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Flashcards in Working Capital Langley Deck (20)
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What do we finance?

1. Mix of short-term and long-term assets
2. “Carry” working capital – accounts receivable, inventory
-Average investment in accounts receivable
-Inventory turnover:
(CGS/average inventory)
may differ significantly depending on the industry, product, specific company, etc.
3. Objective – match assets with appropriate mix of debt/equity


The appeal of debt financing

1. Assume the after tax cost of debt is 5% and a company earns 12.5% after tax on its equity.
2. Then, the after tax return on book equity is:(12.5 % - 5.0%)(debt %) + (12.5%)(equity %)
equity %


Cash flow projections – key ingredients

1. operating earnings/cash flow (net income + non-cash expenses)
2. capital expenditures (CAPEX)
3. capital investments in subsidiaries (incl. foreign)
4. investment in working capital assets
5. principal repayments on long-term debt (assume short-term debt is rolled over)
6. dividends


Which currency do we borrow?

1. Match assets and cash flows
- "natural" hedge – doing something in the normal course of business
- principal hedges assets
- interest hedges cash flow/income statement
2. Accounting issues for public companies
- ASC 830 (FAS 52) – foreign currency translation
- ASC 815 (FAS 133) – accounting for derivatives and hedging activities


Hedging vs. speculating

1. hedging – entering into transactions to preserve the value of other underlying transactions (receivables, payables, etc.)
2. speculating – entering into transactions solely for the purpose of making a profit – no underlying transactions exist


Fixed or floating?

1. Establish policy – match asset base?
short-term floating rates may be cheapest over time, but subject to volatility
fixed rates may be higher, but with less volatile impact on the income statement (a “tradeoff” between rates and volatility)
2. Monitor policy vs. changing market conditions – be willing to change policy to take advantage of opportunities


What maturity?

1. Match asset base
2. Maturity “ladders” (debt “skyline”)
3. Key – what’s available under current market conditions
4. Issue for small/medium-sized companies – “borrowing short to finance long” (violates matching principle)


The financing “continuum”:

- Short-term, floating –rate financing

- Long-term, floating-rate financing

- Long-term, fixed-rate financing


Two “risks” of debt, for the issuer

1. Liquidity risk
- Long-term debt -- lower
- Short-term debt -- higher
2. Repricing risk
- Long-term fixed rate debt-- higher
- Short-term floating rate debt -- lower


Limitations imposed by debt

1. Lenders’ restrictions/covenants
2. Rating agency issues, especially if management has a targeted bond rating
3. Fear of liquidity constraints, violation of debt covenants, etc. may lead to conservative operating management decisions
4. Hidden “agency” costs of monitoring debt covenants, mortgages, performance guarantees, etc.


Counterparty exposure

1. This exposure arises when we are, or could be, owed money by a counterparty
2. It is also an important issue when transactions are “marked-to-market” on an ongoing basis and we would be owed money (have a receivable) from that counterparty
3. Companies need to establish a policy for managing counterparty exposure on a portfolio basis
4. Guidelines should be developed for the amount of risk we’re willing to take at each credit rating level
5. This counterparty exposure policy is typically approved by the Board


Financing decisions

1. Not made in a “vacuum” - decisions made on a cross functional team basis
2. Accounting policies, especially for public companies
3. Tax planning – on a global, consolidated basis
4. Legal issues – “WSJ test”/”headline risk”


Internal “funding”

1. cash management – use of available technology and daily cash forecast
2. working capital management
- accounts receivable (essentially “lending” to customers)
- inventory
- payables (essentially, "borrowing" from suppliers/vendors)
3. sale of underutilized assets



# days accounts receivable = (average accts. receivable / annual sales) X 365



# days inventory = (average inventory / annual cost of goods sold) X 365



# days payables = (average accounts payable / annual cost of goods sold)
X 365



“cash cycle” = # days receivables
+ # days inventory
- # days payables
# days in the cash cycle


Trade financing

1. both domestic and international
2. types of payment
- prepay – discount? – risk to importer (buyer)
- open account – risk to exporter (seller)
- letters of credit – bank credit at risk; assures exporter of payment
- consignment – title doesn’t pass until product is sold


Letters of credit – two basic types

1. trade – payment expected to be made
2. standby – payment not expected; “contingent”
- performance – contracts;
project finance; bid bonds
- guarantee – leases; international loans (bank becomes credit intermediary)



1. also known as “barter”
2. oldest known form of trade
3. no cash exchanged – instead, equivalent amounts of goods and/or services are exchanged, based on pre-agreed upon values