing
Credit Checks
Terms of Loan
Capital
Adequate Amount of
Long-Term Funds
Especially Equity
SCHEDULE OF AGE OF
RECEIVABLES
Age Days Amount (000) Percent of Total
0 30 $200 46.51%
31 60 150 34.88%
61 90 50 11.63%
Over 90 30 6.98%
Total $430 100%

Trade-off Between Non-Collection and Stringent and
Expensive Collection Methods as well as Loss of Customer
Goodwill
Inventory
Financial Overview of Inventory
Management
Benefits of Increased Inventory
quantity discounts for purchasing
avoids stock outs
lessens ordering costs
Costs of Increased Inventory
Higher carrying costs (Financing, storage,
insurance, etc.)
Potential obsolescence
Short-Term Financing
Outline
Selection Criteria
Covenants
Effective Annual Rate of Borrowing
Instruments
Line of Credit
Cost of Trade Credit
Short-term Financing Sources
Accounts
Payable
Regular
Interest
Discount
Interest
Variable-Rate
Interest
Term
Loan
Regular
Interest
Variable-Rate
Interest
Line of
Credit
Bank
Loans
Commercial
Paper
Factoring
Criteria in Selecting Short-term Finance
Lowest effective net cost considering
interest
fees
offsetting benefits in reduced administrative
costs
net amount borrowed
Flexibility of Repayment Terms
Amount of Credit Available
Conditions of Credit e.g. collateral,
covenants etc.

CREDIT
PACKAGE
Interest
Rate
Fees
Application
Administration
Covenants
Collateral
Structure Including
Repayment Schedule
Guarantees
Personal
Related Company
Third Party
Amount
PRIVATE & CONFIDENTIAL
Victoria Main Office
1225 Douglas Street
Victoria, B.C.
V8W 2E6

Bank of Montreal is pleased to offer the following lines of credit to
upon and subject to the following terms and conditions.
Loan Types
All loans are payable on demand, subject to periodic review by the Bank not less frequently
than annually, unless otherwise indicated.
Interest Rates
For the purpose of this Offer, "Prime Rate" is the floating annual rate of interest established
from time to time by the Bank of Montreal as the base rate it will use to determine rates of
interest on Canadian dollar loans to customers in Canada and designated as Prime Rate.
Prime Rate is currently 6.25%
Loan Structure
1) First Bank Cash Management Account (FCMA) $2,750,000.
contd


September 8th, 1992

Purpose: Operating assistance.
Interest Rate: Prime plus 1/4%
Repayment: Interest only, payable monthly. Exact dollar borrowing.
Above operating line includes:
- Maximum $100,000 Letter of Credit facility to cover periodic import of food stuffs.
- Maximum $250,000 overdraft facility to cover periodic settlement of U.S. payables.
Margin Conditions:
Operating advances contained within 66.6% eligible accounts receivable (60 days and
under) plus 50% inventory at cost as indicated by monthly signed Inventory Declarations,
Eligible receivables to include current 30/60 day accounts that have formal repayment program
established for any over 61 day payments. Estimate of Priority Payables to be provided on
monthly Inventory Declaration.
Secondary Margin
Operating advances are not to exceed eligible receivables.
contd

Information Requirements:
- Monthly aged Account Receivable Listings, Inventory and Account Payable Declarations
signed by company Signing Officer.
- By October 15
th
, 1992 - In-house Balance Sheet and Income Statements as at July 31st,
1992.
2) Commercial Mortgage $1,990,000. (Approx. Balance)
Purpose: Refinance existing Commercial Mortgage $1,671,000 with additional
$329,000 to repay Demand Loan, Non-Revolving $300,000 balance $29,000 to company
current account.
Interest Rate: 11.00%, 3 Year Term due October 1st, 1994 (25 year amortization).
Repayment: Monthly blended payments $19,300, 25 year amortization.
Security - Already In Place
- Debenture security providing overall Fixed Charge $3,500,000 over property and various
company owned vehicles/equipment along with Floating Charge over all other company
assets.
Debenture Restrictive Covenants:
- Not to declare or pay dividends without Bank approval.
- Company not to provide Guarantee to any other financial institution without Bank
approval.

contd


- Standard Mortgage Clause Fire/All Perils Insurance.
- Assignment of Book Debts.
- Subrogation of shareholder loans signed by
- Subrogation of loan by Holdings Ltd.
- Corporate Letter of Undertaking re: Financial Test Covenants (To be replaced - replacement
letter attached).
- First Commercial Mortgage $2,000,000 providing Fixed Charge over Victoria warehouse
complex, including charge over company's freehold and leasehold interest in the subject
property.
- General Assignment of Rents.
- Priority Agreement over existing Bank of Montreal Debenture charges.
Security - To Be Obtained
- Revised Corporate Letter of Undertaking, detailed as follows:
1) Maintain debt/equity ratio maximum 2.75:1 as determined by Fiscal 1993 year end Financial
Statements with equity defined as Shareholder Loans, Retained Earnings and net tax Bonus
Payable.

contd



2) Achieve Working Capital ratio minimum 1.25:1. (Current liabilities to exclude Directors
Wages after tax).
3) Restrict Annual Capital Expenditures to $1,500,000 as detailed in Controller prepared Fiscal
1993 Capital Expenditure Summary.
Please note Capital Expenditures at $1,500,000 level are approved in principle in that the Bank
will be reviewing the anticipated and resultant financing requirements with you in the near
future.
- Revised FCMA Agreement.
- Insurance Waiver.
Given the scale and complexity of company financial operations, we would appreciate the
opportunity to revisit the need for provision of Annual Audited year end Financial Statements.

contd

We are pleased to be of assistance to you. We shall be grateful if you will sign and return
copy of this Offer of Credit to the undersigned.
Congratulations on your strong Revenue and Profit performance.
With best wishes for a successful year.


J. Cash
Corporate Manager
JC/eg
THE UNDERSIGNED HEREBY ACCEPTS THE ABOVE OFFER, ITS TERMS AND
CONDITIONS AND AGREES TO BE BOUND THEREBY.
DATED AT VICTORIA, IN THE PROVINCE OF BRITISH COLUMBIA THIS ___ DAY OF
SEPTEMBER 1992.

Example of Typical Bank Loan Covenants for
Closely Held Company
Gordon Manufacturing is 100% owned by Sam Gordon
Minimum Current Ratio of 1.25 to ensure liquidity
Minimum Adjusted Net Worth of $2 million to ensure
solvency
Adjusted Net Worth equals
Shareholders Equity from Balance Sheet plus Loans from
Shareholder/Related Companies
less Loans to Shareholder/Related Companies
less Goodwill
Effective Annual Cost of Short-
term Financial Instrument
Effective before tax rate over life of
instrument


Effective before-tax annual interest rate
Interest Fees Savings
Net Amount Borrowed
+
|
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.
|
1
Interest Fees Savings
Net Amount Borrowed
1
365
Days to Maturity
+
+
|
\

|
.
|

(

Effective Annual Interest Rate on Regular
Interest Term Loan
Example: A bank charges a 5% annual regular interest rate on
a $100,000 91-day term loan. There is an annual fee of 1%.
Solution:
Interest paid is 5%* $100,000*91/365 or $1,247
Fee is 1%*$100,000*91/365 or $249
Net amount borrowed is $100,000 1,000 or $99,000
Effective annual interest rate equals
1
0
100,000
1 = 6.21%
365
90
+
+
|
\

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.
|

(

1247 249 ,
Effective Annual Interest Rate on Discount
Interest Term Loan
Example: A bank charges a 5% annual discount interest rate
on a $100,000 91-day term loan. There is an annual fee of
1%.
Solution:
Interest paid is 5%* $100,000*91/365 or $1,247
Fee is 1%*$100,000*91/365 or $249
Net amount borrowed is $100,000 1,247 or $98,753
Effective annual interest rate equals
1
0
98,753
1 = 6.29%
365
90
+
+
|
\

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.
|

(

1247 249 ,
Line of Credits
Used to finance seasonal fluctuations in working capital.
Firm can borrow up to a maximum level over a specified
time period.
Repayment obligation varies (e.g., 3% of principal per
month), although balance must be zero by termination of
the loan agreement.
Borrowing firm may withdraw as need requires up to a
preset maximum.
Committed means bank obliged (written loan agreement) -- fee
on unused balance about 1%. (Commitment fee)
Uncommitted means bank not obliged -- no fee on unused
balance.
Bank usually has option to terminate.
Line of Credits
Assume interest calculated on average balance of
loan used over period.
Assume commitment fee calculated similarly.

Calculating Effective Interest Rate on Line of
Credit
Example: A bank charges a 5% interest rate on a $100,000 line of credit
for amounts used and a commitment fee of 1% for amounts available but
not used. The fee is calculated based on the average unused balance
during the period. If average loan balance was $40,000 for 180 days , what
was effective interest rate on line of credit?
Solution:
Interest Expense = 5%*$40,000*180/365 or $986
Commitment Fee = 1%*60,000*180/365 or $296
Net Amount Borrowed = $40,000
Effective Annual Interest Rate equals
1
0
40,000
1 = 6.61%
365
180
+
+
|
\

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.
|

(

986 296
Exercise #1
Example: A 120-day $200,000 line of credit. The line of credit would have an
annual interest rate of 5% and an annual commitment fee of 1% of the unused
balance. During the first 60 days the loan is outstanding, $50,000 will be
borrowed. During the last 60 days, $150,000 will be borrowed.
Interest Expense = 5%*$50,000*60/365 + 5%*$150,000*60/365 = $1,644
Commitment Fee = 1%*$150,000*60/365 + 1%*$50,000*60/365 = $329
Net Amount Borrowed = $50,000*60/120 + $150,000*60/120 = $100,000
Effective Annual Interest Rate equals
6.12% 1
000 , 100
329 644 , 1
1
120
365
=
(

+
+
Exercise #2
Example: A 180-day $300,000 line of credit. The line of credit would have an
annual interest rate of 6% and an annual commitment fee of 0.5% of the
unused balance. During the first 100 days the loan is outstanding, $100,000
will be borrowed. During the last 80 days, $250,000 will be borrowed.
Interest Expense = 6%*$100,000*100/365 + 6%*$250,000*80/365 = $4,932
Commitment Fee = 0.5%*$200,000*100/365 + 0.5%*$50,000*80/365 =
$329
Net Amount Borrowed = $100,000*100/180 + $250,000*80/180 = $166,667
Effective Annual Interest Rate equals
6.50% 1
667 , 166
329 932 , 4
1
180
365
=
(

+
+
Additional Exercises
For additional exercises on lines of
credit, try problems 24.6 and 24.7 and
Davis and Pinches
Calculating Effective Cost of Deferring
Payment on Accounts Payable
Example: A company has 2/10 n45 terms with its supplier. If the company
currently pays within 10 days and receives the 2% discount, what is the
effective annual cost of delaying payment until day 45?
Solution:
Rather than paying 98% of face value on day 10, company gets to pay
100% of face value on day 45. This is equivalent to borrowing a discount
interest loan equal to 98% of face value on day 10 and repaying loan back
on day 45.
Interest Expense = 2% (discount foregone)
Net Amount Borrowed: = 98% of face value of payables
Effective Annual Interest Rate equals
1
98%
1 = 23.45%
365
45-10
+
|
\

|
.
|

(

2%
Factoring Receivables
Selling receivables to a factor (Finance company) for
discounted cash value (with advance factoring) without
recourse to the seller (borrower)

Factor bears risk (where no recourse) and collection
expenses

Fees are fairly high in factoring arrangements; in most
industries, factoring is one of the most expensive methods
of short-term borrowing
Factoring: Example
Dont Pay for One Full Year!
Salesperson screens client for credit eligibility with
Citifinancial on site using Citis in-store computer
system. Citi controls credit quality. Bad risks are not
offered credit.
Citi pays Leons the discounted value of the purchase
price immediately.
Citi collects full payment from client at end of year. If
client cant pay, then Citi starts charging interest.
Advantages of Factoring Over Pledging of
Accounts Receivables
Allows Companies to Avoid Credit Checking,
Bookkeeping and Collection Costs

With Advance Factoring, Firms can Shorten Cash
Conversion Cycle

With Non-Recourse Factoring, the Financial
Institution Absorbs Bad Debt Losses
Effective Annual Interest Rate of Advance Factoring
Example: A company has $200,000 or accounts receivable. A finance company
charges a 1% commission on all receivables factored. The finance company will
loan an amount equal to 70% of the receivables factored and will charge a 12%
annual interest rate on this amount. However, credit department costs will be
reduced by $750 a month. The average collection period is 60 days (2 months).
What is effective annual cost of factoring?
Solution:
Fee is $200,000*1% or $2,000
Net amount borrowed is $200,000*70% or $140,000
Annual interest paid is 12%* $200,000*70%*60/365 or $2,762
Savings over 2 months = $750*2 =$1,500
Effective annual interest rate equals
1
140,000
1 = 15.04%
365
60
+
+ |
\

|
.
|

(

2 762 2000 1500 ,
XYZ Corp. currently has monthly receivables of $83,333. It
advance factors all receivables to Bank. Receivables typically
collected on 25
th
of month, so term = 25 days. Bank lends 75% of
receivables, charges 1.5% commission and 3% above Prime
(Prime=6%). XYZ Corp, saves $1,000 a month on book-keeping
and collection expenses. What is the net cost to XYZ?
Commission = 0.015 * 83,333 = $1,250
Savings = -$1,000
Interest = 0.09*0.75*$83,333*(25/365) = $385.27
Total = $635.27
15.91% 1
$62,499.75
$635.27
1 k
25
365
EAR
=
|
.
|

\
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+ =
Exercise #1
Beamscope monthly receivables of $400,000. It advance factors
all receivables to Bank. Receivables typically collected at the end
of each month, so term = 1 month. Bank lends 70% of
receivables, charges 0.5% commission and 2% above Prime
(Prime=9%). Beamscope, saves $1,000 a month on book-keeping
and collection expenses. What is the net cost?
Commission = 0.005 * 400,000 = $2,000
Savings = -$1,000
Interest = (0.09/12)*0.7*400,000 = $2,567
Total = $3,567
16.41% 1
$280,000
$3,567
1 k
12
EAR
=
|
.
|

\
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+ =
Exercise #2
Ratio Analysis
Outline
Ratios
Du Pont Analysis
Ratio Analysis
Financial ratios show relationships among financial statement
accounts.

Investors predict future earnings and dividends of firm in order
to value shares

Creditors predict likelihood of default by firm on claim

Management decides upon investment in short and long-term
asset and establish amount and type of credit financing
Ratio Analysis
Steps:
Type:
1. Decide on ratios that are appropriate
2. Calculate ratios
3. Compare ratios to industry norms
4. Evaluate reasons for discrepancies
from industry norms
5. Identify trends in ratios over time
6. Evaluate reasons for trends
7. If discrepancies arose because of
underlying problems, evaluate
alternative solutions to problems.
I. Liquidity
II. Asset Management Ratios
III. Debt Management Ratios
IV. Profitability Ratios
V. Market Value Ratios
II. Asset Management Ratios
- measures how effectively management is utilizing the companys assets

Turnover Measures

1) Inventory Utilization = Sales/Inventory
Too high Too low
- loss of profitable sales - obsolescence
from stock outs - warehousing constraints
-costs from excessive - financing and insurance
reordering costs are excessive

2) Average Collection Period = Receivables____
Average Sales per Day
Too low Too high
- loss of profitable sales from - bad debt
tight credit terms - financing costs

3) Fixed Asset Utilization = Sales/Net Fixed Assets

4) Total Asset Utilization = Sales/Total Assets
III. Debt Management (Leverage) Ratios

- measures extent to which non-equity financing is used

1) Total Debt/Total Assets

2) Total Debt/Total Equity

3) Long-term Debt/Common Equity

- measures ability of company to meet fixed financing charges with operating
income

1) Times Interest Earned
= Earnings Before Interest and Taxes (EBIT)
Interest Charges

2) Fixed Charge Coverage Ratio
Leverage

- creditors will charge higher financing rates to firms which are highly
levered

1) Greater likelihood of bankruptcy because of added
interest costs

2) Loss of creditors upon liquidation of firm is likely higher because
amount of debt increases but liquidation value of assets does not.

3) Common shareholders have smaller stake in firm that is financed by
debt rather than solely by equity - may lead them to misappropriate firm
assets or take excessive risks especially where firm is nearing
bankruptcy.

if firms are too highly leveraged, they may be unable to obtain
financing from creditors.
Advantages to Shareholders from Leverage

1) leverage allows firms to experience higher returns in
good times (but lower returns in bad times) -
generally expected EPS increases to compensate for
greater risk with higher leverage

2) existing shareholders can maintain control by
borrowing debt rather than issuing new common shares
esp. important for shareholders who are also managers -
leverage buy outs

3) tax advantages - interest charges are deductible from
taxable income while dividends are not
IV. Profitability Ratios

- measure combined effect of liquidity, asset management and leverage on
operating results

1) Gross Profit Margin on Sales = Gross Margin/Sales

2) Net Profit Margin on Sales = Net Income Available to
Common Shareholders/ Sales

3) Basic Earning Power Ratio = EBIT/Total Assets

4) Return on Total Assets = Net Income Available to
Common Shareholders/ Total Assets

5) Return on Equity = Net Income/Common Equity

- Profitability analysis often focuses on means to improve the gross margin
through new pricing policies, changes in product lines and methods to reduce
the cost of goods sold.

V. Market Value Ratios

- measures the stock markets evaluation of liquidity, asset
management, debt management and profitability

1) Price Earnings Ratio = Price per share/EPS

2) Market/Book Ratio = Stock Price /
Book Value Per Share

Book Value Per Share = Shareholders
Common Equity / Shares Outstanding
The Dupont equation
Highlights relationship between financial ratios
ROE
ROA
Net profit
margin
Asset
turnover
x
x
1+ debt/equity
The DuPont System
(

+ - =
=
= =
=
(

+ = =
= =
=
Equity
Debt
* t turnover total asse in t m net prof i ROE
nover asset tur in * total t m net prof i ROA
Assets
Sales
Sales
Net Income
Sales
Sales
Assets
Net Income
ROA
Assets
Net Income
ROA
Equity
Debt
ROA
Equity
Assets
ROA ROE
Equity
Assets
Assets
Net Income
Assets
Assets
Equity
Net Income
ROE
Equity
Net Income
ROE
1 arg
arg
1
Auto
Parts
Building
Materials
Gold and
Precious
Metals
Food and
Beverage
Technology Pipelines
Liquidity
Current 2.69 1.96 10.17 2.76 2.47 0.71
Quick 1.60 1.10 9.67 1.57 1.82 0.51
Asset
Management
Days Sales
Outstanding
44.7 59.9 21.2 35.9 70.6 46.5
Inventory
Turnover
7.66 11.15 7.76 11.01 34.52 26.22
Long-term
Asset Ratio
5.03 3.84 0.59 6.40 9.85 0.89
Debt
Management
Total Debt to
Total Assets
0.30 0.36 0.25 0.49 0.35 0.67
Times Interest
Earned
62.37 8.14 (76.08) 9.00 23.35 1.97
Average Industry Ratios
Average Industry Ratios (Continued)
Auto
Parts
Building
Materials
Gold and
Precious
Metals
Food and
Beverage
Technology Pipelines

Profitability


Margin (%)


5.96

5.27

(72.71)

5.96

(2.01)

5.03

Return on
Assets (%)

8.36

7.28

(19.52)

7.61

0.09

6.18

Return on
Equity (%)

14.29

11.06

(25.68)

12.09

(0.83)

12.28


Market




Average P/E

18.7

29.8

50.2

16.2

26.0

15.1

Dividend Yield
(%)


1.24


0.71

0.25

1.72

0.39

4.20


Source: Industry Reports (July 5, 1998) The Financial Post
Datagroup.
Capstone Case: Working Capital
and Financial Statement Analysis
Beamscope Canada
Capstone Case: Working Capital
and Financial Statement Analysis
The chart below shows the price of the stock of Beamscope, a
distributor of electronics products in Canada and South
America, from 1997 to 2001.
Beamscopes Working Capital Management
Ratio 1996 1997 1998 1999 2000
Current 1.93 1.61 1.70 1.35 1.01
Quick 1.38 1.06 1.06 0.58 0.44
Average Collection Period 62 84 80 54 50
Days Inventory 29 46 53 64 66
Days Payable 53 71 69 47 49
Operating Cycle 91 131 133 118 115
Cash Cycle 38 60 64 71 67
Three major problems occurred with working capital in 1997-1998:
1. Company couldnt cope with growth in managing inventory & AR
2. Company didnt properly process goods returned from customers.
3. Company didnt have an adequate returns policies with suppliers.
Beamscopes Debt Management
Ratio 1996 1997 1998 1999 2000
Total Debt/Total Assets 0.48 0.59 0.57 0.71 0.77
Total Debt/Equity n.a. 0.43 0.33 1.29 1.37
Short-term Debt/Equity n.a. 0.23 0.18 1.07 1.36
Times Interest Earned n.a. 9.69 8.50 -5.24 -2.62
Increased Debt Levels Relative To Equity
1. Increase in Accounts Receivable and Inventory needed to be financed.
2. Company wrote off Uncollectible Accounts Receivable and Overvalued
Inventory in 1999.
Lower Debt Servicing Ability because of higher interest and lower profits.
Beamscopes Profitability
Ratio 1996 1997 1998 1999 2000
Gross Profit Margin 9.8% 9.6% 9.2% 2.4% 4.1%
Net Profit Margin 2.0% 1.5% 1.7% -3.4% -2.8%
Sales/Total Assets 3.6 2.3 2.4 2.5 2.4
Return on Assets 7.2% 3.5% 4.1% -8.5% -6.7%
Total Assets/Equity 1.93 2.45 2.35 3.41 4.35
Return on Equity 13.9% 8.6% 9.6% -29.0% -29.1%
Company became very unprofitable in 1999
1. Both gross and net profit margins shrunk because of writeoffs in that year.
2. DuPont analysis reveals that the lack of operating profitability after 1998 is
major reason for low return.