Chapter 18

Solvency

• refers to firm long-term financial health

• concerned with entire balance sheet (TA vs TL)

• measured by long term leverage ratios (D/E, Debt Ratio, Interest Coverage)

Liquidity

• refers to firm ability to meet short term obligations

• concerned with CA and CL (working capital) and cash flow generation

• measured by current ratio/quick ratio

How do liquidity problems lead to solvency problems

• liquidity problems turn into solvency problems when short term cash shortages force a firm to take actions that permanently weaken the balance sheet

Liquidity of an asset

• how quickly an asset can be converted into cash, without giving up value

Factors that influence Working capital and liquidity

• Asset Growth

• Sales vs Production Schedules

• Operating and Cash Cycles

Cash Formula

• Cash = LTD+E+CL-CA(other than cash) - FA

Sources of Cash

• Increasing LTD, E, CL

• Decreasing CA, FA

Uses of Cash

• Decreasing LTD, E,CL

• Increasing CA,FA

Operating Cycle

• time between purchasing the inventory and collecting the cash

  • Inventory period

  • A/R period

Inventory Period

• time required to purchase and sell inventory

• measured by # of days of inventory

• Inventory purchased → Inventory sold

A/R Period

• time to collect on credit sales

  • measured by # of days of receivables

• Inventory sold → cash received

Operating cycle formula

• Operating cycle = Inventory Period + A/R Period

Cash Cycle

• time period for which we need to finance our inventory

• Cash paid for inventory → Cash received on sale

Accounts Payable Period

• time between purchase of inventory and payment for the inventory

• measured by # days of payables

• Inventory purchased → Cash paid for inventory

Cash Cycle formula

• Cash cycle = Operating cycle - Accounts payable period

Inventory period formula

• Average Inventory = (B/B inv + E/B inv)/2

• Inventory Turnover = COGS / avg inv

• Inventory period = 365 / inventory turnover

Receivable Period Formula

• Avg Rec = (B/B rec + E/B rec) / 2

• Receivables turnover = Credit sales / Avg Rec

• Receivables period = 365 / Rec turnover

Payables Period formula

• Avg Pay = (B/B A/P + E/B AP)/2

• Payables turnover = COGS / Avg AP

• Payables Period = 365 / Payables Turnover

Is our rec period too high/low?

• what are our credit terms

• are our customers paying on time

• would we sell more by extending our terms

Is our AP period too high/low?

• are we paying suppliers on time

• would they be willing to give us more time

• are we already paying too late and potentially hurting our relationship

• what is the cost of extending terms

Is our Inv period too high/low?

• could we hold less inventory without the risk of selling out

• could we afford the storage and financing costs of holding more inventory?

What makes the cash cycle longer

• Higher inventory/Higher receivables (CA)

• Lower payables

Comparison of Cash Cycle and Dupont

• Higher assets and lower liabilities lead to lower ROE

• prefer shorter cash cycle if we have adequate inventory and receivables

Inventory Management Issues

• hold optimal amount of inventory to satisfy customer demand while minimizing ordering and carrying costs

• too much inv = high carrying costs

• too low inv = potential lost revenue and/or too high ordering and production costs

Carrying Costs

• Storage

• Insurance

• Financing costs

• Shortages

• Damages

• Loss and Theft

• Writeoffs of obsolete stock

Ordering costs

• Purchasing

• Receiving

• Processing

Production costs

• Scheduling

• Scale efficiencies

Cash Budget

• forecast of cash inflows and outflows over the next short term planning period

• primary tool in short term financial planning

What does the cash budget determine

• determines when the firm should experience cash surpluses and when it will need to borrow to cover working capital costs

• allows a company to plan ahead and search for financing before the money is needed

Average Collection Period / Payables Period

• # of days / 90 = % of sales/payables collected in the current quarter vs the following quarter

Operating Loans

• agreement in which a firm is authorized to borrow a specific amount per period (credit card)

• committed - formal legal arrangement, involves commitment fee paid to bank

• non committed - informal agreement

Letter of credit

• bank issues letter promising to make a loan if certain conditions are met

• letter contains payment on a shipment of goods provided goods arrive as promised

A/R Financing

• assigning receivables to the lender under a general assignment of book debts

• bank holds receivables as collateral, borrower responsible if receivables can’t be collected

Factoring

• Sale of AR to a purchaser at a discount

• factor (outside company) provides insurance to selling firm against bad debts

Securitized Receivables

• A/R pooled together and sold to investor as asset backed securities

• converts future payments into immediate cash

Trade Credit

• purchasing supplies on credit (AP)

Money Market Financing

• firms with good credit ratings can secure MM instruments in commercial papers and bankers acceptances