FIRE654 Oct 3 Mid-Term Review

Present Value and Future Value
C0
CT
PV0
Present Value at Time = 0
FVT
Future Value at Time = T
r = Nominal Interest Rate

n = Number of periods interest will be paid in an year
FIRE654: Short Term Financial Management
VCU School of Business
Ceyed Baiju, Fall 2012
Different Compounding Methods

No Compounding: FV = C0 * (1 + r*T)
Discrete Compounding: FV = C0 * (1+r/n)n*T
Continuous Compounding: FV = C0 * er*T
Effective Annual Interest Rate
Net Present Value (NPV)
C1
C1
C2
C3
CT
C4
C0
r = discount rate (interest rate) for each period
Discount Rate at which NPV = 0 is called Internal Rate of Return (IRR)
Annuity
PV
FV
PV and FV of an Annuity
r = Interest Rate for the period

T = # of periods
PV of Perpetuity = C / r
PV
PV of a Growing Perpetuity = C / (r g)
PV
C*(1+g) C*(1+g)2 C*(1+g)3
Cash Flow Timeline

Purchase Order
Released
Inventory
Received
Goods Sold
AR Created
Inventory
Payment
Received
Accounts Receivable
Cash
Received
Collection
Float
Time
Accounts Payable
AP
Created
Payment
Float
Payment
Cash
Sent
Disbursed
Cash Conversion Period = Lag time between Cash Received and Cash Paid
Longer Cash Conversion Period indicates financing problem

Shorter Cash Conversion Period indicates efficient working capital management
Profit and Cash Flow Relationship

Maintain a cost structure that results in
required profit
Manage Working Capital accounts (Accruals,
Payables, Receivables and Inventory) so that
an adequate amount of liquidity is maintained
Accrual to Cash basis Income Statement

Income Statement Account
Adjustment Account
Cash Flow Account
Sales
Change in Accounts Receivable
= Cash collected from Customers
Cost of Goods Sold
Change in Accounts Payable

+ Change in Inventory
= Cash paid to Suppliers
Change in Operating Accruals

Depreciation
= Cash paid for operating expenses
Interest
Change in Accrued Interest
= Cash paid to Creditors
Taxes
Change in Accrued Tax

Change in Deferred Tax
= Cash paid for Taxes
Operating Expenses
Cash collected from Customers

Cash paid to Suppliers
Cash paid for Operating Expenses
Cash paid to Creditors
Cash paid for taxes
= Cash Flow from Operations
Profit and Cash Flow Relationship

BALANCE SHEET
Cash
Accounts Receivable
Inventory
Fixed Assets
Less: Accumulated Dep.
Total
Accounts Payable
Operating Accruals
Debt
Stockholders Equity
Retained Earnings
Total
June 1
1,000
June 2
400
300
600
1,000
1,300
300
500
500
500
500
1,000
1,300
INCOME STATEMENT
Sales
COGS (Cost of Goods Sold)
Gross Profit
Operating Expenses:
SGA (Selling/Gen/Admin)
Depreciation
Operating Profit
Interest
Tax
Net Profit
Dividends
Added to Retained Earnings (RE)
June 30
325
700
0
600
(100)
1,525
July 1
125
700
0
600
(100)
1,325
July 15
(175)
700
0
600
(100)
1,025
July 31
525
0
0
600
(100)
1,025
300
200
500
500
25
1,525
300
0
500
500
25
1,325
0
0
500
500
25
1,325
0
0
500
500
25
1,025
Jun 1-30
700
300
400
Jun 1Jul 15 Jun 1Jul 31

700
700
300
300
400
400
200
100
100
50
25
25
0
25
200
100
100
50
25
25
0
25
9
200
100
100
50
25
25
0
25
Accrual to Cash basis Income Statement

INCOME STATEMENT (ACCRUAL)
Sales
COGS (Cost of Goods Sold)
Gross Profit
Operating Expenses:
SGA (Selling/Gen/Admin)
Depreciation
Operating Profit
Interest
Tax
Net Profit
Jun 1 Jun 30
700
300
400
Jun 1 Jul 15
700
300
400
Jun 1 Jul 31
700
300
400
200
100
100
50
25
25
200
100
100
50
25
25
200
100
100
50
25
25
INCOME STATEMENT (CASH)

Cash Collected from Customers
Cash Paid to Suppliers
Cash Paid for Operating Expenses
Cash Paid to Creditors
Cash Paid for Taxes
= Cash Flow from Operations
Jun 1 Jun 30
0
0
0
50
25
(75)
Jun 1 Jul 15
0
300
200
50
25
(575)
Jun 1 Jul 31
700
300
200
50
25
125
10
Working Capital policies of a firm impact

Solvency, Liquidity and Financial Flexibility
Solvent if the firms assets exceed liabilities
Liquid if the firm can meet its obligations on time
Financially flexible if the firms financial policies are

consistent with respect to growth
11
Solvency and Liquidity Ratios

Current Ratio =
Quick Ratio =
Current Assets
Current Liabilities
Current Assets Inventories
Current Liabilities
Net Working Capital = Current Assets Current Liabilities

Net Working Capital (NWC) = Working Capital Requirements (WCR) + Net Liquid Balance (NLB)
WCR = Current Operating Assets Current Operating Liabilities
WCR = AR + Inv + Prepaids + Other Cur. Assets (AP + Oper. Accruals + Other Cur. Liabilities)
NLB = Current Financing Assets Current Financing Liabilities

NLB = Cash + Mkt Securities (Notes Payable + Current Maturities of LT Debt)
12
Dell Inc. Balance Sheet, Income Statement and Common Ratios

BALANCE SHEET ($M)
Cash + Equivalents
Account Receivables
Inventories
Prepaid Expenses
Other Current Assets
Total Current Assets
Plant, Property, Eqpt (PPE)
Accumulated Depreciation
Other Assets
Total Assets
LT Debt due in one year
Notes Payable
Accounts Payable
Taxes Payable
Accrued Expenses
Other Current Liabilities
Total Current Liabilities
Long-Term Debt
Other Liabilities
Total Liabilities
Stockholders Equity
Retained Earnings
Less: Treasury Stock
Total Stockholders Equity
Total Liabilities + Equity
1999
3,181
2,481
273
0
404
6,339
775
(252)
15
6.877
0
0
2,397
0
355
943
3,695
512
349
4,556
1,781
540
0
2,321
6,877
2000
4,132
2,678
391
0
480
7,681
1,140
(375)
3,025
11,471
0
0
3,538
0
337
1,317
5,192
508
463
6,163
3,583
1,725
0
5,308
11,471
2001
5,438
2,895
400
0
758
9,491
1,534
(538)
2,948
13,435
0
0
4,286
0
428
1,829
6,543
509
761
7,813
4,795
827
0
5,622
13,435
2002
2003
3,914
4,638
2,269
2,586
278
306
0
0
1,416
1,394
7,877
8,924
1,438
1,662
(612)
(749)
4,832
5,633
13,535 15,470
0
0
0
0
5,075
5,989
5
54
1,127
1,458
1,312
1,432
7,519
8,933
520
506
802
1,158
8,841 10,597
5,605
6,018
1,338
3,394
2,249
4,539
4,694
4,873
13,535 15,470
INCOME STATEMENT ($M)

1999
Sales
18,243
Cost of Goods Sold (COGS)
14,304
Gross Profit
4,209
Selling Gen Adm Exp (SGA)
2,060
Depreciation
103
Operating Profit
2,046
Interest Expense
26
Net Oper. Income/(Expense)
64
Special Items
0
Net Income before Tax (NIBT) 2,084
Income Taxes
624
Net Income after Tax (NIAT)
1,460
Extraordinary Items
0
Adjusted NIAT
1,460
Current Ratio
1.72
1.48
1.45
1.05
1.00
Quick Ratio
1.64
1.40
1.39
1.01
0.96
Net Working Capital ($M)
2,644
2,489
2,948
358
(9)
Net Liquid Balance ($M)
3,181
4,132
5,438
3,914
4,638
WCR ($M)
(537) (1,643) (2,490) (3,556) (4,647)
WCR/Sales
(0.03) (0.07) (0.08) (0.11) (0.13)
Cash flow from Operations ($M) 2,436
3,926
4,195
3,797
3,538
Operating Profit Margin
11.2%
9.7%
8.7%
7.3%
8%
Net Profit Margin
8.0%
6.6%
6.8%
4.0%
6.0%
Cash Conversion Efficiency
13.4% 15.5% 13.2% 12.2% 10.0%
Days Inventory Held (DIH)
7.1
7.2
5.8
4.0
3.9
Days Sales Outstanding (DSO) 49.6
38.7
33.1
26.6
26.7
Days Payable Outstanding (DPO) 62.3
64.9
62.1
72.3
75.8
Cash Conversion Period
(5.6) (19.1) (23.1) (42.3) (45.3)
13
2000
25,265
19,891
5,374
2,761
156
2,457
34
222
(194)
2,451
785
1,666
0
1,666
2001
31,888
25,205
6,683
3,675
240
2,768
47
578
(105)
3,194
958
2,236
(59)
2,177
2002
2003
31,168 35,404
25,422 28,844
5.746
6,560
3,236
3,505
239
211
2,271
2,844
29
17
231
200
(742)
0
1,731
3,027
485
905
1,246
2,122
0
0
1,246
2,122
Cash Flow Activities Classification

Cash Inflow
Cash Outflow
Operating
Activities
Payment to suppliers
Payment to employees
Payments of interest
Payments of tax
Receipts from sale of PPE

Receipt from loans
Receipts from loan sales
Receipts from sale of security
Investing
Activities
Payment to acquire PPE

Loans made to other businesses
Loans purchased from businesses
Payments to acquire security
Proceeds from issuing security

Proceeds from issuing debt
Financing
Activities
Payments of dividends
Payments to repurchase stock
Payments of debt
Receipts against receivables

Dividends from ST securities
14
Cash Conversion Period measures Liquidity from the

perspective of a firms going-concern
Purchase Order
Released
Inventory
Received
Goods Sold
AR Created
Payment
Received
Days Inventory Held
Days Sales Outstanding
Inventory
Accounts Receivable
Days Payables Outstanding
Time
Accounts Payable
AP
Created
Payment
Sent
Inventory
Days Inventory Held =
Cost of Goods Sold/365

Receivables
Days sales outstanding =
Sales/365
Cash Conversion Efficiency =

Cash Flow from Operations
Sales
15
Cash Conversion Period measures Liquidity from the

perspective of a firms going-concern
Days Inventory Held =
Days sales outstanding =
Days Payables outstanding =
Inventory
Receivables
Sales/365
Payables
Operating Cycle = Days Inventory Held + Days Sales Outstanding

Cash Conversion Period = Operating Cycle Days Payables Outstanding
Cash Conversion Period = DIH + DSO DPO
16
Management of inventory plays an important

role in the management of cash flow timeline
Smaller inventory balance means less idle investment
Increases the probability of inventory shortage
Larger inventory balance means more idle investment

Reduces the probability of inventory shortage
Inventory acts as the shock absorber between product demand

and supply
17
Investment in Inventory is based on demand,

cost of holding and cost of ordering
Increase in cost of holding leads to stocking less inventory
Increase in cost of ordering leads to more items per order
18
Total cost of managing inventory is the sum of

ordering and holding costs
Total Cost = (F x T/Q) + (H x Q/2)
Ordering Cost
T
Q
F
H
Holding Cost
Total Inventory units demanded

Order Quantity
Fixed Ordering Cost per Order
Holding Cost per Inventory unit
19
Optimal trade-off between ordering cost and

holding cost will lead to Economic Order Quantity
Total Costs
Dollar Cost
Holding Costs
Order Costs
Order Quantity
EOQ =
2xTxF
H
20
EOQ Example
EOQ = Sqrt(16,000) = 4,000
Average Inventory Bal = 2,000
Number of orders = 125
Usage Rate = 1,333 tons per day
Delivery Time = 2 days
Reorder Point = Usage Rate x Delivery Time
Reorder Point = 2,666 tons
T = 500,000 tons
F = $20 per Order
H = $1.25 per ton
Period = 375 days
4,000
Reorder point
2,666
1,333
5
8
21
9
Basic EOQ model can be extended based on the

concepts of safety stock and discounts
Safety Stock concept should be added whenever sales
are not stable or production/delivery is uncertain
Average Inventory Balance = EOQ/2 + Safety Stock
Reorder Point = Usage Rate x Delivery Time + Safety Stock
Total Costs analysis should be considered whenever the

supplier offers quantity discount for volume purchases
Total Cost = (F x T/Q) + (H x Q/2) + Purchase Cost (Variable)
22
EOQ Example Revisited based on Total Cost

Quantity
0 999
1,000 2,999
3,000 4,999
5,000+
T = 500,000 tons
F = $20 per Order
H = $1.25 per ton
Quantity
# Order
Purchase Cost
Order Cost
Cost per Unit

$0.50
$0.48
$0.45
$0.40
Holding Cost
Total Cost
500
1,000
250,000
20,000
313
270,313
1,000
500
240,000
10,000
625
250,625
1,500
333
240,000
6,667
938
247,604
2,000
250
240,000
5,000
1,250
246,250
2,500
200
240,000
4,000
1,563
245,563
3,000
167
225,000
3,333
1,875
230,208
3,500
143
225,000
2,857
2,188
230,045
4,000
125
225,000
2,500
2,500
230,000
4,500
111
225,000
2,222
2,813
230,035
5,000
100
200,000
2,000
3,125
205,125
5,500
91
200,000
1,818
3,438
205,256
6,000
83
200,000
1,667
3,750
205,417
23
Time Value analysis helps making decisions

on quantity discounts
Scenario 1
T = 1,000
Q = 200
C = $10
F = $5
H = $2.5
D = 100
Scenario 2
T = 1,000
Q = 500
C = $9.5
F = $5
H = $2.5
D = 100
Discount Rate = 15%
Demonstrate Calculation using Excel in Class

24
Constant monitoring of inventory balance

ensures proper investment in inventory
Inventory Control Systems
Information based integrated systems
Inventory Turnover Approach

Inventory Turnover Ratio = COGS / Inventory Balance
Days Inventory Held = Inventory Balance / COGS per day
Balance Fraction Approach

Convert Inventory Balance as a fraction of Inventory Purchase
25
Even though investment in Receivables are the highest asset

percentage, firms lack proper receivables and credit policies
Finance managers can add value by influencing:

Aggregate investment in Receivables
Its Credit Terms
Its Credit Standards
26
NPV analysis helps to decide whether to allow a credit

extension (allow deferred payment to a customer)
S EXP (S)
NPV =
VCR (S)
1+r
S = Dollar Amount of Credit Sale

EXP = Expense for Credit Administration and Collection per $1 of Sales
VCR = Variable Cost Ratio per $1 of Sales
r
= Interest rate for the collection period of the Sale
If NPV > 0 Extend credit
If NPV = 0 Probably extend credit (marginally acceptable)
If NPV < 0 Do not extend credit
27
Key Financial Ratios for Credit Analysis
Liquidity
Debt Management
Performance
Current Ratio
Net Working Capital
Quick Ratio
Cash Flow to Debt
Cash Flow from Operations
Cash Turnover
Net Liquid Balance
Defensive Interval
Times Interest Earned

Long-term Debt to Capital
Total Liabilities to Total Assets
Return on Equity
Profit Margin on Sales
Return on Assets
28
Companies develop various Credit Scoring Models

to decide extending Credit
Weighted Score
Probability Weighted
29
NPV Analysis helps to evaluate changes in Credit Policy
Loosening Credit Standards

Lengthening Credit Period
Offering Cash Discount
30
NPV Valuation: Loosening Credit Standard

Decision: Whether to extend Credit to Marginal Customers
Annual Sales
Incremental Annual Sales
Variable Cost Ratio
Bad Debt Losses
DSO
Weighted Average Cost of Capital
100.00
10.00
0.65
4%
45
15%
$M
$M
per $ Sales
days
31
NPV Valuation: Lengthening Credit Period

Decision: Whether to change terms from Net 30 to Net 60
Annual Sales
Incremental sales
Variable Cost Ratio
Bad Debt Losses at Net 30
DSO Net 30
DSO Net 60
Credit + Collection Expenses Net 30
30.00
5.00
0.70
5.0%
6.0%
45
68
2.0%
2.5%
14%
$M
$M
per $ Sales
days
days
Sales
Sales
32
NPV Valuation: Offering Cash Discount

Decision: Whether to offer 2/10 Net 30 instead of Net 30
Annual Sales
Incremental sales
Variable Cost Ratio
Bad Debt Losses at 2/10 Net 30
DSO Net 30
DSO Net 2/10
Credit + Collection Expenses 2/10 Net 30
20.00
3.0%
0.60
3.0%
2.5%
35
10
4.0%
4.0%
12%
$M
per $ Sales
days
days
Sales
Sales
33
When a firms working capital cycle begins with purchase

of Inventory, an Accounts Payable balance is initiated
As the firm continues its operation to convert Inventory to
Finished Goods, Expenses are accrued in the form of
Salaries, Wages etc
Payables and Accrued Expenses are paid some time in the
future generally before converting Receivables to Cash
Firms get in to cash flow problems when more cash is needed to

pay Creditors and Suppliers than collected from Sales
34
Spontaneous Financing is one that occurs

automatically as a result of operations
Trade credit such as Accounts Payable and Accrued
Expenses perform as spontaneous financing
Materials and Services obtained this way will facilitate
sales without actually paying for them
Collections from sales can be used to pay off Payables
and Accruals
Payment terms against Payables are dependent on the type of

Industry the firm belongs to
35
Cash Flow Timeline and Accounts Payable

Purchase Order
Released
Inventory
Received
AP Created
Discount Date
Payment Due
Normally payment is delayed till the last date of the credit period
If payment is missed, the usual penalty is 1% to 1.5% per month until payment is made
Delinquency on payment results in firms not sending items on future orders
NPV Analysis helps to make the decision when to pay on Payables

36
Finance Manager has several Payment Options

Pay on date of purchase
Pay before discount period expires
Pay before credit period expires
Pay with penalty after credit period expires
Key considerations by Finance Manager:
Payable should never be paid until the last day of the
discount period or at the end of the credit period
A discount should be taken only when the NPV is positive
at the opportunity cost
A payable should not be stretched past the credit period
37
NPV Analysis on making payment against Payable

Days from Invoice Date
Decision: Whether to make the payment

Invoice Value
Term
Firms Investment Rate
Firms Cost of Borrowing
Annualized Late payment Rate
$10,000
2/5 Net 45
10%
12%
18%
NPV @ 10%
NPV @ 20%
9,800
9,800
9,797
9,795
9,795
9,789
9,792
9,784
9,789
9,779
9,787
9,773
10
9,973
9,946
15
9,959
9,918
20
9,946
9,892
25
9,932
9,865
30
9,918
9,838
35
9,905
9,812
40
9,892
9,786
45
9,878
9,759
46
9,880
9,759
47
9,883
9,759
48
9,885
9,758
49
9,887
9,758
50
9,889
9,757
38
Delayed Payment Fee has both tangible and intangible impacts
Late fee indicates the tangible impact of paying past the

credit period
Ill will generated by constantly paying late indicates the
intangible impact of paying past the credit period
Even though NPV Analysis helps to identify the most beneficial

time to pay considering penalties and invest opportunity rates,
Payments should be stretched beyond the credit period only if the
firm is financially unable to make the payment
39
Constant monitoring of Payables balance

ensures proper investment in Payables
Payables Turnover Approach
Payables Turnover Ratio = Purchases (COGS) / Payables Balance
Days Payables Outstanding = Payables / Purchase (COGS) per day
Balance Fraction Approach

Convert Payables Balance as a fraction of Purchase
The greater the DPO (Days Payable Outstanding) is, the slower the
Payables Turnover and the longer the firm is taking to pay its suppliers
As we discussed in Inventory Management, Balance Fraction Approach

gives a consistent monitoring of Payables Management
40
Two forms of Accruals provide a short-term

financing for the firm
Accrued Wages and Salaries
Service rendered by employees without an immediate payment
Bi-weekly or monthly payment instead weekly payments
Accrued Taxes
Government requires firms pay taxes quarterly
Firms have 3-month financing from Tax dollars
41

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Present Value and Future Value

r = Nominal Interest Rate

FIRE654: Short Term Financial Management

VCU School of Business

Ceyed Baiju, Fall 2012

Different Compounding Methods

Effective Annual Interest Rate

FIRE654: Short Term Financial Management

VCU School of Business

Ceyed Baiju, Fall 2012

Net Present Value (NPV)

Discount Rate at which NPV = 0 is called Internal Rate of Return (IRR)

FIRE654: Short Term Financial Management

VCU School of Business

Ceyed Baiju, Fall 2012

r = Interest Rate for the period

VCU School of Business

Ceyed Baiju, Fall 2012

C*(1+g) C*(1+g)2 C*(1+g)3

FIRE654: Short Term Financial Management

VCU School of Business

Ceyed Baiju, Fall 2012

Cash Flow Timeline

Longer Cash Conversion Period indicates financing problem

FIRE654: Short Term Financial Management

VCU School of Business

Ceyed Baiju, Fall 2012

Profit and Cash Flow Relationship

FIRE654: Short Term Financial Management

VCU School of Business

Ceyed Baiju, Fall 2012

Accrual to Cash basis Income Statement

Cash Flow Account

Change in Accounts Receivable

= Cash collected from Customers

Cost of Goods Sold

Change in Accounts Payable

= Cash paid to Suppliers

Change in Operating Accruals

= Cash paid for operating expenses

Change in Accrued Interest

= Cash paid to Creditors

Change in Accrued Tax

= Cash paid for Taxes

Cash collected from Customers

FIRE654: Short Term Financial Management

VCU School of Business

Ceyed Baiju, Fall 2012

Profit and Cash Flow Relationship

Jun 1Jul 15 Jun 1Jul 31

Accrual to Cash basis Income Statement

INCOME STATEMENT (CASH)

FIRE654: Short Term Financial Management

VCU School of Business

Ceyed Baiju, Fall 2012

Working Capital policies of a firm impact

Financially flexible if the firms financial policies are

FIRE654: Short Term Financial Management

VCU School of Business

Ceyed Baiju, Fall 2012

Solvency and Liquidity Ratios

Net Working Capital = Current Assets Current Liabilities

NLB = Current Financing Assets Current Financing Liabilities

C(1+g) C(1+g)2 C*(1+g)3