Effective Current Liabilities Management for Financial Stability

1. CHAPTER 15 Current liabilities management

2. Learning Objectives • Discuss the firm’s credit terms • See the effect of stretching accounts payable • Describe unsecured types of short term credit • Describe secured types of short term credit • Explain how to use inventory as collateral

3. Spontaneous liabilities Spontaneous liabilities are types of funding that arise from the normal operations of the firm • two main types • accounts payable • accruals • advantages • unsecured short term financing (no pledging of specific assets as collateral involved) • interest-free financing (no borrowing involved)

4. Spontaneous liabilities Accounts payable management involves maximising the time between purchase of supplies and paying the supplier (without damaging credit rating) eg. if the terms are net 30, the account should be paid 30 days from the beginning of the credit period  result: ‘stretching’ accounts payable allows maximum use of interest-free loan

5. Spontaneous liabilities • In the CCC demonstration in Ch. 14, MAX Company had an average payment period of 35 days, resulting in average accounts payable of $467,466. • Thus, the daily accounts payable generated by MAX was $13,356 ($467,466/35). • If MAX pays in 40 days instead of 30, its accounts payable would increase by $66,780 ($13,356 × 5), MAX’s cash conversion cycle would decrease by five days, and the firm would reduce its investment in operations by $66,780. • If this action did not damage MAX’s credit rating, it would be in the company’s best interest.

6. Exercise • Now try to do problem 15-1 from the Gitman chapter 15 handout

7. Spontaneous liabilities Analysing credit terms involves choosing whether to pay invoices early or late eg. if the firm is offered credit terms for N days that include a cash discount (CD), it has two options: to take the cash discount or forgo it • result depends on cost of forgoing cash discount = CD/(100%-CD) x 365/N

8. Analysing credit terms • Taking the cash discount If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no cost associated with taking a cash discount. • Lawrence Industries Ltd purchases $1,000 worth of merchandise on 27 February from a supplier extending terms of 2/10 net 30 End of Month (EOM). • If the firm takes the cash discount, it will have to pay $980 [$1,000 – (0.02 × $1,000)] on 10 March, thereby saving $20.

9. Analysing credit terms • Forgoing the cash discount If the firm chooses to forgo, or give up, the cash discount it should pay on the final day of the credit period. There is an implicit cost associated with forgoing a cash discount. • 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.

10. Analysing credit terms • In the preceding example, Lawrence Industries could take the cash discount on its 27 February purchase by paying $980 on 10 March. • If the cash discount is forgone, payment can be made on 30 March (EOM). • To keep its money for an extra 20 days (from 10 March to 30 March), the firm must forgo an opportunity to pay $980 for its $1,000 purchase - it costs $20 to delay payment for 20 days. • Figure 15.1 shows the payment options open to the company.

11. Analysing credit terms

12. Analysing credit terms • To calculate the cost of forgoing the cash discount, the true purchase price must be viewed as the discounted cost of the merchandise, - $980 for Lawrence Industries. • To delay paying for an extra 20 days, the firm must pay $1,000. • The annual percentage cost of forgoing the cash discount can be calculated using Equation 15.1.1

13. Analysing credit terms • where • CD = the stated cash discount in percentage terms • N = the number of days payment can be delayed by forgoing the cash discount • Substituting the values for CD (2%) and N (20 days) into Eqn 15.1 results in an annualised cost of forgoing the cash discount of 37.25% [(2% ÷ 98%) × (365 ÷ 20)]

14. Analysing credit terms • Mason Products has four possible suppliers, each offering different credit terms. Except for the differences in credit terms, their products and services are identical. Table 15.1 presents the credit terms offered by suppliers A, B, C and D, respectively, and the cost of forgoing the cash discounts in each transaction.

15. Analysing credit terms • If the firm needs short-term funds, currently available from its bank at an interest rate of 13%, and if each supplier (A, B, C and D) is viewed separately, which of the suppliers’ cash discounts will the firm forgo? • For supplier A, the firm will take the cash discount. The cost of forgoing it is 37.24%. The firm will borrow the funds it requires from its bank at 13% interest. • With supplier B, the firm will forgo the cash discount. The cost of this is less than the cost of borrowing money from the bank (8.19% vs 13%). • With suppliers C and D, the firm should take the cash discount, since the cost of forgoing the discount is greater than the 13% cost of borrowing from the bank.

16. Exercise • Now try to do problem 15-2 from the Gitman chapter 15 handout

17. Analysing credit terms • Stretching accounts payable—that is, paying bills as late as possible without damaging its credit rating • Lawrence Industries was extended credit terms of 2/10 net 30 EOM. The cost of forgoing the cash discount, assuming payment on the last day of the credit period, was found to be 37.25 %. • If the firm stretches its account payable to 70 days without damaging its credit rating, the cost of forgoing the cash discount would be only 12.41%. • Stretching accounts payable reduces the implicit cost of forgoing a cash discount

18. Exercise • Now try to do problem 15-6 from the Gitman chapter 15 handout

19. Do: 15-6 - Credit terms • Answer: • a. (i) 1/15 net 45 date of invoice • (ii) 2/10 net 30 EOM • (iii) 2/7 net 28 date of invoice • (iv) 1/10 net 60 EOM • b.(i) 45 days • (ii) 49 days • (iii) 28 days • (iv) 79 days

20. Spontaneous liabilities Accruals are liabilities for services received for which payment has yet to be made • examples: wages, taxes • eg. delay payment of wages and/or taxes • result: interest free loan from workers, government • Tenney Coy pays its employees at the end of each working week. The weekly payroll totals $400,000. If Tenney changes the pay period to fortnightly (that is, one week later), the employees would in effect be lending the firm $400,000 each year. • If the firm could earn 10% annually on invested funds, this strategy would be worth $40,000 per year (0.10 × $400,000). By delaying payment of accrued wages in this way, the firm could save this amount of money.

21. Unsecured sources of short term loans Unsecured types of financing involve no collateral being pledged by the borrower • bank loans are a common form - typically in the form of an overdraft - can be used by small firms and big firms - provides funding for seasonal peaks

22. Unsecured sources of short term loans Bank loan interest rates • prime rate = lowest rate charged by banks to their best customers • fixed rate loan = loan with constant rate until maturity (set at a fixed margin above the prime rate) • floating rate loan = loan with variable rate (set at a flexible margin above the prime rate)

23. Unsecured sources of short term loans Bank loan interest rate calculation • nominal rate of interest - equals the contract rate - reflects the borrower’s credit standing • effective rate • = (interest)/(amount borrowed) if interest paid at maturity • discount loan rate = (interest) / (amount borrowed - interest)

24. Calculating interest • Wooster Company wants to borrow $10,000 at a stated rate of 10% interest for one year. If the interest on the loan is paid at maturity, the firm will pay $1,000 (0.10 × $10,000) for the use of the $10, 000 for the year. The effective annual interest rate is 10% • If the money is borrowed at the same stated rate but interest is paid in advance, the firm still pays $1,000 in interest, but receives only $9,000 ($10,000 –1,000). • Thus, the effective annual interest rate in this case is: 1,000/9,000 = 11.1% • Paying interest in advance makes the effective interest rate (11.1%) greater than the stated interest rate (10%).

25. Exercise • Now try to do problem 15-13 from the Gitman chapter 15 handout

26. Unsecured sources of short term loans Bank loan terminology • ‘overdraft’ • a short term self liquidating loan subject to a pre-determined limit • operates by allowing the borrower’s cheque account to go into deficit • may involve an interest charge onthe unused portion of the overdraft

27. Unsecured sources of short term loans • line of credit • An agreement between a bank and a business for ongoing short-term finance by way of overdraft or bill facility • revolving line of credit • An extended line of credit provided by a bank subject to annual review. • commitment fee • The fee that is normally charged on a revolving credit agreement. It often applies to the average unused balance of the borrower’s credit line.

28. Unsecured sources of short term loans • REH Coy has a $2 million revolving credit agreement with its bank. Its average borrowing under the agreement for the past year was $1.5 million. The bank charges a commitment fee of 0.5% on unused funds. • The average unused portion of the committed funds was $500,000 ($2 million – $1.5 million), so the commitment fee for the year was $2,500 (0.005 × $500,000). • REH also pays interest on the actual $1.5 million borrowed. If $160,000 interest was paid on the $1.5 million borrowed, the effective cost of the agreement was 10.83% [(160,000 + 2,500)/$1,500,000]. • Although more expensive than a line of credit, a revolving credit agreement can be less risky from the borrower’s viewpoint, because the availability of funds is guaranteed.

29. Unsecured sources of short term loans • Clemens Cutters recently negotiated a $100,000 overdraft limit with bank A. The interest rate was set at 3% above bank A’s prime rate of 6.5% per annum. • Clemens Cutters overdrew its current account by $80, 000 on the first day of the agreement. The overdraft stayed at $80,000 for 30 days, rose to $98,000 during the next 30 days, fell to $75,000 on the next 30 days and was reduced to zero on day 91. • Bank A’s prime rate stayed at 6.5% for the first 30 days, fell to 6.25% for the next 30 days and rose to 6.75% for the next 30 days. • The unused overdraft limit charged by bank A is 2% per annum. Clemens Cutters would pay the following interest on the overdraft for the first 90 days:

30. Unsecured sources of short term loans • Overdraft interest: • (Prime rate + excess)(period)(amount) • Unused fee: • (rate x period x unused balance)

31. Unsecured sources of short term loans Bank loan terminology • ‘operating change restrictions’ are contractual regulations the bank imposes on the borrower eg - regular financial statements - notification of major business changes • ‘compensating balances’ is an amount the bank may require the firm to maintain in its cheque account • ‘annual clean-ups’ require the borrower to keep a zero overdraft balance for N days per year

32. EG borrows $1 million (10% pa interest rate) under a line of credit agreement and must maintain a compensating balance equal to 20% of the amount borrowed, ($200,000), in its cheque account. Thus, it can use only $800,000. • The firm pays interest of $100,000 (0.10 x $1 million). The effective annual rate is 12.5% ($100,000 ÷ $800,000). • If the firm has $200,000 or more in its cheque account, the effective annual rate is 10% because none of the $1 million borrowed is needed for the compensating balance. • If the firm has $100,000 balance in its cheque account, only an additional $100,000 needs to be tied up, leaving it with $900,000 of usable funds. The effective annual rate is 11.1% ($100,000 ÷ $900, 000).

33. General formula for interest • The general approach to calculating interest on short-term financing is: • Nominal Interest rate/(amount borrowed – all deductions) • = Nominal interest/(net amount received) • Eg. A 10%, $1,000 loan with 20% compensating balance and 0.5 % initiation fee, would be: • 100/(1,000 – 200 – 5) = 100/795 = 12.58% • Or, 0.1/(1 – 0.2 – 0.005) = 0.1/0.795 = 12.58%

34. Unsecured sources of short term loans Bill and note finance • a ‘bill of exchange’ is a written, unconditional order involving three parties for a specified sum to be paid on a specified date  the drawer is the issuing party (= borrower)  the acceptor agrees to pay ( = bank)  the endorser purchases the bill (= lender)

35. Unsecured sources of short term loans Bill and note finance • ‘bank-accepted bills of exchange’ are bills that have been accepted by a bank • implications: • the bank guarantees the credit risk • the bill trades as a low-risk security • the bill trades at a low yield • the bill is highly liquid

36. Unsecured sources of short term loans Bill and note finance

37. Unsecured sources of short term loans Bill and note finance • ‘commercial bills of exchange’ are bills not accepted or endorsed by a bank • ‘promissory notes’ are short term unsecured commercial loan instruments note: CBs need to be endorsed when transferred PNs are transferable without endorsement

38. Unsecured sources of short term loans Bill and note finance interest calculation  interest is determined by the size of the discount (D) and length to maturity (N days) Example: Bertram Ltd issues $1m worth of P-notes with 90-day maturity at price of $980,000 At maturity, Bertram pays $1,000,000 to the lender Solution: the 90-day interest rate is 2.04% (=$20,000/$980,000) and the effective annual interest rate is 8.41% = [(1+0.0204)4 -1] if the loan is rolled over each 90 days

39. Unsecured sources of short term loans • promissory notes normally have a yield of 2% - 4% below the prime bank lending rate. Firms are able to raise funds through the sale of bills and notes more cheaply than by borrowing from a commercial bank • Although the stated interest cost of borrowing through the sale of bills and notes is normally lower than the prime bank lending rate, the overall cost of bills and notes may not be cheaper 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 paper more saleable, and flotation costs

40. Secured sources of short term loans Secured types of financing involve collateral being pledged by the borrower • a ‘security agreement’ specifies the collateral held against the loan, including: - nature of asset - conditions of release - rights of claim

41. Secured sources of short term loans Ordinary collateral  lenders try to match collateral duration to loan length  a ‘percentage advance’ is a % of the asset’s book value that constitutes the principal  a service charge will be payable for the lender’s administration expenses

42. Secured sources of short term loans Accounts receivable as collateral • a ‘pledge of accounts receivable’ involves using the firm’s accounts as security to obtain a loan • the pledging process involves scrutiny by the lender of the quality and value of the accounts • pledges can be on a notification or non-notification basis, depending on whether the account customer is informed their account is being used as collateral

43. Secured sources of short term loans Factoring accounts receivable  involves the outright sale of accounts receivable at a discount to a bank (called the ‘factor’) in exchange for credit Invoice discounting  is the sale of accounts receivable to a discounter, where the accounting function is retained by the firm

44. Secured sources of short term loans Factoring and invoicing discounting agreements  a lender selects accounts for purchase based on acceptable credit risk  usually on a ‘non-recourse’ basis, which is an understanding that the factor accepts all credit risks

45. Secured sources of short term loans • Graber Company discounts its invoices. The discounter provides 80% of value of each invoice discounted to Graber within 48 hours, charges a 2% service fee and charges 1% per month interest (12% per year) on advances. • Graber wishes to obtain an advance on discounted invoices having a book value of $1,000 and due in 30 days. The proceeds to the company are calculated as follows: • The firm receives $772.20 now and the balance when the customer pays the discounter. The method used to calculate the amount advanced depends on the terms of the discounting agreement. • If both the discount service fee of $20 and the interest of $7.80 are included, the annual discounting cost for the transaction would be approximately 43% [($27.80/$772.20) × 12] – see next slide.

46. Secured sources of short term loans

47. Secured sources of short term loans Using inventory as short term collateral  seen as second to accounts receivable as collateral  advantage: inventory has greater market value than its book value  a ‘floating charge over inventory’ is a lender’s claim on the borrower’s inventory

48. Secured sources of short term loans • Prescott needs a loan of $125,000 for 60 days. The company’s bank offers a loan secured under a floating charge over inventory. The annual interest rate would be 14%, 5% above the bank’s prime rate. • The bank advances 40% of the average book value of the secured inventory. The company would have to put up $312,500 in book value of inventory as collateral—the loan required divided by the loan advance ratio ($125,000/0.40). • The cost of this loan is $2,917 ($125,000 × 14% x 2/12) - an effective rate of 2.33% [0.14/(2/12)] for two months ($2,917/$125,000) or the stated 14% rate annually [2.33% × (12/2)], assuming this is a single transaction.

49. Secured sources of short term loans • floor plan inventory loan • An agreement under which the lender advances 80 to 100% of the cost of the borrower’s saleable inventory items in exchange for the borrower’s promise to immediately repay the loan, with accrued interest, on the sale of each item.

50. Exercise • Now try to do problem 15-38 from the Gitman chapter 15 handout