ACFINA FINALS REVIEWER

LESSON 1 INTRODUCTION TO FINANCIAL MANAGEMENT

Finance

 WHAT? Can be defined as the science and art of managing money. Concerned with how much of their earnings
they will save or spend.
 SERVICES – financial services is concerned with the design and delivery of advice and financial products.
 MANAGERIAL – concerned with duties of which the financial manager would administer the financial affairs.

Goal of a firm

 Maximization of shareholders wealth

o Manager’s primary goal
o Simplest and best measure would be the firm’s share price.
o “to maximize the wealth of the owners for whom it is being operated” or “ maximize share price”.
o Key variables that managers must consider when making business decisions would be RETURN and
RISK.
 Profit Maximization
o “SHORT RUN GOAL”.
o Commonly measure through the earnings per share (EPS).
 Does Profit Maximization lead to highest possible share price
o NO
o TIMING – firm can earn a return on funds it receives; receipt of funds sooner is preferred than later.
o CASH FLOW – profits does not necessarily result in cash inflow; higher earnings does not necessarily.
mean higher stock price.
o RISK – fails to be accounted by profit maximization; stockholders are RISK AVERSE.

PROBLEM : WHICH SHOULD BE PREFERRED

EPS
INVESTMENT YEAR 1 YEAR 2 YEAR 3 TOTAL
X 1.40 1.00 .40 2.80
Y .60 1.00 1.40 3.00
ANSWER : “Y” Results to higher earnings.

Forms of Business

Sole Proprietorship Partnership Corporation

Owners One Two More than 5
Liability Unlimited -General ( unlimited ) Limited
-Limited ( limited)
Transferability of Hard Hard Easy
ownership

 Sole Proprietorship
o Owned by one person.
o Major drawback: “Unlimited Liability”.
 Partnership
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o Consist of two or more owners.

o Established by a written contract “Articles of Partnership”.
 Corporation
o Entity created by law, thus having legal power of an individual person.
o Owners are “stockholders” whose ownership are in the form of common stock.
o Has limited liability.
o Disadvantage: Double taxation on dividends.

10 Principles of Finance

1. Risk – Return trade off – the more risk the higher the expected return.
2. Time Value of Money - a money received today is worth more than the money received in the future.
3. Cash flow more than profits – Cash flows are more important than profit.
4. Incremental Cash Flows – Difference of cash flows if a project is taken or not.
5. Curse of competitive market
6. Efficient Capital Market – values of all assets and securities of any instant fully reflect all available info.
7. Agency problem – conflicts arising from the separation of management and ownership.
8. Taxes bias business decision
9. All risk are not equal
10. Ethical Behavior

LESSON 2 THE FINANCIAL MARKET ENVIRONMENT

Financial Institutions

 Intermediaries by channeling the savings of individuals, business and government into loans.
 Key Customers of Financial Inspirations
o Individuals – Net supplier for financial institutions. They save more money than they borrow.
o Business – Net demanders of funds. They borrow more than they save.
o Government – Net demanders of funds. They borrow more than they save.
 Commercial Banks – among the most important financial institution. Prove savers with a secure p[lace to invest funds
and also offers loans.
 Investment Banks – assist companies in raising capital, also gives advice to firms on major transactions and engage in
trading and market making activities.
 Shadow Banking System – group of institutions that lends but does not accept deposits.

Financial Market

 Role – to be a liquid market where firms can interact with investors to obtain valuable external financing
 Market where suppliers of funds and demanders can transact directly.
 Money Market - short-term debt instruments / marketable securities. Created by the need for short-term funds.
Composed of short-term debt instruments like Treasury bonds and commercial papers.
 Capital Market - long-term instruments. Created for the need oflong-term bonds.
o Bonds - long term debt instrument
o Common stock – units of ownership
o Preferred stock – special form of ownership where there is a promised fixed amount of dividend.
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 Types of Capital Market

o Broker Market – where buyer and seller re brought directly
o Dealer Market – Where there is no direct contact between buyer and the seller.
 One can raise money in:
o Private placement – sake if a new security directly to an investor.
o Public offering – sale of either bonds or stock to the general public.
 Market where trading is done:
o Primary market – company of government entity, which sells stocks or bonds to an investor and
receives cash. Usually a place where “new” securities are sold.
o Secondary market – trading which does not involve the issue directly. Usually sells “pre-owned’
securities.

Business Taxes

 Ordinary Income – a corporations’s income income earned through the sale of goods and or services.
 Marginal tax VS Average tax rate
o Marginal tax rate – rate at which additional income is taxed.
o Average tax rate – a firm’s taxes divided by its taxable income.
o In business decisions Marginal tax rate is what really matters.
 Interest and Dividend Income
o Interest received by the corporation is usually ordinary income.
o Dividends are different because they are subject to double taxation which is where the taxed
income is once again taxed.
 Tax – deductible expenses
o Corporations are allowed to deduct operating expenses as well as interest expense.
o Net loss = “0” tax liability
o Dividends are not tax-deductable

LESSON 3 STATEMENTS AND RATIO ANALYSIS

The Stockholder’s Report

 Financial reports are under specific guidelines named the “Generally Accepted Accounting Principles” (GAAP) and
its authorized by the Financial Accounting Standard Board (FASB)
 Stockholder’s Report – annual report released by publicly owned corporations.
 Letter to Stockholders – primary communication from management
 Four key financial statements + Notes to financial statments
1. Income Statement – provides a financial summary of the firm’s operating result
2. Balance Sheet – summary statement of the firm’s financial position at a given time. Balances the firm’s
assets against its firm’s debt and equity
o Asset – listed from the most liquid (cash) to its least (Inventories). May either be current or non-
current. Defined as what the company owns.
o Liability – what the company owes. May either be Current or Non-current.
o Equity – what was provided by the owners. Defined by the common sotock. Paid-in-capital n
excess of par. Retained Earnings (Cumulative total of all earnings)
3. Statement of Cash Flows – summary of cash flows over the period of concern.
4. Statement of Retained Earnings – reconciles the net income, dividends paid and the changes in retained
earnings
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5. Notes to Financial Statements – provide detailed information on the accounting policies, procedures,
calculations and transactions.

Using Financial ratios

 Analysis of financial statements is based on the use of ratios or relative values.

 Types of Ratio Comparisons
1. Cross-Sectional Analysis – comparison of different firm’s financial ratios at the same time. Comparing with
a key competitor is called Benchmarking.
2. Time-Series Analysis – evaluates performance over time, which enables analysts to evaluate progress.
Significant year-to-year change may be problematic.
3. Combined Analysis – most informative approach. Combines both cross-sectional and time-analysis which
makes it possible to assess the trend in the behaviour of the ratio and the trend in the industry.
 Cautions in using ratio analysis
1. Ratios that show large deviations from the norm may indicate a problem.
2. A single ratio does not provide sufficient information.
3. Ratios being compared should use financial statements with the same point of time.
4. Use audited financial statements. (non-audited may have mistakes)
5. Financial data being compared should have been developed in the same manner. (consistency)
 Liquidity Ratio – Computes the solvency of the firm’s overall financial position. Liquidity is the ability to satisfy its
short-term obligations as they come due.
1. Current ratio – measures the firm’s ability to meet its short-term obligations . The higher the ratio the
better.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
o
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
2. Quick (Acid-test) Ratio – eliminates the effect of current assets that are least liquid like inventory and
prepaid expense. Better measure of overall liquidity when a firm cannot easily convert inventory into
cash.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠−𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦−𝑃𝑟𝑒𝑝𝑎𝑖𝑑 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
o
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
 Activity Ratio – Speed with which various accounts are converted into sales or cash or inflow or outflow.
Company’s efficiency in its operations.
1. Inventory Turnover – measures the activity, or liquidity of a firm’s inventory. Best when compared.
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
o
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
2. Average Age of Inventory – also known as Days Sales in Inventory. Measures how long the company
replaces the inventory. Also measures how many days of inventory the firm has on hand. The lower the
better.
360
o
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
3. Receivable Turnover – measures how many times the company sales and collect from the customer. The
lower the better.
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
o
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
4. Average Collection Period – also known as Average Age of Collection. Useful in evaluating credit and
collection period.
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360
o
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
5. Average Payment Period – also known as Average Age of Accounts Payable. Not normally used because
“annual purchases” which is not usually stated in the Financial Statements.
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑏𝑙𝑒
o 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
360
6. Total Asset Turnover – Indicates the efficiency of the firm in using its asset to generate sales. Shows
whether the firm’s operations have been financially efficient.
𝑆𝑎𝑙𝑒𝑠
o
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡
 Debt ratio – amount of other people’s money being used to generate profit. The higher the debt the greater the
risk. Also known as Solvency ratio.
- Financial leverage – magnification of risk and return through the use of fixed cost financing, such as
debt and preferred stock. There are different types of leverage measures:
o Degree of ineptness – amount of debt relative to other significant balance sheet amounts
o Ability to service debts – ability to pay debts that are scheduled over its life.
1. Debt ratio – measures the proportion of total assets financed by the firm’s creditors
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
o
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡
2. Debt-to-Equity ratio – measures the proportion of total liabilities to common stock equity.
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
o
𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘 𝐸𝑞𝑢𝑖𝑡𝑦
3. Times Interest Earned Ratio – also called as interest coverage ratio. Measures the firm’s ability to make
contractual interest payments.
𝐸𝐵𝐼𝑇 (𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒)
o
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
 Profitability Ratio – useful when comparing performance across years because it is easy to see if certain expenses
are going up or down. Ability of the company to generate profits.
1. Gross Profit Margin – Percentage of each sales dollar remaining after the firm has paid for its debt. Also
known as the company’s mark-up on sale.
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
o
𝑆𝑎𝑙𝑒𝑠
2. Operating Profit Margin – company’s efficiency to generate income from operations Represents the “pure
profit”, because they measure only the profit earned on operations
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
o
𝑆𝑎𝑙𝑒𝑠
3. Net Profit Margin – percentage of each sales dollar remaining after all cost and expenses.
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
o
𝑆𝑎𝑙𝑒𝑠
4. Return on Asset – also called Return on Investment. Overall effectiveness of management in gerenating
profits with its available assets.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
o
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡
5. Return on Equity – return earned on the common stock holder’s investment
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
o
𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘 𝐸𝑞𝑢𝑖𝑡𝑦
6. Earnings per share – number of dollar earned during the period on behalf of all outstanding common
stock.
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𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑜𝑤𝑛𝑒𝑟

o
# 𝑜𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘
 Market ratio – relates to the firm’s market value, as measured by its current share price which is used to certain
accounting values. Gives insight on how investors see the how the company is doing. Measures the company’s
work or value.
1. Price / Earnings (P/E) Ratio – asses the owner’s appraisal of the share value.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
o
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
2. Market / Book ( M/B) Ratio – assessment on how the investor’s view the companies performance.
Company’s value in terms of its book value.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
o 𝐶𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑒𝑞𝑢𝑖𝑡𝑦
# 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘

Dupont System of Analysis

 Used to dissect the firm’s financial statements and assess its financial condition.
 Merges the income statement and balance sheet
 Uses the table :

Categories of Financial ratios:

RISK RETURN RISK & RETURN

Liquidity , Activity and Debt Profitability Market

LESSON 4 MASTER BUDGET AND RESPONSIBILITY ACCOUNTING

Budget

 Could be easily defined as the quantitative expression of a proposed plan of action by management for a specified
period.
 An aid to coordinating what needs to be done to implement the plan.
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 Blueprint for the company to follow.

 Purpose
o Communicate directors and goals which helps organize an action,
o Judge performance by measuring financial results against planned objectives, activities and timelines to learn
about potential problems.
o Helps motivate employees.

Strategic Plans and Operating

 Budgeting is most useful when its integrated with a company strategy

o Strategy – how an organization matches its capabilities with the opportunities in the market place.
o Uses the chart:
Strategy

Long-Run planning
(Strategic plans)

Advantages and Challenges

 Budgets are integral part of management control system. When done thoughtfully would do:
1. Promote coordination and communication among sub-units
2. Provide a framework
3. Motivate managers and employees
 There are challenges in creating and implementing budgets:
1. Time consuming
2. Should not be administered rigidly
3. Upper management’s support is crucial

Time Coverage of Budgets

 The timeline for a budget is dependent on the motive for creating the budget.
 The most frequently used budget period is 1 year.
 Rolling Budget – also called Continuous Budget or Rolling Forecast. This is because it is always available for a specified
future period.
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Overview of the Master Budget

 Basic Operating Budget Steps

1. Prepare the revenue budget – usually based on expected demand because the demand for a company’s
product is the limiting factors for achieving the profit goals.
2. Prepare the production budget – drives the various budget cost
o Formula – Budgeted sales (units) + Target ending inventory (units) – Beginning finished goods (units)
3. Prepare the Direct Martials Usage and Purchases budget – key to continuing the usage of direct materials in
both quantity and peso. Based on the quantity required for each unit to be produced.
4. Prepare the direct labor budget – managers must estimate wage rates, production methos, process and
efficiency improvement and hiring plans.
5. Prepare the MOH budget – requires understanding the activities required for the production.
o Activity Based Costing – budgeting method that focuses on the budget cost of the activities necessary
to produce and sell.
6. Prepare the ending inventory budget
7. Prepare the COGS budget
8. Prepare the OPEX budget
9. Prepare the Income Statement budget
 Basic Financial Budget Steps
1. Capital Expenditure budget
2. Cash Budget
3. Budgeted balance sheet
4. Budgeted Statement of Cash Flows
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Financial Planning Models and Sensitivity Analysis

 Financial Planning models – mathematical representations of the relationships among the factors that affect the
master budget.
 Sensitivity Budget – “what if” technique that examines how a result will change the original predicted data or
underlying assumption.

Budgeting and Responsibility Accounting

 Responsibility Center – a part, segment or sub-unit of an organization whose manager is accountable for a specified
set of activities.
 Responsibility Accounting – system that measures the plans, budgets, actions and actual result of each responsibility
center.
 4 levels of responsibility center:
1. Cost
2. Revenue
3. Profit
4. Investment
 Budgets offer feedback in the form of variances.

Responsibility and Controllability

 Controllability – degree of influence a manager has over the cost.

 Responsibility Accounting – helps manager to focus on gaining info.

Human Aspects of Budgeting

 Budgeting Slack – underestimating or overestimating budget to make it achievable.

 Stretch target – challenging but achievable target.
 Kaizen Budgeting – practive whereby each budget process incorporates continuous improvement from past results.

LESSON 4 FINANCIAL PANNING AND FORECASTING

Overview

 Primary objective
o Estimate the future financing requirments in advance of when the financing is needed
o Process of planning is critical to force managers to think systematicall about the future, despire the
uncertainty of the future
 Most firms engage in three type of planning
1. Strategic Planning – how the firm plans to make money in the future. It serves as a guide for all other plans.
2. Long term financial plan – generally encompasses 3-5 years. Incorporates estimates of the firm’s income
statement and balance sheet.
3. Short term financial plan – spans from one year or less and is very detailed. Typically uses cash budget as a
format.

Developing a Long Term Financial Plan

 Three Basic Types

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1. Sales Forecast – generally based on past trend in sales, influence of any anticipated events that might
materially affect the trend.
2. Pro-forma – statements help forecast a firm’s asset requirements needed. The most common technique is
Percent of Sales where expenses, assets and liabilities for a future period as a percentage of sales.
3. Estimate Financing Needs – extract the cash flow requirements.
 Sources of Financing
o Spontaneous Financing – includes accounts payable and accrued expenses or liabilities directly related to sales
o Discretionary Financing – financing that requires management discretion. Includes notes payable , long term
debt, Common stock and retention of earnings (dividends policy)

Formula for DFN

𝑫𝒊𝒔𝒄𝒓𝒆𝒕𝒊𝒐𝒏𝒂𝒓𝒚 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒏𝒈 𝑵𝒆𝒆𝒅𝒔

= 𝑷𝒓𝒐𝒇𝒐𝒓𝒎𝒂 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 − 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑷𝒂𝒚𝒂𝒃𝒍𝒆 − 𝑨𝒄𝒄𝒓𝒖𝒆𝒅 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔 − 𝑵𝒐𝒕𝒆𝒔 𝑷𝒂𝒚𝒂𝒃𝒍𝒆
− 𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎 𝑫𝒆𝒃𝒕 − 𝑪𝒐𝒎𝒎𝒐𝒏 𝑺𝒕𝒐𝒄𝒌
OR

𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 𝒊𝒏 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 − 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 𝒊𝒏 𝑺𝒑𝒐𝒏𝒕𝒂𝒏𝒆𝒐𝒖𝒔 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 − 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 𝒊𝒏 𝑹𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔

Where : Retained Earnings = 𝑺𝒂𝒍𝒆𝒔 × [𝟏 + 𝒈𝒓𝒐𝒘𝒕𝒉] × 𝑷𝒓𝒐𝒇𝒊𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 × 𝑹𝒆𝒕𝒆𝒏𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆

Retention Rate = 𝟏 − 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒓𝒂𝒕𝒆

LESSON 5 FINANCIAL PANNING AND FORECASTING

Analysing the Firm Cash Flow

 Cash flow – primary ingredient in any financial valuation model

 Firms focus on two types of cash flow
o Operating Cash Flow – used in managerial decision making
o Free Cash Flow – closely monitored by participants in the capital market

Depreciation

 Depreciation – portion of the cost of fixed assets charged against annual revenues over time.
 Reduces the income the company reports thus decreases the tax to be paid.
 Depreciation is not associated with any cash outlay

Developing the Statement of Cash flows

 Summarizes the firm’s cash flow over a given period.

 Falls into three categories
1. Operating – cash flows directly related to sale and production of the firm’s production and services.
2. Investment – cash flows associated with purchase and sale of both fixed asset and equity investment.
3. Financing – cash flows that result from debt and equity financing transactions.
 Inflows and Outflows:

INFLOWS OUTFLOWS
 Decrease in any asset  Increase in any asset
 Increase in any liability  Decrease in any liability
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 Net profit after tax  Net loss after tax

 Depreciation and other non-cash activities  Dividends paid
 Sale of Stock  Repurchase / Retirement of stocks
1. Depreciation is a non-cash expense and is treated as a separate inflow, only gross
2. Direct entries of changes in Retained Earnings are not included.

Interpreting Statement of Cash Flows

 The statement of cash flows ties the balance sheet at the beginning of the period with the balance sheet at the end
after considering the performance of the firm through the Income Statement
 The net increase (decrease) in cash and marketable securities should be equivalent to the difference between the
cash and marketable securities on the balance sheet at the beginning and end of the period.

Operating Cash Flows

 Operating Cash Flow –cash flow generated from normal operation from the production and sale of goods and services.
 Formula :

𝑬𝑩𝑰𝑻 × (𝟏 − 𝑻) + 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏
Free Cash flows

 Free Cash flow – amount of cash flow available to investors (creditors and owners) after the firm has met all operating
needs and paid for investments in net fixed asset (NFAI) and Net Current Assets (NCAI)
 Formula :

𝑶𝑪𝑭 − 𝑵𝑭𝑨𝑰 − 𝑵𝑪𝑨𝑰

Where : NFAI = 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑵𝒆𝒕 𝒇𝒊𝒙𝒆𝒅 𝒂𝒔𝒔𝒆𝒕 + 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏

NCAI = 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕 − 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒔𝒑𝒐𝒏𝒕𝒂𝒏𝒆𝒐𝒖𝒔 𝒇𝒊𝒏𝒂𝒏𝒄𝒊𝒏𝒈

 Often considered a more reliable measure of a company’s income than retained earnings.

The Financial Planning Process

 Begins with long–term or strategic , financial plans that in turn guides the formulation of short-term or operating,
plans and budget
 Two aspects:
1. Cash Planning – Cash Budget
2. Profit Planning – pro-forma
 Long term (Strategic) Financial Plans
o Planned actions and the anticipated impact of actions for 2 – 10 years.
o Firms that are subject to high degree of operating uncertainty, relatively short production cycles or both then
to use shorter planning horizons
o Plans are generally supported by a series of annual budgets and profit plans.
 Short term (Operating) Financial Plans
o Specify short-term financial actions and the anticipated impact.
o Key Input : Sales Forecast
o Key Output: Operating cash budget and Pro-Forma statements.
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Cash Planning : Cash Budget

 Cash Budget or Cash Forecast – statement of the firm’s planned inflows and outflow of cash that is used to estimate its
short term cash requirements. This budget is usually designed to cover a year. The more seasonal and uncertain a
firm’s cash flows the greater the number of intervals.
 Sales Forecast – prediction of the sales activity during a given period based on internal and external data. Used as a
basis to estimate the monthly cash flows that will result from sales and outlays. Based on two information:
o External Forecast – relationship between sales and key external economic indicators.
o Internal Forecast – build-up or consensus of sales forecast
 Evaluating
o Indicate the extent to which cash shortages or surpluses are expected.
o Firm is assumed first to liquidate its marketable securities then loan accounts payable to pay or finance its
deficits.
 Coping with Uncertainty
o Scenario analysis or “what-if” could be used.
1. Prepare several cash budget to prepare for several scenarios
2. Create a simulation.

Profit Planning : Pro-forma Statements

 Pro-forma – projected or forecast

 Normally uses the following:
1. Financial statements of the preceding year.
2. Sales Forecast
3. Key assumptions about a number of factors
 Income Statements
o Uses Percent of Sales where it starts the sales forecast then expresses the COGS, OPEX etc. as a percentage of
the projected sales.
o The use of past cost and expense ratio may underestimate or overestimate the prfit.
o Best way to create the Income Statement is thru segmenting the firm’s expenses into fixed and variable.
 Balance sheet
o Judgmental Approach – simplified approach where the firm estimates the values of certain balance sheet
accounts and uses its external financing as a balancing or “plug value”
o Positive value for external financing means the firm will not generate enough internal financing.
o Negative value will mean the company will generate enough financing
 Evaluation
o Two weaknesses:
 Firm’s past financial performance will be replicated
 Certain variable can be forced to take “desired” value.

LESSON 6 WORKING CAPITAL AND CURRENT ASSET MANAGEMENT

Net Working Capital Fundamentals : Working capital Management

 Working Capital Management – also called Short term Financial Management. Management of current assets and
current liabilities.
o If working capital is minimized it would be able to reduce financing cost or increase funds for expansion
o Goal is to achieve balance between profitability and risk.
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 Working Capital – current assets, present portion of investment that circulates in the ordinary course of business.
 Net Working Capital – difference between current assets and current liabilities. May be positive or negative.
o If Positive it means that current assets is greater than current liability.
o If negative it means that current assets is less than current assets.

Trade-off between Profitability and Risk

 Profitability – relationship between revenues and costs generated using the firm’s assets. Firm can increase its profits
by increasing the revenue or reducing its costs.
 Risk – probability that a firm will be unable to pay its bills as they come due.
o Insolvency – when the firm is unable to pay
 Effects of changes
o Current Assets – indicated by the ratio of percentage of total assets.
 Increase would decrease profitability because current assets are less profitable than fixed asset.
 Increase would decrease risk because the increase in net working capital would decrease the risk of
insolvency ( Investment in inventory is less risky than investment in FA )

CHANGE IN RATIO PROFIABILITY RISK

Increase Decrease Decrease
Decrease Increase Increase
o Current Liability – using the ratio of Current Liability over Total Asset
 Increase would increase profitability because the company uses current liabilities which is less
expensive than Non-Current Liabilities which has interest.
 Increase would increase risk because the increase in current liabilities would decrease the net
working capital.

CHANGE IN RATIO PROFIABILITY RISK

Increase Increase Increase
Decrease Decrease Decrease

Cash Conversion Cycle

 Length of time required for a company to convert the cash invested.

 Goal is to minimize the length of the cash conversion cycle which could be accomplished by:
1. Turnover inventory as quick as possible
2. Collect Accounts receivable as quickly as possible without losing sales
3. Manage mail, processing and clearing time
4. Pay Accounts payable as slowly as possible.
 Operating Cycle – time from the beginning of the production process to collection of cash from the sale of the finished
product. Encompasses two short-term assets : Inventory and Accounts receivable
o Formula : 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑔𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑
 Cash Conversion Cycle – Includes accounts payable which reduces the number of days a firm’s resources are tied
o Formula: 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑔𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 − 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑

Permanent VS Seasonal

 Permanent Funding Requirements – firm’s sales are constant, investments in operating assets should also be constant
o Formula: 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
 Seasonal Funding Requirements – firm’s sales are cyclic, investments in operating assets vary over time.
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o Formula: 𝑃𝑒𝑟𝑚𝑎𝑛𝑒𝑛𝑡 + 𝑃𝑒𝑎𝑘

 Where Peak : 𝐻𝑖𝑔ℎ𝑒𝑠𝑡 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 − 𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔

Aggressive VS Conservative

 Aggressive funding strategy – firm funds its seasonal requirements with short-term debts and its permanent
requirements using long-term
o Formula:

Cost of short term = 𝑹𝒂𝒕𝒆 × 𝑺𝒆𝒂𝒔𝒐𝒏𝒂𝒍 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 xx

Cost of long term = 𝑹𝒂𝒕𝒆 × 𝑷𝒆𝒓𝒎𝒂𝒏𝒆𝒏𝒕 xx
Less: Earnings on Surplus 𝒁𝒆𝒓𝒐 (xx)
Total Cost xx

 Conservative funding strategy – firm funds both seasonal and permanent requirements with long term debt.
o Formula :

Cost of short term = 𝒁𝒆𝒓𝒐 xx

Cost of long term = 𝑹𝒂𝒕𝒆 × 𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕 xx
Less: Earnings on Surplus 𝑹𝒂𝒕𝒆 × (𝑷𝒆𝒓𝒎𝒂𝒏𝒆𝒏𝒕 − 𝑷𝒆𝒂𝒌) (xx)
Total Cost xx

Inventory Management

 Common Techniques
1. ABC System – divides inventor to three groups; A(largest dollar investment) , B (second to the largest),
C(smallest investment). It also makes use of two bin method where the method would use the first bin then
when fully consumed transfer to the other.
2. Economic Order Quantity Model – considers various costs (odder and carrying) then determines what order
size minimizes cost. Analyses the trade-off between the order cost and carrying cost to determine the order
quantity.
 Order Cost – fixed clerical cost of placing and receiving
 Carrying Cost – variable cost per unit of holding an item.
 Formula:

𝟐 ×𝑺×𝑶
𝑬𝑶𝑸 = √ Where : S – Usage in units
𝑪

O – Order cost per order

C - Carrying cost per unit

Q – Order quantity in units.

 Reorder Point – reflects the number of days of lead time the firm needs to place and receive an order
and also the daily usage
 Formula
ACFINA FINALS REVIEWER

𝑫𝒂𝒚𝒔 𝒐𝒇 𝒍𝒆𝒂𝒅 𝒕𝒊𝒎𝒆 × 𝑫𝒂𝒊𝒍𝒚 𝒖𝒔𝒂𝒈𝒆

3. Just in Time – used to minimize inventory investment. Ideally, firm would have only work-in-process. Uses no
or very little safety stock.
4. Computerizes Systems for Resource Control
 Materials Requirement Planning (MRP) – uses the concept of EOQ to determine how much to order.
Stimulates a bill of materials
 Materials Requirement Planning II – integrated data from numerous sources or areas.
 Enterprise Resource Planning (ERP) – expand focus to external environment.

Average Receivable Managements

 Average Collection Period – average length of time from a sale on credit until the payment becomes usable funds. Two
part which would be the time from sale until payment then payment to firm.
 Credit Selection and Standards
o Credit Selection – application of techniques to determine which customer receives credit.
o Credit Standards – minimum requirement for extending credit.
o Five C’s of Credit
1. Character – record of meeting past obligations
2. Capacity – ability to repay
3. Capital – debt relative to equity
4. Collateral – assets available as security
5. Conditions – current general, industry and economics
o Credit Scoring – method of credit selection that firm uses. It applies statistically derived weights.
o Changing Credit Standard – relaxation. Table:

VARIABLE EFFECTS (INCREASE IN RELAXATION)

Sales Volume Positive
Investment in Accounts Receivable Negative
Bad Debts Expense Negative

Making Decision Computation

 Cost of Marginal Investment in Accounts Receivable – determine te difference between the cost of carrying receivable
under the two standards. The main concern would be the variable cost
o Formulas:
𝑻𝒐𝒕𝒂𝒍 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑨𝒏𝒏𝒖𝒂𝒍 𝑺𝒂𝒍𝒆𝒔
Average Investment In Accounts Receivable =
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒐𝒇 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆

Cost of Marginal Investment =

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑵𝒆𝒘 XX

− 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑶𝒍𝒅 XX
𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒊𝒏 𝑨𝑹 XX
× 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑭𝒖𝒏𝒅𝒔 𝑻𝒊𝒆𝒅 XX
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 XX
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Cost of Marginal Bad Debts =

𝑷𝒓𝒐𝒑𝒐𝒔𝒆𝒅 𝑷𝒍𝒂𝒏 𝑩𝒂𝒅 𝑫𝒆𝒃𝒕𝒔 (𝑹𝒂𝒕𝒆 × 𝑺𝒂𝒍𝒆𝒔 𝑷𝒓𝒊𝒄𝒆 XX

× 𝑼𝒏𝒊𝒕𝒔)
− 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑷𝒍𝒂𝒏 𝑩𝒂𝒅 𝑫𝒆𝒃𝒕𝒔 (𝑹𝒂𝒕𝒆 × 𝑺𝒂𝒍𝒆𝒔 𝑷𝒓𝒊𝒄𝒆 XX
× 𝑼𝒏𝒊𝒕𝒔)
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 XX

o Credit terms – terms of sale for customers who have been extended credit by the firm. Cash Discount is the
percentage deductions. Heavily influenced by the firm.
o Cash Discount – incentive. Formula for lost cash discount is
𝒅 𝟑𝟔𝟎
× Where: d = discount and n= Difference between dates.
𝟏𝟎𝟎−𝒅 𝒏
o Cash Discount Period – number of days after the beginning of the credit period where cash discount is
available.
 Credit Monitoring – on-going review of the firm’s accounts receivable to determine whether customers are paying.
Slow payments are costly to the firm. Uses two techniques.
o Average Collection Period
o Aging of Accounts Receivable

Management of Receipts and Disbursements

 Float – funds that have been sent by the payer but are not yet useful funds. Important because its presence lengths
both ACP and APP, however the goal is to shorten ACP and lengthen APP. Three types:
1. Mail Float – delay between payments is placed in mail and received.
2. Processing Float – delay between receipt of payment and deposit into account.
3. Clearing Float – delay between deposit of funds and availability.
 Lockbox System – speeding-up collection technique where instead of mailing payments the customers mail payment
to a post box. Reduces processing time but with a cost.
 Cash Concentration – process to bring lockbox and other deposits together into one bank (concentration bank)
o 3 Advantages:
1. Creates large pool of funds
2. Reduces transaction cost
3. Allows choosing from variety of short-term investment vehicles.
 Different mechanisms:
1. Depository Transfer Check – unsigned check drawn on one of the firm’s bank accounts and deposited
in another
2. Automatic Clearing House Transfer – pre-authorized electronic withdrawal from the payer’s account.
3. Wire Transfer – electronic communication those remotes funds from payer to payee. Most expensive
mechanism.
 Zero-Balance Account – disbursement account with zero balance at the end of the day. Eliminate non-earning cash.
Considered as disbursement management tool.
 Investing In Market Securities
o Marketable Securities – short term, Interest earning, money market instrument.
o Divided into two possible: Government issued and also non-government issued.
ACFINA FINALS REVIEWER

o Government issue has a lower interest because it has lower interest rate.
o Popular securities:

LESSON 7 WORKING CAPITAL MANAGEMENT

Liquidity

 Managing
o Requires balancing the firm’s investments in current assets in relation to its current liabilities which could be
accomplished by
1. Efficiently managing its inventories and Accounts Receivable
2. Seeking the most favourable credit terms
3. Monitoring short term borrowings

Risk-Return Trade-off
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 A firm may enhance its profitability by reducing its current assets; however this will increase the isk of default.

Working Capital Policy

 Managing a firm’s net working capital involves deciding an investment strategy

 Principle of Self Liquidating Debt
o Maturity of the source of financing should be matched with the length of time that the financing is needed.
 Permanent and Temporary Investment
o Temporary – current assets that will be liquidated and not replaced within the current year.
o Permanent – composed of assets that the firm wil be liquidated and hold for a period longer than 1 year.
 Spontaneous, Temporary and Permanent Sources of Financing
o Spontaneous – arise from day-to-day operations and consist of trade credit and Accounts Payable
o Temporary - current liabilities that is on discretionary basis, overt decision must be made.
o Permanent – available for a longer period of time.

Operating and Cash Conversion Cycle

 Indicates how efficiently a firm has managed its current assets. The shorter the better.
 Operating Cycle – measures the period that elapses from the date that an item is purchased until the firm collects
from sale. If on credit it is when AR is collected.
o AP deferral period – period where cash is not tied up
𝟑𝟔𝟎
 Formula : 𝑪𝑶𝑮𝑺
𝑨𝑷
 Cash Conversion Cycle – shorter than Operating Cycle because it does not include time when the firm pays the accounts
o Formula: 𝑶𝑪 − 𝑨𝑷 𝒅𝒆𝒇𝒆𝒓𝒓𝒂𝒍 𝒑𝒆𝒓𝒊𝒐𝒅

Managing Current Liabilities

 Current Liabilities – debt obligations to be repaid within one year

1. Unsecured – trade credit, unsecured bank loans, commercial paper
2. Secured – has collateral
 Annual Percentage Rate
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
o Formula:
𝑷𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍 ×𝑻𝒊𝒎𝒆
 Sources
1. Trade Credit – arises from normal course of business.
2. Line of credit – informal agreement between borrowers and the bank about the maximum amount of credit
allowed.
3. Bank Transaction Loans – form of unsecured short-term bank credit made for a specific purpose
4. Commercial Paper – short term debt issued by a high credit worthy firm which is bought and sold in the
market
5. Pledging
6. Factoring

Managing the Firm’s Investment in Current Assets

 Current Assets
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1. Cash and Marketable Securities – held to pay the firm’s bills on time. Holding to little could cause default, but
holding too much is bad
o Two problems and solutions:
 Mainlining Balance – accomplished by cash budget
 Composition – choose wisely
2. Accounts Receivable – cash flow cannot be invested until collected this efficiency in collection is needed.
o Determinants:
 Level of credit sales
 Level of sales
 Credit and collection policy
 Customer quality – as the quality of the customer declines, it increases cost of credit
investigation, default cost and collection cost
 Collection Efforts

LESSON 7 CURRENT LIABILITIES MANAGEMENT

Spontaneous Liabilities

 Spontaneous Liabilities – liabilities that arise from the normal course of business. Composed of two major liabilities;
accounts payable and accruals.
 Unsecured Short-term Financing - short-term financing obtained without pledging specific assets as collateral. Usually
interest-free.

Accounts Payable Management

 Accounts payable are the major source of unsecured short-term financing for business firms. They result from
transactions in which merchandise is purchased but no formal note is signed to show the purchaser’s liability to the
seller.
 Role in the Cash Conversion Cycle
o The average payment period is the final component of the cash conversion cycle. Which is composed of two
parts:
1. the time from the purchase of raw materials until the firm mails the payment
2. payment float time - the time it takes after the firm mails its payment until the supplier has withdrawn
spendable funds from the firm’s account
o Accounts Payable Management – firm’s management of the time that elapses between its purchase of raw
materials and its mailing payment to the supplier.
 When the seller charges no interest and no discount. The buyer’s goal is to pay as slowly as possible.
This timing would allow the maximum use of interest-free loan.
 For some firm’s they offer an explicit or implicit “grace period”
 Analysing Credit terms
o Credit terms – offered by its suppliers to enable companies to delay payments.
o Taking the Cash Discount – If a firm intends to take a cash discount it should pay on the last day of the
discount period.
o Cost of giving up the Cash Discount – implied rate of interest paid to delay payment of an account payable for
an additional number of days.
o Formula:
𝒅 𝟑𝟔𝟎
× Where: d = discount and n= Difference between dates.
𝟏𝟎𝟎−𝒅 𝒏
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o Approximate cost of giving up a cash discount- Formula:

𝟑𝟔𝟎
𝑫× Where: d = discount and n= Difference between dates.
𝒏

 Effects of Stretching Accounts Payable

o Stretching Accounts Payable - paying bills as late as possible without damaging the firm’s credit rating.
Through this strategy the company may reduce the cost of giving up a cash discount.
 Raises ethical issues because the firm may violate an agreement it entered with a supplier

Accruals

 Accruals - liabilities for services received for which payment has yet to be made. Most common type would be wages
and taxes.
o Taxes – payments to the government that cannot be manipulated
o Wages – accruals that can be manipulated to an extent. This is accomplished by delaying payment of wages,
thereby receiving an interest-free loan.

Unsecured Sources of Short-term Loans

 Bank Loans
o Short-term Self liquidating loan - an unsecured short-term loan in which the use to which the borrowed money
is put provides the mechanism through which the loan is repaid. These loans are intended merely to carry the
firm through seasonal peaks
 As the firm converts inventories and receivables into cash, the funds needed to retire these loans are
generated.
 Three basic ways:
1. Single payment notes
2. Lines of credit
3. Revolving credit agreements
 Loan Interest Rate – these interest rates could either be fixed or floating and other times based on the prime rate of
interest.
o Prime rate of interest - lowest rate of interest charged by leading banks on business loans to their most
important business borrowers.
 This interest rate fluctuates with changing supply-and-demand relationships for short-term funds.
o Fixed or Floating Rate Loans
 Fixed Rate Loans – loan with a rate of interest that is determined at a set increase above the prime
rate and remains unvarying until maturity
 Floating Rate Loans – loan with a rate of interest initially set at an increment above the prime rate and
allowed to “float,” or vary, above prime as the prime rate varies until maturity.
o Method of Computing Interest
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
 Actual rate of interest paid :
𝑨𝒎𝒐𝒖𝒏𝒕 𝑩𝒐𝒓𝒓𝒐𝒘𝒆𝒅
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
 Effective annual rate for a discount loan :
𝑨𝒎𝒐𝒖𝒏𝒕 𝒃𝒐𝒓𝒐𝒘𝒆𝒅−𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
 Single Payment Notes – obtained form a commercial bank by a creditworthy business borrower. Usually a one-time
loan made to a borrower who needs funds for a specific purpose for a short period. Usually matures from 30 days to 9
months. The interest charges are usually tied in some way to the prime rate of interest.
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 Line of credit – agreement between commercial bank and a business about an amount of unsecured short-term
borrowing the bank will make available to the firm over a given period of time.
o If it is not a guaranteed loan – indicates that if the bank has sufficient balance it will allow up a certain amount.
o Interest rate – normally stated as a floating rate or prime rate plus premium. The more credit worthy the
lower the prime rate.
o Operating Change restrictions - contractual restrictions that a bank may impose on a firm’s financial condition
or operations as part of a line-of-credit agreement. This would also mean that the bank should be informed in
case of a shift in key managerial personnel.
o Compensating Balance - required checking account balance equal to a certain percentage of the amount
borrowed from a bank under a line-of-credit or revolving credit agreement
o Annual Cleanups – borrower must have a loan balance of zero for a certain number of days during the year.
 Revolving Credit Agreements – Guaranteed line of credit. Guaranteed in the sense that the commercial bank assures
the borrower that a specified amount of funds will be made available regardless of the scarcity of money.
 Commitment Fee - the fee that is normally charged on a revolving credit agreement; it often applies to the average
unused portion of the borrower’s credit line.

Commercial paper

 Commercial Paper - form of financing consisting of short-term, unsecured promissory notes issued by firms with a high
credit standing. Usually given to companies who have financial soundness
 Interest on Commercial paper – may either be sold at a discount from its par or face value.

International Loans

 International Transactions – the difference is that payments are often made or received in foreign country. Usually
exposed to exchange rate risk.
o Exchange rate risk can often be hedged by icing currency forward, future or options market
o Usual transactions are large in size and have long maturity.
 Financing International Trade
o Most important financing vehicle letter of credit - letter written by a company’s bank to the company’s
foreign supplier, bank guarantees payment of an invoiced amount if all the underlying agreements are met.
o Firms that do business is usually on-going basis often financing their operations in the local market.
 Transactions between subsidiaries

Secured sources of Short-term Loans

 Secured Short term financing – financing that has specific assets pledged as collateral. Collateral commonly takes the
form of an asset, such as accounts receivable or inventory.
 Security agreement - agreement between the borrower and the lender that specifies the collateral held against a
secured loan.
 Characteristics of Secured Short-term Loans
o Presence of collateral has no impact on the risk of default.
o Collateral and terms – prefer collateral that has a duration closely matched to the term of the loan. Current
assets are the most desirable for short term loans.
 Percentage Advance - percentage of the book value of the collateral that constitutes the principal of a
secured loan.
o Institutions extending secured short term loans
1. Commercial banks
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2. Commercial finance companies - lending institutions that make only secured loans—both short-term
and long-term—to businesses. Are not permitted to hold deposits.
 Use of Accounts Receivable as Collateral
1. Pledging f Accounts Receivable - use of a firm’s accounts receivable as security, or collateral, to obtain a short-
term loan.
 May either be in notification (account customer whose account has been pledged or factored is
notified to remit payment directly to the lender or factorer) or non notification basis (borrower,
having pledged an account receivable, continues to collect the account payments without notifying
the account customer.)
2. Factoring Accounts Receivable - outright sale of accounts receivable at a discount to a factor or other financial
institution.
 Factor - financial institution that specializes in purchasing accounts receivable from businesses.
 May be in a nonrecourse basis - basis on which accounts receivable are sold to a factor with the
understanding that the factor accepts all credit risks on the purchased accounts.
 Use of Inventory as a collateral – inventory normally has a market value higher than book value. The most important
characteristic is its marketability (perishable = high cost of storing , Specialized item = hard to sell )
1. Floating Inventory Liens - secured short-term loan against inventory under which the lender’s claim is on the
borrower’s inventory in general.
 Attractive when the firm has a stable level of inventory that consists of a diversified group of relatively
inexpensive merchandise.
2. Trust Receipt Inventory Loans - secured against inventory under which the lender advances 80 to 100 percent
of the cost of the borrower’s relatively expensive inventory item. In exchange the borrower’s promise to
repay the lender, with accrued interest
 Made by manufacturers’ wholly owned financing subsidiaries or captive finance companies
 borrower is free to sell the merchandise but is trusted to remit the amount lent
3. Warehouse Receipt Loans - secured short-term loan against inventory where the lender receives control of
the pledged inventory. It is then stored to a designated warehousing company on the lender’s behalf.
 Terminal Warehouse - central warehouse that is used to store the merchandise of various customers
 Field Warehouse Arrangement - the lender hires a field-warehousing company to set up a warehouse
on the borrower’s premises or to lease part of the borrower’s warehouse to store the pledged
collateral.