FI3300

Corporation Finance
Spring Semester 2010

Dr. Isabel Tkatch

Assistant Professor of Finance

1
Learning objectives
☺ Discuss working capital management
☺ Identify the effect of seasonality on monthly cash
flows
☺ Explain the purpose of long-term financial planning
☺ Use the percent of sales method to construct pro-
forma financial statements
☺ Identify spontaneous assets and liabilities,
internally generated funds and financing decision
variables
☺ Compute ‘Outside (External) Funds Needed’
2
Responsibilities of the
Financial Manager

1. Managing the
Financial Manager
working capital

2. Estimating the
seasonal fund needs

3. Long-term financial
planning: forecasting long-
term fund requirements

3
Working Capital on the Balance Sheet

ASSETS LIABILITIES and EQUITY

Current Assets: Current Liabilities:
Cash Notes Payable
Net Accounts Receivable Accounts Payable
Inventories Accrued Expenses
Current Portion of LT Debt

Net Fixed Assets Long-Term Debt

Equity

Total Assets Total Liabilities and Equity

4
Net Working Capital (NWC)
Net Working Capital (NWC) represents the
investment needed to maintain the cash, credit and
inventory necessary for operations – varies over time
Net Working Capital (NWC) =
Current Assets - Current Liabilities
Efficient management of current assets and
current liabilities reduces the investment in NWC
Related liquidity ratios:
Current assets
Current ratio =
Current liabilities
5
Working Capital - Cash
1. Determining minimum cash requirements,
maintaining the checking account and managing
the cash balance

Related liquidity ratios:

Current assets - Inventories
Quick ratio =
Current liabilities
Related financial statement:
Statement of Cash Flows (operating activities)

6
Working Capital - Credit
2. Setting credit policy (for customers) and
managing the collection of accounts receivable

Related activity ratios:

Account receivable
Average collection period = × 360
Annual credit sales

Book example 5.1-5.6 (page 135):

Cost benefit analysis of a new credit policy

7
Working Capital - Inventory
3. Establishing inventory target levels and
managing inventory turnover

Related activity ratios:

Inventories
Inventory conversion period = × 360
Cost of goods sold
Cost of goods sold
Inventory turnover ratio =
Inventories

8
Working Capital – ST Debt
4. Establishing and maintaining banking relations
to ensure access to short-term (ST) funds

☺ Short term funds offset effects on cash flow

(CF) volatility:
☺ Predictable / expected events: seasonality
☺ Surprise / unexpected events: accidents

9
Seasonality and Cash Budgets
☺ Most firms experience seasonality in sales:
☺ Weather
☺ Holidays

☺ Seasonalityin sales leads to cash flow

problems whenever
(cash balance + cash inflow) < cash outflow

☺ Financialmanagers must plan in advance

and secure funds to cover shortfalls

10
Working Capital - Credit
5. Negotiating and monitoring trade credit terms
and managing supplier relationships

Related activity ratios:

Account payable
Payables period = × 360
Cost of goods sold
Discount percent
Effective annual cost = × 360
Extra days if not take discount

11
Working Capital - Interest
6. Monitoring and evaluating operating expenses,
interest and taxes, and maintaining efficient
payment patterns

Related debt utilization ratios:

Operating income
Times Interest Earned =
Interest expense

12
Long-term financial planning

Why do we need long-term financial

planning?
To make sure that funds are available
to support firm’s growth!

13
Long-term financial planning
If the firms is not operating at full capacity
 find ways to use assets more efficiently
If the firm is operating at full capacity (maximum
efficiency - no idle assets)
 increase investment in assets to support LT growth:
Current assets (cash, inventory, A/R )
Fixed assets (plant & equipment)
 The financial manager must find additional funding
sources to support assets growth and decide:
How much is needed?
What sources of funding are available?
14
Three sources of funds
1. “Spontaneous” liabilities:
☺ Accounts payable These liabilities usually increase
as the firm buys more inventory
☺ Accruals and incurs additional expenses

2. Internally generated funds:

☺ Addition to retained earnings
3. External funds (financing decision variables):
☺ Notes payable (credit line – short-term debt)
☺ Long-term debt (issue new bonds, bank loan)
☺ Common stock (issue new stock - equity)
15
Pro-forma financial statements

☺ To determine if and how much outside

(external) funding is needed, financial
managers construct pro-forma financial
statements
☺ We will use the percent of sales method
to construct pro-forma financial
statements
Textbook example: pages 142-147 (Coffy’s coffee Shop)

16
Percent of sales method
Starting point: assume sales growth rate = g
Step 1:
Each assets account on the balance sheet
grows at the same rate as sales (g)
Note: we assume that the growth rates of gross fixed assets,
accumulated depreciation and net fixed assets are also g

Step 2:
Each “spontaneous” liabilities account on the
balance sheet grows at same rate as sales (g):
1. Accounts payable
2. Accruals
17
Percent of sales method
Step 3:
(3a) Compute the expected net income for the
projected period
(3b) Find the addition to retained earnings:
Addition to retained earnings =
net income – dividends
(3c) Use it to determine the retained earnings
account on your pro-forma balance sheet:
Retained earnings (t+1) =
retained earnings (t) + Addition to retained earnings

18
Percent of sales method
Step 4:
Copy all the financing decision variables
from the previous statement (BS):
1. Notes Payable
2. Long Term Debt
3. Common Stock
Result:
Total Assets ≠ Total Liabilities & Equity

19
Outside funds needed

Step 5: Holding the financing decision variables

constant, calculate outside funds needed:
Outside Funds Needed (OFN)
= Total Assets – Total Liabilities & Equity

Next Step: Determine financing sources

1. Increase Notes Payable (ST debt)
2. Borrow or issue new LT Debt
3. Issue new stock (equity)
20
Outside funds needed - Formula

An alternative way to calculate the OFN

Outside Funds Needed =

+ Change in Total Assets
- Change in Spontaneous Liabilities
- Change in Retained Earnings

21
Outside funds needed - Formula
Change in Total Assets =
(total assets on current BS) x g

Change in Spontaneous Liabilities =

(spontaneous liabilities on current BS) x g

Change in Retained Earnings =

+[(1+ g) x sales on current IS] x (net profit margin)
- planned dividend payment

Where g = sales growth rate

22
Summary

Three main responsibilities of the

financial manager:
☺ Working capital management
☺ Monthly cash budgeting
☺ Long-term financial planning
☺ Determine Outside Funds Needed (OFN) to
support long term growth
☺ Find funding sources

23