CIMA F3 Course Notes

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CIMA F3 Course Notes

c

Chapter 3

Short term finance

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1.

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Conservative, Aggressive and Matching strategies

There are three over-riding approaches to short term financing:

conservative, matching and aggressive.

Conservative financing
This involves financing both long term assets (non-current assets) and short
term assets using long term financing, such as equity or long term loans.
This is a safe way of managing debt as there is little risk of non-repayment
in the short term.
On the other hand it is more expensive as equity and long term debt tends
to be more expensive due to the higher risk being taken by these investors
compared with short term lenders.

Matching financing
Matching aims to link closely the short and long term nature of investments
with the short and long term nature of finance used to support them. For
example:

Using long term funding (e.g. equity or long term debt) for long term
projects and assets. The aim is to use the long term returns from
these projects/assets to pay back the long term debt. If returns are
not due for 4-5 years then debt repayment should be delayed until
that point or after.

Short term funding to match against short term needs

o E.g. Leasing for short term equipment use
o E.g. Overdrafts for short term cashflow shortages

Matching aims to balance risk and financing costs.

Aggressive financing
Aggressive financing is the funding of part of long term assets and all
current assets using short-term funds.
Short term funds are usually less expensive due to he lower risks being
taken by lenders, so this can be the cheapest approach to financing.
However risks to the company are higher as the repayment will need to be
made in the short term, which could put the company in cash flow

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difficulties if it is not able to generate cash through sales or raise further

funds from another source.
These are best suited to companies with a strong credit position and good
access to short term funds, and companies which are highly cash generative
with a short working capital cycle (e.g. a supermarket or restaurant).

2.

Working capital management

What is working capital management?

Working capital is the difference between current assets and current
liabilities. The higher the level of working capital then the greater the funds
which are readily available in the short term (current assets) to cover the
short term liabilities (current liabilities) and the lower the risk that
creditors will not be able to be paid.
Decisions relating to working capital and short term financing are referred
to as working capital management. These involve managing the relationship
between a firm's short-term assets and its short-term liabilities.

Goal of working capital management

The goal of corporate finance is the maximisation of shareholder value. In
the context of long term, capital investment decisions, firm value is
enhanced through appropriately selecting and funding positive Net Present
Value (NPV) investments.
These investments, in turn, have implications in terms of cash flow and cost
of capital. The goal of Working capital management is therefore to ensure
that the firm is able to operate, and that it has sufficient cash flow to
service long term debt, and to satisfy both maturing short-term debt and
upcoming operational expenses.

3.

Management of working capital

Management will use a combination of policies and techniques for the

management of working capital. These policies aim at managing the current
assets (generally cash and cash equivalents, inventories and debtors) and
the short term financing, such that cash flows are available to pay debts as
they fall due.

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Cash management
Cash flow forecasting identifying the expected cash balances over coming
weeks and months. It enables prediction of peaks and troughs in the cash
balance and so helps with planning how much and when to borrow and how
much available cash will be available to meet payments due to suppliers or
other creditors.
Often a bank will ask for cashflow forecasts prior to considering a loan as it
helps to give them assurance that both the interest payments and the
capital amount will be paid.

Working capital (or cash operating) cycle

The most widely used measure of cash flow is the working capital (or
operating) cycle. This represents the time difference between cash
payment for raw materials and cash collection for sales. The longer the
operating cycle the longer that the payment for raw materials is tied up
before income is earned from it.
The operating cycle can vary depending on the type of industry the company
is in. In some businesses, such as manufacturing, the operating cycle is
naturally longer. Where this is the case there is a greater need for careful
management of working capital to ensure enough cash is available to meet
debts as they fall due. Other industries generate cash soon after purchase
(e.g. restaurants and supermarkets). In these businesses working capital
management is often comparatively less important.

Calculating the working capital cycle

Working capital cycle = Inventory days + Receivable days Payable days

Inventory management
Inventory management is the management of stocks of raw materials and
finished goods.
Inventory days measures the average number of days that inventory is in
stock. The longer the inventory days the more stock is available to meet
customers needs, but the more capital is tied up in stock and the greater
the likelihood of obsolescence and wastage.

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Inventory
Total operating costs

x365days

(or cost of sales if op. costs not available)

Receivables (debtors) management

Receivables are the amounts due at any one point in time from customers.
From a working capital perspective the quicker debtors repay debts the
better. It shortens the working capital cycle and ensures cash is available to
pay debts as they fall due.
However this needs to be balanced against the needs of the business to
generate sales. The longer the credit period given to customers the more
likely that customers will buy from the company compared with their
competitors.
The aim is to identify the appropriate credit policy which will offer the
customer attractive credit terms (and so encourage greater sales) whilst
reducing the total time for which debtors have access to this free finance
and so ensuring cash is available to pay debts as they fall due.
Discounts can be made for early payment, and this can be a good, simple
practical method of receiving cash earlier when cash is needed in the short
term.
Bad debts are another consideration, and appropriate credit checks should
be used with customers to reduce the risk of default. It should also be noted
that the longer the credit period given to customers the greater the chance
of default, so good management of receivables is also useful as a way to
reduce bad debts.

Accounts receivable days measures the average number of days before

customers pay debts.

Receivables
Revenue

x 365days

Payables management
Payables are the amounts due to suppliers. The longer the company are able
to take to pay suppliers the longer the working capital cycle and the less
pressure there is on cash availability. Longer payables also help to keep
financing costs down as it credit from customers is usually at no cost.

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The downside of taking longer to pay suppliers is the risk of worsening

relationships with them. Like with receivables management, a balance
needs to be struck.
Accounts payable days are the average number of days it is taking to pay
creditors.
Payables
Total operating costs

x 365days

(or cost of sales if available)

Using the ratios

For specific examples of each of these ratios see the chapter on financial
analysis.

4.

Short term financing methods

Methods of short term financing include:

Overdrafts
An overdraft is a highly flexible source of short term funds provided by a
bank up to a set limit. It can be useful a useful method of providing for
short term cash requirements. It can be drawn on at any time and is most
useful for day-to-day expenses.
An overdraft is a relatively expensive way of borrowing short term, as the
bank charges more due to the flexibility provided and lack of security on the
debt.
Advantages
Flexible - borrow as needed (which may make it cheaper than a loan
if the total is only borrowed for a short period of time)
Quick to arrange
Disadvantages
Arrangement fees for setting up or extending overdrafts
Charges for exceeding overdraft limits without authorisation
The bank has the right to ask for repayment of overdrafts at any time
Only available at the companys own bank
The interest rate applied is nearly always variable, making it difficult
to accurately calculate borrowing costs

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Short term loans

A short term loan provides a loan for a specific period of time for a specific
amount of money.
Advantages
Known date for repayment
Availability of full amount of funds for agreed time
Disadvantages
Lack of flexibility
o May be a fee for early repayment
o May borrow funds not needed on which interest is still paid
May require security

Factoring
Factoring is where a business sells its accounts receivable (i.e. invoices)
to a third party (called a factor) at a discount. When used for funding
purposes advance factoring is undertaken where the factor provides
financing to the seller of the accounts in the form of a cash advance often
70-85% of the invoice amount. The balance of the purchase price is paid,
net of the factor's discount fee (commission) and other charges, upon
collection.
E.g. Accounts receivable are 100,000. An agreement is made with a factor
that 80% (80,000) is paid now at a 5% fee. Upon receipt of the debt, 5,000
is kept by the factor and the remaining 15,000 paid over to the company.
Other points:

There are many factoring companies, so a company can negotiate

with a number to find the best rates.

The company can protect from bad debts by taking the nonrecourse factoring service, although the factor charges more for
this due to the risk taken.

Cash is released as soon as orders are invoiced helping to fund future

payments to suppliers.

Factors will credit check customers which can help reduce bad debt
risk.

Internal costs of managing a sales ledger and credit control can be

reduced.

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On the downside, factoring can suggest cash flow problems to customers,

and there is a loss of control over methods used to chase up debts. As such
it may worsen the companys reputation with its customers.

Invoice discounting
Invoice discounting is very similar to factoring.
When a business enters into an invoice discounting arrangement, the finance
company allow the business to draw down a percentage of the outstanding
sales invoices - usually in the region of 80%. As customers pay their
invoices, and new sales invoices are raised, the amount available to be
advanced will change so that the maximum drawdown remains at 80% of the
sales ledger.
The finance company will charge a monthly fee for the service, and interest
on the amount borrowed against sales invoices. In addition, the finance
company may refuse to lend against some invoices, for example if it
believes the customer is a credit risk, sales to overseas companies, sales
with very long credit terms, or very small value invoices. The lender will
require a floating charge over the book debts (trade debtors) of the business
as security for the funds it lends to the business under the invoice
discounting arrangement.
The difference between invoice discounting and factoring where that with
factoring the debt is sold to the factor who processes the debt while with
invoice discounting the responsibility for raising sales invoices and for credit
control stays with the business.
An advantage of invoice discounting over factoring is that it can be arranged
confidentially, so that customers are unaware that the business is borrowing
against sales invoices.

Selective Invoice Discounting

Selective Invoice Discounting allows the company to select individual
invoices to discount and so receive funding on an invoice-by-invoice basis.
This provides greater flexibility, particularly where the company has a small
number of large invoices, or only has seasonal sales, and only needs
additional funds for certain periods.
Fees for selective invoice discounting are higher, but it can be more costeffective as the company does not need to process all invoices through the
factor.

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Advantages
As with invoice discounting the company retains management of sales
and collections and can maintain business relationships
Flexibility
Quick funding
Open contracts without long term ties
No leaving fees for ending an agreement

Export factoring
Export factoring is essentially the same as factoring, but for overseas sales.
Key points
The company can choose to invoice in one currency and be paid in
another. This helps to manage foreign exchange risk as if payment is
made immediately there is protection against currency fluctuations.
The cost of export factoring is usually slightly higher than the cost of
domestic factoring due to the increased currency and credit risks
being faced by the factor.
Bad debt risk can be reduced by purchasing credit protection from
the factor

5.

Over-trading

Over-trading is where fast growing companies aim to grow without

sufficient capital to support trading activities. This tends to be a problem
where there is a long working capital cycle where payments to creditors are
due long before receipts from customers (E.g. manufacturing businesses).
So how can growing too quickly become a problem?
A fast growing company also has the problem of increasing needs for cash to
pay for higher levels of raw materials and a greater number of employees. If
the working capital cycle is long receipts from debtors are now being paid
from a sales made a few months earlier when sales levels were at a much
lower volume (as the business is growing quickly) so the cash received from
those sales may not be sufficient to pay the much higher current levels of
purchases and wages.
This can result in unpaid suppliers refusing to sell to them until paid, or only
selling for cash in the future, and the business grinding to a halt, and in
some cases failing not because of any problem with the underlying
business, but instead because of a lack of cash to pay creditors.
Growing companies in particular need to plan for increasing cash
requirements during the growth period, for which a cash-flow forecast will
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be useful, and may need to raise longer term finance well in advance of
running out of cash to avoid over-trading.

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