Financial Management MGT201
CASH MANAGEMENT AND WORKING CAPITAL FINANCING
After going through this lecture, you would be able to have an understanding of the following topics:
· Cash Management &
· Working Capital Financing
Cash Dividend Payout Decision:
· Link between Dividend Policy & Cash Management Cash Dividends are paid out of Cash!
· Cash is an idle asset that do not generate any return for the company
· How should firm decide to pay Cash Dividend based on Its Impact on Share Price and Firm's
· Gordon's Formula:
Dividend policy issue of the company can be seen through Gordon's Formula.
Po (Share Price) = DIV1 / (rE g)
= EPS x (DIV1/EPS) / (rE (Pb x ROE)).
DIV1 = Forecasted dividend in the next year
rE = Required rate of return on equity
g = Growth rate in dividends
Pb = Plough back ratio
The two criteria that can help to decide about dividend are ROE and rE.
· ROE is financial accounting measure of the firm's ability to internally generate a return. rE
is the return that the firm's shareholders REQUIRE. Firms try to keep ROE HIGHER than
· If ROE < rE then firm is not generating enough return to meet shareholder requirements so it
is better to payout the dividend. Lower ROE means company is not finding sufficient
projects to generate enough return higher than rate of return on equity.
· If firm makes Dividend payout, in this case, share price Po (and Firm Value) will RISE as
dividend announcement has positive impact on company's share price.
· If ROE > rE then firm is better off to Plough the Retained Earnings back into the business
and investing in Positive NPV Projects or the Firm's core business. In this case, company
is generating higher return than the return shareholders require, so the best use of internally
generated retained earnings is to use them as a cheap source of capital or financing.
· In this case of ROE > rE if firm makes Dividend payout, share price (and Firm Value) Po
will FALL. Here it makes sense for the company to keep cash and invest it in investments
as company is generating positive higher returns on its projects rather than paying dividend.
· If ROE = rE then dividend payment has no impact on share price of the company.
In the last lecture we studied working capital and cash management in detail. Now we discuss inventory
management, another part of working capital.
· 3 Types of Inventories: Raw Material, Work in Process, Finished Goods
· Issues to Consider in Inventory Management:
Inventory is acquired BEFORE sales so estimates must be accurate. EOQ (Economic Order
Quantity) difficult to estimate otherwise:
· Shortfall in Inventories: interruptions in production and loss or sales orders
· Surplus Inventories: high carrying costs, wastage, and depreciation
Case of Eid Time Sales: Using Short-term Finance or Loan to buy extra inventory can be Risky
because if you can't sell it, you will be forced to sell at a Deep Discount. So sell at a loss. Cash
trickling in BUT Retained Earnings being wiped out. Not enough cash to pay interest on the
loan. Possibly default and bankruptcy.
· Carrying Costs (cost of capital, storage / warehouse rent, insurance premium, wastage)
as high as 20 30 % of Inventory value!
Financial Management MGT201
· Shipping Costs: Generally Less than 5% of Inventory value!
· Cost of Running Short Loss of sales, customers, and goodwill difficult to estimate.
Inventory Management Policies:
Technology Based: Dynamic Systems not only Static EOQ Software for inventory but
Dynamic Computer Software that considers Usage Growth Rates. MRP (Material Resource
Planning) and ERP (Economic Resource Planning) Software.
JIT: Just in Time. Developed by Toyota. Supplies arrive just a few hours before they are
used. Inventory and Working Capital is minimized. Improves overall Efficiency.
Outsourcing: Instead of making all the parts yourself, buy them from outside suppliers at a
lower cost and avoid any unionism issues. Example: IT Divisions of Large American
MNC's outsource the writing of computer software to Pakistani software houses.
Accounts Receivables Management:
This is another area of working capital. Accounts receivables are created out of credit sales.
· Most firms would prefer to sell for Cash BUT Competition forces them to sell on Credit.
Example: Fabric trading in Pakistan where sellers offer 1 to 3 months credit (and even longer).
· Account Receivables
= Credit Sales per day x Average Number of Days of Credit
=Rs.10000 / day x 30 days
=Rs.300000 of fabric "Stuck in the market" or "In Rolling" at any given time.
· A/c Receivables (other than Profit portion which appears in Retained Earnings) need to be
Financed somehow i.e. Short-term loan, trade credit, etc.
· A/c Receivables = Daily Sales x ACP
ACP = Average Collection Period
= weighted average days of credit. Can be obtained from Ageing Schedule (Financial
Example: Firm makes 30% of sales on 30 day credit and 70% on 60 day credit. So
= (0.3x30) + (0.7x60)
= 9 + 42
= 51 Days
Try to Minimize Average Collection Period and daily credit sales.
· Factors considered for credit:
Credit Quality Aspect: Proper Assessment of Credit-worthiness of each credit customer
Minimize Time (Credit Duration or ACP) and Value (Credit Given)
Creative Credit Terms
· Incentivize Customers to pay cash and to pay quickly
"Sell on 5/10.net 30 basis". 30 basis Means customer must pay full cash value within 30
days. 5/10.net means 5% discount for customers who pay within 10 days. So it is an
incentive for customer to pay cash quickly.
· Impose Carrying Charge on Late Payments
Example: 2% late payment Charges if bill is not paid within 30 days. Means 24% penal
interest per year! Example: If customer does NOT pay Rs.100000 bill within 1 month,
then he will have to pay Rs.2000 extra for every month that he is late!
Working Capital Financing Policies:
It involves the discussion regarding how firms should finance this working capital.
· Sales fluctuate with Nature of Business, Time, Season, State of Economy:
Economic Growth or Boom: High inventories and Current Assets
Economic Recession: Low inventories and Current Assets
Financial Management MGT201
· Never drop to zero because always need minimal "Permanent Current Assets."
Total Assets = Fixed + Permanent Current + Temporary Current.
Total assets steadily grow with life of healthy company.
Temporary Current Assets fluctuate with time. Extra Spontaneous Inventory can be
financed by short-term debt financing or loan
3 Policies for Working Capital Financing (based on Maturity Matching Principle)
· Maximum Short-term financing at low cost (but risk of non-renewal of loan)
· Use short-term financing for Temporary Current Assets and even partly to buy
Permanent Current Inventory
· Maximum Long-term financing. Safe but higher interest costs.
· Use long-term financing for Fixed Assets, entire Permanent Assets, and even
part of Temporary Current Assets
· Balance of Long and Short-term Financing.
· Long Term Financing for Fixed and Permanent Current Assets. Use Short
Term Financing for Permanent Current Assets. Use Spontaneous Current
Liability Financing for Temporary Current Assets
Advantages of Short Term Debt or Loan
Speed of getting finance as they are short run
Flexibility (not locked in)
Lower Interest Rates (generally Upward Sloping or Normal Yield Curve)
Disadvantage of Short Term Debt is that cost of debt is uncertain and variable in long run.
Graphical View of Financing Maturity Matching Principle Match the Maturity of Financing to
Usage of Asset:
Graphical View of Financing
Maturity Matching Principle
Match the Maturity of Financing to Usage of Asset
TEMPORARY CURRENT ASSETS
Usage Less than 1 Year
"PERMANENT" CURRENT ASSETS
Usage More than 1 Year
Usage More than 1 Year
Firms generally pursue moderate policy of financing. Basic logic behind this is MATURITY
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