Difficulty in setting the appropriate terms Uncertainty as to when cash receipts will be received,complicating cash budgeting. Unlike to reduce irrecoverable debts in practice. Factoring:Transfer the debts to a factor company,and receive the money before the debt maturity.The factor also involves in managing the account receivables of the company Factoring: With Recourse:factor only pays collectable debts Without recourse:factor pays value of whole debt even if not recovered. Advantages: Enhance liquidity of the company Saving in administration costs Reduction in the need for management control Particularly useful for small and fast growing businesses where the credit control department may not be able to keep pace with volume growth. Disadvantages: ◆Cost of factoring Endanger trading relationship and damage goodwill. A signal oftight liquidity Lose control over internal credit control system How to assess factoring:Cost benefit analysis method Example 4 A company has monthly credit sales of $200,000,and it gives customers 60 days credit.All customers take the full credit allowed.It has bad debts each year amounting to about 2.5%of sales tumover.It operates with a bank overdraft and pays interest at 8%on its overdraft balance The company's management is considering whether to use a factor to collect its debts,under a non-recourse factoring arrangement.A factor has indicated that it will take over the administration of the sales ledger and debt collection for a fee of2 of annual credit sales turnover.This would save the company internal operating costs of $30.000 each vear. The factor would also charge 1.5%of tumover for credit insurance The factor will advance%of the value of invoices as soon as they are sent out,and charge interest at 7.75% If the services of the factor are used,it is anticipated that there will be no change in annual sales turnover and no change in the collection period of 60 days. Required:Assess the financial consequences of using the factor for non-recourse factoring and factor finance
◆ Difficulty in setting the appropriate terms ◆ Uncertainty as to when cash receipts will be received, complicating cash budgeting. ◆ Unlike to reduce irrecoverable debts in practice. Factoring: Transfer the debts to a factor company, and receive the money before the debt maturity. The factor also involves in managing the account receivables of the company. Factoring: ✓ With Recourse: factor only pays collectable debts ✓ Without recourse: factor pays value of whole debt even if not recovered. Advantages: ◆ Enhance liquidity of the company ◆ Saving in administration costs ◆ Reduction in the need for management control ◆ Particularly useful forsmall and fast growing businesses where the credit control department may not be able to keep pace with volume growth. Disadvantages: ◆ Cost of factoring ◆ Endanger trading relationship and damage goodwill. ◆ A signal of tight liquidity ◆ Lose control over internal credit control system How to assess factoring: Cost benefit analysis method Example 4 A company has monthly credit sales of $200,000, and it gives customers 60 days credit. All customers take the full credit allowed. It has bad debts each year amounting to about 2.5% of sales turnover. It operates with a bank overdraft and pays interest at 8% on its overdraft balance. The company’s management is considering whether to use a factor to collect its debts, under a non-recourse factoring arrangement. A factor has indicated that it will take over the administration of the sales ledger and debt collection for a fee of 2% of annual credit sales turnover. This would save the company internal operating costs of $30,000 each year. The factor would also charge 1.5% of turnover for credit insurance. The factor will advance 80% of the value of invoices as soon as they are sent out, and charge interest at 7.75%. If the services of the factor are used, it is anticipated that there will be no change in annual sales turnover and no change in the collection period of 60 days. Required: Assess the financial consequences of using the factor for non-recourse factoring and factor finance
Step I Cost of existing policy Funding cost=2 x $200.000 x 8%=$32.000 Bad debts1oss=12X$200.000x2.5%6=$60.000 Administrative cost=$30,000 Total cost of existing policy=$122,000 Step 2 Cost of factoring offering Service charges=12x$200.000x2%=$48,000 advance payment charge=2x$200,000x80%x7.75%=$24,800 Funding cost=2 X$200.000X8%X20%6=$6.400 Credit insurance charge=12x$200,000x1.5%=$36,000 Total cos of factoring offering=$115,200 Step3 Make comparison Net benefits=Cost of existing policy-Cost of factoring offering-$122.000 $115,200=$6,800 Invoice discounting(connect with factoring) Invoice discounting is a method of raising finance against the security of debtors without using the sales ledger administration services of a factor. Management in Foreign account receivable Letters of credit:the customer's bank guarantees it will pay the invoice Export factoring and export credit insurance Invoice discounting:sale of selected invoices toa debt factor Bills of exchange:IOU signed by the customer.Until paid,shipping documents that transfer ownership are withheld:can be sold. (3)Management of creditors and short-term finance Source of short-term finance -Trade credit Bank overdraft -Short-term deb Trade accounts payable management may involve analysis ofprompt payment discounts Cost of lower payables--higher overdraft costs Benefit of lower payables---discounts Cost of trade creditor -Early payment discounts(explicit cost) -Loss suppliers'goodwill credit rating problems (implicit cost) More stringent terms for future sales.(implicit cost) (4)Management of cash >Why holding cash Transactions motive to meet day-to-day financial obligations
Step 1 Cost of existing policy Funding cost= 2ｘ$200,000ｘ8% =$32,000 Bad debts loss= 12 ｘ $200,000 ｘ 2.5%=$60,000 Administrative cost=$30,000 Total cost of existing policy=$122,000 Step 2 Cost of factoring offering Service charge= 12ｘ$200,000ｘ2%= $48,000 advance payment charge= 2ｘ$200,000ｘ80%ｘ7.75%= $24,800 Funding cost=2 ｘ$200,000ｘ8%ｘ20%=$6,400 Credit insurance charge= 12ｘ$200,000ｘ1.5%=$36,000 Total cost of factoring offering=$ 115,200 Step 3 Make comparison Net benefits= Cost of existing policy- Cost of factoring offering=$122,000- $ 115,200=$6,800 Invoice discounting (connect with factoring) Invoice discounting is a method of raising finance against the security of debtors without using the sales ledger administration services of a factor. Management in Foreign account receivable ✓ Letters of credit: the customer’s bank guarantees it will pay the invoice. ✓ Export factoring and export credit insurance ✓ Invoice discounting: sale of selected invoices to a debt factor ✓ Bills of exchange: IOU signed by the customer. Until paid,shipping documents that transfer ownership are withheld; can be sold. （3） Management of creditors and short-term finance ✓ Source of short-term finance – Trade credit – Bank overdraft – Short-term debt ✓ Trade accounts payable management may involve analysis of prompt payment discounts: – Cost of lower payables---higher overdraft costs – Benefit of lower payables---discounts ✓ Cost of trade creditor – Early payment discounts (explicit cost) – Loss suppliers’ goodwill & credit rating problems (implicit cost) – More stringent terms for future sales. (implicit cost) （4） Management of cash ➢ Why holding cash Transactions motive to meet day -to -day financial obligations
Finance motive to cover major items like the purchase of fixed assets and the repayment of loans. Precautionary motive to give a buffer against unplanned expenditure Investment motive to take advantage of opportunities that might arise Factors to be considered: liquidity:Available for use when needed; safety:No risk of loss must be taken; Profitability:Earn highest possible after tax returns Cash flow forecasts Cash position Appropriate management action Short-term surplus Pay accounts payable early to obtain discount. Increase sales by increasing accounts receivable and inventories Make short-term investments Short-term deficit Increase accounts pavable Reduce accounts receivable Arrange an overdraft Long-term surplus Make long-term investments Expand Diversity urrent assets ong-term deficit Long-term debt Leasing Sell assets Conside shutdown Stop Cash flow forecasting for January 2013 January Cash receipts Sales receipts(w1) Issues ofshares Total cash receipts Cash payments Purchase payments(w2) (X) Dividends/taxes (X) Wages (X) Repayment of loan ☒ Total cash payments
Finance motive to cover major items like the purchase of fixed assets and the repayment of loans. Precautionary motive to give a buffer against unplanned expenditure Investment motive to take advantage of opportunities that might arise ➢ Factors to be considered: ✓ liquidity: Available for use when needed; ✓ safety: No risk of loss must be taken; ✓ Profitability: Earn highest possible after tax returns ➢ Cash flow forecasts Cash position Appropriate management action Short-term surplus Pay accounts payable early to obtain discount. Increase sales by increasing accounts receivable and inventories Make short-term investments Short-term deficit Increase accounts payable Reduce accounts receivable Arrange an overdraft Long-term surplus Make long-term investments Expand Diversity Replace/update non-current assets Long-term deficit Issue of share capital Long-term debt Leasing Sell assets Consider shutdown Stop investments ➢ Cash flow forecasting for January 2013 January Cash receipts Sales receipts (w1) X Issues of shares X Total cash receipts X Cash payments Purchase payments (w2) (X) Dividends/ taxes (X) Wages (X) Repayment of loan (X) Total cash payments (X)
Cash surplus/deficit for month X Cash balance,b/f(opening) Cash balance,c/f(closing) X >Methods of easing cash shortage Postponing capital expenditure Accelerating cash inflows which would others be expected in a later period Reversing past investment decisions by selling assets previously acquired. Negotiating a reduction in cash outflows.to postpone or reduce payments Treasury management Advantages of a centralised treasury department -Centralised liquidity management -Giving better Short-term investment opportunities Borrowing arranged in bulk at lower cost Foreign exchange risk improved -Funds required for precautionary purposes will be smaller -Employ experts to handle Advantages of a decentralised cash management -Source of finance can be diversified and match local assets -Greater autonomy given to subsidiaries -More responsive to the needs of operating units More limited opportunities of investment >Cash management model Baumol cash management model Assumptions: -Cash use is steady and predictable Cash inflows are known and regular -Day-to-day cash needs are funded from current account -Buffer cash is held in short-term investments. Economic quantity of cash- 2×Annual cash required×cost of ordering cash Net interest cost of holding cash EOQ model calculates the amount of funds which means the optimum regular cash injection into the current account or to transfer into short-term investments at one time Miller-Orr management model >Assumptions: -Assumes that cash flows in any given day are unpredictable
Cash surplus/ deficit for month X Cash balance, b/f(opening) X Cash balance, c/f (closing) X ➢ Methods of easing cash shortage ✓ Postponing capital expenditure ✓ Accelerating cash inflows which would others be expected in a later period ✓ Reversing past investment decisions by selling assets previously acquired. ✓ Negotiating a reduction in cash outflows, to postpone or reduce payments ➢ Treasury management Advantages of a centralised treasury department – Centralised liquidity management – Giving better Short-term investment opportunities – Borrowing arranged in bulk at lower cost – Foreign exchange risk improved – Funds required for precautionary purposes will be smaller – Employ experts to handle Advantages of a decentralised cash management – Source of finance can be diversified and match local assets – Greater autonomy given to subsidiaries – More responsive to the needs of operating units – More limited opportunities of investment ➢ Cash management model Baumol cash management model Assumptions: – Cash use is steady and predictable – Cash inflows are known and regular – Day-to-day cash needs are funded from current account – Buffer cash is held in short-term investments. EOQ model calculates the amount of funds which means the optimum regular cash injection into the current account or to transfer into short-term investments at one time. Miller-Orr management model ➢ Assumptions: – Assumes that cash flows in any given day are unpredictable
-Recognizes that cash flows and outflows vary considerably on a day- to-day basis Steps: -A lower limit(safety stock)of cash is decided upon A statistical calculation is completed taking into account the historic variability of cash flows to agree an allowable range or spread of cash flow fluctuations Variance of cash flow=(standard deviation per day)Interes cost=interest cost per day This model controls irregular movements of cash and sets the spread between the upper and lower cash balance limits. Lower limit=set by the company;(safety stock) Upper limit=lower limit spread Iftoo much or too little cash is held then action is taken to return the cash level to a return point. Return point=lower limit +spread/3 When cash hit upper limit,purchase securities to retum point When cash hit lower limit,sale securities to retum point Upper Limit rn I >Working capital funding strategies(trade off between risk and return) Capital requirement =current assets-current liabilities Permanent and fluctuating current assets a)Non-current (fixed)assets:long-term assets to derive benefit over a number of periods b)Permanent current assets:are the amounts required to meet long-term minimum needs and sustain normal trading activity.For example,inventory and the average level of accounts receivable. c)Fluctuating current assets:are the current assets which vary according to normal business activity,for example due to seasonal variations. (5)Strategies of working capital funding
– Recognizes that cash flows and outflows vary considerably on a dayto-day basis ➢ Steps: – A lower limit (safety stock) of cash is decided upon – A statistical calculation is completed taking into account the historic variability of cash flows to agree an allowable range or spread of cash flow fluctuations Spread=3ｘ[3/4ｘ (transaction costｘvariance)/interest cost]1/3 Variance of cash flow= (standard deviation per day)2 Interest cost= interest cost per day – This model controls irregular movements of cash and sets the spread between the upper and lower cash balance limits. Lower limit= set by the company; (safety stock) Upper limit= lower limit + spread – If too much or too little cash is held then action is taken to return the cash level to a return point. Return point=lower limit + spread/3 ✓ When cash hit upper limit, purchase securities to return point ✓ When cash hit lower limit, sale securities to return point ➢ Working capital funding strategies (trade off between risk and return) Capital requirement = current assets -current liabilities Permanent and fluctuating current assets a) Non-current (fixed) assets: long-term assets to derive benefit over a number of periods. b) Permanent current assets: are the amounts required to meet long-term minimum needs and sustain normal trading activity. For example, inventory and the average level of accounts receivable. c) Fluctuating current assets: are the current assets which vary according to normal business activity, for example due to seasonal variations. （5）Strategies of working capital funding