Chapte

5
Short-Term Finance r
and Planning

LEARNING OBJECTIVES

After studying this chapter you should be able to:

Working Capital

Importance of Working Capital Management

Measuring & Estimating Working Capital Need

The Working Capital & Net Present Value

Estimating the Optimal Level of Inventory

Credit Management

Operating Cash, Reasons for Holding Operating Cash

Defining The Operating And Cash Cycles

Cash And Near-Cash Investments

Mathematical Problems, Solution, Formula & Exercise

 5.1 Working capital

Working capital indicates the liquidity levels of businesses for managing

Day to day expenses and covers inventory, cash, accounts payable, accounts

receivable, and short-term debt. It is an indicator of the short –term

financial position of an organization and is also a measure of its overall

efficiency.

The term net working capital is associated with short-term financial

decision making. net working capital is the difference between current

assets and current liabilities. Often, short-term financial management is

called working capital management . These terms mean the same thing.

There is no universally accepted definition of short-term finance. The most

important difference between short-term and long-term finance is in the

timing of cash flows. Short-term financial decisions typically involve cash

inflows and outflows that occur within a year. For example, short-term

financial decisions are involved when a firm orders raw materials, pays in

cash, and anticipates selling finished goods in one year for cash. In contrast,

long-term financial decisions are involved when a firm purchases a special

machine that will reduce operating costs over, say, the next five years.

5.2 Tracing Cash and Net Working Capital

current assets are cash and other assets that are expected to convert to cash within the year.

Current assets are presented on the balance sheet in order of their accounting liquidity—the ease

with which they can be converted to cash and the time it takes to convert them. Four of the most

important items found in the current asset section of a balance sheet are cash and cash

equivalents, marketable

securities, accounts receivable, and inventories.

Analogous to their investment in current assets, firms use several kinds of short term

debt called current liabilities . Current liabilities are obligations that are expected

to require cash payment within one year (or within the operating period if it is longer

than one year). Three major items found as current liabilities are accounts payable,

expenses payable (including accrued wages and taxes), and notes payable.

Because we want to focus on changes in cash, we start off by defining cash in terms

of the other elements of the balance sheet. This lets us isolate the cash account and

explore the impact on cash from the firm’s operating and financing decisions. The

basic balance sheet identity can be written as:

Net working capital + Fixed assets = Long-term deb t Equity

Net working capital is cash plus other current assets, less current liabilities; that is:

Net working capital = (Cash + Other current assets) - Current liabilities

If we substitute this for net working capital in the basic balance sheet identity and

rearrange things a bit, we see that cash is:

Cash = Long-term debt + Equity +Current liabilities

- Current assets other than cash - Fixed assets

This tells us in general terms that some activities naturally increase cash and some

activities decrease it. We can list these various activities, along with an example of

each, as follows:

Activities That Increase Cash

Increasing long-term debt (borrowing over the long term)

Increasing equity (selling some stock)

Increasing current liabilities (getting a 90-day loan)

Decreasing current assets other than cash (selling some inventory for cash)

Decreasing fixed assets (selling some property)

Activities That Decrease Cash

Decreasing long-term debt (paying off a long-term debt)

Decreasing equity (repurchasing some stock)

Decreasing current liabilities (paying off a 90-day loan)

Increasing current assets other than cash (buying some inventory for cash)
Increasing fixed assets (buying some property)

Activities that increase cash are called sources of cash . Those activities that

decrease cash are called uses of cash . Looking back at our list, we see that sources of

cash always involve increasing a liability (or equity) account or decreasing an asset

account. This makes sense because increasing a liability means that we have raised

money by borrowing it or by selling an ownership interest in the firm. A decrease in

an asset means that we have sold or otherwise liquidated an asset. In either case there

is a cash inflow.

Uses of cash are just the reverse. A use of cash involves decreasing a liability by

paying it off, perhaps, or increasing assets by purchasing something. Both of these

activities require that the firm spend some cash.

5.3 The Operating Cycle and the Cash Cycle

The primary concern in short-term finance is the firm’s short-run operating and
financing activities. For a typical manufacturing firm, these short-run activities might
consist of the following sequence of events and decisions:

Event Decision
1. Buying raw materials 1. How much inventory to order
2. Paying cash 2. Whether to borrow or draw down cash balances
3. Manufacturing the product 3. What choice of production technology to use
4. Selling the product 4. Whether credit should be extended to a particular customer
5. Collecting cash 5. How to collect
These activities create patterns of cash inflows and cash outflows. These cash flows
are both unsynchronized and uncertain. They are unsynchronized because, for example,
the payment of cash for raw materials does not happen at the same time as the
receipt of cash from selling the product. They are uncertain because future sales and
costs cannot be precisely predicted.

DEFINING THE OPERATING AND CASH CYCLES

We can start with a simple case. One day, call it Day 0, we purchase $1,000 worth of
inventory on credit. We pay the bill 30 days later, and, after 30 more days, someone
buys the $1,000 in inventory for $1,400. Our buyer does not actually pay for another
45 days. We can summarize these events chronologically as follows:
5.4 The Operating Cycle
There are several things to notice in our example. First, the entire cycle, from the time we acquire
some inventory to the time we collect the cash, takes 105 days. This is called the operating cycle.
As we illustrate, the operating cycle is the length of time it takes to acquire inventory,
sell it, and collect for it. This cycle has two distinct components. The first part is
the time it takes to acquire and sell the inventory. This period, a 60-day span in our
example, is called the inventory period. The second part is the time it takes to collect
on the sale, 45 days in our example. This is called the accounts receivable period.
Based on our definitions, the operating cycle is obviously just the sum of the inventory
and accounts receivable periods:

What the operating cycle describes is how a product moves through the current asset
accounts. The product begins life as inventory, it is converted to a receivable when it
is sold, and it is finally converted to cash when we collect from the sale. Notice that,
at each step, the asset is moving closer to cash.
The Cash Cycle
The second thing to notice is that the cash flows and other
events that occur are not synchronized. For example, we don’t actually pay for the
inventory until 30 days after we acquire it. The intervening 30-day period is called the
accounts payable period. Next, we spend cash on Day 30, but we don’t collect until
Day 105. Somehow, we have to arrange to finance the $1,000 for 105 2 30 5 75 days.
This period is called the cash cycle.
The cash cycle, therefore, is the number of days that pass before we collect the cash
from a sale, measured from when we actually pay for the inventory. Notice that, based
on our definitions, the cash cycle is the difference between the operating cycle and the
accounts payable period:

5.6 Importance Points of Working Capital

Below is the importance of working capital:
Liquidity Management: By properly analyzing the expenses payable or to be

incurred in the near future the financial team of an enterprise would easily plan

for their funds accordingly.

1. Out of Cash: Inappropriate prepared plans of day-to-day expenses may

result in enterprise liquidity issues. They have to postpone or to arrange

 funds from some other sources which gives a bad impression of an

enterprise at the party.

2. Helps in Decision Making: By correctly analyzing the requirement of funds

for day-to-day operations the finance team can appropriately manage the

funds and can decide accordingly for available funds and for the availability

of funds also.

3. Addition in the Value of Business: As the management accordingly manages

all the day-to-day required funds that help the authorized personnel to

timely pay for all the outstanding creates a value addition or goodwill

enhancement in the market.

4. Helps in the Situation of Cash Crunches: By properly managing the liquid

funds one can help the organization not to affect the situation of crises or

cash crunches and pay for its day-to-day expenses on a timely basis.

5. Perfect Investments Plans: Correctly managing the funds or working capital

one can choose or plan for their investments accordingly and invest the

funds to maximize the return as per their availability.

6. Helps in Earning Short Term Profits: Sometimes it is seen that the

enterprises keep a heavy amount of funds as working capital which is far

over and above the required level of working capital. So by correctly

preparing the required working capital those extra funds could be invested

for a short span of time and could create value in the profits of the

enterprise.

7. Strengthening the Work Culture of Entity: Timely payment of all the day-

to-day expenses mainly focused on the salary of the employees creates a

good environment and a sort of motivation amongst employees to work

harder and strengthen the good working environment.

 8. Improves Creditworthiness of Entity: When the enterprise has adequately

planned their working capital requirements, they will surely pay the payments

to vendors and other creditors timely which improves their creditworthiness

and could help them to get the funds as and when required easily.

9. Act as Guarantor to Other Enterprises: When an enterprise has created

such a good image in the market then the business could also help some

other enterprises and in favor gets business profits and contracts done

easily.

10. Good Reputation of Entity: Easy way to create a good reputation in the

market which in turn helps the organization or entity easily get contracts

because of a good image and fulfilling their commitments on time. Nowadays,

everyone wants to deal and do business with such parties whose market

reputation and creditworthiness are good due to an increase in fraud and

manipulations.

To conclude the working capital in any business plays a crucial and vital

role in achieving the organizational goal and enhancing the profitability of the

business. The calculation of working capital may be done on a monthly, quarterly,

or on yearly basis. Generally, it is preferred to calculate the working capital

requirement and availability every quarter so that further decisions could be

taken accordingly as per the availability and requirements and the spare funds

should be invested in such a manner so that the returns from the same could be

maximized.

5.7 Factors That Affect Working Capital Needs

There are dozens of factors that affect an organization’s working capital

requirement. Not all factors relate to all businesses, and how much capital you need

at any given time depends on your specific business model.

 The nature of the business — Do you manufacture something and sell to

wholesale suppliers? Are you a service business or in the retail industry?

What you do impacts working capital.

 The scale of your business — Are you a large or small business? Small and

medium-sized businesses in all types of industries often need more working

capital to fund growth.

 Seasonal or cyclical business — Are there times when you’re doing booming

business and times when there is little work?  When you’re busy, you need

the working capital to get the job done. When you’re not, you might need it

to get through the slower months. 

 Operating efficiency — What is the turnaround time from production to

sales? Long turnaround times require working capital to sustain.

 Availability of materials — if your business depends on specific materials

which have limited availability from suppliers, you may need more working

capital to get by.

 Potential for growth — if you just won a large contract and need to boost

production to meet the job requirements, you may need more working capital.

This can be especially true if you have a lot of debt or can’t meet the credit

terms for a loan or line of credit from a bank or other financial institution.

 Inflation — Inflation can mean a rise in prices, which means you need

working capital to pay the higher price of goods and materials.

5.8 What are inventory levels?

"Inventory levels" refers to the amount of stock available throughout your

distribution network. By tracking your inventory levels, you can consistently meet

demand without accruing unnecessary holding costs that diminish gross profits.

For instance, when your inventory levels are low, you won't have enough inventory

to fulfill all the demand that comes your way. And as a result, you'll go out of

stock. During that stockout event, you miss out on sales and revenue if you don't

sell those products on backorder.

Meanwhile, holding too much inventory requires a hefty up-front capital

investment. And the longer units sit in your warehouse, the more carrying costs

they rack up, and the more likely they'll turn to dead stock. So, by the time you

sell these units, chances are good that their margins will have shrunk, and you're

no longer making a profit.

The sweet spot, then, is the point between too much and too little inventory.

There, you achieve optimal inventory levels and only carry units guaranteed to sell.

3 types of inventory levels

There are 3 types of inventory levels you should track: your minimum, maximum,

and optimal levels of inventory.

Minimum inventory levels

Minimum inventory levels are the lowest amount of inventory you should have for

each SKU. Anything below this threshold means you might stock out and fail to

meet customer demand that comes your way.

As such, your reorder point should consider what's happening with your supply

chain and how variabilities affect your order lead times. That way, you can ensure

replenishment arrives before you drop below this minimum stock level.
Maximum inventory levels

Maximum inventory levels are the ceiling amount of stock you should have on hand

for each SKU. Anything more above that threshold is considered excess inventory

and puts your brand at risk of accruing unnecessary overhead costs.

As such, your maximum inventory levels should be calculated before you place a

purchase order (PO) to prevent over-ordering.

5.9 Optimal inventory levels

Optimal inventory levels are the ideal inventory quantities your brand should have

on hand. These stock levels match your actual customer demand, so you always have

enough inventory to fulfill that demand. All while keeping inventory costs down,

cash flow moving, and profits as high as possible.

How to calculate min and max inventory levels

To calculate your optimal inventory levels, you need to first know where your

minimum and maximum stock levels are. To do this, you'll need to know your:

 Reorder point (the point when your inventory needs to be replenished so you

don't run into a stockout situation).

 Economic order quantity or optimal order quantity (the most cost-effective

amount of inventory to purchase at one time).

 Minimum consumption (the smallest amount of demand you expect during a

time frame).

 Normal consumption (based on your historical sales, the average forecasted

demand you expect to see during that same time frame).  

 Minimum order lead time (the minimum amount of time it will take to

receive your replenishment at your warehouse once the PO is placed). 

Normal delivery time (the average amount of time it takes to receive your

replenishment at your warehouse once the PO is placed).

Once you have these numbers, you're ready to calculate your inventory levels.

Calculating minimum inventory levels

To calculate your minimum inventory levels, use the following formula:

minimum inventory level = reorder point – [normal consumption × normal

delivery time].

For example, say you sell t-shirts. Your reorder point is 10k shirts with a normal

delivery time of 6 weeks. The normal consumption of these shirts is 1,200 units per

week. 

minimum inventory level = 10,000 shirts – (1,200 shirts per week × 6 weeks) = 2,800

In this example, your minimum inventory level would be 2,800 shirts. 

Calculating maximum inventory levels

To calculate maximum inventory levels, use the following formula:

maximum inventory levels = reorder point + reorder quantity – [minimum

consumption × minimum lead time].

Let's go back to the t-shirt example. Your reorder point is still 10,00- shirts with a

reorder quantity typically of 15,000 shirts. Minimum consumption is 1,000 shirts

per week and your minimum lead time still hovers at the 6-week mark.

maximum inventory levels = 10,000 shirts + 15,000 shirts – (1,000 shirts × 6 weeks)

= 19,000

In this example, the maximum inventory level is 19,000 shirts.

5.10 Calculating optimal inventory levels

Optimal inventory levels are somewhere between your minimum and maximum levels.

And you need to calculate this number to, well, maintain optimal inventory levels. 
But calculating your optimal levels is more complex than just plugging numbers into

a formula. It depends on your real-time inventory data and the growth assumptions

your demand forecasts rely on. 

Admittedly, calculating your exact optimal level of stock is complicated because

these factors are constantly changing.

While some brands calculate this number with spreadsheets, it's time-consuming

and typically unreliable. So, the better (and error-proof) option is to use an

inventory management software or ops optimization tool. (More on this in a minute.)

Why is maintaining optimal inventory levels important

Optimal inventory levels ensure you never have too much or too little inventory at

any given time. And when a DTC brand maintains that kind of inventory control,

they benefit in a myriad of ways.

Consistently meet customer demand

Having the right amount of inventory on hand means none of your generated

demand goes unfilled. Instead, you always have exactly what your customers what

at the moment they want it. This keeps customers happy and revenue flowing.

Build trust and brand loyalty

A whopping 17% of customers will leave a brand after just 1 bad experience (and

59% after multiple instances). But when you continually meet demand with optimal

inventory levels, you create positive experiences for your new and old customers.

And that means they're more likely to come back and purchase from you again and

again.

Maintain low holding costs

Optimal inventory levels ensure you have constant inventory turnover. That's

because you're constantly selling through and replenishing the stock you have in
your warehouse. This eliminates excess inventory (so you're not stuck paying

storage costs), reduces your insurance liability, and keeps you from collecting dead

stock.

Optimize inventory management processes

By forecasting your optimal inventory levels, you also optimize your inventory

planning and inventory management processes. That's because you have a better

sense of what customers will want to buy in the coming months. So, you only order

the inventory that you'll actually sell through (nothing more, nothing less).

Improve cash flow and maximize profits

Optimal levels ensure that you never invest too much capital upfront for

unnecessary inventory. And the stock you do invest in is guaranteed to sell quickly.

This way, your cash flow keeps, well, flowing. And you get a bigger return because

the inventory isn't accumulating unnecessary carrying costs that deplete margins.

5.11 Credit management

Credit management is everything directly related to the processes of approving

customers for onboarding, extending payment terms, setting credit and payments

policy, issuing credit or financing and monitoring business cash flow. 

It is practiced by banks and businesses across all industries and markets. Best

practices, levels of risk and days sales outstanding (DSO) vary in each of these.

(This latter term – DSO – means the average time period. It is usually measured in

how many working days it takes between a sale being made and the payment for

that sale being received or collected.)

Businesses working in the B2B sphere, for example, often grant credit and also

need to manage relatively slow payment cycles. This in turn affects their cash flow.
At its core, credit management is the caretaking of your company’s financial

health. Good credit management can make the difference between a company

surviving, thriving or going bankrupt.

5.12 The main components of credit management

Below is our list of the most important areas involved in good credit management.

1. Assessing and approving new clients

A good credit management system can quickly and effectively assess a customer’s

financial situation.

Balancing these two competing requirements isn’t easy.

If the assessment process takes too long, there is a risk that the potential

customer will find a new supplier. If it isn’t done to a high enough standard, there

is a risk your business will take on bad debts.

2. Setting payment terms

This is the practice of deciding when invoices should be paid.

Companies often need to strike a balance between offering terms suitable for

their industry and the cash flow issues and risks that longer terms bring.

3. Extending credit to existing customers

Extending credit covers multiple scenarios, including issuing credit notes and

offering financing options to your customers.

It is often necessary if you want to retain business. And financing can bring extra

benefits such as higher sales volumes and customer loyalty.

Credit terms can vary according to the credit or payment history of specific

customers. Credit management decisions are critical when considering offering

these services.
 4. Tracking customer credit

An important function of credit management is the ability to monitor and prioritize

your sales ledger.

This area may crossover into the realm of collections. For example, it might

involve dunning, which is an important part of establishing the status of late

payments.

5.13 What are the benefits of credit management? 

One of the key benefits of credit management is the ability to see a clear picture

of your company’s finances so you can avoid unnecessary credit risk credit risk and

seize opportunities.

But that’s not all. The benefits of credit management also include:

 Cash flow protection: ensuring that your cash inflows are always higher than your

cash outflows so that you can pay your bills and employees on time.

 Reducing the number of late payments by detecting them earlier and

preventing bad debts, consequently reducing the possibility that a default will

adversely impact your business.

 Increasing available business liquidity.

 Executing faster and more complete debt recovery.

 Improving your company’s Days Sales Outstanding (DSO).

 Identifying opportunities and freeing up your company’s working capital for

critical business investments that can support strategic growth.

 Helping you plan and analyse performance, which enables you to prepare

financial budgets for the years to come.

 Reassuring potential lenders who can fund your business expansion plans.

Some Aspects of Short-Term Financial Policy

The policy that a firm adopts for short-term finance will be composed of at least

two elements:

1. The size of the firm’s investment in current assets : This is usually measured

relative to the firm’s level of total operating revenues. A flexible or

accommodative

short-term financial policy would maintain a high ratio of current assets to sales. A

restrictive short-term financial policy would entail a low ratio of current assets

to sales.

2. The financing of current assets : This is measured as the proportion of short-

term debt to long-term debt. A restrictive short-term financial policy means

a high proportion of short-term debt relative to long-term financing, and a

flexible policy means less short-term debt and more long-term debt.

THE SIZE OF THE FIRM’S INVESTMENT IN CURRENT ASSETS

Flexible short-term financial policies include:

1. Keeping large balances of cash and marketable securities.

2. Making large investments in inventory.

3. Granting liberal credit terms, which results in a high level of accounts

receivable.

Restrictive short-term financial policies are:

1. Keeping low cash balances and no investment in marketable securities.

2. Making small investments in inventory.

3. Allowing no credit sales and no accounts receivable.

Determining the optimal investment level in short-term assets requires an

identification

of the different costs of alternative short-term financing policies. The objective

is to trade off the costs of restrictive policies against those of the flexible ones

to

arrive at the best compromise.

Current asset holdings are highest with a flexible short-term financial policy and

lowest with a restrictive policy. Thus, flexible short-term financial policies are

costly in that they require higher cash outflows to finance cash and marketable

securities, inventory, and accounts receivable. However, future cash inflows are

highest with a flexible policy. Sales are stimulated by the use of a credit policy

that provides liberal financing to customers. A large amount of inventory on hand

(“on the shelf”) provides a quick delivery service to customers and increases in

sales. 4 In addition, the firm can probably charge higher prices for the quick

delivery service and the liberal credit terms of flexible policies. A flexible policy

also may result in fewer production stoppages because of inventory shortages.

Managing current assets can be thought of as involving a trade-off between costs

that rise with the level of investment and costs that fall with the level of

investment. Costs that rise with the level of investment in current assets are

called carrying costs. Costs that fall with increases in the level of investment in

current assets are called shortage costs.

Carrying costs are generally of two types. First, because the rate of return on

current assets is low compared to that of other assets, there is an opportunity

cost.

Second, there is the cost of maintaining the economic value of the item. For

example,

the cost of warehousing inventory belongs here.

Shortage costs are incurred when the investment in current assets is low. If a firm
runs out of cash, it will be forced to sell marketable securities. If a firm runs out

of

cash and cannot readily sell marketable securities, it may need to borrow or

default

on an obligation. (This general situation is called cash-out .) If a firm has no

inventory

(a stockout ) or if it cannot extend credit to its customers, it will lose customers.

There are two kinds of shortage costs:

1. Trading, or order, costs : Order costs are the costs of placing an order for more

cash ( brokerage costs ) or more inventory ( production setup costs ).

2. Costs related to safety reserves : These are the costs of lost sales, lost

customer

goodwill, and disruption of production schedules.

5.14 ALTERNATIVE FINANCING POLICIES FOR CURRENT ASSETS

In the previous section, we examined the level of investment in current assets.

Now

we turn to the level of current liabilities, assuming the investment in current

assets is optimal.

An Ideal Model In an ideal economy, short-term assets can always be financed

with short-term debt, and long-term assets can be financed with long-term debt

and

equity. In this economy, net working capital is always zero.

Carrying Costs and Shortage Costs

 Financing

Policy for an

Ideal

Economy

Imagine the simple case of a grain elevator operator. Grain elevator operators

buy crops after harvest, store them, and sell them during the year. They have high
inventories of grain after the harvest and end with low inventories just before the

next harvest.

Bank loans with maturities of less than one year are used to finance the purchase

of grain. These loans are paid with the proceeds from the sale of grain.

Long-term assets are assumed to grow over

time, whereas current assets increase at the end of the harvest and then decline

during the year. Short-term assets end at zero just before the next harvest.

These assets are financed by short-term debt, and long-term assets are financed

with long-term debt and equity. Net working capital—current assets minus current

liabilities—is always zero

5.15 WHICH IS BEST?

What is the most appropriate amount of short-term borrowing? There is no

definitive

answer. Several considerations must be included in a proper analysis:

1. Cash reserves : The flexible financing strategy implies surplus cash and little

short-term borrowing. This strategy reduces the probability that a firm will

experience financial distress. Firms may not need to worry as much about

meeting recurring short-term obligations. However, investments in cash and

marketable securities are zero net present value investments at best.

2. Maturity hedging : Most firms finance inventories with short-term bank loans

and fixed assets with long-term financing. Firms tend to avoid financing longlived

assets with short-term borrowing. This type of maturity mismatching

would necessitate frequent financing and is inherently risky because short-term

interest rates are more volatile than longer rates.

3. Term structure : Short-term interest rates are normally lower than long-term

interest rates. This implies that, on average, it is more costly to rely on long-term
borrowing than on short-term borrowing.

5.16 Cash Budgeting

The cash budget is a primary tool of short-term financial planning. It allows the

financial manager to identify short-term financial needs (and opportunities). It will

tell the manager the required borrowing for the short term. It is the way of

identifying the cash flow gap on the cash flow time line. The idea of the cash

budget is simple: It records estimates of cash receipts and disbursements. We

illustrate cash budgeting with the following example of Fun Toys.

5.17 CASH OUTFLOW

Next, we consider cash disbursements. They can be put into four basic categories,

1. Payments of accounts payable : These are payments for goods or services, such

as

raw materials. These payments will generally be made after purchases. Purchases

will depend on the sales forecast. In the case of Fun Toys, assume that:

Payments 5 Last quarter’s purchases

Purchases 5 1/2 next quarter’s sales forecast

2. Wages, taxes, and other expenses : This category includes all other normal costs

of doing business that require actual expenditures. Depreciation, for example, is

often thought of as a normal cost of business, but it requires no cash outflow.

3. Capital expenditures : These are payments of cash for long-lived assets. Fun

Toys

plans a major capital expenditure in the fourth quarter.

4. Long-term financing : This category includes interest and principal payments on

long-term outstanding debt and dividend payments to shareholders.

5.18 The Short-Term Financial Plan
Fun Toys has a short-term financing problem. It cannot meet the forecast cash

outflows in the second quarter from internal sources. Its financing options include

(1) unsecured bank borrowing, (2) secured borrowing, and (3) other sources.

UNSECURED LOANS

The most common way to finance a temporary cash deficit is to arrange a short-

term

unsecured bank loan. Firms that use short-term bank loans usually ask their

bank for either a non committed or a committed line of credit . A non committed

line

of credit is an informal arrangement that allows firms to borrow up to a previously

specified limit without going through the normal paperwork. The interest rate on

the

line of credit is usually set equal to the bank’s prime lending rate plus an additional

percentage.

Committed lines of credit are formal legal arrangements and usually involve a

commitment fee paid by the firm to the bank (usually, the fee is approximately .25

percent of the total committed funds per year). For larger firms, the interest rate

is often tied to the London Interbank Offered Rate (LIBOR) or to the bank’s cost

of funds, rather than the prime rate. Midsized and smaller firms often are

required to keep compensating balances in the bank.

Compensating balances are deposits the firm keeps with the bank in low-interest or

non-interest-bearing accounts. Compensating balances are commonly on the order

of 2 to 5 percent of the amount used. By leaving these funds with the bank without

receiving interest, the firm increases the effective interest earned by the bank on
the line of credit. For example, if a firm borrowing $100,000 must keep $5,000 as

a compensating balance, the firm effectively receives only $95,000. A stated

interest rate of 10 percent implies yearly interest payments of $10,000

(5$100,000 3 .10). The effective interest rate is 10.53 percent

(5$10,000/$95,000).

SECURED LOANS

Banks and other finance companies often require security for a loan. Security for

short-term loans usually consists of accounts receivable or inventories.

Under accounts receivable financing, receivables are either assigned or factored .

Under assignment, the lender not only has a lien on the receivables but also has

recourse to the borrower. Factoring involves the sale of accounts receivable. The

purchaser, who is called a factor, must then collect on the receivables. The factor

assumes the full risk of default on bad accounts.

As the name implies, an inventory loan uses inventory as collateral. Some common

types of inventory loans are:

1. Blanket inventory lien : The blanket inventory lien gives the lender a lien against

all the borrower’s inventories.

2. Trust receipt : Under this arrangement, the borrower holds the inventory in

trust

for the lender. The document acknowledging the loan is called the trust receipt.

Proceeds from the sale of inventory are remitted immediately to the lender.

3. Field warehouse financing : In field warehouse financing, a public warehouse

company supervises the inventory for the lender.

Purchase order financing (or just PO financing) is a popular form of factoring

used by small and midsized companies. In a typical scenario, a small business

receives a firm order from a customer, but doesn’t have sufficient funds to pay

the

supplier who manufactured the product. With PO financing, the factor pays the

supplier. When the sale is completed and the seller is paid, the factor is repaid. A

typical interest rate on purchase order factoring is 3.5 percent for the first 30

days, then 1.25 percent every 10 days after, an annual interest rate above 40

percent.

OTHER SOURCES

A variety of other sources of short-term funds are employed by corporations. The

most important of these are the issuance of commercial paper and financing

through

banker’s acceptances. Commercial paper consists of short-term notes issued by

large,

highly rated firms. Typically, these notes are of short maturity, ranging up to 270

days (beyond that limit the firm must file a registration statement with the SEC).

Because the firm issues these directly and because it usually backs the issue with a

special bank line of credit, the rate the firm obtains is often significantly below

the prime rate the bank would charge it for a direct loan.

A banker’s acceptance is an agreement by a bank to pay a sum of money. These

agreements typically arise when a seller sends a bill or draft to a customer. The

customer’s bank accepts this bill and notes the acceptance on it, which makes it an

obligation of the bank. In this way a firm that is buying something from a supplier

can effectively arrange for the bank to pay the outstanding bill. Of course, the

bank

charges the customer a fee for this service.

5.19 CASH AND NEAR-CASH INVESTMENTS

On every firm's balance sheet, there is a line item for cash and marketable

securities, referring to its holding of cash and near-cash investments. Investments

in short-term government securities or commercial paper, which can be converted

into cash quickly and with very low cost, are considered near-cash investments. We

begin by considering the motives for holding cash and the extent of such holdings

at companies. We then discuss various approaches used to categorize cash holdings

and how best to deal with cash holdings in both discounted cash flow and relative

valuations.

5.20.Short-term financing.

Short term refers to financing that will be repaid in 1 year or less. Short-term

financing may be used to meet seasonal and temporary fluctuations in a company’s

funds position as well as to meet permanent needs of the business. For example,

short-term financing may be used to provide extra net working capital, finance

current assets, or provide interim financing for a long-term project.

When compared to long-term financing, short-term financing has several

advantages; for example, it is easier to arrange, it is less expensive, and it affords

the borrower more flexibility. The drawbacks of short-term financing are that

interest rates fluctuate more often, refinancing is frequently needed, and

delinquent repayment may be detrimental to the credit rating of a borrower who is

experiencing a liquidity problem.

The sources of short-term financing are trade credit, bank loans, bankers’

acceptances, finance company loans, commercial paper, receivable financing, and

inventory financing.
The merits of the different alternative sources of short-term financing are

usually considered carefully before a firm borrows money. The factors bearing

upon the selection of the source of short-term financing include:

Cost.

Effect on credit rating. Some sources of short-term financing may negatively

affect the firm’s credit rating.

Risk. The firm must consider the reliability of the source of funds for future

borrowing.

Restrictions. Certain lenders may impose restrictions, such as requiring a minimum

level of net working capital.

Flexibility. Certain lenders are more willing than others to work with the borrower,

for example, to periodically adjust the amount of funds needed.

Expected money market conditions.

The inflation rate.

Corporate profit ability and liquidity positions.

The stability of the firm’s operations.

5.21 What is revolving credit? How is it different from a line of credit?

(2009,2010)

Answer:

Revolving credit is a type of credit that does not have a fixed number of payments,

in contrast to installment credit. Credit cards are an example of revolving credit

used by consumers. Corporate revolving credit facilities are typically used to

provide liquidity for a company's day-to-day operations.

Revolving credit is a line of credit individuals and corporations can borrow from and

pay back as needed.

Different between Revolving credit & Line of credit are as follows:

 Aspects Revolving credit Line of credit

1.Term It is a medium-term nature It is a short-term nature of

of financing. financing.

2.Cost The cost of revolving credit The cost of line of credit is

is high due to commitment low due to absence of

fee. commitment fee

3.Agreement It is a legal and formal It is an informal agreement.

agreement.

4.Fee The borrowers pay interest The borrowers pay interest

on the utilized amount of on the utilized amount of

loan and pay commitment fee loan and do not pay any

on the unutilized loan. commitment fee on the

unutilized loan.

A line of credit and revolving credit are two ways that a business or individual can

obtain the money needed to make a purchase. A line of credit is a type of revolving

credit, which works similar to a credit card. Both a line of credit and revolving

credit have a set amount available to use, and when you pay down or pay off the

amount, the credit is available for you to use again. A line of credit may use

collateral to secure the loan, such as a business building, or it may be unsecured or

without collateral, such as a credit card.

A line of credit where the customer pays a commitment fee and is then allowed to

use the funds when they are needed. It is usually used for operating purposes,

fluctuating each month depending on the customer's current cash flow needs.
5.22 CALCULATING THE OPERATING AND CASH CYCLES
In our example, the lengths of time that made up the different periods were

obvious.

If all we have is financial statement information, we will have to do a little more

work. We illustrate these calculations next.

To begin, we need to determine various things such as how long it takes, on

average,

to sell inventory and how long it takes, on average, to collect receivables. We start

by gathering some balance sheet information such as the following

(in thousands):

Also, from the most recent income statement, we might have the following figures
(in thousands):

The Operating Cycle

First of all, we need the inventory period. We spent
8.2 million on inventory (our cost of goods sold). Our average inventory was
2.5 million. We thus turned our inventory over 8.2/2.5 times during the year:

Loosely speaking, this tells us that we bought and sold off our inventory 3.28 times
during the year. This means that, on average, we held our inventory for:
So, the inventory period is about 111 days. On average, in other words, inventory
sat
for about 111 days before it was sold. 2
Similarly, receivables averaged $1.8 million, and sales were $11.5 million. Assuming
that all sales were credit sales, the receivables turnover is: 3

If we turn over our receivables 6.4 times a year, then the receivables period is:

The receivables period is also called the days ’ sales in receivables, or the average
collection
period . Whatever it is called, it tells us that our customers took an average of
57 days to pay.

The operating cycle is the sum of the inventory and receivables periods:

This tells us that, on average, 168 days elapse between the time we acquire
inventory
and, having sold it, collect for the sale.
The Cash Cycle We now need the payables period. From the information given
earlier, we know that average payables were $875,000 and cost of goods sold was
$8.2 million. Our payables turnover is:

The payables period is:

Thus, we took an average of 39 days to pay our bills.

Finally, the cash cycle is the difference between the operating cycle and the
payables
period:
So, on average, there is a 129-day delay between the time we pay for merchandise
and the time we collect on the sale.

1.Calculating Cash Collections (Syllabus Ref. Book )

The following is the sales budget for Shleifer, Inc., for

the first quarter of 2013:

 January February March

Sales budget Tk.234,800 Tk.249,300 Tk.271,000

Credit sales are collected as follows:

65 percent in the month of the sale.

20 percent in the month after the sale.

15 percent in the second month after the sale.

The accounts receivable balance at the end of the previous quarter was

Tk.1,06,800

(Tk.76,300 of which were uncollected December sales).

a. Compute the sales for November.

b. Compute the sales for December.

c. Compute the cash collections from sales for each month from January through

March.

Problem.2 Calculating Cash Collections The following is the sales budget for

Shleifer, Inc., for the first quarter of 2013: (Syllabus Ref. Book )
Problem.3
Tanis kids fashion is ready to begin its third quarter, in which Peak sales occur.

The company has their. highest cash requirement in this quarter and they has got

an option of borrowing from bank in the multiple of Tk. 10,000 with and interest

of 10%. They generally borrow at the beginning of the month and repay at the end.

The following data have been assembled to find their cash need for the upcoming

months:

* On July 1 the company have a cash balance of Tk. 44,500.

* Actual sales for the last two months and budgeted sales (all sales are

on account) are as follows :

Taka.

May (actual), 2,50,000

June (actual), 3,00,000

July (budgeted), 4,00,000

August (budgeted), 6,00,000

September (budgeted), 3,20,000

Past experience- shows that the sales are collected in the following pattern:

25% of sales are collected in the month of sales

75% of sales are collected in the month following sales

* Budgeted merchandise purchase and other expenditure are given below:

July August September

Taka Taka Taka

Merchandise 2,40,000 3,50,000 1,75,000

Salaries and 45,000 50,000 40,000
Advertising 1,30,000 1,45,000 80,000
Wages
Rent payments 9,000 9,000 9,000
Depreciation 10,000 10,000 10,000
* Merchandise purchases are paid in full in the month following

purchase. Accounts payable for the merchandise purchases on June 30 was Tk.

180,000.

* Equipment costing Tk. 10,000 will be purchased in July for cash.

* The company needs a minimum cash balance of Tk. 20,000 to start each

month.

Required:

(a) Prepare a cash collection schedule for the month of July, August

and September and for the quarter in total.

(b) Prepare a cash budget from July to September.

Solution

Req.(a) Schedule of cash collection:

Months Total % of July August Septembe Quarter

sales collection r

May 2,50,00 25%, 75% ---- ----- ---- ------

June 3,00,00 25%, 75% 2,25,00 ------ ------ 2,25,000

0 0

July 4,00,00 25%, 75% 1,00,00 3,00,000 ------ 4,00,000

0 0 0

August 6,00,00 25%, 75% ------ 1,50,000 4,50,000 6,00,000

Septembe 3,20,00 25%, 75% ------- ------ 80,000 80,000

 r 0

3,25,00 4,50,000 5,30,000 13,05,000

Req.(b) Tanis kids

Cash Budget

Explanation July August September Quarter

Balance b/d 44,500 25,500 31,500 44,500

Add. receipts:

Collection from customers 3,25,000 4,50,00 5,30,000 13,05,000

Total 0

received (a) 3,69,500 4,75,50 5,61,500 13,49,500

Disbursements/ Payments: 0

Merchandise purchase

Salaries & Wages 1,80,000 2,40,00 3,50,000 7,70,000

Advertising 45,000 0 40,000 1,35,000

Rent payments 1,30,000 50,000 80,000 3,55,000

Equipment Purchase 9,000 1,45,000 9,000 27,000

Total Payments(b) 10,000 9,000 ----- 10,000

Excess/deficiency -----
Financing: 3,74,000 4,44,00 4,79,000 12,97,000
Borrowings
Repayments 0
Interest (4,500) 31,500 82,500 52,500
Total financing
Cash balance c/d
30,000 ----- ----- 30,000
 ----- ----- (30,000) (30,000)

----- ----- (750) (750)

30,000 ----- (30,750) (750)

25,500 31,500 51,750 51,750

FORMULA OF SHORT-TERM FINANCING

# Necessary Calculations
* Calculation of Effective Interest Rate (EIR) Under different Situations
# Situations / Sources
1. Trade Credit
2. Commercial Paper
3. Commercial Bank Loan
4. Bills Discounting
5. Accounts Receivables (A/R) Pledging (a) without processing cost (b) with
processing cost
6. Accounts Receivables (A/R) Factoring
7. Inventory Financing

Cost of Trade Credit

Trade credit doesn’t involve any explicit interest charge. However, there is an
implicit cost of trade credit. It depends on the credit terms offered by the
supplier of goods.
Some Considerations
1. If the supplier offers any discount facility but the company/ customer
doesn’t accept that offer, then there would be some cost of trade credit.
2. If the supplier offers any discount facility, and the company/customer
accepts that offer, then there would be no cost of trade credit.
3. If the supplier doesn’t offer any discount facility, then there would be no
cost of trade credit. Because it’s irrelevant here.
CDR 360 CDR = Cash Discount Rate
× × 100
EIR = 100 − CDR CP − DP CP = Credit Period (Actual)
DP = Discount Period

Cost of Commercial Paper

Commercial paper has no stipulated interest rate. It is sold at a discount and the
amount of the discount determines the interest cost to the issuer. It is redeemed
at its face value.

If maturity is in days, than Here,

FV − SV 360 FV = Face Value
× × 100 SV = Sales Value
EIR(i) = NSV Days of Maturity NSV = Net Sales Value
I = Total Annual Interest
If maturity is in months, than Dt. = Discount Amount
FV − SV 12 FC = Flotation Cost
× × 100
(ii)= NSV Months of Maturity

If interest rate is given & no maturity period is available, than

I Here, SV = FV – Discount
× 100
(iii)= NSV NSV = SV – FC

List of FC
Issuing & Paying Agent (IPA) charges, Stamp duty, Rating charges, Dealing Bank
Fee, Fee for Standby facility.
* FC is to be determined on FV if is given in percentage.

Cost of Bank Loan (Unsecured)

A) Collection Basis if interest is not paid/deducted in advance
i) If there is no CB
TAI
× 100
EIR = TL
ii) If there is any CB
 TAI TAI
× 100 × 100
EIR = UL = TL − CB

B) Discount Basis if interest is paid/deducted in advance

i) If there is any CB
TAI TAI
× 100 × 100
EIR = UL = TL − TAI
ii) If there is any CB
TAI TAI
× 100 × 100
EIR = UL = TL − CB − TAI

C)Installment Basis if loan is repaid installment

2PC P No. of payment in one year
× 100
EIR = A ( n + 1 ) C = Total annual interest
A = Total Loan
n = Total no. of payment

D)Periodic Interest Basis if maturity is less than 1 (one) year

EIR = {( 1 + r ) − 1 } × 100
n
Total Periodic Interest
r= Used Loan
n = Turnover

Here,
Total Periodic Interest = Periodic Interest Rate ¿ Total Loan
Periodic Interest Rate = Annual Interest Rate ¿ Turnover
360
Turnover = Days of Maturity [if maturity is in days]
360
= Months of Maturity [if maturity is in months]

E) Revolving Credit Basis

Total Annual Cost
× 100
EIR = UL [TCA = Total Annual Cost, UL = Used Loan]
Here,

* TAC = Total Annual interest + Total Commitment Fee

* TAI = Used Loan ¿ Annual Interest Rate
= Loan Utilisation Rate ¿ Total Loan ¿ Annual Interest Rate
* Total Commitment Fee = Unused Loan ¿ Commitment Fee Rate
= Loan Unutilisation Rate ¿ Total Loan ¿ Commitment Fee Rate

Cost of Bills Discounting

* Formula
Total Interest
× Turnover ×100
EIR = Discounted Amount [if maturity is less than 1(one) year]
Total Interest
×100
EIR = Discounted Amount [if maturity is 1(one) year]

# Necessary Calculations
Total Interest = Face Value – Discounted value [if there is no interest rate
available]
Total Interest = Annual Interest Rate ¿ Face value
[if there is any interest rate available and maturity is in years]
360
Turnover = Days of Maturity [if maturity is in days]
12
= Months of Maturity [if maturity is in months]
*Periodic Interest Rate = Annual Interest Rate ¿ Turnover [if maturity is less
than 1(one) year]
*Total Periodic Interest = Periodic Interest Rate ¿ Face Value [if maturity is less
than 1(one) year]
*Discounted Amount = Face Value – Total Interest
100
*Amount of the Bill / Face Value = Discounted Amount ¿ 100 − AIR
[if Face Value is not given]

Cost of Accounting Receivables (A/R) Pledging

A) Without Processing Cost

(If there is no processing cost available)
# Necessary Calculations
360
* Turnover = Days of Maturity [if maturity is in days]
 12
= Months of Maturity [if maturity is in months]
Annual A / R or Annual Credit Sales
= Average A / R or Average Credit Sales [if no maturity is available]
1
× 100 R = Annual/Nominal Interest Rate
1
1) EIR = R
() ( )
−
1
N
N = Turnover

It is the short-cut technique to calculate EIR. Then it is to be proved by the

following steps:
Annual A /R or Annual Credit Sales
* Average A/R = Turnover
[if Average A/R is not available]
* Reserve = % of Reserve ¿ Average A/R
* Periodic Interest Rate = Annual Interest Rate ¿ Turnover
* Total Periodic interest = Periodic Interest Rate ¿ (Average A/R – Reserve)
* Annual interest = Total Periodic Interest ¿ Turnover
* Net Loan Amount Received = Average A/R-Reserve-Total Periodic interest
Annual Interest
× 100
2) EIR = Net Loan Amount Received [If 1&2 are equal, then solution is
correct]

*With Processing Cost

(If there is any processing cost available)
360
* Turnover = Days of Maturity [if maturity is in days]
360
= Months of Maturity [if maturity is in months]
Annual A /R or Annual Credit Sales
= Average A / R or Average Credit Sales [if no maturity is available]
Annual A /R or Annual Credit Sales
* Average A/R = Turnover
[if Average A/R is not available]
* Reserve = % of Reserve Average A/R
¿

* Periodic Processing Fee = Average A/R ¿ Processing Fee Rate

* Periodic Interest Rate = Annual Interest Rate ¿ Turnover
* Periodic Interest Payable on the Amount = Average A/R – Reserve – Periodic
Processing Fee
* Total Periodic Interest = Periodic Interest Rate ¿ Periodic interest Payable
on the Amount
* Net Loan Amount Received = Periodic Interest Payable on the Amount –
Total Periodic interest
* Total Annual Cost = (Total Periodic Interest + Periodic Processing Fee) ¿
Turnover
Total Annual Cost
× 100
EIR = Net Loan Amount Received

Cost of Accounting Receivables (A/R) Factoring

# Necessary Calculations
360
* Turnover = Average Collection Period ( ACP )
Annual A /R or Annual Credit Sales
= Average Level of A/ R [if ACP is not available]
Annual A /R or Annual Credit Sales × ACP
*Average Level of A/R = 360
Annual A /R or Annual Credit Sales
= Turnover
* Reserve = % of Reserve ¿ Average A/R
* Periodic Factoring Commission = Factoring Commission Rate ¿ Average Level
of A/R
* Interest Payable on the Amount = Average Level of A/R – Reserve – Periodic
Factoring Commission.
* Periodic Interest Rate = Annual Interest Rate ¿ Turnover
* Total Periodic interest = Periodic Interest Rate ¿ Interest Payable on the
Amount
* Net Amount of Advance = Interest Payable on the Amount – Total Periodic
Interest
* Annual Bad Debt Cost = % of Bad Debt Loss ¿ Annual A/R
[if Bad Debt Loss is in %]
* Annual Administrative Cost = Monthly Administrative Cost ¿ 12

[if there is any monthly Admin. Cost]

* Net Factoring Cost = (Total periodic Interest + Periodic Factoring
Commission) ¿ Turnover – (Annual Administrative Cost + Annual Bad Debt Cost)
 Net Factoring Cost
× 100
EIR = Net Amount of Advance

Cost of Inventory Financing

# Cost of Payroll System
* Cost of Short-term Financing = Average Wages ¿ Opportunity Cost Rate
* Decrease in Accrued Wages = Old Accrued Wages – New Accrued Wages
* Cost of Fund = Decrease in Accrued Wages ¿ Opportunity Cost of Fund
# Cost of Terminal Warehouse Loan
* Terminal Warehouse Loan = Total Loan Required ¿ Terminal Warehouse Loan
%
* Credit Loan = Total Loan Required – Terminal Warehouse Loan
* Cost of Credit Loan,
CDR 360
× 100
EIR = 100 − CDR CP − DP
* Annual Housing Cost = Housing Cost 2 ¿

[If Housing Cost is for 6(six) Months]

* Cost of Terminal Warehouse Loan = (Terminal Warehouse Loan ¿ Cost of
Loan) + (Credit Loan ¿ EIR) + Annual Housing Cost

# Cost of Field Warehouse Loan

* Field Warehouse Loan = Total Loan Required ¿ Field Warehouse Loan %
* Credit Loan = Total Loan Required – Field Warehouse Loan
* Cost of Credit Loan,
CDR 360
× 100
EIR = 100 − CDR CP − DP
* Annual Housing Cost = Housing Cost ¿ 2
[if Housing Cost is for 6(six) Months]
* Cost of Field Warehouse Loan = (Field Warehouse Loan ¿ Cost of Loan) +
(Credit Loan ¿ EIR) + Annual Housing Cost

# Cost of Floating Lien

* Cost of Floating Lien = Total Loan Required ¿ EIR of Floating Lien

Problem.1 BBA-2006
Apex
. 1. Footwear Ltd. wants to increase working capital by Tk. 1 crore. It has four
alternatives sources :—
(i) Credit purchase granted on terms of '3/20\, net 60'
(ii) Borrowing from National Bank Limited at 15% interest per annum maintaining
12% compensating balance
(iii) Issuing commercial paper at 12% p.a. flotation cost of 1%
(iv) Issuing commercial paper face value of Tk. 1,08,00,000 for 6 months. Cost of
issue is Tk. 50,000 per issue. Find out the effective interest rate of all the
alternatives. Which alternative should be preferred by the company?

Solution

CD 360 days
× × 100
Cost of Trade credit = 100 − CD CP − DP
3 360
× × 100
= 100 − 3 60 − 20
= 27.83%

Interest
× 100
(ii) EIR = Loan amount −copensating Balance
1,00,00,000 × .15
× 100
= 88,00,000
= 17.05 %
(iii) Cost of Commercial Paper:

FV −SV 360 days FV= 1,00,00000

× × 100
= NSV MP SV= 1,00,00000-
(1,00,00000x.12=12,00,000)=88,00,000
1,00,00000−88 ,00,00 360 days
× × 100 NSV= 88,00,000-
= 87,00,000 360 (1,00,00000x.01=1,00,000)= 87,00,000
= 13.79%

(iv) Cost of Commercial paper:

FV= 1,0,8,00,000
FV −SV 360 days SV= 1,0,8,00,000
× × 100 NSV= 1,0,8,00,000- (50,000 x 2)
= NSV MP
= 1,07,00,000

1,08 ,00,000−1,08,00,000 360 days

× × 100
= 1,07 ,50,000 360
=
Problem.2. BBA-2007
1.
Meghna Cement Ltd. needs to finance a seasonal needs in inventory of Tk.
10,00,000. The funds are needed for six months and is consider the following
alternatives :—
(a) A terminal warehouse loan from a finance company of 15% annual rate of
interest up to 80% face value of inventory. The warehouse costs are Tk. 15,000
for six month period. The remaining funds requirement of Tk. 2,00,000 will need to
be finance forgoing some cash discount on accounts payable. The standard term
purchase are 2/10 net 30. However company feels that it will pay on 40th day
without any adverse effect.
(b)A field warehouse loan from another finance company at 12% interest rate per
annum. The advance up to 75% and field warehouse cost Tk. 25,000 for six
months period. The remaining finance on cash discount basis as in
alternative(a)
(c)A floating lien arrangement with another finance company with an effective
interest rate 22.50%.
Which alternative method should be selected and why?
Solution

Value of Inventory Tk. 10,00,000

Period is 6 month or 180 days
We Calculate 6 months cost of all alternatives

(a)Terminal warehouse loan

Advance 10,00,000 x 80%= 8,00,000
Trade Credit(10,00,000- 8,00,000)= 2,00,000
Inventory Turnover= 360/180= 2 Times
Periodic interest rate= 15%/2= 7.5%
CD 180days
× × 100
6 months cost of Trade Credit= 100 − CD CP − DP
2 180
× × 100
= 100 − 2 40−10
= 12.24%
Periodic cost of inventory:
Cost of Bank loan= 8,00,000x7.5% = 60,000
Cost of Trade credit=2,00,000 x12.24%= 24,480
Ware housing cost = 15,000
Total Cost 99,480
 Periodic cost
x 100
PPR= Value of inventory
99,480
x 100
= 10,00,000
= 9.948%

(b)Field warehouse loan:

Value of Inventory Tk. 10,00,000
Loan(10,00,000 x70%)= 7,00,000
Trade credit(10,00,000 x 30%)= 3,00,000
Periodic interest rate= 12%/2= 6%
Periodic cost of Trade Credit= 12.24% (Req.a)
Periodic cost of inventory:
Cost of Bank loan= 7,00,000x6% = 42,000
Cost of Trade credit=3,00,000 x12.24%= 36,720
Ware housing cost = 25,000
Total Cost 1,03,720

Periodic cost
x 100
PPR= Value of inventory
1,03,720
x 100
= 10,00,000
= 10.37%

(c) Floating lien:

Periodic interest rate= 22.50%/2= 11.25%
Periodic cost = 10,00,000 x 11.25%= 1,12,500
Periodic cost
x 100
PPR= Value of inventory
1,12,500
x 100
= 10,00,000
= 11.25%
Decision: (a)Terminal warehouse loan= 9.948% Best alternative
(b)Field warehouse loan: = 10.37%
(c) Floating lien= 11.25%

Problem.3.
1.

Determine the effective annualized cost of financing for the following credit
terms, assuming that discounts are not taken, accounts are paid at the end of the
credit period and a year has 365 days:—
(i) 2/10, net 30; (ii) 10/30, net 60; (iii) 3/10, net 90.

Solution
CD
Here,r = 100 − CD
EIR = {( 1 + r ) − 1 } × 100
n
2
= {( 1 + .0204 ) − 1 } × 100 = 100 − 2 = .0204
18

= 43.84 % MP
n = CP − DP
360
= 30 − 10 = 18

(ii) EIR = {( 1 + r ) − 1 } × 100

n
10
= {( 1 + .111 ) − 1 } × 100 r = 100 − 10 = .111
12

= 253.64 % 360
n = 60 − 30 = 12

3
(iii) EIR = {( 1 + r ) − 1 } × 100
n

r = 100 − 3 = .031
= {( 1 + .031 ) − 1 } × 100
4.5
360
=14.726 %
n = 90 − 10 = 4.5

Problem.4. BBA-2012
1.
Nita poulty firm needs Tk. 80,000 to meet working capital requirements
immediately. It has three alternative sources:-
The firm can buy Tk. 1,20,000 of materials on terms 3/30, net. 90.
A bank will lend Tk. 1,00,000 at 13% interest with 20% compensating balance
requirement.
A factor will buy firms accounts receivable of Tk. 1,00,000 per month and will
advance at 12% interest per annum up to 80% of the face value. Average collection
period is 30 days. The factor will charge 2% commission. It has been estimated
that the factor service will save the firm’s average administration cost Tk. 1,000
per month and 1% bed debts loss.
Which alternative should be chosen and why?

Cost of Trade Credit: DR=Discount Rate= 3

DR 360 CP= Credit Period=90
x
Kt= 100−DR CP−DP DP= Discount Period= 30
EAR= Effective Annual rate
3 360
x
= 100−3 90−30
= 18.56%

n
EIR=(1+r) −1
6
(1.030927) −1
= 20.05%

Cost of Bank Loan

Interest amount
Loan amount= 1,00,000
EAR= Loan amount −compensating Balance Interest = 1,00,000x .13=13,000
Compensating balance=
13,000 1,00,000x.20= 20,000
1,00,000−20,000
= 16.25%

(iii)Cost of Accounts Receivable:

Accounts Receivable = 1,00,000 x 1= 1,00,000
Accounts Receivable Turnover = 360/30 = 12 times
Periodic interest = 12% = .12/12 = .01

Advance amount:
Accounts Receivable Tk. 1,00,000
Less.Fact. Commission(1,00,000x 2%)= 2,000
Reserve(1,00,000x 20%) = 20,000 22,000
Advance before interest 78,000
Less. Periodic interest(78000 x.01) 780
Advance amount 77,220

Periodic net exp:

Periodic interest Tk. 780
Add. Factoring commission Tk. 2,000
Total exp. 2,780
Less. Exp. Saving
Administrative exp. (1,000x1)= 1,000
Bad debts exp. = 1,000 2,000
Periodic net exp. 780

Annual net exp.= Periodic net exp. X Turnover

= 780 x 12
= 9,360

Simple Interest:
Annual net exp
EIR = Advance amount
9,360
= 77,220
= 12.12%
Compound Interest:
n
EIR = (1+r) −1 perodic net exp
12
= (1+.0360) −1 r = Advance amount
= 52.868% 2,780
77,220
= =.0360
N= Turn over = 12 times
Decision:
Trade credit = 18.56%
Bank Loan = 16.25%
Accounts Receivable= 52.868%Best.

BBA-2012
Problem.5.
1.
Que Cement Company Limited has just expanded its activities for which it will
soon need an additional working capital of Tk. 10,00,000. The company could
identify three alternative sources:
The company could buy raw materials on terms “3/25, net 75”
Bank loan could be taken Tk.11,00,000 at 13 percent interest rate p.a. that will
require 10 percent compensating balance.
A factor will buy the company’s accounts receivable of Tk. 12,00,000 per month
which have an average collection period of 30 days. The factor will advance up to
85 percent of the face value of the accounts receivable at 12 percent on an annual
basis. The factor will also charge a 2 percent commission on all receivables
purchased, It has been estimated that the factoring services will save Tk. 25,000
per month consisting of the cost of credit administration and bad debts loss.
Which method of financing should be selected?

Solution

Cost of Trade Credit:

DR 360
× DR=Discount rate=3
K t = 100−DR CP−DP CP= Credit period= 75
3 360 DP= Discount Period= 25
×
= 100−3 75−25

= 18.56%
 n
EIR=(1+r) 3
=(1+.030927)
6
r = 97 =.030927
360
= 20.05% =6
n = 60
Cost of Bank Loan:
Interest amount
EIR = Loan amount −compensating balance
1,43 ,000 Loan amount = 11,00,000
= 11,00,000−1,10,000 Interest = 11,00,000 x 13% = 1,43,000
= 14.44% Compensating balance = 11,00,000x 10% =
1,10,000

(iii)Cost of Accounts Receivable:

Accounts Receivable = 12,00,000 x 1= 12,00,000
Accounts Receivable Turnover = 360/30 = 12 times
Periodic interest = 12% = .12/12 = .01

Advance amount:
Accounts Receivable Tk. 12,00,000
Less. Fact. Commission(12,00,000x 2%)= 24,000
Reserve(12,00,000x 15%) = 1,80,000 2,04,000
Advance before interest 9,96,000
Less. Periodic interest(9,96,000 x.01) 9,960
Advance amount 9,86,040
Periodic net exp:
Periodic interest Tk. 9,960
Add. Factoring commission Tk. (12,00,000x .02) 24,000
Total exp. 33,960
Less. Exp. Saving
Administrative exp. & Bad debts exp. 25,000
8,960
Annual net exp.= Periodic net exp. X Turnover
= 8,960x 12
= 1,07,520

Simple Interest:
Annual net exp
EIR = Advance amount
 1,07,520
= 9,86 ,040
= 10.904%
Compound Interest:
n
EIR = (1+r) −1 perodic net exp
12
= (1+.009086) −1 r = Advance amount
= 11.464% 8,960
9,86 ,040
= =.009086
N= Turn over = 12 times

Decision:
Trade credit = 20.05% Best.
Bank Loan = 14.44%
Accounts Receivable= 11.464%

Problem.6. BBA-2013
1.
A manufacturing firm needs $85000 to meet working capital requirement
immediately for 3 months. It has the following alternatives:
i) The company can use trade credit arrangement on terms of 3/15, net 45.
(ii) It can take a simple interest loan of $100000 from Prime Bank @14% with 20%
compensating balance requirement.
iii)The company can also issue commercial paper with a face value of $1000 each
sold at
$950 having 1% floatation cost for 90 days.
You are required to calculate the cost of each specific source and then take a
decision on which one will be preferred for the company.
Cost of Trade Credit:
DR 360
× DR=Discount rate=3
K t = 100−DR CP−DP CP= Credit period= 45
3 360 DP= Discount Period= 15
×
= 100−3 45−15

= 37.11%
 n
EIR=(1+r) -1 3
=(1+.030927)
12
-1 r = 97 =.030927
360
= 44.12% =12
n = 30
Cost of Bank Loan:
Interest amount
EIR = Loan amount −compensating balance
14,000 Loan amount = 1,00,000
= 1, 00,000−20,000 Interest = 1,00,000 x 14% = 14,000
= 17.5% Compensating balance = 1,00,000x 20% =
20,000

(iii) Cost of Commercial paper:

FV= 1,000
FV −SV 360 days SV= 950
× × 100 FC=1,000x1%=10
= NSV MP
NSV= 950-10=940
MP=90
1,000−950 360 days
× × 100
940 90
= =21 .28 %
EIR=
n 50
EIR=(1+r) -1
4 r = 940 =.0532
=(1+.0532) -1 360
=4
= 23.04% n = 90

Decision: Bank loan is the best because its cost is lower than others alternative.

Problem.7. BBA-2014
1.
Three following alternative modes of financing are available:
(i)Forgo cash discount granted on a basis of 3/15, net 40 and pay on the final due
date.
(ii)Borrow Tk.50,00,000 at 14% interest maintaining 15% compensating balance,
interest payment are made in advance.
(iii)Issue Tk.44,00,000 of six month commercial paper to net Tk. 40,00,000.
Further assuming that the firm would prefer the flexibility of bank financing
provided the additional cost of this flexibility was on more than 2.5% p.a.
Which alternative should the company select and why?
Cost of Trade Credit:
DR 360
× DR=Discount rate=3
K t = 100−DR CP−DP CP= Credit period= 40
3 360 DP= Discount Period= 15
×
= 100−3 40−15

= 44.64%

n
EIR=(1+r) -1 3
=(1+.030927)
14.5
-1 r = 97 =.030927
360
= 55.52% =14 .5
n = 25
Cost of Bank Loan:
Interest amount
EIR = Loan amount −compensating balance− Advance Interest
7,00 ,000 Loan amount = 50,00,000
= 50,00,000−7 ,50,000−7 ,00 ,000 Interest = 50,00,000 x 14% = 7,00,000
= 19.72% Compensating balance = 50,00,000x
15% = 7,50,000

(iii) Cost of Commercial paper:

FV= 44,00,000
FV −SV 360 days SV= 40,00,000
× × 100 NSV= 40,00,000
= NSV MP
MP=180
44 ,00 ,000−40,00 ,000 360 days
× × 100
40 ,00 ,000 180
= =20%
EIR=
n 4,00 ,000
EIR=(1+r) -1
=.10
2
r = 40 ,00, 000
=(1+.10) -1 360
=2
= 21% n = 180

Decision: Bank loan is the best because its cost is lower than others alternative.
 Exercises

Ref book/1 Schedule of Expected Cash Collections

Peak sales for Midwest Products, a wholesale distributor of leaf rakes, occur in
August. The compa-ny’s sales budget for the third quarter showing these peak
sales is given below:

Septemb
July August er Total

Budgeted sales (all on account) . . . . . . . $600,0 $900,0 $500,00

. 00 00 0 $2,000,000

From past experience, the company has learned that 20% of a month’s sales are
collected in the month of sale, another 70% are collected in the month following
sale, and the remaining 10% are collected in the second month following sale. Bad
debts are negligible and can be ignored. May sales totaled $430,000, and June
sales totaled $540,000.
Required:
1. Prepare a schedule of expected cash collections from sales, by month and in
total, for the third quarter.
Ref book/2. Assume that the company will prepare a budgeted balance sheet as
of September 30. Compute the accounts receivable as of that date.
Schedules of Expected Cash Collections and Disbursements
Calgon Products, a distributor of organic beverages, needs a cash budget for
September. The following information is available:
a.The cash balance at the beginning of September is $9,000.
b.Actual sales for July and August and expected sales for September are as
follows:

Augus
July t September

Cash sales . . . . . . . . $ $ $
..... 6,500 5,250 7,400
 Sales on account . . . 20,0
..... 00 30,000 40,000

Total
sales . . . . . . . . . . . . $26,50 $35,25 $47,40
. 0 0 0

Sales on account are collected over a three-month period as follows: 10% collected
in the month of sale, 70% collected in the month following sale, and 18% collected
in the second month fol-lowing sale. The remaining 2% is uncollectible.
c. Purchases of inventory will total $25,000 for September. Twenty percent of a
month’s inventory
purchases are paid for during the month of purchase. The accounts payable
remaining from Au-gust’s inventory purchases total $16,000, all of which will be
paid in September.
d.Selling and administrative expenses are budgeted at $13,000 for September. Of
this amount, $4,000 is for depreciation.
e.Equipment costing $18,000 will be purchased for cash during September, and
dividends totaling $3,000 will be paid during the month.
f The company maintains a minimum cash balance of $5,000. An open line of credit
is available from the company’s bank to bolster the cash position as needed.
Required:
1.Prepare a schedule of expected cash collections for September.
2. Prepare a schedule of expected cash disbursements during September for
inventory purchases. 3. Prepare a cash budget for September. Indicate in the
financing section any borrowing that will be
needed during September.

Exercise 1.
Alex Company needs working capital of TK. 40 Lac. There are three alternative
ways to finance which are given below:
(i) Forgo cash discount granted on the basis of 3/10, net 30. If account payable is
stretched by 10 days
(ii) Borrow a loan from a bank at the rate of 10% and maintains 20% compensating
balance
(iii) Issue commercial paper of which face value is TK.700 and sale value TK. 500
with 1% flotation cost for 90 days.
Which way should the company choose?
Exercise 2.
Millan Company wants to raise TK. 20,00,000 as a working capital. There are three
alternative ways to finance which are given below:
(i) Forgo cash discount granted on the basis of 3/20, net 60. Account payable is
stretched by 15 days.
(ii) Borrow a loan TK. 20 Lac from a bank at 10% advance interest without
compensating balance.
(iii) Issue 3 months commercial paper at TK. 200 face value & sale value is TK. 198
with 1% flotation cost.
Which alternative should the company select & why?
Exercise 3.
Zillan Company wants to collect TK. 50,00,000 as a working capital. The following
alternatives are available for short term financing:
(i) Forgo cash discount granted on the basis of 3/10, net 60. The discount period
is
stretched by 10 days.
(ii) Borrow a bank loan at the rate of 15% and maintain 10% compensating balance.
Interest will be paid in advance.
(iii) Issue 6 months commercial paper at TK. 1,000 face value & sale value is TK.
900 with 3% flotation cost.
Which alternative should the company select & why?
Exercise 4.
Dillan Company wants to raise TK. 10,00,000 as a working capital. Three
alternatives are available:
(i) Forgo cash discount granted on the basis of 2.5/10, net 60. Pay on the final
date,
(ii) Borrow a bank loan at 10% advance interest with 20% compensating balance,
(iii) Issue 3 months commercial paper at TK. 100 face value & sale value is TK. 97
with 1% flotation cost.
Which alternative should the company select & why?
Exercise 5.
Tanjim Company wants to collect TK. 10 Lac as a working capital. The following
alternatives are available for short term financing:
(i) A bank agreed to lend TK. 8 Lac on revolving credit agreement. The bank will
charge 10% interest per year & 2% commitment fee on the unused portion of the
credit. The company uses 85% of this loan,
(ii) The Company can borrow TK. 6 Lac from a bank loan at 10% advance interest
with monthly installments for one year,
(iii) TK. 8 Lac accounts receivable for 60 days. The firm can pledge this A/R from
a
bank at 10% interest rate.
Which alternative is the best for financing?