Financial Management: Summary and Definitions.
Financial Management: Summary and Definitions Analysis of ch16: Working capital management is a managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. Implementing an effective working capital management system is an excellent way for many companies to improve their earnings.
This chapter discusses the management of current assets, particularly cash, marketable securities, inventory, and receivables. This chapter answers some Basic questions involving working capital management such as how much cash and inventory should be kept on hand? Will it be affect the liquidity of the firm to sell on credit or not? And how and from which sources the short term financing can be obtained? Therefore this chapter helps us in answering these questions by analyzing the various options available to a firm.
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The first important concept mentioned is Cash Conversion Cycle. he net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. This is very important because a firm needs to know about the time that it takes to convert its production into sales and into cash receipts and also the payment periods in order to have a check on its liquidity. Moreover, investment policies for current assets are also being highlighted for e. g. relaxed current asset investment policy, restricted current asset policy etc. hese policies can be effected by changes in technology. Furthermore, current assets financing policies such as permanent current assets, temporary current assets etc are also discussed. This chapter also discusses the importance of marketable securities to a corporation. Cash although for an individual may include currency and demand deposits, for a corporation marketable securities are also a very important source of cash, these securities are liquid as well as having an interest factor associated with them which leads to stability of the interest rates throughout the world.
Apart from the management of the cash the corporations have to decide on its credit policy which affects the amount of cash available to a firm directly. Credit policies that a firm can use include credit periods, cash discounts, credit standards and collection policy. A tighter credit policy may discourage sales as some customers may choose to go elsewhere if they are pressured to pay their bills sooner. Short-term credit refers to debt scheduled for repayment within 1 year. Major sources of short-term credit include accounts payable (trade credit), bank loans, and commercial loans.
The chapter also discusses the importance of inventory management. Purchases in bulk result in huge inventories which results in the firm incurring a number of costs such as storage, insurance, depreciation, obsolescence, handling costs and property taxes. These costs come under the category of carrying costs. In order to reduce these costs which can be substantial in nature, a firm needs to reduce the amount of inventories the firm has at hand at a particular point of time. Finally the chapter talks about the short term financing techniques.
A firm has a number of options from which to finance its short term operations, these includes promissory notes. Here the banks play a very important role as they decide the interest rate that they are going to charge based on the past record and credit worthiness of the firm. Apart from this, commercial papers are also used by firms which however are not secured. A very important option is short term bank loans. From the firm’s perspective, short term credit is riskier than long term debt as the amount originally is to be paid back in a relatively shorter period of time which may pose difficulties for the firm.
Short-term financing involves speed, flexibility and lower cost than long-term debt. A lower cost is present because of a lower amount of interest payments. However, it has fluctuating interest expense and firm may be at risk of default as a result of temporary economic conditions. Overall this chapter was very important as it showed the importance of efficient working capital management for a firm. A corporation should include the information provided in order to run an efficient business. DEFINITIONS Working capital: all short term or current assets, such as, cash, inventories nd Account receivables. 1. Net working capital: current assets minus all current liabilities. 2. Net operating working capital: current assets minus noninterest bearing current liabilities. 3. Cash conversion cycle: the length of time funds are tied up in working capital or the length of time between paying for working capital and collecting cash from the sale of working capital. 4. Inventory conversion period: average time required to convert raw materials in to finished goods and then to sell to them. 5.
Average collection period: the average length of time required to convert the firm’s receivables into cash. 6. Payables deferral period: the average length of time between the purchase of materials and labor and the payment of cash for them. 7. Relaxed current asset investment policy: relatively large amounts of cash, marketable securities and inventories are carried and a liberal credit policy results in a high level of receivables. 8. Restricted current asset policy: holdings of cash, marketable securities, inventories and receivables are constrained. 9.
Moderate current asset policy: between the relaxed and restricted policies. 10. Permanent current assets: current assets that a firm must carry even at the trough of its cycles. 11. Temporary current assets: current assets that fluctuate between the seasonal and cyclical variations in sales. 12. Current asset financing policy: the way current assets are financed. 13. Maturity matching: a financing policy that matches assets and liability maturities. This is a moderate policy. 14. Cash budget: a table that shows cash receipts, disbursements, and balances over some period. 15.
Target cash balance: the desired cash balance that a firm plans to maintain in order to conduct business. 16. Account receivable: a balance due from a customer. 17. Credit policy: a set of rules that include the firm’s credit period, discounts, credit standards and collection procedures offered. 18. Credit period: The lengths of time customers have to pay for purchases. 19. Credit standards: the financial strength customers must exhibit to qualify for credit. 20. Discounts: These are price reductions given by the creditors/suppliers to the debtors/customers for making early payments. 21.
Credit Standards: The financial strength customers must exhibit to qualify for credit. 22. Collection Policy: The degree of toughness in enforcing the credit terms. 23. Credit Terms: A Statement of the credit period and any discount offered. 24. Credit Score: It’s a numerical score from 1 to 10 that indicates the likelihood that a person or business will pay on time. 25. Aging Schedule: It’s a report showing how long accounts receivables have been outstanding. 26. Trade Credit: It is a debt arising from credit sales and recorded as an account receivable by the seller and as an account payable by the buyer. 7. Free Trade Credit: A credit received during the discount period. 28. Costly Trade Credit: A credit taken in excess of free trade credit, whose cost is equal to the discount lost. 29. Stretching Accounts Payable: It’s a practice of deliberately paying late. Revolving Credit Agreement: A formal, committed line of credit extended by a bank or another lending institution. 30. Prime Rate: A published interest rate charged by commercial banks to large, strong borrowers. 31. Regular or simple Interest: The situation when only interest is paid monthly 32.
Add on Interest: Interest that is calculated and added to funds received to determine the face amount of an installment loan. 33. Commercial Paper: Unsecured, short-term promissory notes of large firms, usually issued in denominations of $100,000 or more with an interest rate somewhat below the prime rate. 34. Accruals: Continually recurring short-term liabilities especially accrued wages and accrued taxes. 35. Spontaneous Funds: Funds that are generated spontaneously as the firm expands. 36. Secured loan: A loan backed by collateral, often inventories or account receivable.
Analysis of ch17: No business can succeed without adequate forecasting and financial planning. These two are the main focus of this chapter. For any important business decision such as the cost of capital, capital budgeting, forecasted profit and loss accounts, capital structure, dividend policy and more importantly working capital management effective financial planning and predictions about the future are needed so that the operations of a business are conducted efficiently and any negative circumstances are avoided.
Thus both managers and investors need to understand how to forecast future results. To do this managers make use of pro forma or projected financial statements and then use them to anticipate the firms future financial needs and for example to determine the future free cash flows and the company’s overall value. The chapter firstly talks about strategic planning and its importance. Strategic planning has 5 main components, the first and foremost is the mission statement. The mission statement should be a clear and succinct representation of the enterprise’s purpose for existence.
It should incorporate socially meaningful and measurable criteria addressing concepts such as the moral/ethical position of the enterprise, public image, the target market, products/services, the geographic domain and expectations of growth and profitability. The intent of the Mission Statement should be the first consideration for any employee who is evaluating a strategic decision. The statement can range from a very simple to a very complex set of ideas. The next steps are defining the corporate scope which defines a firm’s line of business.
The corporate objective is highly important and should be define quantitatively as well as qualitatively. In order to achieve specific objectives, effective strategies are needed, this is the next step. The final component is an operating plan for each unit. Hence by combining all of these components a business reaches its financial plan, the most important part of which is financial statements. These financial statements are not only helpful in evaluating the current strategies but they also provide ample room for alternative strategies. Additional financing need (AFN) consists of required increase in assets, spontaneous increase in liabilities and increase in retained earnings. To generate forvasted sales net working capital must have enough assets, also, the balance sheet must balace. Additional net profit and additional longterm debt can finance AFN. Since the equation method assumes a constant profit margin, a constant dividend payout, and a constant capital structure AFN equation and financial statement method have different results. Financial statement method is a flexible one plus it also allows different items to grow at different rates.
Additional sales could be supported with the existing level of assets if we suppose that fixed assets had only been operating at 75% of capacity in a particular year. The maximum amount of sales that can be supported by current level of assets can be calculated by using the formula Actual Sales/ % of capacity. No additional assets are needed if the answer is less than the 2003 forecasted sales. Excess capacity will affect the forecasted ratios by not affecting the sales but assets would be lower, so turnovers would be better.
There will be less new debt, hence lower interest, so higher profits, earnings per share and return on equity. A company should be using regression analysis and individual ratios such as firm should individually calculate the inventory and accounts receivables ratios In order to improve financial forecasts. In totality the forecasting techniques in this chapter are highly important. For one, if the projected operating results are unsatisfactory, management can “go back to the drawing board”, reformulate its plans, and develop more reasonable targets for coming year.
Plus, it is better to know beforehand that firm will not have enough funds to meet the sales forecast so that they can scale back the projected level of operations. DEFINITIONS chapter 17 1. Pro Forma (Projected) Financial Statements: Financial statements that forecast the company’s financial position and performance over a period of years. 2. Mission statement: A condensed version of a firm’s strategic plan 3. Corporate Scope: Defines firms lines of business and geographic areas of operation 4. Statement of Corporate Objectives: See forth specific goals to guide management 5.
Corporate Strategies: Broad approaches development for achieving a firm’s goal 6. Operating plan: Provides management with detailed implementation guidance based on the corporate strategy to help meet the corporate objectives 7. Financial Plan: The document that includes assumptions projected financial statements, and projected ratios and ties the entire planning process together 8. Spontaneously generated funds: Funds that arise out of normal business operations from its suppliers, employees and the government(such as account payable and accrued wages and taxes) that reduce the firm’s need for external financing 9.
Retention ratio: The proportion of net income that is reinvested in the firm and is calculated as minus 1 the dividend ratio 10. Additional funds needed: The amount of external capital (interest bearing debt and preferred and common stock) needed to acquire the needed capital 11. AFN equation: An equation that shows the relationship of external funds needed by a firm to its projected increase in assets, the spontaneous increase in liabilities, and its increase in retained earnings 12.
Sustained growth rate: The maximum achievable growth rate without the firm having to raise external funds. In other words, it is the growth rate at which the firm’s AFN equals zero 13. Capital intensity Ratio: The ratio of assets required per dollar of sale 14. Excess Capacity Adjustment: Changes made to the existing forecast because the firm is not operating at full capacity 15. Regression analysis: A statistical technique that fits a line to observe data points so that the resulting equation can be used to forecast other data points.