Financing the Business

Financing the Business

USQ_{UNIVERSITY OF SOUTHERN QUEENSLAND}

MBA - ACC5502

Accounting & Financial Management / S1 / 2015

M B G Wimalarathna

Financing through WC

Working Capital (WC) (in an entity) refers to the total funds invested in

current assets.

Concept of Net working capital (NWC) is a key component of working

capital. NWC calculated by eliminating Total Current Liabilities from

Total Current Assets.

WC

CA

NWC

(CA - CL)

Managing suitable level of NWC is essential in following

aspects.

1. Maintaining a healthy liquidity position.

2. To earn required return on assets.

Maintaining an appropriate level of NWC

Appropriate level of NWC is the level at which entity able to meet its

financial obligations without any delays.

Hedging

Many entities practice “hedging” in order to maintain proper level of

NWC. Hedging is matching the maturity of the sources of funding with

their use.

Keys for effective hedging;

 NCA should be financed through permanent funding.

 CA & other assets must financed through temporary funding.

Discussion:

 Permanent Funding. (Maturity Period > 1year)

 Temporary Funding. (Maturity Period ≤ 1year)

 Spontaneous Funding. (Unplanned, Unstructured finance- can either

permanent or temporary)

Managing the components of NWC

Cash & Cash equivalents

C/Assets

Trade Debtors

Inventories

Accrued wages & taxes

Trade Creditors

C/Liabilities

Bank Overdraft

Commercial bills & promissory notes

Factoring/Trade finance

Management of Cash

An entity must manage its cash due to following;  Need to have sufficient cash

 Timing of cash flows  Cost of cash

 Cost of not having enough cash

The need to have sufficient cash

An entity must always maintain sufficient level of cash balance in hand in order to meet its financial obligations.

When determining the level, trade-off between risk & return should taken in to consider.

Risk - inability to meet financial obligations. Return - return get by making an investment.

The timing of cash flows

An entity must ensure the timing of its cash requirement.

Cash Sales

Collection of money from debtors Mode of cash- Sale of assets (idle)

inflows Capital injections Short-term Loans

Long-term Loans

Purchase of Labor, R/M & other services Mode of cash outflows Purchase of assets

The Cost of Cash

An entity might incur cost in following manner when managing its

cash.

 Opportunity cost of (merely)holding money.

 Cost of providing physical Security.

The cost of not having (enough) cash

An entity requires money in order to meet its financial obligations.

When entity not having sufficient cash, it may not pay the debt at

required time which even affect to the going concern. (prone to wind -

up the business in long run or even in short period)

Managing Trade Debtors

An entity must develop a sound system for the debtors’

management by addressing all key aspects.

A Debtor create through the credit sales and following benefits and

cost would involved;

Enhance customer base

Benefits

Increase sales volume

Attract new customers / markets

Eliminate some cost of marketing & selling

Opportunity cost of money

Cost

Bad & Doubtful debts

Administration Cost(Handling, Collecting,

Recording)

Key factors of determining the suitable level of debtors within the entity.

Total Sales

Credit Policies

This refers to the internal policies & applications with respect to credit sales & trade debtors. Selec tion of suit ab le cu st ome r Credit Policy

Determinants of credit Sales

Deciding Payment terms

Se ttin g C red it Lim it

Collection Policies & Procedures

An entity must develop a system which entails clear policies &

procedures with respect to collection of money from the debtors.

This might directly affect to bad/doubtful debtors and working

capital coupled with the liquidity position of the entity.

The level of credit sales

As mentioned before, a trade debtor will create within the entity

as a result of credit sales.

Inventory Management

Inventory has become a most common and crucial element represents current asset in the entity. Inventory is essential for the continuous production process (especially in manufacturing entity)

Raw Materials (RM) Form of Inventories Work in Progress (WIP) Finished Goods (FG)

Benefits

1. Continuous Production - Sales - Profit 2. Retain & gain customers

3. Build good relationship with key players in the market 4. Create & maintain goodwill

Costs

1. Ordering Costs ( Broker, Freight, Clearing) 2. Holding Costs - Storage

Insurance

Deterioration & Obsolescence

Theft

Techniques available to manage the inventory. - Maintain minimum level of stock

- Managing average turnover period - Economic order quantity (EOQ)

Maintaining a minimum stock level refers to the buffer stock keep by entity to make sure continuous operations.

Average turnover period = Average inventory held x 365/52/12 Cost of Sales

EOQ = 2 Do H

Where,

D Total demand for given period

O Ordering Cost

H Holding Cost

Q Quantity

Just in time (JIT) is the technique introduced by Japan (Toyota) through which entity able to produce goods by placing the orders for inventories as and when requirement arise only.

Sources of Short term funding - CL

Accrued wages & taxes

Entity keeps its employees salary for the particular month as an accrual until end of month which indirectly treat as short term source of finance for the entity. Same in the event of GST and other indirect taxes.

Trade Creditors

Trade Credit is most common widely practice mode of short term funding in the business world. An entity purchases materials in the normal course of business while make the payment after 30 - 90 days. (not a norm)

Average Settlement period = Avg. Trade Crs. x 365/52/12

Credit purchases

Bank Overdrafts

Bank Overdraft (OD) is a facility granted by a bank (commercial) exceeding the current account balance as a result of corporate relationship having with the company without pledging securities (in most cases).

Commercial bills & Promissory notes

Both commercial bills & promissory notes are also become popular within the business world through which borrower receives funds less than the face value, with the face value paid in maturity.

Factoring & invoice discounting

Factoring - Formal arrangement of handing over the debtors administration to third party.

Invoice discounting - Sell the debtor/invoice and receives the discounted value of money.

Pledging receivables - Pledge the debtor balances as a security to obtain finance facilities.

Inventory loans or floor - Plan finance

Obtain finance facility by pledging inventory as a security. Floor plan finance, involvement of three parties; the lender, the manufacture and the borrower.

Sources of Long - term debt finance

In addition to the various types of short term funding/finance mode discussed above, following long-term debt finance modes are also become popular within the business world.

 Fixed rate business loans  Variable rate business loans  Installment loans

 Interest - only loans  Fully drawn advances  Leasing

In addition to above, following mode of finance also could be seen in the business world.

 Corporate bonds  Floating rate notes

Hybrid Finance

A Mode of finance which has characteristics of both debt & equity.  Convertible notes / debentures

 Convertible Preference Shares

Equity Finance

Very popular strong mode of financing available for the entity. This could work either issuing ordinary shares or preference shares or both. In addition to above, entities tend to use rights issue and options also as a mode of financing.

International Sources of Funding

International sources of funding occur when foreign investor make investments in the entity (within the local country). Both Direct & Portfolio investment could be seen in the practice.