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BUSINESS FINANCE
Notes:
Working Capital Management
Working capital means the firm’s holdings of current, or short-term, assets such as cash,
receivables inventory, and marketable securities
...
e
...
Cash is initially employed to purchase inventory
which is in turn on credit and results in accounts receivables
...
e
...

There are two possible interpretation of working capital concept;
a)
Balance Sheet Concept
The balance sheet concept is represented by the excess of current assets over current liabilities and is
the amount normally available to finance current operations
...
The excess of current assets over current liabilities is called the net working
capital or net current assets
...
These activities create funds flows that are both unsynchronized and
uncertain
...
)
Current assets, also known as working capital, represent the portion of investment that circulars
from one form to another in the ordinary conduct of business
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Marketable securities are considered part of working capital, as cash securities
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b)

Current liabilities represent the firm’s short-term financing, because they include all debts of the
firm that come due (must be paid) in 1 year or less
...

Commonly, net working capital is the difference between the firm’s current assets and its current
liabilities
...
It is represent the firm’s sources of short-term funds, the amount by which current assets
exceed current liabilities must be financed with long-term funds
...
Therefore, net working capital is the
portion of the firm’s fixed assets financed with current liabilities
...
The cash outlays for current liabilities are relatively predictable
...

Cash inflows is difficult to predict as the conversion of the current assets to more liquid forms
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1

Giving up Cash Discount

If the firm opts to give up the cash discount, it should pay on the final day of the credit period
...
The cost of giving up a cash
discount is the implied rate of interest paid to delay payment of an account payable for an additional
number of days
...
This cost can illustrated by a simple example
...

Jamex Industries could take the cash discount on its February 27 purchase by paying P 980 on
March 10
...
To keep its
money for an extra 20 days, the firm must give up an opportunity to pay P980 for its P 1,000
purchase
...

To calculate the cost of giving up the cash discount, the true purchase price must be viewed
as the discounted cost of the merchandise, which is P 980 for Jamex Industries
...
1:

Cost of giving up cash discount =

CD

X

360

100% - CD

(15
...
1 results in an annualized cost
of giving up the cash discount of 36
...

A simple way to approximate the cost of giving up a cash discount is to use the stated cash discount
percentage
...
1:

Approximate cost of giving up cash discount = CD X 360/ N

(15
...
Using
this approximation, the cost of giving up the cash discount for Jamex Industries is 36% [ 2% X ( 360 /
20)]

The Finance Manager must determine whether it is advisable to take a cash discount
...

2

cash discounts may represent an important source of additional

Cost of Trade Credit

Trade credit is considered a spontaneous source of financing because it normally expands as
the volume of a company’s purchase increases
...
The company increases purchases from suppliers by 20 percent from an
average of P 10,000 per day to an average of P12,000 per day
...

If the terms of sale include a cash discount, the firm must decide whether or not to take it
...
Assuming that the firm does not take the cash discount and wants to make maximum of the
credit offered by suppliers, it should pay its bills on the last day of the discount period
...
The
company can either pay the discounted amount P 14,700 by the end of the discount period (day 10)
or the full amount of the invoice ( P 15,000 by the end of the credit period (day 30)
...

Substituting this information into Equation – 1 yields the following :

AFC =

2 x

365

= 37
...
Therefore, when making financing
decisions, a company should compare this cost to the costs of other sources of credit
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Factors Affecting Credit Terms

3

Credit terms vary by industry and even within industries
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Credit terms of companies are often
set based on competitive condition and rarely changed
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The optimal cash discount depends on a product’s variable cost: the lower a product’s variable
set the higher the possible discount
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2
...


3
...


4
...


5
...


In determining the appropriate accounts receivable policy, these variables will now be analyzed in a
decision making context, which is termed marginal analysis
...
The change should be accepted if the marginal return from a proposed change in the
management of accounts receivable is greater than the marginal costs on additional investment
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The current level of bad
debt losses is P 156,250 and the firm’s required rate of return on any new investment in receivables is
14%
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The company is contemplating a relaxation of its credit policy and the expected
effects of two proposed policies
...
00

5,468,750
...
00

5,781,250
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00

334,375
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The results of the marginal analysis of relaxing credit standards are presented in table 2
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00

5,468,750
...
00

Average collection period

2 months

3months

4months

turnover ratio

6 times

4 times

3 times

Average level of receivables

833,333
...
50

1,927,083
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00

312,500
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00

62,500
...
00

46,875
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00

15,625
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50

559,895
...
60

447,916
...
74

62,708
...

2,708
...
33

Table 2 shows that the marginal benefits by shifting from the present policy to policy A is P 62,500
...
74
...
26 greater than the required return ( or marginal cost ) a change in the credit policy
should be made from the current policy to policy A
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The
required rate of return on the increase in accounts receivable or marginal cost associated with this
change is P 62,708
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Thus, since the marginal benefit is P 47,083
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The logic behind this approach to credit policy is to examine the incremental or marginal benefits, and
costs or required returns associated with any change in the credit policy
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Methods of Computing Interest
Once the nominal (or stated) annual rate is established, the method of computing interest is
determined
...
If interest is paid at
maturity, the effective (or true) annual rate – the actual rate of interest paid-for an assumed 1-year
period is equal to:
Interest
Amount borrowed

6

( 15
...
When interest is paid in
advance, it is deducted from the loan so that the borrower actually receives less money than is
requested
...
The effective annual
rate for a discount loan assuming a 1-year period is calculated as
Interest
Amount borrowed – interest

( 15
...

Example:
Western Company, a manufacturer of footwear, wants to borrow P 10,000 at a stated annual
rate of 10% interest for 1 year
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10 X P10,000) for the use of the P10,000 for the year
...
3 on
the effective annual rate follows:
P1,000

= 10
...
Thus, the
effective annual rate in this case is
P 1,000
P 10,000 - P 1,000

=

P 1,000 = 11
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1%) greater than the stated
annual rate ( 10
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Single Payment of Notes
A single-payment note can be obtained from a commercial bank by a creditworthy business
borrower
...
The resulting instrument is a note, which must be signed by the borrower
...
This type of shortterm note generally has a maturity of 30 days to 9 months or more
...

Example:

Glader Company, a producer of shaver, recently borrowed P 100,000 for each of two
banks, bank A and bank B
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Each loan involved a 90-day note with interest to be paid at the end of 90 days
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A’s fixed-rate note
...
The total interest cost on this loan is P 2,625 ( P100,000
X ( 101/2% X 90/360)]
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625% ( P2,625/P100,000)
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10
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625% for 90 days, it is necessary to compound ( 1+ 0
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e
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02625)4 -1

7

= 1
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1092 = 10
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92%
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The rate charged over the 90 days will vary
directly with the prime rate
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For instance, if after 30 days, the prime rate rises to
9
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25%, the firm would be paying
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854 percent for the last 30 days ( 10
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Its total interest
cost would be P 2,562 [ P 100,000 X (
...
854%)]
Resulting in an effective 90-day rate of 2
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Assuming the loan is rolled over each 90 days throughout the year under the same terms and
circumstances, its effective annual rate is 10
...
02562)4-1
= 1
...
1065 =10
...

Calculating the Compounded Effective Annual Interest Rate
The next question is the cost of financing, after the firm has known the amount of financing
source will yield
...
The compounded EAI is calculated the same way for any source of funding
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To compute
this cost statistic, the analyst obtains the cash flows fro the funding source and their timing, calculates
the internal rate of return (IRR), and compounds this IRR to a yearly basis
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Illustration

Strax Arts maintained an excellent working relationship with its commercial bank
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The Chairman, Hugo White, has made changes that caused
him to question whether the credit arrangement is in the company’s best interest
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The requirement is 20% of actual amounts borrowed
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005 on the average portion of the credit limit
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Hugo believes that the bank will charge 8%
interest on the average borrowing
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He expects the interest on these loans
will average 9%
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20RLA-P60,000
0
...
08 = P54,000
The average unused portion of the line= P 325,000(P1,000,000-P675,000),which has
a cost of P1,675( P325,000 X 0
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09271 (P 55,625/P600,000)
Evaluate the proposal
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090 on the alternative
credit arrangement, the alternative is the better choice
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First, the credit limit guarantees available credit up to
P 1,000,000
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If the prime rate changes, the interest rate charged on new as well as outstanding
borrowing automatically changes
...
The more creditworthiness the borrower, the lower the interest
increment above prime, and vice versa
...
Once the account has been purchased, it is the property and responsibility of the factor
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Maturity Factoring
Maturity factoring consists of the sale of accounts receivable to a factor with no advance of
funds at the time of sale
...
The factor conducts a credit analysis of
the potential customer and, if the risk is acceptable approves the sale and assumes all responsibility
for collection and bad debts
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The
factor forwards cash to the seller in the amount of the receivable less the commission on an agreed
upon average maturity date
...
Whether the factor’s commission is included in the cost of financing
for retail sales
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The receivables appear on the
subsidiary’s books and not on those of the parent
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This is
used by companies as a source of working capital funds since the availability of the credit varies in
proportion to the amount of the collateral itself
...
g
...
The
residual percentage is intended to insure the bank against any risk of bad debt on receivables or
shrinkage of inventories
...

Commercial finance companies are private companies that make commercial loans
...
Commercial banks raise much of their funds from the public in the form of deposits, either
demand or time
...

Commercial finance companies restrict their loans to business firms and do not take deposits
...
Consequently, commercial finance
companies generally charge higher interest rates than banks and concentrate on asset based- lending
...
They
are based primarily on the underlying value of the assets rather than on the financial strength of the
company
...
The loan base is a
percentage of the acceptable receivable
...
Accounts receivable are usually pledged as collateral on a non-notification, full-recourse
basis; receivables customers are not notified of the arrangement, and the borrower has full
responsibility for collection
...

If the amount of acceptable accounts receivable is insufficient to meet the desired financing
requirements, inventory and possible machinery and equipment may be used as collateral
...

Availability problems in Financing
Two problems occur in determining the net availability from a potential source of financing
...
To see this, assume that one option in a firm’s short-term financing package is
180-day discounted not with a P1,000 principal amount
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Such a note will not provide P1,000 in financing
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05 (1000)
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Assume that the firm has the option of skipping the discount on invoices with a
face value of P50,000 that have terms of 2 percent 10 days, net 90 days
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The maximum financing from this source is P49,000, not P50,000
...

A second problem in calculating the net availability from a liability occurs when the financing
from the liability changes over time
...
For example, if the firm takes out a
180-day term loan with monthly amortization payments, the financing will not be the principal amount
of the term loan, Since the principal decreases over time ( in a nonlinear fashion), the average
financing will be some lesser amount
...
00

100
...
48

8,374
...
52

53
...
74

6,732
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78

67
...
16

5,074
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62

50
...
74

3,399
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88

34
...
48

1,708
...
40

17
...
40

Average

35,290
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An analysis of the net availability from a such
a loan is given in the said table
...
48
...
The financing provided by the loan for the second month if P 8,374
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The
average financing over the term of the loan is P 5,881
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The interest paid by the
issuer of commercial paper is determined by the size of the discount and the length of time to
maturity
...
At the end of 90 days, the
purchaser of this paper will receive P1million for its P980,000 investment
...
The effective 90-day rate on the paper is
2
...
Assuming the paper is rolled over each 90 days throughout the year,
the effective annual rate for Janux Corporation’s commercial paper, found by using Equation 5
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41% [( 1+ 0
...

One interesting characteristic of commercial paper is that it normally has a yield of 2 to 4
percent below the prime rate
...
The reason is that many
suppliers of short-term funds do not have the option, as banks do, of making low risk business loans
at the prime rate
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The yields on these marketable securities on January 22, 1999, when the prime
rate of interest was 7
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3 percent for 3-month Treasury bills and about 4
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Although the stated interest cost of borrowing through the sale of commercial paper is
normally lower than a bank loan, Additional costs include the fees paid by most issuers to obtain the
bank line of credit used to back the paper, fees paid to obtain third-party ratings used to make the

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paper more salable, and flotation costs
...

Common Sources of Short-Term Financing

Short- term Financing

Source

Cost or Condition

Characteristics

Accounts Payable

Suppliers of
merchandise

No stated cost except
when a cash discount is
offered
for
early
payment
...


Free
Accruals

Employees and
government

Wages
of employees
and taxes are paid at
discrete points in time
after the service has
been
rendered
...


Unsecured Sources of
Short-Term Financing

Bank Sources

Single-payment notes

Lines of credit

Commercial banks

Commercial banks

Prime plus 0% to 4%
risk premium-fixed or
floating rate
...

Often
must maintain 10% to
20%
compensating
balance and clean up
the line
...
Often must

12

A single-payment loan
used to meet a funds
shortage expected to
last only a short period
of time
...


A
line
of
credit
agreement under which
the availability of funds
is guaranteed
...


Commercial banks
Revolving credit
agreements

Commercial paper

Secured Sources of
Short-term Financing

maintain 10% to 20%
compensating
balance
and pay a commitment
fee of approximately

...

Generally 2% to 4%
below the prime rate of
interest
...


Commercial banks and
commercial finance
companies

Pledging

2% to 5% above prime
plus up to 3% in fees
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1% to 3% discount from
face value of factored
accounts
...

Interest
earned
on
surplus balances left
with factor of about -5%
per month

Factors, commercial
banks, and commercial
finance companies

Selected
accounts
receivable are used as
collateral
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Done
in non-notification basis
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All credit risks
go with the accounts
...

Factor will also pay
interest
on
surplus
balances
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Made when
firm
has
stable
inventory of a variety of
inexpensive items
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Advance less than 50%
of collateral value
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A loan against inventory
in general
...


3% to 5% above prime
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Commercial banks and
commercial finance
companies
Inventory collateral

3% to 5% above prime
plus a 1% to 3%
warehouse fee
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-Floating liens

Commercial banks and
commercial finance
companies

-Trust receipts

-Warehouse receipts

14

Commercial banks and
finance companies

Inventory
used
as
collateral
is
placed
under control of the
lender by putting it in a
terminal warehouse or
through
a
field
warehouse
...

Inventory is released
only on written approval
of the lender

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