Summary
Summary Advanced corporate finance exam preperation and literature (2021)
- Course
- Institution
Summary of the theory and literature taught in the course Advanced Corporate Finance. Can be used as exam preperation.
[Show more]
1 review
By: maxvermeulen • 1 year ago
Seller
Follow
gillesputs
Reviews received
Content preview
Topic 1: Short term financial managementWorking capital management/policy
Working capital management of a company requires a clear specification of the objectives to be
achieved. The two main objectives of working capital management are to increase the profitability of
the company and to ensure that it has sufficient liquidity to meet short-term obligations.
Working capital is therefore an important part of the financial structure. Companies need to create
working capital policies on the inventory, trade receivables, cash and short-term investments in order
to minimalize the possibility of manager making decisions which are not in the best interests of
the company (e.g. giving credit to customers who are unlikely to pay or ordering unnecessary
inventories). Working capital management policies will reflect corporate decisions on the total
investment in current assets, amount in each type of asset, and the way it is financed.
The level of working capital management is maintained in different policies:
- Aggressive policy: Lower levels of cash, receivables and inventory in respect to sales.
Increase profitability because less cash is tied up in WC, more risk for running out of
inventory or have cash shortages.
- Conservative policy: More flexible policy for a given level of sales. The company will hold
more WC, and therefore the return is lower, but risk of running out of inventory or cash is less
than for the aggressive policy.
- Moderate policy: Meet in the middle of the conservative and aggressive policy.
Working capital finance
An overdraft is an agreement by a bank to allow a company to borrow up to a certain limit without
the need for further discussion. The limit is fixed, but the amount the company will use is flexible. The
company will pay a certain daily interest on the amount the company uses.
A short-term loan is a fixed amount of debt finance borrowed by a company from a bank, with
repayment to be made in the near future. A short-term loan is less flexible than an overdraft, because
the amount is fixed.
Trade credit is an agreement to take payment for goods and services at a later date than that on which
the goods and services are supplied to the consuming company.
Short term sources of finance are usually cheaper and more flexible than long-term ones. However,
short term sources of finance are riskier than long-term sources from the borrower’s point of view in
that they may not be renewed. Another source of risk for the short-term borrower is that interest rates
are more volatile in the short term than in the long term and this risk is compounded if floating rate
short-term debt is used.
Financing working
The level of investments in current assets create a trade-off between risk and return, as discussed
above. Because interest rates of short-term finance are lower than for long-term finance, but the risk of
the short-term finance is higher than for long-term finance, we again face this risk-return trade-off.
The assets we need to invest in we can roughly put into three categories: Non-current assets,
permanent current assets (minimum required current assets) and floating current assets
(correspond to variations in the level of current assets arising from normal business activity).
1
,A matching funding policy is one which finances fluctuating current assets with short-term funds and
permanent current assets and non-current assets with long-term funds (See (a)). The maturity of the
funds roughly matches the maturity of the different type of assets.
A conservative funding policy uses long-term funds to finance not only non-current assets and
permanent current assets, but some fluctuating assets as well. As there is less reliance on short term
funding, the risk of such a policy is lower, but the higher cost of long-term finance means that the
profitability is reduced as well (See (b)).
An aggressive funding policy uses short term finance to finance not only floating current assets, but
also some permanent current assets. This policy carries the greatest risk to solvency, but also offers the
highest profitability because short-term financing is cheaper than long-term financing (See (c)).
Working capital and the cash conversion cycle
The WC can be viewed statistically as the balance sheet between current assets and current liabilities.
Alternatively, we can look at the WC dynamically as an equilibrium between the income-generating
and resource-purchasing activities of a company. The cash conversion cycle presents this dynamical
approach. The cash conversion cycle is the period of time between the outlay of cash on raw materials
and the inflow of cash from the sale of finished goods, and represents the days of operation for
which financing is needed.
𝐶𝑎𝑠ℎ 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝐶𝑦𝑐𝑙𝑒 (𝐶𝐶𝐶)
= 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑑𝑎𝑦𝑠 + 𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑑𝑎𝑦𝑠 − 𝑇𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑑𝑎𝑦𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑑𝑎𝑦𝑠 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑/365
𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑑𝑎𝑦𝑠 =
𝑅𝑒𝑣𝑒𝑛𝑢𝑒/365
𝑇𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
𝑇𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑑𝑎𝑦𝑠 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑/365
Based on this cash conversion cycle, companies can determine which level of working capital is
needed. This can also be done based on the sales divided by the net working capital.
Overtrading
Overtrading occurs if a company is trying to support too large a volume of trade from too small a
working capital base. Even if a company is operating profitably, overtrading can result in a liquidity
crisis, with the company being unable to meet its debts as they fall due because cash has been
absorbed by growth in non-current assets, inventory and trade receivables. Overtrading can be caused
by a rapid increase in turnover. There are several strategies that are appropriate to deal with
overtrading:
2
, - Introducing new capital: this is likely to be an injection of equity finance rather than debt
since, with liquidity under pressure, manager will be keen to avoid straining cash flow any
further by increasing interest payments.
- Improving working capital management: Overtrading can also be attacked by better control
and management of working capital, for example by chasing overdue accounts. Therefore, it
could change its working capital policy.
- Reducing business activity: As a last resort, a company can choose to level off or reduce the
level of its planned business activity in order to consolidate its trading position and allow time
for its capital base to build up through retained earnings.
The management of cash
There are three reasons why companies choose to hold cash:
- Transactions motive: Companies need a cash reserve in order to balance short-term cash
inflows and outflows since these are not perfectly matched.
- Precautionary motive: Forecasts of future cash flows are subject to uncertainty and it is
possible that a company will experience demands for cash.
- Speculative motive: Companies may build up cash reserves in order to take advantage of any
attractive investment opportunities that may arise.
Optimum cash levels are determined by forecasts, efficiency in which the cash flows are managed,
availability of liquid assets to the company, borrowing capacity or risk appetite.
If companies face cash flow problems, they can postpone capital expenditures, accelerate the rate at
which cash flows come into the business. This can be done by shortening the accounts receivables
days (with discount for example), by chasing overdue accounts, or sale unwanted inventory. They also
can postpone cash outflows of reschedule debt loan repayments. As a last resort, they can possibly
reduce dividend, but this can be a dangerous signal to investors.
A company should make cash budgets, as so they can signalize eventual period where cash is limited,
so that they can participate in an early stage.
The float is the period of time between initiating payment and receiving cash in a company’s bank
account. The float can be several days and consists of:
- Transmission delay: the time taken for a payment to pass from payer to payee
- Lodgement delay: the delay in banking any payments received
- Clearance delay: the time taken by a bank to clear a presented instruction to pay
Companies have several reasons for holding funds in liquid or near-liquid form. Cash which is surplus
to immediate needs should earn a return by being invested on a short-term basis.
Short-term methods that can be useful in managing corporate liquidity include:
- Term deposits: Cash can be put on deposit with a bank to earn interest, with the interest rate
depending on the size of the deposit;
- Sterling certificates of deposit: These are negotiable bearer securities issued by banks and
building societies. They are for amounts between 100k and 1 million. Because these can be
sold before maturity, they are more liquid than term deposits;
- Treasury bills: These are bills with a short-term maturity given out by the government.
Because of the very low risk, the return is lower than for other options;
- Sterling commercial paper: These are unsecured bearer securities issued at a discount by
companies, banks and building societies. The return is higher, because of the higher default
risk;
3
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller gillesputs. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $12.07. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
62491 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy study notes for 14 years now